Summary of the book "the modern firm", chapters 1-7, Sintesi del corso di Organizzazione Aziendale

Scarica Summary of the book "the modern firm", chapters 1-7 e più Sintesi del corso in PDF di Organizzazione Aziendale solo su Docsity! CHAPTER 1 - Strategy and Organization In the first two decades of the 20th century, a number of managers invented a new way of organising and managing their companies: the new multi-divisional form, a fundamental change in company design and organisation based on divisions defined by product or by geographic area or by function, but also new systems for collecting and recording information, for allocating resources and for controlling behaviour. With what purpose? To efficiently solve the complicated problem of coordinating large numbers of people performing a complex set of interconnected activities, often in different locations (globalization). Companies have changed the scope of their activities, generally refocusing on their core business and outsourcing many of the activities they previously considered central. These changes are reflected in the immense volume of mergers and acquisitions (M&A) and spin-off activity that characterised the 1980s and 1990s. Many companies also redefined the nature of their business and their relationships with customers and suppliers, replacing supplier relationships with long-term partnerships. They also increased the speed of decision-making through improved information and measurement systems and redesigned performance management systems. To facilitate coordination and learning, they directly connected people in different parts of their organisations, so that communications are more horizontal and not just up and down the hierarchy. Increased competitive pressures (global competition) drive the adoption of changes and new technologies (e.g. the Internet) make them feasible, also offering new opportunities to do business away from home. Capital markets (stock exchange) also increase the pressure on business performance. In some cases, the changes are also a response to increased competition for talent, as more companies seek to attract and retain particularly qualified and talented people. HB company and NW Company • service industry: trade • 1° long-established “HB Company,” leader in the market for years, political and economically powerful, superior technology and better access to financing. • 2° newly established “NW Company,” start up, none advantage. Leaders immigrants and refugees, headquarters in a distant, provincial town, no powerful friends. The result was that HB’s costs were estimated to be in the order of one-half those of its rival .... but in a brief time after entering the business, NW Co. became leader of the market and HB was near bankruptcy. How did this happen? • The NW Co. found a way to serve the customers better by getting closer to them, more responsive to their differing needs and to ever-changing market realities. • It simplified the supplier structure and eliminated traditional middlemen. • It avoided excessive bureaucracy. • It recruited people for operating positions who were willing to take responsibility and initiative • It put in place reward systems that encouraged entrepreneurial behaviour. These management innovations enabled it to overcome a seemingly prohibitive cost disadvantage. HB Co. did not realise the competitive advantage offered by NW's new strategy and organisation and its response was very slow. However, HB responded to the threat by essentially copying NW's new approach. However, it did so after the company's managers had been replaced by new executives. NW Co. always knew that it would be condemned by its cost disadvantage if HB Co. copied its rival's customer-oriented strategy. Therefore, NW attempted a pre-emptive takeover of HB before the new management could take control. This failed, however, and ultimately HB Co.’s huge cost advantage did overwhelm the NW Co. (the outcome was a “merger”). What are the lessons of this example, other than, perhaps, that there is nothing new under the sun? My starting point is the assertion that general managers must be organisation designers (responsibility for devising a competitive strategy but also for designing an organisation through which to implement the strategy). The second basis is the idea that economics has much to say about the problem of organisational design. Strategy, Organization, and the Environment The achievement of high performance in a company derives from three elements: the company's strategy, its organisational design and the environment in which it operates. This approach follows Alfred Chandler's dictum (Chandler 1962) that 'structure follows strategy': the organisation is the mechanism through which strategy is implemented, considering a simplified and idealised version of what a company is and does. The starting point is a business opportunity: an unmet need, a market failure. For the NWC, the opportunity lay in the HBC's inefficient exploitation of potential gains from trade. More generally, the opportunity could arise from having lower costs than current market participants or a product that better meets the needs of (at least some) customers. This, in turn, could reflect better technology, greater creativity or previously untapped economies of scale and scope. In the traditional view, the next step is the strategy to exploit the opportunity. First, a strategy includes a goal against which the company can measure and judge its success (e.g. maximisation of profit or shareholder value). The second key element is a purpose statement: a specification of the company's business, the products and services it will offer, the customers and market segments it will serve, the activities it will undertake, the locations where it will perform them, and the technology it will use (including a statement of what opportunities the company will not pursue). A third key element of a strategy is the specification of the nature of the company's competitive advantage, an indication of how the company's offer will lead others to deal with it on terms that enable it to realise its goals. How will it attract a profitable market? How will it create value by generating a willingness to pay on the part of customers that exceeds the cost of serving them? Will it offer an equally good product at a lower price? A less desirable product at a much lower cost? The last component of a strategy is the explanation of why the claimed competitive advantage will actually be realised. Typically, it involves a system that links the particular position occupied by the company and the distinctive capabilities it enjoys to customer choice. In a multi-business enterprise, strategy has a further level, that of corporate strategy. Corporate strategy identifies the set of activities that the company intends to include and the rationale for which this creates additional value over and above what can be created by a set of stand-alone activities. It is therefore essentially a portfolio choice combined with a theory of the role of the corporate centre. A strategy implies a set of activities that must be carried out to achieve it. In a typical company, these include the 'value chain' activities that must be undertaken to meet customer needs, such as product design and development, input procurement, production, distribution, sales