Theory of the Growth of the Firm

by Edith Penrose

  121 For criticism of the notion that research is necessarily a great advantage, see J. Jewkes, ‘Monopoly and Economic Progress’, Economica, Vol. XX (New Series), No. 79 (Aug. 1953), esp. p. 206.

  122 Only about one-fourth of the officials interviewed in the National Science Survey of some 200 United States corporations reported that ‘their companies have a formal method of estimating the financial return on research expenditures. And a few said that their companies make no attempt to appraise the results of their research and development effort’, op. cit., p. 49.

  123 In England the Manchester Joint Research Council, in reporting the results of a survey, stated: ‘One of the questions a firm considering the formation of a research department must ask itself is: ‘What is it going to cost, and what will the firm derive in material benefit?’

  ‘There have been many attempts to answer this question, both here and abroad, but so far as is known none has proved wholly satisfactory. Although it is quite possible to estimate the capital cost of establishing a modest research section and to budget for its annual upkeep, it has generally been found impossible to produce a profit and loss account to show to what extent a research department is paying its way. So many of the advantages of such a department are so intangible that it is, perhaps, not surprising that this survey has not brought to light any new ideas as to how such a balance can be struck, nor how the value of such a department can be assessed. There is nothing which can be pointed to as an infallible indication that a firm needs a research department, or that it will be profitable to found one. Perhaps not unexpectedly, wherever a research department was found to exist it was thought by the board and management to be a most important aspect of the firm’s activities, and the best means of keeping abreast of progress. The decision to institute research can only be taken after mature consideration, but even so, it will still be largely a matter of faith, and a belief that the scientific method has advantages over those of trial and error.’ Manchester Joint Research Council, Industry and Science (Manchester: Manchester University Press, 1954), pp. 48–9.

  124 In many cases, the actual name of the seller may not be so important as the fact that the seller of one product is also the maker of some other well-known product. Advertisements often emphasize the fact that the product in question is produced by the makers of some other widely accepted product.

  125 See Chapter VIII for a discussion of this point.

  126 ‘The Development and Growth of General Motors,’ statement by Harlow H. Curtice, President, General Motors Corporation, before the Sub-committee on Antitrust and Monopoly of the United States Senate, Committee of the Judiciary, Dec. 2, 1955.

  127 ‘In May, 1954, General Mills sold its home appliance business to the Illinois McGraw Electric Company. Under terms of the sale, the purchaser received capital equipment, tooling and inventories and agreed to service appliances now in use.

  ‘The home appliance business accounted for only a small proportion of the Mechanical Division’s sales, employees and facilities, which have always been devoted largely to industrial and defense efforts. To develop the home appliance further would have required a greater investment than its future prospects appeared to justify. Sale of the operation will now make possible more effective specialization in the development and production of precision electro-mechanical instruments.’ Annual Report, 1953–54.

  For further discussion of this kind of problem see the section on the ‘Purchase and Sale of Businesses that are Not Firms’, in Chapter VIII.

  128 In the 1955–56 Annual Report, the firm listed 28 ‘new products of the year.’

  129 See, for example, the recommendations in the report by Arthur D. Little, Inc., Diversification: An Opportunity for the New England Textile Industry (Federal Reserve Bank of Boston, 1955).

  A rather surprising diversification achieved through wartime sub-contracting is described in this report: ‘The Rock of Ages Granite Company, one of the oldest and most renowned monument manufacturers in the United States, diversified into the electronics industry via the subcontracting method. The company established itself as a subcontractor during the war by doing work on proximity fuses. In1945 it moved into the manufacture of electronic components on a subcontracting basis for a large electronics manufacturer. The company trained available labor in this work. Technical assistance was provided by the prime contractor,’ p. 18.

  130 See, for example, David S. Meiklejohn, ‘Financial Aspects of Diversification’, in Charting the Company’s Future, American Management Association, Financial Management Series, Number 108 (New York, 1954); and Roy Foulke, Diversification in Business Activity (New York: Dun and Bradstreet, 1956).

  131 One writer insists that ‘there is a legitimate analogy between a corporation with a new company acquisition and a family with a new baby. The new company, like the new child, does not simply represent the addition of one more member to the corporate family; it changes the relationships between everyone concerned. This requires patient adjustment of the new relationships and readjustments of the old’. Rodney C. Gott, ‘Integrating and Consolidating Company Acquisitions’, in Long-Range Planning in an Expanding Economy, American Management Association, General Management Series, Number 179 (New York, 1956), p. 48.

  132 ‘If growth is the principal objective of the acquiring company, that implies the closest kind of control over the activities of the new subsidiary. On the other hand, ventures into hitherto foreign fields imply a dependence on the local management which has been operating as an independent company in those fields. Too much control by the parent company would threaten the initiative and imagination of the business manager. Too little might threaten the growth of the two enterprises in their new combination.’ Ibid., p. 40.

