Strategic Management: Concepts and Cases Part III: Strategic Actions: Strategy Implementation Chapter 10 and 11: Corporate Governance & Organizational Structure and Controls 1

The Strategic Management Process 2

CG and Its Effect on the Lives of CEOs In 2006 record number of CEOs lost jobs Dismissal Retirement Recruitment to another firm Partly due to increasing scrutiny by Boards Governance activists Increased pressure from the market for corporate control Media Trend: decrease in average tenure (current: 18-24 mo.) Result: CEOs looking at short-term vs. long-term 3

Introduction Corporate Governance (CG) Set of mechanisms used to manage the relationships (and conflicting interests) among stakeholders, and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values) Effective CG interest to nations as it reflects societal standards Firms’ shareholders are treated as key stakeholders as they are the company’s legal owners 4

Separation of Ownership and Managerial Control Introduction Historically, firms managed by founder-owners & descendants Separation of ownership and managerial control allow shareholders to purchase stock, entitling them to income (residual returns) – implies ‘risk’ for this group who manage their investment risk Shareholder value reflected in price of stock 5

Separation of Ownership and Managerial Control Introduction Small firms’ managers are high percentage owners, which implies less separation between ownership and management control Usually implies family-owned businesses This group faces 2 critical issues 1. As they grow, they may not have access to all needed skills to manage the growing firm and maximize its returns, so may need outsiders to improve management 2. May need to seek outside capital (whereby they give up some ownership control) 6

Separation of Ownership and Managerial Control (Cont’d) Agency relationships Relationships between business owners (principals) and decision-making specialists (agents) hired to manage principals' operations and maximize returns on investment (and focus of this chapter) Other agency relationship examples: Consultants/clients; insured/insurer; manager/employee 7

Separation of Ownership and Managerial Control Agency relationships (Cont’d) Managerial Opportunism: Seeking self-interest with guile (i.e., cunning or deceit) Opportunism: an attitude and set of behaviors Managers don’t know which agents will enact managerial opportunism Principals establish governance and control mechanisms to prevent agents from acting opportunistically 8

An Agency Relationship 9

Separation of Ownership and Managerial Control Agency problems: Product diversification Can result in 2 manager benefits shareholders “don’t enjoy” 1. Increase in firm size 2. Firm portfolio diversification which can reduce top executives’ employment risk (i.e., job loss, loss of compensation and loss of managerial reputation) Diversification reduces these risks because a firm and its managers are less vulnerable to the reduction in demand associated with a single or limited number of product lines or businesses 10

Separation of Ownership and Managerial Control Agency problems: Firm’s free cash flow Resources remaining after the firm has invested in all projects that have positive net present values within its current businesses Available cash flows Managerial inclination to overdiversify can be acted upon Shareholders may prefer distribution as dividends, so they can control how the cash is invested Curve S depicts shareholders’ optimal level of diversification where Point A is preferred by shareholders and Point B by top executives 11

Manager and Shareholder Risk and Diversification 12

Separation of Ownership and Managerial Control (Cont’d) Agency costs and governance mechanisms Sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because governance mechanisms cannot guarantee total compliance by the agent Costs associated with agency relationships, and effective governance mechanisms should be employed to improve managerial decision making and strategic effectiveness Transaction Costs 13

Ownership Concentration Introduction: Key concepts Ownership Concentration: Governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own Large Block Shareholders: Shareholders owning a concentration of at least 5 percent of a corporation’s issued shares Institutional Owners: Financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions 14

The Board of Directors (BOD) Introduction Group of shareholder-elected individuals (usually called ‘directors’) whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives 15

The Board of Directors (BOD) As stewards of an organization's resources, an effective and well-structured board of directors can influence the performance of a firm Oversee managers to ensure the company is operated in ways to maximize shareholder wealth Direct the affairs of the organization Punish and reward managers Protect shareholders’ rights and interests Protect owners from managerial opportunism 3 types: Insider, related outsider and outsider 16

The Board of Directors (BOD) (Cont’d) Historically, BOD dominated by inside managers Managers suspected of using their power to select and compensate directors NYSE implemented an audit committee rule requiring outside directors to head audit committee (a response to SEC’s proposal requiring audit committees be made up of outside directors) Sarbanes-Oxley Act passed leading to BOD changes CG becoming more intense through BOD mechanism BOD scandals led to trend of separating roles of CEO and Chairperson 17