and after-sales service, as well as 'support' activities such as human resource management, management information systems and finance. The organisation is thus the means by which these activities are to be carried out and the strategy implemented. A taxonomy identifies the organisation as a set of people and organisational characteristics (people, architecture, routines and culture, giving rise to the acronym 'PARC'). First is the set of people who are part of the organization with their talents and skills. The architectural features include what is on the organization chart: the vertical and horizontal boundaries of the firm; the assembling of tasks into jobs and jobs into departments, business units, and divisions; the reporting and authority relationships; and so on. It also includes such matters as the financing, ownership, and governance structure of the firm. These are relatively “hard” features, often with an explicit contractual element. However, architecture also includes the personal networks that link people throughout the firm and across the firm’s boundaries. These can, in fact, be as important and more than the formal architecture. The routines include all the managerial processes, policies, and procedures, official and unofficial, formal and informal, that shape how information is gathered and transmitted, decisions made, resources allocated, performance monitored, and activities controlled and rewarded. The allocation of decision authority within the firm—what decisions are made by which people at what levels, with what oversight or review—is a key element here. The processes also include the routines through which work is done and the mechanisms through which these are altered. In 1992, the vision that 'voice will become wireless' led the company to abandon the wide range of activities that had contributed 90 per cent of its revenues only a few years earlier and to concentrate on mobile phones and network equipment. By 1999, Nokia had effectively become the leader in the mobile phone industry, while the possibilities of Internet access through mobile phones were becoming apparent. Meanwhile, Nokia's leadership was very aware of the importance of culture in motivating people to act in necessary ways. It therefore worked hard to maintain the culture, even as the company grew by 30 per cent per year and expanded its activities worldwide. The formal structure was changed almost constantly to keep up with emerging needs and networks were used heavily to share knowledge and get the job done. BP and Nokia had great success in the 1990s: the resulting fit between environment, strategy and organisation was the key to success for both companies. CHAPTER 2 - Key Concepts for Organization Design The problem of strategic choice and organisational design is complex. There is a logic behind the idea of 'adaptation'. Some organisational strategies and projects adapt to each other and the environment, and thus produce good performance, while others do not. Moreover, there are often recognisable, understandable and predictable relationships between the characteristics of the environment and the choice variables of the strategy and organisation, which determine which constellations of choices will prove successful and which are less likely to be. But why are there a limited number of consistent models? The key ideas are complementarity between choice variables, non-convexity in the set of available choices, and non-concaveness in the relationship between choice and performance. Complementarity Complementarity concerns the interactions between variations in different variables that affect performance. Consider any pair of variables that the planner determines in order to realise the company's objectives. Prices, service levels, debt-to-equity ratio and aspects of culture are some examples of such variables. The two choice variables are complementary when the use of one increases the returns of the other. For example, price and product quality are complementary if higher quality makes demand less sensitive to price increases. The reason is that make-to-stock production is subject to economies of scale in terms of the level of inventory required to maintain reliability in meeting emerging demand. These ideas of complements and substitutes can be extended to relationships between aspects of the environment. For example, a choice variable is complementary to an element of the environment if an increase in the level of the environment variable increases the returns from introducing or increasing the choice variable. Flexibility can be measured by the speed with which a firm can switch production from one product to another, or by the cost of switching production. In the 1990s, when flexible automation was much more available than in the early years of the century and customer tastes had become more diverse, Toyota was considered the leading company in the global automotive industry. Another example of complementarity is the Lincoln Electric Company. The basis of Lincoln's success was the execution of a strategy of pursuing ever higher productivity and cost reduction, and then passing some of these benefits on to customers through price reductions. The core of Lincoln's organisational design is the extensive use of piecework pay . Piecework rates provide very strong and direct incentives, not only to work hard but also to look for ways to further increase production. In addition, other desirable activities that cannot be paid piecework, such as helping other workers or coping with emergencies, are discouraged. Lincoln responds to each of these difficulties with policies and processes that make piecework rates more effective. As a rule, these bonuses double the employee's basic earnings based on the piecework rate. Perhaps the broadest set of complementarities studied so far concerns traditional mass production and modern lean production. Mass production (Characteristic features of mass production: transfer line, interchangeable parts, and economies of scale) and lean production of modern manufacturing (Characteristic features of modern manufacturing flexibility, speed, economies of scope, and core competencies) represent two consistent patterns of choices on a very large set of policy variables, in which the shift of any one element from the mass production model to the lean model is complementary to the corresponding shift on each of the other variables. In order to fully utilise the capabilities of the workforce, it is worth involving them in the development of process improvements, so that the empowerment of workers and the pursuit of continuous improvement complement their increased competence. Modern lean production is supplanting mass production in many sectors and is having a strong positive effect on performance. When the choice variables are complementary, any environmental change that increases the attractiveness of increasing one of the variables tends to increase all the variables. Non-convexity and Non-concavity Traditional models in economics have usually resorted to particular mathematical assumptions - in particular, the convexity of the choice set and the concavity of the objective. In particular, this assumption implies that the choices are infinitely divisible. This type of situation is illustrated in Figure 3, where