Ch. 8- Corporate Strategy: Vertical Integration and Diversification

Firm as arrangements for organizing economic activity disadvantages

- Administrative costs because of necessary bureaucracy. - Low-powered incentives, such as hourly wages and salaries. These often are less attrac- tive motivators than the entrepreneurial opportunities and rewards that can be obtained in the open market. - The principal-agent problem.

Economies of scale

- occur when a firm's average cost per unit decreases as its output increases - Spreading fixed costs over products produced in addition to the significant buyer power its large market share affords (Larger market share, therefore, often leads to lower costs)

Core competencies

- unique strengths embedded deep within a firm - allow a firm to differentiate its products and services from those of its rivals, creating higher value for the customer or offering products and services of comparable value at lower cost. - Activities that draw on what the firm knows how to do well should be done in-house, while non-core activ- ities such as payroll and facility maintenance can be outsourced. In this perspective, the internally held knowledge underlying a core competency determines a firm's boundaries.

why firms need to grow

1. increase profits 2. lower costs 3. increase market power 4. reduce risk 5. motivate management

Case 2- I have most of the parts but just need a few.

Borrow- look to license

Choosing between the "how's"

Identification of strategic gap (what and why) Take a look at what I have

Case 1- I have everything I need to make this- resources are competitive relevant with those on the market.

Make

4 main types of business diversification

Single business. Dominant business. Related diversification. Unrelated diversification: the conglomerate

Equity alliance

a partnership in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock or assets (in private companies), and thus making an equity investment. The taking of equity tends to signal greater commitment to the partnership. gives companies an inside look into the company. Gaining more information could be helpful if they decides to acquire the other company in the future.

transaction costs

all internal and external costs associated with an economic exchange, whether within a firm or in markets

site specificity

assets required to be co-located

industry value chain

depiction of the transformation of raw materials into finished goods and services along distinct vertical stages, each of which typically represents a distinct industry in which a number of different firms are competing Determined by their corporate strategy, each firm decides where in the industry value chain to participate. This in turn defines the vertical boundaries of the firm

diversification discount

situation in which the stock price of highly diversified firms is valued at less than the sum of their individual business units The presence of the diversification discount, however, depends on the institutional con- text- some research evidence suggests that an unrelated diversification strategy can be advantageous in emerging economies. Unrelated diver- sification may help firms gain and sus- tain competitive advantage because it allows the conglomerate to overcome institutional weaknesses in emerging economies such as a lack of a function- ing capital market

diversification premium

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

vertical integration

the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs Vertical integration can be measured by a firm's value added Fully integrated or disintegrated economies of scope through participating in different stages of the industry value chain. For instance, it now can share competencies in product design, manufacturing, and sales, while at the same time attempting to reduce transaction costs

conglomerate

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

related linked diversification strategy

a kind of related diversification strategy in which executives pursue various businesses opportunities that share only a limited number of linkages

diversification

an increase in the variety of products and services a firm offers or markets and the geographic regions in which it competes A non-diversified company focuses on a single market, whereas a diversified company competes in several different markets simultaneously various general diversification strategies: Product diversification geographic diversification product-market diversification Because shareholders expect continuous growth from public companies, managers frequently turn to product and geographic diversification to achieve it

joint venture

another special form of strategic alliance. A stand-alone organization created and jointly owned by two or more parent companies. partners contribute equity to a joint venture, they make a long-term commitment, which in turn facilitates transaction-specific investments.

Physical-asset specificity

assets whose physical and engineering properties are designed to satisfy a particular customer

Related diversification

can involve sharing of Customers, sales force or channel of diversification, brand name and its image, facilities, R&D, staff and operating systems, marketing and marketing research Proctor and Gamble- selling a lot of products that seem unrelated but they are related because they think there are synergies relating to their existing product base.

