Column 6 - Strategy and Organizational Structure of Japanese Firms: Summary and Analysis of Survey Findings

In the spring of 2007, RIETI's research team on corporate governance, led by Faculty Fellow Hideaki Miyajima (concurrently professor at the Waseda University Graduate School of Commerce), and of which I am a member, conducted the "Survey on Japanese Firms' Business Portfolio and Group Management." The survey targeted firms listed on the first section of the Tokyo Stock Exchange (excluding financial institutions), inquiring about their business portfolios, group management, and corporate governance, and resultantly identified recent trends of Japanese firms in their business strategies, group-based management, and choices of organizational structure. In this paper, I will provide an outline of the survey results and examine the significance of the findings.

In the course of restructuring their business portfolios, firms have taken further steps in implementing "select-and-focus" strategies and branching out into areas related to their core businesses (relevant diversification). From the mid-1980s through the mid-1990s, Japanese firms aggressively diversified their business into areas unrelated to their core business, but stagnation in corporate performance in the post-bubble period prompted them to reconsider this non-relevant diversification. Thus, from around the mid-1990s, "selection and focusing" became a new catchphrase for Japanese firms. Recently, as the economy continues to recover steadily, firms appear more aggressive in moving into relevant areas where they can expect synergies with existing business, while continuing to work to narrow down the list of business areas. That is, firms are consolidating their resources in the core areas of their business portfolios, instead of simply downsizing overall business operations.

Actually, such a shift in corporate strategy is undesirable from the viewpoint of the usual risk diversification hypothesis. Concentration in core business areas certainly generates synergy and enables firms to achieve higher efficiency in business operations. At the same time, however, it makes firms more vulnerable to changes in the business environment in their industries, and the obsolescence of core technologies resulting from technological innovation represents a higher bankruptcy risk. Nevertheless, Japanese firms have dared to push forward with select-and-focus strategies since the mid-1990s. The motivation for this can be found in a range of inefficiencies attributable to non-relevant diversification, such as declining expertise among top managers, a rise in interdivisional coordination costs, and asymmetry of information between the top manager and division chiefs. Many recent empirical findings have confirmed business diversification's detrimental effect on firm value. Thus, Japanese firms' typical business strategies observed in recent years can be seen as attaching increasing significance to the synergistic effect of business consolidation relative to significance attached to the risk-diversifying effect of business diversification in measuring the tradeoff associated with business diversification. By also considering their aggressive approaches toward relevant diversification, Japanese firms may appear to have settled on a middle road where they pursue diversification to the extent that it does not lessen the strength of their core business.

As they proceed with business portfolio restructuring, Japanese firms have been strengthening their group approach in business management. Changes in the ratio of consolidated to nonconsolidated net income imply a steady tendency toward this approach, while changes in the consolidated and nonconsolidated net sales indicate that such realignment of organizational structure has typically been made so as to maintain the streamlined operation of a parent company and increase the weight of its subsidiary operations.

When firms become more group-oriented, they come to face two critical issues: determination of boundaries between a parent company and its subsidiaries and governance of the subsidiaries. That is, they are confronted with such questions as which businesses to retain as their own or operate under relevant subsidiaries, and what influence they should exert on these subsidiaries. When companies' operating divisions and subsidiaries are compared in terms of the degree of authority to which the respective units are entitled, clear differences are seen in human resource management. This finding is consistent with a traditional idea underlying the Japanese-style employment system that flexibility in personnel management encompassing group companies is important for long-term employee retention.