the relationship between choice and performance for a given environment is depicted. As choice increases, realised performance increases, peaks at the choice marked X and then decreases. A second, more subtle implication concerns the task of maintaining the optimal choice when the environment changes. In Figure 4, the company manages to position itself on X, the optimal strategy and organisation. Let us now assume that the environment changes, so that the dotted line reflects the link between choice and performance. In this example, performance at X has not changed, although in general it might have. This contrasts directly with the definition of concavity, whereby performance is not a concave function of choice. The recognition of these simple facts and the acceptance that convexity and concavity do not occur are the consequence of a number of important insights into management problems. CHAPTER 3 - The Nature and Purpose of the Firm Our aim is to understand the problem of enterprise design and to understand organisational change. The main answer is that enterprises exist to coordinate and motivate the economic activity of people. As Adam Smith observed, economies of scale and learning effects lead to enormous efficiency gains if individuals specialise in their productive activities. Finding a solution to the coordination problem is important, but motivation also becomes an issue, because it may not automatically be in the self-interest of individuals or groups. In the presence of interdependencies, the attempts of individuals to grab a larger share of the benefits and avoid the costs can make everyone, including themselves, worse off. Of course, as Smith also noted, markets are a very important mechanism for solving coordination and motivation problems. Market institutions let individuals pursue self-interested behaviour, but guide their choices through the prices they pay and receive. A well-functioning market leads interdependencies between people to be fully 'internalised'. In essence, market prices signal what is to be done, when, where, how and by whom. In this way, markets achieve a remarkable level of coordination without any conscious central planning or control. Let us assume that all interested parties can meet and bargain freely and that the consequences of failure to agree are clearly established. Most economic activity takes place within formal, managed organisations rather than through market exchanges. But there is also the 'market failure'. It can happen that markets do not exist, are not competitive or do not clear themselves properly. To understand when this can happen, we need to understand the nature of market failure and when firms are expected to perform better. Sources and Nature of Market Failure The best known situations are those in which monopoly or other forms of imperfect competition prevail, either through collusion or because barriers to entry or regulation limit the number of competitors. In such circumstances, supply is typically restricted in order to increase profits. Public goods are another traditional example where markets do not work well, because one person's purchases are automatically available to all and so there will be a temptation to exploit the contributions of others. Alternatively, the individual benefits that drive the decision to purchase or provide a public good are only a fraction of the aggregate benefits, leading to under-supply. The inefficiency of excludable public goods (e.g. cable television) is that, in order to induce people to pay for the good, resources are spent to deprive non- payers of the benefits. If the information asymmetry cannot be eliminated, buyers will refuse to pay more than the expected value of the goods, averaged over the different levels of quality they expect to receive. Since the selection of goods offered is not representative of the underlying distribution of quality, but is instead an adverse selection, buyers will rationally lower their willingness to pay even further. At that point, even more potential sellers of goods of relatively high quality may no longer be willing to sell at the lowest price. Much recent research has focused on another problem, that of enforcement of agreements. Simple market agreements can rarely provide such self-enforcement options. For example, suppose that, in order to motivate an employee, his or her pay depends heavily on his or her performance. Suppose also that performance is not completely under the control of the employee, but is subject to random and uncontrollable variations. The company saves in terms of expectations and the employee avoids the risk. However, if the employee anticipates the possibility of renegotiation, he or she may no longer be motivated to make the effort. Moreover, since any real contract is necessarily incomplete, situations not foreseen in the terms of the original contract are very likely to occur. The costs of negotiating the terms of agreement related to contingencies that are not considered very likely may rationally lead to their omission from the contract. Firms versus Markets Why are some economic activities carried out through market transactions, while others are organised according to hierarchical authority relationships within enterprises? The answer is that organisation, coordination and motivation entail costs and that the economisation of these transaction costs explains the organisational models adopted. Assuming that potential improvements can be identified, we should expect such changes to be made. Therefore, if an arrangement persists, there is reason to suspect that it is efficient, at least for those parties that are able to have their interests represented. An example is the adverse selection problem of the 'lemon market' considered above. The result of information asymmetry may be that only the worst cars are offered and sold, even though there are many potential exchanges that would make both sides of the transaction better off. The gains from the exchanges are not realised because information asymmetries prevent them from being satisfactorily identified and shared. For example, a firm's willingness to strike signals that the agreement is not as beneficial as it was thought. In a market context, transaction costs are the costs of finding and qualifying business partners, setting specifications and prices, negotiating and drafting contracts, monitoring and enforcing agreements. They are also the opportunity costs of lost benefits, caused by the difficulty of developing comprehensive and enforceable agreements between separate parties. The example concerns hold-up and specialised investments. In such circumstances, if contracts are incomplete, parties may be forced to negotiate after lock-in has occurred. Both the costs of bargaining and the potential benefits lost if bargaining breaks down and cooperation is not realised are transaction costs of dealing with another party. Lock-in is in fact inevitable when goods are specialised. An asset is specialised for a particular use when the value it can create in the best alternative use is substantially less than the value it produces in current use. Suppose two companies have the ability to trade, but the seller must make specific investments to best meet the buyer's needs. Once the investments have been made, the costs are sunk. This