Session 05 Furrer 2002-2008 1

Corporate Strategy

Fall 2008

Session 5 - Lecture 3

Governance Structure and the Limit
to the Scope of the Firm


Dr. Olivier Furrer

Office: TvA 1-1-11, Phone: 361 30 79
e-mail: o.furrer@fm.ru.nl
Office Hours: only by appointment
Session 05 Furrer 2002-2008 2
The 1980s highlighted the failure of many visible diversification, such
as Exxon entering the office product market and Coca-Cola acquiring
Columbia Pictures. As a result, the notion that sticking to the
knitting (Peters and Waterman, 1982) might be the most desirable
corporate strategy was widely promulgated. Indeed, by the late 1980s,
many managers were struggling to justify the existence of their
multibusiness corporations.
Into this void came the development of generic strategies that
classified corporate strategies according to the ways in which
value was created. Following the success of his notion of generic
strategies at the business unit level, Michael Porter (1987) identified
four types of corporate strategy. These lay along a continuum of
increasing corporate involvement in the operation of the business
units.
Implications of Shareholder Value
Maximization for Corporate Strategy
Session 05 Furrer 2002-2008 3
Implications of Shareholder Value
Maximization for Corporate Strategy
For firms contemplating diversification Michael Porter (1987)
proposes three essential tests to be applied in deciding whether
diversification will truly create shareholder value:
1. The attractiveness test. The industries chosen for
diversification must be structurally attractive or capable of
being made attractive (Five Forces Model Porter, 1980).
2. The cost-of-entry test. The cost of entry must not capitalize all
the future profits (Entry Barriers Bain, 1956, Porter, 1980).
3. The better-off test. Either the new unit must gain competitive
advantage from its link with the corporation or vice versa
(Parenting Advantage Goold et al., 1994).
Session 05 Furrer 2002-2008 4
Goold et al.s (1994) Approach
Corporate Strategy

1. In what business should the company invest its resources, either
through ownership, minority holdings, joint ventures, or
alliances?
2. How should the parent company influence and relate to the
businesses under its control?

The Role of the Parent

The Quest for Parenting Advantage
Session 05 Furrer 2002-2008 5
The Corporate Parent as
Intermediary
Source: Goold, Campbell and Alexander, 1994
The parent has no automatic right to exist. To justify its existence, the
parent should be able to demonstrate that its businesses perform better in
aggregate than they would as a series of individual, stand-alone entities.
Session 05 Furrer 2002-2008 6
How Parents Create Value
Stand-alone influence Linkage influence
Central functions and services Corporate development
Source: Goold, Campbell and Alexander, 1994
Session 05 Furrer 2002-2008 7
The Importance of Fit
In order to create value, the parent must do more than simply avoid
creating misfits. It must have some skills or resources that are
specially helpful to its businesses. It must help its businesses address
opportunities to improve their performance that they would fail to
realize by themselves. Different opportunities can be realized only by
applying different parenting skills or characteristics.

The essence of successful parenting is therefore to create a fit between
the way the parent operates the parents characteristics and
significant improvement opportunities that exist in its particular
businesses. The parents skills are not good or bas in any absolute
sense; their value depends on the nature and needs of their businesses.
Session 05 Furrer 2002-2008 8
Parenting Styles
Strategic
Planning
Strategic
Control
Financial
Control
Planning
Influence
High
Low
Control Influence
Flexible
Tight
Strategic
Tight
Financial
S
o
u
r
c
e
:

G
o
o
l
d

a
n
d

C
a
m
p
b
e
l
l
,

1
9
8
7

Session 05 Furrer 2002-2008 9
Parenting Styles (Contd)
The Strategic Planning Style
Strategic Planning style parents are closely involved with their
businesses in the formulation of plans and decisions. They
typically provide a clear overall sense of direction, within which
their businesses develop their strategies and take the lead on
selected corporate development initiatives.
The Strategic Control Style
Strategic Control style parents basically decentralize planning to
the businesses but retain a role in checking and assessing what is
proposed by the businesses. Thus, businesses are expected to take
responsibility for putting forward strategies, plans, and proposals
in a bottom-up fashion, but the parent may sponsor certain
themes, initiatives, or objectives, and will only sanction proposals
that meet an appropriate balance of strategic and financial criteria.
Session 05 Furrer 2002-2008 10
Parenting Styles (Contd)
The Financial Control Style
Financial Control style parents are strongly committed to
decentralization of planning. They structure their businesses as
stand-alone units with as much autonomy as possible, and with full
responsibility for formulating their own strategies and plans.
Session 05 Furrer 2002-2008 11
Decisions about the Portfolio
Do the parenting opportunities in the business fit
with value creation insights in the prospective
parenting advantage statement: Will the parent
likely to create a substantial amount of value?

