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8 Organizing to Implement Corporate Diversification WHAT IS ORGANIZING AND WHY IS IT IMPORTANT? The previous chapter discussed diversification and how firms expand to own multiple businesses in their portfolio. While embarking on diversification moves to maximize economies of scope is vital to having a successful corporate strategy, a large diversified firm has to be managed and governed efficiently. In other words, the businesses must be run on a day-to-day basis by competing in their product markets effectively and creating corporate value by interacting with other businesses that the parent company owns. Employees must be organized into groups, reporting relationships established, resource allocation processes must be developed – in short, the company should be organized to function as a diversified organization. Slide 8-2 This slide helps place the discussion of implementation in the overall strategic management process. Point out to students that some of the issues examined in this discussion have application in vertical integration, strategic alliances, and mergers and acquisitions. Historically, Alfred Sloan, the CEO of General Motors in the early 1900s, is regarded as the “father” of the M-form (or the multidivisional form) structure. As GM grew exponentially and began diversifying its product line to manufacture cars at different price points and aimed at specific target markets, Sloan realized that the traditional functional or U-form structure was not effective. He came up with the idea of creating independent divisions (Chevrolet, Pontiac, Cadillac, etc.), all of which reported to a corporate office. The divisions had considerable autonomy (within set corporate criteria) in making product-market decisions and were evaluated as independent profit centers. The idea of the M-form structure as the “ideal” way to manage large diversified firms was supported by the research of Alfred Chandler, who found that companies such as Sears and DuPont used this structure to expand. Slide 8-3 Use this slide to introduce three fundamental issues firms face in implementing corporate strategy. Emphasize that these issues become increasingly important as the firm becomes more complex. Briefly explain that in a more complex organization involving more people it becomes more difficult to align the interests of the firm and the people who work in the firm. As firms begin the process of implementing strategy, they confront three key issues: How should information flow within the organization Where, and by whom, are decisions made How to influence the behavior of people Underlying these key issues is the basic question that such firms address: how can the interests of employees be aligned with the interests of the firm? As organizations become larger and more complex, information-processing requirements exceed individual cognitive capacity – managers feel overwhelmed by the amount of information they have to process on a regular basis in order to make decisions. This is a good time to introduce the concept of “bounded rationality” and Herbert Simon’s notion of “satisficing” decisions. Satisficing means that people will make decisions that they think are “good enough” even though they cannot make absolutely maximizing decisions because they are bounded in their rationality. The important implication here is that as the information processing requirements faced by an individual manager grow beyond bounded rationality, the manager will continue to make decisions, but the quality of those decisions will decrease. Organizational structure helps in this regard – to make information processing more manageable. Slide 8-4 Emphasize the fact that information-processing requirements grow with a firm. Explain that bounded rationality means that people have a limit on their capacity to handle information. Because people are “bounded” in their rationality, managers will satisfice—make decisions that are “good enough”—in the face of growing information processing requirements. Organizational structure allows the information processing requirements of a firm to be divided up so that managers can operate effectively within their bounded rationality. Organizational structure is intended to increase the quality of satisficing decisions. Once you have established the background to organizing and the reasons why this is an important topic, the discussion can turn to the M-form structure more specifically and how the agency relationship plays a big role in such structures. Teaching Points • Emphasize the importance of implementation to the success of any strategy effort. • Point out that information processing requirements become increasingly large and complex as organizations grow. • Explain that strategy implementation is how large firms are able to handle the monumental amount of information processing that is required in a large firm. • Elaborate on the notions of “bounded rationality” and “satisficing” as elements necessitated by the limits on managerial cognitive ability. ORGANIZATIONAL STRUCTURE AND IMPLEMENTING CORPORATE DIVERSIFICATION Define The Multidivisional, Or M-Form, Structure and How It Is Used To Implement A Corporate Diversification Strategy In the M-form structure, each business that the firm engages in is managed through a division. For example, under CEO Jack Welch, General Electric was organized into 13 divisions where each business was evaluated separately and yet shared many resources with each other. Divisions in the M-form structure—called strategic business units, business groups, or companies—are true profit-and-loss centers, in that the corporate office calculates profits and losses at the level of the division in these firms. Slide 8-5 This slide shows the basic M-form structure with three divisions – A, B, and C reporting to a senior executive. Emphasize