means that even if the final price received by the seller was reduced almost to the level of variable costs, it would still not be worthwhile to withdraw from serving the buyer. The reason is that the sunk costs must be incurred in both cases and the asset has no other good use. Part of the asset's returns are therefore quasi-returns, i.e. returns higher than those needed to keep the asset in current use once it has been created. The seller is therefore subject to the danger of hold-up. If a preliminary contract exists, but is sufficiently incomplete that it is necessary to negotiate the terms after the investments have been made, it is very likely that negotiating the terms will offer little protection to the seller's investments. This is because sunk costs are irrelevant in determining the value created by the cooperation as opposed to the termination of the relationship, which is what the parties actually bargain over. Even if the terms are nominally fixed in advance, the buyer may be tempted to renegotiate the terms, appropriating part of the quasi-revenue the seller hoped to enjoy. In anticipation of this, the buyer may be reluctant to commit resources to specific activities. For example, if the specificity stems from the seller's knowledge of the buyer's particular needs, the seller may underinvest in this knowledge so as to suffer a smaller loss in the event of delay. Alternatively, the seller may expend resources to protect itself against early termination. To this end, it could make the use of the assets more flexible so that they can be redeployed at a lower cost. Another solution would be to bring the transaction within a single company. One answer is that it is impossible to generate the same intensity of incentives within a single integrated enterprise as when the units are owned separately. The 'property rights' approach to enterprise theory suggests another reason why it may be more difficult to provide strong incentives in a larger, integrated organisation. If the relationship breaks down, the owner of the upstream firm still owns the assets of his firm and can redistribute them as he sees fit, whereas, if the relationship breaks down, the manager cannot keep the assets. Therefore, the ownership of the assets determines the payoffs that the parties receive. Therefore, who owns the assets influences the investments and thus the value created. The Nature of the Firm Many authors have identified the essential nature of the enterprise in the use of hierarchical relationships to replace the inherent equality between participants that characterises market relationships. However, it may be better than a rigid pre-selection of activities, as in a simple market contract. In fact a conception of the enterprise as a mechanism for dealing with market failures: this is actually a somewhat more general conception than the transaction cost approach, because we can think of the market as failing when the costs of using it are higher than those of a non-market organisation. Cooperation and Initiative The fundamental problem of multitasking and an associated set of trade-offs impacts organisational design, is that two types of people behaviour are desired in an organisation: 'initiative' and 'cooperation'. Initiative refers to increasing unit sales, reducing costs, realising successful product innovations and so on. Cooperation refers to promoting the welfare of others and common goals: improving the profits of another unit, developing the overall brand, creditworthiness and reputation of the company's customers and so on. It is clear that both types of behaviour are desirable. Initiative leads to better individual and unit performance, both in the immediate and in the long run. The problem is that we are in a multi-tasking environment. Providing incentives to induce more behaviour can lead to a reduction of the other. The idealised rational bureaucracy, with centralised decision-making and weak performance incentives, would probably gain little initiative, but could achieve high levels of cooperation. Real organisations get less cooperation than the idealised hierarchy, but more than the market. Of course, real companies need more cooperation than market negotiations would induce, because interdependencies abound. The cost is that they do not generate the initiative that the market organisation would. For example, in the 1980s, ABB Asea Brown Boveri attempted a complex strategy that required achieving, simultaneously, global efficiency, the ability to respond to the particularities of each of the hundreds of distinct national markets in which it competed, and the diffusion of learning worldwide. All this had to be done by merging and integrating two previous companies and numerous acquisitions. To do this, ABB needed both strong initiative on the part of its managers in pursuing its goals and, at the same time, a willingness to help other units and contribute to the whole. The small size of the business units meant that responsibilities could be clearly assigned and people in a unit could easily see the impact of their actions on results. This helped generate initiative in the pursuit of unit performance. A powerful financial and operational reporting system provided senior management with the necessary information to monitor results and to motivate and control behaviour. Each operating company was structured as a matrix with double reporting. Holding it all together was a group of global managers who travelled almost constantly between the different business units. Another example in which a change in the environment can also change the necessary mix of cooperation and initiative. In the 1980s Johnson & Johnson, the huge pharmaceuticals, medical The fact that the principal absorbs part of the variability of returns means that part of the impact of the agent's choice of actions must necessarily be borne by him as well. Thus, the agent does not bear all the costs and benefits associated with his choice of effort level. More generally, if there is a minimum payment that the agent must receive in every eventuality, any incentive scheme offered to the agent must provide that he always receives at least this amount, regardless of the measured poor performance. Thus, the principal's problem is to design an incentive scheme that motivates the agent to provide effort in the desired amount. Assuming a risk-neutral principal, an optimal scheme simply induces the level of effort that maximises the principal's expected returns net of what is to be paid to the agent. In fact, in order to obtain the best level of effort that the principal would purchase from the agent under fully observable conditions, it may be necessary to give the agent an expected payment above the expected value of gross returns. In general, incentives should be stronger when the agent is less risk-averse and when performance measures more accurately reflect what the agent actually did. Assuming a risk-neutral principal, an optimal scheme simply induces the level of effort that maximises the expected returns of the principal net of what is to be paid to the agent. In particular, incentives should be stronger when the agent is less risk-averse and when performance measures more accurately reflect what the agent actually did. The Choice of Performance Measures Until now, we have assumed