MGT 247 Chapter 8

Firm Disadvantages

-Administrative costs -Low-powered incentives -Principal-agent problem

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 -The principal-agent problem

Vertical Integration Sources of Costs (C)

-Can increase costs -Can reduce quality -Can reduce flexibility

Vertical Integration Sources of Value Creation (V)

-Can lower costs -Can improve quality -Can facilitate scheduling and planning -Facilitating investments in specialized assets -Securing critical supplies and distribution channels

Related Diversification Sources of Cost (C)

-Coordination costs -Influence costs

Benefits of Taper Integration

-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, _______ ________ allows a firm to retain and fine-tune its competencies in upstream and downstream value chain activities -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 -Firms can combine internal and external knowledge, possibly paving the path for innovation

Market Advantages

-High powered incentives -Flexibility

Advantages of Organizing Economic Activity Within Markets

-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

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

Cash Cows

-SBUs with a dominant market share in a low-growth-potential market -Earnings are high and stable -Cash flow is high and stable -Strategy: Hold

Question Marks

-SBUs with low market shares in fast-growth markets -Earnings are low, unstable, or growing -Cash flow is negative -Strategy: Increase market share or harvest/divest

Types of Strategic Alliances

-Short-term contracts -Long-term contracts: Licensing, franchising -Equity alliances -Joint ventures -Parent-subsidiary relationship

Advantages of Organizing Economic Activity in Firms

-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

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

Variations of Related Diversification Strategies

1. Related-constrained diversification 2. Related-linked diversification

Dimensions of Corporate Strategy

1. Vertical integration 2. Diversification 3. Geographic scope

Cost Leadership

A business-level strategy through which a company seeks cost efficiencies in all operational areas.

Single Business

A firm earning more than 95% of the revenues from a single line of business Ex: Facebook receives almost all of its revenues from online advertising, Coca-Cola, Birkenstock

Dominant Business

A firm that earns more than 70% of revenue from its main line of business and the remainder from other lines across different value chains Ex: Harley-Davidson gets 80% of their revenues from motorcycle sale and 20% from revenue on parts and accessories, Nestle, UPS

Software as a Service (SaaS)

A form of cloud computing where a firm subscribes to a third-party software and receives a service that is delivered online. Ex: Salesforce.com

Liscensing

A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property Ex: Humulin (human insulin), was developed by Genentech and commercialized by Eli Lilly based on a ____ agreement

Credible Commitment

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

Joint Venture

A stand-alone organization created and jointly owned by two or more parent companies. Ex: Dow Corning (owned by Dow Chemical and Corning), Hulu (owned by NBC Universal, Fox, Disney-ABC, and TBS)

Transaction 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 Help managers decide what activities to do in-house ("make") versus what services and products to obtain from the external market ("buy")

Chaebol

A very large South Korean business conglomerate that is composed of numerous smaller companies

Differentiation

Actually differentiating the market offering to create superior customer value

Transaction Costs

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

New Core Competence, Existing Market

Building new core competencies to protect and extend current market position Ex: Gatorade originated at the University of Florida football team to help enhance the performance of their athletes, but Stokely-Van Camp commercialized it

Blue Ocean Strategy

Business-level strategy that successfully combines differentiation and cost-leadership activities using value innovation to reconcile the inherent trade-offs.

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 Ex: HTC

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 Ex: Ford

Divesting

Companies get rid of a product, service, or business.

Conglomerate

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

Business Strategy

Concerns the question of how to compete.

Geographic Diversification Strategy

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

Product Diversification Strategy

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

Product-Market Diversification Strategy

Corporate strategy in which a firm is active in several different product markets and several different countries A company using this strategy pursues both a product and geographic diversification simultaneously

Transaction Cost

Cost associated with a transaction

External Transaction Costs

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

Industry Value Chain

Depiction of the transformation of raw material 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.

