CH-9 Strategic Control and Corporate Governance – Strategic Management: Creating Competitive Advantages : Book Guide

Chapter 9 Strategic Control and Corporate Governance Summary/Objectives The purpose of this chapter is to explain how strategic control systems may be used to effectively implement strategies. As the first of the four chapters in Part 3 of the text, it introduces students to the issues surrounding implementation and leadership. It includes both traditional and contemporary approaches to control, and outlines informational (e.g., monitoring, performance milestones) as well as behavioral (e.g., rewards, culture, boundaries) techniques for achieving control as well as corporate governance. The chapter is organized into three sections: 1. Informational control: We describe contrasting approaches to information control. The first is termed “traditional” and emphasizes setting objectives and standards, and controlling by comparing performance to achievements. The second is “contemporary” in which conditions are continually monitored and strategy is modified in an interactive fashion to adapt to changing conditions. 2. Behavioral control: We introduce the role of cultures, rewards and incentives, and boundaries and how firms must achieve a proper balance between these forces in order to maintain strategic control. 3. We explain the role of corporate governance in ensuring that managerial and shareholder (owner) interests are aligned. Examples of effective and ineffective governance are given and we address three mechanisms for effective governance: committed and involved board of directors; shareholder activism; and effective managerial rewards and incentives. We also propose several external control mechanisms: the market for corporate control, auditor, banks and analysts, the media, and public activists. We close this section with a discussion of corporate governance from an international perspective. Lecture/Discussion Outline The introductory case focuses on the corporate governance problems that have plagued Hewlett Packard for over 10 years. HP has been a tremendously successful computer firm but has seen its reputation suffer in recent years. One of the issue that hampered the firm’s ability to respond to the changing competitive landscape in the computer industry is its dysfunctional board of directors and resulting problems during times of CEO turnover.  Discussion Question 1: What are the most significant problems with HP’s board? Response guidelines: HP’s board was not doing what a board should do, which includes monitoring senior executives. Its decisions should serve the interests of shareholders. Students should understand that in order for boards to function effectively, there should be honest deliberation, sharing of perspectives, and, above all, decision-making that serves the interests of the firm, not the individual interests of board members. HP’s board, however, was sidetracked. Directors were not making decisions in the interests of the firm. They appeared to be making decisions in order to serve their faction and possibly hurt other factions. There are few other explanations for the leaks and other efforts to damage senior executives. As a result, there has been frequent turnover among senior executives, and divisions are reluctant to share information because of potential leaks. Students should understand the difference between constructive conflict, in which individuals differ in approach and substance to issues, and destructive conflict. Destructive conflict is more personal. It involves individuals differing only because they do not like each other, or have other personal differences. In HP’s board, there appeared to be destructive conflict. Answer: HP's board has faced significant issues with frequent leadership changes and internal conflicts, which have undermined strategic consistency and effective governance. These problems have impacted the company's ability to execute long-term strategies and adapt to market changes effectively.  Discussion Question 2: How do we see the problems with the board of directors damaging HP’s ability to compete in its markets? Response guidelines: Students should understand the main issue here; that the conflicts within HP’s board are only a problem if they hurt the firm’s operations. In this vignette, HP’s board problems may have had such effects, including: • Not hiring the best person as CEO • Leaking damaging information about senior executives that caused turnover • Frequent turnover among senior executives that hurts management effectiveness • Limited sharing of information among top executives due to the threat of leaks • Inability for the board and top management to make the best decisions since relevant information may not have been shared • Difficulty in moving the firm forward since the warring factions are unwilling to work together to implement strategic change efforts HP’s performance would likely have been much better if firm governance were more effective. This chapter focuses on how management can develop and use effective strategic control. The first two sections address: 1. informational control (the ability to respond effectively to change) 2. behavioral control (the appropriate balance and alignment among an organization’s culture, reward, and boundaries). The third section, focuses on strategic control from a broader perspective — corporate governance. Here, we focus on a firm’s need to assure that the elected representatives (board of directors) of the owners of the firm (shareholders) ensure that the firm’s executives (the management team — headed by the Chief Executive Officer) strive to fulfill their fiduciary duty of maximizing long-term shareholder value. Answer: The board's instability and conflicts at HP have led to inconsistent strategic direction and poor decision-making, weakening the company's competitive position and hindering its ability to respond effectively to market challenges. I. Ensuring Informational Control: Responding Effectively to Environmental Change This section addresses “traditional” and “contemporary” approaches to informational control. Although both have the same purpose — using information to select, monitor, and implement effective strategies — they have a different impact on employees and organizational outcomes. Also, as environmental conditions become more complex or unpredictable, the need for contemporary approaches to informational control increases. A. A Traditional Approach to Strategic Control With a traditional approach to strategic control, goals and objectives are set, strategies are implemented, and performance is compared to the desired standards. Then there is a feedback loop in which information about how performance compares to goals is used to revise strategies. Thus, it is a highly sequential process. EXHIBIT 9.1 illustrates the traditional approach. Examples of control systems that rely on feedback controls include sales quotas, operating budgets, and production schedules.  Discussion Question 3: What is the value of feedback systems that compare performance to objectives? Answer: Point out that the traditional process can often be time consuming and many firms only update budgets or other control devices once a year during annual planning meetings. Thus, it may be best suited for environments that are relatively simple and stable.  Discussion Question 4: Under what conditions might a traditional sequential control system be inadequate? (in cases where factors in the internal and external environment change very slowly) Answer: A traditional sequential control system may be inadequate in dynamic environments where internal and external factors change rapidly, as it relies on predictable, step-by-step processes and may not respond effectively to sudden shifts or new challenges. B. A Contemporary Approach to Strategic Control Because business conditions typically change rapidly, information controls are needed that can quickly adjust. With contemporary controls, an organization’s assumptions, goals, and strategies are continuously monitored, tested, and reviewed. Thus, anticipating and adapting to change is built into the control process. EXHIBIT 9.2 illustrates the contemporary approach. Notice in EXHIBIT 9.2 that both informational and behavioral controls are needed for the contemporary approach. Informational controls ask whether the organization is “doing the right things.” Behavioral controls, by contrast, ask whether the organization is “doing things right.” With this framework, therefore, you can illustrate how the combination of effectiveness (“doing the right things”) and efficiency (“doing things right”) applies in the context of strategic controls.  Discussion Question 5: What is the advantage of continuously monitoring and updating information controls? Answer: Continuously monitoring and updating information controls provides several advantages: it allows organizations to swiftly adapt to changes in the external environment, mitigate risks by identifying and addressing emerging threats, ensure compliance with evolving regulations, improve decision-making by utilizing the most current data, and enhance overall organizational agility and resilience. This proactive approach helps maintain competitive advantage and operational efficiency. The SUPPLEMENT below provides a more recent example of why a contemporary control system is needed in a changing environment. It is from an article about how to out-manage the competition during an economic slowdown.  Extra Example: Managing through a Down Period – Changing Goals Firms must be especially diligent in their control systems during down periods. One of the key concerns is that firms will stop doing what they’re already doing right. To prevent this, according to senior consultant Ram Charan and Fortune Editor Geoffrey Colvin, it is important for companies to remember three of the most important fundamentals for keeping any business successful: 1. The first is to maintain a clear-eyed view of reality, no matter how unpleasant it is or how it may differ from what you expected. It is amazing how many companies chase after management fads when times are good but refuse to change when the environment changes dramatically. When the economy slows or a firm’s prospects dip, firms need to wipe their whiteboard clean and rethink strategy based on what’s realistically achievable. Firms should ask, how are we going to be No. 1 in a new environment. In other words, how do we continue to do the right things? 2. The second is continual, day-by-day insistence on improving productivity. In other words, companies need to ask if they are doing things right. In an economic or market slowdown, productivity typically goes down, leading some executives to conclude that it is unavoidable in bad times. It’s not. In fact, improving productivity during a downturn puts a company in a stronger competitive position when things turn up again. 3. The third fundamental is to stay focused on people. The quality of the people a company hires is often its only major source of competitive advantage. Yet when times get tough, many companies ease up on recruiting, figuring a slow economy will drive more applicants their way. They also spend less on training as a way to raise profits quickly without doing immediate damage to the business. But the long-term damage can be devastating. If you were an airline, would you postpone aircraft maintenance for six months? Of course not. People also change and grow and even become obsolete if quality is not maintained. Source: Charan, R., & Colvin, G. 2001. Managing for the slowdown. Fortune, February 5: 79-88.  Discussion Question 6: What kind of information controls can companies use to accurately assess the environment, evaluate productivity, and improve the quality of the work force? Answer: Emphasize that contemporary control systems — which require continually monitoring numerous information sources and result in rapid revisions to corporate strategies or direction — may be “easier said than done.” Sometimes, the most important thing strategic managers can do is to continually question assumptions about the business and have frequent face-to-face meetings to discuss direction and outcomes. Companies can use performance dashboards, key performance indicators (KPIs), and regular environmental scanning to assess the environment and evaluate productivity. Employee surveys, skills assessments, and training programs help improve workforce quality. The SUPPLEMENT below emphasizes that old systems often have to be updated. It describes the methods that Praxair recently used to overhaul its budget process and make it more timely.  Extra Example: Creating a Responsive Budget Process In many companies, budgeting involves a ten-week cycle. Besides being overly drawn-out, the process can often cause problems if lower level managers propose budgets that consider only their own priorities and not the company’s overall situation. Then, in budget negotiations, top managers typically ask for more ambitious goals while lower level managers shoot for targets they know they can hit. The result is silo thinking and compromise. Praxair implemented a speedier and more comprehensive system to address this issue. The process begins with the company’s overall goal, articulated by top management and based on the big-picture environment. Managers from each unit then state in a maximum of 50 budget lines, the most important things they believe the firms must accomplish to achieve that goal. Then, the critical 20 to 30 people get together and openly discuss key actions and assumptions for each unit. With information technology, managers can see the effects of changes to the budget instantly. The horse trading goes on for about three days and in the end, everyone understands the total picture and collaboration between units becomes easier. Source: Charan, R., & Colvin, G. 2001. Managing for the slowdown. Fortune, February 5: 79-88.  Discussion Question 7: What are some examples of other information control systems that could benefit from the type of process used by Praxair? Answer: Information control systems that could benefit from Praxair's process include those in industries with complex, dynamic environments like pharmaceuticals or aerospace. For example, a pharmaceutical company might use a similar process to monitor regulatory changes and adjust compliance strategies in real-time. Discussion Question 8: What are some examples from other companies of interactive information control systems? Answer: Examples of interactive information control systems include Google’s use of real-time analytics to adapt its ad targeting, and Tesla’s approach to integrating feedback from its vehicles' performance data into product development and updates. These systems allow for ongoing adjustments based on current data and feedback. STRATEGY SPOTLIGHT 9.1 discusses how the perceptions of managers and employees differ about whether their firms rely primarily on traditional or contemporary controls, with managers being much more optimistic regarding the degree to which firms are moving to contemporary controls. II. Attaining Behavioral Control: Balancing Culture, Rewards, and Boundaries Behavioral control is an approach to implementing strategy that relies on three behavioral forces or “levers” – culture; rewards and incentives; and, boundaries. The aim is to use these levers to evoke appropriate actions in the workforce and also to maintain a proper balance between these three factors. Depending on the type of organization and the business environment, the way these forces are manipulated may vary in order to achieve goals with the greatest degree of efficiency. EXHIBIT 9.3 illustrates the three behavioral controls. Point out that there are two reasons why behavioral controls are important for strategic managers today. 1. Increasingly complex and unpredictable environments make it important that all workers respond quickly. Reward systems and culture provide an implicit type of coordination mechanism. 2. Today’s work force includes younger managers who see themselves as free agents. Traditional controls such as rules and regulations typically will not motivate such employees. Effective behavioral controls are needed to build loyalty and commitment. The SUPPLEMENT below illustrates how poor behavioral controls can lead to tragedy. It discusses the inadequate controls that played a key part in BP’s 2005 refinery disaster that took place in Texas City, Texas that killed 15 people and injured 180. Of course, BP’s disaster in the Gulf on April 10, 2010 was also partly attributed to poor behavioral controls.  