Cs 08 Session 05

Session 05 © Furrer 2002-2008 1

Corporate StrategyFall 2008

Session 5 - Lecture 3

Governance Structure and the Limitto the Scope of the Firm

Dr. Olivier Furrer

Office: TvA 1-1-11, Phone: 361 30 79e-mail: [email protected]

Office Hours: only by appointment


• The 1980s highlighted the failure of many visible diversification, such as Exxon entering the office product market and Coca-Cola acquiring Columbia Pictures. As a result, the notion that “sticking to the knitting” (Peters and Waterman, 1982) might be the most desirable corporate strategy was widely promulgated. Indeed, by the late 1980s, many managers were struggling to justify the existence of their multibusiness corporations.

• Into this void came the development of generic strategies that classified corporate strategies according to the ways in which value was created. Following the success of his notion of generic strategies at the business unit level, Michael Porter (1987) identified four types of corporate strategy. These lay along a continuum of increasing corporate involvement in the operation of the business units.

Implications of Shareholder Value Maximization for Corporate Strategy


Implications of Shareholder Value Maximization for Corporate Strategy

For firms contemplating diversification Michael Porter (1987) proposes three ‘essential tests” to be applied in deciding whether diversification will truly create shareholder value:

1. The attractiveness test. The industries chosen for diversification must be structurally attractive or capable of being made attractive (Five Forces Model – Porter, 1980).

2. The cost-of-entry test. The cost of entry must not capitalize all the future profits (Entry Barriers – Bain, 1956, Porter, 1980).

3. The better-off test. Either the new unit must gain competitive advantage from its link with the corporation or vice versa (Parenting Advantage – Goold et al., 1994).


Goold et al.’s (1994) Approach

• Corporate Strategy

1. In what business should the company invest its resources, either through ownership, minority holdings, joint ventures, or alliances?

2. How should the parent company influence and relate to the businesses under its control?

• The Role of the Parent

• The Quest for Parenting Advantage


The Corporate Parent as Intermediary

Source: Goold, Campbell and Alexander, 1994

The parent has no automatic right to exist. To justify its existence, the parent should be able to demonstrate that its businesses perform better in aggregate than they would as a series of individual, stand-alone entities.


How Parents Create Value

Stand-alone influence Linkage influence

Central functions and services Corporate development

Source: Goold, Campbell and Alexander, 1994


The Importance of Fit

• In order to create value, the parent must do more than simply avoid creating misfits. It must have some skills or resources that are specially helpful to its businesses. It must help its businesses address opportunities to improve their performance that they would fail to realize by themselves. Different opportunities can be realized only by applying different parenting skills or characteristics.

• The essence of successful parenting is therefore to create a fit between the way the parent operates – the parent’s characteristics – and significant improvement opportunities that exist in its particular businesses. The parent’s skills are not good or bas in any absolute sense; their value depends on the nature and needs of their businesses.


Parenting Styles

StrategicPlanning

StrategicControl

FinancialControl

PlanningInfluence

High

Low

Control Influence

Flexible TightStrategic

TightFinancial

Source: Goold and C

ampbell, 1987


Parenting Styles (Cont’d)

• The Strategic Planning Style• Strategic Planning style parents are closely involved with their

businesses in the formulation of plans and decisions. They typically provide a clear overall sense of direction, within which their businesses develop their strategies and take the lead on selected corporate development initiatives.

• The Strategic Control Style• Strategic Control style parents basically decentralize planning to

the businesses but retain a role in checking and assessing what is proposed by the businesses. Thus, businesses are expected to take responsibility for putting forward strategies, plans, and proposals in a “bottom-up” fashion, but the parent may sponsor certain themes, initiatives, or objectives, and will only sanction proposals that meet an appropriate balance of strategic and financial criteria.


Parenting Styles (Cont’d)

• The Financial Control Style• Financial Control style parents are strongly committed to

decentralization of planning. They structure their businesses as stand-alone units with as much autonomy as possible, and with full responsibility for formulating their own strategies and plans.


Decisions about the Portfolio

• Do the parenting opportunities in the business fit with value creation insights in the prospective parenting advantage statement: Will the parent likely to create a substantial amount of value?

• Do the critical success factors in the business have any obvious misfits with the prospective parenting characteristics: Will the parent be likely to influence the businesses in ways that will destroy value?


Governance

• Market, hierarchy, and the limits to the scope of the firm. => Transaction Costs Theory. (Williamson, 1975, 1985)

• Principals, agents, and the limits of the control mechanisms. => Agency Theory.(Fama and Jensen, 1983)

• Stakeholders, Stewards, and the limits of transaction and agency theories.


Governance Structure

• Whether or not should a particular firm perform an activity or compete in a business? Does the firm possess the resources and

competences to create and protect a competitive advantage?

• What are the appropriate boundaries for a particular firms? Market, Hierarchy, or in between.


Limit to Firm Scope

Increasing Firm Scope

$

Market Cost

Benefit

Cost of the Hierarchy

A

B

Org. Boundary Independent of MarketOrg. Boundary Given Market Costs


Co-operationAgreement

PatentLicensing

Franchising

CrossLicensing

R&DConsortia

Co-prod-uction

JointVenture

Strategic Alliances(Hybrids)

CooperationCompetition TYPE OF ARRANGEMENT(Transaction Costs)

Low

High

LEVEL OF INTERACTION(Governance Costs)

Intermediate Governance Structures(Hybrid Forms)

Source: adapted from Beamish, Morrison, Rosenzweig and Inkpen, 2000, p. 114.

