Ch.8: Corporate Strategy: Vertical Integration and Diversification (MGMT 495)

(Understand) Managers respond to relentless growth need by leveraging their existing core competencies to find future growth opportunities

(Understand) Managers respond to relentless growth need by leveraging their existing core competencies to find future growth opportunities

(Understand) Principal-agent problems and information assymetrics can lead to market failures -And this situations where internalizing the activity is preferred

(Understand) Principal-agent problems and information assymetrics can lead to market failures -And this situations where internalizing the activity is preferred

Core competencies (Just understand, review)

CORE COMPETENCIES= Unique strengths embedded deep within a firm. -Allow firm to differentiate products and services from rivals and provide higher value -Internally held knowledge underlying a core competency determines firm's boundaries

Dominant-business Diversification

Dominant-business Diversification= Between 70-90% of revenues from a single business unit, -But pursues at least one other business activity

What is the drawback of short-term contracts?

Drawback= Firms responding to proposals have no incentive to make TRANSACTION-SPECIFIC INVESTMENTS, due to short-term contract

Related diversification strategy

Related diversification strategy= Derives Less than 70% (<70%) of revenues from a single business activity, -But obtains revenues from other lines of business that are linked to the primary business activity -Benefits from Economies of Scale and Scope= multi-businesses can pool and share resources as well as leverage competencies across different business lines (Can be related-constrained or related-linked)

Taper integration

Taper integration= An alternative to vertical integration Involves either: 1.) Backward integration, but also relies on the outside-market for some of its supplies 2.) Froward integration, buy also relies on outside market for some of its distribution

Vertical Value Chain (Industry value chain)

Vertical value chain= Depicts the transformation of raw materials into finished goods and services along distinct vertical stages -Each stage of the vertical value chain typically represents a distinct INDUSTRY in which a different number of firms are competing

What are the 4 main types of Business diversification?

1. Single Business 2. Dominant Business 3. Related Diversification -Related constrained -Related linked 4. Unrelated diversification (Conglomerate)

What are the 3 types of specialized assets?

1. Site specificity -Assets required to be co-located, such as the equipment necessary for mining bauxile and aluminum smelting 2. Physical asset specificity -Assets whose physical and engineering properties are designed to satisfy a particular customer ex.) Bottling machinery for coke and pepsi 3. Human-asset specificity -Investments made in human capital (Knowledge and skill for a specific process)

Internal capital markets (Almost positive don't need to know)

Internal capital markets= Can be a source of value creation in diversification strategy if conglomerate's headquarters do a more efficient job of allocating capital through its budgeting process than what could be achieved in external capital markets -May allow company to access capital at lower costs

Short-term contracts (Alternative)

Short-term contracts= Firms send out requests for proposals to several companies, which initiates competitive bidding for contracts to be awarded within short-duration (one year) -Allows longer planning period than individual market transactions -Can often demand lower prices due to competitive bidding

Single Business Diversification

Single Business Diversification= 95% or more of revenues from one business unit

Specialized assets

Specialized assets= Have significantly more value in their intended use than in their next best use -Have HIGH OPPORTUNITY COSTS= Making specialized investments opens up the threat of opportunism by one of the parties

What is the strategy for Stars?

Strategy= Hold or invest for growth -May turn into cash cows when market growth slows

What is the strategy for Question Marks?

Strategy= Invest to increase market share so turn into stars -If market conditions change, and growth slows, then likely to turn into a dog so should harvest/divest

Vertical integration

Vertical integration= Denote's a firm's addition of value- What % of a firm's sales is generated by the firm within its boundaries -Firm's ownership of its production of needed inputs or of the channels in which it distributes it's outputs -Degree of vertical integration tends to correspond to the number of industry value chain stages in which a firm participates

Credible committment

Credible commitment= A long-term strategic decision that is both difficult and costly to reverse

Diversification Premium

Diversification Premium= Stock price of related-diversification firm is valued at greater than the sums of their individual business unites -Companies that pursue related diversification are more likely to improve performance

What are the 4 advantages of firms organizing economic activity themselves? (May not need to memorize?

