Strategic Management Ch. 8

Several reasons explain why firms need to grow

1. Increase profits. 2. Lower costs. 3. Increase market power. 4. Reduce risk. 5. Motivate management.

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.

conglomerate

A company that combines two or more strategic business units under one overarching corporation; follows an unrelated diversification strategy rsification strategy can be advantageous in emerging economies.56 This arrangement helps firms gain and sustain competitive advantage because it allows the conglomerate to overcome institutional weaknesses in emerging economies, such as a lack of capital markets and well-defined legal systems and property rights

Long-Term Contracts

A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property. Long-term contracts help facilitate transaction-specific investments

Related-Linked Diversification

A kind of related diversification strategy in which executives pursue various businesses opportunities that share only a limited number of linkages.

joint venture

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

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.

RELATED DIVERSIFICATION

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: THE CONGLOMERATE

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.

INCREASE PROFITS

Profitable growth allows businesses to provide a higher return for their shareholders, or owners, if privately held. For publicly traded companies, the stock market valuation of a firm is determined to some extent by expected future revenue and profit streams. If firms fail to achieve their growth target, their stock price often falls. With a decline in a firm's stock price comes a lower overall market capitalization, exposing the firm to the risk of a hostile takeover. Moreover, with a lower stock price, it is more costly for firms to raise the required capital to fuel future growth by issuing stock.

information asymmetries

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

The stock price of related-diversification firms is valued at greater than the sum of their individual business units

industry value chain

also 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 value chain is called vertical integration. 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.

two generic business strategies that firms can pursue their quest for competitive advantage

increase differentiation (while containing cost) or lower costs (while maintaining differentiation) or blue ocean strategy by increasing differentiation and lowering costs

STRATEGIC OUTSOURCING

involves moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain. A firm that engages in strategic outsourcing reduces its level of vertical integration. Rather than developing their own human resource management system

PARENT-SUBSIDIARY RELATIONSHIP

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.

Economies of scale

occur when a firm's average cost per unit decreases as its output increases

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

RISKS OF VERTICAL INTEGRATION.

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

Taper integration has several benefits:

■ It exposes in-house suppliers and distributors to market competition so that performance comparisons are possible. Rather than hollowing out its competencies by relying too much on outsourcing, taper integration allows a firm to retain and fine-tune its competencies in upstream and downstream value chain activities ■ Taper integration also enhances a firm's flexibility. For example, when adjusting to fluctuations in demand, a firm could cut back on the finished goods it delivers to external retailers while continuing to stock its own stores. ■ Using taper integration, firms can combine internal and external knowledge, possibly paving the path for innovation.

BENEFITS OF VERTICAL INTEGRATION

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

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. Highpowered 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.14 ■ Increased flexibility. Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers. The disadvantages of markets include: ■ Search costs. On a very fundamental level, perhaps the biggest disadvantage of transacting 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. ■ 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 contingencies can be anticipated at the time of contracting. It is also difficult to specify expectations (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 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.

core competence- market matrix

A framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets. The first task for managers is to identify their existing core competencies and understand the firm's current market situation managers must come up with ideas of how to leverage existing core competencies to improve the firm's current market position managers must strategize about how to redeploy and recombine existing core competencies to compete in future markets managers must come up with strategic initiatives to build new core competencies to protect and extend the company's current market position

Economies of scope

savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually

Opportunism

self-interest seeking with guile

"mega-opportunities

those that hold significant future-growth opportunities. At the same time, it is likely the most challenging diversification strategy because it requires building new core competencies to create and compete in future markets.

To survive and prosper, companies need to grow. This mantra holds especially true for publicly owned companies, because

create shareholder value through profitable growth. Managers respond to this relentless growth imperative by leveraging their existing core competencies to find future growth opportunities

DOMINANT BUSINESS

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-Constrained Diversification

derives less than 70 percent of its revenues from a single business activity and obtains revenues from other lines of business related to the primary business activity. Executives engage in such a new business opportunity only when they can leverage their existing competencies and resources. Specifically, the choices of alternative business activities are limited— constrained—by the fact that they need to be related through common resources, capabilities, and competencies.

SINGLE BUSINESS

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.

