This Document Contains Chapters 10 to 11 Chapter 10 Corporate Governance LEARNING OBJECTIVES 1. Define corporate governance and explain why it is used to monitor and control top-level managers’ decisions. 2. Explain why ownership is largely separated from managerial control in organizations. 3. Define an agency relationship and managerial opportunism and describe their strategic implications. 4. Explain the use of three internal governance mechanisms to monitor and control managers’ decisions. 5. Discuss the types of compensation executives receive and their effects on managerial decisions. 6. Describe how the external corporate governance mechanism—the market for corporate control—restrains top-level managers’ decisions. 7. Discuss the nature and use of corporate governance in international settings, especially in Germany, Japan, and China. 8. Describe how corporate governance fosters ethical decisions by a firm’s top-level managers. CHAPTER OUTLINE Opening Case: The Corporate Raiders of the 1980s Have Become the Activist Shareholders of Today SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL Agency Relationships Product Diversification as an Example of an Agency Problem Agency Costs and Governance Mechanisms OWNERSHIP CONCENTRATION The Increasing Influence of Institutional Owners BOARD OF DIRECTORS Enhancing the Effectiveness of the Board of Directors Executive Compensation The Effectiveness of Executive Compensation Strategic Focus: Do CEOs Deserve the Large Compensation Packages They Receive? MARKET FOR CORPORATE CONTROL Managerial Defense Tactics INTERNATIONAL CORPORATE GOVERNANCE Corporate Governance in Germany and Japan Strategic Focus: “Engagement” vs. “Activist” Shareholders in Japan, Germany and China Corporate Governance in China GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR SUMMARY KEY TERMS REVIEW QUESTIONS MINI-CASE: The Imperial CEO, JPMorgan Chase’s Jamie Dimon ADDITIONAL QUESTIONS AND EXERCISES MINDTAP RESOURCES LECTURE NOTES Chapter Introduction: The purpose of this chapter is to present and discuss how shareholders (owners) can ensure that managers develop and implement strategic decisions in the best interests of the shareholders (owners) and not be primarily self-serving (working for the best interests of managers only, to the detriment of shareholders). In the absence of effective internal governance mechanisms, the market for corporate control—an external governance mechanism—may be activated. Though it is a subject most frequently associated with firms in the US and the U.K., the effectiveness of governance is gaining attention throughout the world. The chapter begins by describing the relationship that provides the foundation on which the modern corporation is built—i.e., the relationship between owners and managers. However, the majority of this chapter is devoted to an explanation of various mechanisms owners use to govern managers and ensure maximization of shareholder value. OPENING CASE The Corporate Raiders of the 1980s Have Become the Activist Shareholders of Today The opening case provides examples of corporate raiders doing something unexpected of them – helping businesses become stronger and strengthen their corporate governance. In the 1980s, large activist shareholders would buy significant stakes in companies and often seek to make the company weaker to take financial advantage. This caused corporate governance to strengthen in order to survive the raiders’ advances, and businesses were often ruined after the raiders made their profits. The case tells how these same raiders are now causing companies to become stronger, and often times have the support of institutional investors. These activist investors seek stock buybacks and increases in dividends as well as selling off “non-performing businesses.” Over time, corporate governance controls have become more critical and monitoring of top executives more intense. Teaching Note The opening case is a great lesson to how effective corporate governance is necessary in order for businesses to thrive. Ask the students how they would handle the situation if they were the CEO of a company being raided. How would they handle the situation if they were only a shareholder of the company being raided? Why are some of their answers different when the goal of corporate governance is to do what is best for the company overall and the stakeholders.
1 Define corporate governance and explain why it is used to monitor and control top-level managers’ decisions.
Corporate governance is the set of mechanisms used to manage the relationship among stakeholders and to determine and control the strategic direction and performance of organizations. At its core, corporate governance is concerned with identifying ways to ensure that strategic decisions are made effectively. Corporate governance has been emphasized in recent years because, as the opening case illustrates, corporate governance mechanisms increasingly affect all stakeholders and the firm's future. Effective corporate governance is also of interest to nations. Governments want firms operating within their countries to grow and provide employment, wealth, and satisfaction. This raises standards of living and enhances social cohesion. Three internal governance mechanisms examined here are (1) ownership concentration, as represented by types of shareholders and their different incentives to monitor managers, (2) the board of directors, and (3) executive compensation. The external governance mechanism is the market for corporate control. Teaching Note In the chapter, corporate governance is discussed from two perspectives: • The primary purpose of governance mechanisms is to prevent severe problems that may occur because of the separation of ownership and control in large firms by positively influencing managerial behavior. • The ability of governance mechanisms to direct top mangers’ actions toward shareholder objectives is dependent on the correct combination of mechanisms being used.
2 Explain why ownership is largely separated from managerial control in organizations.
SEPARATION OF OWNERSHIP AND MANAGERIAL CONTROL The growth of the large, modern public corporation is based primarily on the efficient separation of ownership and managerial control. Shareholders make investments by purchasing stock (representing ownership), which entitles them to a share of the firm’s residual income (or profits) that remain after all expenses have been paid. • The right to share in residual income also means that shareholders also must accept the risk that no residual profits will remain if the firm’s expenses exceed its income. • Shareholders can manage investment risk by investing in a diversified portfolio of firms. • In small firms, managers and owners are often one in the same—less separation of ownership and control. • As family-controlled firms grow, the owners generally do not have sufficient capital or managerial skills to grow the business and seek other sources of capital and skills to support this expansion. Teaching Note It is helpful to provide a story that would illustrate what the separation of ownership and managerial control is all about, and how it came to be. For example, it is easy for students to see that Henry Ford was involved in both the ownership and the operation of Ford Motor Company in the early days. They can see in their minds the old footage of Model T’s coming off a very crude assembly line, by today’s standards, and understand how much simpler operations were at the time. That has all changed with the advent of the modern, complex corporation. Today there is almost no way to bring ownership and managerial control back together again in a workable model.
3 Define an agency relationship and managerial opportunism and describe their strategic implications.
Agency Relationships Although the efficient separation of ownership and control enables specialization both by owners and managers, it also results in some potential costs (and risks) for owners by creating an agency relationship. An agency relationship exists when one party (the principal[s]) delegates decision making to another party (the agent[s]) in return for compensation as a decision-making specialist who performs a service. This relationship can be broader than just owners and managers—e.g., consultants and clients or insured and insurer. Figure Note Figure 10.1 illustrates how separation of ownership from control results in an agency relationship and is very helpful in getting students to understand the issues involved. FIGURE 10.1 An Agency Relationship Note the following in the figure (Figure 10.1): • Shareholders (principals) hire managers (agents) as decision makers. • The hiring act creates an agency relationship wherein a risk-bearing specialist (principal) compensates a managerial decision-making specialist (agent). The potential for conflicts of interests between owners and managers is created by the delegation of the responsibilities of decision making to managers. Therefore, managers may take actions that are not in the best interests of owners by selecting strategic alternatives that serve managerial interests rather than shareholder or owner interests. An agency relationship enables the possibility of managerial opportunism, the seeking of self-interest with guile (i.e., with cunning or deceit), where opportunism is represented by an attitude or inclination and a set of behaviors. Before observing the results of decisions, it is impossible to know which agents will behave opportunistically and which ones will not because a manager’s reputation is an imperfect guide to future behavior. As a result, principals establish governance and control mechanisms because the opportunity for opportunistic behavior and conflicts of interest exists. Product Diversification as an Example of an Agency Problem Product diversification—discussed in Chapter 6—can be beneficial to both shareholders and managers, but it also is a potential source of agency problems. Managers may pursue higher levels of product diversification than are desired by shareholders to capture the value of opportunities that are available to managers, but not to owners. • Increased diversification generally drives the growth of the firm and firm growth is positively related to managerial compensation. Thus, by diversifying to a greater extent than may be desired by shareholders, managers may enjoy the higher levels of compensation that accompany managing larger firms. • Increased diversification also can reduce managerial employment risk (the risk of job loss, loss of compensation, or loss of managerial reputation). Increased diversification reduces managerial employment risk because the firm (and the manager) is less affected by a reduction in demand for (or failure of) a single product line when the firm produces and sells multiple products. • Increased diversification also may provide managers with access to increased levels of slack resources or free cash flows, resources that are generated after investment in all internal projects that have positive net present values within the firm’s current product lines. Managers may choose to invest excess funds in products or activities that are not related to the firm’s existing core businesses and products if they perceive attractive (positive net present value) investment opportunities. Figure Note Figure 10.2 illustrates the variance between the risk profiles of shareholders and managers based on the level or type of firm diversification. It shows that owners may benefit from managers’ decisions to diversify the firm’s products, but only to the point where investment returns at the margin are no longer positive. That is, diversification is valuable to (and preferred by) owners as long as it has a positive effect on firm value. However, some firms may be over-diversified, despite the lack of profitability in their dominant business. Owners also may prefer that excess funds be returned to them in the form of dividends so they can control reinvestment decisions. FIGURE 10.2 Manager and Shareholder Risk and Diversification Curve S represents the business or investment risk profile for shareholders (owners). It spans a diversification scope from dominant business (which would be to the left of related-constrained) to a point between related-constrained and related-linked diversification. The optimum risk level is at point A, between dominant business and related-constrained diversification. Curve M represents the managerial employment risk profile. It spans a diversification profile from related-constrained to unrelated diversification. The optimum diversification level for