1. Ability to command-and-control decision -by fiat or hierichal lines of authority 2. Coordination -coordination of highly complex tasks allows for specialized division of labor 3. Tansaction-specific investments -Such as robots, which are highly beneficial to firm but not elsewhere 4. Creation of community knowledge -employees within firms have ongoing relationships, exchanging ideas, and working together to solve problems

What are the 3 disadvantages of organizing economic activity within firms? (may not need to memorize?)

1. Administrative cots -Necessary bureaucracy 2. Low-powered incentives -Often less attractive motivators than entrepreneurial opportunities and rewards that can be obtained in open market (wage and salaries) 3. Principal-agent problems

What are the 4 underlying strategic management concepts that will guide our discussion of vertical integration, diversification, and geographic scope?

1. CORE COMPETENCIES -Unique strengths embedded deep within a firm. Allow firm to differentiate products and services from rivals and provide higher value -Internally held knowledge underlying a core competency determines firm's boundaries 2. ECONOMIES OF SCALE 3. ECONOMIES OF SCOPE 4. TRANSACTION COSTS

What is the condition that tells us that the firm should vertically integrate? (Important)

Cost in-house<Cost market= Vertically integrate -When costs of producing in-house are less than costs of obtaining externally, should vertically integrate by owning production needed of inputs or channels of distribution of outputs. -When firms more efficient in organizing economic activity than markets= Should vertically integrate

What are the 5 stages of the vertical value chain?

(Backward vertical integration/ upstream industries) 1. Raw materials 2. Components and intermediate goods 3. Final assembly and manufacturing 4. Marketing and sales 5. After-sales services and support (Forward vertical integration/ downstream industries)

(Important!!) Not all growth motives are equally viable!!! -Increasing profits and lowering expenses are clearly related to enhancing a firm's competitive advantage -Increasing market power can also contribute to a greater competitive advantage, but also result in legal repercussions and anti-trust laws -Growing to reduce risk has fallen in favor with investors= who argue that they are in a better position to diversify their stock portfolio in comparison to a corporation with a number of unrelated SBUs -Managerial motives such as increasing company perks and job security are NOT LEGITIMATE reasons why a firm needs to grow

(Important!!) Not all growth motives are equally viable!!! -Increasing profits and lowering expenses are clearly related to enhancing a firm's competitive advantage -Increasing market power can also contribute to a greater competitive advantage, but also result in legal repercussions and anti-trust laws -Growing to reduce risk has fallen in favor with investors= who argue that they are in a better position to diversify their stock portfolio in comparison to a corporation with a number of unrelated SBUs -Managerial motives such as increasing company perks and job security are NOT LEGITIMATE reasons why a firm needs to grow

(Important!) To gain and sustain a competitive advantage.. -any corporate strategy must support and strengthen a firm's strategic position... -Regardless of whether it is a differentiation, cost-leadership, or blue-ocean strategy

(Important!) To gain and sustain a competitive advantage.. -any corporate strategy must support and strengthen a firm's strategic position... -Regardless of whether it is a differentiation, cost-leadership, or blue-ocean strategy

Cash Cow

Cash Cow= LOW GROWTH market buy HIGH MARKET SHARE -Earnings= high and stable

Diversification discount

Diversification discount= When stock price of a highly diversified firm is valued at less than the sum of the individual business units -Firms that pursue unrelated diversification are often unable create additional value

Diversification

Diversification= An 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

Economies of scope (Review)

Economies of scope= Savings that come from producing 2 (or more) outputs or providing different services at less cost than producing individually... -Using the same resources and technology

Forward vertical integration

Forward vertical integration= Moving ownership of activities closer to the customer point of value chain -Sell own stuff, own marketing, own after-sales support

Does corporate diversification always lead to superior firm performance?

