Organizational Limits to Firm Scope PDF - University of Bern - Session 5, HS2023

Session 5: Organizational Limits to Firm Scope Prof. Dr. Artur Baldauf © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 1 Structural Topics (muddiest points) Value driver tree based on Du Pont scheme (see e.g., Brigham/Houston) Write-up ? Unclear topics → a lot of r...

Session 5: Organizational Limits to Firm Scope Prof. Dr. Artur Baldauf © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 1 Structural Topics (muddiest points) Value driver tree based on Du Pont scheme (see e.g., Brigham/Houston) Write-up ? Unclear topics → a lot of room for interpretation Purposefully “open”, because your corporations are very different, leaves room for your thoughts on the topic and similar questions to the exam Tasks ? Aim of Analysis (write-up and Disney questions) Deepening your understanding on the topic with practical examples and exam preparation Exam ? Whether the closed-book exam will include provisions such as “extra text is not important to your argumentation will lead to a lower grade” Structure of the exam on following slides © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 2 Structural Topics (muddiest points) 1 Structure An Introduction to Corporate Strategy Resources 2 3 2 STRUCTURE SYSTEM 7 9 3 Scale and Scope within an Industry 4 Diversified Expansion Structure, Systems, and Processes PROCESS 6 8 Businesses 4 VISION GOALS Resources and Rents 5 5 Organizational Limits to Firm Scope 6 Managing the Multibusiness Corporation Lecture of today, 2.11.23 Putting It All Together Corporate Advantage © Artur Baldauf l Department of Management l University of Bern 7 Creating Corporate Advantage 8 Corporate Governance 9 Corporate Transformation Corporate Strategy 3 Structural Topics (muddiest points) 1 Structure Resources We discuss the 3 different elements VISION of the triangle 2 4 GOALS STRUCTURE SYSTEM PROCESS 6 7 8 9 5 Corporate Advantage © Artur Baldauf l Department of Management l University of Bern Some of the chapters and topics are connected and related to each other 2 Resources and Rents Businesses 3 Scale and Scope within an Industry 4 Diversified Expansion Structure, Systems, and Processes 5 Organizational Limits to Firm Scope 6 Managing the Multibusiness Corporation Putting It All Together 7 Creating Corporate Advantage 8 Corporate Governance 9 Corporate Transformation Corporate Strategy Structure follows the book An Introduction to Corporate Strategy 4 Information about the Final Exam (50%) General InformationValue driver tree based on Du Pont scheme (see e.g., Brigham/Houston) Language: English, but you may provide your answers either in English or in German. Time & Location 1st Exam – Wednesday, Dec 19, Room 110, Main Building, 18:15 – 20:15 2nd Exam – Friday, Feb 13, Room 110, Main Building, 12:00 – 14:00 Exam Content Overall, the purpose is to apply the framework All course materials (sessions, guest-lecture, readings) are relevant for the exam. The exam consists of several parts: Multiple Choice on selected theoretical content Theoretical (knowledge) questions Case Analysis with short and long answers © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 5 Administrative Information Guest Speaker: Antoinette Hunziker-Ebneter, President of the Board, Bernese Cantonal Bank 8.15 – 11.00, Thursday, November 9th, Attendance compulsory → Guest lecture touches on different topics of the triangle © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 6 Chapter 5: Organizational Limits to Firm Scope Learning Goals: The meaning of „scope“ decisions from a theoretical view. Markets vs. hierarchies from a transaction cost theoretical perspective. VISION GOALS STRUCTURE Organization of the decision process in a practical manner. © Artur Baldauf l Department of Management l University of Bern SYSTEM PROCESS Corporate Advantage Corporate Strategy 7 Chapter 5: Contents Introduction Principles „Scope of the Firm“: Resources and Competitive Advantage „Scope of the Firm“: Market or Hierarchy The Market Advantages Costs of the Market Sources of Market Failure The Hierarchy Advantages Costs of the Hierarchy Summary: Market or Hierarchy? Practice: Choosing the Scope of the Firm Decision Process © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 8 Introduction Expansion Characteristics Expansion within an Industry Expansion between Industries „Scale“ Effects New Markets „Scope“ Effects New Territories Single Business Corporation © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 9 Introduction Expansion Characteristics Scope of the firm: Where are the firm boundaries? ▪ Does the firm possess resources that provide a competitive advantage? ▪ Why should a particular business / activity be performed inside the firm? © Artur Baldauf l Department of Management l University of Bern Expansion within an Industry Expansion between Industries „Scale“ Effects New Markets „Scope“ Effects New Territories Corporate Strategy 10 Scope of the Firm Two basic forms of economic organization / governance structures Market Hierarchy The price system is used to Goods and services are coordinate the flow of goods and produced and exchanged within services across separate (legal) the firm entities © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 11 Scope of the Firm Market or Hierarchy Coase (1937): Why does the entrepreneur not organize one less transaction, or one more? Why do firms exist? Why is not everything organized in one giant corporation? Neoclassic theory argues for the market efficiency (price system; invisible hand) Coase (1937) / Williamson (1975) suggest that markets are preferable, but contractual problems exist (e.g., „cheating“) and there is often a loss of efficiency and/or incentive occurs © Artur Baldauf l Department of Management l University of Bern If markets are efficient, why are activities organized within (costly) hierarchical structures