I am teaching a doctoral class on Al Chandler’s Strategy and structure this week, so I thought I should dig out and clean up my notes on Scale and scope. And publish them here while I am at it. Caveat emptor, of course.
Summary/notes on Alfred D. Chandler Jr. (1990):
The Modern Industrial Enterprise
The modern industrial enterprise grew in three steps:
- investments in production facilities large enough to exploit a technology’s potential for economies of scale and scope
- investments in national and international marketing and distribution network
- the recruitment and organizing of managers to supervise the functional units, and, more important, to coordinate them.
Managerial capitalism (topic of Chandler’s The Visible Hand) refers to “a new type of capitalism–one in which the decisions about current operations, employment, output, and the allocation of resources for future operations were maid by salaried managers who were not owners of the enterprise”.
Scale, Scope and Organizational Capabilities
(General theory of why and how industrial enterprises began and evolved).
The industrial enterprise is a subspecies of the business enterprise. In addition to having a number of distinct operating units and being led by salaried managers (the two basic characteristics of business enterprises), it carries out modern production processes. The industrial enterprises grew by adding new units – different in terms of geography, economic functions or products. These units were added because they provided
- economies of scale: “when the increased size of single operating unit producing or distributing a single product reduces the unit cost of production or distribution”
- economies of scope: “resulting from the use of processes within a single operating unit to produce or distribute more than one product”, also termed “economies of joint production or distribution”
In production, increased output in the old, labor-intensive industries came mainly by an increase in size (adding more machines and people). In the new, capital-intensive industries increase in output came as a dramatic reduction in capital/labor ratios, due to new machines and processes. Thus, economies of scale were much more important in capital-intensive industries, whereas in the labor-intensive one the large firm did not have significant advantages over the small ones. Economies of scope came from producing many different end products with the same raw material and intermediate processes
“The potential economies of scale and scope, as measured by rated capacity, are the physical characteristics of the production facilities. The actual economies of scale or scope, as determined by throughput, are organizational. Such economies depend on knowledge, skill, experience and teamwork–on the organizational human capabilities essential to exploit the potential of technological processes.” (p. 24)
The reason for the sudden appearance of the large hierarchical organization needed to exploit the economies of scale and scope around the end of the nineteenth century stems from modern transportation and communication (telegraph, railroad, steamship, cable) that were reliable and fast enough to maintain throughput. “Thus, the revolution in communication and transportation created opportunities that led to a revolution in both production and distribution”. (p.26)
In distribution, the firms initially grew “by integrating forward into distribution and backward into purchasing” (p.28). One reason for this was the increasing “product-specificity”; as products became more complex, it was not cost-efficient to have a wholesaler handle the difficult transaction processes. Another reason was competition; in the fierce battle for market share in an oligopolistic marketplace an intermediary who made his profit from handling products of more than one manufacturer became redundant. In addition, the sales force provided information about the market. In purchasing, the reason for integration came from a need for coordination, and the cost reduction from buying in volume.
The hierarchical organization was set up along functional line; production and marketing came first, then purchasing, R & D and finance. Later came smaller departments like traffic (transportation), engineering, legal, real estate, and even later personnel and public relations. The head of the major functional departments, the president and sometimes a full-time chairman of the board was the senior decision-making unit.
First-movers into a market or a technology got competitive advantages; in general, challenging the first mover meant taking customers away from him, difficult since the first-mover already had achieved economies of scale and scope compared to the challenger. Since it was difficult to challenge a first mover, only few could do it; the well-established companies who had the financial muscle necessary. Thus the capital-intensive markets quickly became oligopolistic, occasionally monopolistic. The firms competed for market share and profits often using price as a competitive weapon, but mostly by functional and strategic efficiency.
