Are large headquarters unproductive?

Masayuki Morikawa

Headquarters play important strategic roles in modern companies, but downsizing of headquarters is often advocated as a cost-cutting measure. This column presents evidence from Japanese firm-level data that the size of headquarters is positively associated with firms’ overall productivity. Moreover, the benefits of ICT are greater for companies with relatively large headquarters. Downsizing headquarters to cut costs may thus be harmful for long-term company performance.

The role of headquarters

Headquarters – the core service sector inside companies – conduct a wide range of highly strategic activities, including:

the choice of business areas,

the decision to introduce new products and services,

the adoption of investment projects,

human resources management, and

financial management.

Recently, an increase in the number of factoryless goods producers (FGPs) has attracted attention (e.g. Bernard and Fort 2013). These are not simple wholesalers, but can be seen as companies that are highly specialised in headquarters functions.

Since the costs of headquarters functions are treated as ‘selling, general, and administrative’ (SG&A) expenses in the current accounting standard, reducing these indirect costs is often regarded as an effective means of improving profitability and productivity. In particular, during economic downturns, SG&A expenses are likely to be the target of cost reductions. However, headquarters functions conducted in the general affairs, personnel, and accounting departments are not simple routine tasks. Their quality and quantity may determine the excellence of managerial decision-making and, as a result, companies’ overall performance.

Recent studies have made clear that intangible assets contribute significantly to the productivity of companies, industries, and the economy. In estimating the value of intangible assets, executives’ salaries and bonuses are often used as a measure of investment in ‘organisational capital’ – an element of intangible assets (e.g. Corrado et al. 2009, Fukao et al. 2009). However, if organisational capital contributes to company performance, then not only expenditure on executive compensation, but also SG&A expenses related to headquarters functions that support senior executives can be regarded as part of intangible investments. Eisfeldt and Papanikolaou (2013), for example, use SG&A expenses as a proxy for intangible investments, and find a positive association with company performance. This calls into question the popular belief that shrinking headquarters leads to improvements in efficiency.

Centralisation of decision-making and the size of headquarters

The optimal size of headquarters is closely related to the centralisation of decision-making. That is, the more decision rights are delegated to separate business units such as individual factories and shops, the lighter will be the burden of the headquarters. There are many theoretical studies on the trade-off between centralisation and decentralisation of decision-making (see Bloom et al. 2010 for a survey). To summarise concisely, when coordination among business units or establishments is necessary, the role of the central headquarters will be greater. On the other hand, when collection of information at the local level and quick responses to market changes are important, the role of the central headquarters will be smaller. Both centralisation and decentralisation have costs and benefits, and the optimal level of centralisation depends on various company characteristics. In other words, large headquarters are not necessarily inefficient from a theoretical point of view.

The size of headquarters is also related to the effects of information and communications technology (ICT). The use of ICT may strengthen the advantage of centralisation to headquarters through quick and efficient communication with business units and establishments within a company, but another aspect of ICT may promote decentralisation to the individual units due to superior information processing at the local level (Bloom et al. 2013).

According to international comparative studies, Japanese companies are unique in their relatively large headquarters (Collis et al. 2007) and low degree of decentralisation (Bloom et al. 2012). A possible interpretation of these distinct characteristics is that under the Japanese management style – with practices such as long-term employment and frequent rotation of employees – headquarters have strong control over individual business units and establishments.

Headquarters functions and productivity

While the role of headquarters functions has been discussed frequently, formal empirical studies of the relationship between headquarters and productivity have been scarce. In order to shed light on this issue, I analyse the relationship between the size of a company’s headquarters functions and its total factor productivity (TFP) using a panel of more than 40,000 Japanese companies for the period 2001–2011 (Morikawa 2014). The data is taken from the Basic Survey of Japanese Business Structure and Activities (Ministry of Economy, Trade and Industry) – a representative government survey of Japanese companies. The survey has information on the number of employees and the composition by the functional units of the headquarters.

In my analysis, I define the size of the headquarters functions as the proportion of the company’s total employees engaged in the general affairs, personnel, and accounting departments of the headquarters. The mean, median, 10th percentile, and 90th percentile of this ratio are 8.6%, 6.7%, 2.4%, and 16.7%, respectively. There is a large dispersion of this ratio among companies, even within the same industry (see Table 1).

Table 1. Distribution of the size of headquarters functions by industry

Mean p10 p50 p90 All industries 8.6% 2.4% 6.7% 16.7% Manufacturing 8.5% 2.5% 6.4% 16.8% Wholesale 10.6% 3.6% 8.6% 19.0% Retail 6.9% 1.5% 5.3% 13.8% Service 7.7% 1.4% 5.4% 15.6%

Source: Basic Survey of the Japanese Business Structure and Activities (~300,000 observations).

According to my ordinary least squares (OLS) and fixed-effects estimation results, the size of headquarters functions has a positive and statistically significant relationship with the TFP level of the company. In addition, the use of ICT networks (e.g. a local area network) inside the company and the size of headquarters functions have a complementary role for TFP (see Figure 1).

Figure 1. Effects of headquarters functions on TFP

Notes: The bar indicates the effect of a one standard deviation (about 8%) larger headquarters on TFP. The light blue portion is the additional effect of the interaction of headquarters size and the use of ICT networks inside the company. The control variables include company size, company age, three-digit industry dummies, and year dummies.

The results suggest that strengthening of headquarters functions generally contributes to companies’ overall productivity, and that the benefits of ICT are greater for companies with relatively large headquarters functions. Downsizing headquarters to meet the short-sighted objective of reducing indirect costs may be harmful for long-term company performance.

Editor’s note: The main research on which this column is based (Morikawa 2014) first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.

References

Bernard, Andrew B and Teresa C Fort (2013), “Factoryless Goods Producers in the US”, NBER Working Paper 19396.

Bloom, Nicholas, Raffaella Sadun, and John Van Reenen (2010), “Recent Advances in the Empirics of Organizational Economics”, Annual Review of Economics, 2: 105–137.

Bloom, Nicholas, Raffaella Sadun, and John Van Reenen (2012), “The Organization of Firms across Countries”, Quarterly Journal of Economics, 127(4): 1663–1705.

Bloom, Nicholas, Luis Garicano, Raffaella Sadun, and John Van Reenen (2013), “The Distinct Effects of Information Technology and Communication Technology on Firm Organization”, CEPR Discussion Paper 9762.

Collis, David, David Young, and Michael Goold (2007), “The Size, Structure, and Performance of Corporate Headquarters”, Strategic Management Journal, 28(4): 383–405.

Corrado, Carol, Charles Hulten, and Daniel Sichel (2009), “Intangible Capital and U.S. Economic Growth”, Review of Income and Wealth, 55(3): 661–685.

Eisfeldt, Andrea L and Dimitris Papanikolaou (2013), “Organization Capital and the Cross-Section of Expected Returns”, Journal of Finance, 68(4): 1365–1406.

Fukao, Kyoji, Tsutomu Miyagawa, Kentaro Mukai, Yukio Shinoda, and Konomi Tonogi (2009), “Intangible investment in Japan: Measurement and Contribution to Economic Growth”, Review of Income and Wealth, 55(3): 717–736.

Morikawa, Masayuki (2014), “Are Large Headquarters Unproductive? Evidence from a Panel of Japanese Companies”, RIETI Discussion Paper 14-J-028 (in Japanese).