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Downsizing can actually lead your firm to bankruptcy, Research says

Firms are downsizing in the wake of COVID-19 crisis, but is this strategy viable in the longer run?

March 07, 2021
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  • Business
  • Corporates

  • COVID-19 crisis struck the companies with a quandary that they didn't anticipate until a few months ago. It all started with a novel disease that soon turned into a global pandemic affecting economies, businesses, and societies alike. The worse thing was the uncertainty of things going back to normal. During these unprecedented times, many companies responded to the COVID-19 crisis by laying off a major chunk of their workforce. According to an estimate, around 58 million people in the U.S. filed for unemployment insurance which is much more than the claims filed during the 2008 Great Recession.

    Downsizing is the process of permanently reducing a company's workforce by laying off multiple employees at the same time to reduce cost and create a more efficient and productive workspace. Unlike terminating, which is mainly based on the employee's conduct, downsizing is more related to the condition of the business.

    Downsizing during the COVID-19 crisis is not a new phenomenon. Corporates have done it oftentimes during economic crises. For example, during the Great Recession of 2008, American firms cut off about 8 million of their workforce from 2008 to 2010 and by 2010, the U.S economy was recorded as more shaky than that of Canada. Not only during economic crises, but companies also tend to downsize even in stable financial conditions to streamline their workforce and increase productivity while cutting costs and adjusting structures.

    Sad employee

    Some of the major companies that have announced downsizing their labor force in response to the coronavirus crisis include some big names and industries from travel, hospitality, airlines, and hotels. Coca-Cola announced that it will offer a voluntary termination scheme to its 4,000 employees in North America. Cloud-based software company Salesforce downsized their company by laying off 1,000 employees out of 54,000. American Airlines and Boeing announced to lay off their workforce by 20% and 10% respectively. Warner Bros also started laying off their employees which includes some of the top executives too. The parent company of Victoria Secrets, L Brands announced to cut off 15% of its workforce. The parent company of Mercedes Benz, Daimler planned to layoff about 30% of its employees. The parent company of CK and Tommy Hilfiger shut down its 150 stores and cut off 12% of its labor. LinkedIn also announced to reduce 6% of its employees.

    There has always been a debate going on about the viability of this organizational practice. Researchers and business people alike tend to argue about the potential pros and cons of downsizing. The advocates of downsizing justify this practice on the basis that the process of downsizing cut extra costs thus ensuring financial stability and keeping the business on track. Sometimes firms and startups have no other option other than downsizing to ensure their viability. Downsizing can also help eliminate the redundant departments integrating the functions and thus creating lean management. This reduces unnecessary expenditures and an overall increase in profit. Downsizing targets low-performing employees and retains the best talent. With the workforce getting smaller, team-building practice and training them becomes easier for the management. The practice of downsizing makes the decision-making process more efficient and after downsizing, the top management that did not involve in daily activities hitherto would actively take part hereafter.

    The critics of downsizing, on the other hand, points to its negative causes that downsizing adversely affects the performance and productivity especially of the remaining employees and induces stress, burdening responsibilities and a fear of being laying off. Downsizing firms also lose credibility in the market because vendors perceive a downsizing business as going through a bad financial phase and they would definitely think twice before moving their way. Downsizing can also negatively affect the decision-making and communication process because as the structure gets changed it gets difficult to seamlessly execute the projects. The most menacing drawback of downsizing is the lack of knowledge and expertise. Companies spend a lot of time and money training their workforce, the practice of downsizing can take its toll on the skill sets and expertise gained through the years.

    Safety pins

    According to a research published in Harvard Business Review, a team of researchers from 3 universities analyzed the effects of downsizing on large corporations and found that downsizing can lead companies to a plethora of problems including the likelihood of bankruptcy. They concluded that downsizing causes depreciation in knowledge adversely affects the existing employees' productivity and loyalty and affects the organization in the long haul by lessening the innovation which is unable to be gauged in financial terms.

    The datasets included 4000+ public firms from 2010 and then the likelihood of declaring bankruptcy in the succeeding five years was analyzed. The selected firms included a diverse set of industries ranging from tech and manufacturing to services. It was found that 24% of companies out of the sample, cut off their workforce by around 3%. The accuracy of the result was ensured by controlling the other potential variables of downsizing.

    The research found that the chances of companies going bankrupt were twice for those who tended to downsize their workforce. Although downsizing can cut costs in short term but in the long run, it doubles the chances of bankruptcy. The research cites the main reason for this phenomenon that tangible resources cannot replace the knowledge and skill set of the downsized employees. Corporate employees are the ones who contribute to the company culture and act as the knowledge bearers and this thing cannot be replaced by ample capital.

    The research suggests that the downsizing firms should make sure that the short-term benefits of downsizing outweigh the long-term organizational gaps and thus minimize the likelihood of bankruptcy.

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    About Author

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    Hareem Arshad


    Hareem is a university graduate with a major in Politics and International Relations. She is a freelance writer & enjoys writing on the niches of politics, tech, business, lifestyle & personal development. When she is not writing, she'll be mostly found with her art journal. She loves coffee and all things curls!


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