CH. 8: Corporate Strategy: Vertical Integration and Diversification

Risks of Vertical Integration

-increasing costs -reducing quality -reducing flexibility -increasing the potential for legal repercussions

for diversification to enhance firm performance, it must:

-provide economies of scale, which reduces cost -exploit economies of scope, which increases value -reduce costs AND increase value

Types of Corporate Diversification

-single business firm derives 95% or more of its revenues from one business. ex: Coco cola, google, facebook -dominant business firm derives between 70-95% of its revenues from a single business, but it pursues at least one other business activity. ex: harley davidson, nestle, UPS

Determining the boundaries of the firm:

-the degree of vertical integration -the type of diversification -the geographic scope

The underlying strategic mgmt concepts that will guide vertical integration, diversification, and geographic competition are:

1.) core compentencies 2.) economies of scale 3.) economies of scope 4.) transaction costs

corp strategy determines boundaries of the firm along 3 dimensions;

1.) industry value chain 2.) products and services 3.) geography

4 options to formulate corporate strategy

1.) leverage exisiting core competencies to improve current market position 2.) Build new core competencies to protect and extend current market position 3.) Redeploy and recombine existing core competencies to compete in markets of the future 4.) Build new core competencies to create and compete in markets of the future

2 other types of diversifcation strategy

1.) related constrained: <70% revenues from primary activity. all businesses share competencies in products, services, technology or distribution ex: exxonmobil, johnson & johnson, nike 2.) related-linked: <70%. only some businesses share competencies ex: amazon, disney, GE

Benefits of vertical integration

SLIFF -securing capital supplies and distribution channels -lowering costs -improving quality -facilitating scheduling and planning -facilitating investments in specialized assets

conglomerate

a company that combines two or more strategic business units under one overarching corporation and follows an unrelated diversification strategy

product-market diversification strategy

a company that pursues both a product and a geographic diversification strategy simultaneously

short term contracting

a firm sends out requests for proposals (RFPs) to several companies which initiates competitive biding for contracts to be awarded with a short duration, usually less than 1 year. -benefit: the buying firm can demand lower prices due to the competitive bidding process

geographic diversification strategy

a firm that is active in several different countries

product diversification strategy

a firm that is active in several different product markets

Credible Commitment

a long term strategic decision that is both difficult and costly to reverse.

Equity Alliances

a partnership in which at least one partner takes partial ownership in the other partner.

core competence - market matrix

a way to guide managerial decisions in regard to diversification strategies. first task: identify their existing core competencies and understand the firm's current market situation. *chart on page 261* -taken together the market matrix provides guidance on how to diversify in order to achieve continued growth

fully vertically integrated

all activities are conducted within the boundaries of the firm. ex: Weyerhauser owns forests, grows and cuts its timber, mills it, manufactures a variety of different paper and construction products, and distributes them to retail outlets and other large customers. their value added is 100%

industry value chain

also called vertical value chains becuase they depict the transformation of raw materials into finished goods and services along vertical stages. -each stage of the vertical value chain represents an industry stage 1: raw materials stage 2: intermediate goods and components stage 3: original equipment manufacturing stage 4: marketing and actual sales stage 5: after sales serivce and support

principal agent problem

an agent performing activities on behalf of a principal pursues his/her own interests

Franchising

an example of LT contracting. in this case the Franchisor (McDonalds) grants a franchisee (an entrepreneur owning no more than a few outlets) the right to use the Franchisor's trademark and business processes to offer goods and services that carry the Franchisors brand name.

Joint Venture

another form of strategic alliance. Happens when two or more partners create and jointly own a new org

diversification

answers the questions about the number of markets to compete in and where to compete geographically. -focuses on several markets simultaneously

strategic alliances

as a firm moves toward greater integration on the make-to-buy continuum, the next organizational forms are strategic alliances. they are: voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services to lead to comp adv.

site specificity

assets are required to be co-located, such as the equipment necessary for mining bauxite and aluminum smelting

physical-asset specificity

assets whose physical and engineering properties are designed to satisfy a particular customer, such as bottling machinery for Coca-Cola and PepsiCo. since the bottles have different and often trademarked shapes, they require unique molds. Cans dont have this physical-asset specificity because they are generic

caveat emptor

buyer beware. info asymmetries can result in the crowding out of desirable goods and services by inferior ones.

internal capital markets

can be a source of value creation in a diversification strategy if the conglomerates headquarters does a more efficient job of allocating capital through its budegting process than what could be achieved in external capital markets.