Extra Example: Poor Behavioral Controls at BP’s Refinery in Texas The Chemical Safety Board, a U.S. government agency that investigates industrial disasters, had long believed that BP’s executives did not spend enough time and money on the safety of their employees. Its latest report on the subject, released in March, 2007, was no different: It claimed that such failings contributed to the explosion in 2005 at BP’s refinery in Texas City, Texas. Consultants investigating frequent breakdowns at the refinery wrote in 2002: “Budget cuts were imposed on the previous year’s spend and did not take into account the specific needs of the refinery… The prevailing culture at the Texas City Refinery was to accept cost reductions without challenge and not to raise concerns when operational integrity was compromised.” In 2002, an employee noted in an internal email: Orders to slash costs by 25% seem “to have been taken literally” by those in charge of Texas City, whereas managers elsewhere “knew how to play the BP game” He refers to a colleague who thinks “the top level in London need to understand the consequences of their orders.” An internal audit of Health, Safety and Environment (HSE) throughout BP, released in 2004, discovered “widespread tolerance of non-compliance with basic HSE rules…poor implementation of HSE management systems…lack of leadership competence and understanding to effectively manage all aspects of HSE…(and) insufficient monitoring of key HSE processes.” Several employees at Texas City complained that “managers were not nearly worried enough about the ‘real’ dangers and ‘too worried about seat belts’,” according to another set of consultants. Others griped that it was “acceptable to avoid costs related to integrity management because the consequences might occur later, on someone else’s watch.” Consultants also said they had “never heard so many people say they were personally afraid of injury.” Sadly, there was in an email written by an employee a few weeks after the disaster: “It’s a shame what had to happen to get us to where we recommended we go several years back.” Source: Anonymous. 2007. In their own words… The Economist. March 24: 74.  Discussion Question 9: How could such a tragedy have been prevented? (Address behavioral controls of culture, rewards, and boundaries. You might also raise broader leadership and ethical issues.) Answer: To prevent such a tragedy, companies should implement robust behavioral controls, including: 1. Culture: Foster a strong ethical culture emphasizing transparency and accountability. 2. Rewards: Align incentives with ethical behavior and long-term success rather than short-term gains. 3. Boundaries: Establish clear guidelines and checks to prevent unethical practices. Broader leadership issues, such as ensuring leaders model ethical behavior and uphold integrity, are crucial. Addressing these areas can mitigate risks and prevent similar tragedies. A. Building a Strong and Effective Culture Culture refers to the shared values, unspoken understandings, and sense of purpose within organizations. It provides unwritten standards of acceptable behavior. When a culture is strong and positive, it can be a powerful force for accomplishing company goals.  Discussion Question 10: What makes an organizational culture strong? What are some examples of companies with a strong culture? Answer: A strong organizational culture is characterized by clear, shared values, consistent practices, and high employee engagement. It often includes strong leadership, effective communication, and alignment between values and behaviors. Examples include Google, known for its innovation-driven culture, and Patagonia, celebrated for its environmental and ethical commitments. Discussion Question 11: What would be the effect on an organization if its culture was “negative” rather than “positive?” What are some examples of companies that have a negative culture? Answer: A negative culture can lead to low employee morale, high turnover, and poor performance. It often features lack of trust, ineffective leadership, and high levels of conflict. Examples include Uber’s previous culture under Travis Kalanick, which faced issues related to harassment and unethical behavior, and Wells Fargo’s problematic culture surrounding fraudulent accounts. The SUPPLEMENT below discusses how firms can use pictures and stories to help build a strong culture.  Extra Example: Using Pictures and Stories to Build a Positive, Customer-Oriented Culture Most firms will tout that customers are their most important stakeholders. In firms that have value statements, these statement typically list their responsibilities to their customers first. But it is hard to build and maintain a customer-centric culture. Using visual imagery and stories can help firms put customers at the center of their culture. The old saying is that “a picture is worth a thousand words.” This is certainly true when building a culture. A simple snapshot of a customer or end user can be a powerful motivating tool for workers to care about that customer. For example, radiologists rarely see patients. They look at x-rays from the files of patients, but these patients are typically faceless and anonymous to them. However, when a picture of the patient was added to the file, one study found radiologists increased the length of their reports on their reading of the patient’s x-ray by 29% and improved the accuracy of their diagnosis by 46%. Other firms have found the same effect. Microfinance provider Kiva includes the pictures of the entrepreneurs whom they are trying to fund believing that potential donors feel more of a connection with an entrepreneur when they have seen a picture of them. Stories can also help build a customer-centric culture. With inside stories, employees share their positive stories of experiences with customers. These stories provide encouragement for other employees to better meet the needs of customers and also reinforce the employee’s own desire to work hard to serve customers. For example, at Ritz Carlton hotels, employees meet each day for 15 minutes to share stories about how they went the extra yard to meet customers’ needs. With outside stories, firms draw on the accounts of customers to reinvigorate their employees. These can be from personal statements from customers or even from news stories. For example, one researcher gave lifeguards a few short news stories about swimmers who were saved by lifeguards on other beaches. The lifeguards who heard these stories reported that they found their job more meaningful, volunteered to work more hours, and were rated by their supervisors as being more vigilant in their work one month later. The short story is that firms can help build and reinforce a customer-centric culture if they just keep the customer in the center of the stories they tell and make the customer personally relevant to workers. Source: Grant, A. 2011. How customers rally your troops. Harvard Business Review. 89(6): 96-103.  Discussion Question 12: Think about companies you have worked for? How could these companies use pictures and stories to build a customer-centric culture? Answer: To build a customer-centric culture, companies can use pictures and stories to highlight real customer experiences and successes. For instance, showcasing images and testimonials of satisfied customers can reinforce the importance of service quality. Sharing stories about employees who went above and beyond to meet customer needs can inspire others to prioritize customer satisfaction. Additionally, visual displays of customer feedback and success stories can serve as constant reminders of the company’s commitment to its customers. This approach makes customer-centric values tangible and relatable for employees. 1. The Role of Culture Point out that a company’s culture is often what makes it unique compared to other firms in an industry. This uniqueness gives workers a sense of “specialness.” It may also influence other stakeholders. We provide examples of FedEx and Amazon (customer service), Lexus and Apple (product quality), Google and 3M (innovation), and Nucor and Walmart (efficiency).  Discussion Question 13: What are some of the other examples of culture that give companies a sense of uniqueness or set them apart in the mind of employees or customers? Answer: Examples of unique company cultures include: 1. Google: Known for its innovative and flexible work environment, which fosters creativity and employee satisfaction through open spaces and perks like on-site services. 2. Zappos: Emphasizes a customer-first culture with a strong focus on delivering exceptional customer service, supported by a unique set of core values and a fun, informal work environment. 3. Netflix: Promotes a culture of freedom and responsibility, encouraging employees to take risks and make decisions while maintaining high performance standards. 4. Ben & Jerry's: Integrates social activism into its culture, emphasizing environmental and social justice issues alongside its business goals, which resonates with both employees and customers. 5. Patagonia: Known for its commitment to environmental sustainability and ethical practices, creating a strong identity that attracts employees who share similar values. The SUPPLEMENT below addresses the importance of culture at Nucor in maintaining focus and morale during the recent economic downturn.  Extra Example: Culture Keeps Company Strong During an Economic Downturn U.S. Steelmaker Nucor is known for its unique culture. Former Chair Ken Iverson (1925-2002), who transformed a failing nuclear instruments company into a successful chain of steel minimills, established principles that are the key to Nucor’s success: no executive parking spaces or dining rooms; everyone flies coach and gets the same health insurance and benefits package. In other words, Nucor is frugal, fraternal, and egalitarian. Keeping with the tradition of not laying off employees or cutting benefits, Chairman Daniel DiMicco faced the challenge of maintaining a strong culture in the face of a slumping economy in 2008. Some Nucor employees switched from their normal roles into roles where they cleaned bathrooms and mowed lawns. The firm’s bonus-driven pay plan saw dramatic cuts in paychecks because of deep production losses—plants were running at 50 percent capacity and many of Nucor’s employees were working half time. Because of the strong emphasis on operational efficiency, paying for performance lies at the heart of Nucor’s culture. Steel mill workers earn weekly bonuses based on how many steel sheets or beams their group turns out. The bonuses account for two-thirds of take-home pay. “We pay weekly because spouses will perform a good kick in the butt if you have an off week,” says DiMicco. How did DiMicco sustain the fair and efficient culture that has made Nucor strong? Besides shunning layoffs, DiMicco became a vocal spokesman in support of buying U.S. steel and requiring China, which accounts for 30 percent of U.S steel purchases, to abide by the rules of the World Trade Organization. He also fought cap-and-trade legislation that could have added $50 to the cost of a ton of U.S. steel. Nucor has seen its sales nearly double since the depths of the recession in 2009, but its profits are still less than half of what they were before the recession. It is still a struggle, but Nucor appears to be retaining its culture. They still haven’t had a layoff since 1984, and 88% of employees responding to a survey support job DiMicco is doing as CEO. Source: Helman, C. 2009. Test of mettle. Forbes, May 11: 81-82; www.nucor.com; www.glassdoor.com  Discussion Question 14: Given changing economic conditions, is there a potential downside to companies that rely on a strong culture to maintain behavioral control? Answer: Yes, relying heavily on a strong culture for behavioral control can have downsides, especially in changing economic conditions. Here are a few potential issues: 1. Resistance to Change: A strong culture can lead to rigidity, making it difficult for employees to adapt to new strategies or market conditions, potentially hindering innovation and flexibility. 2. Groupthink: When a culture is deeply ingrained, it might promote conformity and discourage dissenting opinions, which can prevent the company from recognizing or addressing emerging challenges. 3. Overemphasis on Culture: Companies might prioritize maintaining their culture over other important factors, such as financial stability or strategic adaptability, which can be detrimental in times of economic stress. 4. Cultural Fit Issues: As the economic environment changes, the existing culture might not align with new business needs, leading to potential conflicts or dissatisfaction among employees who might feel disconnected from the company's evolving goals. Overall, while a strong culture can drive performance and cohesion, it needs to be balanced with flexibility and responsiveness to external changes. 2. Sustaining an Effective Culture Companies use many different techniques to foster a positive culture and create an environment that is fun and motivating. Another advantage of a strong culture is that it builds cohesion within the work force. This can become a critical management activity. Southwest Airlines, known for its culture of enthusiasm and openness, has a culture committee to perpetuate its strong culture. The SUPPLEMENT below describes how one division of Sprint uses fun and group activities to generate cohesion and build enthusiasm.  Extra Example: A Spirit of Playfulness at Sprint’s Small Business Sales Division At Sprint’s small business sales division in Kansas City, Missouri, more than 150 people sell telecommunication services to small businesses. Because it primarily involves cold calling for eight hours a day, it can be tedious work. The result is often high employee turnover. Manager Nancy Deibler and her crew, however, have found a way to counteract the tedium. They’ve created a strong rapport within the sales team by building fun into their work. Making fun a legitimate part of work isn’t all that difficult, says Deibler. For example, Deibler’s team might leave work at 3:00 p.m. to go bowling. “After doing something like that,” she says, “the difference that it makes is measurable and it lasts for weeks.” Add baseball games, cookouts, goofy hats, evenings of karaoke and a host of other ways to introduce positive energy and playfulness into a work world that is often all-too-serious. Deibler knows that all of this may seem hokey to some people – but she doesn’t care. “It lifts productivity,” she says. As a result, Deibler has been able to keep and attract top performers. Source: Reich, R. 1998. The company of the future. Fast Company, November: 124-150.  Discussion Question 15: What are examples of other companies that use culture in unusual ways to build cohesion and enhance productivity? Answer: Emphasize that recreation and “fun parties” are not the only way companies cultivate and maintain a strong culture. In fact, the company leadership is one of the most important sources of a strong and positive culture. Sam Walton was known for his pep talks. Home Depot founders Bernard Marcus and Arthur Blank often held pep rallies over closed circuit TV. Teaching Tip: Ask students how they define organizational culture and how it can be a source of competitive advantage that can be sustainable over time. Point out that it is particularly important in the knowledge economy for several reasons: it helps to combine/leverage resources, it enhances firm-specific ties (which is particularly important given that human capital is highly “mobile”), it can help the firm convert tacit knowledge into codified knowledge, etc. You may wish to draw on some of the core concepts in Chapter 4 to reinforce your points. B. Motivating with Rewards and Incentives Reward systems specify who gets rewarded and why. They can have a powerful influence on individual performance and overall firm outcomes. Reward systems need to be closely linked to culture since they “put the money where the mouth is” of the organization. If rewards don’t match up to the espoused values and beliefs, reward systems can also be a powerful de-motivator. We provide the example of how Not Your Average Joes, a Massachusett’s restaurant chain, uses a sophisticated system to reward its best servers with more tables and a preferred schedule.  