Economies of Scale

Factors that cause a producer's average cost per unit to fall as output rises Ex: Ab InBev merged with SABMiller and now captures some 30% of global beer consumption

Administrative Costs

Internal transaction costs

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

Existing Core Competence, Existing Market

Leveraging core competencies to improve current market position Ex: Bank of America developed from the Bank of Italy entered San Francisco in 1904 and expanded nationwide

Existing Core Competence, New Market

Redeploying and recombining core competencies to compete in markets of the future Ex: Bank of America bought Merrill Lynch in 2008

Value Creation Through a 'Market Power' Logic

Reducing rivalry

Complete Contract

Refers to the contract that specifies exactly what each party will do under all possible future contingencies

Vertical Integration

Refers to the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs 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 Ex: Amazon creates its own video content

Pooled Negotiating Power

Similar businesses working together can have stronger bargaining position relative to: -Suppliers -Customers -Competitors Abuse of bargaining power may affect relationships with customers, suppliers, and competitors

Reduce Risk

Take action to lower the possibility of a negative impact due to the risk

Opportunism

The act of seeking self-interest with guile.

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.

Value Innovation

The simultaneous pursuit of differentiation and low cost in a way that creates a leap in value for both the firm and the consumers; considered a cornerstone of blue ocean strategy

Core Competencies

Things a company does extremely well, which sometimes give it an advantage over its competition Ex: Walmart's ability to effectively orchestrate a globally distributed supply chain at a low cost & Infosys' ability to provide high-quality information technology services at a low cost by leveraging its global delivery model. This implies taking work to the location where it makes the best economic sense, based on the available talent and the least amount of acceptable risk and lowest costCccc

Vertical Market Failure

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

Degree of Geographic Diversification

Why do some firms compete beyond state boundaries, while others are content to focus on the local market? Ex: KFC has 20,000 locations in 120 countries, while Chick-fil-A only operates in the United States

Lemons Problem

With asymmetric information, low-quality goods can drive high-quality goods out of the market.

Short-Term Contracting

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.

Coordination Costs

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

Degree of Vertical Integration

in what stages of the industry value chain to participate

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

Global Strategy

selling the same standardized product and using the same basic marketing approach in each national market

General Diversification Strategies

-Product diversification -Geographic diversification -Product-market diversification

Value Creation Through an 'Economies of Scope' Logic

-Sharing activities -Transferring/leveraging core competencies

Richard Rumelt's Diversification Types

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

Types of Specialized Assets

1. Site specificity 2. Physical-asset specificity 3. Human-asset specificity

Dimensions that Determine the Boundaries of a Firm

1. The degree of vertical integration 2. The type of diversification 3. The geographic scope

Variables for Richard Rumelt's Diversification Types

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

Incomplete Contract

A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

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.

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 Ex: ExxonMobile's strategic move into natural gas when they bought XTO Energy in 2009 for $31 billion, Johnson & Johnson, Nike

Dogs

-In the portfolio matrix, a business unit that has low growth potential and a small market share -Low, unstable earnings -Neutral or negative cash flow -Strategy: Harvest/divest

Risks of Vertical Integration

-Increasing costs -Reducing quality -Loss of flexibility -Increasing the potential for legal repercussions

Benefits of Vertical Integration

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

Diversification

An increase in the variety of products and services a firm offers or markets and the geographic regions in which it competes Encompasses the variety of products and services a firm offers or markets and the geographic locations in which it competes What range of products and services should the company offer? Ex: Amazon offers a wide range of products and services

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. Examples include the bottling machinery for E&J Gallo. Given the many brands of wine offered by E&J Gallo, unique equipment, such as olds and a specific production process, is required to produce the different and trademarked bottle shapes

New Core Competence, New Market

Building new core competencies to create and compete in markets of the future Ex: Salesforce.com

Institutional Arrangements

Different costs attached for markets and firms

Offshoring (Offshore Outsourcing)

Moving operations from the country where a company is headquartered to a country where pay rates are lower but the necessary skills are available.

Equity Alliance

Partnership in which at least one partner takes partial ownership in the other Ex: Coca-Cola Co. and Monster

Economies of Scope

Savings that come from producing two (or more) outputs at less cost than producing each output individually, despite using the same resources and technology Ex: Amazon can offer a large range of different product and service categories at a lower cost than it would take to offer each product line individually

Principal-Agent Problem

Situation in which and agent performing activities on behalf of a principal pursues his or her own interests. Ex: Separation of ownership and control

Diversification Premium

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

Diversification Discount

Situation in which the stock prices of highly diversified firms is valued at less than the sum of their individual business units. Ex: GE's capital unit contributed 50% of profits on 1/3 of the conglomerate's revenues