The Board of Directors (BOD) (Cont’d) Outside directors Improve weak managerial monitoring and control that corresponds to inside directors Tend to emphasize financial controls, to the detriment of risk-related decisions by managers, as they do not have access to daily operations and a high level of information about managers and strategy 18

The Board of Directors (BOD) (Cont’d) Outside directors (Cont’d) Large number of outsiders can create problems Limited contact with the firm’s day-to-day operations and incomplete information about managers results in ineffective assessments of managerial decisions and initiatives. emphasizes financial, as opposed to strategic, controls to gather performance information to evaluate performance of managers & business units, which could reduce R&D investments, increase diversification, and pursue higher compensation to offset their employment risk 19

The Board of Directors (BOD) (Cont’d) Enhancing BOD effectiveness (5 changes) Increased diversity in board members’ backgrounds Establishment and consistent use of formal processes to evaluate the board’s performance Creation of a “lead director” role that has strong agenda-setting and oversight powers Modified compensation of directors Requires that directors own significant stakes in the company in order to keep focused on shareholder interests 20

Executive Compensation (EC) Defined: Governance mechanism that seeks to align the interests of top managers and owners through salaries, bonuses, and long-term incentive compensation, such as stock awards and stock options Thought to be excessive and out of line with performance Alignment of pay and performance: complicated board responsibility The effectiveness of pay plans as a governance mechanism is suspect 21

Executive Compensation (EC) (Contd’) The effectiveness of executive compensation Complicated, especially long-term incentive comp The quality of complex and nonroutine strategic decisions that top-level managers make is difficult to evaluate Decisions affect financial outcomes over an extended period, making it difficult to assess the effect of current decisions on corporation performance External factors affect a firm’s performance in addition to top-level management decisions and behavior 22

Executive Compensation (EC) (Contd’) The effectiveness of executive compensation (Cont’d) Performance-based compensation used to motivate decisions that best serve shareholder interest are imperfect in their ability to monitor and control managers Incentive-based compensation plans intended to increase firm value, in line with shareholder expectations, subject to managerial manipulation to maximize managerial interests Many plans seemingly designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders 23

Market for Corporate Control Definition: external governance mechanism consisting of a set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments Becomes active when a firm’s internal controls fail Need (for external mechanisms) exists to address weak internal corporate governance correct suboptimal performance relative to competitors, and discipline ineffective or opportunistic managers. External mechanisms are less precise than internal governance mechanisms 24

International Corporate Governance Corporate Governance in Germany Concentration of ownership is strong Banks exercise significant power as a source of financing for firms Two-tiered board structures, required for larger employers, place responsibility for monitoring and controlling managerial decisions and actions with separate groups Power sharing includes representation from the community as well as unions 25

International Corporate Governance (Cont’d) Corporate Governance in Japan Cultural concepts of obligation, family, and consensus affect attitudes toward governance Close relationships between stakeholders and a company are manifested in cross-shareholding, and can negatively impact efficiencies Banks play an important role in financing and monitoring large public firms Despite the counter-cultural nature of corporate takeovers, changes in corporate governance have introduced this practice 26

International Corporate Governance (Cont’d) Global Corporate Governance Relatively uniform governance structures are evolving These structures are moving closer to the U.S. corporate governance model Although implementation is slower, merging with U.S. practices is occurring even in transitional economies 27

Chapter 11: Organizational Structure (and Controls) Components of internal strategic fit Role of organizational structure in strategy implementation Basic forms of organizational structure; advantages/disadvantages of each - simple - functional - multi-divisional (M-Form) - - 3 types 11–28

Chapter 11: Organizational Structure (and Controls) Strategic control; financial control Strategy-structure “fit” Contemporary forms of organizational structure - matrix structure - strategic alliances, networks, virtual organizations (Chapter 9) - creative/experimental forms 11–29

Components of Internal Strategic Fit (Froelich Model) Environment Strategy Structure Systems Resources/Capabilities Organizational Culture 11–30

