Cushioning the Blow : Labour Flexibility and Retaining Firm Innovativeness in Times of Downsizing

Innovation in developed countries is known to suffer from downsizing. Despite the importance of innovation for firms in developing countries and their frequent practice of downsizing, the impact of the latter on the former is yet unverified. Moreover, little is known about how to overcome potentially related innovation obstacles. We close this research gap with a study across nine developing countries in Africa and South Asia. We put forward that labor flexibility (numerical, functional, and wage and reward flexibility) can mitigate the negative effect of downsizing on process innovation. To test this idea, we use a firm-level data set that combines the World Bank’s Enterprise Survey and Innovation Follow-up Survey for 2,988 firms. As expected, we find downsizing to be detrimental to process innovation. Labor flexibility, however, allows firms to remain innovative despite downsizing. More specifically, both numerical flexibility (temporary employment) and functional flexibility (training) can buffer the negative impact downsizing has on innovation. Cushioning the Blow: Labour Flexibility and Retaining Firm Innovativeness in Times of Downsizing Firms increasingly engage in downsizing, “the elimination of jobs in an organization” (Chadwick et al., 2004, p. 405) with the goal to increase efficiency, cut costs (McKinley et al., 2000) or align a firm’s structure with its strategy (Aalbers and Dolfsma, 2014; Datta et al., 2010). Still, the vast majority of downsizing firms experience a decrease in performance rather than the desired increase (Guthrie and Datta, 2008; Hansson and Gandolfi, 2011). Furthermore and more specifically, downsizing is detrimental to creativity (Amabile and Conti, 1999) and innovation (Dougherty and Bowman, 1995; Gandolfí and Oster, 2009; Marques et al., 2014). Innovation, however, is pivotal for firms’ competitiveness (Michie and Sheehan, 2005), and it is a driver for economic growth and social welfare. As such, innovation is especially critical for firms in developing countries (OECD, 2012; Peerally et al., 2018). Process innovation in particular can be a way for firms to increase efficiency, decrease cost and secure competitive advantage (Davenport, 1992), which makes it essential for firms operating in this context. Consequently, understanding the thus far unstudied impact of downsizing on process innovation in developing countries as well as finding ways to overcome potentially detrimental effects is essential. Studies conducted in developed countries suggest that certain organizational practices such as improving communication (Chadwick et al., 2004) or increasing perceived organizational justice (Spreitzer and Mishra, 2002) can reduce the negative impact of downsizing (Amabile and Conti, 1999). We expand these insights and shed light on whether labor flexibility mechanisms are appropriate organizational practices to mitigate the innovation challenges firms face after downsizing. Labor flexibility refers to a firm’s 1 ability to respond to changes in market conditions (Wright and Snell, 1998), primarily by the means of three firm-level instruments: numerical, functional, and wage as well as reward flexibility. Numerical flexibility refers to firms’ ability to vary the amount of labor employed, through e.g. temporary employees. Functional flexibility encompasses firms with a workforce capable of accomplishing an extensive range of tasks by nurturing employees’ knowledge and skills through training. Wage and reward flexibility is established by having compensation systems such as bonuses and performance-related pay in place, which encourage and reward improved performance (Michie and Sheehan, 2005). This study enriches existing research by assessing how different forms of labor flexibility can soothe the proposed negative effect of downsizing on firms’ level of process innovation. The contributions of our study are threefold. First, studies identifying organizational practices that enable firms to remain innovative despite downsizing are still scarce (Aalbers and Dolfsma, 2014; Chadwick et al., 2004; Love and Nohria, 2005). One thus far understudied organizational practice, which warrants special attention in this context, is labor flexibility. Labor flexibility allows firms to quickly react to changes in the environment (Arvanitis, 2005) and to flexibly reconfigure their resource base in the face of change (Wright and Snell, 1998). There are many ‘threatening aspects of change inherent in downsizing’ (Mishra and Spreitzer, 1998, p. 582). It is thus especially intriguing to shed light on whether labour flexibility can help firms to react to these changes and to overcome the innovation challenges brought about by downsizing. Second, most research on downsizing has focused on large firms (Amabile and Conti, 1999; Marques et al., 2014; Mellahi and Wilkinson, 2008). However, downsizing also regularly occurs in small and medium enterprises (SMEs) (The World Bank, 2018). In 2 SMEs, the relationship between firm members is particularly close (Torres, 2011), often even familial. Therefore, and given their informality, small firms frequently depend on psychological contracts to govern employment relationships (Nadin, 2007). Psychological contracts specify the unwritten mutual obligations between a firm and its employees (Rousseau, 1989). Downsizing is widely found to result in a breach of employees’ psychological contract (Arshad and Sparrow, 2010; Conway et al., 2014; Datta et al., 2010). This has widespread negative implications for employees’ commitment, motivation and innovation-related behaviors (Ng et al., 2010). Given the close ties between all parties involved and the importance of psychological contracts, the consequences of downsizing are especially traumatic in small firms (Torres, 2011). Shedding light on the relationship between downsizing and innovation is therefore particularly interesting in SMEs and sets our research apart from previous studies. Third, the context of developing countries is both highly unique as well as understudied (George et al., 2016). Given the importance of innovation for developing countries (OECD, 2012) and the frequent practice of downsizing (The World Bank, 2018), it is crucial to study the relationship between the two in this specific context. Two characteristics of developing countries are especially relevant for our study, namely the time perspective of employees and the availability of human capital. Time perspective refers to the nonconscious process of assigning personal experiences to temporal time frames such as past, present or future (Fieulaine and Apostolidis, 2015). Employees challenged with the hardship of poverty in developing countries are frequently found to have a short time perspective (Moseley, 2001), which is expected to change their reaction to the use of labor flexibility practices. Furthermore, developing countries face a scarcity of human capital. 3 Human capital refers to the knowledge, information, ideas and skills of individuals (Wright and McMahan, 2011). In developing countries, getting access to the human capital required for successful innovation (van Uden et al., 2017), is frequently a considerable challenge for firms. This struggle is expected to be relevant for the moderating relationship proposed in this study. Overall, our research contributes to a more nuanced investigation of the impact downsizing has on process innovation with a particular emphasis on the interaction between different labor flexibility forms. By conducting a quantitative study across nine developing countries in South Asia and Africa, we apply a mainstream theory to a nonmainstream context (George et al., 2016). Our study aims at equipping decision makers with managerial knowledge on the effect of downsizing on process innovation as well as on how to remain innovative despite downsizing. THEORY AND HYPOTHESES Innovation and downsizing Innovation is key – not only for highly technologically advanced firms in developed countries but also for small firms in developing countries (Zanello et al., 2016). This insight is supported by the finding that “the build-up of innovative capacities has played a central role in the growth dynamics of successful developing countries“ (OECD, 2012). Innovation can differ in its degree of radicalness and can take various forms such as new products, processes, as well as marketing or organizational methods. The minimum requirement to qualify as an innovation is to be new (or significantly improved) to the firm, even if adopted from other firms (OECD, 2005). In this study, we focus on process innovation, which refers to the “implementation of a new or significantly improved production or delivery method. 4 This includes significant changes in techniques, equipment and/or software” (OECD, 2005). The focus on process innovation is especially intriguing for the following reasons: first, previous research has primarily focused on assessing the effect of downsizing on product innovation (Dougherty and Bowman, 1995; Mellahi and Wilkinson, 2010, 2008). Insights into the effects on process innovation are still scarce. Second, downsizing harms employees’ psychological contract and as a consequence their motivation and commitment. The decrease in motivation and commitment is expected to be especially detrimental to process innovation: in contrast to product innovation, which is usually conducted in dedicated R&D departments, process innovation requires the motivation and willingness of employees across different functions to engage and contribute (Arshad and Sparrow, 2010). Third, downsizing results in the loss of firm-specific knowledge. This poses a significant challenge for process innovation as employees’ insights into existing processes as well as understanding of the newly introduced procedures is vital for its success (Boer and During, 2001). Innovation has been frequently found to suffer from downsizing (Dougherty and Bowma