Lessons V VI: The Transition From “Island-efficiency” to Systemic Competitiveness. Vertical Boundaries of the Firm and

1. Lessons V VI: The Transition From “Island-efficiency” to Systemic Competitiveness. Vertical Boundaries of the Firm and Leadership Inner Organizational Boundaries and Outer Organizational Boundaries of the Firm Upstream, Downstream Defining Boundaries Benefits and Constraints of Using the Market Information Asymmetry The Nature of the Firm Organizing Vertical Boundaries of the Firm Technical Efficiency and Agency Efficiency Asset Ownership and Vertical Boundaries of the Firm

2. Inner Organizational Boundaries and Outer Organizational Boundaries of the Firm • The idea of being a successful organization in a world of competitiveness evolved from the classical approach where “small scale markets allowed for little specialization”[i] to a more specialized, sophisticated, interlinked organizational systems leading to a rather systemic competitiveness. • F. Y. Taylor’s theories emphasized the importance of so-called “scientific management” approach where the automatization was seen as the driven force behind increasing efficiency. It is the taylorism that introduced the idea of achieving maximum efficiency by using the machines and workforce in combination with the principle of simplified work. Taylorism, actually, dominated the science of management until the late of 1970s.[ii] [i] Kaplinsky, Raphael; Morris, Mike. A Handbook for Value Chain Research, Available from: http://www.ids.ac.uk/ids/global/pdfs/VchNov01.pdf [ii] Ibid., p. 9

3. The specialization of the workforce may lead to the idea that performing simple, repetitive tasks would justify the introduction of mechanization as a first step towards “the first examples of electronically-automated production processes, where new automated machines were seen as “islands of automation”.”[i] • Nevertheless, these so-called “islands of automation” regarded as rather separate units performing specific tasks became more integrated with certain tasks performed within an organization and others by other firms sometimes positioned in different geographical markets in a more inter-linked, globalized environment. These “islands of automation” regarded as “islands of efficiency” became more inter-linked like islands being interconnected through more and more so-called “bridges”. Different parts of the entire production process started to be performed by stakeholders sometimes positioned not only within the inner organizational boundaries but, also, within an outer firm’s boundaries. [i] Ibid., p. 9

4. Inner organizational boundaries of the firm refer or are limited to the boundaries of the firm regarded as a legal entity able to enter into contractual arrangements with other entities for buying and selling goods or services. For example, any organization legally entitled to enter into contractual arrangements with other organizations is bounded by certain conditions imposed by certain laws. Any organization’s boundaries are therefore limited by certain conditions. It is the case of the inner organizational boundaries of the firm. • Any organization legally entitled to enter into contractual arrangements with others may choose to participate with other firms in the process of production. For instance, there might be more than one firm contributing to the process of producing certain clothes. A firm might perform the design of the clothes, the production might be carried out by a certain company located elsewhere, sometimes internationally and the retailing activities might be controlled by another firm. It is an example of internationalization in the process of producing and selling a certain good. The firm responsible with carrying out the production flows from our example is not limited only to its inner organizational boundaries as it is not the only one responsible with carrying out the entire process including design, production and selling. Thus, there is a broader perspective to this firm’s activities related to its outer boundaries.

5. The fast pace of globalization changed the way firms compete. They are not any longer regarded as “islands of efficiency”. They entered a world of systemic competitiveness. It is a new approach signaled in the late 1970s by organizations realizing that “the development of just-in-time, total quality management and continuous improvement procedures within the firm might make no discernible difference towards its own competitiveness unless its various tiers of component suppliers – accounting for 60-70 percent of total product costs – adopted similar practices.”[i] This new systemic approach evolved in time as companies from US realized the importance of focusing on those unique organizational capabilities, i.e. core competences or unique resources hardly to imitate by its competitors. The concept of outsourcing became important for firms wishing to “outsource the remaining competences to other firms in the value chain. This extended the complexity of production, and the consequent need to ensure systemic competitiveness between firms.”[ii] [i] Ibid., p. 10 [ii] Ibid., p. 10

6. “Competitiveness is a comparative concept of the ability and performance of a firm, sub-sector or country to sell and supply goods and/or services in a given market.”[i] This definition explains the concept of competitiveness and, also, gives some clues about the boundaries of the manifestation of firm, sub-sector or country’s “ability of an entity to operate efficiently and productively in relation to other similar entities.”[ii] The relations between different entities either firms, sub-sectors or even countries in the process of selling and buying goods and/or services show the boundaries and a framework for understanding competitiveness. These are the outer boundaries of the firm. [i] Wikipedia – The Free Encyclopedia, Available from: http://en.wikipedia.org/wiki/Competitiveness [ii] Spero, Jones; Hart, Jeffrey. The Politics of International Economic Relations. Available from: http://www.indiana.edu/~ipe/glossry.html

