In the recent study “Organizing for Synergies: Allocating Control to Manage the Coordination-Incentives Tradeoff,” University of Chicago Graduate School of Business professors Wouter Dessein, Luis Garicano, and Robert Gertner examine the “organizational cost” of achieving synergies in corporate mergers. The term synergy refers to the higher potential profit companies can realize from a merger.
Merging companies may attempt to realize synergies by sharing
resources in areas such as research and development, manufacturing,
or sales. If it were possible to keep all operations the same
except for the area where there is overlap, such mergers would
always be profitable.
Organizational costs, however, limit the ability of two units
or firms to capture synergies through the coordination of several
previously independent units. To put it in the perspective of
an analyst evaluating a merger, there exists an “organizational
discount factor” that must be applied when estimating the
efficiency gains of a merger. For example, say the potential profit
from a merger is $10 billion. If the organizational cost of the
synergy is low, the merged company may realize the full $10 billion.
If the organizational cost is high, the company may only earn
half that amount.
This organizational discount factor can be studied systematically.
Dessein, Garicano, and Gertner developed a theory that predicts
conditions under which the synergies that two merging firms
hope to realize likely will be difficult to capture.
High synergies are valuable in two ways. “The higher the synergy, the more valuable the merger,” says Garicano. “Also, the higher the synergies, the lower the ‘organizational discount’ that must be applied to the merger—all else constant—because as synergies get sufficiently high, contingent decision making and balanced incentives become less important.”
Determining Optimal Organizational Structure
Dessein, Garicano, and Gertner developed a theory of organizational
structure where decision-making authority is allocated to either
functional or product managers. Giving control to functional
managers (generalists) indicates that the company has chosen
to centralize to achieve synergies. Giving authority to product
managers (specialists) suggests a decentralized structure.
What is the best organizational structure after a merger? The authors found that this depends on the value of synergies, the importance of incentives, and information about, and the value of “local adaptation”—catering to the existing clients/audiences.
Functional managers (generalists) are better informed about the value of synergies, the value of sharing resources across business units, and standardizing operations. In contrast, product managers (specialists) know more about the value of adapting the product to the circumstances of the local market and doing things in “their own way.” Determining whether or not synergies between business units should be implemented requires honest and open communication between managers.
The authors argue that decision-making rights must be allocated
in a way that encourages communication and efficient synergy-implementation
decisions. Moreover, managers must be motivated to work
hard, and this requires that compensation be linked to performance.
However, when the incentives of managers are too strong,
the
interests of the functional manager and product managers
are directly in
conflict, and no credible communication takes place.
“
A local manager whose pay is tightly linked to his performance
will always argue that his needs are special, and will refuse
to agree to standardize his product for the entire company’s
sake,” notes Dessein. “This creates a fundamental
tradeoff between coordination and incentives.”
The authors refer to the general cost of putting two units
together as the “incentive cost of synergy.” In
order to ensure efficient coordination and communication
between business units,
the organization must mute incentives of managers.
Dessein, Garicano and Gertner analyze two possible structures
for mergers:
1) Functional authority (centralization): The functional
manager has control rights over implementation decisions.
2) Product authority (decentralization): Product managers
retain control over their local units.
The tradeoff between incentives and coordination takes
two forms. As incentives become stronger, implementation
by
whichever manager
has authority becomes
more biased. Product managers tend to block all synergies, whereas
functional managers are too eager to implement synergies.
Thus, stronger individual
incentives lead to managers working harder but also
lead to inefficient synergy implementation
decisions. In addition, as incentives become stronger, credible communication
between managers becomes more difficult. The organization must deal
with these tradeoffs, using the tools of allocating
authority and incentive pay.
With functional (centralized) authority, attaining synergies involves organizational costs in the form of lost local adaptation and weaker incentives. Centralized authority may be preferred when synergies are high and when performance incentives are less important. Product authority (decentralization) is not as effective when it comes to achieving coordination, but it allows local managers to have stronger incentives.
When is it optimal to organize for synergies? The authors find that strong incentives hinder the ability of an organization to implement tradeoffs between synergies and adaptation. Ensuring communication requires dulling incentives to make sure managers are sufficiently aligned, and this imposes costs. Organizations thus can choose between strong incentives with little information flow between units or weak incentives with better communication. The analysis suggests that if providing incentives is important, firms may therefore prefer to forego synergies and forego the merger gains, even in the presence of potential synergies.