that most functions are replicated within each division. Information is summarized and passed up through the organization through these replicated functions. Thus, the Senior Executive is able to handle the summarized information flowing from the divisions. This is the hallmark of the M-form firm. Within each division in the M-form structure, the U-form or functional structure is used. The divisional manager oversees and coordinates various functional areas contained within the division. The advantage of the M-form structure is that each independent division can carve out its own destiny in its product-market and focus on making decisions that best suit its specific competitive environment. This is a good point to introduce the concept of the agency relationship between owners and managers and how in an M-form structure we have divisional managers acting as agents of corporate managers in addition. Slide 8-6 This slide suggests that there is a tradeoff when we create a divisional structure between making information processing more manageable and creating a separation of owners and managers. Emphasize that with this separation of owners and managers, comes the possibility that the interests of the two may diverge. This separation of owners and managers creates what is known as the agency relationship. Principals (or the firm owners) make the financial investment in a firm and delegate the decision-making responsibility to managers. Since managers act on behalf of the principals, they are the agents of the principals. This creates an agency relationship between the two parties. The key to an effective agency relationship is for the interests of the two parties to be aligned. In other words, this relationship will work as long as agents make decisions that further the interests of the equity holders. As the examples in the “Strategy in Depth” box point out, unfortunately this does not happen all the time. There have been widely publicized instances of agents acting in their personal interests that conflict with the interests of principals. Such instances lead to agency problems. Two common agency problems are: investment in managerial perquisites, and managerial risk aversion. Perhaps the most egregious example of managers lavishing perquisites on themselves is Dennis Kozlowski of Tyco International. For his wife’s 40th birthday, Kozlowski rented a Greek island and threw a lavish party that cost the company millions. This was in addition to using company money to furnish his house with a $15,000 umbrella stand, a $6,000 wastebasket, etc. Since equity holders can diversify their personal portfolio of investments at a lower cost, they would prefer managers make more risky rather than less risky investments to get the benefit of higher returns. But investments involving greater risks may not be attractive to managers because there is a high likelihood that such investments may fail. Fearing the loss of their jobs, managers may not go in for such projects and may be content operating within their comfort zones. This may result in a conflict of interest. The M-form structure is designed to create checks and balances so that the interests of owners and managers are aligned. One of these important checks is the monitoring role of the board of directors. By clearly delineating the roles of each party involved in managing the organization, the M-form structure attempts to promote congruent objectives. Slide 8-7 This slide helps to clarify the agency relationship. Emphasize that the M-form structure provides a way for the interests of owners to be monitored. The board of directors plays this monitoring role. Point out that institutional investors also play a monitoring role in many corporations today. Some institutional investors have board seats and are able to monitor through the board. Other institutional investors may still monitor the activities of managers very closely even if they do not hold seats on the board. The Board of Directors Describe The Roles Of The Board Of Directors, Institutional Investors, The Senior Executive, Corporate Staff, Division General Managers, and Shared Activity Managers In Making The M-Form Structure Work A company’s board is elected by the firm’s stockholders. The board role is to monitor the decision-making of the managers and ensure that the managers’ interests are aligned with those of the owners. In short, the board plays a key role in minimizing agency problems. A board’s composition is a key issue. Board members can be internal or external. Internal board members are top managers of the firm (typically the firm’s CEO, its CFO, and its COO) who serve on the board in addition to their regular duties. While they cannot be expected to be completely objective in assessing their own performance, they are important because they present the management’s rationale for key decisions. At board meetings, internal members convey to the board why they made a particular decision. They bring valuable company and industry tenure and experience to these meetings. Outside board members do not work for the company – they are either CEOs or senior executives of other companies, or are leading citizens in the community. Ideally, of the 10-15 members in a typical board, the majority should be outsiders. Boards have several important subcommittees. A few of them are: the finance committee (maintains the relationship between the firm and external capital markets), the nominating committee (nominates new board members), and the personnel and compensation committee (evaluates and compensates managers). It makes sense for these committees to be staffed entirely by outsiders. Outside board members are compensated for serving on the board. The final key issue in company boards is the role of the chairman of the board. This person runs the board meeting. In many companies, the CEO serves