Paper to be presented at the DRUID 2011 on INNOVATION, STRATEGY, and STRUCTURE Organizations, Institutions, Systems and Regions at Copenhagen Business School, Denmark, June 15-17, 2011

Perfomance, diversification and marketing strategies: Empirical evidence from professional service firms

Carolina Castaldi Eindhoven University of Technology School of Innovation Sciences [email protected] Marco Giarratana

[email protected]

Abstract The determinants of performance for professional service firms are still a matter of debate. We draw attention to diversification and marketing strategies as two channels through which PSFs leverage their resources, in particular their intangible capital. We propose that diversification is both necessary to meet complex customer demand and allows PSFs to leverage their reputational and knowledge assets across multiple domains. We theorize on a positive relation between diversification and performance, including a moderating effect of marketing strategies directed at building reputation and brand awareness. We propose to test our hypotheses on a sample of US-based management consulting firms and we plan to use trademarks to capture the properties of firms? diversification strategies.

Jelcodes:L20,M3

Perfomance, diversification and marketing strategies: Empirical evidence from professional service firms Preliminary draft Submitted to the 2011 DRUID Society Conference, 15-17 June 2011 Theme B. Strategy, Organization, and Innovation Abstract The determinants of performance for professional service firms are still a matter of debate. We draw attention to diversification and marketing strategies as two channels through which PSFs leverage their resources, in particular their intangible capital. We propose that diversification is both necessary to meet complex customer demand and allows PSFs to leverage their reputational and knowledge assets across multiple domains. We theorize on a positive relation between diversification and performance, including a moderating effect of marketing strategies directed at building reputation and brand awareness. We propose to test our hypotheses on a sample of USbased management consulting firms and we plan to use trademarks to capture the properties of firms’ diversification strategies. Introduction Professional service firms (PSF) are receiving increasing attention from management scholars (Malhotra and Morris, 2009; von Nordenflycht, 2010). PSFs are thought to play a key role in the knowledge economy by acting as sources of new knowledge for client companies and by mastering the intricate process of both producing and using knowledge (Muller and Zenker, 2001; Gallouj, 2002). Yet, the reasons why certain PSFs turn out to be more successful than others remain poorly understood. Traditionally, PSFs have been defined as human capital-intensive activities; indeed, the success of developing and delivering customized services to clients is directly linked with the skills of firm employees. It is not surprising that most of the literature on what Starbuck (1992) first defined as knowledge-intensive firms is devoted to understand how internal management of human resources can improve performance (Teece, 2003; Hinings and Leblebici, 2003;Greenwood et al. 2006). Interestingly, recent literature contributions have put forward two additional explanations of the performance for PSFs. First, corporate diversification. Greenwood et al. (2005) mention four competitive benefits of a diversification strategy for the case of the accounting sector. First, clients only have to deal with one supplier. Second, service firms enjoy economies of scope by using the same distribution channel. Third, firms can sell related services by leveraging existing client relationships. Fourth, diversification helps a PSF to engage its employees in more interesting and diverse assignments, thereby increasing the chance of retaining key human resources. Van Nordenflycht (2011) has posed that growth of PSFs goes hand in hand with increasing diversification. He observes how a process of size matching between clients and suppliers characterizes the evolution of many knowledge intensive industries, with large and diversified companies serving large clients and small companies serving small clients. The very large companies seem to combine the ability to coordinate large projects with the ability to provide whole packages of diversified services that satisfy the complex demand of large clients. 1