Hierarchy

Market


Market:Costs, Benefits & Causes

BenefitsEfficient Information Processing(compared to bureaucracy)

High-Powered Incentives(self-interested, independent owner-managers, cf. agency theory)

Costs High Transaction Costs due to Market Failure

Conditions for Market Failure:• Opportunistic Behavior• Asset Specificity (small

numbers) (location, physical assets, and human capital)

• Uncertainty• High Transaction Frequency• Inseparability of R&Cs• Information Asymmetries• Market Power


The Virtual Corporation

• A virtual corporation is a firm which focuses on a few core competences and outsource about everything else.

• Example: Nike (2008)• $16 billion in revenues for 30,000 employees

(Philips: $37 billion for 124,000 employees)• Manufacturing is subcontracted, many of the product

innovations come from outside design houses, Nike clothing is supplied by another firm under license.


Hierarchy:Costs, Benefits & Causes

Benefits• Authority over Activity• Coordination• Tax Benefits• Quality Control• Information Access• Leverage R&Cs

Costs• Increased Bureaucracy• Agency Costs• Loss of Flexibility• Potential Overcapacity• Attractiveness of Buyer

& Supplier Markets


Choice of Governance Structure:Decision Process

1. Disaggregate Industry Value Chain– Structural Attractiveness– Possession of R&Cs

2. Competitive Advantage?3. Market Failure?

– Assess Conditions– Cospecialized Assets

4. Need for Coordination?– Conditions for Internalization

5. Incentive Problems?– => Agency Theory


Integration/Market-Exchange Decision Process

CompetitiveAdvantage?

CoordinationNeed?

MarketFailure?

FirmHierarchy

IncentiveProblem?

Trade-off

MarketExchange

No

No

No

No

Yes

Yes

YesYes


Incentive Problems &Governance Structures

CoordinateActivities High Low

IndividualContribution Small Large (need high

incentives)

IncentiveScheme

Can beDeveloped

Cannot beDeveloped

EmployeePerformance

Easy toMonitor

Difficult toMonitor

Skill & Creativity Low High

GovernanceStructure Integration Market

Exchange


Directions of Diversification

• Horizontal Diversification (last week)

• Vertical Diversification (today)

• International Diversification (later)


Vertical Integration

• Integration backward into supplier functions– Assures constant supply of inputs.

– Protects against price increases.

• Integration forward into distributor functions– Assures proper disposal of outputs.

– Captures additional profits beyond activity costs.

• Integration choice is that of which value-adding activities to compete in and which are better suited for others to carry out.


Creating Value ThroughVertical Integration

• Advantages of a vertical integration strategy:– Builds entry barriers to new competitors by denying them

inputs and customers.– Facilitates investment in efficiency-enhancing assets that

solve internal mutual dependence problems.– Protects product quality through control of input quality and

distribution and service of outputs.– Improves internal scheduling (e.g., JIT inventory systems)

responses to changes in demand.


• Disadvantages of vertical integration– Cost disadvantages of internal supply purchasing.– Remaining tied to obsolescent technology.– Aligning input and output capacities with uncertainty in

market demand is difficult for integrated companies.

Creating Value ThroughVertical Integration


Bureaucratic Costs and the Limitsof Vertical Integration

• The costs of running an organization rise with integration due to:– The lack of an incentive for internal suppliers to reduce their

operating costs.– The lack of strategic flexibility in times of changing

technology or uncertain demand.

• Bureaucratic costs reduce the value of vertical integration.


Alternatives to Vertical Integration

• Cooperative Relationships• Strategic Alliances

• Strategic Outsourcing• Virtual Corporation


Mode of Expansion

• Firms can implement their diversification strategies through internal development, acquisitions, mergers, joint ventures, alliances, or contracting with external partners.

• None of these, however, guaranties easy expansion. Choosing among the various modes involves unavoidable trade-offs.

• Some would argue, for example, that acquiring a company to gain access to the resources needed to compete in an industry is likely to dissipate future profits. Others would cite the difficulties working across organizational boundaries in joint ventures. On the other hand, internal development can be maddeningly slow and rife with uncertainty.

• In short, each mode of expansion has its own benefits and costs. Thus, a firm must carefully weigh each alternative against its needs and the exigencies of a particular competitive situation.


Mergers & Acquisitions

Benefits– Speed– Access to

complementary assets– Removal of potential

competitor– Upgrade corporate

resources

Drawbacks– Cost of acquisition– Unnecessary adjunct

businesses– Organizational clashes

may impede integration– Large commitment


Internal Development

Benefits– Incremental– Compatible with culture– Internalizes learning– Encourages

intrapreneurship

Drawbacks– Slow– Need to build new

resources– Unsuccessful efforts are

difficult to recoup– Adds to industry

capacity; subscale entry


Strategic Alliance

Benefits– Access to

complementary assets– Speed

Drawbacks– Lack of control– Assisting potential

competitor– Questionable long-term

viability– Difficult to integrate

learning


Next Session: Text Discussion 2

Mergers & Acquisitions

• Cording, Margaret, Petra Christmann, and L. J. Bourgeois III (2002), “A Focus on Resources in M&A Success: A Literature Review and Research Agenda to Resolve Two Paradoxes,” Academy of Management Meeting, August 12, 2002.

• Walter, Gordon A. and Jay B. Barney (1990), “Management Objectives in Mergers and Acquisitions,” Strategic Management Journal, 11(1), 79-86.

• Brouthers, Keith D. (2002), “Institutional, Cultural and Transaction Cost Influences on Entry Mode Choice and Performance,” Journal of International Business Studies, 33(2), 203-211.

• O’Shaughnessy, K. C. and David J. Flanagan (1998), “Determinants of Layoff Announcements Following M&As: An Empirical Investigation,” Strategic Management Journal, 19(10), 989-999.

Documents

Cs 08 Session 05