THE PROFIT VARIABILITY EFFECTS OF THE MANAGERIAL ENTERPRISE

JOHN PALMER‘ University of Western Ontario

Theories of the “managerial enterprise” have predicted that large cor- porations in which no one person or small group of stockholders own enough of the voting stock t o affect management decisions will, inter a h , report more stable profit rates over time than firms which are to some degree controlled by their stockholders. This paper explains why these theories are incorrect, that in fact the opposite should be the case, and presents some empirical results which are consistent with this explanation.

In their theory of the effects of the separation of ownership from control, Monsen and Downs state that

. . . although a very poor management performance may result in a re- bellion, a very good one does not usually cause a powerful movement among stockholders to reward their managers with lavish bonuses. Hence the punishment for grievous error is greater than the reward for outstand- ing success. This asymmetry between failure and success tends to make the managers of a diffused-ownership firm behave differently from the managers of the type of owner-managed firm envisioned by traditional theory [4, p. 22.5).

The asymmetry between rewards and punishments is heightened by the fact, according to this theory, that exceptionally good performances raise the stockholders’ expectations for future good performances, so that if managers expect not to be able to repeat such performances, they will never have any incentive to report higher than normal profit rates [ 1 I . By the same token, however, it is argued that if managers let profit rates slip below those considered acceptable by stockholders, they risk losing their jobs [41. The implication of these theories, then, is that management controlled firms will not let profit rates rise or fall by as much over time as would owner controlled firms, ceteris puribus.

The fallacy in these arguments is that the managers of management con- trolled firms have less t o fear from the stockholders than do the managers of owner controlled firms. If the separation of ownership from control does affect managers’ behavior, those managers in the former group should be able to report nonrepeatable high profit rates in one year with little worry about not satisfying the increased expectations of the stockholders in following years. Their stockholders are too small and diffused t o be able t o take any action against the manager. Instead, it is the managers

*A debt of gratitude to colleague Robin Carter is acknowledged for his helpful suggestions.

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PALMER: MANAGERIAL ENTERPRISE 229

of owner controlled corporations who must alter their behavior over time to keep the controlling stockholders happy. These are the managers who will be reluctant to report exceptionally good or bad profit rates. It is among the owner controlled firms that one should observe more stable profit rates over time.

In an earlier test of the hypotheses put forth by Monsen and Downs and Baumol, Larner regressed the variances over time of profit rates of large corporations on their sizes and types of control [3 ] . His results are consistent with the explanation offered here that management controlled firms should report more variable profit rates, not less, than owner con- trolled firms, but his results were not statistically significant. There is a major problem with his tests, though, because regressing variances as a dependent variable is unlikely to yield error terms which are normally distributed, a requirement for unbiased tests in ordinary least squares rc- gressions. Furthermore, by not allowing for interaction effects between the independent variables, Larner overlooked the only significant differ- ence in variability of profit rates discovered in this paper.

The firms used in this study were the 500 largest industrial corporations in 1965 taken from Fortune. The dependent variable was the coefficient of variation (standard deviation divided by the mean) of each firm's re- ported rate of return on equity from 196 1 - 1969. This measure of profit rate variability was selected because it was felt that a large variance in the rate of return would be more acceptable to stockholders of firms also earning a high average rate of return than would the same variance for firms with a low average rate of return. The coefficient of variation takes this possibility into effect by stating the variability of the profit rates as a percentage of the average profit rates.

The type of control of each firm was measured in a fashion very similar to that of Larner, with those firms having one person or small group own- ing at !east ten percent of the voting stock classified as owner controlled and the remaining firms classified as managenicnt controlled.' The firms were also assigned to four size categories: the largest 125, the next largest 125, etc. Size was included as an explanatory variable because the findings of Hall and Weiss indicated that large firms might have more stable profits over time than smaller firms [ 21.

