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Fighting Cutbacks with Real Options

Fighting Cutbacks with Real Options | Human Resource Executive Online As the downturn continues, employers will be looking for ways to cut costs. Using the theory of financial options, HR executives can better defend against cuts in their departments -- one of the first places CFOs look.

Monday, November 10, 2008
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I've been giving a lot of talks recently, and taking the pulse of the business community along the way, about the fall-out from the financial crisis. Here's the short summary: Those who think things will be OK tend to be under 40; those over 50 think there will be blood in the streets.

It could just be that younger people tend to be more optimistic, but I'm betting that the difference is explained by the fact that people under 40 have never seen a "real" downturn in the economy.

The 2001 recession was the mildest in modern history. Unemployment rates now are already higher than they were in 2001, and the forecasts now -- which sound right to me -- suggest that unemployment will rise to over eight percent.

I'm betting that this downturn will become nasty fast. Employers will start cutting to try to improve their quarterly profit performance, and they will look to human resources as the place to start cutting.

Most companies that want to cut costs quickly have to cut staff because that's where the bulk of the costs are. But why do they turn to the HR department first, to cut things like training and development (always the first to go) or recruiting staff?

There are two related reasons. One is that it is hard to see the immediate damage from such cuts -- we won't be doing much recruiting for awhile -- and the other is that HR folks typically find it difficult to mount a compelling argument for keeping them: While other departments produce estimates to justify the financial value of their programs, the HR objections fall back on platitudes, such as "it's the right thing to do."

There may be many ways to make effective arguments, but here is one approach that can be used to help determine whether it is worthwhile to maintain some continued expense in an uncertain future. To address such a problem, researchers have borrowed from the field of finance and the idea that "options" to act in a particular way in the future can add value to an investor.

Financial options allow one to buy or sell something in the future at a price determined now. The value of the option comes from the fact that investors can reduce the uncertainty associated with future changes in prices.

For example, airlines have reduced some of the risk that fuel prices will spike in the future by purchasing options to buy some quantity of fuel in the future at some guaranteed price. One can think of these options as something like insurance against the risk of a crippling spike in fuel prices. Because an upward spike in fuel costs could sink the airline, the insurance is worth having, but it does depend on what those options cost.

The concept behind financial options can be applied inside organizations to help executives think through some business decisions. Researchers have referred to this way of thinking as "real options," that is, applying the idea of financial options to business decisions.

Here, the operative question is whether it is worth maintaining the "option" to take particular actions in the future when that option requires you to pay something now to maintain it. A good example might be the recruiting function in a down market when the organization is not hiring.

Is it worth maintaining a sophisticated recruiting function, even though we are not currently using it, on the chance that we will need it in the near future?

We can provide a framework for analyzing these decisions that is much more rigorous than the usual "back-of-the-envelope" estimates. A simple decision-tree model illustrates the idea. In our recruiting example, assume that it will cost a company $250,000 next year to retain two key recruiters, who form the core of the recruiting function. At the moment, there is nothing much for them to do. Is it worth keeping them on?

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Let's say we have a very conservative estimate that there is only a one-in-five chance that our business will pick up enough within the year to make use of their skills. That estimate can come from the company's own business forecasts for the next year.

If business does pick up, and we have laid off the recruiters, we will have to add additional staff and other expenditures for recruiting.

But having the key people already in place will allow us to get a big jump on the process. We can reduce our dependency on staffing and search firms, and we can also hire people who are better fits and can be productive sooner.

A back-of-the-envelope estimate is the company will need to pay $2 million if it starts its recruiting function from scratch. The net benefit from retaining the recruiters, therefore, is $2 million minus $250,000 -- or $1.75 million.

Because the odds of needing to exercise the recruiting option within the year are only one-in-five, the net benefit of retaining the recruiters is 1/5 x $1.75 million, or $350,000. But that clearly beats the $250,000 cost of retaining the recruiters. So the option more than pays off and more than beats the cost of capital in most businesses, which demands about a 10 percent return per year.

This is exactly the kind of analysis that appeals to CFOs. It may not seem rigorous enough -- it's based on some educated guesses. But it is at least as good as the arguments that executives in the other functional areas are making to avoid cuts in their areas.

So remember the Grizzly Bear theory of competition: Two people are being chased by a bear, and the first one says, "I don't know how much longer I can outrun this bear." The other replies, "Hey, I don't have to outrun the bear, I only have to outrun you."

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Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at the Wharton School of Business. www.talentondemand.org.

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