Corporate Strategy

decisions that senior mgmt makes and the goal directed actions it takes in the quest for competitive advantage in several industries and markets simultaneously. -provides answers to the Q: where to compete?

restructuring

describes the process of reorganizing and divesting business units and activities to refocus a company in order to leverage its core competencies more fully. ex: GE

Transaction Cost Economics

explains and predicts the boundaries of the firm. Insights gained from this help managers decide what activities to do in-house vs. what services and products to obtain from the external market.

long term contracts

firms in short term contracts have no incentive to make transaction-specific investments....LT contracts work similarly but are much longer. they help facilitate transaction-specific investments

Vertical Integration Along the Industry Value Chain

first key Q: In what stages of the industry value chain should the firm participate?

non-diversified

focuses on a single market

Determine the Boundaries of the firm

in order to gain and sustain comp adv. the framework in strat mgmt used is called: Transaction Cost Economics

Transaction Costs

internal and external costs associated with an economic exchange.

Human-asset specificity

investments made in human capital to acquire unique knowledge and skills, such as mastering the routines and procedures of a specific organization, which are not transferable to a different employer.

Liscensing

is a form of LT contracting that enables firms to commercialize intellectual property such as a patent.

strategic outsourcing

moving one or more internal value chain activities outside the firms boundaries to other firms in the industry value chain -this reduces a firms level of vertical integration

forward vertical integration

moving ownership of activities closer to the end customer. ex: forward integration into distribution and sales allows companies to more effectively plan for and respond to changes in demand ex: PepsiCo forwardly integrated by buying its bottlers in order to obtain more control over its qaulity, pricing, distributionm and instore display.

backward vertical integration

moving ownership of activities upstream to the originating inputs of the value chain. ex: HTC integrated backwardly into smartphone design by acquiring One & Co. a design-based firm

taper integration

one alternative to vertical integration. it is a way of orchestrating value activities in which a firm is backwardly integrated, but it also relies on outside-market firms for some of its supplies, and/or is forwardly integrated but also relies on outside-market firms for some of its distribution ex: apple and nike own retail outlets but also use other retailers, both brick and mortar and online benefits: -exposes in-house suppliers and distributors to market competition -enhances a firms flexibility -paves the path for innovation *exhibit 8.6 page 255*

diversification discount

situation in which the stock price of highly diversified firms is valued at less than the sum of their individual business units.

information asymmetries

situations in which one party is more informed than another because of the possession of private info

Vertical Integration

the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs.

Boston Consulting Group (BCG) growth share matrix

the matrix locates the firms individuals SBUs in 2 dimensions: relative market share (HORIZ axis) and speed of market growth (VERT axis) -either: cows, stars, question marks, or dogs cows: low growth market but hold considerable market share...earnings are high stars: high market share, fast growing market. dogs: underperforming. small market share, and low growth question marks: not clear if they'll turn into dogs or stars

parent-subsidiary relationship

the most-integrated alternative to performing an activity within one's own corporate family. the coroprate parent owns the subsidiary and can direct it via command and control. ex: GM owns its european carmakers

Diversification premium

the stock price of related-diversification firms is valued at greater than the sum of their individual business units.

internal transaction costs

these include costs related to organizing an economic exchange within a firm- for example, the costs of recruiting and retaining employees, paying salaries, setting up a shop floor, and supervising work. -internal costs increase with organizational size and complexity

specialized assets

unique assets with a high opportunity cost. they have significantly more value in their intended use than in their next-best use. They come in 3 types: -site specificity -physical asset specificity -human-asset specificity

degree of diversification

what range of products and services should the firm offer? ex: Coco cola focuses on a single product market. whereas Pepsi co has beverages and food market

related diversification strategy

when a business firm derives less than 70% of its revenues from a single business activity and obtains revenues from other lines of business linked to the primary business activity. -idea is to benefit from economies of scale and scope ex: Exxonmobil bought XTO energy

external transaction costs

when companies transact in the open market they incur external trans costs. : the costs of searching for a firm or individual with whom to contract, and then negotiating, monitoring, and enforcing the contract

unrelated diversification strategy

when less than 70% of its revenues comes from a single business there are few linkages among its businesses. ex: berkshire hathaway

Firm vs. Market: make or buy?

when the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market (C in house < C market), then the firm should VERTICALLY INTEGRATE by owning production of the needed inputs or the channels for the distribution of outputs. ex: Google hires programmers to write code in-house, instead of contracting in the open market for software code *advantages of firm*: ability to command and control decisions, specialized labor, community of knowledge *disadvantages of firm*: administrative costs, low-powered incentives, principal- agent problem *advantages of markets*: high-powered incentives, increased flexibililty *disadvantages of markets*: search costs, opportunism by other parties, incomplete contracting, enforcement of contracts.