Why of CS (other bad reasons)

empire building (just someone who wants to buy stuff). Escape failing core business (try something new and abandon your core business because you screwed up. You wont know anything about the new stuff after you just screwed the previous one up). Reduce risk (strategic diversification, not financial diversification. Bought or aligned with company for purpose of reducing risk- You don't know anything about the new part of the company, so youre actually NOT reducing risk).

potential benefits to firm performance when following a diversification strategy include

financial economies, resulting from restructuring and using internal capital markets

increase market power

firms often consolidate industries through horizontal mergers and acquisitions. larger firms have more bargaining power with suppliers and buyers

Unrelated diversification

happens very rarely because synergies do not appear. Conglomerates. GE, yamaha

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.

managerial motives

managers may be more interested in pursuing their own interests such as empire building and job security—plus managerial perks such as corporate jets or executive retreats at expensive resorts—rather than increasing shareholder value. Although there is a weak link between CEO compensation and firm performance, the CEO pay package often correlates more strongly with firm size

geographic diversification strategy

corporate strategy in which a firm is active in several different countries

single-business firm

derives more than 95 percent of its revenues from one business

restructuring

process of reorganizing and divesting busi- ness units and activities to refocus a company in order to leverage its core competencies more fully

information asymmetry

situation in which one party is more informed than another because of the possession of private information George Akerlof- buyer beware. Information asymmetries can result in the crowding out of desirable goods and services by inferior ones

Why do they 'fail' more than 70% of the time?

- If this is going to break even, you have to return 30% higher than that standalones expectations of the future value (30% premium) - CAGR- compound annual growth rate? - Puts expectations on the acquisition. Forcing friendships even if it should be dropped. - 70% of acquisitions fail to reach expectations in 5 years. Companies share price usually drops after announcing that it will acquire a company. Because they pay too much for it

Risk with partnerships

- Misrepresentation of partners' competencies/contribution (i.e., you looked a lot better from across the bar) - Partner fails to make complementary resources available (e.g., your partner doesn't send its "A" team). What are you actually going to get - Being held hostage through specific invtmts made w/ partner (e.g., we built this plant together, and you're not going anywhere) - Misunderstanding a partner's strategic intent or goals (e.g., partner may have sought to learn trade secrets)

underlying strategic management concepts that will guide our discussion of vertical integration, diversification, and geo- graphic competition

core competencies economies of scale economies of scope transaction costs

product diversification strategy

corporate strategy in which a firm is active in several different product markets

product-market diversification strategy

corporate strategy in which a firm is active in several different product markets and several different countries

lower costs

Firms need to grow to achieve minimum efficient scale, and thus stake out the lowest-cost position achievable through economies of scale.

reduce risk

diversify their product and service portfolio through competing in a number of different industries. The rationale behind these diversification moves is that falling sales and lower performance in one sector might be compensated by higher performance in another. Such conglomerates attempt to achieve economies of scope

Economies of scope

savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology

Opportunism

self-interest seeking with guile Backward vertical integration is often undertaken to overcome the threat of opportunism and to secure key raw materials.

principal-agent problem

situation in which an agent performing activities on behalf of a principal pursues his or her own interests (ex. manager trying to keep his job instead of creating shareholder value) -One potential way to overcome the principal-agent problem is to give stock options to managers, thus making them owners.

internal transaction costs

- Costs within the firm pertaining to organizing an economic exchange within a hierarchy; also called administrative costs - recruiting and retaining employees; paying salaries and benefits; setting up a shop floor; providing office space and computers; and organizing, monitoring, and supervising work. - tend to increase with organizational size and complexity

Understanding Acquisitions Why are they so costly? What is in a purchase price? How do firms get at a WTP for a target?

- Pay a premium - Share price- Intrinsic value to market value (will jump to market value when there's an announcement that a company is interested)Public synergies - Synergy price - Another announcement that a specific company agreed to buy a company and stock price jumps to take out price/sale price

Firm as arrangements for organizing economic activity Advantages

- ability to make command-and-control decisions by fiat along clear hierarchical lines of authority. - Coordination of highly complex tasks to allow for specialized division of labor. - Transaction-specific investments, such as specialized robotics equipment that is highly valuable within the firm, but of little or no use in the external market. - Creation of a community of knowledge, meaning employees within firms have ongoing relationships, exchanging ideas and working closely together to solve problems. This facilitates the development of a deep knowledge repertoire and ecosystem within firms.

