Strategic Flexibility and Firm Performance : The Case of US Based Transnational Corporations

Abbott, Ashok

Abstract

In a fast-paced globalized world it is very important for transnational corporations (TNCs) to be competitively agile. The Asian currency crisis, shifting foreign direct investment and trade patterns, rise of regional trading blocks, and ongoing developments of the Internet have created environmental turbulence. To gain a competitive advantage, strategic flexibility has become a must for most TNCs. Based on the global strategy framework developed by Yip (1995) and the relevant strategy literature three key areas of strategic flexibility were identified. They are: (i) market flexibility, (ii) production flexibility, and (iii) competitive flexibility. The basic research question was "Does strategic flexibility improves firm profitability?" Three hypotheses were developed, and tested on data from 227 Fortune 500 companies. The independent variables were market flexibility, production flexibility and competitive flexibility, and the dependent variables were the three performance measures Return on Sales (ROS), Return on Assets (ROA) and Earnings before Interest and Tax Margin (EBITM). All three areas of strategic flexibility were found to be significantly related to the firm performance measures.

Keywords : competitive environment, firm performance, strategic flexibility

Introduction

During the last decade the global economic and political environment has changed dramatically. Dismantling of the Soviet system, economic liberalization programs in China and India, the growth of democracy in Latin America, the formation of both NAFTA and the European Union have had a tremendous impact on the global economic outlook (Tersine and Harvey, 1998). Continued globalization, coupled with the technological revolution led by the Internet has changed the way most of the transnational corporations (TNCs) operate. These changes have created both enormous opportunities and challenges for global organizations. The change in environment has forced most TNCs to develop a global strategy based on flexible systems that can adapt to the changing external environment.

This study investigates the impact of strategic flexibility on the firm profitability. The basic research question is "Does strategic flexibility lead to higher firm profitability?" For this study we define strategic flexibility as a firm's ability to respond to various demands from dynamic competitive environments (Sanchez, 1995) in a competent manner. It should be able to produce and sell the right products, at the right time, at the right place and at the right price (Roth, 1996).

Strategic Flexibility and Environmental Uncertainty

Strategic flexibility is closely linked to environmental uncertainty. As the external environment becomes more volatile TNCs need to develop greater flexibility in order to respond to the emerging conditions. According to Evans (1991) flexibility is composed of a number of "senses" including "adaptability, agility, corrigibility, elasticity, hedging, liquidity, malleability, plasticity, resilience, robustness, and versatility". He argued that each of these organizational flexibilities would be in response to some form of external environmental uncertainties or pressures. The type of reaction could be "offensive" or "defensive" and he categorized these senses into those categories.

While flexibility is normally considered solely as an adaptive response to environmental uncertainty (Gupta and Goyal, 1989), it is important to realize that a firm may use its strategic flexibility to proactively re-define market uncertainties and make it the cornerstone of its ability to compete. This is exemplified by Toyota and its actions in global automobile industry in the 1980s and the 1990s. Unfortunately, such proactive behavior in using flexibility is often neglected by researchers (Gupta and Goyal, 1989; Nilson and Nordahl, 1995; Prabhaker et al., 1995).

Strategic flexibility implies that the entity as the ability to change according to its needs. Flexibility is the ability to adapt, in a reversible manner, to an existing situation, as opposed to evolution, which is irreversible. This notion reflects the ability to stay operational in changing conditions, whether those conditions are predictable or not, or completely different from conditions known in advance. This adaptability is required from firms that, for economic reasons, are currently turning to efficient techniques of organization and management of the zero stock, just-in-time and tight-flow type which can make them fragile. Strategic flexibility is crucial in hypercompetitive environments because, the established paradigms of sustainability of competitive advantage and stability of organizational form have limited applicability.

Strategy researchers have emphasized stability in a firm's pattern of resource commitments (Ghemawat, 1991). Through resource commitments, firms erect entry barriers (Bain, 1956), mobility barriers (Caves & Porter, 1977), and isolating mechanisms (Lippmann & Rumelt, 1982) that protect their competitive advantages. Although such patterns of resource commitments provide a firm with competitive advantage (Dierickx & Cool, 1989), they can also become impediments to strategic reorientations (Grimm & Smith, 1997).

