Supply Chain Management in Japan

Table of contents

List of abbreviations

1 Introduction

2 Course of the analysis

3 Generic governance structures
3.1 Underlying principles of new institutional economics
3.2 Market
3.3 Hierarchy

3.4 Cooperation as a hybrid

4 Business groups in Japan
4.1 Zaibatsu
4.2 Keiretsu business groups

5 Keiretsu as a governance form for supply chain cooperation
5.1 Classification of Keiretsu governance
5.2 Case study: Keiretsus in the Japanese automotive industry

6 Critical evaluation

7 Conclusion and outlook

List of abbreviations

TAC = transaction costs

KBG = Keiretsu business group

OEM = Original equipment manufacturer

1 Introduction

The stunning success of Japanese corporations during the last decades has raised several questions and drawn profound interest for this topic in the academic literature. It has been argued by several researchers that an important part of the Japanese competitive advantage stems from its supply base that is actively managed as an extension of the enterprise.¹As the face of global competition changes from inter-firm to intercoalition competition taking place between whole supply chains, effective management of value chain partnerships has become a critical success factor.²In contrast to Western corpora- tions, which rely heavily on either arm’s length market transactions or vertically inte- grated hierarchies, hybrid governance structures in the form of inter-organizational Kei- retsu business groups play a dominant role in Japan. In complex-product industries Kei- retsu business groups account for a major share of Japanese competitive advantage: they foster mutual trust, specialization, information sharing and low transaction costs.³

Despite these advantages and the impressive track record, the historically grown Keiretsu structure is forced to adapt to changing market circumstances and undergoing a transformation. This article seeks to shed some light on the evolution of Keiretsu, assess its strengths and weaknesses and depict recent challenges and developments.

2 Course of the analysis

The purpose of this paper is to analyze the potential of Keiretsu business groups as a governance structure for managing collaborations in the supply chain. In an attempt to bring about this goal, the further analysis unfolds into five consecutive parts. Following the introduction, the fundamentals of new institutional economics theory are laid out. They will serve as a framework for the later analysis. Expanding on the insights gener- ated from the analysis, market, hierarchy and hybrid as three generic forms of govern- ance will be analyzed. For the sake of clarity cooperation as a hybrid form of govern- ance will be discussed in greater detail. Next, the evolution of business groups in Japan and its key characteristics will be assessed. Having explained the underlying concepts and the current situation, part five will analyze Keiretsu business groups from a new institutional theoretical perspective. After having classified the Keiretsu within the three generic governance structures, its strengths and weaknesses will be discussed. The Japa nese automotive industry will serve as a case example to further guide the analysis and show the practical relevance of Keiretsu. Before coming to a final conclusion, chapter six will uncover and discuss recent changes and problems arising within the Keiretsu group. The paper ends with a summary of the findings and some forward looking state- ments.

3 Generic governance structures

3.1 Underlying principles of new institutional economics

The new institutional economics theory seeks to model the relationships between insti- tutions and single economic entities. Institution is defined as a system of formal and informal rules and the accompanying mechanisms to enforce these rules.⁴New institu- tional economics theory is based on the three pillars of transaction-cost, principal agent and property rights. For the later analysis of Keiretsu business groups as effective forms of supply chain collaboration, especially transaction cost and principal agent theory can provide a powerful means and will thus be discussed briefly in the following.