Discussion Question 16: Are you familiar with other firms that have different incentives and rewards for individuals at different hierarchical levels? Is the reward system effective? Why? Why not? Answer: Yes, many firms use tiered incentive systems effectively. For instance, Google offers stock options and performance bonuses to lower-level employees, while senior executives receive more substantial stock grants, aligning their interests with company success. Goldman Sachs provides performance bonuses for analysts and significant stock options for higher-level executives to motivate and retain talent. These systems are effective in driving performance and aligning goals, but they can create perceived inequities if not managed transparently. The key is to balance motivation with fairness across hierarchical levels. 1. The Potential Downside While rewards can be powerful tools to get employees to work for the benefit of the firm, they can also have some negative outcomes. First, if the incentive criteria seem out of the control of workers (e.g., stock incentives for lower level employees) or the goals unreachable, they can be demotivating. Second, incentive can sometimes lead to perverse outcomes. For example, if workers are incented to maximize the rate of production or the speed of a process, it can easily lead to quality problems. Rewards and incentive systems can trigger unexpected or unwanted behaviors if the incentives lead to sub-cultures within an organization or perceived competition between organizational units. These issues can lead to a deterioration in the cohesion of the workforce and damage the organization.  Discussion Question 17: What is it about reward systems and incentives that make them an emotional flashpoint within organizational control systems? Answer: Reward systems and incentives can become emotional flashpoints because they directly impact employees' financial well-being and recognition, which are deeply tied to their self-worth and motivation. Discrepancies or perceived unfairness in rewards can lead to dissatisfaction, decreased morale, and conflict. These systems are scrutinized for bias and fairness, and any issues can escalate quickly within an organization. Discussion Question 18: What are some examples of companies that have effectively aligned their reward systems with their goals and culture? Answer: Salesforce aligns its reward system with its culture by offering substantial bonuses and recognition for meeting sales targets, which reinforces its customer-focused and performance-driven culture. Patagonia integrates rewards with its environmental values, providing benefits like environmental internship opportunities to align employee goals with the company's mission. Both examples effectively use rewards to reinforce their organizational culture and goals. The SUPPLEMENT below discusses how Office Depot’s President found that the firm needed to change its incentive systems to provide for a better customer experience.  Extra Example: Office Depot Sees the Error in its Reward System It is important to incent workers to focus on the right items. Office Depot’s President discovered this when he used customer feedback, sales data, and his own experience as a “mystery shopper” to develop new metrics for his store employees. In 2010, Kevin Peters was trying to get to the bottom of some puzzling statistics. Office Depot’s sales were down while its customer satisfaction scores were up dramatically. So, he set out as a “mystery shopper” and visited 70 stores in 15 states, acting as a regular shopper to see why Office Depot’s customers weren’t buying even though they said they were happy with the store. What he found was that their employees did well at working to achieve good scores on the goals the company set out for them (and the items they asked their customers about), but they were incenting and measuring the wrong items. They rewarded store managers and workers for having clean floors, windows, and bathrooms as well as fully stocked shelves. They did well on these items in customer satisfaction surveys, but this isn’t what got customers to buy. Customers wanted the products they needed easy to find, support from sales staff to find and select the right items, easy in and out experiences, and services to help them put their purchases to work, such as software installation help and computer repairs. In short, Office Depot was rewarding the wrong things. They worked to keep the store clean and organized but didn’t incent workers to build and maintain customer relationships. Source: Peters, K.. 2011.Office Depot’s president on how “mystery shopping” helped spark a turnaround. Harvard Business Review. 89(11): 47-49.  Discussion Question 19: What are some examples of firms that appear to reward their employees for the wrong things? Answer: Wells Fargo faced criticism for rewarding employees based on aggressive sales targets, which led to unethical practices like creating fake accounts. Uber has also been criticized for incentivizing rapid growth and driver metrics without sufficient regard for driver welfare or customer service quality. These reward systems led to significant ethical and operational issues, illustrating the risks of misaligned incentives. Discussion Question 20: Have you shopped at Office Depot lately? Does it appear workers are focusing on providing the right kind of service experience? Answer: In recent visits to Office Depot, workers may seem focused on meeting transactional metrics rather than providing personalized service. The emphasis on efficiency and sales targets can sometimes overshadow the quality of customer interactions, reflecting a potential disconnect between reward incentives and customer service experience. 2. Creating Effective Reward and Incentive Programs Another challenge for strategic managers is to create reward and incentive programs that are effective across all parts of the organization. EXHIBIT 9.4 presents the qualities and characteristics of a good reward system: 1. Objectives are clear, well understood, and broadly accepted. 2. Rewards are clearly linked to performance and desired behaviors. 3. Performance measures are clear and highly visible. 4. Feedback is prompt, clear, and unambiguous. 5. The compensation “system” is perceived as fair and equitable. 6. The structure is flexible — it can adapt to changing circumstances. The SUPPLEMENT below addresses what can go wrong when a reward system is abused in order to make performance look better than it really is. Interestingly, Nordstrom is typically considered a paragon of outstanding customer service.  Extra Example: Nordstrom Gets Sued for Reward System Violations One way to motivate strong performance is to empower employees to take initiative in responding to customers’ needs. Whether managers realize it or not, however, there are built-in dangers when empowered employees are held accountable for performance goals — especially for difficult ones — and then left to their own devices to achieve them. Take, for example, Nordstrom, the upscale fashion retailer known for extraordinary customer service. It found itself embroiled in a series of lawsuits related to its sales-per-hour performance measurement system. Used to track the performance of its entrepreneurial salespeople, the system was designed to support the service orientation for which Nordstrom is famous. But without counterbalancing controls, the system created the potential for both exemplary customer service and abuse. Some employees claimed that first-line supervisors were pressuring them to under-report hours on the job in an attempt to boost sales per hour. Settling those claims cost Nordstrom more than $15 million. Source: Simons, R. 1995. Control in an age of empowerment. Harvard Business Review, 73(2): 80-88.  Discussion Question 21: What kind of “counterbalancing” incentives could Nordstrom use to create a reward system that would not be abused? Answer: Discussion Question 21: To avoid abuse in its reward system, Nordstrom could implement counterbalancing incentives such as: 1. Customer Satisfaction Metrics: Incorporate customer feedback and satisfaction scores to ensure that employees are rewarded for genuine service quality. 2. Balanced Scorecards: Use a mix of performance metrics (sales, service quality, teamwork) to prevent overemphasis on any single aspect. 3. Peer Reviews: Introduce peer evaluations to complement managerial assessments, providing a more comprehensive view of performance. 4. Ethics Training: Regularly train employees on ethical standards to align behavior with company values. 5. Long-term Goals: Align rewards with long-term customer loyalty and store performance, not just short-term sales targets. These measures can help create a more holistic and fair reward system. Discussion Question 22: Do some professions or types of work lend themselves to abuses of their rewards and incentive systems more than others? Which ones? Why? Answer: Emphasize that there needs to be a close link between reward systems and an organization’s culture. A culture of risk taking may be present in firms that are entrepreneurial, but then a reward system is needed that encourages risk taking. Similarly, if technological superiority is an organization’s key distinctive competence, then reward systems must be created that highlight technical skills development and performance. Emerson Electric is presented as an example of how reward systems are helping it realign its culture. We also note that incentive and reward systems don’t have to just be about money. We discuss how Mars Central Europe has used recognition events as a powerful motivator for employees. C. Setting Boundaries and Constraints This section discusses how rules and regulations, as well as aspiration levels and goals, can provide effective forms of organizational control. Point out that culture and reward systems often need to be supplemented or reinforced by boundaries and constraints. Used properly they can: 1. Focus individual efforts on organizational priorities. 2. Provide short-term objectives and action plans that channel efforts. 3. Improve efficiency and effectiveness. 4. Minimize improper and unethical conduct. Emphasize that boundaries and constraints must be used sparingly in order to be effective. Excessive regulations or rules that are enforced with poor judgement can be counterproductive. The SUPPLEMENT below illustrates a rather humorous example of regulations being enforced in an excessive fashion in the midst of public emergency.  Extra Example: Firefighting Water Trucks Forced to Dump Water State officials near Coeur d’Alene Idaho issued $100 citations recently to two drivers whose U.S. Government water trucks were on their way to fight forest fires in Montana. The officials discovered that the trucks exceeded the highway weight limit of 17 tons (by 1 and 2 tons respectively). According to the Helena (Montana) Independent Record newspaper, the trucks were permitted to head out to the front lines only after they had dumped enough water to satisfy the inspectors. Source: Shepherd, C. 2000. Water weight. Lexington Herald-Leader, October 27: 29.  Discussion Question 23: Do you think the inspectors acted properly or excessively? Answer: The appropriateness of inspectors' actions depends on context. If they acted based on clear, reasonable guidelines to ensure safety or compliance, their actions could be deemed proper. However, if the rules were applied rigidly without considering context or potential negative consequences, their actions might be seen as excessive. Balancing enforcement with discretion is crucial in such situations. Discussion Question 24: Have you ever been asked to observe a rule that was excessive? What is an example from your own experience? Answer: In my experience, I once had to follow an office rule that required submitting detailed reports for every minor task completed. This rule, intended to ensure accountability, felt excessive and counterproductive, leading to frustration and inefficiency. Discussion Question 25: What effect does an excessive rule or an overly strict regulation have on your behavior? How do you think such rules and regulations affect organizational performance? Answer: Excessive rules or overly strict regulations can stifle creativity, reduce morale, and hinder efficiency. Such constraints may cause employees to focus more on compliance than on their primary work objectives. In organizations, this can lead to a rigid culture, lower job satisfaction, and reduced productivity. Balancing clear guidelines with flexibility and trust is vital for maintaining an effective and motivated workforce. 1. Focusing Efforts on Strategic Priorities It is important that firms focus their attention on a limited number of shared priorities. Vision, mission, and strategic objectives are a type of boundary that was introduced in Chapter 1. Focusing sometimes involve the need to change the boundaries of the firm by selling or spinning off business that don’t fit the firm’s current priorities. We present IBM and Pfizer as examples of firms that sold off businesses to focus on core strategic priorities. Management can also take a role in clarifying the boundaries of the firms priorities. As an example, we discuss how Steve Jobs would have his executive team work to identify the 10 most pressing initiatives in the firm. He would then cross off the bottom seven and say “we can only do three.”  Discussion Question 26: Can you think of firms that have significantly changed their strategic priorities in the last several years? Why did they make this change? Answer: Firms like IBM and Ford have significantly shifted their strategic priorities in recent years. IBM transitioned from hardware to cloud computing and AI services to adapt to declining hardware sales and capitalize on growth areas. Ford has focused on electric and autonomous vehicles in response to evolving market demands and regulatory pressures on emissions. Discussion Question 27: What kind of actions can managers take to highlight the priorities and boundaries for the firm? Answer: Managers can highlight priorities and boundaries by clearly communicating strategic goals through regular updates and company-wide meetings. They should implement performance metrics aligned with these priorities, integrate them into employee evaluations, and ensure that organizational policies and resource allocations reflect the firm’s strategic focus. Additionally, reinforcing these priorities through leadership examples and aligning incentives with desired behaviors can help embed them into the company culture. 2. Providing Short-Term Objectives and Action Plans Strategic objectives and actions plans may have a more direct impact on the behavior of an organization’s employees. Discuss the attributes of short-term objectives that need to be present for them to be effective. They must: 1. Be specific and measurable. 2. Include a specific time horizon for their attainment. 3. Be achievable yet challenging enough to motivate managers who must strive to accomplish them. Short-term objectives must provide proper direction but also be flexible enough to keep pace with changing conditions and unexpected circumstances.  Discussion Question 28: What are some examples of short-term goals that you have been faced with as a student? In your place of work? Did you find that those goals had a positive influence on your behavior? Answer: Action plans are another type of boundary or constraint because they provide specific, measurable frameworks for how a strategy is to be implemented. Once managers understand the outcome that is to be achieved, developing an action plan gives them a sense of ownership of the company’s goals. They also feel a degree of autonomy since they can often select (or modify) the specific means for accomplishing the implementation. STRATEGY SPOTLIGHT 9.2 describes how Marks and Spencer, a British-based retailer translated its sustainability mission into clear, measurable targets. 3. Improving Operational Efficiency and Effectiveness Discuss why rules-based controls are most appropriate in organizations where: 1. Environments are stable and predictable. 2. Employees are largely unskilled and interchangeable. 3. Consistency in product and service is critical. 4. The risk of malfeasance is extremely high (as in banking or casino operations), and controls must be implemented to guard against improper conduct. McDonald’s, the Ritz Carlton, and CA Technologies are used as examples. 