Transaction costs

- all costs associated with an economic exchange - enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification. This implies taking on greater ownership of the production of needed inputs or of the channels by which it distributes its outputs, or adding business units that offer new products and services

Vertical integration risks

- increasing costs (In-house suppliers tend to have higher cost structures because they are not exposed to market competition. Knowing there will always be a buyer for their products reduces their incentives to lower costs. Smaller market- maybe won't reach economies of scale. Increased admin costs) - reducing quality (reduce the incentive to increase quality or come up with innovative new products) - reducing flexibility - increasing the potential for legal repercussions (monopoly concerns)

advantages of markets

-high powered incentives (entrepreneur's ability to capture the venture's profit, to take a new venture through an initial public offering (IPO), or to be acquired by an existing firm. In these so-called liquidity events, a successful entrepreneur can make potentially enough money to provide financial security for life) -increased flexibility (Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers.)

disadvantages of markets

-search costs (scour the market to find reliable suppliers from among the many firms competing to offer similar products and services) -opportunism by other parties (self-interest seeking with guile) -incomplete contracting (all contracts are incomplete to some extent, because not all future contingencies can be anticipated at the time of contracting. also difficult to specify expectations (e.g., What stipulates "acceptable quality" in a graphic design project?) or to measure performance and outcomes (e.g., What does "excess wear and tear" mean when returning a leased car?). Another serious hazard inherent in contracting is information asymmetry) -enforcement of contracts (difficult, costly, and time-consuming to enforce legal contracts)

Boston Consulting Group (BCG) Growth-share Matrix

A corporate planning tool in which the corporation is viewed as a portfolio of business units, which are represented graphically along relative market share (horizontal axis) and speed of market growth (vertical axis). SBUs are plotted into four categories (dog, cash cow, star, and question mark), each of which warrants a different investment strategy. - dogs are underperforming businesses. The strategic recommen- dations are either to divest the business or to harvest it - Cash cows are SBUs that compete in a low-growth market but hold considerable market share. invest enough into cash cows to hold their current position and to avoid having them turn into dogs - A corporation's star SBUs hold a high market share in a fast-growing market. The recommendation for the corporate strategist is to invest sufficient resources to hold the star's position or even increase investments for future growth. Could turn into cows - question marks: It is not clear whether they will turn into dogs or stars

Acquisition advantages and disadvantages

Advantages: Saves calendar time- its immediate Overcomes entry barriers Reduces competition Disadvantages: Costly-usually buy redundant assets at a premium Problem of integrating twoOrganizations

Joint Ventures/Alliances Advantages and Disadvantages

Advantages: Technological/marketing unions can exploit small/large firm synergies Distributes risk (Using each other's knowhow) Disadvantages: Potential for conflict Shared upside Value of one firm may be reduced over time

Make advantages and disadvantages

Advantages: Uses existing resources Avoids acquisition cost Have absolute control over it Disadvantages: Time lag Uncertain prospects

Case 3- I don't have enough to make or rent but I have enough to be an attractive partner.

Ally

What of CS

Figuring out the "scope" (broad or narrow) of the firm across 3 dimensions: Change product (diversification: range of products/services. Related vs. Unrelated diversification- notion of verticals. Inverted U shape- profit low for dominant product), change geography (expand customer base), or change how I make it (integration: expanding along the industry value chain- make vs. buy decisions. Horizontal or vertical) Connections between the 3 Integration- vertical. Can be forward and backwards: Stage 1- design Stage 2- manufacturing Stage 3- Marketing and sales Stage 4- After-sales service and support Integration- horizontal: Companies acquiring companies. Expansion- amazon acquired whole foods

specialized assets

Unique assets with high opportunity cost: They have significantly more value in their intended use than in their next best use. They come in three types: site specificity, physical asset specificity, and human-asset specificity. Investments in specialized assets tend to incur high opportunity costs because mak- ing the specialized investment opens up the threat of opportunism by one of the partners

what, why, how of corporate strategy

WHAT are we hoping to gain?- grow some portion of the company WHY are we doing this? (Good reasons) (less good reasons) (not good reasons) How- Make (Organic development; "corporate entrepreneurship"), borrow (Find assets or resources that are tradeable with simple contract (e.g., license, franchise)), ally (Equity or non-equity relationship (e.g., joint venture, partnership, alliance, etc.), buy (Merger or acquisition) Divest (Cutting fat to focus on areas of growth)

external transaction costs

When companies transact in the open market, its the costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract

taper integration

alternative to vertical integration a way of orchestrating value activities in which a firm is backwardly integrated but 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 - allows a firm to retain and fine-tune its competencies in upstream and downstream value chain activities - enhances a firm's flexibility - firms can combine internal and external knowledge, possibly paving the path for innovation

strategic outsourcing

alternative to vertical integration moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain reduces its level of vertical integration

