Have We Extended the Boundaries of the Firm Too Far?

by James Heskett

Summing Up

"What we are looking at is a fundamental challenge to our assumptions about which corporate structures work," commented Daniel Hayes in response to the recent piece on the future bounds of the organization. Raman Julka was just as dramatic: "The generic value chain described by Michael Porter is being fragmented by organizations; value addition ... is taking place in numerous forms ..." Their comments reflected the general assumptions among respondents that organization boundaries will continue to expand, with better or worse (ranging up to "ruinous") results for those engaged in it.

Those organizations thought to be most able to extend their boundaries are those able to work in a "componentized" manner, with "certain pieces of technology or innovation that can be outsourced" (Sarang Kulkarni), those able to employ the open standards of the Internet and willing to transfer databases to a "rival supplier" in the event of an unsatisfactory relationship (Joshua Doherty), and those maintaining a highly focused in-house R&D capability while outsourcing small portions of strategic needs associated with this capability in order to preserve proprietary information (Kulkarni).

Doherty was concerned that organizations might extend their boundaries without a clear strategy. He offered a "2x2" rule-of-thumb strategy for doing this based on the levels of strategic risk and in-house ability associated with the action. Where both are high, he suggests "insourcing." Where both are low, outsourcing is the answer. Where ability is high and strategic risk low, an effort to establish a separate business opportunity (by "spin off" or other means) might be in order.

Of course, the toughest decisions often are associated with situations in which strategic risk is high but in-house capability is low. Here Doherty suggests a strategic alliance with the purpose of upgrading in-house capability as at least one alternative. Those who have spent a great deal of time examining strategic alliances and their somewhat checkered record might offer a word of caution here. They would ask: Do the justifiably selfish purposes that bring an organization to a strategic alliance contain the seeds of the alliance's demise?

The technological, social, and legal environment appears to favor further extension of organization boundaries. In the future, will this phenomenon be limited primarily by the environment, or by the ability of managers to take advantage of it? What do you think?

Original Article

A byword of the new economy has been "partnering." Small start-ups have pursued, in the words of my colleague Tom Eisenmann, the "get big fast" strategy by focusing on core activities while doing the rest by partnering with others, including competitors.

A large, successful firm such as Cisco Systems has used partnering, often involving minority investments in many partners, to enable its employees to work only on high value-added activities that yield more than $600,000 in revenues for each of its more than 25,000 employees. (The phenomenon is described in a case, "Cisco Systems: Are You Ready?", that I coauthored recently.)

Even GE places high value on what it calls "boundaryless" behaviors among its executives, encouraging them to exchange ideas with each other and, when beneficial to the company, with managers outside GE as well. In short, it is becoming more and more difficult to define the boundaries of an organization.

It is the latest manifestation of a lecture given 68 years ago by Ronald Coase, now professor emeritus at the University of Chicago Law School. Prof. Coase set forth a theory designed to help set limits on organizational boundaries. He proposed that so-called "transaction costs" (which he regarded as quite high at the time, thus providing a justification for the vertical integration of large organizations) set limits on behaviors that we refer to today as partnering, the forming of alliances, and outsourcing.

Transaction costs resulted from the difficulties of communicating between organizations, obtaining full disclosure, and in general exercising oversight in such relationships. Coase's ideas were thought to be so valuable that they earned him the Nobel Prize in Economics in 1991.

One of the most important phenomena of the Internet-based economy is the drastic reduction in transaction costs for those wishing to engage in partnering. Thus, Cisco relies on contract manufacturers for most of the final assembly of its products and nearly all of its basic production, employing the Internet in managing relationships designed to respond to customer needs.

It obtains a large proportion of innovative ideas from its partners, some of whom it eventually acquires. And it is engaged in building a network of more than 4,000 academies in which its partners train tens of thousands of the technicians needed each year to keep the Internet functioning. Often its partners are potential competitors.

Are there limits to boundaryless behavior? If carried too far, can it result in loss of control over the quality of goods and services delivered by the supply chain? Can reliance on others for innovation lead to the neglect of in-house R&D capability? Can it result in the "leakage" of strategic information to partners who are also competitors? When partners fail, can it in fact create a "house of cards" effect, as firms with interlinked investments have to write them down on their books? Given the potential for these behaviors, are transaction costs, regardless of the Internet, as low as they seem?

    • Luis Fernando Pérez
    • Lider de Proyectos SAP, Coca-Cola FEMSA

    It's necessary to have a limit, but maybe it's time to leverage outsourcing in non-core activities that do not add value.

    • Sarang Kulkarni
    • Software Engineer, Structural Dynamics Research Corporation

    First, the generalization of this "boundaryless" behavior across all types of business may not be possible. For companies that can work in a "componentized" manner — in which there are certain pieces of technology or innovation that can be outsourced — this would seem to be a good option.

    Innovating a new technology is good. But what matters for a company is how it is going to make money out of the new technology. So if it can leverage on an outsourced technology and build upon it a piece (to create a value which is more than the sum of the individual pieces), it has gained. A big organization should have well-defined sets of focus that may be flexible. Anything that does fall in the line of that focus could potentially be partnered and the company can keep moving in the direction it wants to go.

