David J. St.

Clair

Microeconomics for Managers

Chapter 12
Countering Diseconomies of Scale
While firms seek out economies of scale, they would like to avoid
diseconomies of scale. Diseconomies of scale are inefficiencies that plague
larger firms (i.e., bigger scale). They are always volume (scale) dependent.
When diseconomies of scale are encountered, the firm must figure out how to
counter them. The key to countering diseconomies of scale is to understand their
sources.
Fortunately, diseconomies of scale stem from only two sources and each
affects a different level of activity in the firm. One diseconomy of scale affects the
firm at the plant level while the second affects the firm at the management level
(often referred to as the firm level). A plant is a producing entity, that is, a
production site. On the other hand, a firm is a financial entity. The distinction
between the two can be easily appreciated by noting that a firm can always run
multiple plants if chooses.

The Diseconomy of Scale at the Plant Level

The most important diseconomy at the plant level arises from congestion
and transportation bottlenecks. When large plants get too large, they experience
lost productivity and higher costs due to the delays and inefficiencies brought on
by congestion and bottle necks (the term bottlenecks refers to volume squeezed
by a narrow opening exactly what you see when you try to pour out of a bottle
but not a jar).
One example should suffice Fords attempt to build a super plant at his
River Rouge plant. Henry Ford was obsessed with volume and integrated
production. To this end, Ford built a gigantic plant at River Rouge where he
wanted to make all of his component parts from basic raw materials, and to
assemble all of his automobiles. Since bigger scale had always worked for him in
the past, Ford was going for the ultimate scale at the River Rouge plant. Fords
annual production volume at the time was about 3 to 4 million cars per year.
Ford began building the River Rouge plant in Dearborn in 1917. It was
completed in 1928, just as Ford was converting from the Model T to the Model A.
The plant measured about 1.5 miles wide by 1 mile long. It had 93 separate

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buildings and 16 million square feet of factory floor space. It had its own docks
that Ford had constructed on the River Rouge after dredging the river. There
were 100 miles of railroad track within the plant facility. It had its own electricity
generating plant, its own steel factory, and its own raw materials processing
plants. More than 100,000 workers were employed at River Rouge during the
1930s.
Question: What do you think a shift change looked like at the River Rouge
plant? The answer is obvious. The River Rouge plant was a congestion
nightmare. All of those workers had to get in and out and they had to compete
with the massive inflow of raw materials and out-flow of finished cars. Ford found
that instead of reducing costs, the congestions and delays hurt productivity and
costs.
Fortunately there is a relatively simple solution for diseconomies of scale
at the plant level - multiple plants. Today, automobile assembly plants usually
target an optimal scale of about 250,000 cars per year at individual auto plants.
Of course, this can vary, especially if more shifts are added, but the industry
quickly moved away from the mega-plant after Fords River Rouge disaster.
Initially, the smaller multiple plants were spread around the Detroit area.
Later, auto companies began locating them around the country to reduce
transportation costs. However, it is worth remembering that multiple plants came
first as a means of countering diseconomies of scale; reducing transportation
costs through strategic plant locations came later.

Diseconomies of Scale at the Firm Level

Historically, the most important diseconomy of scale at the firm level has
been a failure to effectively manage large-scale enterprise. This problem is often
associated with shirking, that is, workers and managers in large firms who do not
(or cannot) do their jobs. Shirking is a broad term that encompasses agency
problems, oversight issues, organizational issues, and motivation problems.
While shirking can occur in both large and small firms, the problem tends to be
worse in larger organizations. Larger firms have more shirking and find it harder
to deal with shirkers who get lost or hide in large organizations. This makes
shirking scale-dependent and a diseconomy of scale.
Two examples should suffice to illustrate the problem.