managers is point B, between related-linked and unrelated businesses. As illustrated by the S-curve (owner business risk preference) and M-curve (managerial employment risk preference), there is a conflict between owners and managers regarding the desired levels of firm diversification and risk. • Owners prefer that the scope be greater than a dominant business but less than related-linked diversification. • Owners’ optimum level of diversification is where the S curve turns up, a point between dominant business and related-constrained diversification. • Managers prefer a greater scope of diversification than owners do. As can be seen from the M curve in Figure 10.2, managers prefer that the firm’s diversification be between related-linked and unrelated diversification. • However, as the curve indicates, there is a point at which managerial employment risk increases as the firm over-diversifies (as discussed in Chapter 6). • The optimum level of firm diversification from a managerial risk perspective is at point B on the M curve, somewhere between related-linked and unrelated businesses. Agency Costs and Governance Mechanisms The potential conflict illustrated by Figure 10.2, coupled with the fact that principals do not know which managers might act opportunistically, demonstrates why principals establish governance mechanisms. For firm diversification to approach the shareholder optimum (point A on curve S in Figure 10.2), managerial autonomy must be controlled by the firm’s board of directors or by other governance mechanisms that encourage managers to make strategic decisions that are in the best interests of shareholders. Agency costs are the sum of incentive, monitoring, and enforcement costs as well as any residual losses incurred by principals because it is not possible for principals to guarantee 100 percent compliance through monitoring arrangements. Research suggests that a more intensive application of governance mechanisms may produce significant changes in strategies. Corporate America needs more intense governance in order for continued investment in the stock market to facilitate growth. However, others argue that the indirect costs are even more telling in regard to the impact on strategy formulation and implementation. Partly in response to governance breakdowns in the U.S., Congress enacted the Sarbanes-Oxley (SOX) Act in 2002 and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010. Most believe that SOX has led to generally positive outcomes in terms of protecting shareholders. Section 404 of SOX, for example, improves transparency and internal controls and this, subsequently, increases shareholder value. However, this resulted in increased costs to firms and a decrease in foreign firms listing on U.S. stock exchanges. Dodd-Frank is the most sweeping set of financial regulatory reforms in the U.S. in almost a century. Dodd-Frank: • Created a Financial Stability Oversight Council headed by the Treasury Secretary • Established a new system for liquidation of certain financial companies • Provided for a new framework to regulate derivatives • Established new corporate governance requirements • Regulated credit rating agencies and securitizations • Established a new consumer protection bureau and provided for extensive consumer protection in financial services
4 Explain the use of three internal governance mechanisms to monitor and control managers’ decisions. .
OWNERSHIP CONCENTRATION Ownership concentration is defined both by the number of large-block owners and by the total percentage of the firm’s shares that they own. Large-block shareholders are investors who typically own at least five percent of the firm’s shares. Diffuse ownership (a large number of shareholders with small holdings and few/no large-block shareholders) • Produces weak monitoring of managerial decisions • Makes it difficult for owners to coordinate their actions effectively • May result in levels of diversification that are beyond the optimum level desired by shareholders (especially when this condition is combined with weak monitoring) The Increasing Influence of Institutional Owners In recent years, large-block ownership by individuals has declined, but they have been replaced by significant positions held by institutional owners. Institutional owners are large-block shareholder positions controlled by financial institutions, such as stock mutual funds and pension funds. The importance of institutional owners is indicated by the fact that these shareholders now control over 50 percent of the stock in large US corporations and approximately 56 percent of the stock of the 1,000 largest US corporations. These ownership percentages suggest that as investors, institutional owners have both the size and the incentive to discipline ineffective top-level managers and can significantly influence a firm’s choice of strategies and overall strategic decisions. Initially, these shareholder activists and institutional investors concentrated on the performance and accountability of CEOs and contributed to the ouster of a number of them. They are now targeting what they believe are ineffective boards of directors. The rising tide of shareholder pressure also is evidenced by actions taken by CalPERS. • CalPERS provides retirement and health coverage to over 1.3 million current and retired public employees. • CalPERS is generally thought to act aggressively to promote decisions and actions that it believes will enhance shareholder value in companies in which it invests. • Institutions’ activism may not have a direct effect on firm performance, but its influence may be indirect through its effects on important strategic decisions. Teaching Note Students should know about a few of the more common anti-takeover provisions. For example, a golden parachute is a type of managerial protection that pays a guaranteed salary for a specified period of time in the event of a takeover and the loss of one’s job. A golden goodbye provides automatic payments to top executives if their contracts are not renewed, regardless of the reason for nonrenewal. In the case of acquisitions, managers may receive this compensation even if they voluntarily decide to quit. Other defense strategies are described in greater detail in Table 10.2. BOARD OF DIRECTORS Even though institutional ownership has increased, the majority of firms still “enjoy” the benefits or advantages of diffuse ownership (i.e., limited monitoring of managers by individual shareholders). Furthermore, large financial institution shareholders—such as banks—are effectively prevented from having direct ownership of firms and are prohibited from placing a representative on the boards of directors. These conditions highlight the importance of boards of directors to corporate governance. Teaching Note: Legally, the board of directors has broad powers, including: • Directing the affairs of the organization • Punishing (disciplining) and rewarding (compensating) managers • Protecting the rights and interests of shareholders (owners) Boards are experiencing increasing pressure from shareholders, lawmakers, and regulators to become more forceful in their oversight role and thereby forestall inappropriate actions by top executives. The board of directors is a group of elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top-level executives. If the board of directors is appropriately structured and operates effectively, it can protect owners from managerial opportunism. Table Note Table 10.1 provides characteristics of three classifications of members of the board of directors: insiders, related outsiders, and outsiders. These will be useful for students as you discuss board effectiveness. TABLE 10.1 Classifications of Board of Director Members Insiders are represented by the firm’s CEO and other top-level managers. Related outsiders are individuals who are not involved in the firm’s day-to-day operations, but may have a relationship with the company. Examples might include the firm’s legal counsel, a large customer or supplier, or a close relative of one of the firm’s top-level managers. Outsiders are individuals who are independent of the firm. They are neither involved in the firm’s day-to-day operations, nor do they have other relationships with the firm. An example of an outsider might be the president of a university or a community volunteer. Because the primary role of the board of directors is to monitor and ratify major managerial actions to protect the interests of owners, there is a call by advocates of board reform that outsiders should represent a significant majority of a board’s membership. Teaching Note Outside directors (and boards) are perceived as ineffective because: • Insiders dominate the board by limiting the flow of information to outside directors. • Outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders. The drawbacks of outside boards: • Because outside directors do not have day-to-day contact with the ongoing operations of the firm, they must obtain detailed, in-depth information about the quality of management decisions. Generally, this information is obtained through frequent interactions, often developed over time, with inside directors (generally, at board meetings). • In the absence of rich information, boards may be forced to emphasize financial rather than strategic controls. Potentially, this means that outsider-dominated boards—because they lack sufficient information—will evaluate managers not on the basis of the appropriateness of their actions (which the board ratified) but based on the financial outcomes of those actions. Enhancing the Effectiveness of the Board of Directors Because of the board’s importance, the performance of individual board members as well as that of entire boards is being evaluated more formally and intensely. Many boards have voluntarily initiated changes, including: • Increasing the diversity of board members’ backgrounds • Strengthening internal management and accounting control systems • Establishing and consistently using formal processes to evaluate the board’s performance • Creating a “lead director” role that has strong powers with regard to the board agenda and oversight of non-management board member activities • Changing the director compensation, especially reducing or eliminating stock options as part of the package Teaching Note The following comments can be used to expand the class discussion of whether a more active board is a more effective board. The findings from research regarding the effectiveness of board involvement in the strategic decision-making process are mixed, indicating the following: • Board involvement in the strategic decision-making process may improve firm performance because it provides the firm’s managers with access to outside opinions, and outside directors should be more objective and interested in protecting owner interests. • Boards are more likely to be involved in strategic decisions when the firm is smaller and less diversified, since information regarding strategic actions is more readily available and both the scope and size of the firm are manageable. • Boards are less active in large, diversified firms. • The board’s access to sufficiently rich information on appropriateness of strategic actions in large diversified firms is limited. • Board may be limited to evaluating financial outcomes (instead of action appropriateness). Teaching Note McKinsey & Co. research found that institutional shareholders were willing to pay an 11 percent premium for the shares of companies when outsiders constitute a majority of the board, own significant amounts of stock, are not personally tied to top management, and when management is subjected to formal evaluation. Research shows that boards working collaboratively with management: • Make higher quality strategic decisions • Make decisions faster • Become more involved in the strategic decision-making process Because of the increased pressure from owners and the potential conflict among board members, procedures are necessary to help boards function effectively in facilitating the strategic decision-making process. Increasingly, outside directors are being required to own significant equity stakes as a prerequisite to holding a board seat. In fact, some research suggests that firms perform better if outside directors have such a stake. One activist concludes that boards need three foundational characteristics to be effective: director stock ownership, executive meetings to discuss important strategic issues, and a serious nominating committee that truly controls the nomination process to strongly influence the selection of new members.
