The Hidden Champions - Joint Project (Paper) - MBA


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The Hidden Champions - Joint Project (Paper) - MBA

  1. 1. The Hidden Champions: Germany’s Secret Success Team Delta: Katie Adgent Paige Bigham Margaret Dischler Matthew Farmer Economics 7100 12/9/10 ABSTRACT On October 12, 2010, 33 Chilean miners were thanking Micon, a small, family-owned company located in a rural German town for producing such a reliable tool that was necessary for their rescue. Micon is just one of the companies that falls under the term Mittelstand, a business model that has allowed German companies to thrive even after the Great Recession. We have used articles, papers, presentations, and professors to accurately outline the relevant economic history of Germany, the Mittelstand trademarks, described an elite group within the Mittelstand known as the “hidden champions,” as well as possible flaws in the model.
  2. 2. Team Delta 2 TABLE OF CONTENTS I. Introduction 3 II. Germany’s Economic History 4 a. Unemployment Before, During, and After the Great Recession 5 b. GDP Before, During, and After the Great Recession 6 c. Germany Compared to Other Countries 7 III. The Mittelstand Companies 8 IV. Governance 10 V. Operational Effectiveness 11 VI. Strategy 12 VII. Market Structure 13 VIII. Potential Problems 15 IX. Conclusion 16
  3. 3. Team Delta 3 I. INTRODUCTION Culture plays a huge role in defining business strategy in each country. In America, we are known for taking risks and making decisions quickly. The Mexican culture focuses on building personal relationships before making business decisions. The Japanese like to see that those looking to conduct business are respectful of cultural traditions. Germany, too, has its own business culture that is not quite as recognizable as the others. In a time of economic recovery after the Great Recession, economists are looking to the past couple of years and noticing trends. Some help to answer questions we have while others generate even more questions. When observing the trends in Europe, it is easy to see that Germany recovered from the recession much more quickly than some of its neighbors like Spain and Greece. In this paper, we seek to explain the exact mechanisms that Germany had in place that both allowed them to flourish over the last fifteen years and come out of the recession with stable growth and a relatively unaffected rate of unemployment. We will posit these explanations by first talking about Germany’s overall economic history leading up to this recent period of prosperity, then going into the details of their exact economic outlook during the recession. We will then move on to the main secret of Germany’s success: the Mittelstand.1 Finally, we will draw some conclusions from all of the data that we have gathered about how effective the Mittelstand is and why it works so well, particularly in Germany. 1 The German phrase “Mittelstand” is translated to “medium sized” and is now used when describing “family-owned companies with fewer than 500 employees and annual sales of less than 50 million euros” (Kirchfeld and Randow 2010). Other distinctive characteristics are the long-term orientation, family ownership, and a responsibility to stakeholders instead of shareholders.
  4. 4. Team Delta 4 II. GERMANY’S ECONOMIC HISTORY In order to fully understand where Germany’s economy is coming from in terms of growth, we need to take a brief look at Germany’s economic history. For the sake of simplicity, and because the mention of earlier periods would be largely irrelevant, we will start with Germany’s situation during the Great Depression. Germany was hit particular hard during the interwar years that followed what is now referred to as World War I. They were affected by the Great Depression, as most European countries were, but they were also landed with the responsibility of paying off the multitude of war reparations that had been imposed on them by the Treaty of Versailles. It was into this period of economic stagnation that the Nazi Party stepped in, bringing with them a quick return to Germany’s former economic prosperity. Unemployment declined significantly, the incredible amount of inflation experienced just years earlier was curbed, and many businesses were finally able to pick up the pieces. All of this came about because of Germany’s transformation into that of a Centrally Administered Economy (Watkins n.d.). After World War II ended, it became increasingly obvious that a strong border was developing that would eventually separate Germany into two separate nations and, accordingly, two separate economies. For the first few years after the war, the allied forces kept many of the unsustainable economic policies of the Nazi regime in place, but they soon realized that they had yet another potential economic disaster on the horizon in the form of explosive inflation. In 1948, in order to avoid such a disaster, the newly forming Federal Republic of Germany instituted a series of sweeping financial reform, not the least of which was a bold currency reform that would go on to help keep German post-war inflation in check (Watkins n.d.). In the decades to follow, Germany, along with the rest of Europe, saw steady and significant growth in
  5. 5. Team Delta 5 GDP and technological prowess. Between 1950 and 1973, the per capita GDP in Germany more than tripled, after adjustment for inflation (Judt 2006). By the late 1980’s and early 1990’s, however, Germany’s growth began to slow significantly, and the country entered a period of economic stagnation that earned them the phrase “the sick man of Europe” (Venohr and Meyer 2007). Then, something changed for the German economy, allowing a specific type of company to flourish and prosper, bringing Germany out of its “sick man” status and into the forefront of the world economy - globalization. Because Germany is a country that emphasizes exporting, globalization increased the market size, which led to an increase in exports. Globalization proved to be a tremendous asset to companies that fell under the definition of “Mittelstand,” a uniquely German term describing small and medium sized companies that focus on producing highly differentiated products. A. UNEMPLOYMENT BEFORE, DURING, AND AFTER THE GREAT RECESSION One of the most commonly observed elements during any period of extreme growth or decline is that of unemployment. Figure 1 shows five of the world’s top economies and how their unemployment rate has changed during the 2000s. Figure 1: Unemployment Rates of Five Top Economies From 2000 to 2009 Source: Bureau of Labor Statistics, 2010.