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Example: US Steel - Putting it together is easier than making it work

US Steel was created through a merger of steel companies. The core of
US Steel was Carnegie Steel Andrew Carnegie had finally had enough of the
business wars and sold out (he retired to go fishing in Scotland). The J.P.
Morgan bank underwrote the stock offer that put US Steel together (what would
be called an IPO or Initial Public Offering today). At its inception in 1901, US
Steel became the largest firm in the world and the first firm with a market
capitalization over one billion dollars (and those were 1901 dollars). Morgan
advertised to potential investors that US Steel would monopolize the steel
industry. (Note the year. In 1901, the E.C. Knight case had still effectively gutted
antitrust laws for manufacturing industries and Morgan was simply advertising
something that was currently legal. The E.C. Knight case is discussed in the last
chapter.)
When it was created, US Steel had 64% of the U.S. steel market. This
was indeed a very large market share in a very large market at the time, the
U.S. steel market was larger than the rest of the worlds steel markets combined.
Two questions about US Steels market share immediately arise. First,
was 64% of the market sufficient to create a monopoly? No, it was not. US Steel
did use its size to try to eliminate competition through a variety of price fixing
schemes, but the large market share alone never did manage to eliminate
competition.
Second, and more importantly, how could anyone effectively manage such
a giant firm in 1901? Note the infrastructure and the technology that US Steels
management were limited to in 1901 - there were no business telephones, no cell
phones, no computers, no printers, no airplanes, no road system, no photo
copying machines, and no fax machines. US Steel plants were located all across
the eastern part of the country, but there was virtually no way to stay in close
contact with these plants or of integrating production operations.
In 1901, US Steel was a dinosaur big body, small brain. (This remained
a common characterization in large businesses until the film Jurassic Park
showed us that dinosaurs are actually smarter than tasty people.) US Steel
enjoyed its maximum market share on the day that it was created. Since then, it
has gone downhill - sometimes rapidly; sometimes slowly. But it never delivered
on the promise and the inability to manage such a large organization was the
cause. In the last century, business analysts and managers worked hard to
overcome the management problems of large scale enterprise. However, it never
happened at US Steel - treat the case of US Steel as a good example of the
problem, but not the solution.

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Example: General Motors and Decentralized Management

General Motors was created by Willy Durant, an entrepreneur who created
the worlds second largest automobile firm through aggressive horizontal and
vertical acquisitions. Though trailing Ford, GM was a very large firm. And like
Ford, Durant was a micro-manager who centralized decision making by trying to
make all of the decisions himself.
In 1920-21, the U.S. experienced a very bad recession. In fact, this
recession featured the fastest decline in economic activity that the country has
ever seen, before or since. It was worse than the Great Depression in this regard
and it was only the very short duration of the contraction that kept it from rivaling
the Great Depression.
As the economy crumbled, Durant encountered a gigantic problem he
discovered that he could not reduce GM operations fast enough. While GM
dealers were reporting mountains of unsold inventory, GM buyers were out
acquiring raw materials and GM plants were busy making more cars. GM was
faced with a massive cash flow crisis as the over-worked Durant tried frantically
to bring GM under control.
Durant finally managed to reduce output but the damage was already
done. To deal with the cash flow crunch, Durant turned to the DuPont family and
sold 25 percent of the company to raise the cash to save the company. That was
the good news. The bad news for Durant was that he was out he lost control of
the company to DuPont.
DuPont brought in Pierre DuPont and Alfred Sloan from the DuPont
Company. Pierre could not stand Detroit and soon left Sloan in charge. Sloan
brought in a new management structure similar to one that had been pioneered
at DuPont.
GM was reorganized into six divisions Cadillac, Buick, Oldsmobile,
Pontiac, Chevrolet, and Fischer Body. Each division was created as a semiautonomous profit center with a vice-president in charge of operations. The
division leaders were told that they were expected to manage their own divisions
as profit centers (that is, as if their division was a separate company). They were
then judged, evaluated, and compensated (e.g., bonuses) on the profitability of
their division. At the same time, GMs corporate management would formulate
strategy at GM while leaving it up to the divisions to implement strategy and to
deal with day-to-day operations.
The re-organization worked very well. Sloan concentrated on creating a
product line compatible with the new inelastic demand for automobiles and he
created a reporting system that kept GM fully abreast of the market. Proof of the
success of the managerial changes at GM came in the Great Depression. As
auto sales were hit hard by the depression, GM was able to cut back on
production ahead of the drop in demand. In 1933, the worst year of the
depression, GM announced record dividends. The dividends underscored the

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success of the new decentralized corporate structure. (The dividends also

reflected diminished investment opportunities in the midst of the depression.)
For the next four decades, GM enjoyed a reputation for superior
management. In addition, GM never tired of telling anyone who would listen
about the advantages of its decentralized management structure.
Like US Steel, GM had a managerial problem. Both companies had grown
to the point where managers could not exercise effective control. But unlike US
Steel, GM found a solution to the problem. The solution was an organizational
change. The type of organization that GM embraced - a decentralized corporate
structure with profit centers - remains one of the main anti-shirking tools at the
disposal of large firms.