Internal Capital Markets

can be a source of value creation in a diversification strategy if the conglomerate's headquarters does a more efficient job of allocating capital through its budgeting process than what could be achieved in external capital markets. Based on private information, corporate managers are in a position to dis- cover which of their strategic business units will provide the highest return on invested capital. In addition, internal capital markets may allow the company to access capital at a lower cost

Forward vertical integration

changes in an industry value chain that involve moving ownership of activities closer to the end (customer) point of the value chain

Backward vertical integration

changes in an industry value chain that involve moving ownership of activities upstream to the originating (inputs) point of the value chain

Business Strategy

concerns the question of how to compete in a single product market

corporate vs. business strategy

corporate- We want to facilitate that business strategy but we're at a higher level now. Saying "why do we actually have these brands?" Still thinking about competitive advantage Manager cs. Shareholder perspective Interested in the collection of markets in which the firm competesWhat determines the boundaries of the firm?- What does the firm look like? Did they buy their supplier due to transaction costs? Advantages of multi-market presence. Advantages of ownership business- How youre going to compete. Larger scale- business analysis and industry analysis. Competitive advantage was our goal. We wanted to think like a manager would think

dominant-business firm

derives between 70 and 95 percent of its revenues from a single business, but it pursues at least one other business activity that accounts for the remainder of revenue.

related diversification

derives less than 70 percent of its revenues from a single business activity and obtains revenues from other lines of business linked to the primary business activity. The ratio- nale behind related diversification is to benefit from economies of scale and scope: These multi-business firms can pool and share resources as well as leverage competencies across different business lines Related-ConstrainedDiversification Related-Linked Diversification

Corporate Strategy

the decisions that senior management makes and the goal-directed actions it takes to gain and sustain competitive advantage in several industries and markets simultaneously. key question of where to compete. Corporate strategy determines the boundaries of the firm along three dimensions: vertical integration (along the industry value chain), diversification (of products and services), and geographic scope (regional, national, or global markets) three questions: 1. In what stages of the industry value chain should the company participate (vertical integration)? 2. What range of products and services should the company offer (diversification)? 3. Where should the company compete geographically in terms of regional, national, or international markets (geographic scope)? In most cases, underlying these three questions is an implicit desire for growth

strategic alliances

voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services long-term contracts, equity alliances, and joint ventures Quicker to form (no due diligence, financing, reg, vote) Flexible (i.e., simply a contract) Easier to dissolve failed project Less risky Requires less cash and other resources Multiple parties can participate Partners can maintain independent brand identities Scalable (i.e., small or grand projects can be pursued) Sheltered from antitrust laws—though changing

increase profits

with a lower stock price, it is more costly for firms to raise the required capital to fuel future growth by issuing stock.

Case 4- missing everything.

Can I purchase the resources for less than our synergy or private value? Can I integrate the target in a manner that is not overly costly or burdensome? If yes to both, I will acquire them. If no, I go back to the beginning and rethink the idea

related diversification strategy

Corporate strategy in which a firm derives less than 70 percent of its revenues from a single business activity and obtains revenues from other lines of business that are linked to the primary business activity.

unrelated diversification strategy

Corporate strategy in which a firm derives less than 70 percent of its revenues from a single business and there are few, if any, linkages among its businesses.

Why of CS (good reasons)

Cost synergies- economies of scale. Lower costs by integrating supply chain. Easier to value Revenue synergies- one-stop-shop. Cross-selling into new customer base. Sharing distribution channels. Leverage reputation or brand. Reduce competition. Access to new markets. Hard to evaluate how much people are willing to pay If we don't have these 2 things, we dont have good reasons to go through with it

Diversification-performance relationship

Inverted U-shaped relationship between the type of diversification and overall firm performance. High and low levels of diversification are generally associated with lower overall performance (fail to achieve additional value creation), while moderate levels of diversification are associated with higher firm performance. Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies into adjacent markets.

why of CS (less good reasons)

