Structural Expansion vs. Structural Reorganization
Susheng Wang1
May 2016
Abstract. This paper discusses firms’ growth strategies: organic growth (internally generated growth) vs. inorganic growth (growth via acquisitions). We try to explain why some firms such as Google mainly rely on inorganic growth, while others such as Apple mainly rely on organic growth. We find that when market uncertainty drops, a decentralized firm (D-firm) is more likely to carry out a structural expansion (inorganic), while a centralized firm (C-firm) is more likely to carry out a structural reorganization (organic). When market competition subsides, a D-firm is more likely to carry out a structural reorganization or stay put, while a C-firm is more likely to carry out a structural expansion or stay put. When the market expands, a D-firm is more likely to carry out a structural expansion or stay put, while a C-firm is more likely to carry out a structural reorganization.
Keywords: structural expansion, structural reorganization, market uncertainty, market competition, market size, synergy
JEL classification: G34
1
Hong Kong University of Science and Technology, Hong Kong. Email:
[email protected].
1. Introduction Firms grow when conditions are favorable. Growth can be achieved either by organic growth (internally generated growth) or inorganic growth (growth via acquisitions). Organic growth comes from internally developing new products or nurturing one’s existing products. Inorganic growth occurs when a firm acquires another firm and starts selling the acquiree’s products so as to enhance its own growth. Some firms such as Apple have traditionally favored organic growth, while others such as Google have traditionally opted for inorganic growth. Yet other firms may choose organic growth in some periods but inorganic growth in other periods. In fact, a firm has three growth options. First, it may focus on organic growth with a reorganization of its structure, in which case we would observe a structural reorganization. Second, the firm may focus on organic growth without a reorganization, in which case the firm structure stays put. Third, the firm may focus on inorganic growth, in which case we would observe a structural expansion. Research on the choice between a structural expansion and a structural reorganization is rare. Hitt et al. (1998) find conditions under which acquisitions are successful and would lead to profitable growth. Levine & Smith (2004) investigate the effect of organizational structure and horizontal disintegration on information sharing among divisions. They investigate a free rider problem in which a decision-maker invests in an uninformative project and free rides on another decision-maker’s investment in an informative project. They propose either centralization or divestiture as a possible remedy. Renucci (2008) considers conditions under which a firm is better off decentralizing. He assumes a capacity constraint for a centralized structure, while we assume a coordination cost; he assumes two independent projects, while we emphasize synergy among divisions. Since economic activities can be better coordinated to achieve synergy in a centralized control structure, synergy plays an important role in the firm’s choice not only between internal and external expansions but also between decentralization and centralization. Acquisitions are typically made with a firm’s own core products in mind, indicating the importance of synergy in the firm’s expansion strategy. Alonso et al. (2015) focus on the choice between decentralization and centralization in a structural reorganization, while we focus on the choice between a structural expansion and a structural reorganization. They show that increased market competition encourages centralization; in contrast, we show that increased market competition encourages a structural reorganization, implying that a decentralized firm (D-firm) prefers centralization while a centralized firm (C-firm) prefers decentralization. Decentralization offers better incentives for division managers to improve a firm’s competitiveness, while centralization offers the benefit of coordination so that a firm can face competition more effectively. Besides, we also show that a structural expansion is an inferior option in this case. Ma & Wang (2016) consider internal restructuring vs. external restructur2/28
ing for firms in trouble. They consider a firm with two divisions. When in distress, the firm can either restructure internally or divest one of its divisions. In contrast, we consider a firm with one division (representing all existing divisions). When market conditions are favorable for expansion, the firm can either expand its division with or without a corresponding structural reorganization or acquire more divisions. According to Williamson (1996, 2002) and Harford (2012), centralization offers better coordination among divisions and better information to guide decision-making. Coordination plays two roles: coordinate divisions to better deal with uncertainty and competition, and coordinate divisions to better capture synergy. However, coordination is costly: a coordination cost is incurred and incentives for division managers are reduced. In contrast, decentralization offers better incentives and is less costly in decision-making, but there is no coordination among decision-makers and a lack of overall market information available to guide their decisions. Besides expanding existing divisions with or without internally reorganizing the control structure, an expanding firm can also acquire divisions. An additional division may offer synergy to the existing divisions, as it encourages competition among divisions in a Dfirm and creates incentives, and depending on market conditions it may be a cheaper expansion option. We analyze these options from the perspectives of market uncertainty, market competition, market size, and synergy among divisions. We consider a firm with one division, which represents all existing divisions in the firm. When it is a good time for expansion, the firm may expand the operations of its division with or without a corresponding reallocation of control rights; it may also expand by acquiring a new division. Therefore, when facing a changing market, besides adjusting contractual relationships with division managers, the firm has three structural options: staying put (no structural change), expanding its structure (acquiring a division), and reorganizing its structure (centralization or decentralization). When an option becomes more likely to be the best one out of the three available options when the business environment changes, the firm is more likely to choose that option. A firm’s structural choices depend not only on each of their advantages and disadvantages but also on its own type. For a D-firm, a centralized structure offers the benefit of coordination, which is important when market uncertainty is high and market competition is intense. For a C-firm, a decentralized structure offers the benefit of better managerial incentives and competing divisions give the firm a competitive edge in the market. On the other hand, for a Dfirm, a structural expansion offers the benefit of improved efficiency among competing divisions (more divisions mean more competition among divisions in a D-firm), besides possible synergy among divisions. For a C-firm, a structural expansion enables coordinating divisions to effectively capture synergy and to better deal with market competition and uncertainty. We investigate firms’ growth strategies under various conditions. We find that when market uncertainty drops, a D-firm is more likely to carry out a structural expansion, while a C3/28
firm is more likely to carry out a structural reorganization. When market competition subsides, a D-firm is more likely to carry out a structural reorganization or stay put, while a C-firm is more likely to carry out a structural expansion or stay put. When the market expands, a D-firm is more likely to carry out a structural expansion or stay put, while a C-firm is more likely to carry out a structural reorganization. Finally, when synergy improves, both types of firms are more likely to carry out a structural expansion. Our work is related to the literature on the boundary of the firm. We determine the boundary of the firm conditional on an endogenous firm structure. Our conclusions depend crucially on the fact that we allow firm structure to adjust. If not, the effects could be much different. For example, when market uncertainty drops, it may be a good time for firms to expand their boundaries via acquisitions. However, we show that it is in fact better for a Cfirm to decentralize. With better incentives in a decentralized structure, the firm would benefit more from expanding the operations of its existing divisions than from making acquisitions. This paper proceeds as follows. Section 2 presents the model. Section 3 finds the solution. Section 4 analyzes the solution for the choice between a structural expansion and a structural reorganization. Section 5 offers several case studies of our theory. Section 6 provides concluding remarks. All proofs are given in the appendix.
