The Costs of CEO Failure
According to Challenger, Gray & Christmas, the number of CEO departures in the U.S. between 2005 and 2007 averaged almost twice that of the preceding three years. By mid-year 2008, this rate was again on the increase.
December 12 2008 by Nat Stoddard And Claire Wyckoff
The fallout from leadership failures, then, plays out in many directions: There are direct costs related to the individual’s compensation (salary and bonuses) and to the cost of maintaining the person in the job (health insurance, travel, office expense, and the like). There are also indirect costs, which result from errors in judgment, bad strategies, poor execution, opportunities foregone and the disruption to the organization caused by inconsistencies, lack of direction and, worst of all, loss of trust.
Trying to isolate and measure the financial impacts to the organization of all these direct and indirect factors on a meaningful basis is a challenging exercise because there are so many moving parts. However, Dr. Bradford Smart, author of Topgrading, has given us a framework for estimating the overall financial effects of failure among CEOs based on research findings from work done by Chris Mursau.9
Through a series of interviews with executives (half of whom were division presidents or higher) about their experiences with 26 “mis-hires,” the amounts these poorly performing “B” and “C” managers (whose salaries averaged slightly more than $168,000 per year) cost their companies during their first 18 months in the job were identified. We conservatively assumed that the impact of the CEO who failed after 18 months in the job (which is 40 percent of the cases) would be, proportionately, no less than that of the lower level executives as reported by Smart.
Clearly, the case can be made as to why these numbers should be greater given the impact the CEO has versus a middle-level manager. Where we made changes to the ratios in Smart’s findings we have provided notes.10
According to the estimates in Table 1.1, the cost of having the wrong CEO at the helm, even for just 18 months, can range between $12 million and $50 million depending on the size of the corporation.
This analysis also reveals two other relevant points:
1. Smaller companies are hurt significantly more by selecting the wrong CEO.
If we assume that the profit margins are the same regardless of the size of the company, then the impact of having selected the wrong CEO to lead the business is greater on the small-cap companies than the bigger ones, even though the absolute dollar impact is roughly five times greater for the large-cap firms. Assuming that the profit margin for mid-sized and small-cap companies is 6.0 percent (as it is for the 487 publicly traded U.S. corporations with revenues in excess of $4.5 billion that constitute the large-cap group) then, the direct (cash) costs of CEO failures as a percent of average profits goes from 0.3 percent for large-cap companies, to 9.6 percent for mid-caps, to a whopping 23.2 percent for small-caps.11 Needless to say, the effect of the wrong leader on a smaller entity can be devastating, as has been seen time and again over the years.
2. The impact on the U.S. economy is nearly $14 billion per year.
Recognizing that the turnover rate of CEOs has plateaued over the past three years at an average of 1,385 per year, the total cost of CEO failures in terms of cash, inefficiencies and opportunities foregone is calculated to be $13.8 billion, assuming the failures are distributed on a quid pro quo basis relative to the number of companies in each of the three segments. And this number does not include the lost shareholder value caused by the mistakes, failed strategies, organizational upheaval and increased stock volatility that comes from having selected the wrong leader-all of which adds up to a very target-rich environment for anyone looking to find disciplined ways to put an end to such waste.