Since the advent of the large corporation in the 1850s, companies have evolved their organizational structures to meet the requirements of higher competencies, globalization, diversification, and automation.
This article discusses how this evolution happened, with a focus on the latest innovation, the nexus organization.
A key aspect of the nexus organization is that a company is more than the incorporated unit. It is the collective competence of a) the company b) and the external advisers.* Some large companies understand this and take actions accordingly , but most do not.
Below is a graph with the four dominant forms of organizational structure plotted over time for large companies (>20,000 employees). The vertical axis shows the share of each form based on our survey of academic literature and own observations.
Before discussing the characteristics of the nexus organization, let’s review the three preceding forms: functional, multi-divisional, and matrix organizations.
In the 1850s, organization as we think of it was innovated at the the newly transcontinental railroad companies. There was a need for coordination and specialization of people at a scale not seen in the earlier days of industrialism.
The benefits of functional organization were immense. But it made companies rigid. It was hard to add products and coordination between departments was increasingly difficult as companies grew. Also, a functional organization by definition only integrates revenue and cost into profits at the CEO level.
Still, functional organizations monopolized management thinking for 70 years,
In 1919, Alfred Sloan, then a second level executive at General Motors, wrote what is arguably the most influential business text ever: the “Organization Study.”**
He argued to his fellow GM exectuives that the company should adopt a multi-divisional form (M-form) of organization. Each division would be a profit center.
GM adopted M-form in 1921 and changed from chaos to order. It quickly overtook Ford as the largest automotive company.
The benefits of M-form were evident not only to GM, but to large companies around the world. Over the next 40 years, M-form went from nothing to 98% share of organizational structures.
The main reason was the effect on profitability. It has been estimated that M-form has a 2 percentage point advantage over functional form in return on equity. If ROE is 10% for functional form, this is a 20% advantage. An astronomical number in competitive markets.
M-form had its limitations though. As companies grew into multinationals, they started having three dimensions: a new geographic dimension, the product dimension, and the functional dimension. Needs for coordination increased.
The solution was the matrix organization which became popular in the 1970s, and still is. Matrixes are much maligned, but as one observer said: “no one talks about matrixes, but most large companies have them.” Below is one variant of the matrix (there are others).
The matrix allows for better coordination and use of resources. But it comes at cost. The matrix succeeds only if managerial skills are built to work in an ambiguous setting where people report in several directions. Building such skills is difficult.
Nevertheless, almost all global companies are organized in some form of matrix today. Sometimes the dominant dimension is the product, other times geography, seldom is it function.
In 1976, Michael Jensen and William Meckling introduced the notion of the firm as a nexus of contracts in one of the top 5 most-read economics papers ever.*** It is theoretical and took some time to be converted into language and ideas useful to management teams.
Our managing director, Staffan Canback, has been a management consultant since the 1980s and started observing large companies thinking in nexus terms around the turn of the century. So what is it?
The nexus organization views itself as a bundle of contracts. Those contracts can be explicit (e.g., third parties), or implicit (e.g., a sales force sells the products coming out of manufacturing).
It is the task of senior management to optimize those contracts so that a) the mix of what is made internally or externally is optimal, and b) they are measured and enforced correctly.
The graph below shows that the nexus corporation itself, but as the nexus of all the expertise available to it.
Importantly, professional services firms are key to maximizing corporate performance. For example, the old mindset of “real companies do things themselves, we do not use consultants” is fading and only laggard companies think like this nowadays.
The new paradigm is instead: “we do as little as possible internally and weave professional services firms into our fabric when they provide skill or other advantages.” Hence the incredible growth of professional services since 1980–much higher than in, for example, the tech sector.
Benefits and drawbacks
The nexus organization carries major benefits:
- It maximizes, in a conscious and deliberate way, all the resources at the disposal to the company, not only the internal resources. This creates a much larger resource base from which competitive advantage is derived.
- Cost effectiveness is higher. The use of external experts may look expensive, but is in fact the lowest cost solution to working on many tasks. The high productivity of external contributors and the flexible use of them across geographies and divisions is impossible to match with internal resources, except under unique circumstances.
- Further, it reduces fixed cost and makes it easier to expand or contract with the ebb and flow of business cycles.
However, there are drawbacks. The most important is that it requires new skills at the corporate center to manage the wider network. Building an institutional nexus capability is more than negotiating contracts. It affects the values and priorities of the company.
Implications for corporations
Developing the next organizational structure should not be an inward-focused task. Instead, the taskforces and steering committees should devote as much effort or more to optimizing the external relationships–to make the nexus a reality.
Rather than endlessly debating whether unit A should report to Division B or Geography C, senior executives should determine which professional services firms should be retained for which tasks, what the contractual relationship should be, and how to safeguard that proprietary methods stays within the corporation and do not leak to competitors.
This last point is of utmost importance. While no respectable professional services firm allows client information to be shared outside the client service team. However, they tend to share generalized ideas internally, and good ideas later show up at competitors. The nexus company seeking true competitive advantage needs to make sure this does not happen.
Implications from our vantage point
We are struck by the variability in nexus thinking.
Some clients view our firm as a fungible resource. They retain us on an arms-length basis for an ad hoc issue. There is no thought given to how the relationship is optimized in the long run. Things just happen.
Sophisticated clients have a different mindset. They think long and hard about how we fit in to work on classes of problems. They create master services agreements that prohibit us from working for a select list of competitors. They share their strategic plans with us, and we attend executive committee meetings routinely. We share an agenda for where the company should be heading.
The latter approach is much more powerful than the former. When we think about where we want to add value, those are the companies we prioritize.
* * *
The nexus organization is here to stay. It today represents around 15% of large companies, but the development has only started.
Senior executives at large corporations, as well as partners at professional services firms, are advised to pay attention to this development and to act deliberately to optimize the benefits of managing the nexus of contracts.
* Suppliers and distributors also play a role, but less so.
** 1) Sloan could not recall if he wrote the memo in December 1919 or January 1920 when he wrote his memoir. 2) Beyond leading GM for many years, MIT’s business school is named in his honor.
*** Jensen and Meckling (1976): Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics: Volume 3, Issue 4, Pages 305-360. “Nexus of contracts” now gives 91,000 Google hits.
Note: this article builds on various parts of academic research and our leadership tea, experience as a management consultants to large corporations.