4. Minimizing Improper and Unethical Conduct Rules and guidelines are often used to control commercial practices such as bribes, kickbacks, and other forms of payment that may be illegal. These guidelines are used in many arenas including maintaining customer confidentiality and developing sourcing strategies for dealing with suppliers. D. Behavioral Control in Organizations: Situational Factors In this section, we take a contingency approach to behavioral control. That is, the effective use of rewards/incentives, culture, and boundaries are dependent on a variety of internal and external factors. To summarize, we suggest that culture is most associated with professional organizations, where high autonomy and norms are the basis for behavior; rules/boundaries are best where there are standardized output, repetitive tasks, and a minimal need for creativity; and rewards are most appropriate when performance evaluation is quite straightforward. EXHIBIT 9.5 provides a summary of alternative approaches to behavioral control. Ask:  Discussion Question 29: Are you familiar with organizations that effectively (or ineffectively) matched their elements of behavioral control with their particular situation (internal and external factors)? Answer: An example of an organization that effectively matched its elements of behavioral control with its situation is Google. They align their innovative culture and flexible work environment with their emphasis on creativity and rapid technological advancement. This approach fosters employee engagement and drives innovation. Conversely, Wells Fargo faced issues with behavioral control when its aggressive sales culture led to unethical practices and regulatory fines. The mismatch between their internal incentives and external ethical expectations contributed to significant reputational damage and operational challenges. E. Evolving from Boundaries to Rewards and Culture In general, the use of culture and reward systems provides a more favorable “internalized” control system than a set of rules and regulations. Often, however, companies have to develop in this direction. We provide four guidelines: 1. Hire the right people, those who identify with the company’s dominant values. 2. Use training and indoctrination to build a strong identity and sense of the company culture. 3. Encourage managers to set examples for the whole company with their behaviors. 4. Align company reward systems with organizational goals and objectives. III. The Role of Corporate Governance on the need for both shareholders (the owners of the corporation) and their elected representatives – the board of directors – to actively ensure that management fulfills its overriding purpose: increasing long-term shareholder value. As noted by Robert Monks and Nell Minow, two of the leading scholars in corporate governance, the primary participants in corporate governance are: (1) the shareholders, (2) the management (led by the Chief Executive Officer), and (3) the board of directors. In recent years, there have been many instances of poor corporate governance and we provide brief, bulleted examples of Hewlett Packard, Cendant Corp., Nortel Networks, Boeing, and Royal Ahold NV. STRATEGY SPOTLIGHT 9.3 provides some empirical evidence linking good corporate governance to higher performance. It includes corporations in the United States, Asia, Europe, and Latin America. This is certainly a topic that should create a lot of student interest. You may want to pose some “lead-off questions” such as:  Discussion Question 30: What are some of the most notable examples of flawed corporate governance? What do you feel were the causes? How could they have been avoided? Answer: Notable examples of flawed corporate governance include the Enron scandal and the Volkswagen emissions scandal. • Enron faced governance failures due to lack of transparency and conflicts of interest among board members, leading to massive financial fraud. Better regulatory oversight and stricter internal controls could have prevented this. • Volkswagen experienced governance issues with its emissions cheating scandal, driven by a culture of aggressive targets and insufficient oversight. More robust ethical standards and a stronger whistleblower system might have mitigated the risk. In both cases, improved oversight, ethical leadership, and stronger internal controls could have helped prevent these failures. A. The Modern Corporation: The Separation of Owners (Shareholders) and Management Here, we address some of the implications for the separation of ownership and management in the modern corporation. We begin with some definitions of the corporation, including a humorous one from The Devil’s Dictionary: “An ingenious device for obtaining individual profit without individual responsibility.” In a nutshell, we mention that a corporation is a mechanism created to allow different parties to contribute capital, expertise, and labor for the maximum benefit of each party. We briefly draw on the classic work of Adolf Berle and Gardiner C. Means who roughly seventy years ago advanced the idea of the divergence of the interests of the owners of the firm (shareholders) and its managers. Such separation is central to agency theory, which addresses the relationship between two primary players — the principals who are the owners of the firm (stockholders) and agents who are the people paid by the board of directors to perform a job on their behalf (management). Agency theory is concerned with resolving two problems that can occur in agency relationships: • when the goals of the principals conflict, and, • when it is difficult or expensive for the principal to verify what the agent is actually doing.  Discussion Question 31: In general, do you believe there are fewer or minimal governance problems in organizations where there is no separation of ownership and management, such as small businesses or family firms? Why or Why not? Answer: In organizations without separation of ownership and management, such as small businesses or family firms, governance issues may be fewer but not necessarily minimal. • Advantages: Direct control by owners often leads to clearer decision-making and alignment of interests. • Disadvantages: The lack of independent oversight can result in unchecked power, potential nepotism, and less formal governance structures. While direct involvement can reduce some conflicts of interest, it can also lead to governance problems due to the absence of independent checks and balances. We also address two instances of conflicts of interests (Wynn Resorts and Apollo) by corporate leaders in the United States. Such actions reflect the individual’s self interest rather than the interests of shareholders. B. Governance Mechanisms: Aligning the Interests of Owners and Managers Three key governance mechanisms are addressed in this section. The first two address the primary means by which the behavior of managers can be monitored: (1) a committed and involved board of directors that acts in the best interests of shareholders, and (2) shareholder activism, wherein the owners of the corporation become actively involved in the governance of the corporation. In addition, a third mechanism of governance is the effective use of managerial incentives, which are intended to align the interests of management with those of the stockholders. 1. A Committed and Involved Board of Directors In effect, the board of directors is the “middlemen” or “middlewomen” who provide a balance between a small group of key managers in the firm and a vast group of shareholders. In the United States, the law requires that the board have a strict and fiduciary duty to ensure that the company is run consistent with the long term-interests of the owners (shareholders). We provide five duties of the board of directors, according to the Business Roundtable. These include such issues as the selecting, evaluation, and replacement (if necessary) of the CEO; review of strategies; financial objectives; providing advice and counsel to top management; etc.  Discussion Question 32: At what point should firms prepare for CEO succession? As the CEOs get older, or as soon as they are instated? Answer: Firms should prepare for CEO succession as soon as a new CEO is instated, not just as they age. • Early Preparation: Proactive planning allows for a smoother transition and continuity, minimizing disruptions. • Leadership Development: It provides time to identify and develop potential successors, ensuring they are ready when needed. • Adaptability: Preparing early helps firms adapt to changes in strategy or market conditions, aligning leadership with long-term goals. Planning from the start ensures a robust succession plan and mitigates risks associated with leadership transitions. Discussion Question 33: Why do companies need to prepare for a CEO transition? Given that most VPs are familiar with the company’s operations, and could quickly take over, is extra preparation necessary? Answer: A key element of effective boards is director influence, i.e., that board members are free of all ties to the CEO or the company. The majority of large firms now have only one or two managers on the board (typically either just the CEO or the CEO and the CFO), but firms need to ensure that the outsider members are not just the friends of the CEO or closely aligned outsiders, such as the CEO of a supplier to the firm. For truly effective governance, firms need to move beyond just setting up an independent board. They need to build an engaged and committed board. We discuss several prescriptions to build an engaged, knowledgeable, and committed board, including: • Building the right expertise on the board to meet the strategic challenges of the firm • Keeping the board to a manageable size • Choosing directors who can participate fully and aren’t overly burdened by other commitments • Balancing the board’s focus on the past, present, and the future • Considering management talent development below the CEO level • Getting a broad view of the firm’s operations by meeting in different locations • Maintaining norms of transparency and trust within the board Financial crises and corporate scandals have led to regulations and new guidelines on the structure of boards. Institutional investors, such as CalPERS, have also pushed for better corporate governance. In EXHIBIT 9.6, we present data on how the boards of major firms have changed over the last 25 years and the reasons for those changes. The SUPPLEMENT below cautions that having outside directors in not a panacea for improving the objectivity of directors. The quality of the outside directors is critical as well, but the same people seem to pop up on boards, even if they have a checkered past.  Extra Example: Recycled Board Members One reason that outside board members may not lead to effective governance is that firms fail to attract strong outside board members. Boards primarily provide value by giving advice and counsel to the firm’s top managers and by monitoring the strategic direction of the firm and the actions of top managers. However, individuals in the “corporate elite” appear to get invited to serve on boards even if their own track record as a corporate manager or board member is spotty or downright unsuccessful. For example, Ellen Futter headed the audit committee for the board of for Brystol-Meyers when the firm had an accounting scandal in 1999 and served as a board member for AIG Corporation when it failed in 2008 and required a nearly $200 billion bailout from the U.S. government. Still, she has plum seats on the boards of JPMorgan Chase and Consolidated Edison. Similarly, Frederic Salerno, who served on Bear Stearns’ board when the firm collapsed, serves on five boards including CBS and Viacom. The recycling of these tainted directors can create two problems. First, these directors are likely appointed to new boards because they are part of the “club” and not necessarily the best candidates who can provide the optimal advice and counsel to the managers of the firm. As Sydney Finkelstein, a professor at Dartmouth’s Tuck School of Business states, “There is a comfort level issue here.” These “tainted” board members are appointed to new boards because CEOs are comfortable with them, not because they are the best candidates. Second, they may not be the best monitors because they feel a strong loyalty to CEOs who nominate them to the board even though they are tainted. Professor Finkelstein puts it this way. “Directors may be more concerned about friendships and connections” than about diligent oversight of the firm. Source: Olson, E. 2011. CEO careers: A case of rinse and repeat? Cnnmoney. September 16: np.  Discussion Question 34: When should the directors of failed firms get another chance on a new board? Answer: Directors from failed firms should get another chance on a new board only after demonstrating they have learned from their previous mistakes and have a clear plan for addressing past issues. Transparency about their role in the failure and evidence of improved strategies or insights are crucial for rebuilding trust. Discussion Question 35: How can firms broaden the pool of potential directors to make sure the end up with the best board? Answer: Firms can broaden the pool of potential directors by: • Seeking Diverse Backgrounds: Recruiting individuals from various industries, disciplines, and geographies. • Leveraging Networks: Using professional and academic networks to find candidates with unique skills and experiences. • Promoting Inclusivity: Ensuring diversity in gender, ethnicity, and experience to bring a range of perspectives to the board. • Utilizing Search Firms: Engaging executive search firms specialized in identifying top talent for board positions. 2. Shareholder Activism Although, as a practical matter, individual shareholders hold relatively little influence, they do — acting collectively — have power to bring about shareholder action suits and demand that key issues be brought up for proxy votes at annual board meetings. In addition, shareholder influence has intensified in recent years because of the growing influence of large institutional holders such as retirement (e.g., TIAA-CREF, CalPERS) and mutual funds (e.g., Fidelity, Vanguard). In fact, institutional investors hold about 50 percent of all listed corporate stock in the United States. Some institutional shareholders are being very proactive in demanding changes. We discuss how CalPERS (the California Public Employees Retirement System) reviews firms’ performance patters and market conditions and works firms they are concerned about to improve their governance practices and to protect shareholders’ rights. CalPERS also holds out the threat of undertaking proxy fights at the firm’s annual meetings or even file a court case if the firm’s board and CEO are unresponsive to its concerns. CalPERS has seen significant success with its investments and has found that its investments have outperformed the overall stock market by nearly 12% over a recent three year period.  Discussion Question 36. Why should firms care about CalPERS’ concerns and complaints? Answer: Firms should care about CalPERS' concerns and complaints because CalPERS is a major institutional investor with significant influence over corporate governance. Addressing their issues can improve investor relations, enhance the firm's reputation, and potentially lead to better financial performance through effective governance practices. Discussion Question 37. What other organizations might have a similar effect as external control governance mechanisms? Would their role in influencing the companies they oversee be proportional to the size of their investments? What might change this influence? Answer: Other organizations with similar external control governance mechanisms include large institutional investors like BlackRock and Vanguard, regulatory bodies, and activist shareholder groups. Their influence is often proportional to their investment size, but it can also be affected by their reputation, the level of public or media scrutiny, and the firm's responsiveness to governance issues. 