5 Discuss the types of compensation executives receive and their effects on managerial decisions.
Executive Compensation As illustrated in the opening case and Strategic Focus, the compensation of top-level managers generates great interest and strongly held opinions. One reason for this widespread interest can be traced to a natural curiosity about extremes and excesses. But furthermore, CEO pay is an indirect but tangible way to assess governance processes in large corporations. Executive compensation is a governance mechanism that seeks to align managers’ and owners’ interests through salary, bonus, and long-term incentive compensation such as stock options. Sometimes the use of a long-term incentive plan prevents major stockholders (e.g., institutional investors) from pressing for changes in the composition of the board of directors, because they assume that long-term incentives ensure that top executives will act in shareholders’ best interests. Alternatively, stockholders largely assume that top-executive pay and the performance of a firm are more closely aligned when firms have boards that are dominated by outside members. Using executive compensation as a governance mechanism is more challenging in international firms. Evidence suggests that the interests of owners of multinational corporations may be served best when the firm’s foreign subsidiary compensation plans are customized to local conditions. Though unique compensation plans require additional monitoring and increase the firm’s agency costs, it is important to adjust pay levels to match those of the region of the world (e.g., higher in the US and lower in Asia). Teaching Note When DaimlerBenz acquired Chrysler, it highlighted the fact that top executives at Chrysler made much more than the executives at DaimlerBenz—but higher-paid Chrysler executives report to lower-paid Daimler bosses. This example is one that students seem to be able to grasp. Developing and implementing an effective incentive compensation program is quite challenging because: • Strategic decisions made by top managers are complex and non-routine. Due to difficulties in judging decision quality, compensation is often linked to more measurable outcomes such as financial performance. • Decisions made by top-level managers are likely to affect firm performance over an extended period of time. As a result, it is difficult to assess the effect of current decisions using current period performance. • Many variables (or outside factors) intervene between management behavior and firm performance (e.g., uncontrollable shifts in the environment). Although incentive compensation plans may increase the value of a firm in line with shareholder expectations, such plans are subject to managerial manipulation. Although long-term performance-based incentives may reduce temptations to under-invest in the short run, they increase executive exposure to risks associated with uncontrollable events—e.g., market shifts, industry decline. The Effectiveness of Executive Compensation The compensation received by top-level managers, especially by CEOs, is often a subject of controversy. Large CEO compensation packages result mostly from the inclusion of stock options and stock in the total pay packages. This is intended to entice executives to keep the stock price high, thus aligning manager and owner interests. Research has shown that managers owning more than one percent of the firm’s stock are less likely to be forced out of their jobs, even when the firm is performing poorly. Furthermore, a review of the research suggests that over time, firm size has accounted for more than 50 percent of the variance in total CEO pay, whereas firm performance has accounted for less than 5 percent of the variance. Teaching Note One way that boards have found to compensate executives is through giving them loans with favorable, or no, interest for the purpose of buying company stock. If done correctly, this can be a governance tool, since it aligns executives’ priorities with those of the shareholders because the executives hold stock, not just options on the stock. They gain or lose money along with the shareholders. It is important to consider that annual bonuses may provide incentives to pursue short-run objectives at the expense of the firm’s long-term interests. Although some stock-option-based compensation plans are well designed with option strike prices substantially higher than current stock prices, too many have been designed simply to give executives more wealth that will not immediately show up on the balance sheet. Research of stock option repricing where the strike price value of the option has been lowered from its original position suggests that action is taken more frequently in high-risk situations. However, it also happens when firm performance was poor to restore the incentive effect for the option. Often, organizational politics play a role in this. Repricing stock options does not appear to be a function of management entrenchment or ineffective governance. These firms often have had sudden and negative changes to their growth and profitability. They also frequently lose their top managers. Interestingly, institutional investors prefer compensation schemes that link pay with performance, including the use of stock options. Again, this evidence shows that no internal governance mechanism is perfect. Option awards became a means of providing large compensation packages, and the options awarded did not relate to the firm’s performance, particularly when boards showed a propensity to reprice options at a lower strike price when stock prices fell precipitously. Option awards are becoming increasingly controversial. Teaching Note Board directors also receive compensation. Some recent figures follow: • Median base compensation for directors in telecommunications was almost $90,000. • Directors at Microsystem Inc. received average compensation of about $410,000 a year, whereas directors at Compaq earned over $360,000 and directors at Pfizer received almost $260,000. • On average, directors at the largest 200 firms received about $134,000. • Similar to executives in the firm, there is a move by large institutional investors such as CalPERS to pay directors at least partially in stock (some estimating that some 50 percent of director pay will be in company stock). STRATEGIC FOCUS Do CEOs Deserve the Large Compensation Packages They Receive? This strategic focus describes the salaries and compensation packages that CEOs notoriously receive, with much media scrutiny. The CEO packages have grown exponentially throughout recent years, while the average worker’s compensation packages have a small increase in comparison. The average worker pay has grown 2.9 times over the last 30 years, bank executives pay has grown 15.4 times while non-bank executives pay has grown 17.4 times. Another point of contention is that CEO’s incentives seem to misaligned with the performance of the company. An example the text refers to is the increasing salary of David Zaslay, CEO of Discovery Communications. In 2014, Discovery’s stock fell 25 percent, while the CEO’s pay continued to increase. While, the company’s revenue and income increased, the shareholders’ best interests were not aligned with Zaslay’s goals, which did not please the public. The research into these seemingly common occurrences refer to the complexity of CEO compensation packages. Instead of an over-emphasis on stock options, top executives have been receiving compensation that is based on restricted stock ownership, which cannot be realized unless they meet significant performance targets over time. Each case must be examined closely for possible problems of excess. However, there is likely to be a large societal problem due to the perception that top management executive compensation relative to the average worker has added to inequality in our society. Teaching Note: Ask the students if they believe that a company’s performance should be directly related to the compensation of the CEO. Then dive deeper and ask which performance indicators dictate the company’s performance, with the goal that the students will realize that it is not a cut and dry issue. Then ask why restricted stock has become a trend, and how it may be causing a societal problem.
6 Describe how the external corporate governance mechanism—the market for corporate control—restrains top-level managers’ decisions.
MARKET FOR CORPORATE CONTROL The market for corporate control generally comes into use as an external governance mechanism only after internal governance mechanisms have failed. A Brief History of the Market for Corporate Control The market for corporate control has been active for some time. The 1980s were known as a time of merger mania, with around 55,000 acquisitions valued at approximately $1.3 trillion. However, there were many more acquisitions in the 1990s, and the value of mergers and acquisitions in that decade was more than $10 trillion. The major reduction in the stock market resulted in a significant drop in acquisition activity in the first part of the 21st century. However, the number of mergers and acquisitions began to increase in 2003, and the market for corporate control has become increasingly international with over 40 percent of the merger and acquisition activity involving two firms from different countries. Though some acquisition attempts are intended to obtain resources important to the acquiring firm, most of the hostile takeover attempts are due to the target firm’s poor performance. Therefore, target firm managers and members of the boards of directors are highly sensitive about hostile takeover bids. It often means that they have not done an effective job managing the company because of the performance level inviting the bid. If they accept the offer, they are likely to lose their jobs; the acquiring firm will insert its own management. If they reject the offer and fend off the takeover attempt, they must improve the performance of the firm or risk losing their jobs as well. The market for corporate control is an external governance mechanism that becomes active when a firm’s internal controls fail. It is composed of individuals and firms who buy ownership positions in (or take over) potentially undervalued firms. They do this in order to form a new division in an established diversified firm, merge two previously separate firms, and usually replace the target firm’s management team to revamp the strategy that caused low firm performance. The market for corporate control governance mechanism should be triggered by a firm’s poor performance relative to industry competitors. A firm’s poor performance, often demonstrated by the firm’s earning below-average returns, is an indicator that internal governance mechanisms have failed; that is, their use did not result in managerial decisions that maximized shareholder value. Managerial Defense Tactics Because of the threat of dismissal, managers have devised a number of defensive tactics designed to both ward off takeovers and buffer or protect managers from external governance mechanisms. These tactics include: • Managerial pay interventions, such as golden parachutes • Asset restructuring, such as divesting a business unit or division • Financial restructuring—e.g., stock repurchases, paying out a firm’s free cash flows as a dividend • Changing the state of incorporation • Making targeted shareholder repurchases (known as greenmail) TABLE 10.2 Hostile Takeover Defense Strategies This table presents a number of defense strategies and identifies them according to category (preventive, reactive), popularity (high, medium, low, very low), effectiveness (high, medium, low, very low), and stockholder wealth effects (positive, negative, inconclusive). The defense strategies mentioned are poison pill, corporate charter amendment, golden parachute, litigation, greenmail, standstill agreement, and capital structure change. Most institutional investors oppose the use of defense tactics. For example, TIAA-CREF and CalPERS have taken actions to have several firms’ poison pills eliminated. The market for corporate control also can be plagued by inefficiency. In the 1980s, roughly 50 percent of all takeovers targeted firms that were high performers. As a result, • Acquisition prices were excessive • Expensive defensive strategies were often implemented to protect the firm Despite its inefficiency, the threat of acquisition by corporate raiders can serve as an effective constraint on the managerial growth motive and result in strategies that are in the best interests of the firm’s owners. Teaching Note: As mentioned throughout the chapter, internal and external governance mechanisms, though they may restrain managerial actions, are imperfect means of controlling managerial opportunism. This means that some combination of both internal and external mechanisms is necessary.