  133 We are not at present concerned with the conditions under which such ‘willingness’ to sell may be forced on the seller.

  134 The argument summarized above is fully developed in the next chapter.

  135 It should be noted that the ‘conglomerate’ category used by the United States Federal Trade Commission in classifying mergers is not wholly applicable for the study of acquisition in unrelated fields in the sense used here. The Commission’s application of the definition includes many mergers that we would not consider unrelated. Conglomerate acquisitions were defined by the Commission as ‘...those in which there is little or no discernible relation between the business of the purchasing and the acquiring firms’. Presumably using this definition, the Commission found that slightly over 20 per cent of the total acquisitions in the period 1940–47 were conglomerate acquisitions. Apparently, however, all mergers that were not horizontal or vertical were classed as conglomerate. For example, new food products acquired by General Foods and Standard Brands (two speciality food concerns), the acquisition of other food products by dairy firms, the addition of new drug products to the line of drug firms, acquisition to manufacture chemical sprays by petroleum corporations, the entry into radio and agricultural equipment manufacture by aircraft concerns, were all treated as conglomerate acquisitions. Some of these would be treated here as diversification within an existing production base, while most of them would be considered to be diversification into new areas related to the old. See: Report of the Federal Trade Commission on the Merger Movement (Washington D.C., 1948), pp. 59–63.

  136 Similarly, in the United States Temporary National Economic Committee survey referred to above, only 95 of 2,051 ‘complex central office’ firms (i.e., firms with a number of establishments controlled from one central office and operating in more than one census industry) were found to have no ‘functional relationship’ between the establishments, and it was noted that ‘ . . . a more intensive analysis of these 95 central offices might have revealed certain relationships among the plants which could not be ascertained in this study’. Temporary National Economic Committee, The Structure of Industry, Monograph No. 27, op. cit., p. 206.

  137 One investigator, for example, sent letters to some 200 busines
smen and executives asking a variety of questions related to the problem of ‘regularizing business investment’. He reported that ‘The idea of developing supplementary product lines that either are more or less depression-proof or have a different cycle was endorsed more frequently by the respondents than any other single idea. . . . There is considerable experience, as well as statistical evidence, to show that new products and diversification provide some insurance against a general market decline’. See Emerson P. Schmidt, ‘Promoting Steadier Output and Sales’, Regularization of Business Investment, report on a conference of the Universities-National Bureau Committee for Economic Research. (Princeton: Princeton University Press, 1954), p. 343.

  138 Assume, for example, that the committed resources of a firm can be used only to produce existing products and that in this use the firm earns $1,000,000 over its direct costs. Assume now that an investment of $100,000 is required next year to effect a change in the major product in order to match innovations of competitors and that without this investment the firm could expect to lose virtually its entire market. The investment of $100,000 may raise net earnings by only $100 (or not at all) and yet the entire $1,000,000 is properly classed as a return on the $100,000. Of course, wherever committed resources have some alternative use, or can be sold, the relevant comparison is with their alternative earning power.

  139 The fact that several products can be and in fact are produced with the same general collection of productive resources is surely one of the primary reasons for the widespread use of ‘full-cost pricing’. Under such conditions it would be thoroughly inappropriate for a firm to use variable direct cost (sometimes erroneously assumed to reflect marginal cost) for the calculation of the profitability of a given product. Direct costs do not correctly reflect marginal cost because they do not include the ‘internal’ opportunity cost of the fixed resources used for the product, and it is of course well recognized that ‘cost’ from an economic point of view must include opportunity cost. As the production of a particular product increases, more of the firm’s fixed resources are absorbed by it and this should be taken into account in calculating the marginal cost of that product. In other words, what is fixed cost for the firm as a whole becomes variable cost for each product. In so far as a firm’s calculation of the average cost of a product reflects the variation in the use of fixed resources at different levels of output, it becomes an approximation of the correct marginal cost. In other words, ‘full-cost pricing’ (or the ‘cost-plus’ principle) is appropriate policy if it means that the firm compares average profit margins in order to decide whether to make changes in the prices and output of its several products. Thus if several firms are producing roughly the same products in the same markets under similar cost conditions and the products are ‘substitutable in production’, the price of each product will tend to stay considerably above direct costs; the competitive emphasis may be on market strategy, with price competition avoided, because each firm may in fact lose money if the profit margin on any product falls below that on the other products. See also the comment of D. H. Robertson, Economic Commentaries (London: Staples Press, 1956), p. 39.

  140 For an example of an extensive diversification programme that failed primarily because the programme was too extensive and too diverse for the company’s existing experience and because preparations for the new activities were inadequate, see H. F. Williamson, Winchester: The Gun that Won the West (Washington D.C.: Combat Forces Press, 1952), especially Chapters 7 and 8.