Principal agent theory deals with the relationship between the principal and its agent, which carries out a task or delivers a resource as desired by the principal and receives a fixed payment in return. Crucial to the principal-agent theory is the information asym- metry between the better informed agent and its principal. Given the fixed nature of the payments the agent receives from the principal, the agent is inclined to engage in risky actions, which create problems for the principle.⁵The interaction between principal and agent also plays a strong role in transaction cost theory, which was coined by Ronald Coase in his pioneering paper attempting to explain the raison d’être of firms in parallel to markets. Under certain circumstances coordination of economic activities can be brought about more efficiently within the firm’s hierarchy as opposed to turning to the market. Consequently, vertical integration can provide advantages over the costly exe- cution of transactions on the market. Transactions have been described as the conclu- sion of a contract of sale with another economic individual by relying on the market and its underlying clearing and price mechanisms. Each and every time a company triggers a transaction on the market it incurs transaction costs (TAC). Central to the transaction cost approach is the notion that perfect contracts do not exist and this imperfectness creates additional costs. While arising in numerous forms and at numerous stages vis-à vis the timing of contract closing, the occurrence of TAC can be broadly clustered into costs for searching, contracting, controlling/monitoring and enforcing the contracts.⁶ Apart from the aforementioned polar economic organizations of market and hierarchy, the hybrid form marks the third generic form.⁷Transaction cost theory provides a framework to assess these generic forms of institutions and their underlying control and monitoring structures with regards to the TAC they cause. However, the adequacy of a specific institutional form depends heavily on the nature of the underlying transactions.⁸ Williamson identified frequency of transactions, uncertainty and asset specificity as the three key dimensions that impact the nature of transactions and substantially drive TAC. Whereas frequency and uncertainty exposure of transactions are self explaining, asset specificity is of dominant importance and thus deserves further explanation. It describes the degree of heterogeneity and uniqueness of a resource as supplied by the agent. The more specific the resource supplied, the higher the productivity gains. Asset-specificity can take several forms such as site specificity (geographic location of facilities for op- timized logistics performance when interacting with the principal), physical asset speci- ficity (specialized tools), human asset specificity (exchange of personnel) and dedicated assets (plant erected solely for the agent). Despite its ability to yield substantial effi- ciency gains, asset specificity makes it costly to redeploy them to alternate uses and/or users.⁹Neglecting the potential possible efficiency gains of asset specificity, William- son points out that “asset-specificity increases the transaction costs for all forms of gov- ernance” as parties must safeguard against the hazard of opportunism.¹⁰

Having laid out the basic principles of transaction cost theory, advantages and disadvan- tages of the three generic economic organizations can now be assessed in the following.

3.2 Market

The institutional form of markets describes the exchange of resources between anony- mous firms for a fair price at adequate quality as determined by the forces of the market. Transactions are governed by classical contracts that are concluded on the spot on an “as-needed basis”. Legalistic in nature these contracts try to determine all parameters of the contractual relationship ex-ante. They bear no dependency relation between buyer and seller and the existence of competition among various sellers allows the buyer to exit contracts at negligibly low costs and switch to alternative sellers. Apart from this increased flexibility, other advantages flow from economies of scale, economies of scope and specialization effects as the seller caters to various other anonymous firms. This also holds true for competencies and innovations that can be procured via the market. Last but not least, sellers have a strong incentive to perform since all profits generated from the transactions accrue to their accounts, which fosters their motivation as their revenues are now variable.¹¹

3.3 Hierarchy

Hierarchy as “a continuation of market relations by other means”¹²expands on the short-comings inherent in market transactions. Repeatedly occurring transactions cause significant costs, especially if they are highly specific. High specificity reduces the population of potential sellers and eases the pressure of the market mechanism that usu- ally assures fair prices, quality and control. The arising bilateral dependencies have to be coped with by more complex and costly neo-classical contracts that lead to higher TAC as contingency clauses for adapting to changes in market condition need to be in- corporated. Furthermore, highly specific market transactions and bilateral dependency nurture the threat of opportunism. Both parties might exploit its power and try to cap- ture the seller or buyers quasi rent. Economists speak of “quasi rents” if the value of the resource depends on the configuration of the parties involved in the transaction. That is to say that a seller might recoup a significantly lower price if he sells its product to an- other buyer and vice versa. By vertically integrating parts of the value chain, resources are now exchanged within the firm, which uniformly manages these aspects under common ownership. The rational for firms is that TAC for searching partners, aligning their interests, being exposed to opportunistic behaviour and re-negotiating for the adap- tation of contracts to changed circumstances can be avoided. Therefore, the hierarchical government mode relies on contracts that do not fix every transaction parameter ex- ante, but bundle numerous spot-contracts into a long-term and less precise contract. They are more elastic and continuous. Disputes are resolved rather through arbitration than courts. Efficiently coordinated by internal instruction, the firm internally allocates tasks and resources as needed and thus achieves a higher degree of adaptability when dealing with uncertain transactions. However, new and additional TAC arise as the lack- ing market mechanism needs to be imitated by costly internal control mechanisms. Fur- thermore, the changed ownership status creates incentive problems because agents who are now part of the firm can rely on their fixed payment but generally do not participate in the benefits achieved through their effort. Furthermore, exclusion of the competitive market forces might further impede external pressure to perform efficiently.¹³