Do the critical success factors in the business have
any obvious misfits with the prospective parenting
characteristics: Will the parent be likely to
influence the businesses in ways that will destroy
value?
Session 05 Furrer 2002-2008 12
Governance
Market, hierarchy, and the limits to the
scope of the firm. => Transaction Costs
Theory. (Williamson, 1975, 1985)
Principals, agents, and the limits of the control
mechanisms. => Agency Theory.
(Fama and Jensen, 1983)
Stakeholders, Stewards, and the limits of
transaction and agency theories.
Session 05 Furrer 2002-2008 13
Governance Structure
Whether or not should a particular firm perform an
activity or compete in a business?
Does the firm possess the resources and
competences to create and protect a competitive
advantage?

What are the appropriate boundaries for a particular
firms?
Market, Hierarchy, or in between.
Session 05 Furrer 2002-2008 14
Limit to Firm Scope
Increasing Firm Scope
$
Market Cost
Benefit
Cost of the Hierarchy
A
B
Org. Boundary I ndependent of Market
Org. Boundary Given Market Costs
Session 05 Furrer 2002-2008 15
Co-operation
Agreement
Patent
Licensing
Franchising
Cross
Licensing
R&D
Consortia
Co-prod-
uction
Joint
Venture
Strategic Alliances
(Hybrids)
Cooperation Competition
TYPE OF ARRANGEMENT
(Transaction Costs)
Low
High
L
E
V
E
L

O
F

I
N
T
E
R
A
C
T
I
O
N

(
G
o
v
e
r
n
a
n
c
e

C
o
s
t
s
)

Intermediate Governance Structures
(Hybrid Forms)
Source: adapted from Beamish, Morrison, Rosenzweig and Inkpen, 2000, p. 114.
Hierarchy
Market
Session 05 Furrer 2002-2008 16
Market:
Costs, Benefits & Causes
Benefits
Efficient Information Processing
(compared to bureaucracy)

High-Powered Incentives
(self-interested, independent owner-
managers, cf. agency theory)


Costs
High Transaction Costs due to
Market Failure
Conditions for Market Failure:
Opportunistic Behavior
Asset Specificity (small
numbers) (location, physical
assets, and human capital)
Uncertainty
High Transaction Frequency
Inseparability of R&Cs
Information Asymmetries
Market Power
Session 05 Furrer 2002-2008 17
The Virtual Corporation
A virtual corporation is a firm which focuses on a few
core competences and outsource about everything
else.
Example: Nike (2008)
$16 billion in revenues for 30,000 employees
(Philips: $37 billion for 124,000 employees)
Manufacturing is subcontracted, many of the product
innovations come from outside design houses, Nike
clothing is supplied by another firm under license.
Session 05 Furrer 2002-2008 18
Hierarchy:
Costs, Benefits & Causes
Benefits
Authority over Activity
Coordination
Tax Benefits
Quality Control
Information Access
Leverage R&Cs
Costs
Increased Bureaucracy
Agency Costs
Loss of Flexibility
Potential Overcapacity
Attractiveness of Buyer
& Supplier Markets
Session 05 Furrer 2002-2008 19
Choice of Governance Structure:
Decision Process
1. Disaggregate Industry Value Chain
Structural Attractiveness
Possession of R&Cs
2. Competitive Advantage?
3. Market Failure?
Assess Conditions
Cospecialized Assets
4. Need for Coordination?
Conditions for Internalization
5. Incentive Problems?
=> Agency Theory

Session 05 Furrer 2002-2008 20
Integration/Market-Exchange
Decision Process
Competitive
Advantage?
Coordination
Need?
Market
Failure?
Firm
Hierarchy
Incentive
Problem?
Trade-off
Market
Exchange
No
No
No
No
Yes
Yes
Yes Yes
Session 05 Furrer 2002-2008 21
Incentive Problems &
Governance Structures
Coordinate
Activities
High Low
Individual
Contribution
Small
Large (need high
incentives)
Incentive
Scheme
Can be
Developed
Cannot be
Developed
Employee
Performance
Easy to
Monitor
Difficult to
Monitor
Skill & Creativity Low High
Governance
Structure
I ntegration
Market
Exchange
Session 05 Furrer 2002-2008 22
Directions of Diversification
Horizontal Diversification (last week)