A Solution to the Large-firm Management Problem that does not Work

Solutions to diseconomies at the firm level have been more difficult to
come by than solutions to diseconomies at the plant level. We will look at
techniques that have addressed this problem below. However, we first need to
confront a non-solution that does not work downsizing.
While a firm acquires a serious diseconomy of scale from becoming too
large, simple downsizing generally does not solve the problem. In fact, it often
makes the problem worse. Shirking arises in a large organization, but
subsequently reducing the size of the organization seldom eliminates the
opportunistic behavior that has become ingrained in the organization. Worse,
downsizing usually results in job losses that tend to push more work onto the
surviving work force at a time when the survivors are feeling particularly
vulnerable about their futures. Consequently, the firm usually gets more nervous
shirking, not less. As a firm flounders, cut-backs are inevitable, but management
must seek more proactive solutions to the problem of shirking rather than simply
relying on downsizing.

Techniques to Combat Shirking and Agency Problems

Most solutions to managerial diseconomies of scale involve addressing
the problem of "shirking." We will review and summarize different approaches to
this problem.

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Punishment for Shirking

Firms could simply punish workers or managers for shirking with fines,
sanctions, or even job termination. Indeed, unless a firm retains termination as
the ultimate sanction, it may not be able to deal with extreme (and extremely
dangerous) cases of shirking. In this regard, many economists and business
managers have criticized laws and/or union rules that keep management from
disciplining or terminating employees, even for gross misbehavior or gross
shirking. For example, job security laws in many European countries have made
it virtually impossible to get rid of grossly incompetent workers. Likewise, union
rules in the U.S. have created similar problems. This is one of the major reasons
why all Japanese auto makers who have located plants in the U.S. have only
located in regions of the country where they can prevent unionization.
Punishment may need to be the ultimate sanction, but it can seldom serve
as the first line of defense. Punishment creates a negative and confrontational
atmosphere. In addition, punishment requires extensive monitoring and can
impose high enforcement costs.

Hostile Take Overs

The discussion above of punishment was directed at punishment imposed
on workers and managers by management. However, there is another dimension
to this issue hostile take overs. This is a very different type of sanction imposed
from the outside on the highest levels of management. In this case, an outside
group seeks to acquire control of the firm and depose the current mangers. It is
the ultimate sanction against shirking at the highest managerial level and is
usually very effective.
The need for such a sanction is very clear. For example, Phillips
Electronics, a Dutch firm, has acquired a notorious reputation for poor
management over the last few decades. But how can bad management survive
long enough to acquire such a reputation? European law and European politics
have, especially in the past, worked to thwart a hostile take over of Phillips (or
other take overs). Bad management persists in Europe because bad managers
hide behind these laws and political influence. Had Phillips been an American
firm, a take over by a group convinced that they could do a better job would have
happened long ago. On the positive side, the EU has worked hard to remedy this
situation by trying to eliminate protectionism.
But it is not absolutely necessary to have an American-style hostile take
over in order to address the problem. For example, hostile take overs are just as
difficult to do in Japan as they have been in Europe. In Japan, interlocking
corporate ownership and directors are common (however, they are usually illegal

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in the U.S.). Firms belong to a kieretsu, or industry group which owns shares in
the company. The company in turn owns shares in other firms in the kieretsu.
These interlocking connections make a hostile take over virtually
impossible. However, in Japan, this is counterbalanced by the leverage that other
kieretsu member have for dealing with poor performance. Poor managers may
be deposed by other kieretsu members. In comparison, the European experience
seems to be the worst of both worlds.

Monitor what everyone does

Fredrick Taylor is the best know advocate of this approach. Taylorism
incorporates close supervision of workers as they do their jobs and it features
time-and-motion studies of worker and managerial activities to improve job
performance. In other words, the monitor watches you do your job and then tells
you how you can do it better and faster.
How do workers and managers react to having a man with a clipboard and
a stop watch following them around? Yes, thats right workers hated it.
Consequently, this has usually not been a very effective solution to the shirking
problem.
It is interesting that V.I. Lenin, the Soviet leader, was a great admirer of
Taylor and his methods. Lenin was aware that workers in capitalist countries
hated Taylorism, but he attributed this to the bosses being the ones holding the
clipboards and the stop watches. He reasoned that if comrades held the
clipboards and the stop watches, workers would not object. Lenin was wrong
Soviet workers hated it just as much.