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 Outsourcing

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

Harvesting

when a company retains the product but reduces marketing costs

Sources of Value Creation

-Economies of scale -Economies of scope -Financial economies

Diseconomies of Scope

situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product

Information Asymmetry

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

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

Unrelated Diversification Sources of Value Creation (V)

Financial economies (restructuring and internal capital markets)

Related Diversification Sources of Value Creation (V)

-Economies of scope -Economies of scale -Financial economies (restructuring, internal capital markets

Platform as a Service (PaaS)

A cloud service in which consumers can install and run their own specialized applications on the cloud computing network. Ex: Salesforce.com

Separation of Ownership and Control

The dispersal of ownership among many small shareholders, in which control is largely concentrated in the hands of salaried, professional managers who own little (or no) equity.

Firm Advantages

-Command and control: Fiat; Hierarchical lines of authority -Coordination -Transaction-specific investments -Community of knowledge

Generic Business Strategies

-Cost leadership -Differentiation -Value innovation

Strategic Business Unit (SBU) Categories

-Dog -Cash cow -Star -Question mark

Increase Market Power

-Horizontal mergers typically increase market share and have a greater ability to influence prices -Vertical may increase market power by decreasing dependency on suppliers -Controlling supply inputs can create control of outputs and market prices -Guarantees materials will be available

Value Creation Through 'Complementary' Logic

-Products in various markets work together to create more value -Bundling as a potential strategy

Stars

-SBUs with products that have a dominant market share in high-growth markets -Earnings are high, stable, or growing -Cash flow is neutral -Strategy: Hold or invest for growth

Disadvantages of Organizing Economic Activity Within Markets

-Search Costs: On a very fundamental level, perhaps the biggest _____ in transacting in markets, rather than owning the various production and distribution activities within the firm itself, entails significant 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 or suppliers would require transaction-specific investments, an advantage of firms -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. 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 -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

Market Disadvantages

-Search costs -Opportunism: Hold up -Incomplete contracting: Specifying and measuring performance; Information asymmetries -Enforcement of contracts

Why Firms Need to Grow

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

Industry Value Chain Stages

1. Raw materials such as chemicals, ceramics, metals, oil, etc. 2. Intermediate goods and components such as circuits, displays, touchscreens, cameras, and batteries 3. Final assembly and manufacturing 4 and 5. Marketing, sales, after-sales service, support

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 Ex: Amazon began by selling only books, but expanded, Disney, GE

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 Ex: McDonald's

Resource-Based View

A model that argues that rare and inimitable resources help firms maintain competitive advantage

Coinsurance

A provision under which both the insured and the insurer share the covered losses Low corrleation across revenue streams makes firm less risky

Make or Buy

A situation where an organization may decide between manufacturing a product or buying in from an outside supplier.

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. Firms who use this approach typically have achieved superior performance in both innovation and financial performance when compared with firms that relied more on vertical integration or strategic outsourcing, according to a study of 3,500 product introductions in the computer industry

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. Rationale 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 Most likely to lead to superior performance because it taps into multiple sources of value creation (economies of scale and scope; financial economies)

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. Ex: Samsung, Berkshire Hathaway, Yamaha

Internal Transaction Costs

Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs Tend to increase with organizational size and complexity Ex: 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. 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

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 Ex: Anheuser-Busch InBev sold its theme park called Busch Entertainment to a group of investors for roughly $3 billion, allowing them to focus more fully on its core business of brewing and distributing beer across the world

Diversification-Performance Relationship

High and low levels of diversification are generally associated with lower overall performance, while moderate levels are associated with higher overall performance, implying that companies that focus on a single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation

Unrelated Diversification Sources of Cost (C)

Influence costs

Geographic Scope

The extent of a company's international activities Where should the company compete geographically in terms of regional, national, or international markets?

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.

Degree of Product Diversification

What range of products and services should the firm offer? Ex: Coca-Cola focuses on soft drinks and thus on a single product market, while Pepsi sells a wide variety of soft drinks and other beverages

Requests for Proposals (RFPs)

a form developed by firms and distributed to qualified potential suppliers that helps suppliers develop and submit proposals to provide products as specified by the firm

Core Competence-Market Matrix

a framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets

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

Diseconomies of Scale

the situation in which a firm's long-run average costs rise as the firm increases output