Corporate Strategy

Fall 2008

Session 5 - Lecture 3

Governance Structure and the Limit to the Scope of the Firm

Dr. Olivier Furrer

Office: TvA 1-1-11, Phone: 361 30 79 e-mail: o.furrer@fm.ru.nl Office Hours: only by appointment
Session 05 Furrer 2002-2008 1

Implications of Shareholder Value Maximization for Corporate Strategy

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.
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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).
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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

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Session 05 Furrer 2002-2008

The Corporate Parent as Intermediary

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.
Source: Goold, Campbell and Alexander, 1994
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How Parents Create Value

Stand-alone influence

Linkage influence

Central functions and services

Session 05 Furrer 2002-2008

Corporate development
Source: Goold, Campbell and Alexander, 1994
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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 parents characteristics and significant improvement opportunities that exist in its particular businesses. The parents skills are not good or bas in any absolute sense; their value depends on the nature and needs of their businesses.
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Parenting Styles
High

Strategic Planning

Source: Goold and Campbell, 1987

Planning Influence

Strategic Control
Financial Control
Low Flexible

Tight Strategic

Tight Financial
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Session 05 Furrer 2002-2008

Control Influence

Parenting Styles (Contd)

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.
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Parenting Styles (Contd)

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.

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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?
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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.

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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.
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Limit to Firm Scope

Cost of the Hierarchy $
B A

Market Cost

Benefit
Increasing Firm Scope
Org. Boundary Independent of Market
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Org. Boundary Given Market Costs

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Intermediate Governance Structures

(Hybrid Forms)
High
LEVEL OF INTERACTION Co-production R&D Consortia Cross Licensing

Hierarchy
Joint Venture

(Governance Costs)

Franchising Patent Licensing

Co-operation Agreement

Strategic Alliances (Hybrids)

Low

MarketCompetition
Session 05 Furrer 2002-2008

TYPE OF ARRANGEMENT
(Transaction Costs)

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

Market: Costs, Benefits & Causes

Benefits
Efficient Information Processing (compared to bureaucracy) High-Powered Incentives (self-interested, independent ownermanagers, 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

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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.

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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

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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 Conditions for Internalization => Agency Theory
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4. Need for Coordination?

5. Incentive Problems?

Session 05 Furrer 2002-2008

Integration/Market-Exchange Decision Process

Competitive Advantage?
Yes

No

Market Failure?
Yes

No Coordination

Need?
Yes No

No

Market Exchange

Firm Hierarchy

Incentive Problem?
Yes

Trade-off
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Incentive Problems & Governance Structures

Coordinate Activities Individual Contribution Incentive Scheme High Low Large (need high incentives) Cannot be Developed

Small
Can be Developed

Employee Performance
Skill & Creativity

Easy to Monitor
Low

Difficult to Monitor
High

Governance Structure
Session 05 Furrer 2002-2008

Integration

Market Exchange
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Directions of Diversification
Horizontal Diversification (last week)

Vertical Diversification (today)

International Diversification (later)

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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.
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Creating Value Through Vertical 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.

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Creating Value Through Vertical Integration

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.

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Bureaucratic Costs and the Limits of 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.

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Alternatives to Vertical Integration

Cooperative Relationships
Strategic Alliances

Strategic Outsourcing
Virtual Corporation

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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. Session 05 Furrer 2002-2008

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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

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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

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Strategic Alliance
Benefits
Access to complementary assets Speed

Drawbacks
Lack of control Assisting potential competitor Questionable long-term viability Difficult to integrate learning

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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.

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