Six Deadly Orthodoxies of Recessions
February 11 2009 by Pierre Loewe And Dave Jones
It’s now official: the U.S. economy is in a recession, the most severe since at least the early 1980s and perhaps since the Great Depression of the 1930s. No day goes by without announcements of more layoffs, bankruptcies, or additional requests to the government for a bail out. The advice given to executives in every industry can be summed up in a few words: hunker down, retrench, cut costs - and if you happen to be in the right industry, ask the government for help. This advice comes with a corollary: forget about innovation - it was fine when times were good, but it’s now a luxury you can’t afford.
There is only one problem with this advice: it’s wrong. It reflects a number of entrenched orthodoxies — deeply held and widely shared beliefs about how to succeed — that may have been right a long time ago, but are now outdated. Unless your organization is on the brink of immediate collapse, reacting to recessions through these knee-jerk strategies can have deadly consequences. Long-term success requires challenging these orthodoxies, and in most cases overturning them.
Orthodoxy #1: Cutting costs aggressively is the way to succeed in tough times. The economy is down, customers aren’t buying, sales are declining, inventories are bulging - it seems obvious that the only way to avoid a financial disaster is to cut costs aggressively. Indeed, an Accenture survey of business executives conducted during the last recession, in 2002, shows that at the time cost cutting was a top priority for 53% of executives while developing new services was a top priority for only 15%.
Actively searching for opportunities to reduce costs should be a normal part of business activities even in good times. But you should distinguish between pruning and hacking. Evidence from several sources suggests that aggressive cost cutting results in serious long term problems. A Mercer Management Consulting study of 116 companies that cut costs aggressively during the 1990-91 recession showed that in a subsequent five year period, 46% saw a decline in sales and profits - this at a time when the US economy was booming. Clearly, the aggressive cost cuts had endangered the companies’ future prosperity.
Aggressive cost cutting often has a deep negative impact because of its impact on people. An American Management Association study of firms that downsized between 1989 and 1994 shows that productivity increased in 34%, stayed the same in 26%, and decreased in 30% — hardly a resounding success. At the same time, morale declined in 86% of these firms.
The lesson: Reduce costs selectively, not indiscriminately, and monitor carefully the impact of cost cuts on your people.
Orthodoxy #2: Investing during a recession is irresponsible. Axing investments is another way to preserve badly needed cash. An analysis from the Bureau of Economic Analysis shows that after rising sharply between 1993 and 2000, business investment declined in 2001 and again in 2002 as the economy slipped into recession.
But the evidence suggests that smart investments in a recessionary environment pay off. A McKinsey analysis of 1,000 US companies shows that those that remained industry leaders or became successful challengers during recessions maintained or increased M&A and advertising activities1. This is not news to today’s foresight-driven leaders. In a November 6, 2008 address to the Council on Foreign Relations in New York, Sam Palmisano, Chairman and CEO of IBM, commented: “Over the next couple of years, there will be winners and there will be losers…I believe we will see new leaders emerge who win not by surviving the storm, but by changing the game.”
There’s also a silver lining about investing during a recession – talent, assets and even whole companies are cheap. Witness IBM’s 2002 purchase of PWC Consulting for $3.5 billion, a mere two years after HP came close to offering $18 billion for the same business.
The lesson: Don’t stop investing - instead look for undervalued assets and for opportunities to upend your rivals who only think of retrenching.
Orthodoxy #3: Don’t innovate during recessions, because innovation is risky and costly. In 2003, Strategos surveyed over 500 executives about the main obstacles to their companies’ ability to extract value from innovation. Two of the top six barriers mentioned were high cost and high risk. But innovation doesn’t have to be risky or costly.
As explained in a recent article “Funding Growth in an Age of Austerity2,” there are a number of ways to innovate on the cheap. Two among them are particularly noteworthy in recessionary times: Raising the ratio of externally sourced innovation to internally sourced innovation - in other words, embracing “Open Innovation”; and raising the ratio of knowledge over investment in innovation projects through a series of well thought out, low cost experiments. The latter has the double advantage of reducing both cost and risk, as illustrated below.
P&G’s Chairman and CEO A.G. Lafley certainly doesn’t believe that innovation should stop during recessions. In a recent interview with Business Week3, he said “(Entering a recession) really doesn’t change my thinking on innovation… I would argue that innovation is even more important in a recession.” Jeff Immelt, Chairman and CEO of GE, sings the same tune: “Companies and countries that really play offense vis-Ã -vis technology and innovation are going to come out ahead4.”
The lesson: De-risk and lower the costs of your innovation efforts by reaching outside your company and by conducting well-designed experiments.