as the chairman of the board. This dual responsibility is the subject of much debate. The key is to strike the right balance between the board’s objectivity and its effectiveness in aligning the interests of owners and managers. ► Example: McDonald’s Board The McDonald’s Corporation has 13 board members. Of them, just one is an insider – Donald Thompson, the president and CEO. Of the external members, Susan E. Arnold is formerly a senior executive of Procter and Gamble; Robert Eckert is CEO of the toy company, Mattel; and Miles D. White is CEO of Abbott Laboratories., the pharmaceutical company. All six members of the compensation committee are external, as are the four members of the audit committee. The non-management directors elect the chairman of the board. In addition, the non-members (i.e., outsiders) meet separately. All directors are expected to own stock in the company. (McDonald’s Proxy Statement, 2013) Institutional Owners Institutional owners are usually pension funds, mutual funds, insurance companies, or others who own large blocks of shares in a company. There has been a historical trend for a greater percentage of stock to be owned by institutional owners – from 32 percent in 1970 to 59 percent in 2005. Institutional investors are not passive investors – because of their sizeable investment, they tend monitor the company’s actions more closely and are often quite vocal in demanding changes. ► Example: CalPERS CalPERS (California Public Employees Retirement System) is the largest public pension in the United States. It manages the retirement savings of over 1.7 million members and has an investment portfolio of $283.5 billion in 2013. CalPERS has the resources to closely monitor its investments. CalPERS is quite vocal in voicing its criticism of companies and is unrelenting in seeking change. (CalPERS website: www.calpers.ca.gov) One fear is that institutional investors may promote short-term performance measures instead of long-term improvements. However, research has not supported this notion. The Senior Executive You should emphasize an important point here: in an M-form structure, the senior executive is the only one likely to have the breadth of perspective to assess the entire portfolio of businesses owned by the company. Divisional managers know their divisions very well, but their focus is too narrow. They may not know much about the other divisions owned by the company. It is important, therefore, that the senior executive consults with the divisional managers to identify economies of scope that can be leveraged across the portfolio. The main functions of the senior executive are to: • formulate strategy, and • implement strategy. In large M-form firms, these functions of the senior executive are often handled by dividing these responsibilities among two or more people and referring to them collectively as the office of the president. Usually there are three main roles in the office of the president: 1) the chair of the board of directors—monitors management decisions 2) the chief executive officer—strategy formulation 3) the chief operating officer—strategy implementation In some firms, one person fulfills all these roles. The obvious concern is that the monitoring role of the board chair is compromised. Such an executive is able to wield a great deal of power in a firm. In other firms, two people may fulfill the roles. When one person fills more than one of these roles, it is referred to as ‘duality’. In many firms, three people fulfill the roles in the office of the president. Slide 8-8 This slide illustrates how the office of the president may be occupied by one, two, or three people. Point out the potential conflicts of having one person occupy all three roles. Also point out that people often move through these offices as a succession to the top or ‘grooming’ process. Important Point: As information flows up through the organization from the divisions, there is a summarizing and filtering process. The idea is that the information flowing up through the organization is the best and most necessary for decision-making at the next level. Each manager should have that information which allows for the best decision-making at that level. Too much information can become counterproductive as it exceeds the bounded rationality of managers. Effective executives manage this flow by ensuring that the appropriate amount of information exists at each level in the organization. Slide 8-9 Use this slide to show students that executives can manage the flow of information and decision-making in a firm. The important point is that information is filtered as it rises through the organization. The quality of information flow influences the quality of decisions made based on that information. Corporate Staff It is a good idea to go back to Figure 8.2 in the text and look at the redrawn M-form structure. The corporate staff’s position can be clearly identified. They report to the senior executive and provide advice on functional issues. The information provided by the corporate staff helps the senior executive make important strategy formulation and strategy implementation decisions. Important Point: There is a difference between a direct, “solid-line” reporting relationship and an indirect, less formal, “dotted-line” reporting relationship. Very often, this differentiation can cause conflicts in the organization. Divisional staff managers have a direct, “solid-line” reporting relationship with their respective corporate staff functional managers. They have a less formal, “dotted-line” relationship with their division general manager. For example, the division accounting manager reports directly to the corporate staff accounting manager and has a dotted-line relationship with the division manager. The solid-line relationship helps the organization collect valuable division-specific