7 Discuss the nature and use of corporate governance in international settings, especially in Germany, Japan, and China.
INTERNATIONAL CORPORATE GOVERNANCE Our discussion of internal and external governance mechanisms—and their effectiveness in controlling managerial behavior—has been centered on the US and the U.K. But this does not necessarily apply to the systems of corporate governance used elsewhere in the world, e.g., German and Japanese firms. Although the stability that has been associated with the German and Japanese systems has been perceived as a strength, it is possible, given the dynamic and uncertain nature of the new competitive landscape, that stability may be a potential source of weakness. Corporate Governance in Germany and Japan The owner-manager relationship in Germany differs from that described for the US. For example: • In many private German firms, the owner and manager are the same person. • In publicly traded firms, there often is a dominant shareholder. Banks historically have occupied a central position in German governance structure. • Banks became major shareholders when companies they financed either sought new capital in the stock market or defaulted on loans. • Banks generally hold less than 10 percent of a firm’s stock. • Bank ownership of a single firm’s stock is limited to 15 percent of the bank’s capital. • Three large banks—Deutsche, Dresdner, and Commerzbank—hold majority positions in large German firms through their own holdings and proxy votes for shareholders who retain shares with the banks. • German firms with more than 2,000 employees must have a two-tiered board structure, with supervision of management being separated from other board duties and all of the functions of direction and management being placed in the hands of the Vorstand or management board. • Appointment to the management board is the responsibility of the Aufsichtsrat or supervisory board. Despite the ability of major owners and banks to monitor and control the managers of large German firms, maximizing shareholder value has not been a historical focus. However, this is changing. Teaching Note A shift is taking place in German firms’ historic lack of focus on maximizing shareholder value. For example, SGL Carbon AG lost more than $71 million in the early 1990s and was later restructured to turn the corporation around. In particular, the firm’s governance structure was changed, transparent accounting practices were adopted, and the firm set a goal of enhancing shareholder value. The firm’s performance has since improved, and many attribute this to the new governance structure. Corporate governance in Japan is affected by the concepts of obligation, family, and consensus. In Japan, obligation goes beyond principles but is more a product of specific causes, events, and relationships. It can mean returning a service for one that has been rendered. The concept of family goes beyond the American concept to include the firm—individuals see themselves as members of a company family. And the family concept is extended to include members of the firm’s keiretsu, a group of firms that are tied together by cross-shareholdings, interrelationships, and interdependencies. Consensus represents one of the most important influences on governance structure in Japan. This requires that managers—among others—expend significant amounts of energy to win the hearts and minds of people rather than proceed by the edicts of top-level managers. As in Germany, banks also play an important role in financing and monitoring large public firms in Japan. • The bank owning the largest share of stocks and the largest amount of debt—the main bank—has the closest relationship with the company’s top executives. • Banks occupy an important position in the governance system, both financing and monitoring firms. • The main bank—the bank holding the largest share of a firm’s debt—provides financial advice and assumes primary responsibility for monitoring the firm’s management. • Japanese banks can hold up to five percent of a firm’s stock. • Groups of banks can hold up to 40 percent of a firm’s stock. • In many cases, bank relations are an integral part of the Japanese firm’s keiretsu (an industrial group of firms that interact with the same bank). Teaching Note Keiretsus are both diversified and vertically integrated to the extent that they generally include one or more firms in almost all-important industrial sectors. As in Germany, Japan’s corporate governance structure is changing. For example, the role of banks in the monitoring and control of managerial behavior and firm outcomes has become less significant. STRATEGIC FOCUS “Engagement” vs. “Activist” Shareholders in Japan, Germany and China Activism is spreading around the globe, including in Japan, Germany, and China. There has been an organic rise of activism because of activist funds, where outside parties will have an influence on how the funds will be used. Also, the shareholders are now open to outside perspectives as portfolio of businesses are becoming more and more international. China has been a hot target for its activist funds because Hong Kong companies have been loosening rules for foreign ownership. Shareholder activism has been spreading globally throughout the world, and there are owners in emerging economies participating in the market for corporate control and in restructuring investments, especially sovereign wealth funds that also have influence in developed as well as developing countries based on their large ownership positions. Teaching Note Ask the students which of the activist shareholder trends are going to help the world’s economy. What effect will these activists have on the scope of globalization throughout the world? What would happen if these activists never targeted the emerging and already prosperous economies? Corporate Governance in China Corporate governance in China has undergone major changes over the past decade, along with the privatization of business and the development and integrity of the equity market. Though these changes are significant, the state still dominates the strategies that most firms employ. Research indicates that firms with higher state ownership have lower market value and more volatility than those with less. This is due to the fact because the state imposes social goals on these firms and executives are not trying to maximize shareholder wealth. Overall, the Chinese system of corporate governance has been moving toward a Western-style model. Chinese executives are also being compensated based on the firm’s financial performance. Teaching Note Examples of differences and changes in international governance follow: • In France, anger has been growing over the lack of information on top executive compensation. A recent report recommended that the positions of CEO and chairman of the board be held by two different individuals. It also recommended reducing the tenure of board members and disclosing their pay. • In South Korea, principles of corporate governance are being adopted to provide proper board and management incentives to pursue the interests of both the company and the shareholders and to facilitate effective monitoring. • Changes in corporate governance are occurring even in transitional economies, such as China and Russia, though implemented more gradually. The use of stock-based compensation plans has influenced foreign companies to invest (particularly in China).
8 Describe how corporate governance fosters ethical decisions by a firm’s top-level managers.
GOVERNANCE MECHANISMS AND ETHICAL BEHAVIOR Governance mechanisms discussed in this chapter focus on ensuring that managers work effectively toward meeting their obligation to maximize shareholder wealth. However, shareholders are only one group of the firm’s stakeholders (as discussed in Chapter 1). Over the long term, the demands of other key stakeholders—such as employees, customers, suppliers, and the community—also must be satisfied in order to maximize shareholder wealth. For that reason and others, governance mechanisms must be carefully designed and implemented so that managers’ attention is not focused on maximizing short-term returns and to ensure that they consider the interests of all stakeholders. Teaching Note John Smales (outside director of the board at GM) has commented that the most fundamental obligation of management is to perpetuate the organization, taking priority even over stockholder interests. His comments may provide a good opportunity to engage students in a discussion about the purpose of the firm and its obligations to all stakeholders. Chapter 11 Organizational Structure and Controls LEARNING OBJECTIVES 1. Define organizational structure and controls and discuss the difference between strategic and financial controls. 2. Describe the relationship between strategy and structure. 3. Discuss the different functional structures used to implement business-level strategies. 4. Explain the use of three versions of the multidivisional (M-form) structure to implement different diversification strategies. 5. Discuss the organizational structures used to implement three international strategies. 6. Define strategic networks and discuss how strategic center firms implement such networks at the business, corporate and international levels. CHAPTER OUTLINE Opening Case: Luxottica’s Dual CEO Structure: A Key to Long-term Success or a Cause for Concern? ORGANIZATIONAL STRUCTURE AND CONTROLS Organizational Structure Strategic Focus: Changing McDonald’s Organizational Structure: A Path to Improved Performance? Organizational Controls RELATIONSHIPS BETWEEN STRATEGY AND STRUCTURE EVOLUTIONARY PATTERNS OF STRATEGY AND ORGANIZATIONAL STRUCTURE Simple Structure Functional Structure Multidivisional Structure Matches between Business-Level Strategies and the Functional Structure Matches between Corporate-Level Strategies and the Multidivisional Structure Strategic Focus: Sony Corp.’s New Organizational Structure: Greater Financial Accountability and Focused Allocations of Resources Matches between International Strategies and Worldwide Structure Matches between Cooperative Strategies and Network Structures IMPLEMENTING BUSINESS-LEVEL COOPERATIVE STRATEGIES IMPLEMENTING CORPORATE-LEVEL COOPERATIVE STRATEGIES IMPLEMENTING INTERNATIONAL COOPERATIVE STRATEGIES SUMMARY KEY TERMS REVIEW QUESTIONS MINI-CASE Unilever Cooperates with Many Firms and Nonprofit Organizations to Implement Its Strategy While Creating a More Sustainable Environment ADDITIONAL QUESTIONS AND EXERCISES MINDTAP RESOURCES LECTURE NOTES Chapter Introduction: As students will recall, the discussion in Chapter 10 described how governance mechanisms are used to align the interests of a firm’s top-level managers with those of the firm’s owners. It also described how those mechanisms influence the firm’s ability to execute strategies that have been implemented successfully as the firm strives to achieve a competitive advantage in the new competitive landscape. The same could be said of organizational structure, the focus of the current chapter. OPENING CASE LUXOTTICA’S DUAL CEO STRUCTURE: A KEY TO LONG-TERM SUCCESS OR A CAUSE FOR CONCERN? Luxottica, the world leader in eyewear, has recently changed its organizational structure significantly by appointing co-CEOs. Long-term Procter & Gamble executive Adil Mehboob-Khan accepted the responsibility for distribution in the firm’s markets while long-time Luxottica manager Massimo Vian was appointed as co-CEO with the responsibility for products and operations. As you would assume, a dual CEO structure is very unusual, and critics believe that this structure cannot be successful. Critics also say that “The adoption of a co-CEO model is often a symptom of weakness. Having two people at the same level shows that the company is undecided about its leadership and it invites too much confusion.” Luxottica officials claim that the dual CEO structure is for a strong strategic rational. Officials say that there is a new phase of development that will take advantage of opportunities in a competitive global market of growing complexity. Whatever the reason, Luxottica’s board must carefully monitor the firm’s performance of the company and actions of the co-CEOs and be prepared to make a change if evidence shows that the new structure isn’t in the company’s best interest. Teaching Note Ask the students to brainstorm about Luxottica’s current situation. Can a company have two CEO’s and be successful? What will need to happen in order for the co-CEOs to effectively run Luxottica. What can go wrong with this structure? If you had to run a business, would you choose this structure?