2. The Model The Firm There is a firm with one division (representing all existing divisions), named division 1. This firm may acquire an additional division, named division 2. Each division produces a separate product. Division produces output
where
is the price and
is a random factor. If the two divisions are not within the same
firm, their cost functions are cost functions are
and faces the following inverse demand:
If the two divisions are within the same firm, their where the dependence of the costs on each other’s output
represents synergy among the divisions. Inorganic growth has been viewed as an important strategy for innovations. Firms typically acquire divisions that can help boost the development of their core products. We use synergy among divisions in our model to capture these motives for acquisitions.
Control Structure We take the incomplete contract approach. A control variable in the incomplete contract approach is similar to an effort variable in the complete contract approach. Instead of verifia4/28
bility of an effort variable, we focus on control rights or decision-making rights over a control variable. Division ’s output
is a control variable, which may be decided by the division manager
or by the CEO of the firm. When the control rights of all outputs reside at the firm level, we call the firm a centralized firm or C-firm; when the control rights of all outputs reside at the division level, we call the firm a decentralized firm or D-firm. In a C-firm, the CEO decides on both
and
ex post after the random factor
is realized with a coordination cost
or
, depending on whether there is only one division or two. The coordination cost may arise from asymmetric information as in Alonso et al. (2015) or bureaucratic inefficiency as in Wang & Xiao (2009). In a D-firm, the manager of division decides on coordination cost. The two division managers decide on
and
ex post without a
simultaneously in Nash
equilibrium in the ex post subgame. The solution for each type of firm is a subgame perfect Nash equilibrium (SPNE). In practice, while putting the CEO in control incurs a coordination cost, she does know the overall market better than anyone else. Various reports about market trends go directly to the CEO. The chief information officer reports directly to the CEO. The chief operating officer, who looks after day-to-day activities including marketing and sales, provides feedback to the CEO. We hence assume that the division managers do not observe
; only the CEO does. In
fact, a division manager in our model has no incentive to obtain market information her income is based on her own division’s output
since
. The coordination cost at the firm level
includes the cost of gathering market information. Note that we assume the two divisions are located physically in close proximity so that the division managers would not have better local information than the CEO. When divisions are set up in the same location, a division manager is likely to be less knowledgeable about the overall market than the CEO. A division manager may know her own market well, but not the markets of other divisions. The relationships between the CEO and the division managers are defined by contracts. The CEO offers a contract to each division manager. In this contractual relationship, the CEO is the principal and a division manager is the agent. The contract for division ’s manager is denoted by
, specifying the payment
to the division manager when output is
.2
When designing the contracts, the principal aims to maximize the firm’s overall profit; when a division manager decides on her division’s output, she aims to maximize her own income. Assume that a division’s output
is verifiable, but the random factor
and cost
are not.
The sequence of events is illustrated in the timeline of Figure 1.
2
We have used a simple contract form. The contract can also be of the form or
if the cost
,
is verifiable, and our main results would remain. That is, the form
of contract itself is not crucial to our results. The contractual relationships are not the focus of our paper.
5/28
Allocating revenue
Nash equilibrium in
is resolved
Contracting
Ex Post
Ex Ante
Figure 1. Timing of Events
Structural Reorganization vs. Structural Expansion When market conditions improve, the CEO will adjust contractual relationships with division managers. If the changes are substantial, the firm may also carry out a structural change. The firm has several options for a structural change. The firm can expand internally by expanding operations of its existing divisions with or without reorganizing its structure. A structural reorganization involves either decentralization or centralization of the control structure. Alternatively, the firm may expand externally by acquiring a division, called a structural expansion. That is, when market conditions improve, a firm can expand by acquiring a division, in which case we would observe a structural expansion; or it can expand its existing divisions coupled with a reorganization of the control structure, in which case we would observe a structural reorganization; or it can expand its existing divisions without reorganizing its structure, in which case the firm structure stays put. A firm typically makes one structural change at a time. A structural change is very costly to a firm in terms of effort and time. Each structural change typically takes a few months from planning to execution. Hence, a firm in our model is assumed to make one structural change only. This is consistent with our case studies in Section 5.