In the last decade many industries have experienced "a fundamental shift in the rules of competition and the way the game of competition is played" (Ilinitch, D'Aveni, & Lewin, 1996: 211). Teece, Pisano, and Shuen (1997) argued that organizations should rely on dynamic capabilities to build competitive advantage in regimes of rapid change, and Sanchez (1995) and Garud and Kotha (1994) suggested that strategic flexibility enables firms to compete successfully under such conditions. McGrath, MacMillan, and Venkatraman (1995) showed that firms in dynamic environments seek to continuously renew their competitive advantage through competence-generating strategic processes of comprehension and deftness. Thomas (1996) documented that the ability to take action and adopt swiftly is a primary determinant of superior performance in many industries. In a related vein, scholars who study competition on the Internet have suggested that pervasive interconnectivity and network externalities, conditions that characterize the Internet, also require that firms adopt inherently dynamic strategies, including "product versioning," rapid product development, direct relationships with users, and frequent "partnering" (Shapiro & Varian, 1999).

In order to develop strong strategic flexibility capabilities a TNC need to have the three types of flexibilities: (a) market flexibility, (b) production flexibility, and (c) competitive flexibility (Yip, 1989). This we term as the "Flexibility Triad Model".

Market flexibility deals with TNCs, ability to have a high global market share, ability to sell its major products in a large number of international and geographic markets, and have a strong presence in those markets that are the home bases of global competitors. For most TNCs, production flexibility arises from spreading its value creation activities in those markets where it has a major market share. A TNC can shift production from one base to another, in order to take advantage of the foreign exchange rate fluctuations and access the best factors of production (Porter, 1990). Similarly, the competitive flexibility of a TNC arises from its ability to coordinate its global competitive moves. This helps the TNC to have a large number of competitive points and a bigger strategic space to build appropriate offensive and defensive moves that may often include counter-parry, cross-subsidization and sequential competitive entries.

Market Flexibility

The first component of strategic flexibility is market flexibility. We define market flexibility as the ability of a TNC to recalibrate its marketing efforts in a short period of time (Grewal & Tanshuhaj, 2001) in response to changing environmental context. Most TNCs operate in a large number of markets spread over various countries across the world. The more number of markets a TNC operates in, the lower is its dependence on any one or a group of markets. Hence, it can spread the market risk over a large number of markets. Similarly, if it faces stiff competition in one market it can switch its efforts to another market. The ability to cross-subsidize between business operations and country markets also goes up.

The volume of the total sales of the TNC is also important. The larger the market share the greater the market power of the TNC in that given market. This often results in a higher profitability for the TNC. It also gives the TNC ability to withstand a "marketing offensive" from a competitor. If the TNC has a large market share in some of the key markets it can effectively block the entry of new firms and thereby reduce competitive pressures. Similarly a strong presence in the home market of a major competitor provides it with the ability to hold the competitor firm "hostage" in a cross-parry situation.

Market flexibility also includes the ability to develop and roll out a uniform product in markets with similar demand characteristics. That helps in controlling product development, promotion and other marketing costs. Similarly, global brands are a major source of competitive advantage for most TNCs. Hence, they are developed, nurtured and protected by global corporations. Globally recognized brands increases market acceptability of a product via ready recognition and reduce sales and promotional costs for the product. It also improves corporate visibility and provides the TNC with a great competitive advantages resulting in superior profitability. Hence, it may be hypothesized that:

Hypothesis 1: The greater a TNC's market flexibility, the higher will be the level of firm performance.

Production Flexibility

The second broad area we looked at was production flexibility. We defined production flexibility as the ability of a TNC to manufacture / provide goods or services, in most major markets around the world, with a short lead time at competitive costs. Where to locate manufacturing activities and coordinating them is a critical choice in developing strategic flexibility. According to Yip (1995) most TNCs have four key choices, Ca) either to duplicate the activities in multiple locations, (b) setup part of the value chain at various locations that provide the best opportunity and resources to carry out that particular activity, (c) concentration production in one country and sell all over the world, and (d) outsource production in some markets and in-house production in others. Depending on the type of goods or services produced, perhaps the highest level of flexibility it may have is when it can replicate the value chain (either via in-house production or by out sourcing) in the major markets it operates in.

