Separation of Ownership from Management Function.
The traditional economic model of the firm is Adam Smith's pin factory. The "representative" firm of traditional economics identified the form of business as a property of the owner-manager. Under sole proprietorship forms of enterprise, the high level of risk-taking involved in the undertaking of a business constrained business development and limited participation in commerce to the very wealthy capable of assuming such risks. The model fits the factory, retailer, and trading establishment as these organizations existed at the beginning of the Industrial Revolution and as business enterprise, in the main, existed until the twentieth century. But, even as the model of sole proprietorship, in which the business firm is identified legally and in economic theory with the owner, persisted, the business organization was developing into the modern corporation, separating the business entity legally from the liability of owners and diffusing ownership across multiple, disparate owners.
Emergence of the Corporation.
While trading corporations with multiple investors is an idea that goes back at least to the fifteen century in which maritime trade and exploration was carried on under the aegis of the government, often backed by private investors, each expedition was considered a separate speculation with independently subscribed capital. The business enterprise was not an-ongoing concern. In 1600 the East India Company was formed to exploit commerce and imperialist adventures in the Asian subcontinent. This venture, unlike previous corporations, was prolonged. By 1613 stocks were being subscribed for four year periods, providing continuity, permanence, and transferability of capital invested in an enterprise.
Although the stock company was the foundation for the rise of corporate enterprise, the incorporated firm did not take root until the 1800's - largely because stock companies were commonly associated with speculations and scandal. With the Industrial Revolution the combination of new technologies in power and in manufacturing required large amounts of capital; and, by 1856 the English Joint Stock Companies Act granted limited liability. Stock holders could invest in an on-going business concern and have limited liability as for as the activities of the business were concerned. The business enterprise was a "legal fiction" held responsible under laws to its own actions. Similarly, in the United States, the demand for capital, especially for financing of the intercontinental railroad lead to the development of the corporate form of enterprise.
In the United States the emergence of the modern business enterprise is usually traced by historians to the railroads. The railroads in the 1850's faced new problems of coordination and control: coordination of activities beyond a single location and across a vast expanse of track, scheduling of trains running two directions on a one-way track, moving of freight and passengers with variable demands, and variable pricing of freight and other services. Management emerged when railroads traversed a distance greater than one person and personal assistants could supervise. The railroad firm was a multi-unit organization consisting of geographic divisions responsible for 50 to 100 miles of track. Each of these divisions had sub-unit organizations, departments responsible for specialized functions: such as, train movement, passengers and freight traffic, railroad and machinery maintenance. Each function had to be controlled and coordinated, giving rise to the need for middle managers. Middle management was an invention of the railway business and did not exist prior to the 1850's. Middle managers supervised discrete lower-level activities and reported to higher level management - the general superintendent, the president, the board of directors. This new form of organization is the horizontally integrated firm.
The railroad was but one species of the new business firm coping with innovative ways of coordination within an organization no longer fixed at one location. In Germany, Georg Siemens between 1870 and 1880 grappled with development of management structures for the Deutsche Bank. The Deutsche Bank was not the first universal bank. The French Crédit Mobilier, established by the Pereire Brothers in Paris in 1850, pioneered private banking as a source of capital for industrial development. The bank failed, largely because it lacked a base of depositors and relied upon speculative investors as the source of funds. Commercial banking in England also failed to flourish. Unlike the French experience, English banking developed a broad deposit base, but failed to link bank funds with industrial financing. And, hence, played no significant role in the development of a capital market required to support national economic development.
The Deutsche Bank combined both a broad base of depositors for a source of capital and commercial banking to invest in industrial development. Different from earlier European banks, banking was not centralized at one location. The Deutsche Bank operated from banking centers in Hamburg, Frankfurt, and Munich. This permitted the Deutsche Bank to establish strong expertise and relationships with regionally based businesses, as well as, expand its national depositor base. The coordination of specialized banking and investment functions across multiple geographical markets required that top management be an integrated group of professionals with expertise in specific areas. Siemen's innovation was to transform the traditional European bank from family owned partnerships to an enterprise managed by a team of professionals. Under Siemens, as head of the management team and chairman of the board, a team of managers oversaw specific, key activities: such as, underwriting or industrial investments. Management of the new, evolving enterprise required a specialized organization to achieve effective coordination and control.
The modern business enterprise, as it was developing the U.S. through the
railways and in Germany through banking, differed from the traditional firm in
two fundamental respects:
(1) It was not fixed at one location. The modern business was an organization of
multiple operating units, each in different locations and carrying out diverse
economic activities. This is the horizontally integrated firm.
