The Japanese and operational excellence often go together. When we talk of Just-In-Time inventory management, we are bound to talk about Toyota: the inventors of the JIT method.
But what are some unique structural advantages Japanese companies have built to make a high-risk, low-redundancy system like Just-In-Time work so well?
It has to do with Japan's unique Keiretsu system: the way in which its companies link together and work together under a single monolithic conglomerate structure.
But first, some history.
From the time the Japanese economy started modernizing and coming of age, it lacked a strong middle class who owned the financial means to start a business and invest in business development. At the time, there were only a few leading merchant families experienced in banking and business activity — political merchants so to speak — who commanded all the resources, connections with government officials, and the raw capital needed to start an industry.
And the way these merchant families expanded into various industries was via a system called Zaibatsu: the spiritual precursor to the Keiretsu system.
The zaibatsu followed a pyramidal structure, where one family clan had guaranteed control over the entire network of companies. In this structure a holding company (Honsha) was situated at the very top, wielding control over the network of suppliers and subsidiaries as well as dependent firms.
Large merchant families issued stock which allowed the financing of industrialization and creation of large pyramidal zaibatsu groups.
The way this worked was as follows.
Say a family has a fortune of 1 billion yen and invests it in a family business, Choten Corp. At the time of institution, the family sees a multitude of profitable business opportunities and feels it could profitably invest many billion yen.
To do this, the family expands Choten Corp. (parent company in the pyramid) by issuing new public shares worth almost 1 billion yen. Public shareholders now own almost 50% of Choten Corp., which is now worth almost 2 billion yen. This means that the family now has close to 1 billion yen cash, but still preserves full control of the family business. This is because its 50% plus stake lets it appoint the board of directors.
Choten Corp. is now the apex firm of the pyramidal group.
Next, the family starts two new firms, Hitotsu-Ichi Corp. and Hitotsu-Hi Corp. Each is offered 500 million yen initial investment by Choten Corp. and each further launches a public offering to raise another ~500 million yen by selling shareholders in both child companies slightly less than 50% shares.
But again, the family still retains full control of the board in both Hitosu-Ichi Corp. and Hitotsu-Hi Corp. while raising another 1 billion yen cash from public investors.
The family continues this strategy to expand further and sets up four new firms under the child companies, and again raises cash by offering up almost 50% stake to public shareholders. But once again, it retains full control of all child companies.
This process can be repeated until the family runs out of attractive investment opportunities in diverse industry segments.
In a model zaibatsu group, a single family can fully control fifteen or more firms and raise cash with every new public offering, while still maintaining full control of the board.
Now you might be thinking, what's the advantage of doing this?
In a zaibatsu system, a five-tier pyramid lets the family raise 14 billion in public equity but retain complete control. Had the family instead issued 14 billion in additional Choten shares, their stake would have been diluted to one-fifteenth or 6.67% and it would have lost control.
Why this emphasis on control? Because it allows the companies to tap public markets for capital while excluding public shareholders from corporate governance!
The effect of a zaibatsu system was that only leading conglomerates like Mitsui and Sumitomo managed to win economic and political influence. And due to the centralized nature of control, it led to economic hegemony by only a few families in Japan.
But after Japan lost World War II, American occupation authorities in brought in reforms aimed at making the economy more egalitarian. They ordered the dissolution of zaibatsu family conglomerates and considerably changed their ownership structure by eliminating large private capital.
The occupation authorities aimed to introduce an economic deconcentration program that would give all Japanese businessmen the opportunity to engage in the modern sector of the economy and remove all conditions which would preserve the right of starting a business for a chosen few. In short, the USA rewrote the constitution of Japan to abolish the monopolistic and undemocratic nature of these zaibatsus. Hence, holding companies were illegal in Japan from then until 1995.
In response, Japanese companies organized into a new structure that we now know as Keiretsus.
Today, Nissan, Yamaha and Canon are all united under one conglomerate. Sony, Fujifilm, and Toshiba are also united under another conglomerate that also builds fiber components for Dodge and Boeing. These are modern keiretsus.
And the structure can only be described as steeped in tradition and relationships.
In general, keiretsu groups are defined as clusters of independently managed firms maintaining close and stable economic ties, cemented by a governance mechanism such as presidents’ clubs, partial cross-ownership, and interlocking directorates.
Horizontal keiretsus are conglomerates covering several industries linked by cross-shareholding, intra-group financing and high-level management by a central body of directors. Vertical keiretsus are groups around one big manufacturer and consist of a multi-layered system of suppliers focused on the core company.