1 Define organizational structure and controls and discuss the difference between strategic and financial controls.
The match or degree of fit between strategy and structure influences the firm’s attempts to earn above-average returns. Thus, the ability to select an appropriate strategy and match it with the appropriate structure is an important characteristic of effective strategic leadership. The focus of this chapter is on the structure- and control-related issues of strategy implementation, including: • The pattern of growth and changes in organizational structure experienced by strategically competitive firms • The organizational structures and controls used to implement separate business-level, corporate-level, international, and cooperative strategies • A series of figures to highlight the structures firms match with different strategies ORGANIZATIONAL STRUCTURE AND CONTROLS When the firm’s strategy isn’t matched with the most appropriate structure and controls performance declines. Teaching Note Selecting the organizational structure and controls that result in effective implementation of chosen strategies is a fundamental challenge for managers, especially top-level managers. The reasons for this are: • Firms must be flexible, innovative, and creative in the global economy if they are to exploit their core competencies in the pursuit of marketplace opportunities. • Firms must also maintain a certain degree of stability in their structures so that day-to-day tasks can be completed efficiently. STRATEGIC FOCUS Changing McDonald’s Organizational Structure: A Path to Improved Performance? For its size and prominence around the world, many would believe that McDonalds is doing very well. But, according to the new CEO, Steve Easterbrook, McDonalds may be in trouble. 2014 was one of the worst performances in the company’s 60-year history. The change will be aligned with the strategy for McDonalds to become a “progressive burger company.” The focus is to change the speed and efficiency of its structure, which was based on geographic segments with many layers to the hierarchy. A McDonald’s leader said the following: “You’ve told us that there are too many layers, redundancies in planning and communication, competing priorities, barriers to efficient decision making, and too much talking to ourselves instead of to and about our customers.” Easterbrook has made changes to McDonalds and has stripped away the bureaucracy so the company can anticipate trends as a foundation for moving nimbly to fully understand and appropriately respond to customer’s interest. This was done by dividing McDonalds into four market segments; United States, International lead markets, High-growth markets, and foundational markets. Corporate officials are optimistic that this will increase revenues and profitability with the increased focus on the common needs of each market segment. Teaching Note Have a conversation with the students about how difficult a change like this could be for a company that is massive. Use concepts from this chapter to determine what may have hindered the implementation of these changes. Talk about the risk that is being taken for implementing these changes and what needed to be done before executing the new structure. Organizational Structure Organizational structure specifies the firm’s formal reporting relationships, procedures, controls, and authority and decision-making processes. Developing an organizational structure that effectively supports the firm’s strategy is difficult, especially because of the uncertainty (or unpredictable variation) in cause-effect relationships in the global economy’s rapidly changing, dynamic competitive environments. Structure facilitates effective implementation of a firm’s strategies when elements of that structure (e.g., reporting relationships, procedures, and so forth) are properly aligned with one another. Thus, organizational structure is a critical component of effective strategy implementation processes. Structure specifies the work to be done and how to do it (given the firm’s strategy or strategies) by specifying the processes to be used to complete organizational tasks. Effective structures provide the stability the firm needs to rely on its current competitive advantages to successfully implement today’s strategies while providing the flexibility required to develop competitive advantages that will be needed to use for future strategies; thus, an effective organizational structure allows the firm to exploit current competitive advantages while developing new ones. Modifications to the firm’s current strategy or selection of a new strategy call for changes to organizational structure. This is not uncommon since organizational inertia often inhibits structural changes, even if performance declines. Because of inertial tendencies, structural change is often induced by the actions of stakeholders who are no longer willing to tolerate the firm’s inadequate performance. Organizational Controls Organizational controls guide the use of strategy, indicate how to compare actual results with expected results, and suggest corrective actions to take when the difference between actual and expected results is unacceptable. Properly designed organizational controls—strategic and financial—provide insights into behaviors that enhance firm performance. Strategic controls are largely subjective criteria intended to verify that the firm is using strategies that are appropriate given the conditions in the external environment and the company’s competitive advantages. Thus, strategic controls are concerned with examining the fit between what the firm might do (external environment) and what it can do (its competitive advantages). Effective strategic controls help the firm understand what it takes to be successful. Strategic controls demand rich communication between managers and those implementing the firm’s strategy. These frequent exchanges are both formal and informal in nature. Strategic controls help evaluate how well a firm is focusing on what it takes to implement its strategies. • For a business-level strategy, the concern is to study primary and support activities (see Tables 3.6 and 3.7) to verify that those that are critical to successful execution of the chosen strategy are being properly emphasized and executed. • With related corporate-level strategies, strategic controls are used to verify that intended levels of sharing of relevant strategic factors—such as knowledge, markets, technologies, and so forth—are taking place. When evaluating related diversification strategies, executives must have a deep understanding of each unit’s business-level strategy. Extensive diversification often requires that financial controls be emphasized. Teaching Note The use of strategic controls, which are behavioral in nature, requires high levels of cognitive diversity among the firm’s top-level managers. Cognitive diversity is a term that captures differences among top-level executives regarding their beliefs about cause-and-effect relationships and outcome-related preferences. Financial controls are largely objective criteria used to measure the firm’s performance against previously established quantitative standards, including accounting-based (e.g., return on investment, return on assets) and market-based (e.g., Economic Value Added) measures. Both strategic and financial controls are important aspects of each organizational structure; thus, any structure’s effectiveness is determined by using a combination of strategic and financial controls.