that there was only one measure on which to base pay. Often, however, there are many possible performance measures. The answer from agency theory is that pay should depend on any freely available measure that is 'informative' (allows a more accurate inference to be made about the agent's actual choice of effort than would be possible without it) about the agent's effort. But a noise- related variable of measured performance can be usefully employed in performance evaluation, since it is an additional measure can be used to filter out some extraneous randomness. Another application of this 'informativeness principle' concerns executive managers pay. It is common for executives to receive bonuses based on accounting profits and for part of their remuneration to be linked to the share price (explicitly or through the granting of shares or options). This does not make sense from the point of view of agency theory. The use of multiple measures to increase the overall accuracy of performance measurement can be complicated, but is often useful. Rewarding the sales function on the basis of profitability is particularly important if it controls prices, because this reward system encourages the sales force to take costs into account in pricing decisions. In addition, there is a logic of performance benchmarking; it has been shown that CEO compensation responds not only to the performance of one's own company, but also to that of comparable companies in the same industry. An extreme form of this performance benchmarking occurs in 'tournaments', where remuneration is based solely on the performance ranking of the different participants, not on their performance in an absolute sense. They have proven to be as effective motivators as explicit performance pay; not least because performance pay is no longer universal. Multi-tasking in Agency Relationships A richer set of insights emerges when we extend the model to recognise that the agent might devote his time to more than one task that is useful to the principal. In this case, the principal needs both to justify the overall effort and to define its allocation between tasks. The problem in the context of multi-tasking arises when there are no separate measures for performance in the two tasks, but inducing the agent to do a good job in one task requires very different incentives from those required for the other task. Cooperation, on the other hand, is likely to be much more difficult to measure effectively, as the behaviour itself may be difficult to observe and the results will be linked to the performance of the other units and thus to the efforts made by their members. Another example is the realisation of current performance and the development of new activities. Performance in the former case is relatively easy to measure, while information on the quality of effort devoted to the latter is much less certain and slower to emerge. The problem is to induce the agent to devote the right amount of effort to both activities. Furthermore, let us assume that there are separate and independent performance measures for each type of effort. In this case, the incentives for each activity can be set independently to achieve the desired effort levels. Lincoln Electric provides an example of using strong and balanced incentives in a multi-tasking context. This has led Lincoln to achieve unprecedented productivity and a reputation of the highest quality, resulting in an extraordinary record of decades of business success. Providing incentives of equal intensity for different tasks, however, becomes problematic when the available measures for the two tasks differ significantly in terms of accuracy or timeliness. In general, the more accurately one measures the performance of a task, the less costly it is to provide stronger incentives for the task and thus induce greater commitment to it. Giving strong incentives for some desirable tasks can therefore be a bad idea, because these become negative incentives for other tasks that cannot be similarly rewarded. An example is teacher pay, which today is generally based on credentials and experience, so explicit financial incentives for performance are rather weak. Proponents of reform argue that providing stronger incentives would lead to better performance by teachers and their pupils. In all likelihood, this would induce teachers to do more to help their students perform well on tests. However, it is also likely to induce them to spend much less time and effort on aspects that are not measured in tests. In fact, in California, where school funding is tied to student performance on standardised tests in maths and reading, it is claimed that teachers have cut back on teaching other subjects, even though their pay is not directly affected by test results. In fact, there have been some cases of this kind of behaviour in New York State, where state test results at the end of high school are extremely important. Therefore, if multi- tasking is desired, it is best to provide relatively weak incentives for both activities. Any effective incentive scheme for multi-tasking must be balanced. Group Performance Pay Many management experts have spoken out against individual performance pay. The problem is that a free-rider phenomenon may occur: this is an argument in favour of maintaining small group sizes for performance measurement and rewards. These free-rider problems are particularly relevant to the common practice of paying bonuses based on overall company performance, whether through bonuses, profit sharing, stock awards or options. One explanation lies in the norms that support hard work and mutual control. If share ownership somehow changes the mindset of employees, making them 'think like owners', then it could be an effective motivational tool. This is especially likely if the company combines it with a number of other measures in what is often called a 'high-commitment' work system. Manipulation of Performance Measures Examples are numerous: bonus payments for reaching annual performance targets lead managers to accelerate or delay sales in the last quarter of the year in order to reach the numbers and not 'waste' sales that exceed the target. Subjective Evaluations Firstly, once the work is done, the principal may gain by reneging on the promised rewards. The solution to many of these difficulties lies in the reputation of the principal. In effect, his reputation becomes a value-generating asset, influencing the behaviour of the principal and the agent. Reputations For the reputation mechanism to be effective, it means that future opportunities to utilise reputation must exist and thus limits are placed on the possibility of using reputation. Even large gains from inducing +good behaviour in the future by maintaining a reputation for fairness and keeping promises will not be enough to motivate the principal if he heavily discounts future returns. Emerging private companies rely heavily on reputation. PARC and Motivation In reality, all aspects of the organisation can be employed, alone or in concert, as well as managerial vision and strategy. If there is clarity about what the company will do and what it will not do, well-done efforts are more likely to be rewarded and thus realised. In this context, it is important to recognise that the formal reward systems offered will induce