According to Porter's (1990) cluster analysis theory, if the TNC operates in an industry that works as a global oligopoly it may be better off by locating its production close to that of its competitor's. Such close proximity will provide the TNC chance to "keep an eye" on the competitor's activities and share the common resource base. Being located in the same cluster the TNC can swiftly react to its competitor's moves and expand or contract its production base depending on its needs.

A TNC can also create production flexibility by setting up agile manufacturing systems (Upton, 1994) which can produce various products on the same assembly line by relatively low downtimes. A prime example of this type of flexibility is the Toyota Production System that can switch from producing one particular vehicle model to another in less than hour's time. Also, the TNC can develop a common product or service mix (Yip, 1995) and thereby increase flexibility and reduce cost per unit of production. At present Ford uses a common platform for various models of cars like the Lincoln LS and Jaguar S type though they are produced at different locations and geared to different markets. Sharing of common platforms is a key trend in the automobile industry and other assembly based industries. Common platforms also help TNCs to "Mass Customize" its products where the products share "a common core and have a customized periphery" (Yip, 1995). Such sharing reduces production cost, shortens development time, increases customer satisfaction and provides greater flexibility to the TNC. Hence, it may be hypothesized that:

Hypothesis 2: The greater a TNC's production flexibility, the higher will be the level of firm's performance

Competitive Flexibility

Competitive flexibility provides a TNC with the capability to compete in a global market that has high competitive intensity, and demand / technological uncertainty. Competitive intensity is the degree of competition a TNC faces, that requires firms to take a flexible approach so that they can adapt and improvise to the changing conditions to put their best foot forward (Moorman and Miner, 1998). In highly competitive environments, strategic flexibility becomes a valuable asset (Aaker and Mascarenhas 1984). Often a technological shift or a strategic move by a competitor in a particular market has the potential to change the very basis of competition. Firms that have the flexibility to respond to new competitive behaviors are at a definite advantage; they can easily redeploy critical resources and use the diversity of strategic options available to them to compete effectively.

Similarly, demand uncertainty creates difficulty in assimilating information and devising strategic plans. Managing in uncertain environments requires concerted deployment of resources devoted to the product-market operations and response to demand idiosyncrasies. Competitive flexibility, by definition, emphasizes answering to the unique needs of consumers, business partners, and institutional constituents (Alien and Pantzalis, 1996). Because firms are more likely to face challenging and unique situations in uncertain markets than in stable markets, competitive flexibility becomes a key asset to a TNC at times of demand uncertainty.

Change in technology stemming from product and process innovations contributes to technological uncertainty. Strategic flexibility involves capability building to respond quickly to changing market conditions. Such capability building usually involves investing in diverse resources and possessing a wide array of strategic options (Bowman and Hurry 1993). Because technologically uncertain markets are likely to offer a greater number and range of threats and opportunities for firms to adapt and improvise, we expect competitive flexibility to be of crucial importance in an environment that is characterized by high levels of technological uncertainty. Hence we hypothesize that:

Hypothesis 3: The greater a TNC's competitive flexibility, the higher will be the level of firm's performance.

Methods

Dependent and Independent Variables

This study follows the Global Competitive Strategy Model developed by Yip (1989), and uses flexibility measures identified by Yip (1995). We define three independent flexibility measurement variables - market flexibility, production flexibility and competitive flexibility. Each of these is a composite variable calculated as the average of four measures of flexibility. They are as follow:

Market Flexibility

* Global Market Share (Ml): Business's Global Volume divided by the total volume of the worldwide market.

* Global Share Balance (M2): Index of the worldwide business's geographic split of revenues compared with that of the worldwide market.

* Global Market Presence (MJ): Number of countries in which the worldwide business sells.

* Marketing Element Uniformity (M4): Share of the business's worldwide revenues accounted for by the countries that have a uniform approach.

