How can firms address the adverse effects of geographic friction during expansion?

Distance and other geographic frictions between firms’ headquarters and their establishments have a negative effect on performance. This column shows that hiring middle managers helps firms mitigate the impact of geographic frictions, by improving the efficiency of management resources. Factors affecting the efficiency of a local establishment have knock-on effects for the whole firm, regardless of distance.

The Death of Distance (Cairncross 2001) or The World is Flat (Friedman 2005) – book titles like these suggest that new information and communication technology (ICT) reshapes the landscape of economic activity and renders geography largely irrelevant. However, while ICT has certainly facilitated the geographic expansion of firms, distance still matters. Empirical evidence shows that geographic frictions between the headquarters and establishments have a significantly negative impact on the performance of multi-establishment firms as well as multinational firms (e.g. Giroud 2013, Kalnins and Lafontaine 2013, Keller and Yeaple 2013).

How can firms address the adverse effects of geographic frictions to fully reap the benefits of geographic expansion? We argue that adjusting their managerial organisation can help firms mitigate the negative impact of distance and other geographic frictions. In a recent paper (Gumpert et al. 2019), we empirically and theoretically analyse how geographic frictions affect the managerial organisation of firms. We show that geographic frictions increase the use of middle managers in multi-establishment firms. Importantly, geographic frictions affect the managerial organisation of both the establishments and the headquarters.

Data

Our empirical analysis is based on a new, detailed and linked firm-establishment-employee dataset for Germany that combines information from the social security records of the German Federal Employment Agency and balance sheet data from the Orbis database by Bureau van Dijk.1 To measure managerial organisation, we assign employees to managerial layers based on their occupation in the social security data (following Caliendo et al. 2015).

Geographic frictions affect the size and managerial organisation of firms in the data

We start by establishing a set of descriptive facts regarding the following questions.

1) How do geographic frictions affect the investment probability and size of establishments?

2) How do geographic frictions affect the managerial organisation of firms?

3) How do firms reorganise over time?

Concerning the investment probability and establishment size, we find that firms set up additional establishments to benefit from wage or factor price differences across counties in Germany, or to be closer to their customers. This pattern is consistent with cost-cutting or market-seeking motives for investment. Importantly, geographic distance from the headquarters has a significantly negative effect on the probability that a firm locates an establishment in a county. The farther away from the headquarters they are located, the smaller the establishments are.2

Prior research on the managerial organisation of firms focuses on size as the main determinant of the managerial organisation (e.g. Caliendo and Rossi-Hansberg 2012). Importantly, we find that geography also affects firm organisation. Multi-establishment firms use more middle managers, the larger the distance between their headquarters and their establishments. Figure 1 shows that the number of managerial layers of multi-establishment firms increases with the maximum distance between their establishments and their headquarters. We run a series of regressions taking into account firm size as well as location characteristics to make sure that this relationship is not just driven by larger firms with more managerial layers investing at more distant destinations. We show that distance has a sizeable effect on the managerial organisation – doubling the distance is associated with the same increase in the number of managerial layers as 14% higher sales. Distance increases the use of middle managers both at the headquarters and the establishments.

Figure 1 Bin scatter plot of the number of managerial layers and the maximum distance to headquarters

When we study the reorganisation patterns of firms over time, we find that firms do not add or drop managerial layers at the headquarters and establishments at the same time. Instead, they typically add or drop middle managers either at the headquarters or the establishments. This suggests that middle managers at the different units of a firm are substitutes.

Geographic frictions affect the organisation of the headquarters and establishments in theory

Why do geographic frictions affect the managerial organisation of firms? To answer this question, we develop a model of multi-establishment firm organisation based on the knowledge hierarchy framework (Garicano 2000), as shown in Figure 2.

Figure 2 Intuition of the model mechanism

For simplicity, we consider the smallest possible multi-establishment firm – a firm with headquarters and one establishment. The CEO of the firm is located at the headquarters and manages both the headquarters and the establishment. An important feature of our model is that we explicitly take into account that the CEO has only limited time – the day has only 24 hours, after all (Figure 2 top-left).

Our model assumes that geographic frictions between the headquarters and the establishment increase the amount of time that the CEO needs to manage the establishment. This captures that the CEO of a multi-establishment firm may have to regularly travel to the establishment, for example. As a result, the CEO spends a disproportionate amount of time on the establishment (Figure 2 top-right). The time spent on the establishment cannot be spent on managing the headquarters. Geographic frictions therefore decrease efficiency both at the establishment and the headquarters.

How can the firm address this problem? A middle manager at the establishment can take over part of the managerial duties of the CEO. Hiring a middle manager at the establishment therefore allows the CEO to reduce the amount of time spent managing the establishment (Figure 2 bottom-left). The CEO now has more time for managing the headquarters (Figure 2 bottom-right). Hiring a middle manager at the establishment is therefore beneficial for both the establishment and the headquarters.

The model explains why geographic frictions decrease the probability that a firm maintains an establishment at a location as well as establishment size, why they increase the use of middle managers in multi-establishment firms, and why firms typically add managerial layers at either the headquarters or the establishment.

Response to opening of high-speed train routes confirms model predictions

An important prediction of the model is that geographic frictions between the headquarters and the establishment affect not only the organisation of the establishment, but also the organisation of the headquarters. To assess whether this prediction holds in the data, we exploit the opening of high-speed train routes in Germany (see Figure 3). We study the effect of faster travel times between the headquarters and the establishment on the managerial organisation. Faster travel times reduce the geographic frictions faced by German multi-establishment firms.

Figure 3 Map of German long-distance railway network (black) with new high-speed train routes (bold red)

Our results are consistent with the model. The new train routes increase the size of the establishments that benefit from faster travel times. Importantly, their effects are not restricted to the establishment. Firms adjust the managerial organisation of the headquarters and other establishments of the firm after the opening of the new routes.3

Implications for the propagation of shocks across space

To summarise, geography matters for the managerial organisation of firms. Middle managers can help firms mitigate the negative effect of geographic frictions between establishments and headquarters on firm performance. Firms adjust their managerial organisation not only at the establishment, but also at the headquarters in response to geographic frictions. An important implication of this finding is that local economic conditions affect not only the organisation of the local establishment, but also the headquarters and other establishments of a multi-establishment firm. Local conditions thus propagate across space through multi-establishment firm organisation.