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«Noël Houthoofd Jef Hendrickx HUB RESEARCH PAPERS 2012/17 ECONOMICS & MANAGEMENT MAART 2012 Industry segment effects and firm effects on firm ...»

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Industry segment effects and firm effects on

firm performance in single industry firms

Noël Houthoofd

Jef Hendrickx

HUB RESEARCH PAPERS 2012/17

ECONOMICS & MANAGEMENT

MAART 2012

Industry segment effects and firm effects on firm performance in single industry

firms

Noël Houthoofd, HUBrussel, Department of Economics and Management

noel.houthoofd@hubrussel.be

Jef Hendrickx, HUBrussel, Department of Economics and Management jef.hendrickx@hubrussel.be Abstract The purpose of the paper is to identify the sources of variation in firm performance. This is one of the cornerstones of strategy research, i.e. the relative importance of industry and firm level effects on firm performance. Multilevel analysis is well suited to analyze variance in performance when the data are hierarchically structured (industry segments consist of firms, firms operate within the context of industry segments). The Belgian industry studied is a service industry that consists of about 25 electrical wholesalers. Data were collected from 20 firms during the period 1998-2003 from responses to a questionnaire sent to all the firms in the market. The sample in the data set covers more than 95 percent of the market (in sales), as the missing firms were just fringe competitors. The results show that firm effects explain most of the variance in four performance variables. That bears out the importance of each firm having its own specific, idiosyncratic resources and competences. The explanatory power of firm effects varies by about 30 to 40 percent while the intra-industry effect explains around 10 percent of the variance. Even though firm effects are dominant, intra-industry effects explain a significant portion of the variance in firm level performance. The firm effect is smaller than in previous studies. The firm effect varies across the performance measures: firm effects are higher for returns on assets than for profit margins. The industry segment effect (or intra-industry effect) is more independent of the dependent variable. The industry segment effect is in line with previous studies on the strategic group effect. Top managers should carefully choose and monitor the intra-industry domain they are in.

Key words: firm effect vs. industry effect, electrical wholesale sector, performance differences, multilevel analysis

1. Introduction Identifying the sources of variation in firm performance is one of the cornerstones of strategy research, i.e. the relative importance of year, country, industry, strategic group, corporate, and firm level effects. The literature focuses on comparing the relative importance of industry and firm effects on performance heterogeneity. The confrontation of these two effects is then interpreted as an empirical test of the practical relevance of the two fundamental research streams that aim to explain differences in firm performance: perspectives that highlight firm characteristics as the key determinant of firm performance - e.g. the resource based view (RBV) (Wernerfelt, 1984; Barney, 1986, 1991), the competence-based view (CBV) (Sanchez, 1997;

Sanchez & Heene, 1997) or the dynamic capabilities view (DCV) (Teece, Pisano and Shuen, 1997; Teece, 2010), and perspectives that emphasize the impact of the environment - e.g.

industrial organization (IO) (Porter, 1979, 1980, 1981) and population ecology theory (Hannan and Freeman; Nelson and Winter, 1982).

This paper starts with a conceptualization of the different effects studied in previous research and positions the industry segment effect amidst the other effects studied in this research stream. A third section provides a review of past studies on the topic of the relative importance of the different drivers of firm performance. A fourth section presents the research setting. The fifth section discusses the research method. Section six presents and discusses the results.

2. Explaining heterogeneity in firm performance - theoretical background

2.1. Firm effects and industry effects The main focus of interest in the literature on explaining performance differentials is the industry versus the firm effect. The continuing debate in the literature about the relative weight of the industry versus the firm (or business unit) reflects a debate between the importance of looking through the window (the industry or market) vs. looking in the mirror (the company itself) (Bowman and Helfat, 2001) The industry effect captures the effect of the structural characteristics of industries on firm performance. This effect has strong theoretical foundations in the IO tradition. The IO approach, emerging from the early works of Mason (1939) and Bain (1951, 1956), specifies that the contextual factors associated with the industry in which a firm competes, have a determining influence on the firm’s performance. This approach places little emphasis on the influence of firm-specific traits or managerial choices (with the exception of market share). In IO, firms are mostly homogeneous while contexts (industries) differ (e.g. in structure, timing, costs, demand, etc). The IO view explains firm performance differences through the relative attractiveness of forces in a firm’s industry (Porter, 1979, 1980, 1981). According to the IO-view, the industry affects firm performance independently of the firm itself (Arend, 2009). Industry-level determinants studied consist of concentration, economies of scale, entry and exit barriers.





The IO framework was challenged in the 1980s by the incipient RBV, which modeled the firm as a unique collection of resources and competences which forms the main driver of firm performance. Firm effects capture the influence of firm-specific factors such as heterogeneity in resources and competences and also the differences in corporate and competitive strategies.