Orthodoxy #4: A recession is no time to start new businesses or launch new products. It seems obvious. If consumers are in a funk, they are not going to spend their scarce cash buying unfamiliar products and services. They will focus on the tried and true.
But ask yourself a different question. If the value proposition changes significantly enough, would customers purchase even during difficult times? The long list of products - and even companies - that were successfully launched during just about every recession the US has experienced in the last 100 years suggests that they will. Ford introduced the assembly line in 1913; Fidelity Funds was started in 1930; Xerox launched its photocopier in 1949; Boeing’s airline customers started flying the 707 in 1957; Fred Smith started Federal Express in 1973; Microsoft introduced MS-DOS in 1981; Intel invested $5 billion in Pentium factories in 1990-91; Apple introduced the iPod and iTunes in 2001. No additional evidence needed.
The lesson: If your company has developed a new product or business that significantly enhances the customer value proposition, a recession is a great time to introduce it and get a lasting advantage over your more timid competitors.
Orthodoxy #5: Innovation has no role in cost reduction efforts. Most cost reduction efforts are fairly simplistic. They typically focus on one or more set of actions aimed at making the existing business system more efficient, for example laying people off, cutting overheads, incrementally improving existing business processes, squeezing suppliers or rationalizing the supplier base, eliminating “discretionary” expenses such as advertising, R&D or travel, and shutting down facilities such as plants, stores, or offices.
Missing from these efforts is usually a more systemic attempt to re-invent the company or the industry’s business model through radical cost innovation. It is what a number of leading companies have achieved successfully. Toyota’s lean manufacturing system was a radical innovation when the company introduced it and it enabled the company to reduce costs (and improve quality) dramatically and set the stage for the Japanese manufacturer to become the dominant force in the automotive industry. Southwest Airlines’ unrelenting focus on capital efficiency — maximizing the use of its expensive fleet by turning planes around quickly at each stop - provided one of the key foundations for its growth and profitability in an industry notorious for its chronic negative financial returns. Dell’s build-to-order business model enabled the company to achieve negative working capital - getting paid by its customers before it had to pay its suppliers - and to become the leading personal computer company. Wal-Mart’s emphasis on complete supply chain automation catapulted it to its leadership position in retailing. All of these innovations were squarely focused on the cost side of the equation.
The lesson: A recession is a great time to move away from incremental cost reduction efforts and to focus your employees’ energy on innovation aimed at dramatic cost reduction.
Orthodoxy #6: It’s easy to restart innovation efforts stopped during a recession when the recovery gets under way. Many of the executives who participated in the 2003 Strategos innovation survey confessed that their companies behaved as if they held that belief. One executive wrote “Our big innovation effort has been quietly swept under the rug since the economic difficulties of the last few years,” while another commented “It’s a roller coaster - start innovations with excess cash when times are good; abandon anything which is not very quickly profitable when times get hard,” and a third said “It’s a cyclic process - famine or feast of resources.”
But restarting a stopped innovation effort is hard and costly. Your innovation pipeline will be empty if you stopped feeding it - so refilling it will take time. Many of the people working on innovation - generally the best ones - will have left for greener pastures or started their own business, often leveraging the ideas generated by your past innovation efforts. Meanwhile, your remaining employees will most likely feel that “once burned, twice shy.”
Perhaps most importantly, the hunkering down period your company has gone through will negatively affect its ability to monitor emerging customer and market trends, and therefore its ability to identify and bring to market innovations that will meet changed customer needs. As innovation guru Gary Hamel puts it5: “Focus too much on retrenchment, and your company will emerge from the downturn weakened, diffident, and uncertain of its future.”
The lesson: Even if you have to curtail innovation efforts to conserve cash, maintain a sufficient level of activity so you can ramp-up efforts quickly, retain your key innovators, and most importantly keep your pulse on the changing dynamics of the market.
The bottom line: While recessions are painful, they can represent a great opportunity to get decisively ahead of your competitors - but not if you follow the herd and adhere to the conventional wisdom. If you have the courage to challenge it and head North while others go South, your chances of getting and staying ahead are much greater in a tough economic environment than they are in more prosperous times.
Pierre Loewe is a Founder and Director of Strategos, a global Chicago-based innovation consulting firm. Dave Jones is an Associate with the firm.
- McKinsey Quarterly, 2002 Special Edition: Risk and Resilience “Learning to Love Recessions”
- Harvard Business Review, July-August 2004
- Business Week, April 17, 2008
- Quoted in The Economist, November 22, 2008
- Business 2.0, April 2003