How A Firm's Capabilities Affect Boundary Decisions

Question 1

Introduction

Answer 1

A world of corporate refocusing, downsizing and outsourcing→ senior managers need to determine their firm’s boundary

• Wrong business activities within their boundaries risk losing strategic focus and becoming bloated (paranoid) and bureaucratic

Question 2

Transactions cost economics

Answer 2

specifies the conditions under which firms should manage a particular economic exchange within their organizational boundary and the conditions under which it should be outsourced

Only requires managers to consider only a single characteristic of an exchange – the level of transaction-specific investment – in order to decide whether to include an exchange within a form’s boundary

Question 3

3 Transactional Cost Analysis of Boundary Decisions

Answer 3

1. Governance
2. Opportunism
3. Transaction-specific investment

Question 4

1. Governance

Answer 4

“control over resources or capabilities”

• The mechanism through which a firm manages an economic exchange

• • Increases with the degree of ownership of the resource or capability
• • Governance is costly

Choosing how to govern an exchange → firm determines its boundary

Question 5

3 types of governance

Answer 5

1. Market governance
2. Intermediate Governance
3. Hierarchical Governance

Question 6

1. Market Governance

Answer 6

• Cooperate with firms who already possess the capabilities needed
• manage an exchange when they interact with other firms at arm’s length across nameless, faceless market
• rely primarily on market-determined prices to manage exchange

Examples:

• Oil refineries→ gain access to crude oil purchased on the spot market
• Electronics firms→ obtain standardised electrical components from component distributors
• Food processors→when purchasing food from farmers and food brokers

Question 7

2. Intermediate governance

Answer 7

• Cooperate with firms who already possess the capabilities needed
• use complex contracts and other forms of strategic alliances (joint ventures) to manage an exchange
• Complex contractual forms of governance replace independent arm’s-length market relations
• Contracts→ protect industries (especially by government)→ small firms especially leverage on contracts to protect them from the threat of opportunism

Examples:
- Retail firms→obtain products by negotiating long-term supply contracts with suppliers. Suppliers locate critical operations near a retail firm’s HQs

• Partnering to form joint venture→ use complex franchise agreements to manage an exchange
• Coca Cola→ only sell the concentrate, focus more on the marketing function

Question 8

3. Hierarchical Governance

Answer 8

• Bringing an exchange within their boundary
• Parties to exchange are no longer independent→ the boss has the right to direct actions and decision making
• Either develop capabilities in house or acquire another firm who already possesses the capabilities needed

Example:
- Manufacturing firm→when it owns and operated a factory supplying the product that is sells.

• Retail firm→ when it owns and operates its own stores
• A diversified firm → when it operates a sales and distribution network that 2 or more of the businesses it owns use to sell and distribute their products

Question 9

Cost of Governance Mechanism

Answer 9

• The more elaborate→ the more costly
• Cost of using market governance < cost of using intermediate governance < cost of hierarchical governance
• If minimizing cost was the only concern then firms would always use non-hierarchical governance – would always narrowly draw the boundary of the firm

Question 10

3. Transaction-Specific Investment

Answer 10

“any investment that is significantly more valuable on a particular exchange than in any other alternative exchange”

Question 11

Threats of Opportunism in an exchange

Answer 11

Threat of opportunism exists when 1 party to an exchange has made a transaction-specific investment, while others have not made such an investment

The more elaborate the governance mechanism = the more effective in reducing the threat of opportunism

• • High levels of transaction-specific investment = hierarchical governance
• –▪ The high cost of hierarchical governance is offset by its ability to reduce threat of opportunism
• • Moderate levels of transaction-specific investment = intermediate governance
• –▪ Can reduce the threat of opportunism without the extra cost of hierarchical governance
• • Low levels of transaction-specific investment = market governance
• –▪ Low levels of transaction-specific investment are not prone to opportunism so firms should go for the least costly governance

Firm capabilities do not a play a significant role in traditional transaction cost analyses of firm boundaries

Question 12

Capability considerations in boundary decision

Answer 12

1. Cooperate with other firms and access their capabilities
2. Create Capabilities on its own
3. Acquire another firm to gain access to its capabilities

Question 13

Capability considerations in boundary decision

Answer 13

1. Cooperate with other firms and access their capabilities
2. Create Capabilities on its own
3. Acquire another firm to gain access to its capabilities

Question 14

2. Create Capabilities on its own

Answer 14

Reasons why it can be costly
1. Ability to create a capability in a cost-effective way may depend on unique historical conditions that no longer exist.

2. Creation of capability may be “path dependent”
3. Capability may be socially complex
4. Actions that a firm would need to take to create a capability may not be fully known

Question 15

2. Create Capabilities on its own

Answer 15

Reasons why it can be costly
i. Ability to create a capability in a cost-effective way may depend on unique historical conditions that no longer exist.

ii. Creation of capability may be “path dependent”
iii. Capability may be socially complex
iv. Actions that a firm would need to take to create a capability may not be fully known

Question 16

i. Historical Context –

Ability to create a capability in a cost-effective way may depend on unique historical conditions that no longer exist.

