The Dynamics of Firm’s Boundaries and Organizational Strategic Process Unique Organizational Capabilities The Boun

1. Lessons XV XVI: Towards a New Strategy of the Firm: How to Create a Culture for Success. Achieving Unique Corporate Capabilities As a Condition for Being a Leader in the Market (I) The Dynamics of Firm’s Boundaries and Organizational Strategic Process Unique Organizational Capabilities The Boundaries of the Firm Bounded Rationality Knowledge-based Theory of the Firm Dynamic Transaction Costs Options-based Theory of the Firm

2. The Dynamics of Firm’s Boundaries and Organizational Strategic Process • Any firm’s boundaries are dynamic due to the following potential factors: • ØChanging market demand’s conditions; • ØChanging configuration of competition within the market; • Ø Changing internal organizational configuration. • Organizations adjust their boundaries in order to: • ØReact to both external and internal environments. External environment is the business environment surrounding the organization as business entity. Internal environment is the organization and dynamic of business entity. • ØLeverage the use of core competences in order to achieve competitive advantage in the market.

3. Decision-makers in organizations take corrective actions in order to adjust firm’s internal capabilities to external influencing factors. The strategic processes are long-term actions taken to adjust firm’s outcomes and goals to external business environment. A change in legal environment might induce business failures. • For example, changing environmental protection laws might bring in a significant increase of associated costs. Many organizations from economies located in Central and Eastern Europe are facing high costs due to environmental regulations imposed by EU legal frameworks. • Therefore, decision-makers in organizations should take preempting decisions based on agreed strategic processes. Any strategic process is a set of continuous and changing planning and actions implemented in order to preempt potential risk factor coming from internal, i.e. organizational and external business environments.

4. The organizational strategic processes should be regarded as ways of minimizing potential transaction costs induced by market transactions. There is little evidence that firms can eliminate transaction costs at all. There are always market factors inducing transaction costs. The reason is that the market is a collection of separate entities with independent decision mechanisms. Any organization has its own decision process. Firm’s stakeholders might have interests in more than one organization but there is no evidence that one stakeholder can have the power to control all of the entities (i.e. organizations) in the market.

5. The firm cannot get rid of the transaction cost. Nevertheless, organizations can minimize it. The extent to which any firm can get maximum benefits from minimizing the potential transaction costs depends on the way how different actors (e.g. decision-makers, employees, etc.) have the ability to leverage present and potential organizational capabilities and resources in order to achieve competitive advantages in the market. Long-term planning and being successful in managing changes within strategic processes are prerequisites in the process of achieving competitive advantages by any organization. • Organizations choose either to buy products and services from “market firms” or produce them internally. Firms make alliances, joint ventures with other firms or expand their businesses through franchising. “Make-or-buy” decisions, alliances, joint ventures and franchising are all different types of “strategic moves”. The extent to which a firm choose to either make or buy a product or services, enter into alliances or joint ventures, expand their operations through franchising depends on its capability of foreseeing the potential associated costs.

6. A multinational firm might be advantaged in terms of costs incurred when entering an alliance or joint venture with a local firm. Choosing to enter into alliance or joint ventures with a local or regional player might be less expensive in terms of capital costs. • For example, SABMiller[i] would consider outsourcing some of its costs through joint ventureswith local partners in different markets. Therefore, SABMiller would, finally, use potential local partner’s resources and capabilities in order to leverage its own capabilities and resources. A joint venture’s advantage is joining partners’ capabilities and resources. Both profits and associated risks are shared. [i] SABMiller is one of the world’s largest brewers with a brewing presence in over 40 countries across four continents.

7. The theory of the firm is concerned with explaining the economic organization, i.e. how organizations shape their boundaries in a business environment where transaction costs influence the decision-making processes. There is a continuous reconfiguration process of firm’s boundaries, as stakeholders want to maximize their potential benefits. Thus, stakeholders having various interests in different organizations influence the decision-making processes in order to maximize their own benefits and minimize potential costs. The firm’s boundaries are changeable as the decision-making processes within different organizations are dynamic due to various influencing power of different stakeholders. • Give some examples of influencing powers induced by different stakeholders.

