A Timeless Lesson Of Circuit City's Bankruptcy: Solve The Right Problem

As the holiday season approaches, I am reminded that 13 years have passed since Circuit City, one of the leading electronics retailers in the country, filed for bankruptcy.

By applying Five Whys Analysis -- a technique developed to fix problems at Toyota -- I think Circuit City vanished from the business world for a chain of reasons ending with this: its CEO Philip Schoonover, wanted to earn his $7 million bonus.

Before getting into the details of how I think this goal led to Circuit City's bankruptcy, let's examine a tool that leaders should master to make sure they are solving the right business problem.

Five Whys Analysis -- which is a core part of my Babson College Strategic Problem Solving course -- is simple in concept. Observe a problem in your business, and ask why it is occurring. When you have the answer, ask why that happened. Keep repeating this process at least five times and you will find the problem's root cause -- which is the right problem.

To explain how Schoonover's bonus-hunger resulted in Circuit City's November 10, 2008 bankruptcy, I needed Seven Whys. Here they are.

1. Why did Circuit City go bankrupt?

In November 2018, Circuit City filed for bankruptcy because it had no cash to pay its debt to suppliers. As I wrote in my book, Goliath Strikes Back, the bankruptcy left in the lurch suppliers such as HP, which was owed $118.8 million, Samsung (a $115.9 million creditor), and Sony ($60 million) - who topped the list of its 100,000 creditors.

2. Why was Circuit City unable to repay its debt?

Turning this response into a question -- leads to investigating why Circuit City was unable to pay the suppliers. The answer was that the company had purchased more inventory than it could sell.

3. Why was Circuit City unable to sell its inventory?

Customers were taking their business to rivals such as Best Buy and Amazon. As a result, Circuit City's inventory remained in the warehouse instead of in customer's homes and offices.

4. Why did customers switch from Circuit City to Best Buy?

Circuit City chose inconvenient store locations and consumers chose to visit the more convenient Walmart stores; it was slow to supply its customers gaming technology, failed to promote products from popular vendors like Apple; and its Web site was underdeveloped just as Amazon was beginning to surge in popularity.

But that long-standing disadvantage was not the whole story. The thing that triggered a nearly 12 percent decline in Circuit City revenues in the months preceding its bankruptcy were hundreds of thousands of customer complaints on Circuit City's website.

5. Why did customer complaints soar?

In March 2007, Schoonover replaced 3,400 experienced sales people with 2,100 inexperienced and lower paid hourly workers.

At the time, this move struck me as a bad idea. As I told AP in January 2008, that change in strategy "violated a basic principle of good business [when it made the decision to let the workers go. Schoonover] was so focused on cutting costs that he failed to take into account the real value of good salespeople."

A comparison to Best Buy reveals the value of experienced sales people. Customers look at them as consultants who can advise consumers on how to design a home entertainment center that meets their specific needs.

Circuit City replaced its experienced sales people with fewer, lower-paid, inexperienced ones and it is no wonder that customer complaints soared.

6. Why did Schoonover replace 3,400 experienced salespeople with 2,100 lower paid hourly workers?

The answer is that he knew that the move would reduce the company's costs and increase its earnings per share. How so?

At the time of the layoffs, he was proud of the cost reduction that would result from his decision. As he told Reuters, the move would "deliver improvements in our selling, general and administrative expense rate."

2007 also marked four years of stock buybacks -- amounting to $1 billion which reduced the number of shares in the earnings per share calculation.

7. Why did Schoonover want to increase Circuit City's earnings per share?

The answer to this one is simple. In 2007, Schoonover - whose bonus increased along with the company's earnings per share - received about $7 million in compensation.