Answer 16

• Sometimes creating cost-effective capabilities depends on being at the “right place at the right time”→ recreating the opportunities may be impossible
• i.e. Caterpillar created a low cost worldwide service and support network for its heavy construction equipment business→ was the major supplier of equipment to Allies forces during WWII so the Allies subsidized the creation of the network → gained enormous competitive advantage

Question 17

ii. Path Dependence –

Creation of capability may be “path dependent”

Answer 17

• Must go through a long, difficult learning process to create the capabilities (no short-cuts)→ time consuming→ increase cost
• i.e. The capability that some Japanese firms have to work cooperatively with the suppliers (Experience that develops over 500 years)
• • Many U.S. manufacturers want these capabilities to gain access to the low-cost, high-quality supplies that seem to be available to at least some Japanese firms
• • U.S. manufacturers cannot quickly create these capabilities

Question 18

iii. Social Complexity –

Capability may be socially complex

Answer 18

• i.e. difficult to create a firm’s culture, reputation among customers and suppliers, trustworthiness→ enable a firm to pursue valuable business and corporate strategies
– Firms without these capabilities find it difficult to conceive or implement these same strategies

• Socially complex capabilities are generally beyond the ability of managers to change in the short term – they evolve and change slowly over time

• E.g. “Visionary” firms→ e.g. General Electric, Hewlett-Packard, Johnson & Johnson, Merck, Sony, Disney → organized visions of their roles in the economy, responsibilities to their customers and suppliers, commitment to their employees→ affected decision making
– Provide higher returns for shareholders than competitors that do not have such socially complex visions

Question 19

iv. Casual Ambiguity –

Actions that a firm would need to take to create a capability may not be fully known

Answer 19

• Sometimes it’s not clear which actions a firm should take to create a particular capability
• Causal ambiguity: multiple competing hypotheses about how to create those capabilities and when these hypotheses cannot be tested
• • Particularly likely when the sources of a firm’s capabilities are taken-for-granted, unspoken, and tacit attributes of a firm
• • Such organisational attributes = “invisible assets”

• Invisible assets→ create capabilities
– Assets needed to create capabilities are invisible → clueless

• Multiple competing hypotheses about what a firm needs to do to create particular capabilities exist, a condition of causal ambiguity prevails, and firms cannot be sure what they must do to create them

Question 20

3. Acquire another firm to gain access to its capabilities

Answer 20

5 reason why it can be costly
a. Legal constraints

b. Acquisition reduces value of capabilities
c. High cost of leveraging acquired capabilities
d. Unwanted “baggage”
e. Strategic Flexibility and Uncertainty

Question 21

a. Legal constraints

Answer 21

• Antitrust and local ownership restrictions – prevent monopoly or anti-competitive practices
– e.g. Microsoft wanted to acquire Intuit – developed the most successful home accounting software on the market. Microsoft did not pass the antitrust scrutiny

• Foreign ownership restrictions i.e. can make it illegal for non-domestic firm to acquire a domestic firm

Question 22

b. Acquisition reduces value of capabilities

Answer 22

• Acquisitions can sometimes reduce the value of capabilities]
• i.e. Publicis’ greatest asset was its long-term contracts with several large French companies
• • However, these clients preferred working with a French advertising agencies
• • If in the late 1980s and early 1990s, Publicis was acquiried by a US agency, they would have jeopardized the capability they wanted (the relationship with large French companies)
• • Publicis would have rather entered a strategic alliance than be acquired

Question 23

c. High cost of leveraging acquired capabilities

Answer 23

• Acquisition alone can be costly
• It is often difficult to leverage the acquired capabilities across the relevant parts of the acquiring firm’s operations
• Reason for failure = inability of acquiring firms to take full advantage of newly acquired capabilities
• Integration difficulties stem from differences in culture, systems, approach, etc.→ raise cost

Question 24

d. Unwanted “baggage”

Answer 24

• Capabilities may be difficult to disentangle from one another
– Very rarely are capabilities conveniently located in one group or division
– Desired capabilities are often spread globally across multiple
individuals, divisions, and groups – cannot be easily extracted

• Usually you have to acquire the whole firm
– When you acquire the whole firm then you get both the desirable and undesirable

• Solution to unwanted “baggage”= spin off those unwanted and useless parts
– However, if the capabilities are so diffused that you cannot separate the desirable from undesirable – cost of acquisition increases significantly

Question 25

e. Strategic Flexibility and Uncertainty

Answer 25

• In a highly uncertain market, firms don’t know what capabilities are needed for the long term
– They want to maintain flexibility so they can move quickly to develop required capabilities when uncertainty is resolved

• Hierarchical governance is less flexible than intermediate and market governance
• If the capability in the newly acquired firm isn’t valuable, then have to resell – hierarchical governance has a high withdrawing cost

• Under conditions of high uncertainty, firms prefer to gain access to another firm’s capabilities through strategic alliances (intermediate governance) rather than through acquisitions
– Only after the uncertainty is resolved, then firms use acquisitions

Question 26

Prevalence of These Exchange Conditions

Answer 26

Hierarchical→ costly→ esp. in rapidly evolving high-technology industries (biotechnology, microelectronics, computer software)

Question 27

Costliness of Creating Capabilities

Answer 27

• Technology industries are highly path dependent

• • i.e. biotechnology firms need to learn how to manufacture in small batches
• • i.e. firms that want to write complex software must learn how to write them then how to integrate them

• Also rely on socially complex capabilities
– i.e. research in the pharmaceutical industry suggest that some firms are high skilled at integrating product development across multiple scientific disciplines but some aren’t

• High uncertainty in these industries – a lot of causal ambiguity

• • Lack of scientific knowledge and thousands of small decisions
• • Firms cannot know definitively what they should do to build capabilities

Question 28

Costliness of Acquiring Capabilities

Answer 28

• Legal, ownership, & asset value constraints on acquisitions
• Uncertainty about the future puts a premium on maintaining flexibility in these industries

• Acquisitions in high-technology industries constrain a firm’s options in a costly-to-reverse-way
– Non-hierarchical forms of governance as a way to gain access to capabilities are preferred

• Due to the rapidly changing technical needs of the firms – they only need the capabilities for limited activities, short periods of time or highly specialized purposes

• • Unlikely the firm will be able to integrate the other firm rapidly enough
• • Even if they can, after they no longer need them, they become unwanted “baggage”