information. However, the division staff person interacts on a regular basis with the division manager. This could resulting in divided loyalties – should I be loyal to the corporate staff person who is my direct superior, or should I be loyal to the division manager with whom I interact on a daily basis? It is important to be clear about one point: staff functions support line managers, they don’t run the division, rather they help the division manager run the division. Help from the corporate staff can sometimes be conjured as the corporate equivalent of “I’m from the government and I’m here to help you!” Some companies get around this problem by minimizing the corporate staff. Since there aren’t too many people working as corporate staff, they figure only in exceptional situations and not day-to-day operations. Division General Manager Slide 8-10 Emphasize that the division general manager and the senior executive fill similar roles in that they both oversee several different functions. The division general manager reports to the senior executive. Point out that the division managers are concerned primarily with business level strategy, whereas the senior executive is concerned primarily with corporate level strategy. Division general managers operate the division – they coordinate the various functions within the division and make decisions to compete effectively in the product-market. As general managers, their responsibilities are similar to that of the senior executive, except on a smaller and narrower scale. They formulate strategies for their division within the broader strategic context established by the senior executive. In coordinating the activities of the functional units within the business, they are fulfilling the strategy implementation role. In addition to the two roles indicated above, division general managers have two specific responsibilities: to compete for corporate capital, and to cooperate with other divisions to exploit corporate economies of scope. Since the capital available to a company is limited, divisions compete for resources by demonstrating the ability to generate high returns on capital employed. Divisions that have a good track record in doing this stand a better chance than those that do not. Since the rationale for diversified firms hinges on its ability to obtain economies of scale, division general managers work with shared activity managers, corporate staff managers, and the senior executive to isolate, understand, and use economies of scope. Important Point: The potential for conflict between these two specific responsibilities should be emphasized. Division general managers compete for resources with other divisions and cooperate with other divisions to exploit economies of scope. This requirement of simultaneously competing and cooperating with other divisions very often puts an undue burden on the division general manager. Shared Activity Managers Slide 8-11 This slide shows how some activities (functions) can be shared by two or more divisions in an M-form firm. Point out that this sharing creates an economy. A sales and marketing function shared by multiple divisions may be able to offer a higher level of service to all three than any one division could afford on its own. Call attention to the fact that shared activities can be treated as cost centers or as profit centers. Sharing activities helps exploit economies of scope. The cost of the activity is now borne by multiple businesses (or divisions). Activities that are typically shared include: sales force research and development manufacturing distribution Individuals who manage shared activities are responsible for supporting the operations of the divisions that share the activity. Going back to Figure 8.2 in the text, the redrawn M-form structure clearly indicates that R&D is shared by all three divisions, while sales is shared by divisions B and C. Shared activities have “internal customers” – divisions that depend upon them. Shared activities are often managed as cost centers. This means that the shared activity has a budget and is evaluated on how well it can manage its budget. The cost of the shared activity is usually allocated to the divisions that use the services of the shared activity. When the cost of obtaining the service from the shared activity is less than what it would cost the division to get the activity in the external market, true economies of scope result. Divisions would be motivated to use the services of the shared activity. On the other hand, if the cost of obtaining the service from the shared activity is greater than what it would cost the division to get it in the external market, there are no real economies of scope for this activity. In this case, there is no economic incentive for the division to use the services of the shared activity. As an example, take the case of a large multi-business company that has a heavy travel requirement for its staff. Say the firm has a travel department, which is managed as a cost center. Suppose it costs the divisions less to make travel arrangements through the internal travel department; they would have a strong incentive to use it. On the other hand, if it costs less to use an outside travel agency, then economies of scope do not exist in this activity. In order to promote efficiency, there is a growing tendency to regard shared activities as profit centers and evaluate them as such. In such cases, the shared activity “bills” its internal customers on a cost plus profit basis. Such firms also typically do not require their divisions to use the services of the shared activity. In other words, if they can find a cheaper vendor of the service outside, they are encouraged to use it. This creates a sense of competition for the shared activity and forces it to become more efficient. The problem with this is that if one division chooses not