Production Flexibility

* Mix Standardization (Pl): Percentage of worldwide revenues in a common product or service mix.

* Content Standardization (P2): Percentage of cost of product or service that is in components that are standardized.

* Concentration of Individual Activity (P3): Share of global spending on activity in the country with most of that activity.

* Concentration of Entire Value Chain (P4): Weighted average of the concentration indices of individual value activities.

Competitive Flexibility

* Global Coverage (Cl): Share of global volume accounted for by the countries in which the worldwide business sells.

* Global Strategic Market Share (C2): Business's volume in globally strategic country-markets only divided by the total volume in those markets.

* Multi-country Competitive Moves (C3): Moves that involve three or more country markets.

* Counter-parry Moves (C4): Response to a competitive attack in one country with a move in a different country.

Each of the measures was converted to a five point scale and the mean for each of the independent variables were calculated based on the following formulae:

Market flexibility (MAKT) = (Ml + M2 + M3 + M4) / 4

Production Flexibility (PROD) = (Pl + P2 + P3 + P4) / 4

Competitive Flexibility (COMP) = (Cl + C2 + C3 + C4)/ 4

The dependent variables for this analysis are indicators of firm's performance measured by Return on Assets (ROA), Return on Sales (ROS), and Earnings Before Interest and Tax Margin (EBITM). These variables are widely accepted measures of firm performance and have been used extensively in the strategy and international business literature (Contractor, Kundu and Hsu, 2003).

Data CoI lection

We developed a questionnaire to elicit responses measuring the hypothesized relationships and mailed it to all the companies on the 1999 Fortune 500 list. Initial mailing was followed up with two more mailings at two weeks intervals and a phone call after one week of the last mailing. This resulted in a total of 227 returned questionnaires, a response rate of 45.4%. Financial data items for the responding firms were extracted from the Standard and Poors' Research Insight database (Tables 1 and 2)

In general, these firms were found to be profitable (positive ROA, ROI, and ROE) be a little bit less risky than the market portfolio (mean beta 0.88). The sample firms had positive profit margins measured as Return on Sales (ROS) and EBIT margins.

Discussion and Results

All three measures of flexibility are significantly positively correlated with each other. The correlation between market and production flexibility is very high. A possible reason for this being that most firms establish a production facility in the host country only after they have established a market for their products in that country (Johanson & Vahlne, 1977), hence the two variables correlate with each other. The possible reason may be a construct validity issue. The measures used in developing these two variables are similar in nature hence they are highly correlated. We did not want to change the measures, as they were part of the model developed by Yip (1995).

The three measures of profitability, Return on Assets (ROA), Return on Sales (ROS), and the Earnings before Interest and Taxes Margin (EBITM) are significantly positively related with the measures of flexibility. EBITM relationship with market and production flexibility measures is positive but not significant.

We also found that the Firm Beta, the measure of relative riskiness is significantly correlated with the measures of flexibility. Interestingly while higher levels of competitive flexibility appear to be related with lower beta firms, the opposite is true for the measures of market and production flexibility. Higher beta firms tend to exhibit higher levels of market and production flexibility. It appears that as the competitive flexibility goes up the TNC develops its ability to shift production to the most favored location in a relatively short period. Also, it develops capability of engaging the competitors in multiple markets at the same time. This reduces the competitive risk in any one given market.

We explore causal relationships between the measures of firm performance and the measures of flexibility. In view of the strong correlation between the measures of production and market flexibility, we expected their confounding effects to affect the predictive ability of the variables. Therefore, we estimate three regression models for each independent performance variable. Initially we estimate a regression model of full rank, including the three flexibility variables and their interactions and follow up this analysis by two reduced rank models in each case, omitting the market flexibility and production flexibility variables in turn. The results of the reduced rank models allow us to observe the effect of each of these variables in absence of the confounding effects of the alternate variable. (see Appendix I and II)

Return on Assets (ROA) is often used to measure the efficiency of operations (Contractor, Kundu and Hsu, 2003). In this study the full rank model regression is significant with an F statistic of 5.19 (Pr>F F F