2 Describe the relationship between strategy and structure.
RELATIONSHIPS BETWEEN STRATEGY AND STRUCTURE Strategy and structure have a reciprocal relationship, highlighting the interconnectedness between strategy formulation (Chapters 4–9) and strategy implementation (Chapters 10–13). In general, structure follows the selection of the firm’s strategy. However, once in place, structure has the potential to influence current strategic actions as well as choices about future strategies. Regardless of the strength of the relationships between strategy and structure, those choosing the firm’s strategy and structure should be committed to matching each strategy with a structure that provides the stability needed to use current competitive advantages as well as the flexibility required to develop future advantages. Teaching Note Using the four criteria of sustainability, the firm’s strategy/ structure match is an advantage when that match is valuable, rare, imperfectly imitable, and nonsubstitutable. EVOLUTIONARY PATTERNS OF STRATEGY AND ORGANIZATIONAL STRUCTURE Chandler found that firms tended to grow in somewhat predictable patterns: volume geography integration (vertical, horizontal) product/business diversification. Figure Note: Figure 11.1 graphically illustrates the evolution of structure as the organization grows. This evolution is explained in subsequent sections of this chapter. At this point, students should begin to be aware of the necessity of fit. Just as a firm’s strategy must fit with its resources, capabilities, and core competencies, so its strategy must fit with its structure if it hopes to achieve strategic competitiveness. FIGURE 11.1 Strategy and Structure Growth Pattern As indicated by Figure 11.1, firm structure evolves from simple to functional to multidivisional. This evolution is caused by sales growth and/or coordination and control problems that prevent the firm from efficiently implementing its formulated strategy. Thus, as implementation efforts falter due to growth or other problems, the firm may need to change its organizational structure to achieve an appropriate fit between strategy and structure. Simple Structure A simple structure is an organizational form in which the owner-manager makes all major decisions directly and monitors all activities, and the firm’s staff is merely an extension of the manager’s supervision authority. The simple structure is characterized by: • Little specialization of tasks • Few rules • Little formalization • Unsophisticated information systems • Direct involvement of owner-manager in all phases of day-to-day operations • Frequent and informal communications between the owner-manager and employees Teaching Note In the U.K., some analysts believe that the simple organizational structure may result in competitive advantages for some small firms relative to their larger counterparts. These competitive advantages include a broad openness to innovation, greater structural flexibility, and an ability to respond more rapidly to environmental changes. If they are successful, small firms grow larger; and as a result, the firm outgrows the simple structure. • There is a significant increase in the amount of competitively relevant information that requires analysis. • More extensive and complicated information-processing requirements place significant pressures on owner-managers (often due to a lack of organizational skills or experience). At this evolutionary point, firms tend to move from the simple structure to a functional organizational structure. Functional Structure The functional structure consists of a chief executive officer and limited corporate staff with functional line managers in dominant functions: production, accounting, marketing, R&D, engineering, human resources. This structure allows for functional specialization, facilitating active knowledge sharing within each functional area. Knowledge sharing usually supports career paths and professional development of functional specialists. However, compared to the simple structure, there also are some potential problems. For example, differences in functional specialization and orientation may impede communication and coordination. Teaching Note Functional specialists often may develop a myopic or narrow perspective, losing sight of the firm’s strategic vision and mission. When this happens, the problem can be overcome by implementing the multidivisional structure. The functional structure supports implementation of business-level strategies and corporate-level strategies with low levels of diversification (e.g., dominant business). Multidivisional Structure Because of limits to an individual CEO’s ability to process complex strategic information, problems related to isolation of functional area managers, and increasing diversification, the structure of the firm must change again. In these instances, the multidivisional or M-form structure is most appropriate. The multidivisional (M-form) structure is composed of operating divisions where each division represents a separate business to which the top corporate officer delegates responsibility for day-to-day operations and business unit strategy to division managers. As initially designed, the M-form was thought to have three major benefits. 1. It allowed corporate officers to accurately monitor business unit performance, simplifying control problems. 2. It facilitated comparisons between divisions, which improved the resource allocation process. 3. It stimulated managers of poorly performing divisions to look for ways to improve performance. Teaching Note: An expanded discussion of M-form may be helpful at this point. Some facts related to use of the multidivisional structure at DuPont and GM follow. • The multidivisional or M-form structure was developed in the 1920s, in response to coordination and control problems in large firms such as DuPont and GM. • Functional departments often had difficulty dealing with distinct product lines and markets, especially in coordinating conflicting priorities among the products. • Costs were not allocated to individual products, so it was not possible to assess an individual product’s profit contribution. • Loss of control meant optimal allocation of firm resources between products was difficult. • Top managers got over-involved in short-run matters (e.g., coordination, communications, and conflict resolution) and neglected long-term strategic issues. The new, innovative structure adopted at General Motors called for • Creating separate divisions, each representing a distinct business • Each division would house its functional hierarchy • Division managers were given responsibility for managing day-to-day operations • A small corporate office would determine the long-term strategic direction of the firm and exercise overall financial control over the semi-autonomous divisions This would enable the firm to • Accurately monitor performance of each business, simplifying control problems • Facilitate comparisons between divisions, improving the allocation of resources • Stimulate managers of poorly performing divisions to seek ways to improve
3 Discuss the functional structures used to implement business-level strategies.
Matches between Business-Level Strategies and the Functional Structure Different forms of the functional organizational structure are used to support implementation of the cost leadership, differentiation, and integrated cost leadership/differentiation strategies. The differences in these forms are accounted for primarily by different uses of three important structural characteristics or dimensions—specialization (the type and number of jobs required to complete work), centralization (the degree to which decision-making authority is retained at higher managerial levels), and formalization (the degree to which formal rules and procedures govern work). Using the Functional Structure to Implement the Cost Leadership Strategy Firms using the cost leadership strategy want to sell large quantities of standardized products to an industry’s or a segment’s typical customer. The cost leadership form of the functional structure usually features: • Simple reporting relationships • Few layers in the decision-making and authority structure • A centralized corporate staff • A strong focus on process improvements through the manufacturing function rather than the development of new products through an emphasis on product R&D Teaching Note Because of firm restructuring during the late 1980s and early 1990s—and the reduction in the number of management layers—firms now have flatter structures. “Higher” in the organizational structure has thus become a relative term. Cost leadership strategies emphasize: • Centralization of decision-making to maintain cost reduction • Jobs that are specialized to increase efficiency • Formalization of rules and procedures to converge on the most efficient approaches Figure Note Figure 11.2 summarizes the functional structural characteristics required for successful implementation of the cost leadership strategy. FIGURE 11.2 Functional Structure for Implementing a Cost Leadership Strategy Key points include the following: • Dotted lines from the centralized staff to each function represent tight controls and centralized coordination. • The focus is on the operations (production) function. • Emphasis is placed on process engineering not on new product research and development. • Relatively large central staff coordinates functions. • Job roles are highly structured. • The overall structure is mechanical. • The structure may be either relatively tall or flat (depending on the extent of firm restructuring). Teaching Note Southwest Airlines has successfully implemented the cost leadership strategy, encouraging the emergence of a low-cost culture by (1) using specialized work tasks and (2) striving continuously to reduce costs below those of competitors. Using the Functional Structure to Implement the Differentiation Strategy Firms offering products that are considered unique by customers usually are following a differentiation strategy. A differentiation strategy requires: • The firm to sell nonstandardized products to customers with unique needs • Relatively complex and flexible reporting relationships • Frequent use of cross-functional product development teams • A strong focus on marketing and product R&D rather than manufacturing and process R&D • Continuous product innovation, requiring people be able to interpret and take action based on ambiguous, incomplete, and uncertain information • A strong focus on the external environment to identify new opportunities • Rapid responses to collected information suggesting a need for decentralization • Creativity and the continuous pursuit of new sources of differentiation and new products requiring a lack of specialization (i.e., workers have a relatively large number of tasks in their job descriptions) • Low formalization, decentralization, and low specialization of work tasks allowing people to interact frequently to further differentiate products while developing ideas for new products Figure Note Figure 11.3 summarizes the discussion of the relationships between the differentiation strategy and the functional structure. FIGURE 11.3 Functional Structure for Implementing a Differentiation Strategy A first glance, Figure 11.3 appears to be very similar to Figure 11.2 (Functional Structure for Implementing a Cost Leadership Strategy). However, there are several subtle but important differences. • The centralized corporate staff (between the president and the individual functions) has been replaced by the central staffs of R&D and marketing, which work closely together. • Dotted lines between the centralized staff and individual functions have been removed, indicating a decentralization of decision making. Formalization is limited to enable emergence of new product ideas and enhanced ability to change. • Marketing is the main function for keeping track of new product ideas. • Job roles are less structured. • The structure is organic. Using the Functional Structure to Implement the Integrated Cost Leadership/Differentiation Strategy As discussed in Chapter 4, some firms may attempt to implement simultaneously both the cost leadership and differentiation strategies by providing value through • Low cost relative to a differentiated firm’s products • Differentiated features relative to features offered by cost leadership firms’ products The integrated cost leadership/differentiation strategy is used frequently in the global economy, though it is difficult to implement. This difficulty is due largely to the fact that different primary and support activities (see Chapter 3) must be emphasized. • Low-cost strategies emphasize production and manufacturing process engineering and few product changes. • Differentiation strategies require an emphasis on marketing and new product R&D. Teaching Note: Toyota Motor Corporation has become a world leader in the auto industry primarily through its ability to implement cost leadership and differentiation at the same time. The key to Toyota’s success has been the differentiated design and manufacturing process that the company has implemented through its integrated product design process.
4 Explain the use of three versions of the multidivisional (M-form) structure to implement different diversification strategies.