to use the services of the shared activity, it makes this activity less efficient for other divisions, thereby creating a chain of negative effect in the firm. From the shared activity manager’s point-of-view, the key is to be important enough for the divisions so that they continue to use the activity for their needs. Teaching Points • Emphasize that structure allows an organization to grow very large and continue to benefit from good decision-making because information can be divided into manageable blocks. • Students need to understand the agency relationship and the potential problems that come with it. • Explain that each of the roles covered in this section fit within the M-form structure and provide a way for the agency relationship to be managed so that the interests of the organization can be pursued. • Shared activities provide a way for M-form firms to further realize economies of scope. • Organizational structure, information flows, and decision-making can all be managed. In fact, these are important responsibilities of the senior executive (office of the president). MANAGEMENT CONTROLS AND IMPLEMENTING CORPORATE DIVERSIFICATION Describe How Three Management Control Processes—Measuring Divisional Performance, Allocating Corporate Capital, and Transferring Intermediate Products—Are Used To Help Implement A Corporate Diversification Strategy This is a good time to move the discussion away from structural issues and introduce the students to issues of management controls. While structure groups people, assigns tasks, and establishes reporting relationships, controls are needed to monitor performance. Three important controls in the M-form structure are: systems for evaluating divisional performance systems for allocating capital across divisions systems for transferring intermediate products between divisions Slide 8-12 Explain that the three issues covered in this slide represent the main concerns that are addressed through management controls. Listed under each main issue are sub-issues that deserve specific attention. Emphasize that evaluating division performance is fraught with ambiguity even when seemingly objective systems are put in place. Allocating capital across divisions invites gamesmanship. Point out that there are multiple ways for firms to set inter-division prices, but no single method is perfect. Ask students to briefly discuss the merits of each approach. Remind students that a firm’s response to these issues constitute, in large measure, the firm’s management controls. Evaluating Divisional Performance Divisions in a M-form are more or less autonomous units, each charged with the responsibility of being successful in their product-markets. Evaluating divisions is a necessary but oftentimes difficult task. What yardstick(s) should be used to measure division profitability? How should economies of scope be factored into the performance metric? These are thorny issues that large diversified companies wrestle with all the time. Accounting measures are commonly used to measure divisional performance. These measures include: return on assets controlled by a division return on the division’s sales division’s sales growth Once the metric is calculated for the division, it has to be compared with something else. That could be a hurdle rate (say 15% return on assets, for example) that is common for all businesses owned by the company. It could also be compared to the division’s budget or the average profitability of firms in the division’s industry. Each of these standards has its advantages and pitfalls. At this point, astute students will start talking about the limitations of accounting measures in general. It is best to hold off on these and come back to it when the specific pros and cons of each are identified. A single hurdle ensures that every division is clear about what is expected of them. On the other hand, it does not ensure equity among the businesses because some may be in more profitable industries than others. Richard Rumelt found empirical support for the fact that up to 25% of a firm’s profits is explained by its participation in a particular industry. The budgeting process allows the organization to establish specific performance expectations for each division, rather than hold all divisions to the same yardsticks. On the other hand, the budgeting process is time consuming and often very political. They can also be very inflexible. Finally, they also provide incentives for managers to “game” the budget. Managers may deliberately set low targets that can be easily achieved, for example. Using industry peers to compare may be equitable for the divisions because it underscores the fact that profitability varies across industries. The problem is in identifying the comparison or “peer” group. Managers may identify a peer group, which allows their division to come out favorably. Now is a good time to look at accounting measures in general. Accounting measures have a short-term bias. They provide a current snapshot of performance and do not take a long-term view. ► Example Let’s say that a company has three divisions – A, B, and C. The company uses return on assets as the performance metric. At the end of one particular year, this is how the divisions reported their results: Division A – profits of $16 million on assets of $50 million Division B – profits of $10 million on assets of $40 million Division C – profits of $14 million on assets of $70 million By calculating the returns (32% for A, 25% for B, and 20% for C), it is clear that A has outperformed both B and C, and B has outperformed C. But that is only at this particular point in time. It does not say anything about future performance. What if the manager of A has under invested and thereby reduced his asset base. The returns are going to be high now but the future may be in jeopardy. On the other hand, C