Chapter 8 Lecture and Book

Why firms need to grow

1) Increase Profits 2) Lower Costs 3) Increase Market Power 4) Reduce Risk 5) Motivate Management

credible commitment

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

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.

product diversification strategy

Corporate strategy in which a firm is active in several different product markets.

geographic diversification strategy

Corporate strategy in which a firm is active in several different countries.

product-market diversification strategy

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

Cost drivers support

Cost Leadership strategy

External Transaction Cost

Costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

Value drivers support

Differentiation Strategy

Single Business (Type of Diversification)

Single Business leverage its competencies

Principal Agent Problem

Situation in which an agent performing activities on behalf of a principal pursues his or her own interests. is a major disadvantage of organizing economic activity within firms, as opposed to within markets. It can arise when an agent such as a manager, performing activities on behalf of the principal (the owner of the firm), pursues his or her own interests.

information asymmetry

Situation in which one party is more informed than another because of the possession of private information.

Diversification Discount

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

Diversification Premium

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

parent-subsidiary relationship

describes the most-integrated alternative to performing an activity within one's own corporate family.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 budgeting process and transfer prices, among other areas.

Executives must determine their corporate strategy by answering three questions: (Strategic Management 253)

1. In what stages of the industry value chain should the company participate (vertical integration)? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages. 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)? (Strategic Management 253)

Four 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 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.

BCG Matrix Star

Earnings: High, Stable, or Growing Cash Flow: Neutral Strategy: Hold or Invest for Growth

BCG Matrix Cash Cow:

Earnings: High, Stables Cash Flow: High, Stable Strategy: Hold

BCG Matrix Dog:

Earnings: Low, Unstable Cash Flow: Neutral or Negative Strategy: Harvest/Divest

BCG Matrix Question Mark:

Earnings: Low, unstable or growing Cash Flow: Negative Strategy: Increase market share or harvest/divest

Does corporate diversification lead to Firm Performance?

High and Low Levels of Diversification-Lower Performance Moderate Levels of Diversification- Higher Firm Performance

Business level strategies answers:

How we compete

The degree of vertical integration

In what stages of the industry value chain to participate

Vertical Integration Risks:

Increase in costs Reduction in quality Reduction in flexibility Increase in the potential for legal reprecussions

Diversification

Increase in: The variety of products/services a firm offers, or The markets/geographic regions in which it competes Can be targeted towards: Products Geography Product-Market

How diversification can enhance firm performance Exploit Economies of Scope:

Increases Value

Exploit economies of scope:

Increases value

Vertical Integration Benefits:

Lower Costs Improves Quality Facilitates scheduling and planning Facilitates investments in specialized assets Secures critical supplies and distribution channels Unique Assets with high opportunity cost: (3 Types) 1) Site Specifically: Co-Location requirements (Machine Collaboration) 2) Physical Asset Specificity: Unique physical and engineering properties (Coca Cola Bottle) 3) Human Assets Specificity: Investments made in human capital (Knowledge and skills for a specific process)

Strategic Outsourcing

Moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain.

Strategic Outsourcing:

Moving one or more internal value chain activities outside the firms boundaries to other firms in the industry value chain EX) Off-Shoring Most Active Sectors of off-shoring -Banking and Financial Services -IT -Health Care

Unrelated Diversification (Type of Diversification)

No Businesses share competencies

Provide economies of scale:

Reduces Cost

How diversification can enhance firm performance Provide Economies of Scale:

Reduces Costs

Related Diversification (Type of Diversification)

Related constrained all businesses share competencies Related Linked: Some Businesses share competencies

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. (Strategic Management 253)

vertical integration

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

STRATEGIC ALLIANCES

Voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services.

Type of Diversification

What range of products and services to offer

Offshoring

When outsourced activities take place outside the home country

Vertical Market Failure

When the markets along the industry value chain are too risky, and alternatives too costly in time or money.