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

principal-agent problem

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.12 Indeed, the separation of ownership and control is one of the hallmarks of a publicly traded company, and so some degree of the principal-agent problem is almost inevitable

Vertical market failure

occurs when transactions within the industry value chain are too risky, and alternatives to integration are too costly or difficult to administer. This recommendation corresponds with the one derived from transaction cost economics earlier in this chapter. When discussing research on vertical integration, The Economist concluded, "Although reliance on [external] supply chains has risks, owning parts of the supply chain can be riskier—for example, few clothing-makers want to own textile factories, with their pollution risks and slim profits." The findings suggest that when a company vertically integrates two or more steps away from its core competency, it fails two-thirds of the time.

competence-market matrix

provides guidance to executives on how to diversify in order to achieve continued growth. Once managers have a clear understanding of their firm's core competencies (see Chapter 4), they have four options to formulate corporate strategy:

Executives must determine their corporate strategy by answering three questions

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)?

The four main types of business diversification are

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

Boston Consulting Group (BCG) growthshare 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.

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.

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 outsidemarket firms for some of its distribution. 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

fully vertically integrated

All activities are conducted within the boundaries of the firm. As a consequence, it faces different competitors in each stage of the industry value chain.

diversification

An increase in the variety of products and services a firm offers or markets and the geographic regions in which it competes. A non-diversified company focuses on a single market, whereas a diversified company competes in several different markets simultaneously

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.

LOWER COSTS

Firms are also motivated to grow in order to lower their cost. As discussed in detail in Chapter 6, a larger firm may benefit from economies of scale, thus driving down average costs as their output increases. Firms need to grow to achieve minimum efficient scale, and thus stake out the lowest-cost position achievable through economies of scale.

INCREASE MARKET POWER

Firms might be motivated to achieve growth to increase their market share and with it their market power. When discussing an industry's structure in Chapter 3, we noted that firms often consolidate industries through horizontal mergers and acquisitions (buying competitors) to change the industry structure in their favor (we'll discuss mergers and acquisitions in detail in Chapter 9). Fewer competitors generally equates to higher industry profitability. Moreover, larger firms have more bargaining power with suppliers and buyers

REDUCE RISK

Firms might be motivated to grow in order to diversify their product and service portfolio through competing in a number of different industries. The rationale behind these diversification moves is that falling sales and lower performance in one sector (e.g., GE's oil and gas unit) might be compensated by higher performance in another (e.g., GE's health care unit)

MANAGERIAL MOTIVES

Research in behavioral economics suggests that firms may grow to achieve goals that benefit its managers more than their stockholders.4 As we will discuss in detail when presenting the principal-agent problem later in the chapter, managers may be more interested in pursuing their own interests such as empire building and job security—plus managerial perks such as corporate jets or executive retreats at expensive resorts—rather than increasing shareholder value.

diversification premium

Situation in which the stock price of related diversification firms is valued at greater than the sum of their individual business units. allows the conglomerate to overcome institutional weaknesses in emerging economies such as a lack of a functioning capital market. can be advantageous in emerging economies

vertical integration

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?25 The degree of vertical integration tends to correspond to the number of industry value chain stages in which a firm directly participates

vertically disintegrated with a low degree of vertical integration

These firms focus on only one or a few stages of the industry value chain.

where to compete in terms of regional, national, or international markets

This decision determines the firm's geographic focus

internal transaction costs

Transaction costs can occur within the firm as well; 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 organizing, monitoring, and supervising work. Internal transaction costs also include administrative costs associated with coordinating economic activity between different business units of the same corporation such as transfer pricing for input factors, and between business units and corporate headquarters including important decisions pertaining to resource allocation, among others. Internal transaction costs tend to increase with organizational size and complexity.

specialized assets

Unique assets with high opportunity cost: They have significantly more value in their intended use than in their nextbest use. They come in three types: site specificity, physicalasset 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. Strategic alliances is an umbrella term that denotes different hybrid organizational forms— among them, long-term contracts, equity alliances, and joint ventures

external transaction costs:

When companies transact in the open market; the costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

lemons problem

When firms transact in the market, such unequal information can lead to a lemons problem. Nobel Laureate George Akerlof first described this situation using the market for used cars as an example.15 Assume only two types of cars are sold: good cars and bad cars (lemons). Good cars are worth $8,000 and bad ones are worth $4,000. Moreover, only the seller knows whether a car is good or is a lemon