Matches between Corporate-Level Strategies and the Multidivisional Structure The firm’s level of diversification is a function of decisions about the number and type of businesses in which it will compete, as well as how it will manage the businesses (see Chapter 6). Geared to managing individual organizational functions, increasing diversification eventually creates information processing, coordination, and control problems that the functional structure can’t handle. This requires a shift from a functional structure to a complex multidivisional structure. The demands created by different levels of diversification require that each strategy be implemented through a unique organizational structure. Teaching Note From 1950 to the late 1980s, among Fortune 500 firms, diversification and implementation of the multidivisional structure increased dramatically. • The percentage of diversified firms increased from 30% to approximately 75%. • The multidivisional structure increased from less than 20% to approximately 90%. Figure Note Figure 11.4 should be used to indicate to students that there are three variations (or versions) of the multidivisional structure. FIGURE 11.4 Three Variations of the Multidivisional Structure The three variations of the multidivisional structure that will be discussed from the perspective of how each is best suited to specific diversification strategies are the: • Cooperative form • Strategic Business Unit (SBU) form • Competitive form Teaching Note It is important to reiterate that the functional structure is not as well suited to managing and controlling multiple businesses as is the multidivisional structure or M-form. Using the Cooperative Form of the Multidivisional Structure to Implement the Related Constrained Strategy The cooperative form structure uses horizontal integration to bring about interdivisional cooperation. The divisions in the firm using the related-constrained diversification strategy commonly are formed around products, markets, or both. Figure Note Figure 11.5 summarizes the structural characteristics of the Cooperative M-form that create and encourage cooperation. FIGURE 11.5 Cooperative Form of the Multidivisional Structure for Implementing a Related Constrained Strategy The first variant of the M-form structure—the Cooperative M-form—is characterized by an increased emphasis on integration devices and horizontal human resource practices. The large box at the top of Figure 11.5 illustrates what is referred to as the central, corporate, or headquarters office. It includes the firm’s top-level executives and all staff specialty functions. All divisions are controlled by the central office and integrated by one of the integrating mechanisms (such as division managers meeting face-to-face, integrating teams, or task forces). Integrating mechanisms are indicated by the dotted line connecting the divisions, which create: • Tight linkages between divisions • Corporate office emphasizing centralized planning, human resources, and marketing to facilitate cooperation • Centralized R&D to coordinate new product introductions and/or process engineering improvements • A subjective reward system emphasizing corporate and division performance • A cooperative, sharing culture All of the related-constrained firm’s divisions share one or more corporate strengths. Production competencies, marketing competencies, or channel dominance are examples of strengths that the firm’s divisions might share. • Production expertise is one of the strengths of Sony’s divisions, but they have had difficulties coordinating across divisions to create joint products in online music. • Outback Steakhouse, Inc. has sought to diversify across eight different chains using a cooperative M-form structure to centralize a number of critical functions across the businesses for activities sharing, and to share its expertise in running franchise operations across contracting, advertising, training, and more. The sharing of divisional competencies facilitates the corporation’s efforts to develop economies of scope (cost savings resulting from the sharing of competencies developed in one division with another division) that are linked with successful use of the related constrained strategy. Interdivisional sharing of competencies depends on cooperation, suggesting the use of the cooperative form of the multidivisional structure. Increasingly, it is important that the links resulting from effective use of integration mechanisms support the cooperative sharing of both intangible resources (e.g., knowledge) as well as tangible resources (e.g., facilities and equipment). The following are different characteristics of structure that are used as integrating mechanisms by the cooperative structure to facilitate interdivisional cooperation: • Centralization—control at the corporate level allows the linking of activities among divisions. • Frequent, direct contact between division managers—encourages and supports cooperation and the sharing of competencies or resources that can be used to create new advantages. These mechanisms include liaison roles, temporary teams/task forces, formal integration departments, and a matrix organization configuration. • Coordination among divisions sometimes results in an unequal flow of positive outcomes to divisional managers. In other words, when managerial rewards are based at least in part on the performance of individual divisions, the manager of the division that is able to benefit the most by the sharing of corporate competencies might be viewed as receiving relative gains at others’ expense. Strategic controls are important in these instances, as divisional managers’ performance can be evaluated at least partly on the basis of how well they have facilitated interdivisional cooperative efforts. Furthermore, using reward systems that emphasize overall company performance, besides outcomes achieved by individual divisions, helps overcome problems associated with the cooperative form. Using the Strategic Business Unit Form of the Multidivisional Structure to Implement the Related Linked Strategy The strategic business unit (SBU) structure is most appropriate for the related linked (mixed related and unrelated) strategy. A strategic business unit (SBU) structure consists of at least three levels, with a corporate headquarters at the top, SBU groups at the second level, and divisions grouped by relatedness within each SBU at the third level. This means that: • Within each SBU, divisions are related to each other • SBU groups are unrelated to each other • Within each SBU, divisions producing similar products and/or using similar technologies can be organized to achieve synergy • Individual SBUs are treated as profit centers and controlled by corporate headquarters • Corporate headquarters can concentrate on strategic planning rather than operational control Figure Note Figure 11.6 summarizes structural characteristics of the SBU multidivisional structure and leads to a discussion of this structural form’s potential pitfalls or disadvantages. FIGURE 11.6 SBU Form of the Multidivisional Structure for Implementing a Related Linked Strategy Although the SBU M-form appears similar to the Cooperative M-form (Figure 11.5), there are several differences. • The SBU M-form includes an additional layer—the strategic business unit or SBU—between the corporate headquarters and product divisions. • There may be integration and coordination between divisions in a specific SBU. • There is independence among and between SBUs. • Headquarters manages approval of strategic planning of SBUs for the president. • Individual SBUs may have budgets and staffs for within-SBU integrating mechanisms. • Corporate headquarters staff serves as consultants to SBUs and divisions on product strategy (rather than having direct input). STRATEGIC FOCUS Sony Corp.’s New Organizational Structure: Greater Financial Accountability and Focused Allocations of Resources Sony has been known for their innovation and being “first to market” since the 1960s. A perfect example is the Sony Walkman, which changed the way people listened to music in 1979. Sony then realized the value that could be gained by sharing resources, capabilities, and core competencies across types of businesses such as film, music, and digital electronics. But, this related constrained strategy has caused issues. An inability to efficiently process information and coordinate an array of integrated activities between units are problems that plagued Sony. In response, Sony’s CEO recently accounted significant changes to the company’s organizational structure. Put into place in October 2015, these structural changes are thought to be the foundation for improvements to Sony’s ability to create value for customers and enhance wealth for shareholders. Sony is now structured into three core sectors or business units—growth drivers, stable profit generators, and volatility management, a SBU form of the multidivisional structure. For all three units, return on equity (ROE) is the performance criterion being used to judge the success of each business that is included in one of the units. Each business is expected to achieve an annual ROE of 10 percent. Teaching Note This is a perfect example of a strong CEO enacting changes to help the firm perform. Without the alignment of strategy and structure, the changes would have not been successful. Ask the class to think about why the three business unit structure could be successful, and what the CEO should be thinking about to play to Sony’s core competencies of innovation. Using the Competitive Form of the Multidivisional Structure to Implement the Unrelated Diversification Strategy Recalling the discussion in Chapter 6, firms following an unrelated diversification strategy can create value by: • Efficient internal capital allocations • Restructuring, buying, and selling businesses Unrelated diversified firms should adopt the third variant of the multidivisional structure, the competitive form of the multidivisional structure, where controls emphasize competition between separate (usually unrelated) divisions for corporate capital allocations. Figure Note Figure 11.7 summarizes structural characteristics of the Competitive M-form. FIGURE 11.7 Competitive Form of the Multidivisional Structure for Implementing an Unrelated Strategy The Competitive M-form differs from both the Cooperative and SBU M-forms (see Figures 11.5 and 11.6) by: • Establishing a smaller headquarters office, generally containing three functions: 1. Legal affairs, which increases in importance when a firm acquires or divests units 2. Auditing, which monitors divisional performance to ensure performance data are accurately reported 3. Finance, which manages the firm’s cash flow and allocates capital • Allowing independent divisions so financial performance can be monitored separately for each • Setting up divisions that retain strategic control, but give up cash flow control • Allowing competition between divisions for capital allocations The efficient internal capital market that is the foundation for use of the unrelated diversification strategy requires organizational arrangements that emphasize divisional competition rather than cooperation, and three benefits are expected from this internal competition: 1. Internal competition creates flexibility, allowing resources to be allocated to the division that is working with the most promising technology to fuel the entire firm’s success. 2. Internal competition challenges the status quo and inertia, because division heads know that future resource allocations are a product of excellent current performance as well as superior positioning of their division in terms of future performance. 3. Internal competition motivates effort. Teaching Note Textron Inc., is a large “multi-industry” company that seeks to identify, research, select, acquire, and integrate companies, and has developed a set of rigorous criteria to guide decision making. Features of the firm that match this structural selection include the following: • Textron continuously looks to enhance and reshape its portfolio by divesting non-core assets and acquiring branded businesses in attractive industries with substantial long-term growth potential. • Textron operates four independent businesses— Bell Helicopter (31 percent of revenue), Cessna Aircraft (24 percent), Textron Systems (19 percent), Finance (2 percent), and Industrial (24 percent). • The firm uses return on invested capital (ROIC) as a way to evaluate the contribution of its diversified set of businesses as they compete internally for resources. • To emphasize competitiveness among divisions, the headquarters office maintains an arm’s-length relationship with them, intervening in divisional affairs only to audit operations and discipline managers whose divisions perform poorly. • In emphasizing competition between divisions, the headquarters office relies on strategic controls to set rate-of-return targets and financial controls to monitor divisional performance relative to those targets. The headquarters office then allocates cash flow on a competitive basis rather than automatically returning cash to the division that produced it. • The focus of the headquarters’ work is on performance appraisal, resource allocation, and long-range planning to verify that the firm’s portfolio of businesses will lead to financial success. Table Note Table 11.1 compares the structural attributes of the three variants of the multidivisional structure from the perspectives of centralization, integrating mechanisms, divisional performance appraisal criteria, and bases of incentive compensation. TABLE 11.1 Characteristics of the Structures Necessary to Implement the Related Constrained, Related Linked, and Unrelated Diversification Strategies Table 11.1 provides a handy reference that can be used to compare the structural attributes of the Cooperative, SBU, and Competitive M-form structures based on the • Degree that operations are centralized or decentralized • Extent to which each form uses integrating mechanisms • Emphasis on subjective or objective criteria for appraising divisional performance • Linkages to corporate, SBU, and/or divisional performance as bases for divisional incentive compensation