Organizational Structure Organizational structure specifies: The firm’s formal reporting relationships, procedures, controls, and authority and decision-making processes It is critical to match organizational structure to the firm’s strategy 11–31

Relationships between Strategy and Structure Strategy and structure have a reciprocal relationship: Structure flows from or follows the selection of the firm’s strategy but … Once in place, structure can influence current strategic actions as well as choices about future strategies 11–32

Strategy and Structure Growth Pattern Efficient implementation of formulated strategy As firms grow larger and become more complex, structural challenges emerge Firms’ larger sizes dictate the need for more sophisticated workflows and integrating mechanisms Simple Functional Multidivisional Efficient implementation of formulated strategy 11–33 Figure 11.1

Strategy and Structure: Simple Structure Owner-manager Makes all major decisions directly Monitors all activities Staff An extension of manager’s supervisor authority Matched with focus (or niche) strategies and small single business strategies Commonly compete by offering a single product line in a single geographic market 11–34

Strategy and Structure: Functional Structure Chief Executive Officer (CEO) Limited corporate staff Functional line managers in needed organizational areas, possibly: Manufacturing ➢Marketing ➢Engineering Accounting ➢R&D ➢HRM Supports use of business-level strategies and some corporate-level strategies (larger) Single or dominant business with low levels of diversification Facilitates centralization/company-wide coordination 11–35

Functional Structure for a Differentiation Strategy Notes: • Marketing is the main function for keeping track of new product ideas • New product R&D is emphasized • Most functions are decentralized, but R&D and marketing may have centralized staffs that work closely with each other • Formalization is limited so that new product ideas can emerge easily and change is more readily accomplished • Overall structure is organic; job roles are less structured 11–36 Figure 11.3

Functional Structure under a Differentiation Strategy Marketing is the main function for tracking new product ideas New product R&D is emphasized Most functions are decentralized Formalization is limited to foster change and promote new ideas Overall structure is organic Job roles are less structured 11–37

Functional Structure for Cost Leadership Strategy Notes: • Operations is the main function • Process engineering is emphasized rather than new product R&D • Relatively large centralized staff coordinates functions • Formalized procedures allow for emergence of a low-cost culture • Overall structure is mechanical; job roles are highly structured 11–38 Figure 11.2

Functional Structure under a Cost Leadership Strategy Operations is typically the main function Process engineering is emphasized over research and development Large centralized staff oversees activities Formalized procedures guide actions Structure is mechanical Job roles are highly structured 11–39

Implementing an Integrated Cost Leadership/Differentiation Strategy The integrated form of the functional structure must have: Decision-making patterns that are partially centralized and partially decentralized Semi-specialized jobs Rules and procedures that allow both formal and informal job behaviors A hybrid form; no wonder it is hard to implement! Copyright © 2004 South-Western. All rights reserved. 11–40

Functional Structure Differences in orientation among organizational functions can: Impede communication and coordination Cause functional-area managers to focus on local versus overall company strategic issues Increase the need for CEO to integrate decisions and actions of business functions Facilitate career paths and professional development in specialized functional areas Copyright © 2004 South-Western. All rights reserved. 11–41

Evolutionary Growth of the Firm leading to increased diversification A firm’s continuing success that leads to: Product diversification, or Market diversification, or Both product and market diversification Increasing diversification creates information processing and coordination problems that the functional structure can’t handle 11–42

Strategy and Structure: Multidivisional Structure Top corporate officer delegates responsibilities to division managers For day-to-day operations For business-unit strategy Appropriate as a firm grows through diversification 11–43

Multidivisional Structure (cont’d) Major Benefits Corporate officers are more detached as they monitor and compare performance of divisions, facilitating resource allocation decisions Stimulates divisional managers to optimize performance of their units Provides for faster reaction to change and a stronger customer focus at division level Development of “general management” expertise within the firm 11–44

Multidivisional Structure (con’t) Major Disadvantages Increased complexity of the firm overall Difficulties coordinating and sharing expertise across divisions Duplication of resources Tendency to rely on financial controls rather than strategic controls 11–45

