Corporate culture as a theory of the firm: The role of values, customs, and norms

Business leaders have long recognised that corporate culture is vital to a company’s identity and success. In one of the more colourful descriptions of the importance of corporate culture, the legendary management author Peter Drucker wrote: “culture eats strategy for breakfast, technology for lunch, and products for dinner, and soon thereafter everything else too.” Similarly, former IBM Chairman and CEO Louis V. Gerstner Jr. wrote: “I came to see, in my time at IBM, that culture isn’t just one aspect of the game, it is the game.”

And yet, economists have consistently overlooked corporate culture in their theories of the firm. For the most part, existing theories have focused on the costs and benefits of asset ownership and/or incentive contracts to explain whether a company produces parts and services ‘in house’, or instead purchases them in a market (the ‘make-or-buy decision’). Bengt Holmström and John Roberts (2005) provide a detailed survey of numerous current theories and Robert Gibbons (2005) supplies an elegant synthesis of several theories.

In a recent paper (Gorton and Zentefis 2020a), we provide a novel theory of the firm based on corporate culture. We model how corporate culture takes shape and demonstrate how it affects a firm’s internal organisation. We then use this framework to explain the make-or-buy decision, why certain parts of production are more likely outsourced than others, why some mergers fail, and why corporate cultures are difficult to change.

Corporate culture

Building on our previous work (Gorton and Zentefis 2020b), we define culture as the values, norms, customs, traditions, symbols, and language that are widely shared by members of a group and that govern their collective behaviour. This definition is consistent with definitions found  within anthropology (Tylor 1871, Goodenough 1957, Keesing 1974), sociology (Williams 1995, Macionis 2013), and organisational behaviour (Schein 1983, Deshpande and Webster Jr. 1989, Martin 1992).

Corporate culture begins forming when a CEO communicates her desired values and norms to all employees (i.e. setting a ‘tone from the top’). For example, she might express views and give directions on fostering innovation, improving safety standards, prioritising customer needs, or tolerating dissent. Employees then interpret these instructions from their own perspectives and communicate their views to each other and within their teams. All of these interpretations form a corporate culture comprising values, norms, and customs, which together establish tacitly agreed rules for behaviour.

Once established, corporate culture affects key decisions regarding the firm’s structure (e.g. the make-or-buy decision) and impacts whether mergers and acquisitions will succeed or fail. A corporate culture also turns out to be exceedingly difficult to change. The following scenarios and examples illustrate the impact of culture in these areas.

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Make-or-buy decision

When deciding whether to make or buy a team’s input to production, the CEO can regulate each team’s behaviour in one of two ways: through contractual agreements or through corporate culture. The CEO relies on contracts when buying an input in the market, rather than making it in house. In this system, incentives are aligned by the structure of compensation and the threat of litigation for breach of contract. Those contracts will inevitably have gaps, as the parties will have no way of completely anticipating or describing all possible conditions, needs, and contingencies when tailoring the terms of their agreement.

As an alternative to using detailed contracts, the CEO can make the part internally and rely on a corporate culture to fill in the gaps that bedevil contracts (e.g. as the means to make adjustments, provide flexibility, and resolve uncertainty). In this system, by contrast, incentives are aligned by a fixed wage and social pressures to abide by shared norms and values. In deciding whether to make or buy a part during the production process, a manager chooses which of the two systems achieves the highest output from her perspective. 

Several characteristics distinguish teams that are inside the firm from teams that are outside the firm. If the CEO can manage a team more to her liking by using corporate culture rather than contracts, that team is more likely to be inside. Nevertheless, the CEO will be open to incorporating a team internally (despite its differences from her preference) if that team coordinates well with another team that the CEO wants inside. Teams that are core to the firm’s technology are also more likely to be inside, whereas teams that interact with few other teams or whose inputs are less important to the firm’s output are less likely to be inside.

Mergers and acquisitions

Corporate culture also plays a crucial role in determining the success or failure of mergers and acquisitions (M&A). Over the past 35 years, announced M&A transactions in the US have neared a value of $35 trillion across over 325,000 deals, equivalent to one deal every hour (Institute for Mergers and Alliances 2020). However, overwhelming evidence suggests that M&A activity often leads to disappointing financial performance for acquirers (King et al. 2004, Cartwright and Schoenberg 2006, Haleblian et al. 2009) and targets alike (Ravenscraft and Scherer 1987, 1989). Only half of mergers are considered to be successful by the managers who undertook them (Schoenberg 2006).

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The troubled merger between telecommunication firms Sprint and Nextel in 2005 provides a striking example. The merger was a full integration of the companies’ technology and operations. But Nextel’s entrepreneurial and aggressive style conflicted with Sprint’s top-down bureaucratic approach. Many meetings between the two sides “ended with Nextel employees storming out, leaving the Sprint side baffled.” Meanwhile, Nextel employees “felt their brand and technology had been unfairly dismantled” (Hart 2007). Three years later, Sprint reported a $29.7 billion write-down related to the merger (Holson 2008).

In our model, we show that cultural conflicts (like the one between Sprint and Nextel) are the primary cause of failed M&A transactions. Cultural clashes are costlier if the newly acquired company becomes a core piece of the combined firm’s production, or if it does not coordinate well with the acquirer’s existing teams and suppliers.

Cultural change

Over time, a firm may change CEOs, and each new leader might try to influence the company’s culture. But some CEOs can have more of an effect on the culture than others. Baron et al.(1999) find evidence that the company’s founder has a particularly enduring impact on corporate culture.

Consider the case of Uber after its founder and CEO Travis Kalanick resigned and was replaced by Dara Khosrowshahi. In 2018, one year into his tenure as CEO, Khosrowshahi expressed disappointment that he could not transform the firm’s macho culture quickly enough (O’Brien 2018). Further, in Uber’s pre-IPO disclosures to the Securities and Exchange Commission another year later, the company acknowledged that its culture itself was a risk factor to investors (Uber Technologies 2019).

Consistent with this example and the findings in Baron et al. (1999), we show that once a corporate culture forms, it is hard to change. Large changes are especially challenging to implement, more so than small changes. As a result, a former CEO that had a significant influence on a company’s culture (such as Kalanick at Uber, Lee Kun-hee at Samsung, or Ray Kroc at McDonald’s) can continue affecting the culture long after stepping down.

Conclusion

What causes employees to work together? We propose that it is corporate culture. This culture is the governing force that allocates resources inside firms in place of lengthy contracts. Corporate culture also impacts numerous other key decisions within firms.

Our work significantly departs from the existing research on theories of the firm by focusing on how individuals form groups and cooperate to succeed. In our setting, employees make decisions to maximize utility, but they do so while taking into account their surrounding social and cultural circumstances.  Culture becomes the root of employees’ social cohesion. It regulates internal governance, production decisions, the choice to make or buy, and is the defining characteristic of firms. Indeed, corporations are cultures.    

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References

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Gorton, G B and A K Zentefis (2020b), “Social Progress and Corporate Culture”, NBER Working Paper No. 25484.

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