Chapter 8: Corporate Strategy - vertical integration & diversification

Alternatives: 3) Parent-Subsidiary Relationship

parent-subsidiary = the most-integrated alternative to performing an activity within one's own corporate family - corporate parent owns the subsidiary and can direct it via command and control - transaction costs may arise due to political turd battles - how centralized vs. decentralized in subsidiary unit

Leveraging Core Competencies for Diversification

core competencies = unique strengths embedded deep in a firm that allow a firm to increase perceived value of their product or lower the cost to produce them core competence-market matrix is used to help managerial decisions in regard to diversification strategies: 1) new competencies, same market → 2) same competencies, same market → managers come up with new ideas on how to leverage existing core competencies to improve firms current market position 3) new competencies, new market → build new competencies to compete in future markets 4) same competencies, new market → leaders strategize about how to redeploy and recombine core competencies to compete in future markets

Corporate Strategy: sources of value creation & sources of costs

strategic leader must determine the degree of vertical integration, the type of diversification, and the geographic scope - the corporate Strategy needs to be dynamic over time

Corporate Diversification & Firm Performance

"U-shape" relationship between the type of diversification and overall firm performance - high & low diversification → low performance - medium diversification → high performance

Business Diversification→ Dominant Business

- 70-90% of revenue from a single dominant business - remainder of the revenue comes from another SBU in the firm (another business activity) ex) Harley Davidson - 80% of revenue from selling motorcylces and the other 20% from side business like motercycle parts

3 Benefits of Taper Integration

- Comparative Performance: exposes in-house suppliers (backward) & distributors (forward) to market competition so that performance comparisons are possible → lets the firm fine-tune competencies - Enhances Firm's Flexibility: able to adjust better to fluctuations in demand - Innovation: firm combines internal & external knowledge

Business Diversification→ Single Business

- low levels of diversification - 95% of revenue from one business - remaining 5% is not significant to success

Corporate Diversification - expands beyond a single market

1) Vertical Integration: in what stages of the value chain should the firm participate? 2) Product Diversification: what range of products and services should the firm offer? - do i want to compete in a single product market (only soft drinks) or do i want to diversify and compete in multiple product markets (soft drinks and chips) - number of markets to compete in 3) Geographic Diversification: where should the firm compete in terms of regional, national or international market? - do i want to just compete in local markets or do i want to compete beyond national boarders - where to compete geographically Corporate Strategy: Vertical Integration & Diversification

Firms vs. Markets: 4 Firm Advantages

1. "command-and-control" decisions 2. "Coordination of highly complex tasks" through specialization of labor 3. "transaction-specific investments" 4. "Community of Knowledge"

Firms vs. Markets: 2 Market Advantages

1. High Powered Incentives - instead of working as a salaried engineer for an existing firm, an individual can start a new venture offering specialized software 2. Increased Flexibility - you can compare prices among different providers

Alteratives on the Make-or-Buy Continuum (3 alteratives to firm vs. market)

1. Short-Term Contracts (closest to buy; less integrated) 2. Strategic Alliances - Long-Term Contracts (licensing, franchising) - Equity Alliances - Joint Ventures 3. Parent-Subsidiary Relationship (cloest to make; more integrated)

3 Dimensions of Corporate Strategy

1. Vertical Integration - in what stages of the industry value chain should the firm participate? (value chain is turning raw materials into finished goods) 2. Diversification - what range of products/ services should the firm offer and which not to offer? 3. Geographic Scope - where should the firm compete: regional, national, or global markets?