Once the industrial enterprise was established, it grew in four ways:
- by horizontal combination (acquisition and merger of competitors)
- by vertical combination (acquisition of units upstream and downstream)
offensively: (generally preferred)
- by geographical expansion
- by product diversification (the making of new products related to the firm’s existing technologies or markets)
The two latter strategies resulted in a modification in administrative structure; the multidivisional structure appeared. The corporate office let go of day-to-day operational responsibilities, instead focusing on performance monitoring of the divisions, planning and implementation of long-term corporate strategy, and specialist advice through corporate staff to the top and middle management of the divisions. The staff usually was composed of the old financial department, a corporate personnel office and a central research laboratory. The divisions had responsibilities for a single product line, or sometimes a geographical area.
Labor-intensive industries (such as textile, lumber, printing) did not provide competitive advantages for large integrated companies. In some of these industries the mass retailers came to dominate, with large, efficient purchasing departments that eliminated the intermediaries.
The United States: Competitive Managerial Capitalism
Key characteristics: Oligopolistic competition between large, integrated companies, primarily in consumer goods.
- the Sherman anti-trust act (1890) which ended an era of horizontal cartel organizations, which evolved into single companies capable of enforcing rationalization on the individual units. Change of focus from controlling price and output to maximizing throughput.
- 1911: Standard Oil, American Tobacco and du Pont dissolved by court ruling
- all the mergers and acquisitions decreased owner family influence–instead investment banks became important
- engineering (MIT 1880s) and business schools (Wharton first in 1881) to supply the production and business managers (this also in Germany, not in Britain)
- as the complexities of running a large company increased, the inside directors (full-time managers of single units) gained control of the instruments of power (the organization), whereas the outside directors, who
sat on boards, representing the owners and financiers of the companies, still held the legal power over the companies.
- in the “stable” industries, such as oil, rubber and steel, expansion came mainly by vertical integration through mergers and acquisitions. The primary example is Standard Oil, which initially achieved a monopoly in distribution, but after its dissolution became several fully integrated companies competing in a oligopolistic market
- in food and chemicals the expansion came mainly through diversification into new products (Du Pont started out in explosives but moved into paint, nylon, rayon, other fibers, plastics and photo chemicals) and markets (exemplified by the large producers of perishable foods, such as Anheuser Bush, who invested heavily in distribution, using new inventions such as the refrigerated rail car.
- in machinery the picture is more mixed, but product diversification and geographical expansion was the most common strategies.
- in transportation, the main examples are Ford and GM. Ford achieved first mover advantage by dominating the low end of the auto market. Henry Ford’s autocratic management style and failure to understand marketing led to a disastrous fall in market share (from 57 % in 1921 to 31 % in 1929), which was captured by GM under Alfred Sloan, and Chrysler. GM used R & D heavily, also commercializing the Diesel engine in locomotives, thus replacing steam engines with diesel in railways in less than a decade.
- in electrical and electronic equipment General Electric and Westinghouse became dominant first movers, General Electric being a merger of amongst other companies Edison. these companies became system builders, hiring a technically trained sales force to market their products. The two leaders cross-licensed patents, giving them a stronghold on the market.
The complexity of the machinery industries made the managers most influential; bankers and owners did rarely have much say in the strategy of the companies, except in financial difficulties.
Lessons from the American experience:
- patents not powerful deterrents to entry; the main first-mover advantage in complex products was the investment in product know-how; the challengers would normally take to long to follow up
- mergers not successful when not followed up by rationalization
- advertising not a powerful deterrent either
The overriding importance of the “three-pronged investment” (production, distribution and organizational capabilities) stressed again. The complexity of the decision-making med the American companies to pioneer the multidivisional organizational structure.
Great Britain: Personal Capitalism
Key characteristics: Family-owned companies, where the owners prefer to take out profit as dividends and keep their day-to-day influence, leading to Britain coming in late in the second industrial revolution.
