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Berkshire Hathaway managers flourish in decentralized structure

Berkshire Hathaway managers flourish in decentralized structure

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Berkshire Hathaway managers flourish in decentralized structure

Lawrence Cunningham COMMENTARY

Twenty five years ago, value investing was nowhere to be found in the curriculum at most American business schools. But thanks to Warren Buffett's example as CEO of Berkshire Hathaway Inc., it is now squarely in the mainstream of business education.

Today, decentralized management is likewise neglected in the academy, while Berkshire proves its virtues, suggesting that the subject also may be moving mainstream.

Decentralization — pushing autonomy and responsibility downward throughout the business organization — pervades Berkshire. Some would say it is the secret sauce that makes the company tick. This theme of decentralization is encouraged by the example at the top of the company.

Warren keeps Berkshire simple: There is not even an organizational chart.

He brags of employing only 25 people at Omaha headquarters in a conglomerate brimming with 367,671 employees. Warren makes almost all Berkshire-level capital allocation decisions, including acquisitions.

On major outlays, he consults Charlie Munger, Berkshire vice chairman, and, in the past decade, hired two investors — Todd Combs and Ted Weschler — to manage about $10 billion each of Berkshire's $122 billion securities portfolio.

Formal oversight of Berkshire's 60 direct subsidiaries involves financial matters, led by five officers in Omaha: chief financial officer, controller, director of internal auditing, treasurer and a vice president of finance.

The only other officer is the corporate secretary, something like a general counsel, but primarily overseeing the law firm that handles Berkshire's acquisitions and securities work — Munger Tolles & Olson.

Each Berkshire subsidiary is self-contained, with all traditional corporate functions, and defines its own departments. The result is overhead at Berkshire headquarters of approximately $1 million annually and salary expense under $10 million. For context: Berkshire's annual revenues are $223 billion.

For additional support, each subsidiary has a small board, typically five members. Warren serves on larger and risk-sensitive ones. Each CEO sits on his or her own board, with other directors supplied by Berkshire's board, the Omaha team or sister Berkshire CEOs.

All other corporate functions remain at each subsidiary after acquisition, as before, with their own organizational structures.

As Berkshire has grown in the past two decades into a galactic conglomerate, and Warren's attention spread thin, the company has decentralized not only by maintaining acquired businesses as decentralized autonomous units but by:

Classic decentralization, meaning further pushing functions down at the subsidiary level.

Segmented decentralization, by splitting acquired businesses further.

And by upward decentralization, increasingly pushing senior managers up.

Classic decentralization is illustrated by Berkshire Hathaway Energy (BHE) under Greg Abel. Greg began running the group's main business, MidAmerican, in 1998.

Since then, he has led 15 major acquisitions to build a conglomerate, now generating $18 billion in revenue, with five utilities, two pipelines, numerous renewables and hundreds of real estate brokerages. As often happens with growth, centralization crept in, with many functions at headquarters and related overhead costs.

In recent years, Greg and BHE aggressively decentralized, pushing all functions down. The head office now has 27 employees, out of 20,735 companywide.

The logic for this decentralization runs along both geographic and product lines: The businesses are in specific regions and face different pricing environments, regulatory oversight and labor relations. Each unit gains from autonomous local leadership with their own infrastructure and personnel.

At headquarters, there's a general counsel and three lobbyists to coordinate global regulatory issues, and a human resources director whose consolidated expertise on unionized labor markets helps negotiations in each unit. Except for internal audits, all other functions are pushed down.

Decentralization by segmentation often occurs at Berkshire upon acquisition.

For example, in 2006, Berkshire's Fruit of the Loom subsidiary, the underwear company, acquired Russell Athletics, maker of athletic apparel such as jerseys and uniforms. Russell also owned a few specialty businesses, including Brooks Running Shoes.

After the deal closed, Warren asked Brooks' president, Jim Weber, whether Brooks was similar to or different from Russell and Fruit. Jim said although both primarily manufactured abroad and shipped worldwide, the two had little else in common.

They then moved Brooks out of the Fruit hierarchy to make it a direct Berkshire sub with Jim in charge, responsible for his own profit-and-loss statement, or P&L.