Parametric Functions To analyze our solution, we use the following set of parametric functions:
where
,
and
. Here,
represents the coordination cost, and
repre-
sents the marginal cost of production. We have a linear demand function for each product, where
is the slope of the demand curve and
is the intercept. For a larger (or smaller) ,
demand is less (or more) sensitive to the price. Since competition can generate price sensitivity,
is a measure of market competitiveness. Denote the density function of
mean value of
by
, and demand uncertainty by
by
, the
. When a new division is
acquired, there may be synergy among the divisions, and the cost and coordination functions for the two divisions become
6/28
where
represents synergy among the divisions. If
there is positive synergy; if
there is negative synergy. For our purpose, we have assumed symmetric divisions (identical parametric functions but different products) in this parametric setting.
3. The Solution 3.1. Structural Reorganization The firm has only one division, named division 1. In a structural reorganization, the firm either decentralizes or centralizes its control structure.
Decentralization For a D-firm with a decentralized control structure, the manager of division 1 has the right to decide on division 1’s output and it is decided by her ex post problem:
Its first-order condition (FOC) implies an incentive compatibility (IC) condition. Then, after taking into account the ex post individual rationality (IR) condition for the division manager, the CEO’s ex ante problem is ∗ ⋅ ,
Since the division manager cannot observe ,
is independent of
With the parametric
functions in (1), the solution is ∗
∗
∗
Centralization For a C-firm with a centralized control structure, the CEO has the right to decide on division 1’s output. With coordination cost
, the CEO’s ex post problem is
Its FOC implies an IC condition. Then, after taking into account the ex ante IR condition for the division manager, the CEO’s ex ante problem is
7/28
∗ ∙ ,
where
is a function of . With the parametric functions in (1), the solution is ∗
∗
∗
3.2. Structural Expansion The firm may do better by acquiring a division, called division 2. Before acquisition, division 2 was an independent firm and decides on its own output
which implies an optimal output
∗
∗
by the following problem:
. Then, the ex ante profit of division 2 is ∗
∗
∗
With the parametric functions in (1), the solution is ∗
∗
Decentralized Expansion Suppose now that the firm has acquired division 2. The expanded firm still maintains its control structure and is called a decentralized expanded firm or a DE-firm. With a decentralized control structure, the division managers have the right to decide on outputs. After accepting contracts
and
, the two division managers choose outputs in an ex post sub-
game. Given division 2’s output, division 1’s problem is
Its FOC implies an IC condition condition
. Symmetrically, division 2’s FOC implies a second IC
. The two IC conditions imply a Nash equilibrium
Then, after taking into account the ex post IR conditions
in the ex post subgame. for the two division
managers, the principal’s ex ante problem is
8/28
∗ ⋅ ,
∗
where
⋅ ,
,
is the expected profit. Here, since the division managers cannot observe ,
are independent of ∗
and
With the parametric functions in (1) and (2), the solution is ∗
∗
Then, the total expected profit of the DE-firm is ∗
∗
∗
Centralized Expansion Suppose now that the firm has acquired division 2. The expanded firm still maintains its control structure and is called a centralized expanded firm or a CE-firm. With a centralized control structure, the CEO has the right to decide on outputs. After the two division managers have accepted contracts
and
, the CEO decides on
and
by the following ex
post problem: ,
The two FOCs imply two IC conditions
, which determine outputs
Then, after taking into account the ex ante IR conditions
.
for the two division
managers, the CEO’s ex ante problem is ∗ ∙ ,
where
and
∙ ,
,
∗
are functions of , and
is the expected profit. With the parametric func-
tions in (1) and (2), the solution is ∗
∗
∗
Then, the total expected profit of the CE-firm is ∗
∗
∗
9/28
4. Analysis As market conditions improve, a firm considers an expansion. Besides adjusting contractual relationships with managers (implicitly in equilibrium), a firm may carry out a structural change. The purpose of this analysis is to offer insight into why a firm may sometimes choose a structural expansion instead of a structural reorganization and vice versa. We focus on a few influencing factors, including market uncertainty sensitivity
, market size , and synergy
, market competition measured by price
among divisions. For convenience, assume
Proposition. Each type of firm has two structural options: structural reorganization (decentralization or centralization), and structural expansion (acquisition). (a) A D-firm will choose to centralize if
(b) A D-firm will choose to acquire if
(c) A C-firm will choose to decentralize if
(d) A C-firm will choose to acquire if
Each firm has three structural options: staying put, structural reorganization, and structural expansion. The firm can only make one move at a time. For example, in case (a), a D-firm chooses to centralize. Two conditions are required for this move: centralization must be better than decentralization (i.e., pansion (i.e.,
∗
∗
∗
∗
, and centralization must be better than a structural ex-
. These two conditions are in (12). They are necessary and sufficient
for a D-firm to centralize. The firm may alternatively choose to acquire a division, for which conditions in (13) are necessary and sufficient. If both sets of conditions in (12) and (13) fail, the firm will stay put. Hence, (12) and (13) cover all three possible options for a D-firm. Similarly, (14) and (15) cover all three possible options for a C-firm. Note that these changes are structural. The firm may also make other changes, including contractual changes, which are endogenous to structural changes. For example, if the firm 10/28
chooses to stay put, it means that its structure will not change, but it may make contractual changes and its output may still expand. As the two conditions for a particular option in the Proposition become more likely to hold, that option is more likely to be the best option and the firm is more likely to choose that option. A “more likely” result is convenient for empirical analysis. For example, if a D-firm finds that centralization is better (more profitable) than its current control structure and is also better (more profitable) than a structural expansion, i.e., the two conditions in (12) are satisfied, then it will carry out a structural reorganization (centralization). Table 1 lists the conditions under which the firm may choose to carry out a structural reorganization or a structural expansion based on the Proposition. Table 1. Structural reorganization vs. Structural Expansion Structural reorganization
Structural expansion
Conditions (12) D-firm
Conditions (14) C-firm
When market conditions change, Table 1 implies the following results. Result 1. (a) When market uncertainty
drops, a D-firm is more likely to carry out a structural
expansion, while a C-firm is more likely to carry out a structural decentralization. (b) When market uncertainty
rises, a D-firm is more likely to carry out a structural cen-
tralization, while a C-firm will stay put.
