Companies Fail

Megan McArdle’s recent Atlantic piece on how GM’s ossified culture affects turnarounds sparked some thoughts on the way strategists and managers talk about culture in the modern corporation.

Culture as a Black Box:

“Unfortunately, corporate culture is a sort of black box; from the outside, you can’t see what’s going on. You have to wait to see what emerges.” –Megan McArdle

This is an interesting turn of phrase since black box development and manufacturing¹ was one of the superior processes that Toyota and Honda used to gain critical advantage over American auto companies. The mechanisms by which culture calcifies into business practices that create advantage or disadvantage are inherently less interesting than understanding those advantages per se. The story of Japanese auto at a process level is a fascinating example of this. So much of what they did was counterintuitive to bright and well-educated American executives at the time, and the time it took to comprehend those advantages gave Japan, Inc. insurmountable advantages in research, development, and manufacturing. An enormous amount of literature at the time obsessed over cultural explanations, and not nearly enough effort was put into understanding the advantages themselves and how to recreate them.

Is culture set in stone?

“Why is corporate turnaround so difficult and rare? The answer is often culture—the hardest thing of all to change.” –Megan McArdle

Is culture the hardest thing to change? Given McArdle’s focus on the role of the UAW in GM’s downfall, I can’t believe she didn’t talk about NUMMI, a joint-venture manufacturing plant in Fremont CA run by Toyota and operated by UAW workers. It turns out that Toyota had no problems carrying their productivity advantage into an American labor environment — which they should not have been able to do if culture is so hard to change. If you want to prove that culture overrides other factors at a big auto company, you have to talk about NUMMI at some point.

Corporate fatalism and faith in the turnaround.

What if McArdle’s piece was titled “Companies Fail” instead of “Why Companies Fail?” As my colleague Mike Arauz astutely noted, this is a semantic distinction that you may find extremely boring so feel free to skip. But here goes: failure can be relatively simple to explain, and it happens to everyone eventually, so why is liquidation looked at as failure? In reality, it is just an outcome, and it’s actually a positive outcome for at least one stakeholder group, since liquidation should occur when Market Value of Assets (A) + Liabilities (L) > Market Value of Equity (E), whereas accounting book value is always A + L = E, an equation which, by the way, is probably one of the most important innovations and sources of Western economic advantage in history. Apologies for the digression: the question is why are turnarounds such a fixation? It’s easier to sell advice if you promise a turnaround, of course, but let’s not pretend that it’s reality. Most companies fail. The question then becomes: does the manner and circumstances of their failure result in the destruction of value?

The difficulty of this question is readily apparent. For example, McArdle provides the following anecdote of a case where liquidation seems optimal:

“Years ago, I listened to an earnings call with the head of a biotech firm that had sold off the income streams from all its patents, had nothing in its pipeline, and was rapidly burning through its cash. Nonetheless, the CEO kept talking about ‘our future’ as if the company had one, other than liquidation. The equity analysts on the call didn’t seem fazed; apparently, that’s how companies in these situations usually behave. Management and workers seem oblivious to their failures. They wait too long before they act, and even when they do take action, it’s often inadequate.”

Her conclusion glosses over the realities of liquidation as an outcome of business failure, however. First, a profitable firm such as the one described above should avoid liquidation and prefer a sale to avoid double taxation at the corporate and shareholder level. To the extent that the CEO’s efforts improve chances of a sale, this could be optimal behavior. The analyst’s behavior is similarly explicable: accurately assessing the market value of the underlying assets, even if fairly liquid, is inherently risky and time-consuming, and liquidations frequently take years, outlasting the stamina of most investors and analysts.

Some Endnotes

1. Instead of designing their own components, as American auto did, Japanese companies would outsource the challenge of designing satisfactory parts to their suppliers, requiring only that the parts meet the functional specifications required by the overall vehicle design, such as a brake that fit within a specified enclosure while stopping a vehicle of a certain weight in a certain distance a certain number of times. Suppliers were thus incentivized to overbuild parts in order to make them suitable for diverse applications, and the cost advantages versus American manufacturing became dramatic.

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2. On a side note, are returns to vertical integration increasing? One of the more interesting trends in big companies is the increase in strategic returns to vertical consolidation we are witnessing in consumer electronics. Toyota and Honda won in the 1980s in part because of the industrial combines they participated in (the keiretsu approach), and Dell and others adopted similarly horizontal approaches. Black box manufacturing is a key part of this process – outsourcing R&D to suppliers reduces development costs significantly. But recently, as we’ve seen with Apple (and Boeing to some degree), vertical integration of R&D back into product design has become a significant part of their supply chain advantage. Apple doesn’t outsource any facet of the design — even battery chemistry — to other companies. This is exactly how Detroit’s Big 3 used to do everything before getting crushed by Toyota and Honda. The question is: why? Is a car any less complicated to manufacture than a phone? Is design and user experience any less important? If you want to bet either way, go long or short on Quirky, the ne plus ultra of outsourced design.