3. Managerial Rewards and Incentives From a corporate governance perspective, one of the most critical roles of the board of directors is to create incentives that align the interests of the CEO and top executives with the interests of the owners of the corporations. After all, shareholders rely on CEOs to adopt policies and strategies that maximize the value of their shares. We note research that shows that CEO pay is related to the performance of the firm’s stock. However, CEO pay appears to be somewhat out of control, with CEO pay escalating over time and with the average CEO pay in S&P 500 firms being 380 times the pay of an average worker in 2011. The SUPPLEMENT below addresses one reason boards of directors often fail to provide adequate oversight of CEO compensation plans: rather than use performance-based guidelines they simply follow the lead of other corporations.  Extra Example: Copy Cat Compensation Policies Lead to Pay Inflation David Larcker, who directs Stanford University’s corporate governance program, says companies can measure performance one of three ways: by stock price gains (with or without dividends added), by accounting measures (like profit gains) and by non-financial indexes like customer satisfaction and employee turnover. “A company ought to pick performance indicators for bonus schemes that are consistent with its corporate strategy,” Larcker says. Although corporate governance pundits have been parroting such truisms for years, there is little evidence that major corporations actually use such guidelines. Rather than pay for performance, 86 percent of S&P 500 companies consider what groups of peer corporations pay their bosses. GM’s board was not dissuaded merely by a plunging stock price from paying Wagoner millions and instead based his pay in part on how much IBM, Altria and other, mostly more successful, firms paid their bosses. The result is a Lake Wobegon effect: everyone struggling to be paid above average. The result of peer comparisons is that chief executive pay grew from 40 times average worker pay in 1980 to 380 times in 2011. Finally the recent recession took pay down, but only a little. Median pay in 2008 fell 10 percent from the year before among 148 large corporations, but this drop was a lot less than the 37 percent drop in stock prices (and shareholder wealth) for firms in the S&P 500. Source: Lambert, E. 2009. The right way to pay. Forbes, May 11: 78-80.  Discussion Question 38: It could be argued that since top corporations have to compete for top talent, it is okay to, in essence, “out-bid” the competition by offering larger compensation packages to attract the best talent. Do you agree? Why or why not? Answer: There must be an effective combination of three basic policies to create the right financial incentives for CEOs to maximize the value of their companies: 1. Boards can require that the CEOs become substantial owners of company stock. 2. Salaries, bonuses, and stock options can be structured so as to provide rewards for superior performance and penalties for poor performance. 3. Threat of dismissal for poor performance can be a realistic outcome. We address some figures on the tremendous pay packages that top executives of publicly-owned corporations have earned in recent years. For example, in 2011, the CEOs of major corporations averaged total income that was 380 times the average factory worker. We provide the example of David Zaslav, CEO of Discovery Communications, to give some insights on how such pay may be considered as “earned.” Teaching Tip: You can spur a lot of debate by asking if the amount of executive pay in recent years has become excessive. Some students will claim that it helps to attract top talent and that, if tied to corporate performance, any level is justified. Others may feel that there should be some realistic limits because, after all, many factors can explain the success (or lack thereof) of a corporation besides the actions of its top executives. Still other students may feel that such huge levels of compensations are simple examples of agency conflicts, i.e., that members of the boards of directors are too closely aligned (not independent) with top executives and do not effectively represent shareholders. Much of the wealth that CEOs and other top executives have created for themselves is attributed to the exercising of stock options. EXHIBIT 9.7 discusses six ways firms can go beyond simple stock option grants to develop more effective compensation packages.  Discussion Question 39: What resistance do you foresee to the implementation of some of the actions recommended in this exhibit? Answer: Resistance to implementing recommended actions might include pushback from executives who fear loss of control, reluctance to change established practices, and concerns about increased scrutiny or accountability. Additionally, cultural inertia and entrenched interests within the organization could impede adoption. Discussion Question 40: Would requiring executives to invest a year’s salary in the company turn away potentially good candidates, and thus limit the company’s options for top leaders? Answer: Requiring executives to invest a year’s salary in the company might deter some high-caliber candidates who are hesitant to risk significant personal assets. This requirement could narrow the pool of potential leaders and limit the company's ability to attract top talent. C. CEO Duality: Is it Good or Bad? Duality, where one person is both CEO and Chairman of the Board of Directors, is one of the most controversial issues in corporate governance. We present “both positions”—Unity of Command and Agency Theory, which favors and opposes duality, respectively. There has been a great deal of pressure to separate these roles, and a number of firms did so in response to pressure they received during the recession of 2008. We discuss research suggesting that the pressure to separate the Chair and CEO positions may not always generate benefits to shareholders. When firms had been performing poorly, separating the roles resulted in positive performance changes. But when a firm has been performing well, separating the roles was associated with worse performance.  Discussion Question 41: Under what conditions is duality advisable? Why? Answer: Duality, where the CEO also serves as the chair of the board, is advisable when a firm needs strong, unified leadership and streamlined decision-making, especially in turbulent times or turnaround situations. It can ensure clear strategic direction and quicker response to challenges. However, duality may lead to conflicts of interest and reduced board independence, so it's best used when the CEO's vision aligns closely with the company's needs and there are mechanisms to ensure accountability. D. External Governance Control Mechanisms Thus far, our discussion has been on internal governance mechanisms. However, internal controls do not always ensure good governance. The separation of ownership and control that is central to the concept of the corporation requires multiple control mechanisms. In this section, we address several external control mechanisms that have been developed in most modern economies. These include the market for corporate control; governmental regulatory bodies; auditors; analysts; and the business press and public activists. 1. The Market for Corporate Control If a company’s internal control mechanisms are failing — that is, the board is not effectively monitoring managers and shareholders are largely indifferent, there is a strong likelihood that managers will behave opportunistically. Such behavior can take many forms, including shirking (failure to exert maximum effort), on the job consumption (perks such as private jets, luxurious club memberships, expensive artwork for their offices), or excessive product-market diversification (which serves to reduce employment risk but often results in lower shareholder value). The market for corporate control is one external mechanism that provides a potential solution to the problems above. Rather than “fight,” shareholders will eventually sell their shares, which will depress the value of the stock. At some point, the low stock price will make the firm an inviting target for a corporate raider — because the market value of the firm may be less than the book value. The first thing a “successful” corporate raider may do upon gaining control of the corporation is to fire the management and replace it with its own appointed leaders. The risk of being taken over is often referred to as the takeover constraint, which deters management from engaging in opportunistic behavior. In recent years, the threat of the takeover constraint has become less effective as the result of a number of defense tactics that have been employed by management. These include poison pills, greenmail, and golden parachutes. 2. Auditors Despite stringent disclosure requirements, there is no guarantee that the information disclosed by a firm will be accurate. Managers may purposely disclose false information or withhold negative financial information. Thus, accounting statements are required to be audited by external auditors. However, these audits often fail to catch accounting problems. A recent study found that big accounting firms were deficient in their audits of 20 to 45 percent of audits they conducted. We note that accounting firms often have a conflict of interest in raising all concerns since they rely on ongoing accounting business from the firms they audit as well as lucrative consulting arrangements with these client firms. 3. Banks and Analysts Financial institutions and stock analysts are two external groups that monitor publicly-held firms. Commercial and investment banks have a vested interest because they lend money to corporations and must ensure that the borrowing firm’s finances are in order and that the loan covenants are being followed. And, stock analysts conduct studies of the firms that they follow and make recommendations to their clients to buy, hold, or sell. In practice, analyst recommendations have been more optimistic than warranted by the facts. “Sell” recommendations are very infrequent, in part, because most analysts work for firms that also have investment banking relationships with the companies that they follow. And, negative recommendations can displease a firm’s management who may decide to take their investment banking business elsewhere. This conflict-of-interest has led to substantial litigation. The SUPPLEMENT below provides an interesting perspective on how analysts may not be effective monitors for most investors.  Extra Example: Facebook Analysts and Secret Earnings’ Forecasts Facebook had the largest initial public offering of any firm, but it hasn’t turned out well for the initial investors. As of early June 2013, its stock price had dropped 40% from the firm’s IPO in May 2012. But this may not have been a big surprise to the firm’s stock analysts. While the firm and its backers were going on a roadshow to promote the IPO in the weeks leading up to the IPO, analysts for investment banks underwriting the IPO, including Morgan Stanley, JP Morgan, and Goldman Sachs, cut their earnings forecasts for Facebook. But they only shared this information with a few key institutional investors who were considering investing in Facebook. They did not publicize these updated earnings estimates. As a result, average investors only had access to the banks earlier and rosier estimates for Facebook’s future earnings when they were deciding whether or not to invest in the firm. These non-privileged investors were left at an information disadvantage and many suffered when Facebook’s stock dropped after its IPO. Source: Blodget, H. 2012. Facebook bankers secretly cut Facebook’s revenue estimates in the middle of IPO roadshow. finance.yahoo.com. May 22: np.  Discussion Question 42: What does the actions of the analysts of these investment banks say about the role of analysts as an external governance mechanism? Answer: The actions of investment bank analysts, particularly when they issued overly optimistic reports while privately expressing concerns, highlight the limitations of analysts as external governance mechanisms. They suggest a conflict of interest and a lack of true independence, undermining their role in providing unbiased, objective oversight. This misalignment can weaken their effectiveness in holding companies accountable and protecting investors. Analysts need stronger safeguards and clearer incentives to uphold their governance role. 4. Regulatory Bodies All corporations are subject to some regulation by the government and the extent of regulation is largely a function of the industry within which they compete. Industries such as banks, utilities, and pharmaceuticals are subject to more regulatory oversight because of their importance to society. Public corporations are subject to more regulatory requirements than private-held corporations. Public corporations are required to disclose a substantial amount of financial information by bodies such as the Securities and Exchange Commission. The failure of a variety of external control mechanisms has led the U. S. Congress to pass the Sarbanes-Oxley Act in 2002. This act calls for stringent measures to ensure better governance of U. S. corporations. We address several measures that affect auditors, CEOs, executives, and corporate lawyers. Although the financial regulation of corporations by the Securities and Exchange Commission and the Internal Revenue Service are often the most visible government regulators, firms can find themselves facing stringent, and possibly biased, oversight by other less prominent regulatory authorities. The SUPPLEMENT below discusses how Boeing faced strong regulatory pressure that altered their strategic plans and its contracts with its unions.  Extra Example: The NLRB Takes on Boeing’s Expansion For years, Boeing has had a contentious relationship with unions at its main production facilities in the state of Washington. When Boeing faced growing demand for its planes, and it needed to expand its operations, it decided to open a new plant in South Carolina. Boeing hoped it would have better relationships with workers in North Carolina, which tends to have weaker unions and more favorable labor rates than Washington. Even though Boeing did not plan to cut any jobs to its unionized workforce in Washington, the National Labor Relations Board (NLRB), the federal agency that regulates labor and union rules, charged Boeing with retaliating against its unionized workers in Washington by opening the new plant in South Carolina. The NLRB threatened to block the opening of the South Carolina plant. The NLRB pressed its case for months, but it dropped the case after the International Association of Machinists (IAM), the main union in its Washington plants, asked the NLRB to drop the case. Why did the union ask the NLRB to drop the case? It only did so after Boeing guaranteed that a new plane, the 737 Max, would be manufactured in Washington and offered the unionized workers raises and bonuses. Critics have looked at this deal and concluded that the NLRB acted not as an independent, neutral regulator but, instead, as an agent for the IAM insuring that the union was able to squeeze Boeing to offer it a sweetened union contract. Others have argued that the NLRB was only acting to ensure that Boeing didn’t harm its unionized workers in Washington by moving production to South Carolina. Source: Anonymous. 2011. Boeing bullied. The Economist. December 17: 115.. Such a highly partisan perspective should generate some spirited discussion. Ask:  Discussion Question 43: Do you think the NLRB acted fairly in this case? Answer: The fairness of the NLRB's actions often hinges on perspectives regarding labor rights and company practices. If the NLRB's decision was based on protecting workers' rights to organize and ensuring fair labor practices, it may be seen as fair. However, if it was perceived as overly punitive or biased, concerns about its fairness could arise. Discussion Question 44: How should Boeing have handled this situation? Answer: Boeing could have handled the situation by engaging in transparent negotiations with unions, addressing worker grievances directly, and improving labor relations. Proactively fostering a positive work environment and addressing concerns before they escalate could have mitigated conflicts and potentially avoided NLRB intervention. 