When market uncertainty drops, it may be a good time for firms to expand. Result 1(a) indeed indicates that a D-firm is more likely to expand via acquisitions, but a C-firm is more likely to engage in a structural reorganization. For a D-firm, acquiring a division has two advantages: the divisions may create synergy, and competing divisions in a decentralized structure improves efficiency. Hence, when market uncertainty drops, a decentralized firm becomes more likely to expand via acquisitions. However, for a C-firm, when market uncer11/28
tainty drops, the advantage of a centralized structure in dealing with uncertainty diminishes. In addition, a decentralized control structure offers better managerial incentives. Hence, a Cfirm may choose to decentralize. Further, given the benefits of decentralization and those of a structural expansion, the C-firm would prefer decentralization. On the other hand, when market uncertainty rises, by Result 1(b), firms will not choose a structural expansion. A centralized control structure offers better coordination among divisions, which allows a firm to deal with uncertainty more effectively. Hence, a D-firm becomes more likely to centralize and a C-firm will stay put. Result 2. (a) When market competition subsides ( rises), if
, a D-firm is more likely to carry out
a structural centralization, otherwise it will stay put; while if
, a C-firm is also more
likely to carry out a structural expansion, otherwise it will stay put. (b) When market competition intensifies ( drops), both types of firms are more likely to carry out a structural reorganization if
for a D-firm and
for a C-firm, other-
wise they will stay put. When market competition subsides, it may be a good time for firms to expand. Our Result 2(a) indicates that, when market competition subsides, only a C-firm may carry out a structural expansion. We have ∗
∗
∗
∗
Conditions in (16) imply that, when
rises, a D-firm is less likely to benefit from a structural
expansion, while a C-firm is more likely to benefit from one. As expected, by comparing the output in (4) with that in (6) and the output in (9) with that in (11), we can see that a C-firm’s equilibrium output is lower than a D-firm’s equilibrium output, implying that a C-firm’s equilibrium price is on average higher than a D-firm’s equilibrium price. When market competition subsides or demand becomes less sensitive to price, a higher price would boost profits, inducing a D-firm to centralize its control structure in order to raise its equilibrium price. On the other hand, when market competition intensifies, intuition suggests that it is not a good time for firms to expand. Indeed, our Result 2(b) indicates that, when market competition intensifies, neither type of firm is likely to carry out a structural expansion; instead, they may reorganize internally to cope with the situation. When synergy does not exist among firms or is too small, both types of firms will rule out a structural expansion. Centralization has the advantages of coordination and better overall market information for the decision-maker. Hence, a D-firm is likely to centralize. On the other hand, centralization has the disadvantages
12/28
of lower incentives and a coordination cost. Hence, a C-firm is likely to decentralize if the coordination cost is large enough such that
.
Our finding of market competition implying a preference for decentralization is consistent with the dominant view in the literature; and our finding of market competition implying a preference for centralization is consistent with Alonso et al. (2015). We show that the choice between decentralization and centralization depends on firm structure. As expected, effects of market competition on firms differ substantially if firm structure is fixed. Schmidt (1997), Raith (2003), and Vives (2008) discuss effects of market competition on firms when firm structure is fixed. With a fixed firm structure, market competition will have a negative effect on managerial incentives as it lowers a firm’s profit. However, with an endogenous firm structure in our model, the firm can carry out a structural expansion so as to alleviate the incentive problem. In fact, a structural change can reverse the effect on incentives so that market competition would have a positive effect on managerial incentives. For example, if
is doubled (the market becomes twice as competitive), we find that ∗
If
∗
this condition is equivalent to
√
That is, if the market is not too uncer-
tain and the coordination cost is large enough, a C-firm is more profitable than before if it decentralizes when market competition intensifies. Similarly, if the market is sufficiently uncertain, a D-firm is more profitable than before if it centralizes when market competition intensifies. Result 3. (a) When the market expands ( rises), a D-firm is more likely to carry out a structural expansion or stay put, while a C-firm is more likely to carry out a structural decentralization. (b) When the market shrinks ( drops), a D-firm is more likely to carry out a structural centralization or stay put; but if
, it will stay put; while a C-firm is more likely to
carry out a structural expansion or stay put; but if
, it will stay put.