In this sense diversification is deemed important for the growth of PSFs not because of economies of scale and scope in production, but because of demand forces shaping market strategies of PSFs. Still, it remains unclear whether diversification also explains differential performance of the very large firms. A complementary stream of analysis focuses more on the antecedents of diversification. Diversification in the skills of a firm human capital seems to be a characteristic of most innovative PSFs because it enhances the combinatorial possibilities of developing new solutions (Kogut and Zander, 1992; Wennberg, 2009). On this line of reasoning, Consoli and ElcheHortelano (2010) describe the tasks of PSFs as ‘semantically rich domains’ requiring specific and variegated repertoires of skills in order to craft customized solutions. Additionally, reputation strongly shapes the fates of PSFs. Services remain an experience good with a highly intangible character. Also, the more specialized the services, the more difficult for customers to judge ex-ante their quality. Clients’ judgement has then to rely on social mechanisms or on firm-level reputation or status (Podolny, 1993). Greenwood at al. (2005) argue that firms with a stronger reputation enjoy benefits on both the supply side and the demand side: they can attract the best human resources and save on transaction costs, but they can also charge higher prices to clients, who are also typically less willing to switch supplier. In sum, current research is still struggling to develop an understanding of the performance effects of the different elements of PSFs corporate strategy. On one hand, systematic empirical evidence on the positive relation between downstream diversification and performance is lacking. On the other hand, a more theoretical research gap relates to the understanding of appropriation strategies by PSFs. If intangible capital (i.e. human and reputation capital) is a significant driver of firm performance, then PSFs face significant challenges in managing and protecting their intellectual assets. The importance of corporate reputation for PSFs is starting to be tackled (see the recent Davies et al, 2010), but the role of marketing strategies therein remains poorly understood (for an exception not specific to PSFs, see Fombrum and Shanley, 1990). This paper aims to answer these two related questions. First, we test the relationship between PSFs diversification and performance. Second, we investigate how the former relationship is mediated or affected by the intangible assets of a firm. Empirically, we select a sample of 86 US-based management consulting firms and analyze their performance in the period 2000-2009. We capture the downstream diversification of PSFs service offering by considering their portfolios of trademarks. Trademarks are the legal counterparts of brands and can be used by firms to identify unique product/service offerings in crowded markets. Given that trademarks are registered for given product and service class, they carry the potential to be used to measure market diversification at the firm level. We also use trademarks to capture different types of reputation building marketing strategies. Among the formal IPR tools available to service companies, trademarks are an interesting alternative for protecting intangible services and creating brand equity. In fact, trademarks capture a significant share of investment in branding strategies (Krasnikov et al. 2009). A strong brand is positively related to a high reputation, which, as discussed, has a positive effect both on the ability to retain human resources and on the market position of PSFs. We rely on the distinction put forward by Krasnikov et al (2009) between brand identification and brand association strategies. Brand identification trademarks are those that build brand awareness, while brand association trademarks relate to ability of the customers to associate the identified brand with certain attributes (i.e. trustworthiness, innovativeness, expertise in a given field, etc.).

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Given that PSFs target professional customers, it remains unclear whether marketing strategies focusing either on brand awareness or brand association have different effects on corporate performance. In sum, we propose that a diversified portfolio of trademarks signals to the market a PSF able to offer a diversified portfolio of solutions, while the firm’s investment in a brand awareness strategy signals efforts to enhance reputation. By addressing the issues above our paper contributes novel theoretical and empirical insights to the understanding of the relationship between diversification and performance for PSFs and the role played by intangible capital (Hall, 1993; Sandner and Block, 2011). We demonstrate that the two processes together are positively related to PSFs corporate performance. Diversification and performance in PSFs They way PSFs function and organize their activities bear implications for the mechanisms supporting diversification. PSFs typically work in a project-based form and experience a range of requests from clients in terms of solutions needed (Acha et al, 2005). During each new project PSF experts are involved in a process of customization or contextualization of knowledge in response to the client’s needs, a process which can be referred to as interactive learning. The knowledge being exchanged is mostly of a tacit nature and resides in the experts, in such a way that human resources represent key assets for PSFs (Hitt et al, 2001). The heterogeneity of tasks performed is on average much higher than for experts in manufacturing companies and puts pressure on project teams in terms of the range of knowledge they need to use. At the same time, task heterogeneity limits significantly the opportunities for developing stable routines simply from experience accumulation (Zollo and Winter, 2002). Instead, only the deliberate investment in inductive learning and codification enables PSFs to identify patterns across tasks through a process of de-contextualization (Strambach, 2008). We contend that the ability of a firm to develop a new service offering appealing to clients that demand complex solutions depends on firm ability to recognize the right combination out of its heterogeneous and sometimes scattered competences (Garud and Kumaraswamy, 1993). The investment devoted to the accumulation of this knowledge can be seen as a fixed investment which translates into a competitive advantage for those firms that are able to diversify. This means the ability to recombine competences and to exploit economies of scope through the deployment of intangible resource across multiple production domains (Teece, 1982). Such a process lies also at the heart of efforts aimed at diversification, if diversification can be thought to entail, at least to some extent, activities such as replication, translation and re-contextualization of expertise to alternative domains. We then propose that more diversified PSFs enjoy higher performance because of their investment in learning processes that ultimately foster economies of scale and scope on the production side. On the other hand, our claim can also be supported by a different mechanism, which relates more to the demand side. In line with von Nordenflycht (2011), more diversified PSF firms are better able to meet the diversified and complex demand of large clients, conditional on a large size. We then expect that companies that profile themselves, for instance by diversified brands, as being able to offer services in various domains, should enjoy higher performance. These diversified companies basically follow a ‘one stop shop’ strategy and exploit their assets across multiple product and service domains. This type of advantage essentially refers to economies of scope.. H1: More diversified PSFs show a higher performance