  6. 6. Team Delta 6 It should be noted that, although Germany’s unemployment peaked around 2005, it then sharply declined and leveled off during the most recent recession. That sharp peak can mainly be explained by particularly cold winters that caused many construction workers to be laid off and a significant change in the definition by which Germany defined the “unemployed” (Dougherty 2005). One of the reasons that Germany was able to maintain a level unemployment rate was because of the number of barriers that German law has in place to prevent companies from easily laying off workers. Indeed, most German companies found it easier to simply reduce employee hours and then increase them later on, when the economic outlook was less bleak, rather than lay off workers, have to pay out the mandated unemployment benefits, and then go through the lengthy process of rehiring workers a few years later (Ydstie 2010). This process, known by the Germans as Kurzarbeit (short-time work), saved an estimated 200,000 jobs (Employment Outlook 2010 - How Does GERMANY Compare? n.d.). B. GDP BEFORE, DURING, AND AFTER THE GREAT RECESSION Another important aspect of any period of economic turmoil is the GDP growth and contraction itself. It is helpful to look at the trends in unemployment and GDP simultaneously to have a deeper understanding of the actual economic situation (see Figure 2). Figure 2: Germany GDP Growth Rate Source: Trading Economics, 2010.
  7. 7. Team Delta 7 The years in which Germany was particularly hurt by the recession is clear; between mid-2008 and mid-2009, Germany’s economy was contracting instead of growing. This can be attributed to the loss of trade overseas, which was particularly hard on an export-driven economy like Germany’s. This period of GDP decline did not affect the unemployment rates during the same time frame (see Figure 1) due to the practice of Kurzarbeit, mentioned above, which causes much more underemployment than unemployment. C. GERMANY COMPARED TO OTHER COUNTRIES In order to understand Germany in the context of its neighbors, we will now look at a pair of graphs that show how Germany compares to the rest of Europe. Figure 3 refers back to Germany’s trade dominance, which was mentioned earlier. Figure 3: Europe’s Unbalanced Economy Source: Eurostat. Europe’s Unbalanced Economy, 2010. Germany has been able to maintain a significant lead with its trade surplus, not only among its neighbors in Europe, but also worldwide. Germany is second only to China in trade surpluses
  8. 8. Team Delta 8 worldwide (International Trade Statistics 2010 n.d.), despite the decrease in international demand of its companies’ products. Figure 4 shows how Germany’s GDP growth compares to that of its European neighbors. Figure 4: European economies’ GDP Source: Eurostat. Germany Leading the Way – Europe’s Economy Following an Upward Trend, 2010. Based on the information represented in Figure 4, Germany is second only to Lithuania in terms of GDP growth for the second quarter of 2010. It is necessary to note that their percentage change from the previous year is higher than any of the other countries represented, meaning that Germany is quickly picking up steam. The recent economic strength of Germany, as exemplified in these two charts, is so strong that Germany no longer deserves the title of "sick man of Europe.” The remainder of this paper is a review of the "Mittelstand," a group of companies who are largely responsible for Germany's current economic strength. III. THE MITTELSTAND COMPANIES Mittelstand is a German term that translates to “middle-sized.” It is used to describe a unique business model that has surfaced in Germany within the past few decades. These
  9. 9. Team Delta 9 companies are small to medium in size, they are usually family-owned, and they have a narrow focus with a global orientation.2 Although these characteristics may describe businesses in other countries, the German politics and philosophies allow them to prosper. Small and medium sized companies (employ less than 500 people) describe 99% of all German companies (Meyer and Venohr 2007). Furthermore, a small or medium sized company employs 70% of the German population (Kirchfeld and Randow 2010). Even though they have been in existence since the middle of the 20th century, they gained global notoriety from the works of Hermann Simon, a German economist and professor. He published Hidden Champions of the 21st Century, a book in which he elaborates on the details of the Mittelstand. It was also