7. Upstream, Downstream • Any firm’s activity is part of a vertical chain in a particular industry or economic sector. • Goods “flow” in any economy within different vertical chains, where raw materials at manufacturing level become finished goods distributed and retailed to final customers. • Vertical chains are processes where added value is being generated at each step, i.e. manufacturing, distribution and retailing. Economists argue that “early steps are upstream in the production process, and later steps are downstream (…).”[i][i] Besanko, David; Dranove, David; Shanley, Mark. “Economics of Strategy”, p. 71, New York: John Wiley & Sons, Inc. 1986

8. Any firm has four decision choices, as follows: • Ø      Going upstream along the vertical chain, • Ø      Performing downstream along the vertical chain, • Ø      Having “in-house” professional supporting activities, • Ø   Buying professional supporting activities from a • market firm. The four decision choices form the “make-or-buy” decision framework. A good manager should make the right decision according to firm’s unique capabilities. Going upstream or downstream is a strategic choice that any organizational leader should make based on firm’s unique capabilities.

9. Defining Boundaries • A firm must decide whether it needs to use the market or performing the activity in-house. Firm’s boundaries are determined by “the capabilities of the firm relative to the capabilities of the market.”[i] In the long run, if the costs of using firm’s capabilities exceed the benefits, the firm will have to find alternative ways by buying specialized supporting activities from a market firm. • In the same way, on the long run, if the costs of using market’s capabilities are greater than the benefits, the firm will have to develop its in-house capabilities. • The organizational abilities of maximizing potential benefits of using either in-house capabilities or professional supporting activities from market firms are factors that shape firm’s boundaries. [i] Langlois, R. N., & Robertson, P. L. 1995. “Firms, Markets and Economic Change: A Dynamic Theory of Business Institutions”, London: Routledge, p. 33

10. Benefits and Constraints of Using the Market • Benefits of Using the Market Organizations use market firms when the potential benefits of “employing” market’s capabilities are greater than its incurring costs. Moreover, firms use the market if they “can take advantage of the hard-edged incentives that only the market can offer.”[i][i] Besanko et al. Op. cit., p. 77 Here are some potential advantages of using the market: - “Market firms can achieve economies of scale.”[i][i] Ibid. p. 77 - “Market Firms are Subject to the Discipline of the Market”[i][i] Ibid. p. 84 Organizational leaders should be aware of market’s capabilities that might be used for the business. The leaders should, also, be aware of the additional costs that might occur when the effort paid for using those market capabilities become greater than the cost paid for using the organizational capabilities.

11. Information Asymmetry • The information is asymmetric when one or more parties in a contract or organizational context have more or better information than the other one(s). • The CEO of a complex organizational structure may face the risk of not having access to the correct information or the information provided is not reflecting the real “picture”. • The decision making process is, sometimes, a multistage process with the information being, firstly, received by the division-level management and, then, communicated to upper managerial level. The information might be distorted when there is a multistage decision making process. • There are voices arguing that it might be a sort of distorted competition, i.e. competition between more than one organizational divisions for influencing the distribution of benefits within the organization. • It is the influence cost that is made out of the followings: -“Direct costs of influencing the activities (e.g., the time consumed by a division manager lobbying central management to overturn a decision that is unfavorable to his or her division).”[i] [i] Besanko et al. Op. cit., p. 87 - “The costs of bad decisions that arise from influence activities (…).”[i] [i] Ibid. p. 87

12. Costs of Using the Market A. Coordination of decision flows through the vertical chain. Successful decision-making process through the vertical chain, influencing the flows of information and material resources, depends on: Efficient coordination between the different steps within the vertical chain. B. “Leakage of Private Information” Firms risk loosing private information when making contractual arrangements with market firms. C. Transaction Cost. It is a “cost incurred in making an economic exchange.”[i][i] Wikipedia – The Free Enciclopedia, 2005. Available from: http://en.wikipedia.org/wiki/Transaction_cost