The term “personal capitalism” refers to the fact that British companies to a much larger extent than their American and German counterparts were “personally managed”, both in terms of having smaller managerial hierarchies and being managed in a “personal” style; the British senior managers directly supervised middle and lower level managers, and therefore did not need the elaborate organizational structures and artifacts of the American and German corporations. The entrepreneurs and their heirs played retained their power; the salaried manager never got to have the final say about corporate strategy. The owners were more interested in stable income than reinvestment in competitive advantage, taking out profit as dividends rather than making the “three-pronged investments”. Stabilization in the market was achieved by cooperation between competitors.
The British population was smaller and more urban than the American. The mass distributors in Britain concentrated on the urban working class, carrying a smaller line of goods, integrating backward, and being managed non-hierarchically. Cooperatives were much more prevalent than in the US. Investments were made in distribution, but in production the investments were smaller and followed an evolutionary pattern. British industrialists concentrated on branded and packaged consumer goods, particularly food. A notable exception to the personally managed firms was the large Irish brewery Guinness.
In the capital-intensive industries large firms appeared in rubber (Dunlop), glass (Pilkington), explosives (Nobel), chemicals (Courtaulds). Growth was financed from retained earnings, keeping the families in control. In machinery and electrical equipment, chemicals and steel, American and German firms won the competition, largely because the British industrialists failed to invest enough. Once foreign firms had made the scale and scope investments, the opportunity window was difficult to reopen.
Mergers and acquisitions in Britain were motivated by market control, and the merged companies remained discrete units, with committees doing the coordination. Little rationalization was done. The family domination continued, with managers being trained at work instead of at educational institutions. There never was established a tight link between universities and the industrial community, as in Germany and USA.
Chandler divides British industries into the “stable” (oil, rubber, industrial materials, textile) and the “dynamic” (machinery, industrial chemicals and branded, packaged products).
In oil, the first world war gave the British oil companies. Anglo-Persian, (Anglo-Iranian in 1935, BP in 1954), became a vertically integrated company in the years from 1912 to 1920, creating a large, functionally departmentalized organization structure. In the world’s first oil glut in 1928, Anglo-Persian, Royal Dutch-Shell and Jersey Standard met at a hunting castle in Achnacarray in Scotland to set up an agreement which stabilized market share and prices “as is”. Texaco, Gulf, Standard Oil of California and Socony-Vacuum (later Mobil) joined the Big Three in 1932; this oligopoly of the “Seven Sisters” remained in power up to the 1970’s.
In rubber, Dunlop became the dominant firm by expanding its production and marketing facilities. The founding family, which had created its domestic dominance, lost control in 1922, after which it expanded internationally, competing successfully in all markets except USA and Canada, were the American first-movers were too strong.
In industrial materials (rayon, stone, glass, clay, paper, metal fabrication and making) some strong organizations emerged (such as Pilkington Brothers in glass, and Stewart & Lloyds in steel). The firms remained family-owned and operated, with formal or informal agreements to restrict competition. Attempts at rationalization through mergers in iron and steel had limited success. Textiles was a much more important industry in Britain than in the US, but automation was slow to come compared to USA. The British textile industry was the world’s largest buyer of dyes, mainly buying from Germany.
Of the dynamic industries, machinery was dominated by American subsidiaries, although British auto makers such as Morris and Austin regained most of the market, much like GM and Chrysler had taken it from Ford in the USA. In electrical consumer products, EMI was the exception, becoming a worldwide market leader along with RCA. In chemicals, following extensive rationalization, Nobel and Brunner Mond merged into ICI in 1926. ICI became Britain’s dominating industrial company, organized like du Pont with patents-and-process agreement which called for full exchange of technical infor
mation between the two firms. Similar agreements were made with IG Farbenindustrie, SO New Jersey and Royal Dutch-Shell for coal-based fuel technologies, with German and Norwegian (Norsk Hydro) in nitrates, and with the International Dye Cartel in dyes. ICI established ties with researchers, inventing polyethylene in 1935. ICI soon rivaled du Pont in inventiveness, making it an even partner in the technological agreement. In 1962, ICI changed into a multidivisional structure, with the help of McKinsey.