potential employees to self-select. Lincoln Electric's reward system offers an exceptional monetary reward to production employees who are willing and able to work very hard. Employee turnover is well below average, employees willingly work overtime. Organisational architecture can also be used to influence motivation. For example, the creation of small business units can have strong effects through a number of different mechanisms. Firstly, it makes it easier to measure performance more accurately and thus encourages the granting of stronger incentives. The managers of these units were paid according to the performance of their units, which was closely monitored through the company's ABACUS reporting system. Secondly, people see the impact of their efforts more clearly, which in itself is directly motivating. Furthermore, organising in small units reduces the possibility of free riding, because the credit for extra results is shared more narrowly. The recent popularity of the 'front-and-back' organisational model reflects the impact of architecture on motivation. In this model, production and product development are functionally organised as the 'back-end' of the company, while the market-facing 'front-end' units deal with customers. The effect of organisational architecture on motivation and behaviour is also behind Stanford University's decision not to divide its faculty into academic departments, although many other leading business schools have a departmental structure. The provision of strong and balanced incentives can more easily take place outside the employment relationship. Remarkably, contractors are much more often subject to explicit performance incentives than employees doing similar work. Another way in which company boundaries can affect motivation is outsourcing. The transfer of supply to an external contractor can reduce influence activities within the organisation, as there is no longer a common boss over buyer and seller. The management buyouts that became widespread in the 1980s resulted in agents becoming principals, with the effect, in many cases, of radically improving performance. For instance, developing even imperfect indicators of actual behaviour, instead of relying only on results, can be very useful, especially when results are uncertain or only arrive with a long delay. optimal match between person and job, the quality of the average match can be better due to better information. Thus, for example, if customer lists can be shared or if a common brand is profitably used by several companies, integration can have advantages: the expansion of the Walt Disney Company from its animated film base to television shows, theme parks, retail shops, cruise lines and more. In each case, the characteristics of the brand (wholesome, family-oriented entertainment) were exploited to the benefit of the new activities. Complementarities can be a basis for interdependence between potentially separate activities, which can facilitate their integration. Another example is Sony's consumer electronics and recorded entertainment business. Film and record companies had historically resisted all the new broadcasting technologies that had emerged. In fact, each innovation eventually created huge new profits for the content providers. Meanwhile, Sony believed that the CD was only successful because it controlled the record companies and forced them to release recordings in the new format. Sony tried to limit the influencing activities and the complexity problem with a managerial approach: Hollywood supervised the entertainment business from an office in New York rather than from the headquarters in Tokyo. An important example is the acquisition of Houston Oil and Minerals by Tenneco. Houston was engaged in the exploration and development of hydrocarbon deposits. Tenneco was a conglomerate with some oil and gas exploration activities. Houston was known for the strong incentives it offered its exploration personnel, including the award of a share in all oil fields found. At the time of the acquisition, Tenneco promised to run Houston separately from its other activities to maintain its entrepreneurial spirit, which it hoped would spread to the acquiring company. Within a few months, however, Tenneco had imposed uniform business processes and remuneration systems on Houston. The allocation of capital between assets is a particularly important potential source of inefficiency in the diversified enterprise. As already mentioned, one of the earliest justifications for conglomerates was the possibility that the internal allocation of capital was actually better than that obtained from the market. More recently, the billions of dollars of investment lost by dotcom start-ups and the collapse of the tech and telecom stock bubble have revived the belief that the market can do a less than perfect job of allocating capital. It therefore seems possible that internal capital allocation processes can do a better job. Moreover, this cross-subsidisation has an additional cost: the incentives are mitigated compared to those in an independent operation. In the 1980s, Nokia Corporation undertook a series of acquisitions to shift from its traditional focus on low- growth consumer goods to electronics. However, it kept the old companies, with all the costs: it is clear that this kind of behaviour can be costly and therefore a 'diversification discount' is appropriate. The US stock markets valued the diversified companies at a lower multiple of the replacement cost of their assets than the more focused companies. The stock market performance and investment choices of real and constructed companies were then compared. This revealed that diversified firms apparently invested less in strong divisions with good prospects than focused firms in these same divisions and, consequently, overinvested in weak ones. The discovery of the conglomerate discount has had a major impact: management consultants refer to it to advise their clients to 'stick to the knitting', limiting the scope of their firms to a narrow range of activities. Certainly there are cases where empire-building by executives has occurred, but diversification is not simply empire-building, at least in the United States, as executives of large companies generally have significant shareholdings and options that should make them very sensitive to the value of companies. In a performance organisation context, we would expect greater diversification to be part of a strategy that emphasises growth. A reduction in scope, on the other hand, would be consistent with a strategy that emphasises increasing value by focusing on achieving results in current activities. The amalgamation of activities into a single company means that the company has to deal with the complexity and difficulties of comparison that maintaining organisational differentiation entails, or that organisational models have to be made more common so that they are no longer optimised for individual activities. Internal Organization and Performance Much economic research has dealt with the vertical and horizontal boundaries of the firm and provided a basis for analysing and evaluating changes, but not with the internal organisation of the firm and its impact on performance. The Northwest Company overcame the Hudson Bay Company's huge cost advantage by