around this time that the Mittelstand rose to its dominant position. According to Simon, the Mittelstand is a small to medium-sized business that dominates its world market as the leading company, operates business to business, and has a niche product (Simon 1996). Those companies in the Mittelstand that are described as a “hidden champion” are relatively unknown, yet are a dominating force in the German economy. These businesses are considered to be “hidden” because they operate in a business-to-business manner, meaning they are unknown to the average consumer and are not common household names. Ninety percent of the Mittelstand “shun the limelight” and strictly operate business-to-business. Additionally, seventy percent of all of the Mittelstand organizations are headquartered or located in rural areas instead of in large, metropolitan cities (Schumpeter 2010). Although it can be difficult to compel potential employees to move to small, rural towns, the German culture helps overcome this feat 2 The term “Mittelstand” refers to a broad range of companies with these characteristics. The companies defined as “hidden champions” are an elite group of companies within the Mittelstand who occupy the number one or number two spot in the global niche market, do not generate more than €800 million a year, and have low public visibility (Meyer and Venohr 2007).
  10. 10. Team Delta 10 with their apprenticeship program. The apprentices begin as early as 11th and 12th grade and become highly specialized in the field. In order to further define and further understand the Mittelstand, it is helpful to view the business model with respect to three interdependent functions: governance, operational effectiveness and strategy. IV. GOVERNANCE The authoritative system of the Mittelstand is distinctive because the majority of them are privately owned yet have outside professional management. The private ownership and professional management combination is known as “enlightened family capitalism” (Meyer and Venohr 2007). Normally in family-owned businesses, those who own the company also lead the company. However, the blend of the familial and professional qualities enables the Mittelstand to have an unusually successful approach to business by encompassing the positive aspects of both managerial styles. The owners have an emotional attachment to the company and tend to strive for survival instead of profit maximization. Because less than 500 people are employed, the work environment is more familial and the employees interact as if they were “extended family” instead of coworkers (Schumpeter 2010). Moreover, the structure of the organization is a flat hierarchy, which strengthens the idea of a family and nurtures open communication amongst the employees and owners. The familial feature of the governing structure indicates that the Mittelstand is focused on long-term survival, relentless customer service, and conservative business decisions. External management contributes in a way that promotes more risk, innovation, and professional leadership. As an overall result, enlightened family capitalism proves that “family control ensures long-term investment horizon and balanced stakeholder
  11. 11. Team Delta 11 philosophy [as well as] state-of-the-art management practices contributed by professional managers” (Meyer and Venohr 2007). The governing structure of the Mittelstand is under constant criticism from outsiders. They are said to be too conservative and too small to play such a considerable role in the global markets (Schumpeter 2010). However, these very characteristics have helped to lead them to a quick recovery after the recession. The “extended family” feel combined with the savvy business sense pushes these companies to make conservative, yet well-informed business decisions. V. OPERATIONAL EFFECTIVENESS These companies have more than an understanding of world-class key processes. This is best exemplified in their superior commitment to quality and customer service. “Do one thing and do it well” is a maxim that drives the Mittelstand companies. They have a differentiated product and are determined to make sure it is of the best quality. Many companies claim to have superior customer support, yet few live up to the claim with the sort of vigor and emphasis exemplified by the Mittelstand and their elite “hidden champions.” They excel in managing the “value chain” by spending approximately twice as much time with their customers as large firms in Germany do (Venohr and Meyer 2007).