13. The Nature of the Firm • Why firms exist? Wouldn’t be more appropriate to have contractual arrangements between self-employed persons? • “(…) search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs” are all different kinds of transaction costs. These all add up to the initial cost of goods of services. Firms emerge when the production of certain goods or services might be performed internally and, consequently, having some transaction costs reduced. • Company grows as a result of “finding the optimal balance between the competing tendencies of the costs outlined above.”[i][i] Ibid. • There might be several stages of firm’s life as outlined bellow: • ØThe first stage occurs when firms actually emerge due to a more efficient use of internal resources. At this stage, some transaction costs might be avoided by choosing to produce a certain product “in-house” instead of having it supplied based on a contractual arrangement in the market. • ØThe second stage takes place when the firm grows. It means that the company found out the optimal balance between the two competing categories of costs, i.e. transaction cost and the cost associated with “decreasing returns to the entrepreneur function”.

14. ØThe third stageoccurs when the firm reached its peak and started to fall. At this stage the costs associated with “decreasing returns to the entrepreneur function”[i] started to overcome the transaction costs. The firm reached an adjourning phase. The growing phase reached a peak and firm move to a decreasing phase. [i] Ibid. • Firms exist because the conditions of a competitive market are reproduced within the organization at a lower cost comparing to market conditions. • Managing long-term contract arrangements with different stakeholders create the conditions for cost savings due to cost redistribution on a portfolio of long-term contracts.

15. Organizing Vertical Boundaries of the Firm • Firms can either choose to organize in-house required supportive operations or enter into market transactions with specialized organizations supplying certain specialized functions. Organizations can, also, integrate some or all of its supportive functions along its vertical chain. • Companies choosing to organize one or more specialized supportive functions internally are advantaged in terms of costs relative to the situation when they would have rather chosen to enter into transactions with a specialized market firm. The reason is that the perceived cost related to the developing and organizing some supportive functions (e.g. HR and accounting) is less than the cost paid for specialized services provided by market firms. • On the other hand, firms choosing to have some supportive functions supplied by specialized market firms are advantaged in terms of costs comparing with the effort paid for having these specialized functions developed and organized “in-house”. • The decision to either have some functions outsourced or organized internally depends on the cost advantage of each option related to the other.

16. Technical Efficiency and Agency Efficiency Technical Efficiency • A firm is technically efficient when using “the least-cost production process.”[i]. • Example: Some successful retailers are technically efficient as they managed to use the least-cost sourcing and selling processes. Value-for-money retailers secured their profit margins by using the least-cost sourcing and selling processes and capabilities. [i] Besanko et al. Op. cit., p. 134 Agency Efficiency • “Agency efficiency refers to the extent to which the exchange of goods and services in the vertical chain has been organized to minimize the coordination, agency, and transaction costs (…)”[i] [i]Besanko et al. Op. cit., p. 134 Firms failing to minimize transaction costs do not achieve agency efficiency.[i] Failing to achieve agency efficiency is similar to failing to manage efficiently the exchange process of goods and services along the vertical chain.[i] See Besanko et al. Op. cit.

17. Asset Ownership and Vertical Boundaries of the Firm • Owning assets and controlling different steps along the vertical chain can make the difference comparing vertical integration with market exchange. Some firms expanded vertically by taking control on other firm’s assets or creating their own capabilities positioned upstream or downstream within the vertical chain. • For example, PepsiCo developed relations with two types of bottlers, i.e. independent bottlers and company-owned bottlers. PepsiCo has no direct control over an independent bottler’s management. PepsiCo can, also, acquire one of its independent bottlers. In this final case, PepsiCo has direct control over the management of the newly acquired bottler.[i] [i] Ibid. • “Sanford Grossman and Oliver Hart analyze three different organizational arrangements: • ØNonintegration • Ø      Forward integration • Ø      Backward integration.”[i]

18. - Nonintegration refers to the situation when two units, unit 1 being upstream of unit 2, are independent firms, each one being in control of its own assets. - Forward integration: unit 1 owns the assets of unit 2: “unit 1 forward integrates into the function performed by unit 2 by purchasing control over unit 2’s assets”.[ii] - Backward integration: unit 2 owns the assets of unit 1: “unit 2 backward integrates into the function performed by unit 1 by purchasing control over unit 1’s assets”[iii]. [i] Besanko et al. Op. cit., p. 144 [ii] Ibid., p. 144 [iii] Ibid., p. 144 In conclusion, firms’ decision processes depend on the way assets are owned and controlled by different units regarded as organizations performing different steps along the vertical chain.