When to vertically integrate? (firm produce instead of market)

1st corporate strategy question: in what stages of the industry value chain should the firm participate? - cost of pursuing activity in-house < cost of activity in market - firms should vertically integrate when the firm is more efficient in organizing economic activity than the markets which rely on contracts

2 Alternatives to Vertical Integration

2 alternatives to gain some benefits of vertical integration without the risks of full ownership of the supply chain 1. Taper Integration = a way of orchestrating value activities in which a firm is either: - backwardly integrated, but it also relies on outside-market firms for some of its supplies and/or forwardly integrated, but also relies on out-market firms for some of its distribution benefits = comparative performance to competitors enhances firm's flexibility, combines internal+external knowledge 2. Strategic Outsourcing = involves moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain - you hire another company to be responsible for a business acitivity - reduces firm's level of vertical integration - firms outsource noncore activities like HR to leverage deep competencies and produce scale effects

4 main types of business diversification by 2 key variables

2 key variables for PRODUCT Markets (not geographic diversification) 1. the percentage of revenue from the dominant/ primary business - Single Business - Dominant Business 2. the relationship of the core competencies across the business - Related Diversification - Unrelated Diversification: the conglomerate

Corporate Diversification & Core Competencies

Core Competence-Market Matrix = a framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets 4 Options to Formulate Corporate Strategy via Core Competencies: 1) leverage existing core competencies to improve current market position 2) build new core competencies to protect & expand current market position 3) redeploy & 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

Corporate Strategy

Corporate Strategy = the decisions that the leaders make & the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously; formulated to guide continued growth - done by the CEO - PURPOSE OF CORPORATE STRATEGY = *GROWTH* - any corporate strategy must align with the firms business strategy - strategy determines WHERE to compete - strategy determines the boundaries of the firm along 3 dimensions

Diversification & 3 diversification strategies

Diversification = an increase in the variety of products / services a firm offers or markets, and the geographic regions in which is competes - non-diversified company focuses on single market 3 Diversification Strategies: 1) Product Diversification Strategy - firm is active in several different product markets 2) Geographic Diversification Strategy - firm is active in several different countries 3) Product-Market Diversification Strategy - firm is active in several different product markets AND several different countries

Diversification Makeup

Diversification → regards to questions about the # of markets to compete & where to compete geographically - a non diversified company focuses on a single market - a diversified company competes in several different markets simultaneously

Industry Value Chain / Vertical Value Chain

Industry Value Chain = transforming raw materials into finished goods, along distinct vertical stages → each of which represents a distinct industry in which many firms are competing a firms degree of vertical integration = number of industry value chain stages in which a firm directly participates - participating in different levels helps a firm achieve economies of scope

Alternatives: 2) Strategic Alliances

Strategic Alliances = voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services - let a firm gain transaction-specific assets without encountering internal transaction costs with vertical integration 1) Long-Term Contracts - Licensing - Franchising 2) Equity Alliances 3) Joint Venture

Strategy Formulation

Strategy Formulation: where & how to compete 1. Business Strategy = how to compete in a single product market - differentiation - cost-leadership - blue ocean (if trade-offs can be reconciled) 2. Corporate Strategy = where to compete overall

Boundaries of a Firm: Transaction Cost Economies

Transaction Cost Economics = theoretical framework to explain and predict the boundaries of the firm - helps leaders decide what activities to do in-house vs. what products/services to obtain from external market → WHICH IS CENTRAL TO FORMULATING a corporate strategy that's more likely to lead a competitive advantage - key insight of transaction cost economics is that different institutional arrangements (markets vs. firms) have different costs attached

corporate strategic decisions & guiding strategic management concepts

fundamental corporate strategic decisions: where to compete in terms of industry value chain, products & services, and geography strategic decisions guided by the underlying strategic management concepts: 1) Core Competencies - unique strengths that allow a firm differentiate its product/service 2) Economies of Scale - average cost per unit decreases as output increases 3) Economies of Scope - use the same resource to produce 2 or more different products 4) Transaction Costs - all costs associated with an economic exchange - is it cost effective for firm to grow through vertical integration of diversification?