that explicitly include planning and control („Theory of the Firm“)? Sometimes market failure arises; e.g., governance costs of the transaction (negotiating, writing, monitoring, etc.) are higher than the benefit of low production costs. Corporate Strategy 12 Governance Structures: Market vs. Hierarchy Market (Decentralization) … Price system (invisible hand) coordinates … … Corporate Hierarchy (Integration) internal administration of activities Markets are (usually) NOT perfect, there is FAILURE © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 13 Market or Hierarchy Transaction Cost Economics (TCE) Goal: to develop the most efficient governance form (i.e., with the lowest transaction costs) Organization: Number of transactions within and between organizational boundaries Transaction: Exchange of goods and services between groups within and between organizations (across separable interface) (unit of analysis) Transaction costs: All costs appearing in the framework of transactions in order to solve information and communication problems. So-called: “friction losses" of the economy (ex-post/ex-ante). Production costs (direct costs): Costs incurred in the physical production and exchange of the item Governance costs (indirect costs): Costs of negotiating, writing, monitoring, enforcing, and possibly also bonding to the terms of the organizational agreement Decision makers Bounded rationality (prevents error-free information exchange; incomplete contracts) Maximize profits; asymmetric information © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 14 Market or Hierarchy Transaction Cost Economics (TCE) Transaction costs theory … … works to identify the benefits and costs of market exchange. In particular, it’s concentrated on identifying the conditions under which markets are very expensive ways to organize transactions or, in the extreme, fail because those costs are so high. (Because of the intrinsic merits of markets, transaction cost theory argued that only in such circumstances would the corporate hierarchy become the preferred mode of organization.) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 15 The Market Benefits and Costs Benefits Efficient information processing (price mechanism and decentralized decisions) High incentives (self-interest, individual vs. collective) Competition (market discipline) Flexibility (one can easily undo every relationship) Costs Market failure: Opportunism Asset specificity Uncertainty High transaction frequency (small numbers) Asset specificity, uncertainty and high frequency create the potential for a firm to act opportunistically. High transaction costs from market failure (e.g. GM vs Fisher Body) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 16 Classic make or buy example “Holdup problem”: Originally, General Motors relied on Fisher Body to deliver essential components for GM cars. GM depended on Fisher Body entirely. Fisher Body, aware of that dependence, raised prices. GM paid the higher price. Eventually, Fisher Body raised prices too much and GM bought the company. If the supplier has a valuable input, the supplier will have bargaining power. If the firm asks the supplier to build a specialized machine that only can be used to make their product, the firm will have bargaining power. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 17 Market Failure Market relationships fail, when they are subject to: Opportunism Asset specificity Uncertainty High transaction frequency (small numbers) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 18 The Market Opportunism (transaction cost theory) People act in their own self-interest: e.g., lying, cheating, stealing Try to benefit themselves Consequences: cost-intensive processes are necessary to limit the opportunities of opportunistic behavior, e.g., through the exact wording of contracts and inclusion of all eventualities (however: incomplete contracting) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 19 The Market Asset Specificity (transaction cost theory) … assets dedicated to a particular use The degree of the specificity of a transaction object is measured when comparing its economic value (e.g., a machine) to a next best alternative. The higher the difference, the more specific the transaction object. Investment decisions of specific assets influence how organizations define their relationships to employees and other corporations. Types of Asset Specificity: Location specificity (e.g., if the use at another location is possible only at an economic loss in value) Physical asset specificity (e.g., if the use of a transaction object outside the original planned application is realizable only at an economic loss in value) Human capital specificity (e.g., if know-how of employees is transferable to other projects/companies only at an economic loss in value) Consequence: very specific and fixed assets can influence the flexibility and the investing firms bears the risks © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 20 Choice between Market and Hierarchy (TCE, transaction cost theory) Linking the degree of specificity and transaction costs The height and specificity of the necessary investments is the most important determinant for the height of the transaction costs. Therefore, the focus is on specificity. The higher the specificity, the higher are the transaction costs (if free market is chosen) With increasing specificity, a contractual protection (hybrid form) is efficient Integration is efficient if there is a very high specificity Transaction Costs (T) Market Hybrid Form Hierarchy Degree of Specificity (S) Source: Williamson, „Comparative Economic Organization“, 1991, pp. 13-49 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 21 The Market Uncertainty / Complexity (transaction cost theory) Uncertainty: it is impossible to exactly predict the future Two types of uncertainty (Williamson): Environment