According to the RBV, internal firm-specific factors are of central concern because these internal factors drive performance, not external industry forces (Barney, 1991). Wernerfelt (1984:172) defines a resource as “anything which could be thought of as a strength or a weakness”. In more recent work, a distinction is made between a wide variety of tangible and intangible assets and competences (Hall, 1994; Hunt, 2000). Scholars in the RBV literature theorize that firms possessing resources that are valuable, rare, inimitable, and nonsubstitutable can achieve sustainable competitive advantage by implementing fresh value-creating strategies that are difficult for competitors to duplicate (Barney, 2002; Wu, 2010). Examples include intellectual property, process know-how, customer relationships, and the knowledge possessed by groups of especially skilled employees. Within RBV, competitive advantage can flow at one particular moment from ownership of scarce but relevant and difficult-to-imitate assets, especially knowhow. But in fast-moving business environments open to global competition, sustainable advantage requires more than the ownership of difficult-to-replicate (knowledge) assets (Teece, 2007). Scholars of the CBV and the DCV are extending RBV to dynamic markets. The CBV and DCV can be seen as more actionable versions of the RBV, with more emphasis on the sources of competitive advantage in the firm over time. The CBV shifts the focus from the specific content of the firm as an open system at a given point in time to the dynamic processes by which a firm identifies and develops strategic resources on an ongoing basis (Sanchez, 1997). Thus the competence perspective analyzes processes in organizations in terms of making sense in a changing environment, for developing new internal resources and capabilities, for accessing new external resources, for defining new organizational goals, and for coordinating available resources and capabilities in the pursuit of an evolving set of strategic goals. As such there is a strong link with organizational learning theory. The dynamic capabilities are the skills, procedures, organizational structures, and decision rules that firms utilize to create and capture value (Teece, 2010). Dynamic capabilities can be disaggregated into the capacity (1) to sense and shape opportunities and threats, (2) to seize opportunities, and (3) to maintain competitiveness through enhancing, combining, protecting, and, when necessary, reconfiguring the enterprise’s intangible and tangible assets (Teece, 2007). Though DCV emphasizes more organizational agility, cognition and entrepreneurship whereas CBM calls attention to strategic flexibility, the CBV and the DCV frameworks are complementary.

2.2. Incorporating intra-industry effects

The persistent observation of shared similarities in the endowment of resources among (strategic) groups of firms in the same industry reinforced the need to consider intra-industry effects which affect subgroups of firms within the industry. Firm effects would be overestimated if intraindustry differences and similarities were not accounted for. The existence of significant intraindustry effects may stimulate practicing managers to align the firm’s corporate strategy within the industry context. Unfortunately, only a few studies have taken into account these intraindustry effects of firm heterogeneity on performance variation. According to Hawawini, Subramanian, and Verdin (2003), industry effects and firm effects may vary between different classes of firms within the same industry - for example, if the industry is made up of distinct strategic groups. This argument is generalizable to form the hypothesis that industry effects and firm effects may vary if different intra-industry segments exist. If this is the case, then it follows that in a single industry research design, firm effects will be lower than estimates in previous studies, because these studies decompose performance variation between firms without taking intra-industry effects into account. Even when industry is defined at the four digit level, a large variation in firm level performance is usually found, as is the case in this paper. Trying to explain these large variations calls for consideration of intra-industry structural differences which can give rise to an “industry segment effect” or “intra-industry effect”, and this in turn may reduce significantly the influence of firm effects on performance.

The existence of industry segments may trigger practicing managers to align their corporate strategy with this intra-industry context. Even when CEOs face the same general external environment (e.g. the industry), they will react differently to the threats and opportunities perceived within that context. This study is one of the few addressing the performance differentials which can be attributed to an industry segment effect. This is correlated with the effect of corporate level scale and scope decisions but must not be confused with the ‘corporate effect’ as this is usually conceptualized. The notion of corporate effect means the effect on profitability in multi-industry firms in relation to factors associated with the common membership of multiple businesses within an individual corporation (Bowman and Helfat, 2001).

Corporate strategy in a multi-industry firm deals with the ways in which a corporation manages a set of businesses as a whole. Firms differ in the way they deploy corporate-level resources and this is likely to result in performance heterogeneity across firms. In single industry firms, corporate level decisions comprise three different strategic areas, which, together, define the intra-industry segment or intra-industry domain which the firm operates in. These three basic dimensions are (Cool and Schendel, 1987, 1988; Porter, 1986; Martens, 1988, 1989; McGee and

Segal-Horn, 1990):

- Buyer scope: what types of buyers are targeted?

- Product scope: how broad is the variety of products commercialized?

- Geographical scope: what is our geographical reach?

Industry segment effects would capture the heterogeneity of firm performance that derives from factors internal to the firm at the corporate level (e.g. scale and scope decisions, (re)structuring the organization) (Adner and Helfat, 2003). This paper focuses primarily on scale and scope decisions. Hence the following research question: do corporate level decisions differ across firms within an industry, and, if so, does it matter? In this study, the industry effect is let aside because the present sample considers a single industry, the electrical wholesale sector. The intra-industry domain is a three-dimensional (cf. infra) "strategic space" constituting the arena within which firms position themselves in order to compete successfully. Variation in any of these three dimensions significantly affects a firm's structural position in the industry. We hypothesize that the variation has relevant performance implications. We use multilevel analysis to answer the question of whether heterogeneity in corporate level decisions accounts for a portion of heterogeneity in performance.

3. Empirical literature review

Since the seminal empirical research of Schmalensee (1985) more than 25 studies have contributed to the assessment of the relative importance of various different drivers of heterogeneity in firm performance. Table 1 summarizes the research setting and the main results of the most influential papers published in the academic literature. This list is based on, and extends, the reviews by Bowman and Helfat (2001); Brush, Bromiley, and Hendrickx (1999);

Chen and Lin (2006); Misangyi, Helms, Greckhamer, and Lepine (2006) and Arend (2009). Most of the studies are based on US data and just a few of them analyze information concerning European firms. The recent contribution of Goddard, Tavakoli, and Wilson (2009) uses European data from the Amadeus database. This paper adds to previous literature through an analysis of a country effect that is considered together with firm and industry effects. Almost all the papers reported in the Appendix rely on published financial performance data. Only Powell (1996) and, more recently, Galbreath and Galvin (2008) use subjective performance data with US and Australian data respectively.



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