    So the company still has an in-house R&D facility, but restricts research on its target direction. This does not necessarily "leak" strategic information to partners — at least not in the sense that they can leverage on it. The partners usually are smaller companies and work in niche areas, and will have great difficulty entering the already established business of the bigger company. Even if they do start something along similar lines, they might be a good target for acquisition.

    The companies we are talking about are huge and build huge products. The technology they outsource from one partner may only form a small part of the whole product. This reduces the impact in case the partner fails. Of course, it would still affect the company, but recovery might not be as difficult. It could partner with someone else or develop it in-house.

    This particular approach underlines synergy across businesses, which is what matters for the complete economy.

    • Joshua Doherty
    • Senior Consultant, Luminant Worldwide

    Transaction costs have been lowered by technology along three main fronts:

    1. Reduction of coordination costs by reduction of the cost of exchanging and processing information;

    2. Reduction of the risks associated with the asymmetry of information by an increase in the availability and transparency of information;

    3. Reduction of costs associated with asset specificity.

    It is the last point that has allowed many firms to disintegrate value chain activities. For example, the open standards of the Internet allow firms to employ technology solutions that are not too relationship-specific between the vendor and the buyer. In that manner, databases can be easily transferred to a rival supplier if the current supplier attempts to raise prices beyond the average market price (assuming a competitive market and little-to-no differentiation).

    While outsourcing does have many immediate benefits, it can be ruinous if not approached in a strategic manner. In order to evaluate activities within each segment and layer of the value chain, firms should consider the strategic risks associated with the activity and the ability of the firm to perform the activity.

    Strategic risk falls along three dimensions: The risk that trading partners will attempt to leverage perceived supplier power to appropriate profits from the buyer; the risk that as the product or service moves away from the original source, the quality will diminish; and the risk that proprietary knowledge will accrue to trading partners.

    Each risk must be considered on an activity-by-activity basis. Those that score high will reveal themselves as being associated with core or strategic endeavors of the firm.

    The ability of the firm can be thought of as the internal ability to meet or beat the economies of scale or scope available externally from specialist firms.

    The combination of the these two levels of evaluation will reveal a framework that will provide strategic guidance to managers. The generic decision rules are:

    High strategic risk(s) + Low ability = strategic alliance to ingrain ability

    High strategic risk + High ability = Insource

    Low strategic risk + Low ability = Buy from best supplier

    Low strategic risk + High ability = leverage scale/scope, spin off or become a supplier to others

    Using a framework such as this will allow managers to approach outsourcing decisions on a more strategic basis.

    • Daniel Hays (HBS MBA 1999)
    • Manager, Pittiglio Rabin Todd & McGrath

    The boundaryless organization requires a complementary, structured set of operating structures and methodologies to make it work. The walls of the old days are being knocked down by things like Service Level Agreements and integrated information systems, which make it possible to share information as if two or more organizations were one. What we are looking at is a fundamental challenge to our assumptions about which corporate structures work.

    • Devdip Ganguli
    • Student, Sri Aurobindo International Centre of Education (Pondicherry, India)

    The globalization we talk of today started the day the first traders sold their wares to unknown cultures. Money is in essence a form of energy, and corporations have access to large quantities of this "money energy." Their responsibility is to channel its free flow. When they fail in this, they fail as corporations.

    As companies use each other as resources to channel money energy more efficiently (more commonly known as "increasing profits"), they are actually on their way to interdependence. Perhaps we will see a day when each organization is dependent on the other, regardless that each may be the other's strongest competitor. This in turn will lead to a strong support system that aids an ailing partner by teaming it with a competitor! Circumstances now seem to show the road toward greater collective harmony.

    • Raman Julka
    • MBA (first year student), Indian Institute of Management, Lucknow, India

    The value chain of organizations is undergoing drastic change. The generic value chain described by Michael Porter is being fragmented by organizations; value addition per se is taking place in numerous forms, such as alliances and boundary extensions.

    The collection of external expertise is becoming imperative due to fast-changing notions of value. Core competencies no longer lie in being competitively superior in an activity, but in being able to deliver a plethora of values. As a result, organizations are looking for others to fill the gaps — by outsourcing, alliances, takeovers, partnerships, etc.

    The benefits of such boundary expansions far outweigh the transaction costs of managing the relationship. And wherever this is not so, an organization is bound to contract.

    • Mathew Varghese

    Partnership is the best thing in this modern age. Because companies are becoming globalized, competition is much greater than in previous generations. So getting things done through partnerships helps companies concentrate on their core business. Also, if a business turns out to be a success, surely that helps the partner company.

    • A. Murat Seferoglu
    • Strategist, Sabanci Cement SBU

    Regardless of how we feel about the far reaching boundaries of the firm, evolution will take its toll to determine the optimum set of strategies a company should adopt. In the mean time we must device and empower institutions to minimize externalities and industrial crime.