NO! -There is a U-shaped relationship between type of diversification and overall performance 1.) High and low levels of diversification= Lower performance 2.) Moderate levels of diversification= High firm performance

Offshoring

Offshoring= Act of outsourcing some of the firm's activities outside of home country to another nation -Market expected to grow quickly -Most active sectors: Banking and financial services, IT, and Health Care

Opportunism

Opportunism= Self-interest seeking with guile of one party -Backward vertical integration is often undertaken to overcome the threat of opportunism and secure key raw materials

Parent-subsidiary relationship (Alternative)

Parent-subsidiary relationship= Corporate parent owns the subsidiary and can direct it via command and control (Most integrated alternative to performing economic activity within one's corporation) -Transaction costs that arise are frequently due to political turf battles which may include the capital budgeting process

Related-constrained diversification

Related-constrained = Executives only pursue businesses where they can apply the competencies and resources ALREADY AVAILABLE IN PRIMARY BUSINESS -Choices of alternative business activities are limited (constrained)= need to be related through common resources, capabilities, and competencies

Related-linked diversification

Related-linked diversification= Executives pursue various business opportunities that share only a limited number of linkages -Don't necessarily all have to be related through common resources, capabilities, and competencies

Restructuring

Restructuring= The process of reorganizing and divesting business unties and activities to refocus the company in order to leverage its core competencies more fully -Executives can restructure the business portfolio of the company

Star

Star= HIGH MARKET SHARE in HIGH GROWTH MARKETS -Earning= High, stable, and growing

Strategic alliances (Alternative)

Strategic Alliances= Voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities... - with the intent of developing process, products, or service -Can FACILITATE TRANSACTION SPECIFIC investments without encountering internal transaction costs involved with owning firms in various stages of value chain

Strategic Outsourcing

Strategic Outsourcing= Moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain -Reduces vertical integration ex.) Rather than developing own human resource management system, could outsource to other companies where it is their core competence, which will leverage their competencies and produce scale effects

What is the strategy for Dogs?

Strategy= Harvest/Divest

What is the strategy for Cash Cows?

Strategy= Hold -Invest enough into cash cow to hold position so they don't turn into dogs

Principal-agent problems

Principal-agent problems= When an agent such as a manager, performing actions on behalf of the principal (owner of firm), acts in own self-interest -Major disadvantage of organizing activity within firms -Separation of interest between principal and agent

Question Marks

Question Marks= LOW MARKET SHARE and HIGH MARKET GROWTH -Not sure whether will turn into stars or dogs -CF= negative

Transaction costs

Transaction Costs= All costs associated with economic exchange (Can be within or external to the firm) -MAKE OR BUY DECISION= Should we make it internally or go to market? -Determines whether it is cost effective to: a.) Vertically integrate b.) Diversify

Transaction costs Economics

Transaction costs Economics= Helps explain and predict the boundaries of the firm Helps managers decide: a.) Which activities to perform in-house ("make") b.) Services and products to obtain from external market ("buy")

Unrelated diversification (Conglomerate)

Unrelated diversification (Conglomerate)= Less than 70% (<70%) of revenues come from a single business... -and there are few, if any, linkages among its businesses

Vertical market failure

Vertical Market failure= When transactions within the industry value chain are too risky, and alternatives to integration are too costly or difficult to administer -When a company vertically integrates two or more steps away form its core competencies, it fails 2/3 of the time

(Just Understand) Related diversification strategy benefits from Economies of Scale and Scope: -multi-businesses can pool and share resources as well as leverage competencies across different business lines

(Just Understand) Related diversification strategy benefits from Economies of Scale and Scope: -multi-businesses can pool and share resources as well as leverage competencies across different business lines

(Just understand) Degree of diversification= What range of products and services a firm provides

(Just understand) Degree of diversification= What range of products and services a firm provides

(Understand) -Unrelated diversification suffers from a diversification discount -Related Diversification= Diversification Premium

(Understand) -Unrelated diversification suffers from a diversification discount -Related Diversification= Diversification Premium

(Understand) Each alternative goes from low integration to higher integration: 1. Long-term contracts= Lowest -Licensing -Franchising 2. Equity Alliances= Medium 3. Joint ventures= Medium/High 4. Parent-subsidiary relationship= Highest

(Understand) Each alternative goes from low integration to higher integration: 1. Long-term contracts= Lowest -Licensing -Franchising 2. Equity Alliances= Medium 3. Joint ventures= Medium/High 4. Parent-subsidiary relationship= Highest

(Understand) There is a U-shaped relationship between type of diversification and overall performance 1.) High and low levels of diversification= Lower performance 2.) Moderate levels of diversification= High firm performance (Implies that companies that focus on single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation) (Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies in adjacent markets)