Pay workers by the piece

Piece-rate pay is pay based on the output produced by each worker. For
example, it is common in agriculture where workers are paid by the bag of fruit
picked or by the pound, etc. This type of pay links worker pay with how much the
worker does. This is often an effective way to motivate workers and to reduce
shirking (because shirking costs the worker money).
However, piece-rate pay is often difficult if not impossible to incorporate
into most manufacturing and service sector jobs because it is often not possible
to count what the worker has produced. In addition, piece-rate pay requires a
monitor. For example, in picking fruit, workers who were paid by the bag and not
monitored would run through the orchard and pick all of the fruit near the ground,

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but leave the fruit higher up on the trees unpicked. To prevent this, a tree
checker monitors the workers. A worker cannot move to another tree until the
tree checker confirms that all of the full-sized fruit has been picked on his tree.
Tree checkers are not the most-loved people in the orchard. (I was a tree
checker many years ago. There were two of us I was the biggest person there
and the other checker was a recently-paroled ex-felon. Problem solved.)

Pay workers or managers pay based on their performance

Performance-based pay is similar to piece rate pay in that reward is tied to
performance, but with a difference. Rather than simply counting what a worker or
manager does, a performance-based pay program create performance standards
against which workers and managers are evaluated.
Performance-based pay can be very effective, but there are potential
problems. First, the standard for performance must promote maximum effort
while remaining attainable. There may be nothing worse than a bar set too high.
Second, one must be aware of the horizon problem you do not want managers
taking a short term perspective in order to increase short run performance and
profits at the expense of long term goals. Also beware of the risk problem
mangers should not assume more risk to reach performance goals than the firm
is comfortable with. Finally, beware of the ratchet effect or problem. When
bonuses get too big, many firms raise the bonus threshold. To a certain extent,
this is to be expected, but it can also create a ratchet problem that promotes
managerial shirking. For example, managers will hide their capacity to produce in
order to exceed their bonus target by only a small amount if they are convinced
that a better performance will only cause the bonus threshold to be raised
dramatically in the future.

Decentralized Management
This has proved to be a very good counter to diseconomies of scale.
General Motors pioneering efforts at implementing and popularizing this form of
corporate organization were described above. We do not need to repeat the
details here. However, we will return to this in conjunction with the discussion of
residual claimants below.

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Creating Residual Claimants

A residual claimant is a worker or manager whose pay is dependent on
the residual, that is, what is left over. Profit is essentially revenues minus costs,
that is, what is left over; it is a residual. A capitalist owner of a company is an
automatic residual claimant because her earnings are based on the residual (i.e.,
profits accrue to the owner).
In companies managed by managers rather than the owner, the automatic
residual claimant disappears. However, many companies have tried to replicate
residual claimants in their managerial structure. For example, one reason for the
success of GMs decentralized corporate structure was the residual claimants
created in the reorganization. General Motors decentralized its corporate
structure with vice presidents in charge of its divisions. The vice presidents and
their managerial staffs were then paid according to how much profit the division
earned. Division managers did not keep the divisions profits, but they made
more money when the division made more profits. This made them residual
claimants.
Just as important, division managers were given sufficient power to make
decisions that could affect the size of the residual. Effective residual claimants
must have the power and authority to act to increase the residual. If not,
managers have responsibility without power and they cannot respond to shirking.
Some Soviet economic reforms tried to get Soviet managers paid bonuses based
on the level of profitability. (Thats profitability, not profits profits would get you
sent to Siberia). However, managers were never given enough power to actually
affect profitability - the reforms failed.

