Thursday, June 23, 2005

The Balance Sheet

My Finance Professor at Pepperdine was quite brilliant. He spent all semester teaching ratio after ratio after ratio and teaching all of the rationale for making business decisions based on technical analysis. I love math, but I was still challenged by the logic of the ratios, so this Finance class was one of my favorite classes of all time. I really thought I was ready for a leading role in business by the time I finished my final exam in Finance.

The semester following the semester I took Finance, I took a Business Strategy class. My Business Strategy Professor was no where near as brilliant as my Finance Professor, but the first words out of his mouth made most of what I had learned in Finance the previous semester irrelevant. He started the Strategy class by telling us, "The business is not the balance sheet." It made sense to me when he said it then and it makes even more sense to me now; twenty years later.

A couple of weeks ago General Motors announced plans to cut 25,000 jobs. It’s not clear from the news reports how many people will actually become unemployed as a result of the changes, but it is fairly clear that the decision is being made by the finance side of the business for the financial investors because it doesn’t make very much long term strategic sense.

GM will not sell one additional car, they will not generate one additional loan, and they will not develop one new technology as a result of reducing jobs. GM will reduce expenses in the short term which may make the balance sheet look better, but they have also potentially lost 25,000 auto and loan customers, they have increased the cost of running the business per employee, they have created bad will with many of the remaining employees, they have signaled to all of their customers and competitors that they are in trouble, and they have reduced their ability to grow, among other things.

Forty years ago, most of the costs associated with an employee were variable costs. Salary, administration, and overhead all went up proportionally when an employee was hired and went down proportionally when an employee was fired. Today, with the exception of salary, health care, and taxes, many of the costs associated with an employee are fixed. Many of the administration and overhead expenses are the same regardless of the number of employees a company has.

GM is in many different types of businesses besides building automobiles. Every business needs employees in order to produce profits. Some businesses need more employees than others, but they all need workers. Strategically, it would make much more sense for GM to keep the employees and divert them to other businesses. Even if profits shrunk slightly in the short term, the long term benefits and goodwill from keeping people employed would far out way the risk of letting them go. The business still isn’t the balance sheet. Sadly, GM thinks it is.

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