Monday, September 27, 2010

Cost-Cutting: Corporations Cutting Their Own Throats?

Cost-cutting has become so ingrained in corporate culture since the 1980s that it may ultimately kill off much of the corporate system. Like a patient cut down by blood pressure medication or anti-cancer drugs, a corporation that initially undertakes cost-cutting for its own survival can end up collapsing because of it.

Cost-cutting is a good thing when it enables a business to decrease its losses or increase its profits by eliminating unnecessary work. But corporations under pressure can start making decisions out of fear. Cost-cutting then becomes expensive, as each new change results in more costs, leading to more changes, in a downward spiral. You can find examples of cost-cutting gone too far in every day’s business headlines.

Consider these recent high-profile examples:

  • BP made zero progress on capping its out-of-control oil well as long as its CEO was personally taking charge of the operation. Within days after the CEO was removed, the oil mostly stopped flowing. That happened, I believe, because the CEO had been making engineering decisions based on the fear of the costs the company might face. When engineers took over the engineering decisions, and made them out of a basic sense of problem-solving responsibility, things started to work. (A parliamentary committee this month was not entirely convinced when the CEO testified that the oil well’s problems were the result of bad luck rather than cutting corners.)
  • GMAC Bank, Fannie Mae, and probably other major institutions in the mortgage business are in big trouble after it emerged that many foreclosure affidavits filed with courts in foreclosure proceedings were signed by workers who did nothing but sign affidavits all day. Two officers in particular are said to have signed nearly 10,000 foreclosure documents per month, or about one per minute, indicating that they could not have known what documents they were signing, never mind reading and verifying each one. This shortcut approach saved the companies millions of dollars, but now they face embarrassing questions and tens of billions in new expenses, as lawyers file motions to withdraw the erroneous documents, and some past foreclosures are sure to be overturned. Ally Financial, the parent company of GMAC Bank, has been forced to suspend foreclosure evictions in half the country while it checks its paperwork, a process that may take months, and Fannie Mae may be facing a similar delay.
  • Wall Street companies that rushed to sell mortgages to investors in 2007, before the market collapsed, made similar shortcuts in paperwork, and as a result, neglected to tell investors of the deficiencies in the mortgages. If this can be shown in court, the Wall Street companies could be forced to take the mortgages back and refund investors’ money, and this could easily lead to the bankruptcy of half of Wall Street.
  • Documents turned over to Congressional investigators in the Johnson & Johnson case paint a picture of a drug-manufacturing executive obsessed with cost-cutting, to the point of authorizing a “phantom recall” of defective drugs that a contractor purchased from store shelves so that J&J could avoid the expenses involved in notifying the public, something required by law and a necessary step in any product recall. J&J initially claimed that the phantom recall had never taken place. Abandoning that story, its new story is that the phantom recall was authorized by the FDA. Investigators could not find any evidence to support that story, however, and the FDA does not even have the statutory authority to authorize a phantom recall. The cost-cutting obsession may also explain the hundreds of manufacturing lapses that led to moldy Tylenol being sold for more than a year, and eventually prompted hundreds of recalls and the closing of the factory involved. The cost to Johnson & Johnson: the reputation of Tylenol and other brand names may have been permanently damaged.
  • PG&E had budgeted money in 2007, from a rate increase approved that year, to replace the pipeline that spectacularly exploded south of San Francisco this month, but postponed the project several times, finally scheduling it for 2013. The company pocketed the money in the meantime, according to critics. State regulators now are likely to order PG&E to accelerate its neglected maintenance, which will cost the company far more in the short run than the roughly $5 million it was keeping in the bank for the pipeline project.

It is normal for large corporations to shrink. Established corporations, in total, shed enough jobs every year to put the U.S. economy into a recession, if new companies didn’t pick up the slack. In an aging corporation, however, if cost-cutting moves create large new expenses, this can put a business into a downward spiral in which no amount of cost-cutting can restore the company to financial health. This is the position General Motors finds itself in after failing to significantly restructure itself in bankruptcy, and you could make the case that half of the conglomerates in the United States are perilously close to that same predicament. But large corporations depend on each other to a significant extent, so the failure of some large corporations could lead, in a domino effect, to the decline and eventual failure of others. Corporations could, in theory, avoid this outcome by being more selective with their cost-cutting moves, but with cost-cutting so much a part of the corporate psyche now, I am not sure that is possible in practice.