  12. 12. Team Delta 12 Figure 5: Percent of German World Market Leaders with Wholly-Owned Subsidiaries Source: Venohr, Bernd. The Power of Uncommon Common Sense Management Principles – The Secret Recipe of German Mittelstand Companies – Lessons for Large and Small Companies, 2010. The “hidden champions” typically accomplish this with wholly-owned subsidiaries placed strategically throughout the world in proximity to their largest customer-base (Meyer and Venohr 2007). (see Figure 5). Globalization has increased the market for the hidden champions and allowed them to see lower transportation and communication costs. The CEO of one of the Mittelstand companies is quoted as asserting that they know their customers intimately and that many of their employees have flown to China more than 100 times. They “categorically reject” sales agents despite the small size of their firm and prefer to handle the job themselves (Meyer and Venohr 2007). This dedication to quality and customer loyalty solidifies a loyal customer base that will pay a little more for the product because they know it is of the highest quality. VI. STRATEGY Operational excellence is obviously a key trait of the Mittelstand companies. However, it is really part of the larger picture in terms of the firm’s strategy. As stated above, a majority of the firms are privately owned, and as a result, there is no pressure from the shareholders for sort-
  13. 13. Team Delta 13 term gains. Instead, the Mittelstand companies are able to focus on pleasing stakeholders and emphasize the long-term. The Mittelstand is composed of many “hidden champions” who excel at producing a highly specialized and differentiated product (usually in the manufacturing industry). A niche market is more risky than a highly diversified company, yet the Mittelstand companies have succeeded because of their reliance on technology and innovation as a key aspect of the strategy. The Mittelstand model calls for a higher than average infusion of monies into Research and Development. On average, the 1,000 largest research and development spenders in the world spend 2.2% of sales on R&D, while the Mittelstand companies almost double this percentage spending 5% of sales on R&D (Meyer and Venohr 2007). With less diversification than many large companies, they are able to allocate all of the R&D resources to the improvement of one product. This allows for constant incremental innovations and improvements. VII. MARKET STRUCTURE This commitment to continuous improvement reduces the threat of substitutes and new entrants due to the high barriers of entry created by differentiation. Michael Porter, an expert on company strategy, identifies five forces that contribute to the sustainability of a company, including threat of substitutes, buyer and supplier power, intensity of rivalry, and barriers to entry (Porter 1998). Because the Mittelstand operates in a niche market with a highly specialized product, the barriers to entry are very high, allowing for very few substitutes and less rivalry for the major companies. In consideration of the continuum of market structures (McGuigan, Moyer and Harris 2008), we would see many of them as having a market structure along the lines of a monopolistic competition because of a few key factors: (1) It is easier to enter these markets although effective entry is still difficult, (2) There is more than one dominant firm and there are
  14. 14. Team Delta 14 many less threatening rivals, (3) The firms produce highly differentiated products and perform in niche markets. Figures 6 and 7 help analyze monopolistically competitive firms. Figure 6: Monopolistic Competition, Long Run Figure 7: Monopolistic Competition Short Run Source: Monopolistic Competition, 2010. In a monopolistically competitive market, demand is relatively elastic and substitution is somewhat possible. In the short run, if the price is set where marginal revenues are equal to marginal costs, the firm is making a profit. However, because the barriers to entry are not set as high as in a monopoly, other firms will enter and will drive the price down. In the long run, monopolistically competitive industries will earn only a normal profit where P= ATC. Again, the Mittelstand companies have a long run mindset, and are mostly concerned with the survival of the company. While the majority of the Mittelstand are monopolistically competitive, the “hidden champions” sector function in a monopoly or, at least, a monopoly-like market structure because of their strong control on a niche market. The strongest “hidden champions” hold absolute product differentiation whereas the rest of the firms that fall under the Mittelstand category may have high product differentiation, but it is not absolute. In addition, the monopolistic nature of
