CH 8 Corporate Strategy: Vertical Integration and Diversification

if costs (in-house) < costs (market)

- vertically integrate - own production of the inputs - or own output distribution channels

when does vertical integration make sense?

- when there are issues with raw materials - to enhance the customer experience - vertical market failure

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.

product diversification

Corporate strategy in which a firm is active in several different product markets. Increase in variety of products/services

external transaction costs

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

internal transaction costs

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

the key insight of transaction costs economics is that:

different institutional arrangements (markets versus firms) have different costs attached

single business

A firm earning more than 95 percent of revenues from a single line of business. (low level of diversification)

licensing

A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property. class: granting permission to another company to use your 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.

two variations of related diversification strategy

related-constrained diversification strategy related-linked diversification strategy

moving from transacting in the market ("buy") to full integration ("make"), alternatives include:

short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) ad parent-subsidiary relationships

one solution to the principal-agent problem:

stock options to make agents owners

alternatives to vertical integration that provide similar benefits without accompanying risks:

taper integration strategic outsourcing

information asymmetry can result in...

the crowding out of desirable goods and services by inferior

if costs (market) < costs (in-house)

the firm should consider purchasing instead

Principal and their goal

the owner of the firm goal: create shareholder value

examples of information asymmetry

used cars, e-commerce, mortgage backed securities, R&D projects

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

coordination costs

a function of the number, size, and types of businesses that are linked to one another

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

cash cows

compete in a low-growth market but hold considerable market share

a related-diversification strategy entails two types of costs:

coordination and influence cost

Since a firm's external environment never remains constant over time,

corporate strategy needs to be dynamic over time

types (3)

long-term contracts equity alliances joint ventures

High and low levels of diversification =

lower performance

________ levels of diversification are associated with higher firm performance

moderate

influence costs

occur due to political maneuvering by managers to influence capital and resource allocation and the resulting inefficiencies stemming from suboptimal allocation of scarce resources

vertical integration

refers to the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs (what percentage of a firm's sales is generated within the firm's boundaries?)

Types of Diversification

-product diversification -geographic diversification -product-market diversification

internal capital markets

- Can be a source of value creation in diversification strategy. (A way to allocate capital at a lower cost, if more efficient than external markets.) - A related-diversification strategy can enhance corporate performance. (Consider coordination and influence costs.)

underlying concepts that guide the three dimensions of corporate strategy (4):

- core competencies - economies of scale - economies of scope - transaction costs

agent

- manager or employee - should act on behalf of the principal

internal transaction costs examples

- recruiting and retaining employees - setting up a shop floor

Taper Integration benefits (3)

-exposes in-house supplies/distributors to market competition so performance comparisons are possible -enhances firm's flexibility in order to adjust to fluctuations in demand -allows firm for combine internal and external knowledge to possibly generate innovation

benefits of vertical integration

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

4 main types of corporate diversification

1. Single business 2. Dominant business 3. Related diversification - constrained - linked 4. Unrelated diversification: the conglomerate

advantages of organizing economic activity within firms include: (4)

1. ability to make command and control decisions by bias along clear hierarchical lines of authority 2. coordination of highly complex tasks to allow for specialized division of labor 3. transaction specific investments, such as in AI or specialized robotics equipment that is highly valuable within the firm, but of little or no use in the external market 4. creation of a community of knowledge, meaning employees within firms have ongoing relationships, exchanging ideas and working closely together to solve problems

disadvantages of organizing economic activity within firms include: (3)

1. administrative costs because of necessary bureaucracy 2. low-powered incentives, such as hourly wages and salaries 3. the principal-agent problem

advantages of organizing economic activity within markets include: (2)

1. high-powered incentives 2. increased flexibility

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

for diversification to enhance firm performance, it must do at least one of the following: (3)

1. provide economies of scale, which reduces costs 2. exploit economies of scope, which increases value 3. reduce costs and increase value

the Boston Consulting Group (BCG) growth-share matrix locates the firm's individual SBUs in two dimensions:

1. relative market share (horizontal axis) 2. speed of market growth (vertical axis)

disadvantages of organizing economic activity within markets include: (4)

1. search costs 2. opportunism by other parties 3. incomplete contracting 4. enforcement of contracts

Richard rumelt developed a helpful classification scheme that identifies four main types of diversification by identifying two key variables:

1. the percentage of revenue from the dominant or primary business 2. the relationship of the core competencies across the business units

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. class: - guides portfolio planning - each category warrants a different strategy

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. class: all businesses share competencies

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. class: some businesses share competencies

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.

joint venture

A standalone organization created and jointly owned by two or more parent companies. class: two or more companies start a joint third company, each providing equity

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.

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.

transaction costs

All internal and external costs associated with an economic exchange, whether within a firm or in markets. class: cost effectiveness of vertical integration vs. diversification

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. class: owning activities closer to the customer

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. class: owning inputs of the value chain

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. (no businesses share competencies)

geographic diversification

Corporate strategy in which a firm is active in several different countries. Increase in variety of markets/geographic regions (regional, national, or international markets)

product-market diversification strategy

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

strategic outsourcing

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

the principal-agent problem

Situation in which an agent performing activities on behalf of a principal pursues his or her own interests (like corporate jets, golf outings, and expensive hotels). (a major disadvantage of organizing economic activity within firms)

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.

Stages of Industry Value Chain (5)

Stage 1. Raw Materials Stage 2. Components/Intermediate Goods Stage 3. Final Assembly/Manufacturing Stage 4. Marketing/Sales Stage 5. After-Sales Service and Support

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. (where to compete)

parent-subsidiary relationship

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.

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.

strategic alliances

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

vertical market failure

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

geographic scope

Where should the company compete geographically in terms of regional, national, or international markets?

equity alliance

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

a non-diversified company focuses on ____________ ______________, whereas a diversified company comes In ________ ________ ___________ _________________.

a single market, several different markets simultaneously

site specificity

assets 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

dominant business

between 70% and 95% of revenue comes from a single business, but it pursues at least one other business activity that accounts for the remainder of revenue

caveat emptor

buyer beware

facilitating investments in specialized assets:

co-located assets, unique equipment, human capital

diversification

encompasses the variety of products and services a firm offers or markets and the geographic locations in which it competes

other potential benefits to firm performance when following a diversification strategy include:

financial economies, resulting from restructuring and using internal capital markets

when firms are more efficient in organizing economic activity than are markets, which rely on contracts among many independent actors,

firms should vertically integrate

Stars

hold a high market share in a fast-growing market

dogs

hold a small market share in a low-growth market

question marks

hold low market share in a fast-growing market

reasons that explain why firms need to grow (5)

increase profitability lower costs increase market power reduce risk motivate management

risks of vertical integration (4)

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

a cumulative body of research indicates an ___________ ___________ relationship between the type of diversification and overall firm performance

inverted U-shaped

human asset specificity

investments made in human capital to acquire unique knowledge and skills

long term contracts types

licensing franchising