When the market expands, it is a good time for firms to also expand. As the market expands, the benefit of a decentralized structure in stimulating incentives increases, inducing a C-firm to carry out structural decentralization. That is, a C-firm is more likely to expand internally accompanied by structural decentralization. On the other hand, a decentralized structure implies high incentives. A structural expansion increases the benefit of a decentralized structure. Hence, as the market expands, a D-firm is more likely to stay put or carry out a structural
13/28
expansion. In particular, when there is synergy
and market risk is high enough
, a D-firm is more likely to expand structurally. When the market shrinks, it is cheaper to acquire a division and centralization offers better coordination to cope in difficult times. Hence, a C-firm may carry out a structural expansion. Result 4. (a) When synergy if
rises, a D-firm is more likely to carry out a structural expansion, while
, a C-firm is also more likely to carry out a structural expansion, otherwise it will
stay put. (b) When synergy while if
drops, a D-firm is more likely to carry out a structural centralization,
, a C-firm is more likely to carry out a structural decentralization, other-
wise it will stay put. When synergy
rises, it is obviously a good time for firms to expand. Indeed, as Result
4(a) indicates, when synergy rises, both types of firms are more likely to expand structurally. Symmetrically, when synergy
drops, the benefit from a structural expansion diminishes, and
a structural expansion is unlikely.
In sum, when market uncertainty drops, a D-firm is more likely to carry out a structural expansion, while a C-firm is more likely to carry out a structural reorganization. When market competition subsides, a D-firm is more likely to carry out a structural reorganization or stay put, while a C-firm is more likely to carry out a structural expansion or stay put. When the market expands, a D-firm is more likely to carry out a structural expansion or stay put, while a C-firm is more likely to carry out a structural reorganization. When synergy rises, both types of firms are more likely to carry out a structural expansion.
5. Case Studies Firms often expand internally under favorable market conditions. With expanded operations, a structural reorganization is sometimes necessary. In particular, centralization has often been a strategy to streamline operations, and decentralization has often been a strategy to improve managerial incentives. However, as large technology firms grow in scope and age, acquisition has become an increasingly important alternative. Spending on tech acquisitions was $170 billion in 2014, up 54% from the previous year and more than double the amount spent in 2010. For growing companies, acquisitions not only broaden their businesses but also sustain the pace of innovation. “Companies are buying innovation,” explains Peter Levine, a 14/28
general partner at venture capital firm Andreessen Horowitz. “As large companies need to be competitive and want to increase their footprints in a variety of different areas, one of the best ways to do that is through acquisition.” Buying innovation is represented in our model by synergy, as innovations that are purchased via acquisitions are typically related to the acquirer’s core products. We now offer a few case studies in relation to our theory.
Google Inc. Google’s expansion strategy has been to make acquisitions repeatedly. It expanded its offerings by buying products, including Android, YouTube, Maps, Docs and Analytics, most of which have become well known. As of 2015, it has acquired about 200 companies. Today’s Google is a sprawling empire of products, applications, services and computing platforms for PCs and mobile devices. As Geis (2015) points out, Google’s expansion strategy has become a model for companies hoping to increase their core competency through acquisitions. As Google has a fairly centralized control structure, its expansion strategy is consistent with Result 2(a).
Apple Inc. Apple’s expansion strategy is sharply different from Google’s. Apple has mainly relied on organic growth. Until 2012, Apple had rarely engaged in acquisitions. Apple believes that innovation should essentially originate from within. A suitable organizational structure can create opportunities for firm growth. Apple’s organizational structure is an important factor contributing to its successful innovation. Apple has carried out a few radical structural reorganizations in its history. In particular, in February 1997, following years of increasing losses, Apple carried out a dramatic reorganization—one that gave Steve Jobs a powerful decisionmaking role at the company. Apple’s new organizational structure supported the leadership of Steve Jobs. Abandoning divisionalization, Steve Jobs adopted the concept of “one Apple, one strategy, one brand and one message.” The idea was for software development to contribute software to all products, for finance to serve all product groups, and for the entire advertising budget to be spent on the main products only. This reorganization streamlined research and development efforts on products. This strategy is consistent with Result 2(b). However, Apple has recently switched to the acquisition strategy. It bought at least 30 companies, including Beats. This strategy is also consistent with Result 2(b).
Facebook (FB) The pre-bureaucratic structure is a centralized structure where all decisions are made by the CEO, while the divisional structure is a decentralized structure where decisions on products are made by division managers. FB carried out a major structural reorganization in De15/28
cember 2011, which transformed its structure from a pre-bureaucratic one into a divisional one. This is consistent with Result 3(b). FB recently used its fast-growing cash hoard to acquire many companies, including WhatsApp (which is adjacent to its core product), Oculus VR (for virtual reality technology), Instagram, Wit.ai, and Parse. These acquisitions are geared toward making FB a more interactive, diverse and indispensable social platform for end users and advertisers. This acquisition strategy is expected to have a lasting effect on its future valuation. This is consistent with Result 3(a).