  15. 15. Team Delta 15 these companies (Meyer and Venohr 2007) insures that they will continue to shy away from quantity (over quality) since their marginal revenue would diminish as they increased their quantity of output (see Figure 8). In a monopoly, a firm will set the price for the product where marginal revenue is equal to marginal cost. The market demand is the same as the firm’s own demand curve since there are no substitutes. This is how the “hidden champions” prosper and dominate in their niche market. Figure 8: Profits for Monopolistic Firms Source: Monopolistic Competition 2010. Again, the firms use technology as their saving grace, allowing them to constantly innovate and stay ahead of the rest of the marketing in order to maintain the top position in the industry. VIII. POTENTIAL PROBLEMS The Mittelstand model is not flawless. Demand is affected by many factors, such as price, tastes and preferences, income, substitutes and complements. If the demand for the product decreases because of obsolescence, the firm will have to diversify which can be very costly. The firms may also feel pressure to outsource because of lower labor costs, which would eliminate the familial atmosphere that is one of the key factors in the model. Because this model is now becoming more defined and distinct, it will be interesting to see if more companies decide to
  16. 16. Team Delta 16 imitate this model, adding more competition for the Mittelstand companies. For the firms in monopolistic competition, as others enter the market, the supply curve shifts outward, decreasing the price of the product. In turn, the firms will have less money to spend on R&D, which could have a detrimental effect on the future and success of the product. Additionally, because the firm is constantly innovating, the level of inventory could increase due to the incremental changes. The cost of holding the inventory and the cost of producing in excess could be damaging to the firm. The size of the firm is also something to consider. It needs to be small enough to maintain the familial atmosphere and feel less pressure to become public, yet large enough to obtain enough resources to allocate to R&D in order to stay ahead of the potential competition. IX. CONCLUSION The Mittelstand model is comprised of concepts that seem to be common sense for any company. They are value leaders who are committed to customer satisfaction and producing high quality products. They are niche market leaders who give their undivided attention to one product to ensure its success. They operate as an extended family and are more concerned with the long-term survival of the company as opposed to profit maximization in the short run. Constant innovation, strong relationships with employees as well as customers, long-term orientation, and a commitment to one global niche market seem like qualities that many firms could adopt. It is the synergy of all of these qualities along with the German philosophy, economy, and politics that enable such great success in a time when other countries are struggling to maintain their footing. The Mittelstand have been hiding in the background for too long, and although they are not used to the limelight, it is time that they earn the recognition they deserve.
  17. 17. Team Delta 17 References Bureau of Labor Statistics. A Distressing Picture: Unemployment In The U.S. Compared With Other Countries, (accessed December 1, 2010). Dougherty, Carter. "German Unemployment Reaches 12.6 %." The New York Times. March 2, 2005. (accessed December 7, 2010). Employment Outlook 2010 - How Does GERMANY Compare? (accessed December 6, 2010). Economics Online. Monopolistic Competition. (accessed December 4, 2010) Eurostat. Germany Leading the Way – Europe’s Economy Following an Upward Trend. (accessed December 3, 2010). Eurostat. Europe’s Unbalanced Economy. (accessed December 1, 2010). "Germany Trade, Germany Exports, Germany Imports." Economy Watch. (accessed December 1, 2010). "International Trade Statistics 2010." World Trade Organization. (accessed December 3, 2010). In Postwar: A history of Europe since 1945, by Tony Judt, 325-328. Penguin, 2006. Kirchfeld, Aaron and Jana Randow. “Germany’s Mittelstand Still Thrives.” Bloomberg Business Week. (accessed November 30, 2010). McGuigan, James, Charles Moyer and Frederick deB. Harris. Managerial Economics: Applications, Strategy, and Tactics. United States of America: Cengage Learning, 2008. Meyer, Klaus E. and Bernd Venohr. "The German Miracle Keeps Running." MBA-Berlin. May 2007. (accessed December 3, 2010). Porter, Michael. Competitive Strategy. (Cambridge, MA: The Free Press, 1998).
  18. 18. Team Delta 18 Schumpeter. “Mittel-management.” The Economist, November 15, 2010. Simon, Hermann. Hidden Champions : Lessons From 500 of the World's Best Unknown Companies. Boston: Harvard Business School Press, 1996. (accessed December 2, 2010). Trading Economics. Germany GDP Growth Rate, (accessed December 1, 2010). Venohr, Bernd. The Power of Uncommon Common Sense Management Principles – The Secret Recipe of German Mittelstand Companies – Lessons for Large and Small Companies. In: 2nd Global Drucker Forum Vienna 2010; Nov 18-19, 2010. Watkins, Thayer. The Economic History of Germany. (accessed December 6, 2010). Ydstie, John. "On Jobs, U.S. Ranks Worse Than Similar Nations." National Public Radio. September 10, 2010. (accessed December 7, 2010).