8. Therefore, decision processes influenced by various stakeholders having interests in different organizations generate transaction costs. The market is a collection of transactions and their associated costs shaped by a multitude of stakeholders’ groups. • The transaction costs are not only those costs associated with market factors. There are, also, some other influencing factors coming from different stakeholders that may shape transaction costs. • Give some example of transaction costs induced by different stakeholders having different “stakes” in an organization.

9. The firm exists because the economic organization provides the conditions for lowering these costs. Economic organizations are based on the ability to negotiate long-term contracts with some of its stakeholders. Employers negotiate long-term employment contracts in order to “direct the work of the employee whereas such a power did not exist in a principal-agent agreement.”[i] The firm’s owners have the ability (…) to (re)direct the work of their employees”[ii] based on long-term employment contracts. It is a way of diminishing the associated transaction cost by spreading it over a long-term contract carried out within the firm. Every contract made either internally or in the market generates associated transaction costs. The ability of firm’s owners to minimize these costs is what, actually, brings in distinct characteristic of the economic organization. [i] Phelan, Stevan E.; Lewen, Peter. “Arriving at a Strategic Theory of the Firm”. School of Management, University of Texas at Dallas, 1999, Available from: www.utdallas.edu/~plewin/phelan.PDF [ii] Ibid., p. 11

10. Unique Organizational Capabilities • Firms develop a set of resources used for adding value within the business. • Resources are inputs into the firm’s complex system. Added value is the output. Technical equipments, patents, human resources are example of resources. The business success depends, finally, on firm’s abilities to leverage those unique capabilities, i.e. “the ability to perform a task or activity that involves complex patterns of coordination and cooperation between people and other resources”[i]. Examples of unique capabilities are high quality and excellent customer services. [i] Phelan, Stevan E., op. cit., p. 17

11. Strategic management might be regarded as changing organizational processes based on a set of complex and unique organizational capabilities, including managerial ones, for generating sustainable competitive advantages. • Strategists are concerned with those capabilities and resources that generate rents, i.e. surplus of revenue over cost. “Strategists seek to create, and protect, rents in order to enhance the value of their firm.”[i] Competitive markets induce rents due to “luck or differences in expectations concerning the value of a resource”[ii] The strategic value of organizational resources “depends on the way a firm combines, coordinates, and deploys that resource with other firm-specific and firm-addressable resources”[iii]. The unique organizational capabilities are difficult to imitate by the competition “because of time compression diseconomies, asset mass efficiencies, interconnectedness of asset stocks, asset erosion, and causal ambiguity”[iv]. [i] Ibid., p. 17 [ii] Barney cited by Phelan, Stevan E., op. cit., p. 18 [iii] Sanchez & Heene, 1997 cited by Phelan, Stevan E., op. cit., p. 18 [iv] Dierickx & Cool, 1989 cited by Phelan, Stevan E., op. cit., p. 18

12. The Boundaries of the Firm • The boundaries of the firm are changeable as both the internal and the external environments are dynamic. The organizational settings are, also, changeable, as some of those unique organizational resources might be reallocated in order to get maximum benefits. The managerial ability or inability to reallocate organizational resources and capabilities within the organizational settings or in the business environment influence the boundaries of the firm. • Companies can achieve competitive advantages by expanding into similar activities. “Complementary activities lie in the same value chain but require dissimilar capabilities.”[i] Some firms have chosen to expand along the vertical chain by developing their own capabilities and capital at early steps within the vertical chain. [i] Phelan, Stevan E., op. cit., p. 19

13. For example, some retailers developed their own distribution facilities positioned upstream in vertical chain. Distribution and retailing activities might be complementarily regarded as operations performed within inter-linked stages along the vertical chain. Implementing replenishment systems along vertical chains in retail industry created the premise for developing complementary activities. It is a way of vertical integration along the vertical chains in retail industry where retailers control both distribution and retailing activities.