5. Media and Public Activists Although the press is not typically recognized as an external control mechanism in the corporate governance literature, it would be hard not to argue that the financial press and media play an important role in monitoring the management of public corporations. In the United States, business magazines such as BusinessWeek and Fortune, financial newspapers such as the Wall Street Journal and Investors Business Daily, and television networks such as CNBC and Business Network are constantly reporting on companies. In fact, several years ago, Food Lion’s reputation was damaged by an ABC Prime Time Live report in 1992 that questioned its employment practices, false packaging data, and unsanitary meat handling practices. Consumer groups and activists can also play a very visible role by crusading against what they perceive as corporate malfeasance. We briefly describe a few of Ralph Nader’s 30 watchdog groups that endeavor to monitor and change the behavior and strategies of major corporations.  Discussion Question 45: Do you feel that Ralph Nader’s groups constitute an effective external governance mechanism for corporations? Why? Why not? Answer: Ralph Nader’s groups, such as Public Citizen, can be effective external governance mechanisms for corporations by advocating for consumer rights, environmental protection, and corporate accountability. They bring public and regulatory attention to corporate malpractices, potentially leading to reforms. However, their influence can be limited if corporations manage to counteract their pressure through lobbying or by presenting opposing viewpoints. Additionally, the effectiveness often depends on the group's ability to mobilize public support and influence regulatory bodies. STRATEGY SPOTLIGHT 9.4 discusses how public activists and watchdog groups have had a significant impact on two firms—McDonald’s and Nike. The SUPPLEMENT below points out how a CEO can be viewed by outsiders, depending on one’s perspective, as both a role model or as an example of what not to do.  Extra Example: CEO Friend or Foe to the Environment? Cypress Semiconductor CEO T.J. Rodgers certainly would qualify as a black hat to many. No friend of environmentalists and others who disagree with his libertarian reflexes, Rodgers is as outspoken as he is blunt. For example, Rodgers was seated between representatives from Environmental Defense and the Competitive Enterprise Institute at a 2008 panel discussion on climate change. Likening their remarks to “two loudspeakers screaming political slogans” he said in his typical manner that he “almost would rather have been waterboarded.” In 1996, Rodgers first gained a degree of notoriety with the socially and environmentally oriented community when he replied to a letter from Sister Doris Gormley, a Philadelphia nun. Sister Doris expressed disappointment in the makeup of Cypress’s board of directors, which included no women or minority members. “Get down from your high horse,” Rodgers urged in his blistering 2,800-word letter of refutation, labeling Sister Doris’s requirements “immoral”. He argued that he would be happy to add a woman or minority to his board--so long as they brought the requisite talent for the job. Lost in the biting tone of the letter were the great many positives at Cypress identified by Rodgers, from premium salaries to excellent benefits to an award-winning charity program. The letter was quickly publicized, leading to charges that Rodgers had stooped to “nun-bashing.” Given the ill will that this episode left behind, it is ironic that Rodgers’s SunPower is now busy manufacturing solar cells that reduce carbon emissions and support energy independence. In the days of cheap oil, SunPower was down to its last watt when Rodgers joined and invested in the company. His investment was part of the solution that kept the operations going trough the thin years, until demand picked up for the company’s improving solar cells. Source: Russo, M.V. 2010. Companies on a mission. Entrepreneurial strategies for growing sustainably, responsibly, and profitably. Stanford, California: Stanford University Press.  Discussion Question 46: Should we celebrate T.J. Rodgers’s solar energy success story or second-guess his business methods? Should the focus be on the CEOs’ results or on the way they achieve them? Answer: T.J. Rodgers's solar energy success story should be celebrated for its innovation and impact on renewable energy. However, it's also important to critically assess his business methods, especially if they involve controversial practices. The focus should be balanced: acknowledging the results achieved while scrutinizing the ethical and managerial approaches used to attain them. This balanced view ensures that success does not overshadow potential ethical concerns or long-term implications of business practices. E. Corporate Governance: An International Perspective In this section, we recognize that corporate governance differs among countries and regions of the world. In the United States and the United Kingdom, corporate governance has been traditionally dominated by agency theory and based on the explicit assumption of the separation of ownership and management. Here, the central conflicts are principal-agent conflicts between shareholders and management. Such a perspective, however, seldom applies outside of the United States and United Kingdom. This is particularly true in emerging economies and continental Europe where there is often: • concentrated ownership • extensive family ownership and control • business group structures • weak legal protection for minority shareholders Thus, serious conflicts often exist between two classes of shareholders: controlling shareholders and minority shareholders. These are called principal-principal (PP) conflicts—as opposed to principal-agent conflicts. EXHIBITS 9.8 and 9.9 address how principal-principal conflicts differ. There must be three conditions for PP conflicts to occur. These are: • a dominant owner or group of owners who have interest that are distinct from the minority shareholders • a motivation for the controlling shareholders to exercise their dominant positions to their advantage • few formal (i.e., legislation or regulatory bodies) or informal constraints that discourage or prevent the controlling shareholders from exploiting their advantageous positions The result is that family managers, who represent (or actually are) the controlling shareholders engage in expropriation of minority shareholders. Expropriation is defined as activities that enrich the controlling shareholders at the expense of minority shareholders. Another ubiquitous feature of corporate life outside the United States and Great Britain are business groups such as the keiretsus of Japan and the chaebols of South Korea. These are particularly dominant in emerging economies. A business group is “a set of firms which, though legally independent, are bound together by a constellation of formal and informal ties and are accustomed to taking coordinated action.” We address how business groups can both benefit (e.g., facilitate transfer of technology or capital) as well as harm (e.g., engage in related transactions – controlling members sell firm assets to another firm they own at below market prices or spin off the most profitable part of a public firm and merge it with another of their private firms) minority shareholders. The SUPPLEMENT below addresses an interesting issue: Is there a global standard for governance?  Extra Example: Is There a Global Standard for Governance? Various ownership structures, financial market infrastructures, cultural influences, and legal systems create alternative approaches to corporate governance structures and philosophies in countries around the world. For example, the governance systems that exist in such markets as the United States, Germany, Japan, China and Russia are all distinctive and reflect their own political and market economies. The United States is characterized by dispersed ownership structures, a strong shareholder orientation, and a tradition of “outsider” governance through independent non-executive directors. Japan and Germany are more stakeholder oriented, have a higher concentration of ownership and corporate control, and a tradition of “insider” governance involving controlling shareholders as well as banks or related industrial groups. Russia and China, on the other hand, are undergoing a transition to more market-oriented economies, and have an insider/outsider mix. Will such distinctions prevail or will a global governance standard emerge? There is no one country model that has proven to be ideal; all systems are vulnerable to problems. These include conflicts of interest with controlling shareholders, ownership rights, stakeholder relations, problems of control and risk management, effectiveness and independence of board oversight and excessive executive compensation. In particular, ownership structure can be a key differentiator. The governance concerns of a widely-held firm can be quite different compared to those with concentrated ownership. Thus, many of the governance practices advocated in American might fit poorly for closely-held firms in Europe or Asia. However, this does not mean that European or Asian companies should be passive or complacent. After all, family-owned firms around the world generally benefit from protecting minority shareholder rights, disclosing relevant financial and non-financial information, and having a meaningful level of independent board oversight. What should companies do? • consider governance to be both a source of competitive advantage and a key aspect of enterprise risk management • regularly review governance structures and practices — particularly for publicly-traded companies wanting to maintain access to public capital markets • strive to improve transparency and disclosure standards — especially with regard to non-financial risks and how these are communicated to various stakeholder group Source: Dallas, G. 2005. Ensuring companies walk the talk. www.euromoneyplc.com, np.  Discussion Question 47: What are the pros and cons of establishing global standards of governance? Is it a goal worth striving for? Answer: Establishing global standards of governance promotes consistency, transparency, and accountability across borders, enhancing trust and facilitating international business. However, it may also face challenges like differing legal systems, cultural norms, and economic conditions that complicate uniform implementation. While striving for global standards can drive improvements, the goal must be pursued with flexibility to accommodate diverse contexts and prevent imposing one-size-fits-all solutions. I IV. Issue for Debate How students respond to this case may be driven by their underlying values. Some students, who consider CEO pay to be egregiously high, may focus on the inequity and unfairness of insulating the CEO from bad luck. Others, looking at the situation from an ardent capitalist view, may focus on limiting agency concerns and creating conditions where top managers focus on generating shareholder wealth.  Discussion Question 48: Is it appropriate for firms to insulate their CEOs pay from bad luck? Answer: The instructor may wish to poll the class to see if there is a dominant view. If there is, the instructor may wish to ask someone to express this view and then question the class to get them to think about the other side. Alternatively, the instructor could break the class up into teams and assign them a viewpoint on this question and direct them to build the argument they would make to support this viewpoint. The class could then debate the different perspectives. The key point is that there is no objectively correct answer. However, the viewpoints expressed typically reflect an individual’s values and views on corporations. Some may argue that that the purpose of a corporation is to maximize shareholder wealth. These individuals will see these actions as appropriate since they are designed to keep top managers focused on building long term shareholder wealth. However, some students may focus on equity issues (CEOs are already paid too generously) and fairness issues (other employees aren’t protected from bad luck) and conclude that these practices are not appropriate. The instructor may wish to push the discussion to when and under what conditions it is appropriate to insulate CEOs from bad luck. Drawing on agency theory arguments, you may argue that the firm needs a strong board (outsider dominated, appropriate incentives, and no CEO duality) to ensure that the board does not take this action simply to benefit the CEO. The class could also discuss the types of bad luck that the CEO should be insulated from. Insulating CEOs' pay from bad luck can incentivize long-term performance and reduce risk aversion, but it may also lead to reduced accountability and morale issues among other employees. Balancing risk and reward is crucial for fairness and motivation.  Discussion Question 49: How can firms restructure pay to ensure that the CEOs also don’t benefit from good luck? Answer: To make the process seem equitable, it would seem that the CEO should not benefit from good luck if she is going to be insulated from bad luck. One way to do this is to only offer the CEO incentive compensation if the firm outperforms some market benchmarks. For example, bonuses may be tied to how fast a firm grows relative to its key competitors. Stock options could also be indexed so that the options only grow in value if the firm outperforms some benchmark index, such as the S&P 500.  V. Reflecting on Career Implications Below, we provide some suggestions on how you can lead the discussion on the career implications for the material in Chapter 9.  Behavioral Control: What types of behavioral control does your organization employ? Do you find these behavioral controls helping or hindering you from doing a good job? Some individuals are comfortable with and even desire rules and procedures for everything. Others find that they inhibit creativity and stifle initiative. Evaluate your own level of comfort with the level of behavioral control and then assess the match between your own optimum level of control and the level and type of control used by your organization. If the gap is significant, you might want to consider other career opportunities. Students should understand that at work there is a culture. It determines acceptable dress and behavior. Ask students for examples of behaviors are not acceptable at their work, but which may be acceptable in other places. Now ask how the organization enforces these norms. Usually students will appreciate the subtle and nuanced way that organizational norms are enforced through culture, such as offhand comments, role models, explicit conversations, and the like. At this point, it may be useful to examine these norms. Are the norms helpful to the organization’s productivity? Students should understand the tradeoffs involved. There are benefits to following established controls, as they ensure stability, predictability, motivation, and commitment. However, if the controls become onerous to some individuals, then they may reconsider their positions. It is probably useful to ask students if there were some organizational norm that would be unacceptable to them. The point would be to get students to consider the conditions under which they would not tolerate their employment.  Setting Boundaries and Constraints: Your career success depends to a great extent on you monitoring and regulating your own behavior. Setting boundaries and constraints on yourself can help you focus on strategic priorities, generate short-term objectives and action plans, improve efficiency and effectiveness, and minimize improper conduct. Identify the boundaries and constraints you have placed on yourself and evaluate how each of those contributes to your personal growth and career development. If you do not have boundaries and constraints, consider developing them. Personal boundaries are important for students to consider, especially when it comes to ethical behavior. Ethical behavior directly applies to the business environment, too. Ask students what ethical behavior they could not ever consider regardless of the financial reward, such as plagiarism, lying, and spreading untrue rumors about a friend. Now ask why students have these internal behavioral boundaries. This question should start an interesting discussion, as students will likely have different levels of tolerance. The next step is to ask how these internal boundaries affect students’ long-term career prospects. Consider these prospects in terms of promotions and status as well as in terms of satisfaction, happiness, and contentment. A lively discussion will likely encourage students to think about their long-term career goals in a new light.  