  141 Sometimes a firm is required to produce a ‘full line’, not so much because of consumer convenience, but because of the technological relationship between the various ‘products’; this also promotes vertical integration. Of integration and diversification in the early electrical companies, for example, Passer writes: ‘Electrical products had to be part of a system—a lighting system, a power system, or a transportation system. To ensure that the component parts would operate together in a satisfactory manner, manufacturers found it advantageous to produce all, or nearly all, of the components of any system they chose to market. They also found it advantageous to sell and install the complete system. It was primarily the system characteristics of electrical products, therefore, that led an electrical firm to manufacture a full line of products and to assume the responsibility of placing them, in operating condition, in the hands of users.’ Harold C. Passer, ‘Development of Large-Scale Organization: Electrical Manufacturing around 1900’, Journal of Economic History, Vol. 12, No. 4 (Fall, 1952), p. 390.

  142 In a recent survey of 500 firms in four industries in four geographical areas, it was found that ‘one of the more important effects of competition among manufacturers is that it induces “product dynamics”. Because of the appearance of a competitive product, new products were introducedby 36 per cent of the food firms surveyed,42 per cent of the textile and apparel firms, 51 per cent of the electricity and electronics firms, and 31 per cent of the metal fabricating and light manufacturing firms.’ Herner, Meyer and Co., Research and Development and the Use of Technical Information in Small and Medium Sized Manufacturing Firms: (A Report to the Office of Technical Services, U.S. Department of Commerce, 1956), pp. 22–3.

  143 The analysis above has been the analysis of a process leading to a particular result, that is, to the development of a certain type of ‘situation’ or ‘state’. Wherever the process in reality is a continuing one (and few results or situations are final), there is a serious difficulty inherent in any attempt to demonstrate or illustrate theoretical conclusions with reference to observed facts. This difficulty is particularly evident in statements like the one in the text; for a firm may be ‘long-established’ and ‘successful’, but this fact alone does not guarantee its future, especially since its own actions and policies may at any time depart radically from those of the past. For example, such a firm may become so impressed by the vogue for ‘diversification as such’ that the policies and actions to which we have traced its strength in the past no longer characterize its present, and statements treating its present position as a ‘result’ of its past history must take such changes into account when recent history is substantially different in kind from earlier history.

  144 On the other hand, the firm may be concerned about the continuing availability of resources, especially labour, if its activities fluctuate severely. It may also feel some responsibility to its work force, and for this reason attempt to stabilize its production.

  145 The traditional coal-ice diversification was surely prompted as much by the similarity of resources and markets as by the complementary fluctuations of demand.

  146 For discussion and examples of this see the Universities-National Bureau Conference volume, Regularization of Business Investment (Princeton: Princeton University Press, 1954). Especially the paper by Emerson P. Schmidt, pp. 319–68.

  147 As was pointed out in Chapter II, a preoccupation with growth does not necessarily conflict with an equal preoccupation with profits. We have assumed that firms are concerned with increasing their total profits over the long period from their own operations. They therefore will invest as much as they profitably can in these operations, for all profitable investment in the firm will increase total profits. Hence behind the notion that diversification as a general policy is conducive to growth lies the notion that it will turn out to be more profitable than specialization.

  148 See the motion filed in the Federal courts by the Cudahy Packing Company requesting that it be freed from the restrictions imposed on its diversification by a consent decree following an antitrust action in 1920. The Company complained that its opportunities for profit were limited because its diversification outside the meat-packing industry was prevented, that it was unable to compete with other similar companies because it could not take advantage of the changed conditions of distribution, and that ‘instead of promoting free competition, the application of the provisions of the decree to Cudahy restricts competition’. Wall Street Journal, Feb. 2, 1956.r />
  149 In other words, the estimates of the cost savings traceable to backward integration, like the profit estimates with respect to other possible avenues of expansion, do not include the opportunity cost of resources, for these can only be discovered after the alternative calculations are made. Hence, the carefully calculating firm will not integrate backwards merely because a comparison of the costs of production with the cost of buying outside the firm shows a decisive saving. It could not, from this information alone, decide whether integration would be the most profitable use of the resources that would be absorbed by it. A reduction in cost is therefore a necessary, but not a sufficient, condition for profitable integration. That many firms have an insufficient appreciation of this fact can perhaps be inferred from the numerous strictures of accountants and management experts directed to the alleged propensity of firms to ignore, not only the fact that resources will be absorbed which can be used elsewhere, but also the increase in fixed cost which the taking on of new activities will eventually, if not immediately, cause. Robert L. Dixon has called the ‘piecemeal attachment of relatively minor activities of service and supply’ by the name of ‘creep’, because a firm may start out with a small activity which seems to have cost-saving opportunities without considering whether or not the increment of new investment which will be required if the integration is successful will be the best use of its resources. See his ‘Creep’, Journal of Accountancy, Vol. 96, No. 1 (July 1953), pp. 48–55.