Give managers and workers a stake in the company

This is a policy similar to creating residual claimants, but it stops short of
creating actual residual claimants and opts instead for creating a broader class of
workers and managers who will get paid more if the company earns more profits
and its stock goes up. The most well-know version of this approach is the stock
option. A stock option program gives employees the ability to purchase the
companys stock at a discount. The value of the program then depends on how
valuable the companys stock is. The idea is to make employees work harder
(less shirking) in order to enhance the firms profits, which in turn will be reflected
in a higher stock price. It works best when employees can actually connect their
performance with the firms results. This may be why employee stock owners
programs (ESOP) often dont work. In these cases, workers own all of the shares
in the company, but each worker owns such a small share that there is little

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incentive to reduce individual shirking because it makes very little difference in

the workers return.
A few firms (such as Baxter International) have required senior managers
to actually purchase shares of the companys stock with their own money as a
condition for keeping their jobs. This goes beyond stock options and has never
really caught on. It is not clear if this policy has any great advantage over stock
options and it must certainly pose enforcement costs on the firm.

Instill in workers and managers a sense of mission

This approach tries to create a feeling of a great quest or mission that is
supposed to motivate employees to give their best. This works great when
workers actually embrace the mission. However, in the U.S. it has usually taken
an emergency to create and maintain such a mission. And it is easily lost when
the emergency passes. For example, during World War II, American workers and
managers embraced the war effort and worked long hours at maximum intensity.
In addition, they received wages for their work, but war rationing severely
restricted their ability to spend their pay. Still, they worked hard and labor
negotiations and strikes were subordinated to the war effort.
However, the sense of mission did not survive the war-time emergency.
The immediate aftermath of the war saw a huge increase in labor strife and
strikes as the emergency passed and normal life returned.
Much has been made of the willingness of Japanese workers to work with
a sense of mission. Many get up early to sing the company song as the company
flag is raised. They take breaks with their co-workers, go out to dinner and clubs
with their co-workers after work, and even go on vacation with their co-workers (I
shudder at the thought of going on vacation with my co-workers!) This sense of
mission may have its roots in the postwar experience of an older Japanese
generation. What bears watching in the future is the behavior of younger
Japanese workers are they as interested as their parents in singing the
companys anthem before work each morning?

Pay an efficiency wage

In 1913, Henry Ford began paying his workers $5 per day, double the
prevailing wage rate for such work. Ford made sure that everyone knew about
his new wage policy and he milked it for as much publicity as possible. Some
saw Ford as an enlightened employer who cared about his workers. Others saw

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him as a shrewd businessman; Ford himself explained his wage policy as an

effort to pay his workers enough for them to go out and buy a Model T.
What Ford was really doing was paying his workers an efficiency wage,
that is, a wage that was higher than prevailing wages in order to make workers
take care not to lose such a high-paying job. Ford did this to reduce shirking
among workers and to curb the high labor turn over at Ford (working the
assembly line was hard work, and about as boring as it gets).
Many firms have followed Ford in paying efficiency wages and the practice
is very effective in keeping workers and managers on their toes for fear of losing
a job that they know will be hard to replace.

Backloading Compensation
Backloading compensation is the practice of paying workers higher wages
or benefits in the future based on their earlier performance and seniority. This
often occurs in sports when players earn more in their later years, even though
they are less productive than they were earlier in their career. The higher pay
later reflects their earlier performance. For example, baseball superstar Ted
Williams of the Boston Red Socks became the first (confirmed) player to earn
$100,000 for a single season. He received this salary in the last full year of his
playing career.
Outside of sports, backloaded compensation has been a feature of the
Japanese lifetime employment system. In this system, workers were hired for life
and younger Japanese workers were paid less even though they were usually
more productive. They accepted this with the understanding that their lifetime of
service to the firm would be rewarded in the future when that had acquired
seniority. In addition, during hard times, lifetime employees would work longer
and/or take pay cuts to get the firm through its rough times. In exchange, the firm
would reward them later when the crisis had passed.
Backloaded compensation can be a powerful tool for eliminating shirking.
However, it is difficult to establish in the general work place. It seems to be
declining in Japan and has never been used extensively in the U.S. or Europe. In
addition, backloaded compensation is readily destroyed if the bond of trust
between firm and worker or manager is broken or even threatened. If players or
workers or managers fear that their services will not be adequately rewarded in
the future, the entire system comes crashing down.