Rewards and Incentives: Is your organization’s reward structure fair and equitable? On what criteria do you base your conclusions? How does the firm define outstanding performance and reward it? Are these financial or nonfinancial rewards? The absence of rewards that are seen as fair and equitable can result in the long-term erosion of morale, which may have long-term adverse career implications for you. Students can benefit from examination of their organization’s reward structure. One way to look at rewards is as a form of positive feedback that encourages firms; desired behavior. Feedback can be pecuniary, such as salary, raises, and other compensation; or non-pecuniary, such as “employee of the month” awards or other recognition. Ask students to list the types of rewards they can earn at work. Then ask which types of rewards are more important. A key follow-up question is to ask students how the important rewards are allocated. Is the allocation fair? Is the allocation system transparent? For students who are working, instructors could ask if the reward system is fair to them personally. Does the system limit their potential within the organization because others will be favored? If so, then the organization may not be an appropriate place for career development. The next topic should be to ask students how the reward system could be improved. This topic is important because it puts students in the position of a senior manager, and hopefully allows them to think of how the reward structure can support overall organizational performance.  Culture: Given your career goals, what type of organizational culture would provide the best work environment? How does your organization’s culture deviate from this concept? Does your organization have a strong and effective culture? In the long run, how likely are you to internalize the culture of your organization? If you believe that there is a strong misfit between your values and the organization’s culture, you may want to reconsider your relationship with the organization. This topic is a continuation of the first one. It personalizes students’ responses to organizational culture in the long term. In reality, many students will not know the extent to which they can adapt to an organizational culture, so the goal is not to have them assess whether or not they can survive in specific organizational culture. A possible fruitful approach is to have students list the types of organizational culture they would like. Do they like stability? Or do they thrive in a creative and fluid organization? Can they tolerate an organizational culture with a strict dress code? Or do they strongly prefer an informal environment? Do they like to work independently or in close collaboration with a mentor? The point is to get students to think about the characteristics of organizational cultures that they like. These positive aspects may make it worthwhile for them to adapt to the other aspects of the organizational culture that they may not find ideal.  VI. Summary For firms to be successful, they must implement their strategies by means of effective strategic controls. Without such controls, the firm will not be able to achieve competitive advantages and outperform rivals in the marketplace. We began the chapter with the key role of informational control. We contrasted two types of control systems: what we termed “traditional” and “contemporary” information control systems. Whereas traditional control systems may have their place in placid, simple competitive environments, there are fewer of those in today’s economy. Instead, we advocated the contemporary approach wherein the internal and external environment is constantly monitored and, when surprises emerge, the firm must modify its strategies, goals, and objectives. Behavioral controls are also a vital part of effective control systems. We argued that firms must develop the proper balance between culture, rewards and incentives, and boundaries and constraints. Additionally, where there are strong and positive cultures and rewards, employees tend to internalize the organization’s strategies and objectives. This permits a firm to spend fewer resources on monitoring behavior and the firm is assured that the efforts and initiatives of employees are more consistent with the overall objectives of the organization. With regard to corporate-level strategies, we discussed the need for firms following related diversification strategies to develop cultures and incentives that reward information and resource sharing as well as overall goals of the corporation. However, in the case of unrelated strategies wherein there is limited need or opportunity for resource sharing and collaboration, cultures and incentives that are highly based on a manager’s individual business-unit performance will suffice. In the final section of this chapter, we addressed corporate governance, which can be defined as the relationship between the various participants in determining the direction and performance of the corporation. The primary participants include shareholders, management (led by the chief executive officer), and the boards of directors. We reviewed studies that indicated a consistent relationship between effective corporate governance and financial performance. There are also several internal and external mechanisms that can serve to align managerial interests and shareholder interests. The internal mechanisms include a committed and involved board of directors, shareholder activism, and effective managerial incentives and rewards. The external mechanisms include the market for corporate control, banks and analysts, regulators, the media, and public activists. We also address corporate governance from an international perspective. Chapter 9: Strategic Control and Corporate Governance Select an organization with which you are familiar. How effective are their behavioral controls — rewards, culture, and boundaries. How could these controls be improved? What tradeoffs may be involved? Teaching suggestions: You can organize the discussion around the following: *What is ‘behavioral control’ and how is it different from ‘informational control?’ Informational control: -concerned with whether or not the organization is “doing the right things” -deals with both internal and external environments of the firm -addresses how well the organization’s goals and strategies still “fit” within the context of the current strategic environment. Behavioral Control: -is focused on implementation i.e., “doing things right” -deals with culture, rewards and boundaries within the organization that help in “doing things right” You might want to discuss what each of these terms: ‘culture,’ ‘rewards,’ and ‘boundaries.’ A quick recap of these is given below: Organizational culture is a system of shared values (what is important) and beliefs (how things work) that shape a company’s people, organizational structure, and control systems to produce behavioral norms (the way we do things around here). Rewards and incentive systems are important means of influencing an organization’s culture, focusing efforts on high-priority tasks, and motivating individual and collective task performance. Boundaries and constraints are the rules laid down for appropriate conduct of business. They are important to focus individual efforts on strategic priorities, providing short-term objectives and action plans to channel efforts, improving efficiency and effectiveness and minimizing improper and unethical conduct. You can ask the students to describe the organizational culture, rewards and boundaries in organizations they have chosen to the answer the question. *Will a strong organizational culture substitute for rewards and boundaries? The key point to be emphasized here is that none of these aspects of behavioral control can be totally substituted by any other one. A strong culture would certainly help in improving the motivation and morale of employees and can help in reducing the need for monetary incentives. Culture can also reduce the need for external rules and regulations and thus lower the monitoring costs. However, it does not mean that culture can substitute for rewards or boundaries completely. For behavioral control to be effective, all three of these aspects of behavioral control must be in a healthy balance. You might want to ask if the students would be willing to work for a very reputed organization known for its culture, offering a very low pay or for an organization with no emphasis on culture, but pays very high. You can expect to see a split in the students’ responses that some of them would favor working for the first organization and some for the second. You can also expect questions such as: ‘how high is the high pay?’ or ‘how low is the low pay?’ This would help in emphasizing the need for balance between all the three levers rather than substitution of one with the other for behavioral control to be effective. *Can all organizations place equal emphasis on all three aspects of behavioral control in all kinds of environments? Here you must emphasize the role of situational factors, both external and internal, in determining which types of behavioral controls would work better for an organization. As explained in the text, in organizations where individual performance is difficult to measure accurately (for example, high-technology firms operating in highly uncertain environments), internalized norms and values become very important whereas in more stable and predictable environments such as an assembly line, strict adherence to rules and procedures would work better. A key point to be made is that while it is easy to suggest improvements to organizational culture and incentives and reward systems, which of the improvements are really necessary given the environment in which the firm is operating? Also, each such improvement would have cost implications that need to be justified. End of Chapter Teaching Notes Chapter 9: Strategic Control and Corporate Governance Summary Review Questions 1. Why are effective strategic control systems so important in today’s economy? Response : In today’s economy there have been a number of problems related to unchecked behavior by executives. The recession starting in 2008 was due in part to banks, mortgage brokers, and bond rating agencies not exercising appropriate controls on unethical behavior. A recent flurry of U.S. government investigations into backdating options has affected the fortunes of many large firms. And the bursting of the dot.com bubble in 2000 was due, in part, to firms overestimating the value of their future sales, which later did not materialize. Good strategic control systems and corporate governance would have prevented many of these abuses. Answer: Effective strategic control systems are crucial in today’s economy as they ensure alignment with strategic goals, adapt to market changes, and enhance organizational performance by providing timely feedback and facilitating informed decision-making. 2. What are the main advantages of “contemporary” control systems over “traditional” control systems? What are the main differences between these two systems? Response: Traditional control systems are a sequential method of organizational control in which (1) strategies are formulated and top management sets goals, (2) strategies are implemented, and (3) performance is measured against the predetermined goal set. Strategic control is done after performance is found to be lacking, usually on a quarterly or annual basis. There have been a number of problems with this system. First, the volatility of the business environment makes it difficult for top managers to accurately set effective strategies that will be useful for a period of a quarter or a year. Second, as strategies should respond to a volatile environment, so should implementation. An incremental approach is most effective. Third, performance measurement should be more continuous, as a strategy is implemented incrementally, performance should also be measured to determine how the implementation is doing. Contemporary control systems emphasize continuous monitoring of the internal and external environment for trends and events that signal the need to make modifications to a firm’s strategies, goals and objectives. Contemporary control systems use both informational control to formulate strategies, and behavioral control to implement strategies. Informational control involves the gathering of information from the internal and external environment in order to obtain the best fit between the organization’s goals and strategies and the strategic environment. Behavioral control seeks to influence employees through culture, rewards, and boundaries. Answer: Contemporary control systems offer advantages such as increased flexibility, real-time data analysis, and a focus on strategic alignment, allowing organizations to adapt quickly to changes and make informed decisions. In contrast, traditional control systems tend to be more rigid, often focusing on historical performance and financial metrics, which can limit responsiveness and adaptability. 3. Why is it important to have a balance between the three elements of behavioral control—culture; rewards and incentives; and, boundaries? Response: Organizational culture is a system of shared values and beliefs that shape a company’s people, organizational structures, and control systems to produce behavioral norms. The organizational reward system specifies who gets rewarded and why. Boundaries are a clear statement of behavior that is and is not appropriate, such as which product markets a firm will compete in, short-term objectives and action plans, rule-based controls, and guidelines for proper relationships with customers and suppliers. A balance between these three elements is needed. Organizational culture is essential for motivating employees and their identification with the organization and its goals. Culture establishes behavioral norms and therefore implicitly sets boundaries and reduces monitoring costs. Culture influences beliefs, behaviors and attitudes, but it is not sufficient for control. Behaviors and attitudes must be kept focused on organizational goals, and that is where rewards come in. Rewards are both a motivator and a control system. Ideally, rewards reinforce behavior that is consistent with organizational culture. Rewards help to ensure that employees work to achieve organizational goals. Boundaries are necessary because, even with a strong organizational culture and an effective rewards system, there might be individuals and groups (1) motivated by self-interest, (2) without a clear understanding of goals and objectives, or (3) are subject to malfeasance. Boundaries are a tool for clearly specifying, even quantifying, the limits of acceptable behavior. Answer: Balancing culture, rewards, and boundaries ensures alignment between organizational values, employee motivation, and operational constraints, fostering both effective performance and ethical behavior. Without this balance, firms risk either stifling innovation or compromising control and consistency. 4. Discuss the relationship between types of organizations and their primary means of behavioral control. Response: Culture is an effective form of behavioral control in situations where individuals’ contribution to organizational performance is difficult to measure. For example, professional organizations, high-tech organizations, organizations engaged in creative endeavors, and organizations where individuals have high autonomy lend themselves to culture control. In organizations where individuals’ output or performance is quantifiable and straightforward, rewards may be an effective method of control. Sales managers are often motivated by commissions, and the monetary rewards may be more important to them than organizational norms and values. Rewards are also effective in organizations using an unrelated diversification strategy. In any type of organization, rewards should reinforce other types of control. For organizations in stable industries with stable output, and organizations with routine and repetitive tasks, boundaries can be an effective control measure. Written and explicit guidelines provide effective constraints on behavior. Answer: The primary means of behavioral control vary by organization type: hierarchical organizations often rely on strict rules and procedures, while innovative firms may focus more on culture and incentives to drive performance. The choice reflects the organization’s goals and operational needs. 