Corporate Strategy Fall 2012 Session 3 Lecture 2

Corporate Strategy Fall 2012 Session 3: Lecture 2 Governance Structure and the Growth of the Firm Dr. Olivier Furrer Office: Tv. A 1. 1. 22, Phone: 361 30 79 e-mail: o. furrer@fm. ru. nl Office Hours: only by appointment Session 03 © Furrer 2002 -2012 1

Implications of Shareholder Value Maximization for Corporate Strategy • The 1980 s 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 1980 s, 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. Session 03 © Furrer 2002 -2012 2

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 2002 -2012 3

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 2002 -2012 4

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 et al. , 1994 Session 03 © Furrer 2002 -2012 5

How Parents Create Value Stand-alone influence Linkage influence Central functions and services Corporate development Session 03 © Furrer 2002 -2012 Source: Goold et al. , 1994 6

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 2002 -2012 7

Corporate Strategies Framework Source: Goold et al. , 1994 Session 05 03 © Furrer 2002 -2010 2002 -2012 8

Parenting Styles High Strategic Control Planning Influence Financial Control Source: Goold et al. , 1994 Strategic Planning Low Flexible Session 03 © Furrer 2002 -2012 Tight Strategic Control Influence Tight Financial 9

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 2002 -2012 10

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 formulating their own strategies and plans. Session 03 © Furrer 2002 -2012 11

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 2002 -2012 12

Ashridge “Fit” Matrix Source: Goold et al. , 1994 Session 05 03 © Furrer 2002 -2010 2002 -2012 2002 -2008 13

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 2002 -2012 14

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 2002 -2012 15

Limit to Firm Scope Cost of the Hierarchy $ A Market Cost B Benefit of the Hierarchy Increasing Firm Scope Org. Boundary Independent of Market Session 03 © Furrer 2002 -2012 Org. Boundary Given Market Costs 16

Intermediate Governance Structures (Hybrid Forms) Hierarchy LEVEL OF INTERACTION High (Governance Costs) Co-production Low Joint Venture R&D Consortia Cross Licensing Franchising Patent Licensing Strategic Alliances (Hybrids) Co-operation Agreement Market. Competition Session 03 © Furrer 2002 -2012 TYPE OF ARRANGEMENT (Transaction Costs) Cooperation Source: Adapted from Beamish, Morrison, Rosenzweig and Inkpen, 2000, p. 114. 17

Market: Costs, Benefits, and Causes Benefits Efficient Information Processing (compared to bureaucracy) High-Powered Incentives (self-interested, independent ownermanagers, cf. agency theory) Session 03 © Furrer 2002 -2012 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 18

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 2002 -2012 19

Hierarchy: Costs, Benefits, and Causes Benefits Costs • • • Authority over Activity Coordination Tax Benefits Quality Control Information Access Leverage R&Cs Session 03 © Furrer 2002 -2012 Increased Bureaucracy Agency Costs Loss of Flexibility Potential Overcapacity Attractiveness of Buyer & Supplier Markets 20

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 2002 -2012 21

Stages in the Raw-Material-to. Consumer Value Chain Upstream Raw materials Examples: Dow Chemical Union Carbide Kyocera Session 03 © Furrer 2002 -2012 Downstream Intermediate manufacturer Examples: Intel Seagate Micron Assembly Examples: Apple Compaq Dell Distribution End user Examples: Computer World Office Max Source: Hill and Jones, 2001 22

Integration/Market-Exchange Decision Process Competitive Advantage? Yes No No Market Failure? Yes Firm Hierarchy Coordination Need? Yes No No Market Exchange Incentive Problem? Yes Session 03 © Furrer 2002 -2012 Trade-off 23

Incentive Problems & Governance Structures Coordinate Activities High Low Individual Contribution Small Large (need high incentives) Incentive Scheme Can be Developed Cannot be Developed Employee Performance Easy to Monitor Difficult to Monitor Skill & Creativity Low High Integration Market Exchange Governance Structure Session 03 © Furrer 2002 -2012 24

Directions of Diversification • Horizontal Diversification (last week) • Vertical Diversification (today) • International Diversification (later) Session 03 © Furrer 2002 -2012 25

Session 03 © Furrer 2002 -2012 26

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 2002 -2012 27

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 2002 -2012 28

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. Session 03 © Furrer 2002 -2012 29

Full and Taper Integration Full Integration Taper Integration Session 03 © Furrer 2002 -2012 30

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 2002 -2012 31

Alternatives to Vertical Integration • Cooperative Relationships • Strategic Alliances • Strategic Outsourcing • Virtual Corporation Session 03 © Furrer 2002 -2012 32

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 2002 -2012 33

Mergers & Acquisitions Benefits – Speed – Access to complementary assets – Removal of potential competitor – Upgrade corporate resources Session 03 © Furrer 2002 -2012 Drawbacks – Cost of acquisition – Unnecessary adjunct businesses – Organizational clashes may impede integration – Large commitment 34

Internal Development Benefits – – Incremental Compatible with culture Internalizes learning Encourages intrapreneurship Session 03 © Furrer 2002 -2012 Drawbacks – Slow – Need to build new resources – Unsuccessful efforts are difficult to recoup – Adds to industry capacity; subscale entry 35

Strategic Alliance Benefits – Access to complementary assets – Speed Session 03 © Furrer 2002 -2012 Drawbacks – Lack of control – Assisting potential competitor – Questionable long-term viability – Difficult to integrate learning 36