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Just-In-Time Inventory
Inventory policies were earlier in conjunction with economies of scale;
here we discuss a Japanese inventory practice, Just-In-Time (JIT) inventory
practices, that have a very different rationale. JIT is an attempt to overcome
shirking.
Many large scale firms that carry large inventory have had problems with
poor product quality. This is not simply a matter of the firms workers shirking it
sometimes involves shirking by suppliers. In other words, supplier parts come
into the large firm and are sent to the warehouse. Problems with part quality are
only discovered when parts are pulled from inventory much later. In many cases,
the problem is not discovered for many months. By that time, the problem has
accumulated and the firm now has to figure out what to do to fix the problem. In
addition, it has to figure out what to do with a warehouse filled with defective
parts. Equally important, it is difficult to hold suppliers accountable for mistakes
that were made so long ago.
JIT tries to synchronize parts delivery with production. Faulty parts are
then quickly discovered and the problem quickly corrected at the plant and with
the supplier. In addition, suppliers that have just delivered faulty parts are quickly
discovered and held accountable.
JIT has been embraced by firms around the world, but it is not clear that
they really understand the rationale behind JIT. Many seem to think that JIT
entails having delivery trucks conform to rigorous schedules, however, this is
only a surface feature. Others seem to think that JIT is primarily an inventory cost
minimization policy. While it may serve to reduce inventory carrying costs, this
was not its primary goal. (Besides, inventory cost minimization models have been
around at least since the 1920s nothing new here.) JIT is definitely a policy
designed to counter shirking and overcome a diseconomy of scale.

Specific Remedies at the 3M Company

Minnesota Mining and Manufacturing Company (3M) has acquired a welldeserved reputation for innovative management. Like GE, it is a diversified
conglomerate that excels at running a wide array of businesses. It is also a firm
with a reputation for fostering and promoting innovation. We will review of some
of 3Ms most notable policies.
First, all firms want to promote innovation, but is this promotion just
something that gets featured in a mission statement or company press releases?
In the field of innovation, the firm suffers when shirking employees or managers

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with ideas that could benefit the company dont come forward out of fear, or
laziness, or a feeling that there is nothing in it for them. All firms will tell their
workers not to do this, but it is often equivalent to telling people to do the right
thing. It may sound good, but it accomplishes little.
The unique thing about 3M is that it backs up its stated commitment to
innovation with specific policies. First, the company encourages innovations that
fail. This does not mean that it encourages failure; it means that it recognizes that
most innovative ideas do fail. That is the way it is. 3M wants its employees to
know that failure is okay and is not a career-ender. They want them to try again.
This is a bit nebulous, but it can be illustrated with an example. In 1922,
Francis Okie was a 3M employee trying to create more uses for 3M sand paper.
He came up with a novel idea: sandpaper could be used to replace shaving.
Instead of shaving with a razor blade, men could sandpaper their faces. Indeed,
Okie continued to sand paper his own face for years, even after 3M rejected his
idea.
This may be one of the stupidest ideas imaginable. However, the point is
that 3M welcomed the suggestion and Okie kept his job after the company
passed on his idea. Of course, you are never going to live this down with your
friends you will always be the guy with the crazy sand paper idea. But 3M had
the correct reaction to this failure, and it paid off later when Okie developed
water-proof sandpapers that were used extensively by automobile companies
seeking a smoother, dust-free finish. This product became 3Ms first blockbuster
product. (Guess where he got the idea for water-proof sandpaper.)
Second, 3M wants innovation and it has created performance criteria that
incorporate specific innovation targets. For example, 3M requires that each of its
divisions obtain at least 25% of its revenues from products created within the last
five years. This 25 percent rule translates the rather nebulous goal of we want
innovation into a specific target.
3M has also created the 15 percent rule (or 15% option). This rule
allows just about anyone at 3M to devote up to 15% of their work week to new
product development. Again, this is an attempt to support creative endeavor
through a specific policy. 3M also gives in-house grants to pursue new
innovations.
If an employee does create a new innovation, 3M moves quickly to
support it by creating residual claimants. The creator of a promising innovation
will quickly find herself at the head of a new product division earning salaries and
bonuses closely tied to the success of the new venture. 3M did not invent the
idea of creating residual claimants, but it has perfected the art of applying the
concept for maximum effectiveness.