Microsoft Corporation Facing intense competition and after many years of poor performance, in July 2013, Microsoft carried out the “one Microsoft” reorganization by centralizing technology decisions and collapsing eight divisions into four. Most corporations have a divisional structure. Deviating from the mainstream, Microsoft shifted from a divisional structure to a purely functional structure, by grouping organizational functions into separate divisions that span all products in the organization. This reorganization bundled functional responsibilities of all products and services into a single organizational division. In a functional organization, the CEO and his leadership team play a dominant role in all products. This is consistent with Result 2(b). Microsoft recently made a few big-ticket purchases, including Minecraft developer Mojang, Tumblr and video game streaming site Twitch. This is consistent with Result 3(b).
Hewlett-Packard Company (HP) During its expansion phase beginning from its founding in 1938 to the mid-1990s, HP transformed from a highly centralized organization into a highly decentralized organization. Up until 1996, HP had performed well and took many steps to decentralize its organizational structure. By the early 1970s, HP had grown from a highly centralized company into one with many diverse divisions. It embraced the concept of “local decentralization”, wherein a division was given the full responsibility for a product line. In the 1990s, HP carried out a reorganization by further decentralizing decision-making, cutting a layer of management from the hierarchy, and dividing its computer business into two primary groups. This reorganization enabled HP to gain market share in workstations and minicomputers. This is consistent with Result 3(a). During its expansion phase, HP also acquired many companies. From 1986 to 2012, HP made 129 acquisitions, including the F.L. Moseley Company for its plotter business, Apollo Computer for its workstation business, Compaq for its PC business, and Mercury Interactive for its software business. This is also consistent with Result 3(a).
16/28
Acer Inc. In 1991, as a fast growing company, Acer decentralized many decision-making rights, which is consistent with Result 3(a). However, in 1998 and again in December 2000, with a shrinking PC market, Acer centralized its product management, manufacturing, customer services and brand management functions, which is consistent with Result 3(b). After 2008, with a fast growing market in mainland China, Acer made a few acquisitions, including Packard Bell, E-Ten, and iGware, which is consistent with Result 3(a).
Alfa Corporation Alfa is a Mexican business group, which was on the edge of collapse in 1982 amid an economic crisis in Mexico. The company centralized decision-making, strengthened the core business, and regrouped management control of those subsidiaries that had synergy. This is consistent with Result 2(a). Following the recovery of the Mexican economy in 1987, Alfa carried out a decentralization program, which is consistent with Result 3(a).
The US Federal Reserve System (Fed) The Fed has implemented several major reorganization programs in its history. In 1919, due to the expanding demand for US banking services during World War I, the Fed decentralized some of its control rights to the departmental level, which is consistent with Result 3(a). In 1935, the Fed centralized many of its control rights (Wheelock, 1999) amid the shrinking demand for banking services during the 10 years of economic recession after the 1929 stock market crash, which is consistent with Result 3(b).
6. Concluding Remarks When the business environment changes, contractual relationships among managers will change. In addition, the firm may carry out a structural change. This work focuses on a structural change, which is conditional on a corresponding contractual change. A centralized control structure offers better coordination among divisions and better information for decision-making, but it incurs a coordination cost and leads to lower incentives for division managers. A decentralized control structure offers better incentives and is less costly in decision-making, but there is lack of coordination and overall market information for division managers. Acquisitions may offer value in terms of synergy and a lower cost of expansion. Consequently, the general tendencies are: increasing market uncertainty encourages firms to centralize (for the benefit of coordination); increasing market competition encourages firms to decentralize (for better incentives and competitive pricing); an expanding market
17/28
encourages firms to decentralize or acquire other businesses (for better incentives); and greater synergy among divisions also encourages firms to acquire other businesses. Globalization is a recent trend and is driven predominantly by multinationals. However, little is known about their boundaries (see a survey by Antràs & Rossi-Hansberg (2009)). Why do multinationals often choose a structural expansion over an internal expansion? What factors limit a multinational’s size and determine its control structure? Our study offers an understanding of how multinationals develop and evolve. This work is related to the literature on the boundary of the firm. By investigating the firm’s choice between a structural expansion and a structural reorganization, we determine the boundary of the firm depending on the optimal firm structure. We analyze the firm’s options based on market uncertainty, market competition, market size, and synergy among divisions.
Appendix A.1. Structural Reorganization Decentralization For problem (3), if the IR condition is not binding in equilibrium, given the optimal contract
the CEO can always offer
Contract
for some
to satisfy the IR condition.
also satisfies the IC condition. This contract raises the firm’s profit, which
contradicts the fact that contract
maximizes profit. Hence, the IR condition must be
binding in equilibrium. By the binding IR condition, problem (3) becomes ∗ ⋅ ,
Since
does not appear in the objective function of problem (17), the problem can be
solved in two steps. First, we solve the following problem for optimal output ring to
∗
without refer-
: ∗
Second, given
∗
, we find an
that satisfies: ∗
∗
∗
∗
With functions in (1), problem (18) becomes ∗
18/28
Since
does not depend on
in this case, the problem becomes ∗
which implies ∗
Given
∗
, we try to find an
that satisfies (19). Consider a linear contract of the form:
. Then, (19) becomes
implying
and
That is, there is indeed an optimal linear contract satisfying (19),
which is ∗
Then, ∗
Centralization For problem (5), if the IR condition is not binding in equilibrium, given the optimal contract
the CEO can always offer
Contract
for some
to satisfy the IR condition.
