Chapter 8: Corporate Strategy: Vertical Integration & Diversification

The advantages of firms

-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.

Vertical Integration

Is 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?

The advantages of markets

High-powered incentives. —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.

Stage 1

Raw Materials -The raw materials to make your cell phone.

Cash Cow

—Their earnings and cash flows are high and stable. —The strategic recommendation is to invest enough into cash cows to hold their current position and to avoid having them turn into dogs.

Question marks

—It is not clear whether they will turn into dogs or stars. Their earnings are low and unstable, but they might be growing. The cash flow, however, is negative. Ideally, corporate executives want to invest in question marks to increase their relative market share so they turn into stars. —If market conditions change, however, or the overall market growth slows, then a question-mark SBU is likely to turn into a dog. In this case, executives would want to harvest the cash flow or divest the SBU.

The disadvantages of organizing economic activity within firms

-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. -Principal-agent problem.

Risks of Vertical Integration

Depending on the situation, vertical integration has several, some of which directly counter the potential benefits, including: -Increasing costs. -Reducing quality. -Reducing flexibility. -Increasing the potential for legal repercussions.

Restructuring

Describes the process of reorganizing and divesting business units and activities to refocus a company to leverage its core competencies more fully. Corporate executives can restructure the portfolio of their firm's business, much like an investor can change a portfolio of stocks.

Corporate Strategy (three dimensions & three questions)

comprises the decisions that leaders make and the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously. It provides answers to the key questions of where to compete. —(1) Vertical integration: In what stages of the industry value chain should the company participate? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages. —(2) Diversification: What range of products and services should the company offer? —(3) Geographic scope: Where should the company compete geographically in terms of regional, national, or international markets?

Market Share Matrix

One helpful tool to guide corporate portfolio planning. Relative market share (horizontal axis) Speed of market growth (vertical axis) —Four categories: All four categories shape the firm's corporate strategy. As a general rule, strategic leaders would want to manage their SBU portfolio in a clockwise manner.

Principal-agent problem

-Is a major disadvantage of organizing economic activity within firms, as opposed to whin 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. -Indeed, the separation of ownership and control is one of the hallmarks of a publicly traded company, and so some degree of the problem is almost inevitable.

Information Asymmetry

-a situation in which one party is more informed than another, because of the possession of private information. When firms transact in the market, such unequal information can lead to a lemons problem. -The important takeaway is caveat emptor—buyer beware. Can result in the crowding out of desirable goods and services by inferior ones. This has been shown to be true in many markets, not just for used cars, but also in ecommerce (eBay), mortgage-backed securities, and even collaborative R&D projects.

Benefits of Vertical Integration

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

Strategic Alliances

Are voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services. —Can facilitate investments in transaction-specific assets without encountering the internal transaction costs involved in owning firms in various stages of the industry value chain.

Industry value chain

Called vertical value chains, because they depict 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 number of different firms are competing. This is also why the expansion of a firm up or down the vertical industry chain is called vertical integration.

Stage 3

Final Assembly and Manufacturing -Original equipment manufacturing firms (OEMs) such as Flextronics (Singapore) or Foxconn (China) typically assemble cell phones under contract for consumer electronics and telecommunications companies.

Stage 2

Intermediate Goods and Components -Elements such as integrated circuits, displays, touchscreens, cameras, and batteries.

Taper Integration

It is a way of orchestrating value activities in which a firm is backwardly integrated, but it also relies on outside-market firms for some its supplies, and/or is forwardly integrated but also relies on outside-market firms for some of its distribution. —The firm sources intermediate goods and components from in-house suppliers as well as outside suppliers. In a similar fashion, a firm sells its products through company-owned retail outlets and through independent retailers. —> Both Apple and Nike, for example, use taper integration: they own retail outlets, but also use other retailers, both the brick-and-mortar type and online.

Stages 4 and 5

Marketing, Sales, After-Sales Service, Support —Finally to get wireless data and voice service, you pick a service provider such as AT&T, Sprint, T-Mobile, or Verizon in the United States.

Firm vs. Market (make or buy)

Predictions derived from transaction cost economics guide strategic leaders in deciding which activities a firm should pursue in-house ("make") versus which goods and services to obtain externally ("buy"). These decisions help determine the boundaries of the firm. —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 contracts among many independent actors, firms should vertically integrate.

The disadvantages of markets

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. Opportunism by other parties. —Opportunism is behavior characterized by self-interest seeking with guile. Incomplete contracting. —Although market transactions are based on implicit and explicit contracts, all contracts are incomplete to some extent, because not all future contingencies can be anticipated at the time of contracting. 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.

External Transaction Costs

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

Internal Transaction Costs

These include costs pertaining to organizing an economic exchange within a firm—for example, the costs of recruiting and retaining employees; paying salaries and benefits; setting up a shop floor; providing office space and computers; and —Tend to increase with organizational size and complexity.

Benefits and Risks of Vertical Integration

To decide the degree and type of vertical integration to pursue, strategic leaders need to understand the possible benefits and risks of vertical integration. At a minimum, they need to proceed with caution, and carefully consider the countervailing risks at the same time they consider the benefits.

Transaction costs

are all internal and external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets.

Star

—Hold a high market share in a fast-growing market. Their earnings are high and either stable or growing. —The recommendation for the corporate strategist is to invest sufficient resources to hold the star's position or even increase investments for future growth.

Dog

—They are the underperforming business. Dogs hold small market share in a low-growth market; they have low and unstable earnings, combined with neutral or negative cash flows. —The strategic recommendations are either to divest the business or harvest it. This implies stopping investment in the business and squeezing out as much cash flow as possible before shutting it or selling it.