uncertainty (adaptation problem) Because of environmental complexity the decision maker does not know all conditions. Environmental dynamics (changes) complicate efficient decision making. Behavior uncertainty (performance measurement problem) Based on the assumption of opportunistic behavior, the „true“ intentions of the contract partner is uncertain (moral hazard) Consequences: When formulating contracts activities for reducing environmental uncertainty are necessary (e.g., search for information) Phenomena such as „moral hazard“ lead to costs (e.g., for screening or monitoring activities to reduce and/or remove asymmetric information); contract relations create control and monitoring costs © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 22 The Market High Frequency (transaction cost theory) Frequent transactions expose a firm to holdup (more coordiantion needed) At a higher number of cyclical transactions between the same contract partners, confidence (trust) in the non-opportunistic behavior of the contract partner can be developed Certain information and control processes can be left out, thereby saving transaction costs. On markets with a small number of contract partners, switching possibilities are limited; organizations with only a few trade partners (oligopoly) can be shortchanged more easily. On markets with homogeneous or standardized goods, it is possible to make a credible threat of changing the contract partner. Consequence: There may be an incentive towards opportunistic behavior. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 23 The Hierarchy Benefits and Costs Benefits Costs Unified ownership Increasing bureaucracy (establishing Authority Coordination (design interconnectedness) Regulation advantage lower personal incentives, lower Quality control/process optimization performance/ motivation …) Information acquisition Lower flexibility Leverage of resources and skills Potential overcapacity authority has a cost) Agency Costs (e.g. increasing monitoring; Central assumption: Firm – a nexus of contracts © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 24 The Hierarchy Agency Costs - Asymmetric Information Principal and agent often have different goals and follow their own self-interest (asymmetric information) Information in exchange processes (of transactions) is not equally distributed Agents have certain information about their own behavior and the principal does not have this information Consequences: Costs emerge through the gathering of additional information and in reference to different governance mechanisms © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 25 Choice between Market and Hierarchy Incentive Problems and Governance Structures Hierarchy Market high low small large (require high incentives) Incentive System can be developed cannot be developed Employee Performance easy to regulate hard to regulate Skills and Creativity low high Coordination Activities Individual Contributions / Efforts © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 26 Choice between Market and Hierarchy Market Hierarchy - Informational efficiency - Authority - High power incentives - Coordination Benefits - Transaction costs - Bureaucracy - Market power - Agency costs Costs Source: Collis and Montgomery, Corporate Strategy, 2005, p. 133 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 27 Choice between Market and Hierarchy Limits to Firm Scope Cost of the Hierarchy Cost/ Benefit Benefit of Transaction A Cost of the Market B Increasing Firm Scope Limit to Firm Scope Source: Collis and Montgomery, “Corporate Strategy”, 2005, p. 134 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 28 Choice between Market and Hierarchy Example Automotive Industry: DYER’s “Make or Buy” Model Partner (compare capabilities) High Component Value Low - Seats - Air conditioners - Tires Make - Engines - Transmissions Partner (compare capabilities) Buy - Bolts - Nuts - Belts - Filters - Engine components - Interior and exterior trim products Low © Artur Baldauf l Department of Management l University of Bern Asset Specificity High Corporate Strategy 29 Governance Structures: A Spectrum Spot market exchange Long-term contracts Alliances Joint Ventures Corporate Hierarchy (Integration) Most Common “Swollen Middle” © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 30 PRACTICE Decision Process Should a company (vertically) integrate into a particular activity? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 31 PRACTICE “Scope of the Firm” – Decision Process Decision Process Step 1: Disaggregation of the Industry Value Chain Step 2: Competitive Advantage Step 3: Market Failure Step 4: Need for Coordination Step 5: Importance of Incentives © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 32 PRACTICE “Scope of the Firm” – Decision Process Step 1: Disaggregation of the Industry Value Chain Disaggregation of the industry value chain into all steps that can be separated sensibly. Simplified Value Chain: Suppliers Corporations Horizontal Integration: with firms on the same business levels Customers Central Question: Horizontal and vertical corporate boundaries? Vertical Integration: within the value chain © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 33 PRACTICE “Scope of the Firm” – Decision Process Step 2: Competitive Advantage Is there a competitive advantage when performing a specific activity? Is a corporation able to earn revenues which are higher than the capital costs? Firm which possess the resources should achieve a competitive advantage (e.g., Microsoft & Intel) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 34 PRACTICE “Scope of the Firm” – Decision Process Step 3: Market Failure Do market failures exist? Are the costs of market governance extremely high? Can dominant firms exercise market foreclosure? Specific assets Uncertainty Co-specialized assets (e.g., two firms with market power: patents and distribution channels) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 35 PRACTICE “Scope of the Firm” – Decision Process Step 4: Need for Coordination Is there an ongoing need for intensive coordination? Are continual and integrated changes required? Is there a distinct interface between activities? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 36 PRACTICE “Scope of the Firm” – Decision Process Step 5: Importance of Incentives How high are agency costs inside the hierarchy? How much do worker skill and efforts affect outcomes? Can an effective incentive scheme be designed? What is more important: coordination or high-powered incentives? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 37 PRACTICE “Scope of the Firm” – Decision Process Step 5: Importance of Incentives Franchising One of the fastest-growing forms of corporate organization-trade-off Geographically dispersed service or retail businesses provide high powered incentives for individual unit owners (franchisees) Store manager’s skill and effort determine store performance Monitoring operations of hundreds of stores across the country would be very expensive Standardization of the product provides a clear interface between the store and franchisor, limiting need for coordination © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 38 PRACTICE Choosing the Scope of the Firm Decision Process Competitive Advantage? Yes No Market Failure? No Yes Firm Hierarchy Coordination Need? No Yes No Incentive Problem? Yes Market Exchange Trade-Off Source: Collis and Montgomery, Corporate Strategy, 2005, p. 145 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 39 Summary Slides: Self study © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 40 Summary TCE, Agency Theory, Relational View Unit of Analysis TCE Agency Theory Relational View Transaction Contract between principal and agents Relationships between firms and stakeholders (internal & external) (Organization) Market Failure Costs – production- & transaction costs Assumptions - Opportunism - Uncertainty Selected Sources Human-based - Self-interest - Bounded rationality - Risk aversion Critical corporate resources can be leveraged across corporate boundaries Organization-based - Conflict of goals b/w principal & agent - Asymmetric information (Information can be bought) Knowledge transformation - Bounded rationality - Asset specificity Explanatory Variables (Individuals, groups) Relational Assets Complementary resources/skills Effective governance Governance structure, risk of transaction (opportunity costs), coordination costs, asset specificity Efficiency, interests, risk sharing, successful contract design Inter-organizational competitive advantage, relational rents, transaction costs, synergies Coase (1937), Williamson (1981), Klein, Crawford, Alchian (1978) Alchian, Demsetz (1972), Eisenhardt (1985), Jensen/Meckling (1976) Dyer/Singh (1998) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 41 Summary: Vertical Integration and the Scope of the Firm Characteristics of the Vertical Relationship How many firms are there in the vertically adjacent activity? Do transaction-specific investments need to be made by either party? How evenly distributed is information between the vertical stages? Are market transactions in intermediate products subject to taxes or regulations? © Artur Baldauf l Department of Management l University of Bern Implication The fewer the number of firms, the greater are the bargaining costs of agreeing contracts The bigger is transaction-specific investment expenditure, the greater the advantages of vertical integration The greater are information asymmetries, the more likely is opportunistic behavior and the greater the advantages of vertical integration Taxes and regulations are a cost of market contracts that can be avoided with vertical integration Corporate Strategy 42 Summary: Vertical Integration and the Scope of the Firm (contd.) Characteristics of the Vertical Relationship How uncertain are the circumstances of the transactions over the period of the relationship? Are two stages similar in terms of optimal scale of operation? Are the two stages strategically similar (e.g., similar key success factors, common resources/capabilities)? How great is the need for continual investment in upgrading and extending capabilities within individual activities? © Artur Baldauf l Department of Management l University of Bern Implication The greater are the uncertainties relating to costs, technologies and demand, the greater the difficulty of writing contracts, and the greater are the advantages of vertical integration in avoiding transaction costs The greater the dissimilarity, the greater the advantages of market contracts as compared with VI The greater the strategic dissimilarity, the greater the advantages of market contracts as compared with vertical integration The greater the need to invest in capability development, the greater the advantages of vertical specialization over vertical integration Corporate Strategy 43 Summary: Vertical Integration and the Scope of the Firm (contd.) Characteristics of the Vertical Relationship How great is the need for entrepreneurial flexibility Implication The greater the need for entrepreneurship and and drive in the separate vertical activities? flexibility, the greater the advantages of high-powered How uncertain is market demand? incentives provided by market contracts, and the Does vertical integration compound risk, exposing greater the administrative disadvantages of vertical the entire value chain risks affecting individual integration stages? The greater the unpredictability of demand, the more costly is vertical integration in terms of capacity adjustment costs The heavier the investment requirements and the greater the independent risks at each stage, the riskier is vertical integration © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 44