In branded, packaged products (“the bastion of the family firm”) the only other major British firm to adopt a multidivisional structure, Lever Brother (Unilever from 1929) did almost everything different from their competitors. It started out as a family owned soap company, investing in production, marketing and management until it was the largest soap producer in Britain. It integrated backwards, buying suppliers of raw materials around the world. From 1910 to 1920, it acquired all its major rivals, largely through exchange of stock. In 1926, despite still being a family-led operation, it had an organizational structure close to multidivisional. In 1929 it merged with the Dutch company Margerine Unie, the dominant producer of margarine in Britain. It was the largest international merger before World War II and made Unilever the largest industrial enterprise in Britain. After rationalization it retained the most of the British market, competing chiefly with Procter & Gamble and Colgate-Palmolive-Peet.
Lessons from the British experience:
- the failure to use scale as a competitive weapon, and the failure to set up a managerial organization, was the main reasons Britain slipped from second to third place in production.
- British firms paid no attention to organizational structure; they developed in an evolutionary manner rather than as a result of careful planning
- a large and stable income rather than risky investments was the rule for the family-operated companies (with some exceptions) may be the most important reason that Britain lost out in the second industrial revolution
“In sum, the collective histories of British enterprises demonstrate the essential need to create and maintain competitive capabilities in order to assure continuing profitability and productivity in an industry”.
Germany: Cooperative Managerial Capitalism
Key characteristics: Large, integrated companies, primarily in production goods, managing the oligopolistic markets mainly by cooperation through negotiation.
Despite the competitive setbacks suffered by the German industries during the first World War and the crisis years of 1918-1920, the capability of the German industrial enterprises made them successful competitors abroad. The main difference between Germany and Britain is the dominance of salaried managers, the main difference between Germany and the US is the concentration of integrated enterprises in producer’s goods, the prevailing of some families, and, most important the strong cooperative climate between companies. German companies paid more attention to their work force than their American counterparts, creating a system termed “organized capitalism” by German historians.
Germany had a more rural population pattern than Britain, especially in the Eastern parts. The coming of the railroad was more important than in Britain, where distances were shorter and the availability of alternative transport (canal, sea and road) was more available. The railway was nationalized in the 1870’s at Bismarck’s initiative. The building of railways and other industrial enterprises led to the growth of new, large financial institutions. The new banks played an important part in creating the German industrial enterprises, because of their relative size (compared to American banks) and their participation in top-level decision-making. Contrary to Britain and the US, there were no legal constraints to trade in Germany. Even so, the cartels set up were often not successful, since the trade associations had no means of enforcement.
German institutions of higher learning were pioneers in institutionalizing the systematic acquisition and transfer of knowledge, providing the best technical and scientific training in the world. In 1910 Germany had 16.500 students of engineering, compared to Britain’s 1100. The advent of business schools (Handelshochschulen) came in 1900, about the same time as in the US. The ties between research institutions and the industrial community was especially strong in chemistry, electrical equipment, metals, non-electrical machinery and optics.
In Germany, Chandler divides up the industries in the German contemporary terms the lesser (rubber, rayon, synthetic alkalies, explosives and light machinery) and the great (iron and steel, copper, heavy machinery, dyes, fibers, fertilizer and other industrial materials). Since the German economy was transformed into a “command economy” twice (during the two world wars) he discusses the pre-WWI and the period between the wars separately.
In branded, packaged material there was less entrepreneurial response in Germany than in the US, the direct link between producer and consumer never becoming as prevalent. In other industries there were some success, such as the two oil companies Deutche Petroleum and Deutche Erdöl. These companies, who had their sources in Rumania and the Baku area near the Caspian Sea, would probably have been major members in the world oil oligopoly had not the first world war and the subsequent Russian revolution disrupted them. In rubber, Continental became a major player, along with Michelin of France. Pfaff challenged Singer in sewing machines. Bosch made electrical parts for cars, AEG became a giant in electrical machinery. In general, the first mover dominated the industry.