Below, you can see a vertical keiretsu (left) and a horizontal keiretsu (right).
A horizontal keiretsu has a large bank at its centre, along with a trading company, a life insurance company, and other financial institutions. Rather than a parent company cross-shareholding with the other companies, the bank owns shares of the companies and the companies hold shares of the bank and other companies in the keiretsu.
The bank leads an alliance of 20-30 companies spread out over diversified business verticals across a range of industries like food, paper, automobiles, electronics, pharma, railways, shipping, etc. Each of these hold each other's shares in a cross-shareholding pattern.
The group bank at the centre of the system plays a key role, not only in providing loans directly but also in mobilizing other financial institutions to make financing available to the group companies.
The trading company was also a key player, particularly in the 1950s, when foreign exchange controls were stringent and knowledge of international markets was scarce within the member companies, especially after years of war, and American occupation.
The companies being in diverse and unrelated sectors, are loosely related, while they all benefit from the financing, insurance, and trading expertise brought by the financial institutions at the centre. And every company in the keiretsu has a vested interest in their sibling companies' wellbeing.
This forms an interlocking relationship, especially if the member company borrows from the horizontal member bank. It allows the bank to monitor borrowings, strengthen relationships between group companies, monitor customers, and help with problems such as supplier networks.
Mitsubishi is a great example of a horizontal keiretsu.
The Bank of Tokyo-Mitsubishi is at the centre of the keiretsu, with Mitsubishi Motors and Mitsubishi Trust and Banking as parts of the core group, followed by Meiji Mutual Life Insurance Company, which provides insurance to all members of the keiretsu. Mitsubishi Shoji is the trading company for the Mitsubishi keiretsu.
Unlike a horizontal keiretsu, a vertical keiretsu has a parent company at the top. An apex core company holds controlling shares in the first tier of key subsidiaries. Each holds controlling shares in its subsidiaries, which hold controlling shares in yet another tier of subsidiaries, and so on.
These companies are often all in business with the parent company and a part of its supply chain. A vertical keiretsu, instead of diversifying in unrelated industries, will diversify into increasing branches of specialization within the same industry.
Let's take the example of Toyota.
The core company of the Toyota group produces most of the company’s models of autos and trucks.
The core company in the group concentrates on high-value-added manufacturing (usually but not exclusively final assembly) and R&D for the core businesses of the group.
The group companies are then created with increasingly higher degrees of specialization, say, the manufacture of components and subassemblies; sales and distribution; and other businesses that support the parent company. The strong parent company, in turn, shares manpower, contracts, and shareholdings with smaller companies within the keiretsu.
Unlike most of the corporate manufacturing groups, vertical keiretsu subsidiaries like sales and distribution companies are completely dependent on the core company: they are dedicated to handling the group’s products. These firms make up the supply chain and concentrate on the activities involved in getting the final products produced by the core companies to the customer.
Having said that, vertical keiretsus can also have subsidiaries in adjacent businesses. The core company only focuses on business opportunities that are closely related to its core capabilities. And it decides to spin-off businesses that are not directly related to its central technologies and markets into subsidiaries under the vertical keiretsu.
Both Toyota and Matsushita have a subsidiary in their group engaged in producing and marketing prefabricated housing. For Toyota, this business builds on its capabilities in structural engineering and production (the housing is steel-frame construction); for Matsushita, housing provides a “container” for its consumer electronics products, and its subsidiary, National Home, has been particularly active in the marketing of the “intelligent house”.
But the development, production, and selling of prefab houses are sufficiently removed from each company’s core capabilities. The activity instead has been spun off into a separate child company.
This allows existing conglomerates to be entrepreneurial and experiment with adjacent industries. It also explains why new industries in Japan have so often been fostered by existing companies.
At present, each of Japan's six car companies belongs to one of the big six keiretsus. As does each one of Japan's major electronics companies.
That's all for today. But we aren't done yet.
This was just an introduction to the history that led to the creation of the keiretsu system, starting with zaibatsus, and the nature of both these systems.
Tomorrow, we will explore all the pros and cons of these keiretsu systems; the operational and supply chain advantages such a system creates, and see what important organizational, cultural, and system-design level lessons we can glean from studying them.
Till then, stay tuned!
Keiretsu groups: Their Role in the Japanese Economy and a Reference Point (or a paradigm) for Other Countries