also satisfies the IC condition. This contract raises the firm’s profit, which
contradicts the fact that contract
maximizes profit. Hence, the IR condition must be
binding in equilibrium. By the binding IR condition, problem (5) becomes ∗ ∙ ,
Since
does not appear in the objective function of problem (20), the problem can be
solved in two steps. First, we solve the following problem for optimal output ring to
∗
without refer-
: ∗
Second, given
∗
, we find an
that satisfies: ∗
∗
∗
∗
∗
∗
∗
With functions in (1), problem (21) becomes
19/28
∗
The Hamiltonian function can be defined as
The Euler equation implies ∗
Given
∗
, we try to find an
that satisfies (22). Consider a linear contract of the form:
. Then, (22) becomes
implying
and
That is, there is indeed an optimal linear contract, which is ∗
Then, ∗
∗
∗
A.2. Structural Expansion With functions in (1), problem (7) becomes
which implies ∗
We then have ∗
Decentralized Expansion For problem (8), if the IR conditions are not binding in equilibrium, given optimal contracts
and
the CEO can always offer
satisfy the IR conditions. Contracts
and
and
for some
to
also satisfy the IC conditions.
These contracts raise the firm’s profit, which contradicts the fact that contracts
and
maximize profit. Hence, the IR conditions must be binding in equilibrium. By the binding IR conditions, problem (8) becomes
20/28
∗ ⋅ ,
Since
⋅ ,
,
and
do not appear in the objective function, this problem can be solved in ∗
two steps. First, we solve the following problem for optimal outputs to contracts
and
∗
without referring
:
∗ ,
Second, given
∗
∗
, we find optimal contracts
and
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
that satisfy:
Since the division managers cannot observe , when proposes
∗
∗
they may not accept it if the CEO
which is dependent on . Hence, the CEO has to propose fixed
∗
∗
which is independent of . and
With functions in (2) and fixed
, problem (24) becomes
∗ ,
The FOCs are
which imply ∗
Then, by (25), we need to find
∗
such that
∗
∗
∗
Consider a linear contract of the form
∗ ∗
. Then, (26) implies
∗
implying
∗
∗
∗
∗
∗ ∗
. Hence, ∗
Then, ∗
∗
21/28
and ∗
∗
∗
∗
∗
Centralized Expansion For problem (10), if the IR conditions are not binding in equilibrium, given optimal contracts
and
the CEO can always offer
and
and
satisfy the IR conditions. Contracts
for some
to
also satisfy the IC conditions.
These contracts raise the firm’s profit, which contradicts the fact that contracts
and
maximize profit. Hence, the IR conditions must be binding in equilibrium. By the binding IR conditions, problem (10) becomes ∗ ∙ ,
Since
∙ ,
,
and
do not appear in the objective function of problem (27), the problem
can be solved in two steps. First, we solve the following problem for optimal outputs without referring to contracts
and
∗
∗
:
∗ ,
Second, given
∗
∗
, we find optimal contracts
and an
that satisfy:
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
∗
With functions in (2), problem (28) becomes ∗ ,
By the Hamilton method, the Euler equations are
implying ∗
∗
22/28
Then, ∗
Consider a contract of the quadratic form: ∗
∗
∗
(29) implies ∗
∗
∗
∗
implying ∗
Let
implying
. Then, conditions in (30) imply
and
That is, we find two con-
that satisfy the conditions in (29), where
tracts
∗
Then, ∗
∗
∗
∗
∗
∗
A.4. Proof of the Proposition From the above, we have ∗
∗
∗
∗
(1) A D-Firm Chooses to Centralize A D-firm will switch to a centralized structure if and only if
∗
∗
and
∗
∗
, i.e.,
implying
implying
23/28
Hence, with
, the two conditions are
(2) A D-Firm Chooses to Acquire A D-firm will acquire a division if and only if
∗
∗
and
∗
∗
, i.e.,
implying
implying
implying
(3) A C-Firm Chooses to Decentralize A C-firm will switch to a decentralized structure if and only if
∗
∗
and
∗
∗
, i.e.,
implying
implying
implying
implying
Hence, the two conditions are
24/28
(4) A C-Firm Chooses to Acquire A C-firm will acquire a division if and only if
∗
∗
and
∗
∗
, i.e.,
implying
implying
implying
implying
implying
A.5. Proof of the Results Proof of Result 1 If drops, conditions in (13) are more likely to hold, implying that a D-firm is more likely to carry out a structural expansion.3 If drops, no matter whether or not , conditions in (14) are more likely to hold, implying that a C-firm is more likely to carry out a structural reorganization. If
rises, conditions in (12) are more likely to hold, implying that a D-firm is more likely
rises, conditions in (14) are less likely to hold, to carry out a structural reorganization. If and if , conditions in (15) cannot hold; if , since , conditions in (15) are less likely to hold. Hence, if
rises, conditions in (14) and (15) are less likely to hold, imply-
ing that a C-firm will stay put.
3
If conditions in (13) are more likely to hold, then conditions in (14) are less likely to hold. But even if condi-
tions in (13) are less likely to hold, conditions in (14) may not necessarily be more likely to hold. The situation is similar for the other pair of conditions: (14) and (15).