Similarly, ROS is often used as a measure of the firm's profitability (Contractor, Kundu and Hsu, 2003). In this study, the full rank model regression is significant with an F statistic of 6.45 (Pr>F F F

EBITM is a measure of the firm's efficiency of operations before making any adjustments for leverage and tax rates. The findings are interesting in that only COMP is significant in explaining the levels of EBITM. The full rank model regression is significant with an F statistic of 5.47 (Pr>F

A significant coefficient is observed only for COMP variable, and MAKT, and PROD do not exhibit additional explanatory power. The reduced rank model excluding PROD has a comparable R square of 0.1270 and an F statistic of 10.28 (Pr>F F

Interesting, and somewhat unexpected results are found regarding the relative volatility of returns of the firm, measured as the market beta of the firm, and the flexibility variables. It appears that while competitive flexibility seems to reduce the variability of returns, and increase in market and production flexibilities appears to increase this volatility. The full rank model regression is significant with an F statistic of 3.30 (Pr>FFF

A potential drawback of this study is that we did not control for the size of the firm. As all the responding firms belong to the Fortune 500 list of 1999 and had extensive global operations, all of them were presumed to be very large companies.

lmplicationsfor Managers

The findings of this study have several implications for the managers. The most important implication is "flexibility matters". An improvement in the market, production, or competitive flexibility increases the TNCs' overall competitive agility. The increased flexibility in turn increases its ability to respond to a changing environment and has a strong positive impact on its profitability. A second implication is that managers need to increase their firm's competitive flexibility as it reduces the TNCs' vulnerability to fluctuations in global market conditions. A third key implication is that the TNCs need to improve all three types of flexibility and develop a balance between them. Increasing market and production flexibility helps to generate higher margins by optimizing production and distribution costs but competitive flexibility has to be increased in order to reduce the overall level of risk faced by the TNC and to improve its ability to respond to the volatility of the external environment.

Issues for Further Research

In this study we have presented the framework of "Triad Model of Flexibility" which we feel is a major contribution to this literature. However, there are a number of outstanding areas and gaps that must be filled. Though the body of literature is growing the impact of the various flexibility definitions and classifications on design, implementation, justification and evaluation models needs to be further investigated. There is a need for more empirical investigation of real world practices with respect to the various flexibility categories discussed above. We also need to remember that the flexibility theory is still in its infancy. Development and evaluation of flexibility classifications and testable hypotheses will require ontological developments to help structure the theory (Narain et al, 2000).

Conclusion

The first step in creating the flexible TNC is to identify clearly what forms of flexibility can be important in its competitive environment. As we have seen strategic flexibility is a multidimensional concept and depends on the capabilities of managers of an organization and the "controllability or changeability" of the organization. Hence, a key issue is the capacity of an organization to change while maintaining adequate control of its processes of product creation and realization. Strategic flexibility therefore represents an orderly response capability in a changing world.

To achieve strategic flexibility, a TNC must work to enhance flexible capabilities and should not focus exclusively on developing specialized routines that work well in one competitive situation, but that may not be appropriate in a changed competitive context. Flexible capabilities enable a TNC to anticipate changes in competitive requirements, draw on a broad base of knowledge, absorb new knowledge and ways of doing things, allow managerial experimentation, expand managerial mindsets, and support higher-order learning processes like "double-loop" learning (Argyris & Schon, 1978). To achieve flexible capabilities, managers must learn to manage vertically, horizontally, and ideologically. The greatest challenge to managers who want to create flexible firms is to create the "right" amount and kind of flexibility that a firm needs in its competitive environment - a task that Volberda characterizes as resolving the paradox of forces for change and forces for preservation within organizations, while responding effectively to the dynamism, complexity, and unpredictability of the organization's environment (Sanchez, 2002).

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Ashok Abbott

College of Business & Economics

West Virginia University, Morgantown

USA

Kunal Banerji

College of Business

Florida Atlantic University, Florida

USA

Copyright Global Institute of Flexible Systems Management (GIFT) Jan-Jun 2003
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