How can diversification improve firm performance?

it must do at LEAST one of the following: - provide economies of scale (reduces costs) - exploit economies of scope (increases value) - reduce costs AND increase value

Firms vs. Markets: 3 Firm Disadvantages

1. Administrative Costs 2. Low-Powered Incentives - such as hourly wages & salaries (these are less attractive motivators than the entrepreneurial opportunities / rewards that can come in the open market) 3. Principal-Agent Problem = where an agent performs an activity on behalf of their own interests

2 types of costs for related-diversification strategy:

1. Coordination Costs = this cost depends on the #, size, type of businesses that are LINKED 2. Influence Costs = political things with managers trying to allocate resources across SBUs and they dont do a good job of allocating scare resources - due to political maneuvering by managers to influence capital and resource allocation, and the resulting inefficiencies stemming from suboptimal allocation of scarce resources

5 Reasons Firms need to Grow (Corporate Strategy → Growth)

1. Increase Profits - higher return for shareholder - higher stock market valuation (determined by expected future revenue) 2. Lower Costs - grow in order to achieve economies of scale - must achieve minimum efficient scale (MES) 3. Increase Market Power - grow to increase market share with their market power → M&A 4. Reduce Risk - grow to diversify product/service portfolio by competing in different industries - grow to achieve "economies of scope" 5. Motivate Management - grow to afford career opportunities and professional development for employees - beware of agency problem

4 Vertical Integration: RISKS

1. Increasing Costs - in-house suppliers have higher cost structures because they are not exposed to market competition 2. Reducing Quality - fewer incentives to increase quality or create new innovative products due to lack of competition, not motivated 3. Reducing Flexibility - especially when faced with challenges in the external environment like fluctuations in demand and technological change 4. Increasing the Potential for Legal Repercussions

Vertical Integration: 4 BENEFITS (both types)

1. Lowering Costs 2. Improving Quality 3. Facilitating, Scheduling, and Planning 4. Facilitating Investments in "Specialized Assets" Specialized Assets = unique assets with high opportunity costs → they have significant value in their intended use, rather than in their next-best use i. Site Specificity ii. Physical-Asset Specificity iii. Human-Asset Specificity - high opportunity costs because making the specialized investment opens up threat of opportunism by one of the partners - often backward vertical integration is done to overcome the threat of opportunism and to secure raw materials - normally if getting raw materials from someone in the market they KNOW you need it so they can raise prices bc they know you'll buy it

Firms vs. Markets: 4 Market Disadvantages

1. Search Costs 2. Opportunism by other Parties opportunism = self-interest seeking behavior - this is when the supplier knows you need this product, so they take advantage of the opportunity and make the price so high 3. Incomplete Contracting - hard to specify expectations, performance, outcomes - Risk of "information asymmetry" = one party is more informed than another because of the possession of private information (buyer beware) → info asymmetry can lead to the crowding out of desirable goods/services by inferior ones 4. Enforcement of Contracts - difficult, costly, time consuming

Firm Performance: unrelated vs. related diversification

A) Firm's pursuing "Unrelated Diversification" cannot create additional value Diversification Discount = situation where the stock price of highly diversified firms is valued at LESS than the sum of their individual business units B) Firm's pursuing "Related Diversification" can improve their performance: Diversification Premium = the stock price of related-diversification firms is GREATER than the sum of their individual business units

Vertical Integration: 2 TYPES

Changes in an Industry Value Chain: 1. Backward Vertical Integration = moves ownership of activities upstream to the originating point of the value chain (inputs/raw materials) 2. Forward Vertical Integration = moves ownership of activities closer to the end customer

Business Diversification→ Unrelated Diversification

Conglomerate = a company that combines 2 or more strategic business units (SBUs) under one overarching corporation - generates less than 70% of revenue from single business, and there are few if any linkages between businesses

Alternatives: Strategic Alliances → EQUITY ALLIANCES

Equity Alliances = a partnership where at least one partner takes partial ownership in the other partner - partner purchases ownership through buying a stock - signals commitment - one gains more information with this alliance* - an equity investment is making a "credible commitment" = a long-term strategic decision that is difficult and costly to reverse