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Genentech: A Unique Approach to Promoting Innovation

Genentech has been a pioneer in biotechnology for more than 35 tears.
Genentech uses human genetic information to discover, develop, and
commercialize medicines to treat serious medical conditions. The South San
Francisco firm was acquired by Roche in March 2009, making Roche the worlds
largest biotech firm.
Roche and Genentech have combined their pharmaceutical operations in
the United States at Genentech's South San Francisco campus. Genentechs
Research and Early Development continues to operate as an independent center
within Roche.
Genentech has acquired a reputation for product innovation and was
ranked No. 7 in Fortune Magazines 100 Best Companies to Work For,
(Christopher Tkaczyk, No. 7: Genentech: Encouraging Innovation, Fortune,
October 12, 2009:12). Tkaczyk notes three unique features of Genentechs
approach to encouraging innovation:
1) Genentech encourages innovation by using an extensive postdoc program
to bring outside scholars into the company to work on research projects.
The postdoc program is a great way of re-energizing the idea pool.
2) Genentech encourages risk taking. As in the case of 3M, encouraging risk
taking amounts to the company admitting that it expects most ventures to
fail and ensuring risk-takers that they will not be penalized for failure.
3) Sharing the companys research results in top scientific journals. Rather
than keep its progress under wraps, Genentech encourages publication of
its research results. Having publications in top journals also adds to the
prestige of the postdoc program and encourages top talent to associate
with the firm.
Genentech is in a research-intensive field and its postdoc program is not
amenable to all firms, but Genentech is a good example to all of how to craft and
tailor an anti-shirking program to meet the unique circumstances of the firm.

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Additional Specific Remedies

The 3M Company and Genentech are not the only firms that use specific
remedies to promote entrepreneurship and reduce shirking. The following have
been used by firms in Japan and around the world:

Encourage Product Churning

Product churning is a corporate strategy that essentially tries to promote a
number of new products and new technologies by developing them quickly and
throwing them into the market to see which will work. The company expects most
to fail, but the few winners that emerge will usually more than make-up for the
many losers. For example, in the 1980s, Japanese soft drink firms were
introducing more than 1,000 new soft drinks into the Japanese market each year.
Most failed, but a few succeeded and expanded product lines.
Product churning has also produced some more notable successes. For
example, the Sony Walkman was introduced through product churning. Sony
developers came up with the idea, but the company was not impressed and had
no expectations for the product. But it was introduced into the market and it sold
well. Sony was just as surprised as everyone else when the Walkman took off in
the market. Likewise, Mattel Toy Company introduced its Cabbage Patch Dolls in
the early 1980s. These were arguably the ugliest dolls ever created and Mattel
threw a limited production run of dolls into the market. They were pleasantly
surprised when the doll became a phenomenal success. Mattel was caught
unprepared for the success and shortages of the doll drove prices through the
roof.
Product churning is essentially a shotgun approach and is predicated on
the belief that it is better to try a number of things rather than try to accurately
predict the next big thing. Product churning also encourages risk-taking;
employees are more willing to try something if it is understood that failure is the
norm and that adverse consequences do not accompany failure. With product
churning, you also accept the fact that no one really knows what is going to work
next. Consequently, the firm puts out a wide array of products and stays flexible
enough to go with what works, and to drop what doesnt work.

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Encourage Product Covering

Product covering is a defensive version of product churning. In product
covering, the firm matches the product offerings of its rivals as a matter of
course. If they do it, we do it. Product covering is based on an appreciation of the
distinction between invention and innovation; you do not have to excel at
invention, only innovation. Innovation is successfully embracing opportunity when
it arises. It does not really matter where it came from, just be able to spot it when
it shows up. Like product churning, product covering also accepts the notion that
no one really knows what will work. Consequently, the firm follows what others
do and stays prepared to spot the winners and react. Sonys walkman was
copied quickly by competitors practicing product covering. Likewise, Chrysler
pioneered the mini-van in the 1980s, but other auto companies (especially GM
and Ford) quickly followed as they covered this new segment of the market.

Encourage Parallel Development

Parallel development is the practice of working on successive generations
of a product at the same time. Parallel development is based on the
understanding that competitors will quickly copy our successful products (e.g.,
through product covering) and erode our market share and profits as they
expand production. Parallel development is the counter strategy, that is, we work
on a series of product upgrades simultaneously in order to fend off the copiers.
For example, Intel routinely works on successive generations of microprocessors
simultaneously in order to stay in front of the competition. We have also already
seen an example of parallel development at Mattel with the Barbie doll. Mattel is
constantly working on new Barbie dolls to re-invigorate the market and to stay
ahead of the copiers.

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