The geographic scope

Where to compete

Corporate level strategy answers the question

Where to compete?

conglomerate

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

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.

Dominant Business

A 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. The dominant business shares competencies in products, services, technology, or distribution. In the schematic figure shown here, and those to follow the remaining revenue (R), is generally obtained in other strategic business units (SBU) within the firm.

Related Diversification

A firm follows a related diversification strategy when it 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 rationale 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. The two variations of this type, which we explain next, relate to how much the other lines of business benefit from the core competencies of the primary business activity.

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 by analyzing possible combinations of existing/new core competencies and existing/new markets.

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.

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.

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

Single Business

A single-business firm derives more than 95 percent of its revenues from one business. The remainder of less than 5 percent of revenue is not (yet) significant to the success of the firm. For example, although Google is active in many different businesses, it obtains more than 95 percent of its revenues ($70 billion in 2014) from online advertising.

joint venture

A stand-alone organization created and jointly owned by two or more parent companies.

Transactional Cost Economies

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.

taper 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.

Transactional Costs

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

Tapering Integration:

An alternative to vertical integration Backward integration and relying on other suppliers Forward integration and relying on others for integration

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.

Internal Transaction Cost

Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs.

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.

Spread out risk (Finance)

Diversification

Dominant Business (Type of Diversification)

Dominant and Minor Businesses share competencies

The disadvantages of organizing economic activity within firms include:

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

The advantages of markets include:

■ High-powered incentives. Rather than work as a salaried engineer for an existing firm, for example, an individual can start a new venture offering specialized software. High- powered incentives of the open market include the 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.

BENEFITS OF VERTICAL INTEGRATION. Vertical integration, either backward or forward, can have a number of benefits, including:

■ Lowering costs. ■ Improving quality. ■ Facilitating scheduling and planning. ■ Facilitating investments in specialized assets. ■ Securing critical supplies and distribution channels.

For diversification to enhance firm performance, it must do at least one of the following:

■ Provide economies of scale, which reduces costs. ■ Exploit economies of scope, which increases value. ■Reduce costs and increase value.

The disadvantages of markets include:

■ Search costs. On a very fundamental level, perhaps the biggest disadvantage of trans- acting in markets, rather than owning the various production and distribution activities within the firm itself, entails non-trivial search costs. In particular, a firm faces search costs when it must scour the market to find reliable suppliers from among the many firms competing to offer similar products and services. Even more difficult can be the search to find suppliers when the specific products and services needed are not offered by firms currently in the market. In this case, production of supplies would require transaction-specific investments, an advantage of firms. Strategic Management principal-agent problem Situation in which an agent performing activities on behalf of a principal pursues his or her own interests. ■ Opportunism by other parties. Opportunism is behavior characterized by self-interest seeking with guile (we'll discuss this in more detail later). ■ Incomplete contracting. Although market transactions are based on implicit and explicit contracts, all contracts are incomplete to some extent, because not all future contingen- cies can be anticipated at the time of contracting. It is also difficult to specify expec- tations (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 (which we discuss next). ■ Enforcement of contracts. It often is difficult, costly, and time-consuming to enforce legal contracts. Not only does litigation absorb a significant amount of managerial resources and attention, but also it can easily amount to several million dollars in legal fees. Legal exposure is one of the major hazards in using markets rather than integrating an activity within a firm's hierarchy.

The advantages of firms include:

■ The 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. For example, scientists within a biotech company who worked together developing a new cancer drug over an extended time period may have developed group-specific knowledge and routines. These might lay the foundation for innovation, but would be difficult, if not impossible, to purchase on the open market.11

RISKS OF VERTICAL INTEGRATION. It is important to note that the risks of vertical integration can outweigh the benefits. Depending on the situation, vertical integration has several risks, some of which directly counter the potential benefits, including

■Increasing costs. ■ Reducing quality. ■ Reducing flexibility. ■ Increasing the potential for legal repercussions.