may be investing for the long-term and therefore showing relatively poor performance today. This provides a good segue to the next topic: economic measures of divisional performance. Economic methods use accounting metrics but adjust them to factor in long-term performance. The most widely used economic measure of performance is EVA or economic value added. EVA first of all adjusts accounting earnings to reflect true performance. For example, it capitalizes R&D expenses, so that divisions are encouraged to invest in R&D and not let it affect short-term performance. From this adjusted accounting earnings number, the cost of capital is deducted. The resultant figure is the real value added by the division. Stern Stewart, the consulting firm associated with EVA, has a long list of clients who are attracted by this performance metric. The problem with measuring divisional performance is that economies of scope affect the division’s performance and yet, traditional measures do not include economies of scope. If the R&D function develops a blockbuster product that benefits a particular division, the division’s performance is going to reflect this. But what about the other division(s) that has been contributing to the R&D function and, in effect, is subsidizing it for the benefiting division? The problem is exacerbated when we are dealing with intangible core competencies. Regardless of whether we use traditional accounting measures or EVA, this problem remains. The only way to overcome this problem is to force divisions to be independent. But doing so would preclude exploiting economies of scope – the singular rationale for diversification! Allocating Corporate Capital A recurring problem for diversified companies has to do with allocation of scarce capital. On a regular basis, the corporate office of a diversified firm is likely to get requests for funding by the various divisions. Even after using financial metrics such as net present value, the firm may find itself with more requests than capital. Given the inherent limitations of accounting measures, coupled with the fact that divisional managers have a strong incentive to overstate their individual cases, this becomes a difficult issue to resolve. Zero-based budgeting is an approach that some firms use. Here, capital allocation requests are ranked and requests are funded from the “most important” onwards till the firm runs out of funds. The “zero-base” refers to the fact that in each funding period every division starts with a zero-base, meaning there is no funding for a project automatically because it was funded in the past. In practice, this is a cumbersome process and requires top managers to be able to correctly rank projects. Because of the difficulty associated with internal capital allocation, this is typically a less valuable economy of scope. Transferring Intermediate Products The concept of “internal” customer was referred to earlier in the discussion on shared activities. Large, diversified firms routinely transfer products or services (called intermediate products or services) internally across divisions. This gives rise to the problem of transfer pricing. An example will help here. Let’s say that the motion pictures division of Disney wants to place a commercial for its division in one of ABC’s top rated shows. Since ABC is also owned by Disney, the question arises as to what price ABC should charge the motion pictures division. Economists would argue that the optimal transfer price should reflect the opportunity cost. That is, if ABC had not sold the spot to its sister unit, what would it get in the open market? That is the price that should be charged for the spot. In practice, though, identifying opportunity costs are difficult. It requires identifying marginal costs, cost of opportunities lost, etc. Also, division managers have an incentive to manipulate the information to suit their divisions. So, how do firms deal with transfer pricing? Four schemes are identified in Table 8.3 in the text: exchange autonomy (divisions free to negotiate transfer prices) mandated full cost (transfer price equal to division’s full cost of production) mandated market-based (transfer price equal to selling price) dual pricing (a combination of costs and the market price) Important Point: Each of the schemes listed above has limitations. These limitations are listed in Table 8.4 in the text. It is not unusual for a firm to change its transfer pricing policy every so often. Firms are constantly seeking the “right” transfer pricing practice, but such a practice may not exist. Teaching Points • Ensure that students understand that measuring performance in a large, diversified company is not a clear-cut issue, but one fraught with ambiguities and assumptions. • Emphasize the political nature of performance measurement and capital allocation in organizations. • Help students understand the incongruities in transfer pricing practices. • Remind students that firms must respond to these issues because of the M-form structure. There are tremendous benefits to the M-form structure, but there are also costs associated with its use. COMPENSATION POLICIES AND IMPLEMENTING CORPORATE DIVERSIFICATION Describe The Role Of Management Compensation In Helping To Implement A Corporate Diversification Strategy Executive compensation among top executives of major U.S. firms is a hot button issue. Every year, BusinessWeek produces a survey of top executive compensation and each year the numbers are staggering. ► Example: Forbes.Com’s Executive Compensation Survey The highest compensated CEO in 2012 was John H. Hammergren of McKesson who made a whopping $131 million. The average pay was $10.5 million. Forbes.com calculates an index termed “efficiency.” This is a ratio of company stock performance to CEO pay. Hammergren came in at 121. The #1 CEO on the efficiency scale was