creating an organisation that empowered those close to the information to make key strategic and operational decisions, motivated them with financial incentives, and created mechanisms to ensure that information was shared and decisions were aligned. Creating focused business units and giving their leaders substantial decision-making rights over their activities improves performance. Thus, differentiation and the creation of small, empowered organisational units are complementary in influencing incentives to initiative. Clarity on strategy, so that it is clear what constitutes good performance and what is to be measured, leads to stronger incentives. Finally, improved measurement encourages broader areas of control. In this way, more common characteristics are linked. In addition, the creation of small, empowered units increases the speed of adaptation to new information, at least to the extent that information is available earlier to those working in the operational units rather than at higher levels of the organisation. The increase in the speed of decision-making is all the more valuable the faster the environment changes. The widespread perception among entrepreneurs is that the world is changing at an unprecedented and accelerating pace. This favours moving decision-making to the front line. One cost of moving small units to the front line is that the quality of decision-making may deteriorate. In the traditional hierarchical organisation, a number of decisions were made by middle managers, whose jobs are eliminated by delaying. In particular, decisions that affect several units but not the entire organisation, such as the allocation of capital or customers between two divisions or whether one unit can undertake a project that harms another, would naturally be made by an experienced manager who supervised both units and was responsible for the results of both. Now the responsibility for such decisions shifts, either to lower levels or to the top. It is necessary to establish strong rules for decision-making in the context of spillovers; however, the strongest companies with the best products, which were competitive even when customers were not well served, will not be willing to give up their independence. One difficulty that may arise with the creation of small, focused units is that the organisation may find it difficult to respond to challenges and opportunities that are more naturally addressed on a basis other than the 'natural' connection patterns derived from the primary dimensions of performance. Thus, units located in the same geographical area would not be directly connected to each other. But, for example, regulatory and environmental issues might be better addressed on a national or regional basis. The natural response to these problems is the creation of matrix forms. The Whole System In addition, a smaller team of top executives makes a narrow scope more attractive, as the overload problem is reduced. These observed patterns are in line with the previous argument, with the existence of complementarities between project characteristics and with the new model having positive effects on performance. These results were confirmed by a comprehensive econometric estimation of the determinants of performance. It was shown that the adoption of a consistent set of measures has a strongly positive effect on performance, even though the individual elements adopted in themselves often harm performance. The researchers also found that most of the companies in the sample had begun to move to the new model by adopting at least some of the features. Remarkably, companies that had adopted only one or two of the three elements performed substantially worse than those that had not moved to the model at all. CHAPTER 6 - Organizing for Growth and Innovation Shareholders may like the current results, but they are even happier if its profits and profitability increase. But employees also prefer a growing company; because it means more opportunities, new assignments and promotions, unpleasant conflicts are alleviated, because the ever larger pie being shared can be more abundant for everyone. However, achieving growth without compromising current performance and destroying value can be very problematic. Size brings with it complexity and organisational designs that were appropriate in a small company may not scale successfully in a larger company. However, organic growth has its limits. Management scholars have argued that most industries go through a life cycle, from founding to a period of rapid growth to maturity, when the industry essentially grows with the overall economy, and then perhaps to eventual decline. Although no single firm necessarily follows the entire cycle, because some enter late and others leave before the industry dies, the dynamics of the industry set the context for the growth of individual firms. When the industry grows rapidly, attracting new customers, there is plenty of room for all companies. Acquisitions are one way of entering new businesses: buying products, divisions or companies already in these sectors. The other possibility is for the company to create and develop new opportunities on its own. Acquisitions easily lead to increased sales and total profits, but the implications for value creation and profitability are less positive. Innovation, on the other hand, is an uncertain process. Buying Growth Acquisitions lead companies to new businesses and new growth opportunities. General Electric has made hundreds of acquisitions. In recent years, many of these have been made by the financial services group GE Capital, which has since become a highly diversified company whose growth has been an important element for the parent company. Acquisitions have also been used by some companies to maintain the flow of new products needed to compete and grow in the high-tech sector. Most notable was Cisco Systems' acquisition of dozens of smaller companies to obtain the technology and people they needed to continue innovating their business. Acquisitions have also been used to completely transform companies. In 1997, Westinghouse Electric, a venerable American manufacturing company, transformed into a media company called CBS, owner of the CBS television network, cable channels, and radio and television stations. In Germany, Mannesmann grew to become a major player in the industry, acquiring wireless companies in other European countries. In 1999, the company exited all its industrial activities, completing its transformation. The main problem with acquisition-based growth strategies is the generation of value for the shareholders of the acquiring company. Growth without profits does not make sense, because being bigger has no real value. In general, it seems very difficult for companies to make a profit by acquiring other companies. There are two difficulties. The first is to avoid that all the potential value creation goes to the shareholders of the acquired company. The second is to realise the potential gains once the transaction is completed. A consistent finding from a number of studies is that, when measured by stock market reactions, mergers and acquisitions create value on average, but most or all of it goes to the owners of the target companies. The general pattern is that the share price of the acquired company shows