One remarkable tendency exists in the way companies realign their group-wide organizational structures. With the pursuit of company split-ups coming to a halt, parent companies have increasingly tried to absorb their subsidiaries or turn them into wholly-owned subsidiaries. Spinning-off operating divisions into stand-alone subsidiaries builds their incentive to improve performance by giving them discretion in management decision-making. At the same time, however, excessive decentralization gives rise to problems such as subsidiaries' deviation from group strategy, lack of consistency, and overlapping businesses. Asymmetry of information between a parent company's headquarters and its subsidiaries may be worsened. As a result, costs for control of subsidiaries and relevant coordination will increase. In the latter half of the 1990s, many firms realigned their organizational structure by means of split-up or spinoff as they sought to streamline headquarters operations through business consolidation. Now they are moving in the opposite direction. A strengthened group-based approach to business management, with subsidiaries being merged into their parent companies or turned into wholly-owned subsidiaries, can be seen as a process of adjusting in response to excessive decentralization. In pursuing group-based management, Japanese firms are seeking a balance between the increased incentives of decentralization and the strengthened control of centralization with respect to the tradeoff in transfer of authority.

Two recent, commonly observed trends are the decreased tendency of adopting in-house company systems and the steadily increasing number of pure holding companies being established. In addition to traditional organizational structures, such as functional departmentalization and the divisional system (profit center approach), these two additional structures are gaining recognition and diversifying the range of organizational structures. As a general trend, firms adopting some sort of decentralized structure (divisional, in-house company, or pure holding company system) have been increasing in number. However, progress in changes in "substance" is more important than such changes in "form" or organizational structure. Factually speaking, the steady increase in the number of firms introducing systems for allocating capital across divisions or in-house companies (intra-company capital allocation) and liquidating unsuccessful divisions or in-house companies (intra-company liquidation) is significant.

Usually, the transfer of authority increases the incentive for performance improvement. This is because individual business units are more motivated when they are given discretion in decision-making. Yet the issue of control therein becomes critically important. Transferring authority to individual business units without holding them accountable for the outcome absolves them of responsibility, which increases the possibility of moral hazard. The results of our survey show that the degree of authority transferred to business divisions is higher for firms adopting intra-company capital allocation systems. As such, a complementary relationship exists between transferring authority and monitoring.

Thus, despite the lack of dramatic changes in organizational structures, many firms have implemented monitoring measures that are, in theory, highly consistent with the earlier adoption of decentralized organizational structures, seemingly a characteristic of recent organizational strategies. It is fair to say that Japanese firms have taken steps to refine their internal organizational structures. However, as excessive monitoring may undermine motivation, a balance needs to be struck between incentive improvement through the transfer of authority and discipline through monitoring.

Since the 1990s, flexibility and agility have become important strategic elements for Japanese firms faced with drastic changes in the business environment. While proceeding with selection and focusing in their business portfolios, they have been applying the same strategy in restructuring their payrolls. This means selecting regular employees, a key stakeholder in the Japanese corporate system, and subsequently increasing the proportion of non-regular employees. The increased share of non-regular employees in the total workforce has greater enabled firms to exit existing businesses screened out under select-and-focus strategies, that is, firms gain more ability to implement strategic decisions involving downward employment adjustment. Such changes in company payrolls, which increase flexibility in personnel costs that would otherwise be very much fixed, has reportedly helped firms address the problem of risks posed by business portfolios centered around a core business.

Traditionally, Japanese firms have diversified business via "internal expansion," branching into new fields of business by leveraging existing management resources (particularly, human resources and technology). This approach, however, cannot be reconciled with the increased share of non-regular employees. More recently, firms have frequently taken an "external expansion" approach, diversifying business by means of merger and acquisition (M&A). This is consistent with recent changes in company payrolls and this approach has seemingly increased strategic flexibility and agility in seeking to expand business. Recent trends in inter-firm relationships - such as scaling down headquarters operations to a minimum and utilizing group subsidiaries - and moves to establish pure holding companies can be seen as measures to increase strategic flexibility and agility.

Since 2002, the Japanese economy appears to have entered a long-term recovery phase. Yet, underneath the bright surface, Japanese firms are still struggling to find a delicate balance in restructuring their business portfolios, implementing group management, and redesigning organizational structures. In our future studies, we would like to examine how Japanese firms' business strategies, approaches in group realignment, and choices of organizational structures relate to internal governance reform as well as to changes in external governance, thereby increasing the overall understanding of their strategies and governance.