Why Do Firms Hire Management Consultants?

5 April 2011 at 6:08 pm 5 comments

| Peter Klein |

Academic economists and management scholars are often skeptical of management consulting firms. Their advice seems fluffy, ad hoc, unscientific. But consulting firms continue to prosper. Are their clients irrational?

I always assumed signaling plays a role. One can imagine a Spence-style separating equilibrium in which high-quality firms signal their unobservable characteristics to customers, suppliers, rivals, etc. by hiring an expensive consulting firm, while low-quality firms find this prohibitively costly. Of course, all consulting firms are not alike, and there are many different types of consulting services (e.g., strategy — more fluffy; IT implementation — less fluffy).

An article in the new JMS by Donald Bergh and Patrick Gibbons looks at the signaling value of consulting, measuring the stock-market reactions to firms’ announcements of hiring a consulting firm. Excess returns are positive and significant, and increasing in the client’s prior performance — the market likes it when “good” firms hire consultants. (The effects don’t seem to depend on the reputation of the consulting firm, though.) This is consistent with my story above, though we’d need to know something about firms that could have hired a consultant but didn’t to say more.

Entry filed under: - Klein -, Management Theory. Tags: .

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5 Comments Add your own

  • 1. Duncan  |  5 April 2011 at 6:33 pm

    In vivo research has one major shortcoming: testing for conditions not found in the norm al state of being. This could be just like the research which showed that the performance of Berkshire Hathaway was positively associated with the career of an actress named Hathaway because, most likely, he bots running the trading algorithms can’t distinguish between the actress and the company. It sounds to me as though it is time to look at the market and the price of tea in China, don’t you think?

  • 2. Yves  |  6 April 2011 at 9:54 am

    In my limited experience, mgmt consultants have played a role that might be called signaling, albeit internally, rather than externally. Specifically, I have seen the board of directors (public company) more or less impose management consultants on executives. There seem to be two primary motivations at play: 1) to provide temporary, board-accountable outside evaluations of management’s strategy-making (so an agency-like angle, I guess) and 2) to expose management to ideas and practices which they seem disinclined to discover themselves, but which the board believes are valuable in the current context.

    Note that management can also use the consultants to gain credibility with the board, via similar dynamics. I have no idea how common these contexts are, but they clearly contribute to the demand for management consultancy.

  • 3. Recomendaciones « intelib  |  6 April 2011 at 11:19 am

    [...] Why Do Firms Hire Management Consultants?, by Peter Klein [...]

  • 4. Jim Rose  |  6 April 2011 at 6:27 pm

    The other day I read in an article whose name and author I have forgotten about a 19th century court judgment on fiduciary duty that encouraged banks, insurers and company directors to take professional advice as evidence that they acted wisely and in accordance with their respective duties.

    I have always assumed this is why economists are hired as forecasters and currency and interest rate strategists.

    When being sued for possible breaches of directors’ duties after the firm goes broke, a long-held defence will be we took the best available advice.

  • 5. srp  |  7 April 2011 at 6:17 pm

    There are so many reasons for hiring consultants:

    1) Rent rather than own specialized skills. As Rumelt points out, strategic planning and analysis ought to occur on an irregular and episodic basis, so why pay for those skills only to have them sit idle/

    2) Break up internal political deadlocks. An “outside” report may be useful in breaking down the arguments of other factions in an organizational dispute.

    3) Provide better rationalizations for what you want to do already. Consultants are usually very good at creating presentations and justifications and they provide an “outside” imprimatur that gives a fig leaf of objectivity.

    4) Take advantage of consultants’ exposure to other firms and their practices. May help you avoid going stale or moving too late on new best practices (or trends, or fads, to be realistic).

    5) Signaling various things to the market–lack of complacency, growth opportunities, etc.

    6) Building the entourage for image-polishing or ego-building purposes.

    7) A sounding board for managers who are afraid to say what they really think to their intramural colleagues (paging Chris Argyris).

    8) Inertia–we’ve had these guys around for the last ten years, why not this year?

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