significant positive 'abnormal returns', reflecting investors' perception that the shareholders of the acquired company usually do very well, receiving a significant premium for their shares. An information problem may help to explain the distribution of takeover benefits: in the literature on competitive auctions, this problem is known as the 'winner's curse'. The basic idea is that, in auctions, the winner will tend to pay more than the object is actually worth and all gains will go to the shareholders of the acquired company. The value of a company for any other company can be expressed as an amount that reflects the underlying value of the company, plus an idiosyncratic component that reflects the particularities of the match between the target and the individual bidder. It is likely that no bidder knows these two elements company's share price. To the extent that the share price recognises the company's short-term and long- term prospects, executives have strong and balanced incentives. For this reason, it might seem that an easy solution to the problem of multitasking is to entrust only top management with the responsibility for exploration and exploitation. In this way, individual business units and functions can concentrate on simple performance or growth programmes. Existing units focus on exploiting current opportunities, while new units explore new ones and turn them into activities. The creation of a separate exploration unit also facilitates the application of appropriate processes and measures to a new activity and can help ensure that it receives the necessary managerial attention. However, it does not eliminate conflicts; instead, the battleground shifts to the company level and the resulting influence costs can be even greater. To protect the new business, some companies try to separate them from the existing ones through the 'skunk works' model. In 2000, Nokia had the highest market capitalisation in Europe and the fifth most valuable brand in the world. Completely focused on telecommunications, it was the clear global leader in mobile phone sales and a strong player in the supply of supporting network equipment. It was estimated that its margins on phones exceeded 20 per cent, while those of its main rivals - Ericsson and Motorola - were in the single digits at best. Nokia had achieved this transformation by consistently leading the industry in the development of new models and even after the collapse of the telecommunications boom and the severe difficulties of many companies in the sector, Nokia continued to prosper. In 1992 Nokia chose to focus all its energies and attention on telecommunications, and in the following years exited all other businesses, including those with a global reach and with good results. As deregulation and privatisation opened up the markets for telecommunication services in Europe, Nokia allied itself with new emerging players challenging the established national monopoly service providers. Paying close attention to end-users, Nokia developed new features for its phones that provided customers with points of differentiation that established service providers were slow to match. This pattern of innovation was the result of Nokia's early realisation that mobile phones were a consumer product. This recognition led the company to focus on design, focusing on ease of use and branding. At the same time, Nokia was quick to recognise the possibilities of developing common platforms that would allow it to offer a wide variety of models while saving on product development, procurement and production costs. Nokia's sales more than doubled year on year from 1992 to 1995. CHAPTER 7 - Creating the Modern Firm: Management and Leadership Challenges This book offered a series of frameworks, concepts and tools to help meet the challenges of designing effective organisations. It has also offered a number of examples of companies that have developed strategies and organisational designs that have enabled them to achieve exceptional performance and growth. However, the fact remains that it is very difficult to develop a winning strategy and an effective organisation. Doing so is fundamentally a creative act that requires both the analytical problem-solving that characterises management and the vision, communication and persuasion that are essential characteristics of leadership. To be successful, the elements of the company's strategy and organisation must be aligned with each other and must adapt to the environment in which the company operates. This need for alignment and adaptation, combined with the interdependencies between strategy and organisational design, means that they must be developed in tandem, holistically. Structure does not follow strategy any more than strategy follows structure. Many of these interactions are dynamic. Especially for a large company, a change in strategy can easily affect the business and cause a reaction that leads to the need for further changes in strategy and organisation. The same applies internally: changes in the organisation aimed at a particular change in behaviour may alter other aspects of behaviour. Instead, strategic and organisational choices must be made holistically, recognising interdependencies. It is necessary to decide the scope of the undertaking: what it will do, where, how and for whom. Recognising the relationships of complementarity and substitution that exist between design variables can help suggest the shape of potentially coherent models, thus reducing the complexity of the design problem. However, it remains very difficult and it is necessary to involve all the people in the company. Solving the organisational design problem therefore fundamentally requires both management and leadership. Much of the actual design work is managerial: putting together budgeting processes, specifying reporting relationships, determining what will be outsourced, establishing governance procedures, creating and assigning staff to departments, establishing the funding model. Leaders must provide a vision of the strategy and organisation, stating the basic principles and how fundamental trade-offs are to be resolved. They must also communicate the model clearly and convincingly, so that others understand and embrace it and are motivated to try to implement it in the design of their parts of the organisation. Although company managers can create and implement the formal aspects of the design, they cannot directly control the networks and culture. It is the people of the organisation, individually and collectively, who determine what they will believe in, what they will value, what behavioural norms they will adopt and who they will relate to informally. Leaders should also celebrate and reward those who act appropriately and correct those who do not. Moreover, it is fundamentally a creative process. To be successful, a company must create value and retain some of it. This can only happen if the company's strategy and organisation enable it to be better than its competitors, to offer products or services that meet the needs of target customers more effectively or more economically. A company that does the same things in the same way as its competitors cannot be better than its rivals, and the resulting head-on competition will ensure that it retains little of the value it could create.