(Understand) There is a U-shaped relationship between type of diversification and overall performance 1.) High and low levels of diversification= Lower performance 2.) Moderate levels of diversification= High firm performance (Implies that companies that focus on single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation) (Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies in adjacent markets)

(Understand) Transaction cost economics help managers decide what activities to develop in-house ("make") versus what services and products to obtain from the market ("buy")

(Understand) Transaction cost economics help managers decide what activities to develop in-house ("make") versus what services and products to obtain from the market ("buy")

What are the 3 benefits of taper integration? (May not need to concentrate on)

1. EXPOSES in-house suppliers and distributors TO MARKET COMPETITION -Performance comparisons are still possible 2. ENHANCES FLEXIBILITY ex.) when adjusting to fluctuating demand, firm could cut back on finished goods it delivers to external marketing while stocking own stock 3. Firms can combine external and internal knowledge -Possibly paving path for innovation

What are the 2 advantages of markets in organizing economic activity? (May not need to memorize?)

1. High-powered incentives -Liquidity events= Successful entrepreneur can make potentially enough money to be financially stable for life 2. Flexibility -Transaction in markets enables to compare and contrast prices

What are the 5 reasons why firms need to grow?

1. INCREASED PROFITS -Profit growth means higher stock price 2. LOWER COSTS -Economies of scale 3. INCREASE MARKET POWER -Fewer firms increases profitability of industry, and larger firms have more bargaining power 4. REDUCE RISK -Diversification in different industries: if one fails, accompanied by an offset gain in another 5. MOTIVATE MANAGERS -Firms may grow to achieve goals that benefits management more than stockholders (Bad) -Principal agent problems

What are the 2 alternatives to vertical integration?

1. Taper integration 2. Strategic outsourcing

Under what 2 conditions does vertical integration make sense? (May not need to concentrate on)

1. When there are shortages of raw materials 2. To enhance the customer's experience -Eliminate annoyances and poor interfaces

BCG Matrix

BCG Matrix= The corporation is viewed as a portfolio of businesses, much like a portfolio of stocks in finance -The individual SBUs are evaluated according to relative market share and the speed of market growth -Plotted in one of 4 categories: Dog, Cash Cow, Star, and Question Mark -Each category warrants a different investment strategy

Backward vertical integration

Backward vertical integration= Moving ownership of activities upstream to the originating inputs of value chain -Intergrate toward direction of suppliers -Produce own inputs

Conglomerate

Conglomerate= A company that combines 2 or more strategic business units under one or more overarching corporation -Follows an unrelated diversification strategy

Core Competence-market matrix

Core Competence-market matrix= A way to guide corporate diversification strategy by analyzing possible combination of EXISTING/NEW CORE COMPETENCIES in EXISTING/NEW MARKETS -Provides guidance to executives on how to diversify in order to achieve sustained growth -When applying an existing or new dimension to new competencies and markets, 4 quadrants emerge, each with distinct strategic implications

Corporate Strategy

Corporate Strategy= Decisions and actions taken to gain and sustain a competitive advantage in SEVERAL INDUSTRIES AND MARKETS SIMULTANEOUSLY -Where to compete: a.) Products and services b.) Industry value chain c.) Geographically (regional, national, or global markets)

Dogs

Dogs= SBUS in under performing businesses -LOW MARKET SHARE and LOW MARKET GROWTH -Low and unstable earnings (Neutral or negative CF)

Equity Alliance (Strategic alliance)

Equity alliance= A partnership in which at least on partner takes partial ownership of another -Partner purchases ownership by buying stock or assets (private company) and thus make an equity investment -GREATER COMMITMENT to partnership

What are the 2 External Transaction Costs?

