316 Part 3: Strategic Actions: Strategy Implementation
owners seek varies from firm to firm.^34 Factors that affect shareholders’ preferences
include the firm’s primary industry, the intensity of rivalry among competitors in that
industry, the top management team’s experience with implementing diversification strat-
egies, and the firm’s perceived expertise in the new business and its effects on other firm
strategies, such as its entry into international markets.^35
As is the case for principals, top-level managers—as agents—also seek an optimal
level of diversification. Declining performance resulting from too much diversification
increases the probability that external investors (representing the market for corporate
control) will purchase a substantial percentage of or the entire firm for the purpose
of controlling it. If a firm is acquired, the employment risk for its top-level managers
increases significantly. Furthermore, these managers’ employment opportunities in the
external managerial labor market (discussed in Chapter 12) are affected negatively by a
firm’s poor performance. Therefore, top-level managers prefer that the firms they lead be
diversified. However, their preference is that the firm’s diversification falls short of the
point at which it increases their employment risk and reduces their employment oppor-
tunities.^36 Curve M in Figure 10.2 shows that top-level managers prefer higher levels of
product diversification than do shareholders. Top-level managers might find the optimal
level of diversification as shown by point B on Curve M.
In general, shareholders prefer riskier strategies and more focused diversifica-
tion. Shareholders reduce their risk by holding a diversified portfolio of investments.
Alternatively, managers cannot balance their employment risk by working for a diverse
portfolio of firms; therefore, managers may prefer a level of diversification that maximizes
firm size and their compensation while also reducing their employment risk. Finding the
appropriate level of diversification is difficult for managers. Research has shown that
too much diversification can have negative effects on the firm’s ability to create innova-
tion (managers’ unwillingness to take on higher risks). Alternatively, diversification that
strategically fits the firm’s capabilities can enhance its innovation output.^37 However, too
much or inappropriate diversification can also divert managerial attention from other
important firm activities such as corporate social responsibility.^38 Product diversification,
therefore, is a potential agency problem that could result in principals incurring costs to
control their agents’ behaviors.10-1c Agency Costs and Governance Mechanisms
The potential conflict between shareholders and top-level managers shown in Figure 10.2,
coupled with the fact that principals cannot easily predict which managers might act
opportunistically, demonstrates why principals establish governance mechanisms.
However, the firm incurs costs when it uses one or more governance mechanisms. Agency
costs are the sum of incentive costs, monitoring costs, enforcement costs, and individual
financial losses incurred by principals because governance mechanisms cannot guarantee
total compliance by the agent. Because monitoring activities within a firm is difficult, the
principals’ agency costs are larger in diversified firms given the additional complexity of
diversification.^39
In general, managerial interests may prevail when governance mechanisms are weak
and therefore ineffective, such as in situations where managers have a significant amount
of autonomy to make strategic decisions. If, however, the board of directors controls
managerial autonomy, or if other strong governance mechanisms are used, the firm’s
strategies should better reflect stakeholders and certainly shareholders’ interests.^40 For
example, effective corporate governance may encourage managers to develop strategies
that demonstrate a concern for the environment (i.e., “green strategies”).^41
More recently, observers of firms’ governance practices have been concerned about more
egregious behavior beyond mere ineffective corporate strategies, such as that discovered atAgency costs are the sum
of incentive costs, monitoring
costs, enforcement costs,
and individual financial
losses incurred by principals
because governance
mechanisms cannot
guarantee total compliance
by the agent.