(2) It was characterized by multiple levels or a hierarchy of managers - top and
middle management tiers - who coordinated and controlled operations, making
decisions ostensibly not on the basis of individual self-interest but on the
basis of collective interests of the firm.
Implications of Debt and Equity Capital on Modern Corporate Development.
To finance growth of the modern enterprise, capital was required. The available sources are equity and debt. The simplest forms of equity being the owner's financial contribution and the firm's ability to generate profits as retained earnings. When firms were able to realize sufficient profits to finance growth, family ownership of the business survived. This was especially notable in the retail industry.
By the 1880's mass retailers, such as department stores, chain stores, and mail order businesses, had replaced the traditional shop and wholesaler. Each of these retailers organized by building extensive purchasing departments dealing directly with manufacturers, established multiple branch offices, and coordinated inventory management and marketing through a central headquarters. Profits were generated by high stock turns on competitively priced goods. High stock turnover meant that low priced goods could return high profits because of volume sales. It also meant that overhead, the retailer's management and plant costs per unit of goods sold, were reduced. Low capital requirements and high profits meant that mass retailers could finance growth through retained earnings. The famous retailing families -Wanamaker's, Fields, Filenes, Kresges, the Strauses of Macy's, the Rosenwalds of Sears and Roebuck, and the Hartfords of A and P - retained control over their businesses well into the 20th century. While these retail enterprises developed the form of modern business with multiple units of operations centrally controlled and a hierarchy of management, ownership and top management remained intact until problems of family succession into management roles became problematic and families relinquished management to professionals, or until the requirements of new capital to finance growth lead to wider stock ownership, dissipating family control.
Where vast capital was required, pricing more complex, and business yielded no guaranteed steady stream of available cash, outside financing had to be secured. Although until the twentieth century most of American investments were through bonds, considered less risky, the shear volume of capital required for a vast construction of rail tracks and the high costs of equipment pushed innovation in the search for capital. By the 1850's railroad securities were traded in the hundreds of thousands on the New York Stock Exchange. The volume of transactions and insatiate demand for finance lead to new investment techniques: "puts" and "calls", trading "short" and "long", and trading "on margin". Reputations and vast wealth were made based on dealing in railroad securities in the mid-1800's.
Securities in American railroad companies and projects were sold to major investment bankers both in the U.S. and in Europe. Financial investors in railroads were not interested in management. Even financiers who held positions on railway boards had little more than veto power over operations. They had little information about operations, little experience in the business, and little commitment of time to become involved in management of the business. The railroads were managed by managers, not owners.
The building of a national railroad system in the United States by the turn of the century accompanied other profound changes, the country moved from an agrarian society to an urban one. A national market for business was supported by an extensive transportation system, both by waterways and by train, and by a national communications system developed by the monopoly of Western Union. This infrastructure provided an impetus to the creation of big business and the rise of consumer goods as big business, taking the form of a new organizational innovation - the vertically integrated firm. The vertically integrated firm is a single business enterprise that coordinates and controls the flow of resources from raw materials and manufacturing to distribution. Unlike the traditional, functional form of organization, the vertical firm is a combination of managed business units that are linked in buyer-supplier relationships, providing at each phase of production an activity that is utilized by another business unit.
Swift Meat Packing.
Illustrative of the development of the vertically integrated firm is the story of Swift meat packing. Gustavus F. Swift saw that in the post Civil War period, large urban areas of the East, New York, Philadelphia, Boston, were outgrowing their reliance on local farmers for the supply of beef. He also saw that in the West, large cattle herds were developing. The problem was to bring the two, demand and supply, together. Moving from Massachusetts to Chicago in the mid-1870's, Swift experimented with transporting beef by refrigerated rail car which he demonstrated to be feasible in 1878. During the 1880's Swift established a national network of "branches", each with a storage capacity and an ability to market Swift's products. Warehousing was needed to provide an orderly means of distributing goods to regional markets from the meat packing plants, which by the 1890's were located in Kansas City, Omaha, and St. Louis. The marketing element was needed to overcome consumer prejudice against meat products that were not only not fresh, but originating from cattle slaughtered thousands of miles away. Swift also had to develop a means by which to counter boycotts and efforts by local butchers to prevent the introduction of cheap beef.