5 Discuss the organizational structures used to implement three international strategies.
Matches between International Strategies and Worldwide Structures Forming proper matches between international strategies and organizational structures intended to support their use facilitates the firm’s efforts to effectively coordinate and control its global operations. Importantly, recent research findings confirm the validity of the strategy/structure matches discussed. Using the Worldwide Geographic Area Structure to Implement the Multidomestic Strategy Although centralization of decision-making authority has been recognized as a means of achieving coordination (and control) in organizations, some strategies require that local business units (or divisions) have the flexibility that will enable them to adapt to local market preferences. This may mean that a decentralized structure is needed to provide this flexibility. The multidomestic strategy is a strategy in which strategic and operating decisions are decentralized to business units in each country to facilitate tailoring of products to each country. The structure used to implement the multidomestic strategy is the worldwide geographic area structure, an organizational form in which national interests dominate and that facilitates managers’ efforts to satisfy local or cultural differences. Figure Note Characteristics of the worldwide geographic area structure (presented in Figure 11.8) illustrate the decentralized nature of the structure. FIGURE 11.8 Worldwide Geographic Area Structure for Implementing a Multidomestic Strategy The worldwide geographic area structure is characterized by: • An emphasis on differentiation or adaptation to local market preferences or cultural requirements • Individual national market operations as decentralized and independent • Corporate headquarters coordinating movement of financial resources • Organization representing a decentralized federation The multidomestic strategy requires a decentralized structure. • National or country-specific preferences require local adaptation for success. • Little coordination is required because of local market differences. • There is no need for integrating mechanisms among divisions. • The level of formalization is low. • Coordination mechanisms are informal in nature. However, firms adopting multidomestic strategies and the worldwide geographic area structure must give up the ability to achieve global efficiency. Using the Worldwide Product Divisional Structure to Implement the Global Strategy In contrast with the multidomestic strategy, a global strategy is characterized by • A corporate home office that dictates competitive strategy • A firm that offers standardized products across country markets • The development and exploitation of economies of scope and scale on a global level • Decisions to outsource some primary or support activities The appropriate structure for implementation of a global strategy is the worldwide product divisional structure, characterized by centralized decision-making authority at the worldwide division headquarters and the establishment of effective coordination and joint problem-solving among disparate divisional subunits. Figure Note Characteristics of the worldwide product divisional structure are presented in Figure 11.9. They illustrate the centralized nature of the structure. FIGURE 11.9 Worldwide Product Divisional Structure for Implementing a Global Strategy The worldwide product divisional structure is characterized by: • An emphasis on inter-division coordination devices to facilitate global economies of scale and scope • Information flows that are coordinated by the global headquarters office • Corporate headquarters allocates financial resources in a cooperative way • Organization represents a centralized federation Multiple integrating mechanisms that result in effective coordination through mutual adjustment via personal interaction include: • Encouraging direct, face-to-face contact between managers • Assigning liaison roles between departments • Forming temporary task forces or teams Using the Combination Structure to Implement the Transnational Strategy The last international strategy (the transnational strategy) combines multidomestic and global strategies by • Seeking national or country-specific advantages by emphasizing adaptation to local differences • Attempting simultaneously to achieve global economies of scale and scope The combination structure is an organizational form with characteristics and structural mechanisms that result in an emphasis on both geographic and product structures. The transnational strategy is often implemented through two possible combination structures: a global matrix structure or a hybrid global design. • The global matrix design brings together both local market and product expertise into teams who develop and respond to the global marketplace worldwide. • In the hybrid structure some divisions are oriented toward products whereas others are oriented toward market areas. FIGURE 11.10 Hybrid Form of the Combination Structure for Implementing a Transnational Strategy In this design, some divisions are oriented toward products whereas others are oriented toward market areas. Thus, in some divisions, where the geographic area is more important, the division managers are area-oriented. In other divisions, where worldwide product coordination and efficiencies are more important, the division manager is more product-oriented. As alluded to previously, specific attributes of the transnational structure are difficult to identify because of the conflicting requirements that firms organize to provide the firm simultaneously with the • Flexibility required for adapting to local market preferences • Coordination and control necessary to pursue global economies of scale and scope Firms implementing transnational strategies must encourage employees to understand the effects of cultural diversity on the firm’s operations and adopt a combination structure that is simultaneously • Centralized and decentralized • Integrated and nonintegrated • Formalized and nonformalized Teaching Note Many features of the transnational strategy are tricky to sort out. Emphasize that point here with the chapter’s discussion of the combination structure.
6 Define strategic networks and discuss how strategic center firms implement such networks at the business, corporate, and international levels.
Matches between Cooperative Strategies and Network Structures As discussed in Chapter 9, firms often may develop multiple strategic alliances to implement cooperative strategies. A strategic network is a grouping of organizations that has been formed to create value by participating in an array of cooperative arrangements. It is often a loose federation of partners who participate in the network’s operations on a flexible basis. A strategic center firm is the one around which the network’s cooperative relationships revolve. Figure Note Figure 11.11 illustrates the structure of the strategic network. FIGURE 11.11 A Strategic Network The strategic center firm sits in the middle of the strategic network so that it can coordinate the activities of network members firms. Note: Four critical aspects of functions performed by the strategic center firm—strategic outsourcing, capability development, technology management, and managing learning processes—are discussed next. As coordinator or manager of activities carried out by partners in the strategic network, the strategic center firm—and other network partners—should note four critical aspects of the strategic center firm’s functions: 1. Strategic Outsourcing 2. Development of Competencies 3. Technology Management 4. Race to Learn (or Managing Learning Processes) Strategic outsourcing is one of the strategic center firm’s key functions. In addition to outsourcing more than other members of the strategic network, the center firm also encourages member firms to go beyond contracting to solve problems and to initiate competitive actions that the network can pursue. The competence-related role of the center firm is to build or develop the core competencies of other network member firms and encourage them to share these with other network partners. Technology aspects of the center firm’s role include managing the development and sharing of technology-based ideas among network partners. Emphasizing the race to learn implies that the strategic center firm must encourage positive rivalry among partner firms that strengthen each partner’s (as well as the network’s) value chain. The effectiveness of the center firm is related to how well it learns to manage learning processes among network partners. IMPLEMENTING BUSINESS-LEVEL COOPERATIVE STRATEGIES Recall from Chapter 9 that complementary assets at the business level can be vertical or horizontal. Vertical complementary strategic alliances are more common than horizontal alliances and generally are focused on buyer-supplier relationships. With Toyota’s strategic network of vertical alliances in Japan, Toyota, as the strategic center firm: • Encourages subcontractors to modernize their facilities • Supplies them with any necessary technical and financial assistance • Reduces transactions costs by entering into long-term contracts that allow supplying partners to increase long-term productivity (as opposed to entering into a series of short-term contracts based on unit pricing) • Provides engineers in upstream companies (suppliers) with better communication with contractees • Allows suppliers and center firms to become more interdependent and less independent • Is able to achieve a competitive advantage because of the imperfect imitability of the structure and the proprietary actions that it uses to manage its strategic network Horizontal complementary strategic alliances are much more difficult to manage than vertical complementary strategic alliances because, in a horizontal alliance, it is difficult to select a strategic center firm when several network members have been aggressive competitors. An example is the instability of alliances between large airlines. IMPLEMENTING CORPORATE-LEVEL COOPERATIVE STRATEGIES It is less difficult to select a strategic center firm in corporate-level cooperative strategic alliances structured as centralized franchise networks than in those that are decentralized sets of diversified strategic alliances. McDonald’s has established a centralized strategic network in which its corporate office acts as the strategic center for its network of franchisees. • The headquarters office uses strategic controls and financial controls to verify that the franchisees’ operations create the greatest value for the entire network. • A strategic control issue is the location of franchisee units—McDonald’s believes that its greatest expansion opportunities are outside the United States. • Financial controls are framed around requirements an interested party must satisfy to become a McDonald’s franchisee, as well as performance standards that are to be met when operating a unit. IMPLEMENTING INTERNATIONAL COOPERATIVE STRATEGIES Competing across national borders increases the complexity of the task of managing strategic networks that have been formed through international cooperative strategies and stifles the selection of a strategic center firm because great differences may exist among the regulatory environments of partners’ home countries. In response to this complexity: • Distributed strategic networks are formed • Multiple regional strategic centers are established Figure Note Configuration of a distributed strategic network is illustrated in Figure 11.12. FIGURE 11.12 A Distributed Strategic Network Although the distributed strategic network has a primary or main strategic center firm, it also is characterized by multiple strategic center firms that are distributed throughout the world. For example, firms such as Ericsson and Electrolux establish multiple strategic centers, which enable them to better manage multiple cooperative relationships with partnering firms that may cross national or regional boundaries or to manage specific global product markets more effectively. The distributed strategic network form of organization enables the international cooperative network to ensure that region-, country- or product-specific market requirements are managed by the appropriate distributed strategic center firm. Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781305502147, 9780357033838
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