14. The firm should adjust their own boundaries by expanding into areas where they have competitive advantages. “Growth will thus be constrained by the fungibility and transferability of the firm’s most valuable resources (which are by definition rare and difficult-to-imitate).”[i] Some firms could not have the resources and capabilities for integrating vertically along the vertical chain. Some others may consider inefficient and/or expensive to transfer some of their most valuable resources by expanding vertically or entering into other forms of joint planning between firms. • The reasoning behind reconfiguring firm’s boundaries is that companies should adjust their activities by taking only those actions that will generate competitive advantages. [i] Ibid., p. 19

15. The extent to which some firms choose to enter or not into different forms of joint planning and/or asset ownership depends on the potential abilities or inabilities to perform better in terms of profitability. • Some firms may not succeed in the reallocation process of assets and capabilities. The reason is that these firms cannot realize “gains (through economics of scale, scope and experience) by expanding into similar activities”[i], either horizontally or vertically (through vertical integration). [i] Ibid., p. 19

16. Bounded Rationality • Managers cannot anticipate all the factors influencing organization’s activity. Factors like information asymmetry induce imperfect knowledge of the factors influencing the future state of the business. “Managers do not have perfect knowledge of future states of the world, of alternative actions that may be taken should such states arise, nor of the payoffs from adopting various alternatives”[i]. • Manager’s past experience, beliefs, skills and values influence the resource allocation decisions. There is no single way in using some organizational resources by two managers even if there are identical bundles of resources.[ii] “Managers in competing firms do not face the same set of choices. Rather, they have different menus with different choices”[iii]. [i] Newell & Simon, 1972, cited by Phelan, Stevan E., op. cit., p. 20 [ii] According to Phelan, Stevan E., op. cit. [iii] Teece, Pisano, & Shuen, 1997 cited by Phelan, Stevan E., op. cit., p. 20

17. The owners and/or managers of the firms cannot take full advantage from using the information available in the market as “the future is, to a greater or lesser degree, uncertain and unknowable”[i], according to Austrian and evolutionary theory. • Firms rather adapt than optimize the use of their own resources in a competitive business environment with imperfect information. The firms never know if they reached an optimum position as the information is imperfect or the decision makers cannot have access to all of the information required for reaching an optimum position. [i] Hayek, 1945; Nelson & Winter, 1982 cited by Phelan, Stevan E., op. cit., p. 21

18. Nevertheless, some firms can be efficient and others inefficient in terms of resources and rents’ reallocation between various entities in the competitive environments. • Efficient companies manage to reallocate resources and rents for their own benefits. Inefficient firms fail to reallocate their own resources and capabilities by not generating “rents” from entering into competition in the business environment. • In the neoclassical approach, inefficient firms fail to compete and leave only efficient companies.[i] [i] According to Phelan, Stevan E., op. cit. There is, also, an evolutionary approach that offers new insights into the nature of efficient firms. A company may under-perform on the short run but a new strategic change process would payoff over an extended period of time.[i] [i] Ibid.

19. Knowledge-Based Theory of the Firm • This theory is based on the following assumptions: ØKnowledge is used in generating products and services Knowledge is a strategic resource • Knowledge is created and held by individuals, not firms • Firms exist because the market cannot coordinate the knowledge of individual specialists.[i] • Grant argues that coordination of specialized knowledge is difficult even if there is a cooperation between different organizational members. “Rules and directives”[ii], “sequencing”[iii], “routines”[iv], “group problem solving and decision-making[v]” are mechanisms used for coordinating specialized knowledge. The firm generates competitive advantage based on its “ability to integrate knowledge held by individuals within the organization”[vi]. [i]According to Grant, R.M. (1999) “Toward a Knowledge Based Theory of the Firm”, Institute of Industrial Relations, University of California, Berkeley. Available from: http://ist-socrates.berkeley.edu/~iir/cohre/grant.html [ii] Ibid.; [iii] Ibid.; [iv] Ibid.; [v] Ibid.; [vi] Ibid.

