Session 03 © Furrer Corporate Strategy Fall 2012 Session 3: Lecture 2 Governance Structure and the Growth of the Firm Dr. Olivier Furrer Office: TvA , Phone: Office Hours: only by appointment

Session 03 © Furrer The 1980s highlighted the failure of many visible diversifications, 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

Session 03 © Furrer 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).

Session 03 © Furrer 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

Session 03 © Furrer The Corporate Parent as Intermediary Source: Goold et al., 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.

Session 03 © Furrer How Parents Create Value Stand-alone influence Linkage influence Central functions and services Corporate development Source: Goold et al., 1994

Session 03 © Furrer 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 bad in any absolute sense; their value depends on the nature and needs of their businesses.

Session 03 © Furrer Corporate Strategies Framework Source: Goold et al., 1994 Session 05 © Furrer

Session 03 © Furrer Parenting Styles Strategic Planning Strategic Control Financial Control Planning Influence High Low Control Influence Flexible Tight Strategic Tight Financial Source: Goold et al., 1994

Session 03 © Furrer 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.

Session 03 © Furrer 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.

Session 03 © Furrer 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 be 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?

Session 03 © Furrer Session 05 © Furrer Ashridge “Fit” Matrix Source: Goold et al., 1994 Session 05 © Furrer

Session 03 © Furrer Governance Structure 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.

Session 03 © Furrer Governance Structure 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 particular firms?  Market, Hierarchy, or in between.

Session 03 © Furrer Limit to Firm Scope Increasing Firm Scope $ Market Cost Benefit of the Hierarchy Cost of the Hierarchy A B Org. Boundary Independent of Market Org. Boundary Given Market Costs

Session 03 © Furrer Co-operation Agreement Patent Licensing Franchising Cross Licensing R&D Consortia Co-prod- uction Joint Venture 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 Hierarchy Market

Session 03 © Furrer Market: Costs, Benefits, and Causes Benefits Efficient 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

Session 03 © Furrer The Virtual Corporation A virtual corporation is a firm which focuses on a few core competences and outsource just 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.

Session 03 © Furrer Hierarchy: Costs, Benefits, and 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

Session 03 © Furrer 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

Session 03 © Furrer Stages in the Raw-Material-to- Consumer Value Chain UpstreamDownstream End userDistributionAssembly Intermediate manufacturer Raw materials Examples: Dow Chemical Union Carbide Kyocera Examples: Intel Seagate Micron Examples: Apple Compaq Dell Examples: Computer World Office Max Source: Hill and Jones, 2001

Session 03 © Furrer Integration/Market-Exchange Decision Process Competitive Advantage? Competitive Advantage? Coordination Need? Coordination Need? Market Failure? Market Failure? Firm Hierarchy Firm Hierarchy Incentive Problem? Incentive Problem? Trade-off Market Exchange No Yes

Session 03 © Furrer Incentive Problems & Governance Structures Coordinate Activities HighLow Individual Contribution Small Large (need high incentives) Incentive Scheme Can be Developed Cannot be Developed Employee Performance Easy to Monitor Difficult to Monitor Skill & CreativityLowHigh Governance Structure Integration Market Exchange

Session 03 © Furrer Directions of Diversification Horizontal Diversification (last week) Vertical Diversification (today) International Diversification (later)

Session 03 © Furrer

Session 03 © Furrer 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.

Session 03 © Furrer 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.

Session 03 © Furrer 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 Through Vertical Integration

Session 03 © Furrer Full Integration Taper Integration Full and Taper Integration

Session 03 © Furrer 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.

Session 03 © Furrer Alternatives to Vertical Integration Cooperative Relationships Strategic Alliances Strategic Outsourcing Virtual Corporation

Session 03 © Furrer 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, guarantees 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 03 © Furrer 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

Session 03 © Furrer 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

Session 03 © Furrer Strategic Alliance Benefits –Access to complementary assets –Speed Drawbacks –Lack of control –Assisting potential competitor –Questionable long-term viability –Difficult to integrate learning