25/28
Proof of Result 2 If
rises, when
conditions in (12) are more likely to hold, implying that a D-firm is
more likely to carry out a structural reorganization; when
conditions in (12) are less
likely to hold and conditions in (13) would not hold, implying that a D-firm will stay put. For a C-firm, if
rises, when
, conditions in (15) are more likely to hold, implying that a C-firm
is more likely to carry out a structural expansion; but if
, conditions in (14) are not af-
fected while conditions in (15) cannot possibly hold, implying that a C-firm will stay put. If
drops, when
, conditions in (12) and (13) are less likely to hold, implying that a
D-firm will stay put; but when
, conditions in (12) are more likely to hold, implying that a
D-firm will become more likely to carry out a structural reorganization. If
drops, when
,
conditions in (14) become more likely to hold, implying that a C-firm is more likely to carry out a structural reorganization; but when
, conditions in (14) are not affected and condi-
tions in (15) would never hold, implying that a C-firm will stay put.
Proof of Result 3 We have
and
By (31), if
rises, conditions in (12) are less likely to hold, implying that a D-firm is less likely
to carry out a structural reorganization. By (32), when
and
if
rises,
conditions in (13) are more likely to hold, implying that a D-firm is more likely to carry out a structural expansion; but when to hold, or when
and
conditions in (13) are less likely
, conditions in (13) cannot possibly hold, implying that a D-firm will
stay put. On the other hand, when
rises, conditions in (14) become more likely to hold, im-
plying that a C-firm is more likely to carry out a structural reorganization. If
drops, when
, conditions in (13) are less likely to hold; and if
, conditions in
(13) would not hold, implying that a D-firm is less likely to carry out a structural expansion. If drops, conditions in (14) become less likely to hold, implying that a C-firm is less likely to carry out a structural reorganization. But if
, it is impossible for conditions in (15) to hold.
26/28
Proof of Result 4 If
rises, conditions in (13) are more likely to hold, implying that a D-firm is more likely
to carry out a structural expansion. If
rises, when
, conditions in (14) are not affected
and conditions in (15) can never hold, implying that a C-firm will stay put; but when conditions in (15) are more likely to hold, implying that a C-firm is more likely to carry out a structural expansion. If
drops, conditions in (12) become more likely to hold, implying that a D-firm is more
likely to carry out a structural reorganization. If
drops, when
, conditions in (14) are
not affected while conditions in (15) can never hold, implying that a C-firm will stay put; but when
, conditions in (14) are more likely to hold, implying that a C-firm is more likely to
carry out a structural reorganization.
References Alonso, R.; Dessein, W.; Matouschek, N. 2015. Organizing to Adapt and Compete. American Economic Journal: Microeconomics, 7(2), 158-187. Antràs, P.; Rossi-Hansberg, E. 2009. Organizations and Trade. Annual Review of Economics, 1, 43-64. Geis, G.T. 2015. Semi-Organic Growth: Tactics and Strategies Behind Google’s Success. Wiley. Harford, T. 2012. Adapt: Why Success Always Starts with Failure. Picador, New York. Hitt, M.A.; Harrison, J.S.; Ireland, R.D.; Best, A. 1998. Attributes of successful and unsuccessful acquisitions of U.S. firms. British Journal of Management, 9, 91-114. Killick, M.; Rawoot, I.; Stockport, G.J. 2003. Cisco Systems Inc.–growth through acquisitions. In M.A. Hitt, R.D. Ireland, R.E. Hoskisson (eds.), Strategic Management: Competitiveness and Globalization, 5th ed. Cincinnati: South-Western Publishing. Levine, C.B.; Smith, M.J. 2004. Information externalities, underinvestment, and organizational remedies. Journal of Accounting, Auditing & Finance, 19(4), 435-455. Ma, Q.; Wang, S. 2016. Internal vs. External Restructuring—Boundary of the Firm with an Endogenous Firm Structure. Working Paper, HKUST. Merrifield, D.B. 1991. Value-added: the dominant factor in industrial competitiveness. International Journal of Technology Management, Special Publication on the Role of Technology in Corporate Policy, 226-235.
27/28
Raith, M. 2003. Competition, Risk, and Managerial Incentives. American Economic Review, 93(4), 1425-1436. Renucci, A. 2008. Access to financing, rents, and organization of the firm. Journal of Corporate Finance, 14(4), 337-346. Schmidt, K. 1997. Managerial Incentives and Product Market Competition. Review of Economic Studies, 64(2), 191-213. Vives, X. 2008. Innovation and Competitive Pressure. Journal of Industrial Economics, 56(3), 419-469. Wang, S.; Xiao, J. 2009. The Hierarchy of Public Governance: Resource Allocation vs Bureaucratic Inefficiency. Working Paper, HKUST. Wheelock, D.C. 1999. National Monetary Policy by Regional Design: The Evolving Role of the Federal Reserve Banks in Federal Reserve System Policy. Working Paper, Federal Reserve Bank of St. Louis. Williamson, O. 1996. The Mechanisms of Governance. Oxford University Press. New York. Williamson, O. 2002. The Theory of the Firm as Governance Structure: From Choice to Contract. Journal of Economic Perspectives, 16(3), 171-196.
28/28
