Downsizers have laboured under a grand delusion

The most amazing thing about Stephen Roach's recantation of his belief in downsizing as the secret of success for corporate America is that anybody believed him in the first place. Mr Roach is the Morgan Stanley guru who admitted in print that "maybe I went too far". He had been preaching a productivity-led revolution based on job cuts, plant closures and other forms of downsizing, a euphemism so ugly it should be banned.

The fad for corporate slash-and-burn policies, and for their close relative, labour market flexibility, is not confined to America. The obsession with cutting the workforce as the be-all-and-end-all of management has been taking hold in Europe, as transatlantic fashions tend to do.

It so happens that the European Commission has been pondering the question of what Europe needs to do about its competitiveness. But it, too, became concerned that much of the argument, and especially the contributions from industry, revolved solely around cost reductions to make companies more competitive, the mantra Mr Roach had been chanting until he recanted.

In its European form, this is reflected in an obsession with measures to make labour markets more flexible and to reduce the "social costs" companies have to pay when they employ people. This is all very familiar territory, of course, to anybody who has been following the argument in Britain over the opt-out from the Social Chapter, which is claimed to add to European industry's costs and reduce its competitiveness against the rest of the world.

As a deliberate antidote to this, the EC last month published a research report it had commissioned from the consultancy firm Pims Associates and the Irish Management Institute that put the downsizing fashion into its proper perspective. The suggestion for the research came, to its credit, from Unice, the umbrella organisation for European employers.

The conclusion of the Pims report was that investment focused on cutting labour costs did not usually achieve its objectives. The end result of unthinkingly substituting capital investment for labour, to cut short term costs, can in the longer term, be to destroy both jobs and profits.

There are many other factors much more important than cost-cutting in determining which companies are successful, but they are not necessarily talents that slash-and-burn managers have at their fingertips.

Of course, running a company as efficiently as possible may often have as its consequence plant closures or job losses. These are the prices to be paid for open markets, new technologies and changing consumer tastes. Few would defend the overmanning in, for example, the French railway system or the UK electricity industry before privatisation. But as in so many things, it is all a question of degree.

Managements that can think only in terms of downsizing tend to find themselves the rearguard officers in a retreat from superior forces, because they don't know how to turn the army round and go on the attack again. Companies that manage well, and understand innovation, intellectual property, marketing and their customers, are to be found marching steadily in the opposite direction towards the front line.

These latter qualities, the essential ingredients for growth, are intangible, and much harder to measure and assess than productivity, which is a simple matter of number-crunching. But they are the qualities that determine success, measured in both profits and employment growth.

The lesson from the Pims research is that costs and productivity certainly do matter, but on the whole it is better to be smart than just plain cheap. Innovation and the amount of intellectual property a company owns are the strongest drivers of performance, said the report. Research and development, management ability, providing customers with the choices they want, a good market strategy - all these translate into higher added value and more job creation.

Statements of the blindingly obvious, you might say, if it were not for the fact that so many people seem to have forgotten them over the last decade, including Mr Roach.

Tony Clayton, a director of Pims and co-author of the report, said: "Downsizing was about taking out non-value adding cost in organisations, and it has boosted the productivity and profitability of businesses. But it hasn't, of itself, added any extra value. To achieve growth you have to add extra value."

Mr Clayton believes that economists slaving away trying to explain the workings of the economy in terms of costs, prices and productivity are missing the more important factors that do add value. If they can't measure it, they do not want to know.

Pims itself has a competitive advantage among consultants in this area, because it has built up a database over two decades that includes measurements to assess innovation, product strategy, market structure, management ability, competitive position and customer satisfaction.

These are related in the database to financial performance and productivity, and the package as a whole is able to give a powerful insight into what creates employment and profits.

The measurements taken are at the level of factories and business units, rather than the companies themselves, which may have a number of activities with quite different characteristics and markets that confuse the picture. Each time Pims analyses a client's business, the database grows.

The database, which covers more than 3,000 businesses in Europe and North America, grew out of research begun by General Electric in the US, in the early 1960s, into what makes successful businesses.

The ideas were further developed at the Harvard Business School and were spun off into a consultancy nearly 20 years ago, called Profit Impact of Market Strategy, now shortened to Pims.

The report for the European Commission drew some practical lessons from this "bottom up" research.

One is that government incentives to increase investment and save jobs in slow-moving or declining industries should be dropped because they do not do much good. Wider lessons include the importance of protecting intellectual property and removing accounting and tax disincentives to innovation. As much as anything, the research has the advantage that is has been undertaken by people willing to find out how things work from the bottom up, inside business, before they pronounce on grand strategies for change.

Mr Clayton has already identified what could be the next fad. Mr Roach, in the article in which he recanted, said the remedy for the US was to rebuild industry through greenfield expansion of new production facilities.

But on the Pims thesis, investment in extra capacity cannot on its own guarantee more jobs or greater shareholder value, and may well destroy both. Here we go again.