Jeff Bezos of Amazon, whose compensation was $1.4 million and at the bottom was Michael Fraizer of Genworth Financial (forbes.com article dated 4/4/2012). It is a good idea to go back to the discussion on agency theory and the company’s board of directors to set the stage to talk about compensation practices. Slide 8-13 Emphasize that the theoretical justifications for a compensation committee are not always consistent with actual practice. Point out that compensation is one area in which independence among the roles within the office of the president are very important. Use one of the examples from Forbes.com above and ask students if they think the interests of shareholders are furthered by such high compensation. There are sound arguments on both sides of this issue. While the Board is expected to watch out for the interests of stockholders in setting top management’s compensation, as the Forbes.com survey shows, this may not always be the case. Compensation does not always seem to be related to performance, indicating that the committee may be beholden to the executives. Most firms use salary plus stock-based compensation for top executives. This is because studies have shown that if a substantial percentage of a CEO’s compensation came in the form of stock and stock options in the firm, changes in compensation would be more closely linked with changes in the firm’s performance. Thus, since Terry Semel (former CEO) refocused Yahoo! and helped the firm improve performance, he shared in the improvements. In this sense, executive compensation helps implement corporate diversification strategy. But, as indicated earlier, this is not always the case among firms. Slide 8-14 Use this slide to illustrate the different elements of compensation that can be used to provide incentives to managers. Note that research shows that some forms of compensation seem to be tied to performance while others are not. Explain how different forms of compensation can alter the time orientation of managers. Point out that the interests of owners and managers can be aligned by offering incentives to managers that will simultaneously benefit owners—e.g., stock options. In much of the discussion on corporate diversification, the emphasis was on adding businesses to the portfolio. Sometimes, though, a firm’s corporate level strategy may call for divesting businesses for various reasons. The reasons could include a lack of skills to compete effectively in a business, a lack of economies of scope, the need for funds for other businesses, etc. The choice for the firm is to divest the assets or spin-off the division. The spin-off could be in the form of a management buy out (Harley-Davidson was a management buyout from a conglomerate called AMF), or an initial public offering (Lucent was a division of AT&T before it was separated and subsequently sold to Alcatel). Slide 8-15 Emphasize that there may be a variety of reasons that a firm would need to exit a business. Explain that a firm can exit a business by simply selling the assets of the business or by spinning off the business through a management buyout or an initial public offering. Teaching Points • Stress that compensation policies are important to align the interests of managers and owners. • Emphasize the role played by a company’s board in developing compensation policies for top management and the need for independence. • Help students recognize that in this day and age, the compensation of top managers in large firms is heavily publicized and often is a “hot button” issue. SUMMARY OF IMPLEMENTATION ISSUES It is important to stress that implementation is when the “rubber hits the road.” The opportunity to exploit economies of scope may be the driving force behind a firm’s diversification strategy. But economies of scope may only be a mirage unless the firm is organized to exploit it. It is important to stress that implementation consists of: organizational structure management control processes compensation policies A large, diversified firm has an inordinately immense amount of information flowing through it. Managerial cognitive ability is limited (bounded rationality) and so the information has to be broken up into manageable blocks. The M-form structure helps in this process. The M-form structure also helps in aligning the interests of owners and managers (the agency relationship). It is important to underscore that the M-form structure alone does not enable this. It is complemented by appropriate control systems and reward policies. Control processes address the issues of performance measurement, capital allocation, and transferring intermediate products within the organization. Compensation is the final piece of the implementation puzzle. Tying compensation to economic performance helps in overcoming agency problems. Stock and stock option plans help in this regard. When the firm ventures into the international arena, implementation problems increase. The twin forces of local responsiveness and global integration come into play and offer several options for such firms to structure themselves. Slide 8-16 Use this slide to summarize the salient points in the implementation process and how implementation is achieved through organizational structure, management controls, and compensation policies. It is helpful to remind students of the complexity of diversified firms and the resulting information processing requirements. Given the bounded rationality of human beings, there is simply too much information in a diversified firm without organizational structure. Remind students of the trade-off inherent in organizational structure between the division of information and the separation of owners and managers—the agency problem. This trade-off gives rise to the need for management controls and compensation policies. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