The average coefficient of variation for each control and size class is presented in Table I . These averages indicate both that management con- trolled firms report more variable profit rates than owner controlled firms, as predicted in this paper, and that largc firms report less variable pieofit rates than small firms. They also suggest that the separation of ownership

1. A detailed explanation of the classificatory scheme is provided in IS]

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Table I . Average Coefficients of Variation of Profit Rates, 1961 - 1969, by Control and Size Classes

Size CIasses T:ype of’ Corirrol

All Firms Regardless Management Owner of Control Type Control Control

All Firms Regardless of Size .3586 .2490

Largest 125 .2220 .2282 .20 12

2nd Largest 125 .2982 .3225 ,2678

3rd Largest 125 .349 1 .44 1 2 ,2355

4th Largest 125 .4306 .53 16 .2790

from control has a greater effect on profit rate variability among smaller firms than among large ones, i.e., there is an interaction effect between these two explanatory variables.

Because coefficients of variation are not likely to be distributed nor- mally, the nonparametric Mann-Whitney U-test was used to test whether the managerial enterprise significantly affects profit rate variability (see [ 6 ] ) . Ignoring size classes, the test of whether management controlled firms reported more variable profit rates than owner controlled firms yielded a Z statistic of 1.3 1 , barely significant at the ten percent level for a one-tailed test and not too impressive. Ignoring control-type classes, one-tailed tests, all significant at the two percent level or better, indicated that the largest 125 firms had less variable profit rates than the second largest 125 firms and that the third largest had less variable profit rates than the smallest group, but no significant difference existed between the second and third largest groups. Interestingly, when the interactions be- tween types of control and size classes were tested, only among the smallest size class did the separation of ownership from control have a significant effect on profit rate variability at the five percent level or better ( Z = 1.79). A plausible explanation of this result might be that large firms, regardless of their type of control, because of their size and diversification, are better protected from the whims and vagaries of the market place than are smaller firms which are more likely to be special- ized.2 If so, it is the managers of smaller, owner controlled corporations, who will feel the most pressure to alter their behavior so that stable profits are r ~ p o r t e d . ~

2. This possibility is suggested in 121.

3. A further breakdown of the sample according to the monopoly power of each firm, based on the barriers to entry into industries in which the firms operated. had no effect on these results. I am assuming that no other firm or product characteristic is systematically related to size or type of control and hence imparting bias to these results.

PALMER: MANAGERlAL ENTERPRISE 231

It must be emphasized, however, that although these results arc con- sistent with the theory of the managerial enterprise put for th in this paper, they are also consistent with other theories which take no account of the effects of the separation of ownership from control. For example, suppose that stable rates of return provide positive utility for individuals or small groups of people who might be wealthy enough to own sufficient voting stock in a corporation to control it. Such people might be inclined to place all of their wealth in one firm (making it owner controlled) which can report stable profit rates over time, o r thcy might try to achieve the same effect by diversifying their portfolios over a large number of firms (leaving them management controlled) with offsetting variations in profit- ability. If this alternative hypothesis is correct. the empirical resuits of this study might not be duc t o effects of the managerial enterprise. Rather, the profit rate variability might be intrinsic t o each firm, and the type of control of each firm could simply be a result of portfolio decisions by wealthy individuals.

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REFERENCIS

W . Baumol, Business Behavior, Value and Growth, New York 1959.

M. Hall and L. Weiss, ‘‘Firm Size and Profitability,“ Rev. Econ. Stat . , August 1967 ,4Y . 319-31. R. Larner. Management Cotitrol and the Large Corporation, New York 1970.

R. Monsen and A . Downs, “A Theory of Large Managerial Firms,” Jour. Pol. Econ., J u n e 1965. 73, 22 1 - 36.

J . Palmer, “The Extent of the Separation of Ownership from Control in I a g e U.S. Corpora- tions,” Quart. Rev. of Econ. and Bus., Autumn 1972, 12, 55-62.

S . Siegel, Nonparametric Statistics for the Behavioral Sciences, New York 1956