The great industries in Germany clustered around heavy machinery, chemicals and metals. In machinery, economies of scope were exploited. In locomotives, Hanomag expanded into trucks, BEMAG into typesetting machines. Other makers of transportation equipment included MAN, Opel and Deutz. In electrical machinery, Siemens and AEG (Allgemeine Elektricitäts-Gesellschaft) dominated, concentrating production in massive factories and employing world-wide sales organizations. These two companies, together with GE and Westinghouse, shared the world market. Siemens diversified into telegraph and communications, competing with AT&T. Together they started Telefunken, the continental pioneer in radio.
In chemicals the German industries became dominant through three large companies: BASF, Bayer and Hoechst. These companies exploited the economies of scope heavily, expanding from dyes into pharmaceuticals (Bayer: Aspirin, Hoechst: Novocain). AGFA (somewhat smaller) diversified into photographic film. In pharmaceuticals, Schering, Merck, von Heyden and Riedel built global enterprises before WWI, giving Germany a world lead in chemicals. The companies formed IG’s (Interessengemeinschaften) to coordinate the markets.
In steel, Germany was the leader in Europe, with large works primarily located in the Ruhr area. These works (Thyssen, Krupp and Stumm amongst others) integrated forward into machinery.
The first World War took away the markets for German industrial enterprises. Their facilities in the allied countries was seized by governments, later acquired by their competitors. Competitors from foreign countries moved in. After the 1918 armistice came a political revolution, a weak government, inflation and hyper-inflation, mainly due to the harsh terms of the surrender. France occupied the Ruhr area in 1923. The Dawes plan of 1924 stabilized German economy. From then on the recovery was impressive; generally, the German companies regained their market shares in less than five years. Exceptions were oil, where the British Anglo-Persian Oil company took over, and in to a certain extent the lesser industries. The German automobile industry started, with companies like Daimler-Benz, Adam Opel, BMW, Adlerwerke, Audi, Horch, DKW and Wanderer. Ford, Chrysler and GM established German subsidiaries, but were locked out by tariffs until Sloan of GM bought 80% of Opel in 1929. Opel then quickly became Europe’s largest producer of cars. Ford overinvested in a large plant and was priced out of the market.
In the great industries, recovery was rapid. Siemens and AEG, having lost all their foreign facilities, still recovered to their old glory by 1929. In steel, were Germany lost 70% of its inland ore sources to France, rationalization was needed and came with the merger of most of the industry into the giant Vereinigte Stahlwerke in 1926. In chemicals, the formation of I.G.Farbenindustrie A.G., a giant alliance between Bayer, Hoechst, BASF and 5 other companies in 1925 was followed by rationalization, making the IG the “most powerful industrial enterprise both home and abroad”.
- the dominance of owning families, who preferred income over growth (that is, took dividends rather than reinvesting their profit) in British companies was the main reason for the British industries to lose market share, and subsequently profitability, to the American and German companies.
- organizational capabilities the key. These organizational capabilities were mainly developed in firms that had to compete in production or market development, whereas the more traditional companies, in where the production process remained simple and the markets stable, this did not happen
- first movers often let their advantage disappear, sometimes because the managers moved to competitors (Ford is a poignant example).
- challengers to first movers often large, well established companies moving into new markets
- the role of managers was to develop existing businesses; invention left to outsiders; subsequently, investment in R&D was low
- diversification key to growth
After the wars:
Chandler gives a short history of the evolution after the second world war. The most important trends were:
- the eroding of the British market shares, given away to Germany and USA
- the coming of Japan, who mastered technology transfer
- the diversification in the late 60’s and the divestitures in the 70’s (leading to a lack of communication between corporate and functional offices).
- the change in ownership: form long-term oriented individuals and institutions to portfolio managers
- the coming of managerial capitalism in all countries, even Britain
- the intensified competition from the 60’s on
- the coming of information technology