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The moderating role of branding strategies As already briefly discussed in the introduction, PSFs face peculiar challenges when it comes to promote, protect and leverage their intangible capital. Professional customers who cannot rely on previous experience for making an informed decision typically rely instead on the firm reputation (Fombrun and Shanley, 1990). One way to build up a ‘name’ is to invest in branding strategies and brand equity. Branding, as a specific form of advertising, fulfils different roles. It reduces transaction costs in the market by reducing uncertainty about some of the properties of the provider during information search (Milgrom and Roberts, 1986). It also works as an appropriation tool since it helps to distinguish and identify the product/service in the market (Davis, 2009). Thereby it forms barriers to entry (Appelt, 2009). It increases customer’s loyalty, thereby strengthening the company’s reputational assets. Moreover, firms’ relations with loyal customers are typically characterized by higher levels of trust and commitment, which in turn can enable firms to extract more reliable information about customers’ current and future needs (Cooper and Kleinschmidt, 1995; Prahalad and Ramaswami, 2004). In terms of systematic empirical evidence, a strong brand equity has been related in the literature to higher consumer awareness, higher company performance and higher financial returns (Keller and Lehmann, 2006). According to Krasnikov et al (2009) and their consumer-based perspective, there are two dimensions underlying brand equity. Brand awareness refers to the ability of consumers to recall and identify the brand name. Brand awareness is also a pre-condition for the ability of consumers to associate the brand with given attributes, with brand association being the second dimension of brand equity. The same authors also argue that the two dimensions can be separated both conceptually and empirically by distinguishing two different types of trademarks, i.e. the legal counterparts of brands. Based on firm trademark portfolio, one can then discriminate a brand awareness strategy, aiming at building brand awareness and a brand association strategy, aiming at increasing attribute-based association. From a strategic point of view, we are interested in the mechanisms through which branding, as a strategy to increase reputation and signal the value of PSF’s intangible resources, affect corporate performance. We believe that the specific properties of the intangible resources we have discussed so far should be taken into account. Recently, Levinthal and Wu (2010) revamped the discussion on the performance implications of diversification by classifying organizational resources along the dimensions of fungibility across domains and scale free property (no opportunity costs). While the specific expertise embedded in human resources is a clear example of a resource with positive opportunity costs for alternative applications, brands and corporate reputation possess a higher degree of fungibility across alternative domains. This is particularly the case for brand awareness, rather than for the more specific brand associations: brand awareness refers to the basic recall probability of the company’s brands, while associations cover different sets of attributes which may or may not be relevant for the decision of a given customer to choose the focal PSF. In a different but related interpretation, brand associations might refer to specific elements or properties of the company’s offerings, while brand awareness unifies and strengthens the overall corporate reputation or status. Then, we expect a marketing strategy focusing on strengthening the corporate brand awareness to lend support to corporate diversification strategies dependent on less fungible resources, such as human resources and organizational competences in general. H2: Diversification triggered through a marketing strategy of brand awareness shows higher performance than a diversification triggered through a marketing strategy of brand association