SHORT-TERM CONTRACTS

a firm sends out requests for proposals (RFPs) to several companies, which initiates competitive bidding for contracts to be awarded with a short duration, generally less than one year.18 The benefit to this approach lies in the fact that it allows a somewhat longer planning period than individual market transactions. Moreover, the buying firm can often demand lower prices due to the competitive bidding process. The drawback, however, is that firms responding to the RFP have no incentive to make any 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

Equity Alliances

a partnership in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock or assets (in private companies), and thus making an equity investment. The taking of equity tends to signal greater commitment to the partnership.

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 The key insight of transaction cost economics is that different institutional arrangements—markets versus firms—have different costs attached.

Transaction costs

all costs associated with an economic exchange. The concept is developed in transaction cost economics, a strategic management framework, and enables managers to answer the question of whether it is cost-effective

Transaction costs

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

Core competencies

are unique strengths embedded deep within a firm (as discussed in Chapter 4). Core competencies allow a firm to differentiate its products and services from those of its rivals, creating higher value for the customer or offering products and services of comparable value at lower cost

Corporate managers pursue diversification to gain and sustain competitive advantage. But does corporate diversification indeed lead to superior performance?

ask whether the individual businesses are worth more under the company's management than if each were managed individually. This implies that companies that focus on a single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation.

INTERNAL CAPITAL MARKETS

can be a source of value creation in a diversification strategy 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.

resource-based view of the firm

firm's boundaries are delineated by its knowledge bases and core competencies.6 Activities that draw on what the firm knows how to do well (e.g., Google's core competency in developing proprietary search algorithms) should be done in-house, while non-core activities such as payroll and facility maintenance can be outsourced

vertically integrate

he activity within a single firm and coordinating it through an organizational hierarchy. 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

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, such as bottling machinery for Coca-Cola and PepsiCo. Since the bottles have different and often trademarked shapes, they require unique molds. Cans, in contrast, do not require physical-asset specificity because they are generic.

Human-asset specificity

—investments made in human capital to acquire unique knowledge and skills, such as mastering the routines and procedures of a specific organization, which are not transferable to a different employer.

There are various general diversification strategies:

■ A firm that is active in several different product markets is pursuing a product diversification strategy. ■ A firm that is active in several different countries is pursuing a geographic diversification strategy. ■ A company that pursues both a product and a geographic diversification strategy simultaneously follows a product-market diversification strategy

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.

By formulating corporate strategy, executives make important choices along three dimensions that determine the boundaries of the firm:

■ The degree of vertical integration—in what stages of the industry value chain to participate. ■ The type of diversification—what range of products and services to offer. ■ The geographic scope—where to compete

Richard Rumelt developed a helpful classification scheme that identifies four main types of diversification by looking at two variables:

■ The percentage of revenue from the dominant or primary business. ■ The relationship of the core competencies across the business units.

This ubiquitous device is the result of a globally coordinated industry value chain of different products and services

■ The raw materials to make your cell phone, such as chemicals, ceramics, metals, oil for plastic, and so on, are commodities. In each of these commodity businesses are different companies, such as DuPont (U.S.), BASF (Germany), Kyocera (Japan), and ExxonMobil (U.S.). ■ Intermediate goods and components such as integrated circuits, displays, touchscreens, cameras, and batteries are provided by firms such as ARM Holdings (UK), Jabil Circuit (U.S.), Intel (U.S.), LG Display (Korea), Altek (Taiwan), and BYD (China). ■ Original equipment manufacturing firms (OEMs) such as Flextronics (Singapore) or Foxconn (China) typically assemble cell phones under contract for consumer electronics and telecommunications companies such as BlackBerry (Canada), Ericsson (Sweden), Microsoft (U.S., with its acquired Nokia business unit), Samsung (South Korea), and others. If you look closely at an iPhone, for example, you'll notice it says, "Designed by Apple in California. Assembled in China." ■ 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; América Móvil in Mexico; Oi in Brazil; Orange in France; T-Mobile or Vodafone in Germany; NTT Docomo in Japan; Airtel in India; or China Mobile in China, among others.