Vertical Diversification (today)

International Diversification (later)
Session 05 Furrer 2002-2008 23
Vertical Integration
Integration backward into supplier functions
Assures constant supply of inputs.
Protects against price increases.
Integration forward into distributor functions
Assures proper disposal of outputs.
Captures additional profits beyond activity costs.
Integration choice is that of which value-adding
activities to compete in and which are better suited
for others to carry out.
Session 05 Furrer 2002-2008 24
Creating Value Through
Vertical Integration
Advantages of a vertical integration strategy:
Builds entry barriers to new competitors by denying them
inputs and customers.
Facilitates investment in efficiency-enhancing assets that
solve internal mutual dependence problems.
Protects product quality through control of input quality and
distribution and service of outputs.
Improves internal scheduling (e.g., JIT inventory systems)
responses to changes in demand.
Session 05 Furrer 2002-2008 25
Disadvantages of vertical integration
Cost disadvantages of internal supply purchasing.
Remaining tied to obsolescent technology.
Aligning input and output capacities with uncertainty in
market demand is difficult for integrated companies.
Creating Value Through
Vertical Integration
Session 05 Furrer 2002-2008 26
Bureaucratic Costs and the Limits
of Vertical Integration
The costs of running an organization rise with
integration due to:
The lack of an incentive for internal suppliers to reduce their
operating costs.
The lack of strategic flexibility in times of changing
technology or uncertain demand.

Bureaucratic costs reduce the value of vertical
integration.
Session 05 Furrer 2002-2008 27
Alternatives to Vertical Integration
Cooperative Relationships
Strategic Alliances

Strategic Outsourcing
Virtual Corporation
Session 05 Furrer 2002-2008 28
Mode of Expansion
Firms can implement their diversification strategies through internal
development, acquisitions, mergers, joint ventures, alliances, or
contracting with external partners.
None of these, however, guaranties easy expansion. Choosing among
the various modes involves unavoidable trade-offs.
Some would argue, for example, that acquiring a company to gain
access to the resources needed to compete in an industry is likely to
dissipate future profits. Others would cite the difficulties working
across organizational boundaries in joint ventures. On the other hand,
internal development can be maddeningly slow and rife with
uncertainty.
In short, each mode of expansion has its own benefits and costs.
Thus, a firm must carefully weigh each alternative against its needs
and the exigencies of a particular competitive situation.
Session 05 Furrer 2002-2008 29
Mergers & Acquisitions
Benefits
Speed
Access to complementary
assets
Removal of potential
competitor
Upgrade corporate
resources

Drawbacks
Cost of acquisition
Unnecessary adjunct
businesses
Organizational clashes
may impede integration
Large commitment
Session 05 Furrer 2002-2008 30
Internal Development
Benefits
Incremental
Compatible with culture
Internalizes learning
Encourages
intrapreneurship

Drawbacks
Slow
Need to build new
resources
Unsuccessful efforts are
difficult to recoup
Adds to industry
capacity; subscale entry
Session 05 Furrer 2002-2008 31
Strategic Alliance
Benefits
Access to complementary
assets
Speed

Drawbacks
Lack of control
Assisting potential
competitor
Questionable long-term
viability
Difficult to integrate
learning
Session 05 Furrer 2002-2008 32
Next Session: Text Discussion 2
Mergers & Acquisitions

Cording, Margaret, Petra Christmann, and L. J. Bourgeois III (2002), A Focus on
Resources in M&A Success: A Literature Review and Research Agenda to Resolve
Two Paradoxes, Academy of Management Meeting, August 12, 2002.
Walter, Gordon A. and Jay B. Barney (1990), Management Objectives in Mergers
and Acquisitions, Strategic Management Journal, 11(1), 79-86.
Brouthers, Keith D. (2002), Institutional, Cultural and Transaction Cost Influences
on Entry Mode Choice and Performance, Journal of International Business Studies,
33(2), 203-211.
OShaughnessy, K. C. and David J. Flanagan (1998), Determinants of Layoff
Announcements Following M&As: An Empirical Investigation, Strategic
Management Journal, 19(10), 989-999.