Real World Examples
The problem of organizing to achieve synergies is not unique to
mergers. All companies with related lines of business must decide
which activities to centralize, how to allocate control rights
over complementary decisions, share relevant information, and
create incentives for effective coordination and efficient operations.
The authors focus on two notable examples that illustrate tradeoffs
between incentives, coordination, and implementation of synergies,
and the role that organizational structure and the allocation
of control may play in dealing with these tradeoffs: 1) the
attempts to reorganize the FBI after the first World Trade Center
bombing
in 1993 and 2) the reorganization of Suchard, the Swiss chocolate
company, after the push toward a single European market in 1992.
The FBI faced a set of organizational issues in the period between
the first World Trade Center attack on February 26, 1993, and
the second attack on September 11, 2001, as highlighted in the
9/11 Commission Report.
Traditionally, the FBI operates as a decentralized organization based around field offices that set their own priorities. After the first World Trade Center attack, the FBI determined that this decentralized structure was not well-suited to the counterterrorism task, which requires gathering a wide array of information from human intelligence, satellite intelligence, and communication intercepts.
To deal with these problems, the FBI created the Counterterrorism
and Counterintelligence Divisions. However, the FBI did
not change the career incentives or authority of local offices.
The new head
of the division was left to try to impose new strategies
on
powerful local offices. Thus, the same organizational features
that made
the FBI a powerful and effective machine for securing prosecutions
and fighting crime made it weak as a counterterrorism agency.
Consistent with the authors’ theory, placing a functional
manager on top of a decentralized organization without altering
the incentives of field office managers is unlikely to allow for
synergies. Field managers have little incentive to provide the
right information or implement the directives of the functional
manager. The authors conclude that improving the FBI’s
effectiveness at counterterrorism may imply weakening its
effectiveness at fighting
crime, since it may result in weaker incentives (in order
to encourage sharing knowledge and information), more diffuse
career paths,
and more centralization of decisions to be able to capture
the intelligence synergies.
In the late 1980s, Jacobs Suchard, a Swiss coffee and confectionary
company, had a leading EEC market share in confectionary
products. Suchard had a decentralized organizational structure
with
general managers for large independent business units
organized around
products and countries. Each business unit had its own
sales, marketing, and manufacturing divisions. The autonomy and
incentives of the general managers created an entrepreneurial
environment
that was able to attract and retain talented executives
as general managers.
Tarriff reductions, open borders, and the standardization
of regulation in advance of the 1992 European integration
created
an opportunity
for Suchard to achieve cost savings by combining manufacturing
plants across companies and developing common marketing
strategies. The company planned to shift from nineteen
plants to six primary
plants that would serve all of Europe. Under the new organizational
structure, country managers retained control of sales
and marketing, but not manufacturing decisions. The company
appointed “global
brand sponsors” for each of its five major confectionary
brands. These general managers were given the responsibility
to promote their brands globally, develop new products,
and standardize
brands and packaging across the world.
Suchard’s disappointing experience with its new organizational structure demonstrates the tradeoffs that arise in attempts to reorganize to realize synergies. The outcome was reduced coordination within business units and increased time and effort to communicate, defend, and debate strategic choices. This in turn diminished the firm’s entrepreneurial culture, blunting incentives for general managers. The costs faced by Suchard took the form identified by the theory—poor coordination and incentives within business units, increased conflict, and communication and influence costs.
Beyond Culture Clashes
One practical implication of the study is that it discusses the
relations between potential synergies and those that actually
can be achieved. The authors argue that one should not rely
on the headline value of the potential synergies, but must first
consider the costs from reduced local adaptation and the costs
from reduced incentives.
“ People take too many shortcuts when discussing the culture conflicts that can happen in mergers. Culture is often a black box where every possible difference between existing companies is thrown in. Some of the conflicts result from the incentives provided to managers and the allocation of authority after the merger, and these conflicts can be understood and managed,” says Garicano. “Organizational culture is interesting and has to be understood, but there are many ‘noncultural’ organizational costs to be analyzed that can provide us with insights into the organizational costs of synergies.”