The success of transporting refrigerated beef lead to an expansion into other product markets: poultry, eggs, and dairy products. Before the end of the 1890's, Swift was a vertically integrated firm with functional operations, marketing, processing, purchasing, and accounting, controlled by the central headquarters in Chicago. By telegraph the central office communicated with branch offices to adjust the shipment and supply of products to local market conditions to ensure price levels. Other meat packers followed Swift's lead. Armour, and others, established vertical organizations. Those that did not, remained local companies.
Firms in other consumer goods industries formed similar kinds of integrated organizations. By 1895 James B. Duke had built the American Tobacco Company - a combination of his own tobacco firm, five other merged rivals, a collection of warehouses, and buyers in tobacco-growing areas. Dike's enterprise was. coordinated by a New York based headquarters responsible for manufacturing, marketing, purchasing and finance. Cyrus McCormick's farm equipment company and William Clark's Singer Sewing Machine Company, organized a central purchasing operation that dealt directly with raw material producers, manufactured products, established branch offices to provide sells and service, and pioneered consumer credit to finance sales. Vertically related business units and branch offices increased the growing demand for professional managers.
The Trusts.
The separation of management from ownership also was driven by the emergence of the trust. Partially as a consequence of an economic depression in 1870, firms consolidated into "trusts". The intent was to control prices and levels of production, and thereby maintain levels of profit. Created by the exchange of participating companies' shares for certificates issued by the trust, the trust permitted a central board to manage a number of businesses, typically operating in one industry. The trust was an agreement by rival firms to merge into a larger business that, then, operated as a monopoly. Since the board members held the stocks of all merged firms, the members benefited directly in the prosperity of the trust. Through such an arrangement the Standard Oil Company controlled 90% of oil refining capacity in the country by 1892. Success of the trust in ensuring business profits lead to similar monopolies: the American Cottonseed Oil Trust, National Linseed Oil Trust; National Lead Trust; Distillers' and Cattle Feeders' Trust; Sugar Refineries Trust; and, the National Cordage Company. Under the trust agreement ownership was removed from management. Stock holding was dispersed across a large number of shareholders. To secure greater capital for financing industry-wide growth, the trusts turned to the stock exchanges. In a few cases financial interests were represented on the boards of trusts, but typically were not assertive in managing the enterprise. For management, the trust turned to salaried managers who held no financial investment in the trust.
The Visible Hand of Management.
The Sherman Antitrust Act of 1890 eventually brought an end to the era of trusts in the U.S. By the turn of the century the large integrated firm, professionally managed, and financed largely by outside capital was well established. In Europe restrictions on cartels and monopolies did not fully develop until the 1950's. And, in Europe the influence of family ownership, the use of bank financing, growth through negotiated arrangements with other family owned businesses, and the installment of family members into key managerial positions persisted until fairly recently, delaying the rise of the professional manager. Seen, in part, as a way of rebuilding post-WWII economies, Europe and Japan turned to the education of professional managers.
Although there was no developed "management" literature and no academic discipline called "management", the need of American business for professional managers led to the creation of the first business school, the Wharton School of the University of Pennsylvania. in 1881. Not until 1903 would Frederick Taylor, father of scientific management, publish his Shop Management explaining the role of management in motivating workers and laying the foundation for management as discipline. The Graduate School of Business at Harvard University was founded in 1908. New York University pioneered graduate programs for practicing managers beginning in 1918.
These historical changes in the way in which business is conducted have profound consequences . The traditional firm was a single organizational unit, producing a single product in one market, managed and owned as a sole proprietorship or partnership. The modern business that develops in the later part of the nineteenth century operates in multiple markets, produces a variety of goods and services, is organized as a multi-divisional structure, is operated by a hierarchy of professional managers, and is owned by a diverse, dispersed base of stockholders.
Since WWII the integrated, modern enterprise has become the dominant business form. The development of mass markets, increased demand for consumer goods and, more recently, the globalization of business have fostered greater growth - increasing .both product diversification and the number of markets in which the enterprise competes - and assured the place of the professional manager as not only a trained agent for the conduct of business but as strategist for continued growth and competitiveness of the firm.
Observing the persuasiveness of the modern enterprise, and the effectiveness by which it permitted decision-makers to coordinate and control (1) the diverse production activities across markets and (2) the transactions by which raw materials were converted into intermediate and finished goods and then marketed, the business historian Alfred Chandler concluded that in the twentieth century the "invisible" hand of Adam Smith's market had been replaced by the "visible" hand of management.
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