Organizational Controls Strategic Controls Organizational Controls “Subjective” (strategically relevant) Criteria Philosophy of the “balanced scorecard” Evaluate the degree to which the firm accomplishes key tasks related to success of the particular strategy being implemented Examples = market share, innovation lead time, image, location advantages, product mix requires in-depth knowledge/insight in market 11–46

Organizational Controls Strategic Controls Organizational Controls Financial Controls “Objective” financial criteria Enables comparisons of differing divisions using “standardized financial measures, such as: Requires less strategic understanding Use with caution - do not tell the whole story! 11–47

Matching Control to Strategy Relative use of controls varies by type of strategy Large diversified firms using a cost leadership strategy tend to emphasize financial controls Companies and business units using a differentiation strategy typically emphasize strategic controls Diversification strategy requires firm to change from functional structure to a multidivisional structure Different levels of diversification create the need for implementation of a unique form of the multidivisional structure 11–48

Variations of the Multidivisional Structure 11–49 Figure 11.4

Multidivisional Structure: Cooperative Form Development of integrating mechanisms to bring about cooperation among divisions Goals = activity sharing/skill transfer HQ involved in centralized strategic planning, HRM, marketing, and possibly other functions with synergistic potential R&D is likely centralized Greater use of strategic control measures A more cooperative culture is nurtured A more complex management task compared to the competitive M-Form 11–50 Related-Constrained Strategy

Multidivisional Structure: Competitive Form A structure in which there is independence among the firm’s divisions Divisions do not share common strengths, so integrating mechanisms are not employed Corporate HQ has a small staff; strategy is delegated to divisions, but resource allocation among divisions is centralized Financial controls predominate Prominent functions are finance, auditing; plus legal is acquisitions/divestitures are frequent Culture of competition rather than cooperation between divisions 11–51 Unrelated Strategy

Cooperative Form of Multidivisional Structure: Related-Constrained Strategy Notes • Structural integration devices create tight links among all divisions • Corporate office emphasizes centralized strategic planning, human resources, and marketing to foster cooperation between divisions • R&D is likely to be centralized• • Rewards are subjective and tend to emphasize overall corporate performance in addition to divisional performance • Culture emphasizes cooperative sharing 11–52 Figure 11.5

Competitive Form of Multidivisional Structure:Unrelated Strategy Notes • Corporate headquarters has a small staff • Finance and auditing are the most prominent functions in the headquarters office to manage cash flow and assure the accuracy of performance data coming from divisions • The legal affairs function becomes important when the firm acquires or divests assets • Divisions are independent and separate for financial evaluation purposes • Divisions retain strategic control, but cash is managed by the corporate office • Divisions compete for corporate resources 11–53 Figure 11.7

Matrix Organizational Form Simultaneous use of functional departments and project teams To facilitate and speed strategies relying on innovation Seldom used for structuring an entire organization; rather, used in particular areas of the organization as needed 11–54

Creative/Experimental Structural Forms “Organizational ecosystem” concept of overlapping teams - to facilitate innovation and high employee commitment Bottom-up structures - to emphasize importance of customers and staff Non-hierarchical structures - to focus on organizational mission/shared values 11–55

Even More Structures !!! Structures for international strategies (Network) structures for cooperative strategies Matrix structures to facilitate innovation Creative and experimental structures 11–56

Worldwide Geographic Area Structure: Multi-domestic Strategy Notes: • The perimeter circles indicate decentralization of operations • Emphasis is on differentiation by local demand to fit an area or country culture • Corporate headquarters coordinates financial resources among independent subsidiaries • The organization is like a decentralized federation 11–57 Figure 11.8

Worldwide Product Divisional Structure: Global Strategy Notes • The headquarters’ circle indicates centralization to coordinate information flow among worldwide products • Corporate headquarters uses many intercoordination devices to facilitate global economies of scale and scope • Corporate headquarters also allocates financial resources in a cooperative way • The organization is like a centralized federation 11–58 Figure 11.9

Strategic Center Firm Is the foundation for the strategic network’s structure Manages the complex, cooperative interactions among network partners Is more obvious in stable and vertically arranged networks, but less obvious in horizontally arranged and dynamic networks 11–59

A Strategic Network - for elaborate cooperative strategies (Chapter 9) Center Firm Adapted from Figure 11.10 11–60