External Transaction Costs= When companies transact in the open market 1. Searching for a firm to contract with 2. Negotiating, monitoring, and enforcing the contract

Franchising (Long-term contract)

Franchising= Long-term contract in which a franchiser grants a franchisee the right to use franchiser's trademark and business processes to offer goods and services that carry franchisers brand name

Information Asymmetrics

Information Asymmetrics = Situation in which one party is more informed than the other, because of possession of private information -Frequently sellers have better information about products and services than buyers -MAJOR DISADVANTAGE of buying through external market

What are the 4 internal transaction costs? (May not need to memorize)

Internal transaction costs= Transaction costs inside the firm 1. Recruiting and retraining employees 2. Paying salaries and benefits 3. Setting up a shop floor 4. Providing office space and computers, etc. (Tend to increase with organizational size and complexity)

Joint Venture (strategic alliance)

Joint ventures= 2 or more partners create and jointly own a new organization -Since parties contribute equity to joint venture, they make a LONG-TERM COMMITMENT -Facilitates TRANSACTION SPECIFIC INVESTMENTS

Licensing (Long-term contract)

Licensing= Form of long-term contracting in the manufacturing sector that enables firms to COMMERCIALIZE ON INTELLECTUAL PROPERTY

(Understand) All companies must navigate the dimensions of: 1. Vertical integration 2. Diversification 3. Geographic scope

(Understand) All companies must navigate the dimensions of: 1. Vertical integration 2. Diversification 3. Geographic scope

What are the 2 types of costs of a related-diversification strategy? (May not need to know)

1. Coordination costs= Function of the number, size, and businesses that are linked 2. Influence costs= Occur due to political maneuvering by managers to influence capital and resource allocation and the resulting influences stemming from sub optimal allocation of scarce resources

What are the 4 risks of Vertical integration?

1. INCREASING COSTS (depending on if focusing on value creation or cost reduction -Increased organizational complexity= Transaction costs -Higher costs due to lack of market competition -No economies of scale= Don't serve larger market 2. REDUCING QUALITY -Knowing there is always a buyer and seller may reduce incentive to improve quality 3. REDUCED FLEXIBILITY -Harder to switch to new technology if market changes because already fully committed 4. INCREASING POTENTIAL FOR LEGAL REPERCUSSIONS -Monopoly/anti-trust laws

What are the 4 options to formulate corporate strategy via core competencies? (Core competence-market matrix)

1. LEVERAGING -Leverage existing core competencies in current market to improve position (Existing core competencies/Existing Market) 2. BUILD -Build new core competencies to protect and extend current market position (New core competencies/Existing market) 3. REDEPLOYING AND RECOMBINING -Redeploying and recombining existing core competencies to compete in markets of the future (Existing core competencies/ New markets) 4. BUILD -Build new core competencies to compete in new markets of the future (New core competencies/New markets)

What are the 3 levels of strategic alliances?

1. Long-term contracts= Help facilitate transaction specific investments -Licensing -Franchising 2. Equity Alliances= A partnership in which at least on partner takes partial ownership of another 3. Joint ventures= 2 or more partners create and jointly own a new organization

What are the 5 benefits of vertical integration?

1. Lowering costs (ONLY IF DONE RIGHT!) 2. Improving quality 3. Facilitating scheduling and planning 4. Facilitates investments in SPECIALIZED ASSETS 5. Securing CRITICAL SUPPLIES and distribution channels

Along which 3 dimensions does corporate strategy define where to compete? (concerns the boundaries of the firm along these 3 dimensions)

1. Products and services (Diversification) (What range of products should we offer?) 2. Industry value chain (vertical integration) (What stages of the industry value chain should we participate?) 3. Geographically (regional, national, or global markets) -Geographic scope (Where should we compete geographically?)

For diversification to enhance firm performance, it must do at least one of which 3 things?

1. Provide Economies of Scale= Reduce costs 2. Exploit Economies of Scope= Increase value 3. Reduce costs and increase value

What are the 4 disadvantages of markets in organizing economic activity? (May not need to memorize?)

1. Search costs -Have to scour market to find reliable supplier 2. Opportunism by other parties -Behavior characterized by by self-seeking interest with guile 3. Incomplete contracting -Specifying and measuring performance= may have different idea of what job needs done -Information asymmetrics= Seller has more info. than buyer 4. Enforcement of contracts -Costly

What are the 3 alternatives to the make-or-buy continuum?

1. Short-term contracts 2. Strategic alliances -Long-term contracts (licensing and franchising) -Equity Alliances -Joint Ventures 3. Parent-Subsidiary Rleationships