Warren's logic focused on differences. Fruit and Russell make commodity goods that don't enhance athletic performance to jocks, fans and other ordinary consumers through general retailers in a competitive price environment, with little need for research and development, or R&D.

In contrast, Brooks sells performance-enhancing athletic equipment to avid runners in high-end shops and charges a premium, as rivals compete on quality more than price, in turn making R&D investment considerable.

In another case, in 2000, Berkshire acquired Justin Industries, a mini-conglomerate composed of a few boot companies and several brick companies, called Acme, operating under centralized management. The founder, John Justin, admitted that the products had little in common, quipping that at least all were made of natural materials.

Warren again stressed the differences.

Boots can be produced anywhere and are generally manufactured abroad and shipped worldwide. They're sold through retail outlets to individuals.

With Justin's strong, ad-driven, Western-style branding, its products command some pricing power. Boots wear out naturally, so loyal customers buy again. As an organization, these features tended to make useful a relatively centralized approach to design, manufacturing and marketing.

Brick production, on the other hand, is constrained by weight and geography, and produced and distributed more locally. Buyers are primarily commercial parties in competitive markets that put a premium on relationships, and Acme offers 100-year warranties.

These features make Acme more effective when organized regionally, with production and sales as independent business operations, while investing centrally in quality control.

Warren, therefore, separated the businesses. Each became a direct Berkshire subsidiary, with each chief executive fully responsible for the entire P&L from operations through administration. This decentralization has enabled both companies to prosper far more than they would have under the same corporate roof.

Upward decentralization is illustrated by what Frank Ptak has been doing at Berkshire's Marmon Group, a manufacturing powerhouse boasting $7.5 billion in sales last year.

In 2005, before Berkshire bought Marmon, Frank became CEO. He faced 10 divisional direct reports, which he thought was too many. He therefore segmented the 10 divisions into three companies, with three direct reports.

As Marmon grows, adding divisions, it forms new companies, so today there are four companies with 16 divisions comprised of 175 businesses with separate P&Ls. The rationale is simple: As a company grows ever larger, no manager can master everything, so senior managers must constantly segment and delegate to levels where junior managers, in aggregate, can do so.

Upward decentralization can be an ideal model to handle not only growth, but also the challenges of succession. This is illustrated by recent change at Berkshire's insurance business, with annual revenues reaching $46 billion. Warren has for decades had three direct reports from major units since their acquisition — Tony Nicely at Geico; Ajit Jain for insurance operations; and Tad Montross at GenRe.

Last year, when Tad retired, rather than simply find a successor, Warren added GenRe to Ajit's duties as president of the company's umbrella insurance division, Berkshire Hathaway Reinsurance Group. Now Tad's successor reports not to Warren, but to Ajit. This both expanded Ajit's purview over Berkshire's insurance operations and cut Warren's direct reports.

This change excluded Geico, where Tony still reports to Warren, sensible given Tony's decades-long tenure. But I suspect that Tony's successor will report to Ajit or his successor, not Warren or his. This form of upward decentralization is therefore a model that can be used in the future to accommodate further successions, whether Tony or Warren or others across Berkshire's various segments.

All organizational structures pose trade-offs.

Decentralization allows for efficient and effective decision-making by managers closest to the issue. However, it runs the risk of erroneous decision-making, too.

But Warren justifies it: "We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly — or not at all — because of a stifling bureaucracy."

A commonly cited advantage of centralization is avoiding duplication of resources. But at Berkshire, it seems to work the other way around: There may be 60 legal departments instead of one, but the alternative likely would be a general counsel's office far larger than the sum of those existing at the subsidiaries.

Efficiency follows because each manager has economic and cultural incentives to minimize the size of his own staff. And that is the ultimate advantage of Berkshire's decentralized model: Each CEO can design the structure best suited to his or her specific operations.

Students may not learn these management methods at Columbia Business School or University of Pennsylvania's Wharton School today. But as Berkshire's managers continue to flourish in a decentralized structure, Warren may once again be reshaping the business school curriculum of tomorrow.

Lawrence A. Cunningham is a professor at George Washington University and author and consultant on corporate culture and governance. His books include "The Essays of Warren Buffett: Lessons for Corporate America" and "Berkshire Beyond Buffett: The Enduring Value of Values," both on sale today from the Bookworm at Berkshire's annual meeting.

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