20. Dynamic Transaction Costs • Dynamic transaction costs are defined as: • “…the costs of persuading, negotiating, coordinating and teaching outside suppliers…[about your capabilities and strategic architecture]…it is the cost of not having the capabilities you need when you need them.”[i] • Paul Jaminet argued that, “dynamic transaction costs are transaction costs which are of only transient importance.”[ii] Dynamic transaction costs are generated “during the period of entrepreneurship when the value network is created, not during the operating period when relationships are stable.”[iii] It is the case of vertically integrated organizations during earlier periods of organizational development. The dynamic transaction costs are rather regarded as transition costs incurred in earlier stages of organizational development. [i] Langlois & Robertson, 1995, cited by Phelan, Stevan E., op. cit., p. 25 [ii] Jaminet, Paul (2005), Relationship Economics, Available from: http://www.relationshipeconomics.com/shorter_pieces/subway_v_starbucks.htm [iii] Ibid.

21. The costs associated with the transition from one organizational structure to another are related with the optimal organizational structure: “If the advantages of the optimal structure are great enough to justify the transaction costs involved in switching structures, then the value network will change structures early in the operating period; if not, it may retain a less-than-optimal structure.”[i] [i] Ibid.

22. Options-Based Theory of the Firm • The decision making process in organizations is about choosing one or more options regarding the business activity. The decision process impacts the resource allocation in organizations. The extent to which some organizational resources can be reallocated within the firm or in the market depends on a multitude of constraining factors as follows: • ØFirms’ owners and/or managers decide to reallocate resources based on the least cost way of producing a given output; • ØSome firms’ resources “cannot - or can only with difficulty – be sold or used for another purpose”[i] • ØUncertainty : Firms’ owners and/or managers cannot – or can only with difficulty – control all the factors influencing the decision making processes. [i] Burger-Helmchen, Thierry. “How do real options come into existence? A step toward an option-based theory of the firm”, Bureau d’Economie Théorique et Appliquée, University Louis Pasteur, Available from: http://econwpa.wustl.edu/eprints/fin/papers/0409/0409054.abs

23. Thus, the decision making process is about choosing the least-cost decision option that would induce irreversibility in the reallocation of organizational resources. Strategic decisions should induce irreversibility in the reallocation of resources. “The irreversibility condition is also an entry barrier to potential imitators. The sustainability of the profits flowing from a core competence or an option depends on the difficulty to imitate them.”[i] • Firms’ owners and/or managers cannot – or can only with difficulty – choose the least-cost and most efficient decisions due to uncertainty induced by endogenous (e.g. technological uncertainty) and exogenous (e.g. market uncertainty) risk factors. “In fact the firm is not willing to undertake any action because the very nature of the option is made to catch the value included in that uncertainty in an asymmetric way.” [i] Ibid., p. 7

24. Some firms manage to reduce those risk factors induced by uncertainty by developing a set of unique capabilities required for securing organization’s positioning in terms of competitive advantages. • For example, the organizational leadership can be a unique capability as long as the firm successfully managed to become a leader in the market. • Organizational resources are transformed through various distribution and production processes. Some resources are acquired (e.g. stocks), others are transformed in the production process and, finally, sold as final products, generating added value for the firm. “The decision to acquire a resource must ultimately depend on: • a) its premium (or acquisition price), • b) its current value to the firm, and • c) its ability to be recombined with other resources to create value – the expected value of future gains represents the resource’s option value.”[i] [i] Phelan, Stevan E., op. cit., p. 26

25. Therefore, some inputs should be outsourced and others should be internalized. Some firms might find too expensive to acquire and transform internally (i.e. within firm’s operational activities) certain resources as their acquisition prices and/or firm’s ability to recombine them with other resources exceeds the cost associated with having the same resources acquired and transformed by entering into contractual agreements with so-called “market firms”). • “Firms should internalize only a few inputs that: • 1) are exceptionally difficult to obtain through markets and • 2) are capable of generating superior options values for the firm.”[i] [i] Foss, 1998 cited by Phelan, Stevan E., op. cit., p. 26