Market failure reasons- don't give coasian synergies we're afterhard to write or enforce contracts. Downstream free-riding (relationships between wholesale and retail that the wholesaler will give the margin to the retailer so they spend that margin on advertising to sell the hell out of their product. But some wholesalers say screw you, youre freeriding on our product. Customers are only going to your store because our product is there (ex. Apple and bestbuy)). Tight coordination needed (usually goes with contracts). Internalize capital or labor markets (ex: if capital markets are absent or inefficient. He has mastered his rug making but the transportation in India is shitty. The market has let them down. The company then builds their roads and create their own trucks, then make their own banks to finance it)

vertical market failure

McKinsey identified the main reason to vertically integrate: failure of vertical markets. When the markets along the industry value chain are too risky, and alternatives too costly in time or money The findings suggest that when a company vertically integrates two or more steps away from its core competency, it fails two-thirds of the time

(Un)related diversification

Risk (attention may be diverted from the core business, managing the new business may be difficult, the new business may be over valued) Graph of diversity and profit for single (few synergies, little), dominant, related Reaching some level of synergies as you increase up until related. Then at unrelated, profit drops- organizationally too complex, transaction costs are too much of a pain In the 1980s companies were buying up and becoming unrelated and less profitable, then people bought them (LBOs) and broke them up

Strategic Interdependence and organizational autonomy

SI = Degree to which capabilities must be transferred across organizational boundaries in order to achieve the desired synergies. E.g. Skills, people, information, know-how. Messing with cost synergies. The extent to which my premium synergy price is related to cost synergiesIf however, the reason I bought them is because theyre awesome but I don't want to do anything with them, OA OA = degree to which the pre-merger culture of an organization must be protected in order to preserve the value of the assets acquiredMessing with revenue synergies

Acquisition Integration Framework

Strategic Interdependence and organizational autonomy Preservation- operate in parallel to avoid culture contamination. Low need for strategic interdependence, low need for organizational autonomy Holding- no integration; conglomerate strategy. Low need for strategic interdependence, high need for organizational autonomy Symbiosis- "permeable boundary" actively managed by leaders; gradual evolution of common culture (Ford and jaguar). High need for strategic interdependence, low need for organizational autonomy Absorption- consolidate target into parent. High need for strategic interdependence, high need for organizational autonomy

parent-subsidy relationship

The corporate parent owns the subsidiary and can direct it via command and control. Transaction costs that arise are frequently due to political turf battles, which may include the capital bud- geting process and transfer prices, among other areas.

Make, Ally, Borrow, Buy

The more control you want, the more you have to pay

When to pursue Vertical integration and benefits

When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market (Cin-house < Cmarket), then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs. In other words, when firms are more efficient in organizing economic activity than are markets, which rely on con- tracts among many independent actors, firms should vertically integrate Benefits: - Lowering costs (increase operational efficiencies through improved coordination and the fine-tuning of adjacent value chain activities) - Improving quality. - Facilitating scheduling and planning. - Facilitating investments in specialized assets. - Securing critical supplies and distribution channels.

Choosing a partner

Worst match to best match: Competitors Two weak players (Kmart and ) Strong + weak players Prelude to sale (i.e., courting) - Starts w/ equity alliance - Want to see if they say they are good at what they say they are Complementary equals (not size)

Firms responses to: Are acquisitions & alliances two different ways to achieve the same goals? Does your company have criteria to choose between these two strategies?

Yes: 82% No: 86%

licensing

a form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property

core competence-market matrix

a framework to guide corporate diversification strategy in order to achieve continued growth by analyzing possible combinations of existing/new core competencies and existing/new markets The first task for managers is to identify their existing core competencies and understand the firm's current market situation.

related constrained diversification strategy

a kind of related diversification strategy in which executives pursue only businesses where they can apply the resources and core competencies already available in the primary business

franchising

a long-term contract in which a franchisor grants a franchisee the right to use the franchisor's trademark and business processes to offer goods and services that carry the franchisor's brand name

credible commitment

a long-term strategic decision that is both difficult and costly to reverse. Assures that one companies cannot hold up the other by demanding lower prices or threaten to walk away from the agreement

transaction cost economics

a theoretical framework in strategic management to explain and predict the boundaries of the firm, which is central to formulating a corporate strategy that is more likely to lead to competitive advantage Insights gained from transaction cost economics help managers decide what activities to do in-house versus what services and products to obtain from the external market Ronald Coase: key insight of transaction cost economics is that different institutional arrangements—markets versus firms—have different costs attached.