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Empirical analysis Sample and data We extract a sample of management consulting firms from the Bureau Van Dijk’s Osiris database by selecting all US public firms listed within SIC code 874. The sample includes 86 firms. We choose US companies to ensure comparability in terms of trademarks numbers, since we consider trademarks registered at the USPTO. Foreign companies registering trademarks at the USPTO might do so for strategically different reasons than domestic companies, for instance because they are engaged in export or foreign market penetration activities (Giarratana and Torrisi 2010). We further limit our analysis to public companies, in order to have a wider range of performance measures. Thereby we effectively consider a sample of large firms. If we find differences, the same differences are expected to be even more significant in less restrictive samples. For each company in the sample we also collected the trademarks registered at the USPTO. Trademarks are combinations of “words, phrases, symbols, or designs that identify and distinguish the source of the goods or services” (USPTO Documentation, http://tess.uspto.gov). Firms can register as a trademark a new firm name, a name of a product, a jingle, a slogan, a new image, or a logo. In this way, they secure legal protection of their investment in marketing, reputation for quality, brand names, and distribution channels. Even if trademarks do not protect against the imitation of the product per se, they do help to create barrier to imitation because they avoid that a similar product with a similar name or brand would be sold in a unique market. Trademark owners pay different types of fees for each class of goods or services for which a trademark is registered, and they have to prove periodically that they are using the trademark in the relevant market; even if the owner is willing to pay the fees, a trademark is cancelled if it is not commercially used for five consecutive years after registration. Academic interest in trademarks has only recently emerged. Previous studies show that trademarks represent a good proxy for the products and markets in which a firm operates, and that they are correlated with performance measures and stock market value (Fosfuri and Giarratana, 2009; Krasnikov et al., 2009). We collect trademark data from the TESS database of the USPTO office. Trademarks get assigned to IC and US classes. For each trademark, IC class is unique (one class per trademark) and it identifies the product category in which the product or services is marketed. US classes represent the product categories on which the applicant extends the protection so that each trademark is usually protected in more than one US class. Trademark files account also for the information about the status of the trademark that could be live, i.e. still used in the market, or dead, i.e. dismissed. Granted this, we measure firm diversification by the diversification in IC codes of the portfolio of live trademarks of each company in each year. We think that this represents a good proxy of the annual stock of diversification of the firm because trademarks capture two different dimensions. On one hand, trademarks protect products and services in different markets and signal the actual presence of the company in that market, given the formal requirement that they are used in the market. On the other hand, they also account for the advertising investment related to the different products and services. We follow the guidelines proposed by Krasnikov et al (2009) for dividing trademarks into either brand awareness or brand association trademarks. Brand awarenesss includes: word marks representing company or subsidiary or subdivision names; names of products and services

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offered by the firm; logos used by the firm to identify themselves. Brand association basically includes advertising slogans. We characterize the marketing strategy of firms as either mostly focused on brand awareness or brand association, for each year We collect data for the years 2000-2009 and construct an unbalanced panel dataset, because of missing values in the Osiris database. We exploit panel regression techniques to test for the significance of the proposed relations. Conclusions This paper aims at making several contributions to the emerging literature on PSFs. At a theoretical level, we explore the specific mechanisms underlying diversification of PSFs and we use them to develop theoretical hypotheses on the relation between diversification and performance. We propose that branding strategies, viewed as strategies through which PSFs leverage their intangible capital, play a key moderating role. The empirical study serves the purpose of testing the theoretical hypotheses and exploits trademarks as indicators of intellectual assets, marketing strategies and diversification strategies as well. By testing for the performance implications of given trademark portfolios, the empirical results also add the literature striving to assess the value of intangible capital in knowledge intensive domains. References Acha, V., Gann, D.M. and Salter, A.J. (2005), Episodic Innovation: R&D strategies for ProjectBased Environments, Industry and Innovation, 12 (2): 255-281. Appelt, S. (2009), Early Entry and Trademark Protection: An Empirical Examination of Barriers to Generic Entry, Paper presented at the DRUID Summer Conference 2009. Consoli, D. and Elche-Hortelano, D. (2010), Variety in the knowledge base of Knowledge Intensive Business Services, Research Policy, 39: 1303-1310. Cooper, R. and Kleinschmidt, E. (1995), Benchmarking the Firm’s Critical Success Factors in New Product Development, Journal of Product Innovation Management, 12 (5), 374–91. Davies, G., Chun, R. and Kamins, M.A. (2010), Reputation gaps and the performance of service organizations, Strategic Management Journal, 31: 530-546. Davis, L. (2009), Leveraging trademarks to capture innovation returns, Paper presented at the DRUID Summer Conference 2009. Fombrun, C. and Shanley, M. (1990), What’s in a name? Reputation building and corporate strategy, Academy of Management Journal, 33 (2): 233-258. Fosfuri, A. and Giarratana, M.S. (2009), Masters of War: Rivals’ Product Innovation and New Advertising in Mature Product Markets, Management Science, 55 (2): 181-191.

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