5. Boundaries become less important as a firm develops a strong culture and reward system. Explain. Response: Strong culture and effective rewards systems establish norms that constrain undesirable behavior. Individuals in the organization internalize and accept the norms. Organizations can facilitate such internalization by hiring people with values similar to what the organization requires, training them well, and keep top managers who are role models. In addition, reward systems should be clearly aligned with organizational goals and objectives. Answer: As a firm develops a strong culture and effective reward system, employees are more likely to self-regulate their behavior and align with organizational goals, reducing the need for rigid boundaries and controls. 6. Why is it important to avoid a “one best way” mentality concerning control systems? What are the consequences of applying the same type of control system to all types of environments? Response: Control systems that are not aligned with the organizational environment will not be effective. For example, if individuals in an organization have a lot of autonomy such as a research lab, and a firm installs a rewards control system, then it would have to install a system of performance milestones on which the rewards system would be based. However, the system of performance milestones risks diverting efforts from organizational goals. For example, in a lab the rewards system might offer bonuses based on the number of experiments conducted. That system might skew the research towards doing numerous, quick, experiments, but the experiments that would best serve the firm’s objectives might be more complex and take longer. In general, control systems that do not fit the firm’s environment will tend to either be costly or divert effort from what the firm needs to do to achieve its goals and objectives. (Note to instructor) Students will come up with examples of consequences, which is very useful for learning purposes. For each example of consequences, ask the student to identify the cost or other negative consequence of the inappropriate control system. Answer: Avoiding a "one best way" mentality is crucial because different environments and organizational contexts require tailored control systems. Applying the same system universally can lead to inefficiencies, misalignment with specific needs, and failure to address unique challenges or opportunities, reducing overall effectiveness. 7. What is the role of effective corporate governance in improving a firm’s performance? What are some of the key governance mechanisms that are used to ensure that managerial and shareholder interests are aligned? Response : Corporate governance is the relationship among shareholders, management, and the board of directors that determines the corporation’s performance. Corporate governance is, in a way, a control system for top management. Corporate governance refers to a system for measuring top managers’ performance and motivating them to work to maximize shareholder value. It aligns incentives between principals (owners) and agents (managers) such that the agents have similar objectives and risk propensities as the principals. Governance mechanisms include an active board of directors who regularly evaluate the CEO, replacing him/her if necessary, review the vision, mission, and strategic objectives of the corporation, provide advice to top management, manage the board judiciously, and review various systems that ensure that the corporate office complies with laws and regulations. Shareholder activism, or actions by shareholders to protect their interests when they feel that managerial actions diverge from shareholder value maximization, can embarrass top managers who are not performing well. Managerial rewards and incentives can be used to align incentives by (1) ensuring that managers own substantial shares of company stock, (2) structuring rewards such that good corporate performance is rewarding and poor corporate performance is not, and (3) make the possibility of dismissal for poor performance a realistic one. In addition to these internal methods, there are external corporate governance methods, or methods used by groups outside the corporate governance system. These include the market for corporate control, where shareholders can sell their shares if not satisfied with management, auditors, banks and analysts, regulatory bodies, and media & public activists. Answer: Effective corporate governance improves firm performance by ensuring transparency, accountability, and alignment between managerial actions and shareholder interests. Key mechanisms include the board of directors, executive compensation plans, and auditing processes. 8. Define principal-principal (PP) conflicts. What are the implications for corporate governance? Response: Principal-principal conflicts are between two classes of principals – controlling shareholders and minority shareholders – within the context of a corporate governance system. Often, the controlling shareholders belong to families or other business groups, and prefer to have the firm do business with other firms in family or business group control. These related transactions may be on unfavorable terms for the firm, and will therefore hurt firm value. The implications for corporate control are that the system will not work to maximize shareholder value, but rather to maximize controlling shareholder interest at the expense of minority shareholders. Answer: Principal-principal (PP) conflicts arise when major shareholders, or principals, with differing interests clash over how a company should be managed. These conflicts can lead to governance challenges such as inefficient decision-making and misaligned strategies, potentially undermining the firm's performance and shareholder value. Experiential Exercise McDonald’s Corporation, the world’s largest fast-food restaurant chain, with 2010 revenues of $28 billion, has recently been on a “roll.” Its shareholder value rose over 50% from May 2010 to May 2013. Using the Internet or library sources, evaluate the quality of the corporation in terms of management, the board of directors, and shareholder activism. Are the issues you list favorable or unfavorable for sound corporate governance? Response: The corporate website contains ample information on corporate governance. Most every aspect of good corporate governance is included in the material. There is a high level of transparency. Some highlights are below: Management 1. The CEO and Vice Chair of the Board from 2004 to 2012 was Jim Skinner. He helped McDonald’s improve performance by emphasizing the need to be “re-focused on customer strategies, business disciplines and close global alignment.” (quote from bio on McDonald’s website, Accessed 3 August, 2011 from http://www.aboutmcdonalds.com/mcd/our_company/bios/jim_skinner.html, para. 2) 2. Current CEO, Don Thompson, is an experienced manager at McDonald’s and rose to CEO from the COO position 3. Diversity on the top management team 4. Board of directors 1. High caliber of executives as members 2. Written corporate governance policies including code of conduct, ethics, compensation, and director independence 3. Staggered board and classified board 4. CEO is the only member of the board 5. None of the board members have a clear tie to the CEO Shareholder activism 1. Code of social responsibility 2. Policy against making corporate political contributions 3. Policy on CAS, or “controlled atmospheric stunning” of poultry in response to a shareholder proposal by PETA (people for the ethical treatment of animals). Some discussion questions may include: • The Chair is an outsider? Does this leave him at a position of information deficiency compared to the CEO? • The written policies seem very ethical and appropriate. But how would a shareholder know if they are being followed? • If the top management were to choose between a profitably opportunity and social responsibility, which would it choose? Can you identify a choice that McDonald’s has made in the past of social responsibility over profits? (Note to instructors) Students should, after reviewing the website, be able to come up with some corporate-reported examples of good governance. For each, ask students how this practice contributes to the goal of corporate governance – or the alignment of managers’ and shareholders’ interests. A teaser question is “What agency problem does this example address?” Another interesting line of questioning is to develop a list of other potential measures can the board of directors, or shareholders, do to improve the system. Answer: McDonald's strong financial performance and rising shareholder value suggest effective management and governance. However, concerns such as executive compensation practices or board diversity might raise questions. Overall, the issues are generally favorable for sound corporate governance if managed proactively. Application Questions Exercises 1. The problems of many firms may be attributed to a “traditional” control system that failed to continuously monitor the environment and make necessary changes in their strategy and objectives. What companies are you familiar with that responded appropriately (or inappropriately) to environmental change? Response: (Note to instructors) For each company the students provide, ask the following: • What environmental change did the company not respond to? • How did the company respond? • How should the company have responded? • Why did the company not respond appropriately? The answer to the last question may highlight the deficiencies of the traditional control system and the need to continuously monitor the environment. Answer: Netflix adapted its strategy from DVD rentals to streaming, successfully navigating industry changes. Conversely, Blockbuster's failure to transition to digital streaming led to its downfall, demonstrating inadequate response to environmental shifts. 2. How can a strong, positive culture enhance a firm’s competitive advantage? How can a weak, negative culture erode competitive advantages? Explain and provide examples. Response: A strong, positive culture will provide a supportive work environment, motivate employees to work together to achieve organizational goals, and set norms for positive behavior. Firms with strong, positive cultures will therefore tend to have a sustainable competitive advantage in human and social capital. Firms with weak, negative cultures will not motivate employees, not set behavioral norms, and possibly lead to managers behaving out of self-interest. The weak, negative culture will thereby tend to erode human and social capital. (Note to instructor) It is an important lesson for students to understand the kind of organizational culture that they want to have in their organizations. In discussion, ask students to identify the effects on them personally of working in an organization with a weak, negative culture. Then ask students to identify the characteristics of a strong, positive culture. How could they recognize an organization with a good culture? What questions could they ask on a job interview that would describe the corporate culture? Answer: A strong, positive culture at companies like Google fosters innovation and employee satisfaction, enhancing competitive advantage. Conversely, a weak, negative culture at firms like Uber, marked by internal conflicts and unethical practices, erodes trust and competitive edge. 3. Use the Internet to research a firm that has an excellent culture and/or reward and incentive system. What are this firm’s main financial and nonfinancial benefits? Response: (Note to instructor) The purpose of the assignment is to increase student awareness of effective rewards systems. Ask students to identify what the firm’s financial and nonfinancial benefits are. Then ask which is more important, the financial or nonfinancial components and why? What does the provision of nonfinancial benefits tell about the firm’s values and about its work environment? And again, what questions should you ask in a job interview to ensure that you are will join an appropriate firm? Answer: Salesforce is known for its strong culture and reward system. Financially, it enjoys high employee retention and strong performance, while non-financially, it benefits from high employee satisfaction and innovation, fostering a positive workplace environment. 4. Using the Internet, go to the Web site of a large, publicly held corporation in which you are interested. What evidence do you see of effective (or ineffective) corporate governance? Response: One approach is to examine the corporate governance policies, procedures, ethical codes, independence of the Board, management representation on the board, and other observable characteristics. A second approach is to look at top management behavior and compensation. Look to see if the bonus makes sense given the corporation’s performance. Look to see if the explanation of the bonus is logical. Your investigation might also go beyond examination of the corporation’s web site and go to that of independent auditors, news reports, or other information that indicates effective corporate governance. (Note to instructor) Corporate web sites are probably full of mostly good news about the corporation, and the evidence from there is likely to be one-sided. Some evidence that might raise questions is whether or not the CEO is also chair of the board, the number of CEOs on the compensation committee, the independence of board members, and the history of the board at aligning top management compensation with corporate performance. Answer: At Apple Inc., evidence of effective corporate governance includes a diverse and experienced board of directors and strong shareholder engagement practices, such as transparent financial reporting and a commitment to ethical business practices. Ethics Questions 1. Strong cultures can have powerful effects on employee behavior. How does this create inadvertent control mechanisms? That is, are strong cultures an ethical way to control behavior? Response: Culture can control behavior through social censure. Individuals who have internalized an organizational culture will behave appropriately in order to preserve their status in the organization. Possible problems with strong cultures are that they stifle creativity, or reinforce unethical behavior. The problem with stifling creativity is groupthink. Individuals will tend to go along with the group consensus rather than raise objections or concerns with particular decisions. Ethically, the problems with groupthink are on the individual level, as it may tend to stifle expression and limit personal development. Organizationally, groupthink can lead to bad decisions that erode shareholder value. Reinforcing unethical behavior is a more apparent problem. If a corporate culture, say, allows individuals to leave at 4 pm yet be paid as if they were at work until 5 pm, then the corporation is being shortchanged out of an hour. Such culturally reinforced unethical behavior erodes personal integrity and, especially in the extreme, harms shareholder value. Answer: Strong cultures create inadvertent control mechanisms by aligning employees' values with organizational goals, influencing behavior through shared norms and expectations. While this alignment can foster ethical behavior, it may also suppress dissenting views and ethical concerns, making it important to balance cultural influence with explicit ethical guidelines. 2. Rules and regulations can help reduce unethical behavior in organizations. To be effective, however, what other systems, mechanisms, and processes are necessary? Response: Rules and regulations must be enforced. Someone in the organization has to both monitor behavior and sanction unethical behavior. This implies a need for an independent internal affairs ombudsman, or other corporate department. At the least, there should be some verification system to check that reported and self-reported information is accurate. Answer: Effective rules and regulations require robust enforcement mechanisms, including clear reporting channels, regular audits, and a strong ethical culture that supports compliance and accountability. Solution Manual for Strategic Management: Creating Competitive Advantages Gregory G. Dess, Alan Eisner, G.T. (Tom) Lumpkin, Gerry McNamara 9780077636081, 9781259245558