3.4 Cooperation as a hybrid

The aforementioned forms of hierarchy and market portray the extreme poles on a con- tinuum of possible alternatives. The form of cooperation combines characteristics of both generic forms in a hybrid and is thus located in between.¹⁴Cooperation as a repre- sentative of hybrid forms emerged due to the constraints of both market and hierarchy forms and tries to combine the best of both forms. Hybrid forms try to achieve econo- mies of scale without incurring high TAC while capturing the productivity gains arising from asset-specificity as found in vertically integrated hierarchies without disputing over the distribution of quasi-rents. While a vast body of literature on cooperation ex- ists, similarities in the provided definitions allow for assigning the following common characteristics to the term: Cooperation involves the voluntary collaboration between at least two economically and legally independent entities based on either a formal legal or an informal contract. While both parties remain independent outside of the area of co- operation, bilateral dependencies within the joint activity might arise. By engaging in jointly coordinated activities both parties seek to exploit synergies (cooperation rent) that were not available if they would act on their own (hierarchy) or procure these ser- vices or resources through transactions from the free market. Both parties thus have an incentive to keep alive their relationship which manifests itself in the mid- to long-term horizon of cooperation agreements.¹⁵Disputes are settled internally analogous to the forbearance found in hierarchy forms. Further, partial convergence of goals and expec- tations is a key success factor. This is achieved through mutual trust as found in hierar- chical arrangements on the one hand and through mutual control as found in markets on the other.¹⁶Furthermore, hybrid forms can adapt more quickly and at lower TAC (e.g. by avoiding costly re-negotiations) to market changes than the market governance form. Given the supply chain context of this paper the sub-group of vertical cooperation seems particularly interesting. Cooperation occurring across different stages of the value chain has also been termed strategic network or network organisation.¹⁷Participating suppliers gather around a centre manufacturer and both suppliers and manufacturer seek to symbiotically benefit from specialization gains as each party concentrates on its stage of the supply chain where it possesses its core-competencies.¹⁸

4 Business groups in Japan

When comparing the industrial landscape of Western countries to Japan a key difference arises from the profound domination of business groups. The existence of these specific inter-organizational relations has been considered a potential source of competitive ad- vantage.¹⁹This chapter will briefly overview the evolution of business groups in Japan, portray the characteristics of distinct forms and pave the way for the later analysis.

4.1 Zaibatsu

Zaibatsu, meaning money clique in Japanese, represent great banking and industrial conglomerated that were exclusively controlled by influential firms. The impressive rise in power of Zaibatsu families was clearly triggered by governmental actions. After the Meiji restoration in 1868 generous subsidies and favorable tax-policies on the one hand provided clear incentives for entrepreneurial risk-taking, whereas the government on the other hand hoped to establish and develop the Japanese industry. Heavily involved in the founding and funding of semiofficial enterprises, the Zaibatsu families maintained close relations with major political parties. In 1937 one third of all bank deposits and one third of all foreign trade was under the control of the four leading Zaibatsu and dominated strategically important heavy industries.²⁰

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¹Cf. Liker, J. K. (2004), pp. 199-203.

²Cf. Hamel, G. /Prahalad, C. K. (1994), pp. 36-37; Christopher, M. (2005), pp. 287-295.

³ Cf. Dow, S. /McGuire, J. (1999), p. 47.

⁴Cf. Richter, R. /Furubotn, E. G. (1996), p. 7.

⁵ Cf. Thommen, J.-P. /Achleitner, A.-K. (2003), pp. 780-781.

⁶Cf. Ibid., pp. 779-781; Göbel, E. (2002), pp. 63-64, pp. 129-131.

⁷Cf. Williamson, O. E. (1991), p. 269.

⁸Cf. Göbel, E. (2002), p. 64.

⁹Cf. Williamson, O. E. (1991), p. 281.

¹⁰ Ibid., p. 282.

¹¹Cf. Ibid., p. 271; Göbel, E. (2002), p. 180, pp. 186-187.

¹² Williamson, O. E. (1991), p. 271.

¹³Cf. Göbel, E. (2002), pp. 180-188; Williamson, O. E. (1991), pp. 271-273, p. 275.

¹⁴Cf. Backhaus, K. /Meyer, M. (1993), pp. 331-332.

¹⁵ Cf. Elter, C. (2003), p. 41.

¹⁶Cf. Göbel, E. (2002), pp. 195-196.

¹⁷Cf. Sydow, J. (1992), pp. 107-108.

¹⁸Cf. Thommen, J.-P. /Achleitner, A.-K. (2003), pp. 803-804.

¹⁹Cf. Dow, S. /McGuire, J. (1999), p. 47.

²⁰ Cf. Columbia Encyclopedia (2001), p. 481; Ghosh, A. (1974), p. 318; Buckley, P. J. (2004), pp. 263- 265.