Financial Economies

Financial Economies = resulting from restructuring & using internal capital markets - a source of value creation in a diversification strategy Restructuring = process of reorganizing & divesting business units and activities to refocus a company to leverage its core competencies more fully Boston Consulting GROUP (BCG) growth-share metric = corporation viewed as a portfolio of business units - horizontal axis: relative market share - vertical axis: speed of market growth - 4 categories: dog, cash cow, star, question mark (horizontal axis) and speed of market growth (vertical axis)

Another Benefit to Firm Performance with a Diversification Strategy

Financial Economies which results from restructuring and using internal capital markets Restructuring = reorganizing & divesting SBUs to refocus a firm to leverage core competencies more fully (decide how to reorganize with the BCG growth-share matrix) Internal Capital Markets = if more efficient job og allocating capital through internal budgeting process than what could be achieved in external markets

Internal Capital Markets

Internal Capital Markets = a source of value creation 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 - related diversification is more likely to enhance corporate performance 2 types of costs for related-diversification strategy: 1. Coordination Costs 2. Influence Costs

Alternatives: Strategic Alliances → JOINT VENTURE

Joint Venture = a stand-along organization is created and jointly owned by 2 or more parent companies - partners contribute equally, so it is a long-term commitment - facilitates transaction-specific investments

Alternatives: Strategic Alliances → LONG-TERM CONTRACTS

Long-Term Contracts = facilitate transaction-specific investments - Licensing = a form of long term contracting in the manufacturing sector that enables firms to commercialize intellectual property such as a patent. - Franchising = a form of long-term contract in the service industry where franchisor grants franchisee the right to use the trademark, business processes, and brand name

Business Diversification→ Related Diversification

Related-Constrained Diversification = executives pursue ONLY businesses where they can apply resources & core competencies they already have available in the primary business - less than 70% of revenue is derived from a single business activity & remainder from other related businesses - connected triangle of main activity, to 2 other sources (all sharing resources/competencies) Related-Linked Diversification = executives pursue various business opportunities that share only a limited number of linkages - in a triangle, only 2 of the sides are connected: main business connected to another business and that other business is connected to a third ex) amazon first only sold books and then they expanded into CDs and then they leveraged its online retailing capabilities into a wide array of product offerings

Restructuring

Restructuring = process of reorganizing & divesting business units and activities to refocus a company to leverage its core competencies more fully Boston Consulting GROUP (BCG) growth-share metric = corporation viewed as a portfolio of business units - horizontal axis: relative market share - vertical axis: speed of market growth - 4 categories: dog, cash cow, star, question mark (horizontal axis) and speed of market growth (vertical axis) star = high share, high growth ? = low share, high growth cash cow = high share, low growth dog = low share, low growth

Alternatives: 1) Short-Term Contracts

ST Contract = firm sends out RFP (request for proposals) to a few companies, this initiates competitive bidding for contracts to be awarded with short duration (<1yr) Benefit → the buying firm can demand lower prices because of competitive bidding Drawback → company's responding to RFP have no incentive to make any "transaction-specific investments" (buying a new machine to improve product quality) due to short term duration

Transaction Costs

Transaction Costs = ALL internal + external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or market 1. Internal Transaction Costs = costs pertaining to organizing an economic exchange within a firm: - cost of recruiting / retaining employees - paying salaries and benefits - setting up a shop floor - providing office space and computers - administrative costs 2. External Transaction Costs - cost of searching for a firm / individual in market with whom to contract → negotiating, monitoring, enforcing contract

Vertical Integration

Vertical Integration = the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs - solidifies vertical boundaries; firm must decide where in the industry value chain to compete Measurement of Vertical Integration: measured by a firm's value added, aka. what percent of a firms sales is generated within the firm's boundaries?

When does Vertical Integration make sense?

main reason to vertically integrate → "failure of vertical markets" Vertical Market Failure = when the markets along the industry value chain are too risky, and alternatives are too costly in time or money

Firms vs. Markets: advantages & disadvantages matrix

market = outsourcing firm = in-house making