8A - Corporate Strategy: Vertical Integration and Diversification

(3) Questions to determine corporate strategy

1. In what STAGES of the industry VALUE CHAIN should the company participate (vertical integration)? 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)?

(5) Why Firms Need to Grow

1. Increase profits. 2. Lower costs. 3. Increase market power. 4. Reduce risk. 5. Managerial motives

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

1. Provide economies of scale, which reduces costs. 2. Exploit economies of scope, which increases value. 3. Reduce costs and increase value

Advantages & Disadvantages of firm "make" (just try to remember disadvantages)

Advantages: - command & control - fiat - hierarchical lines of authority - coordination - transaction-specific investments - community of knowledge Disadvantages: - administrative costs - low-powered incentives - principal-agent problems

Advantages & Disadvantages of markets "buy" (just try to remember advantages)

Advantages: - high-powered incentives - flexibility Disadvantages: - search costs - opportunism - hold-up - incomplete contracting - specifying & measuring performance - information asymmetric - enforcement of contracts

Franchising

An example of long-term contracting. The franchisor such as McDonald's, Burger King, 7-Eleven, H&R Block, or Subway grants a "franchisee" (usually an entrepreneur owning no more than a few outlets) the right to use the franchisor's trademark and business processes to offer goods and services that carry the franchisor's brand name. Besides providing the capital to finance the expansion of the chain, the franchisee ALSO generally pays an up-front (buy-in) lump sum to the franchisor plus a percentage of revenues

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.

helpful tool to guide corporate portfolio planning

Boston Consulting Group (BCG) Growth-Share Matrix.

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 - integrating backwards from distribution (manufacturing, raw materials) - protects against "opportunism" and secures raw materials

Forward Vertical Integration

Changes in the industry value chain that involve moving ownership of activities closer to the end (consumer) point of the value chain. (moving forward from distribution -- retail, after-sales service)

Corporate Strategy - answers the key question:

Decisions that senior management makes and the goal-directed actions taken in the quest for competitive advantage in SEVERAL industries and markets SIMULTANEOUSLY. Answers the key question..."WHERE to compete" - products/services to offer - which geographic markets

Industry Value Chain - each stage represents...

Depiction of the transformation of raw materials into finished goods and services along distinct VERTICAL stages - each stage represents a DISTINCT INDUSTRY in which a number of different firms are competing - AKA "vertical value chains" b/c they depict the transformation of raw materials into finished goods and services along distinct vertical stages. - The expansion of a firm up or down the vertical industry value chain is called "vertical integration"

Does corporate diversification lead to superior performance?

High and low levels of diversification are generally associated with lower overall performance, while MODERATE levels of diversification are associated with higher firm performance. 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. Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies into adjacent markets. "Related Diversification" (related constrained/related linked) is BEST

Internal Transaction Costs External Transaction Costs

Internal = Also referred to as "admin costs"—these are costs related to organizing the economic exchange WITHIN a hierarchy. External = Search costs related to contracting individuals and firms and then the negotiating, monitoring and enforcing of it.

Strategic Outsourcing

Moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain. note: when outsourced activities take place outside the home country, the correct term is "offshoring" (or offshore outsourcing).

Vertical Value Chain: Cell-phone example

Raw materials - Chemicals, ceramics, metals, oil for plastic Intermediate goods and components - Integrated circuits, displays, touchscreens, cameras, and batteries Original equipment manufacturing firms - Assembly of cell phones under contract Service provider - AT&T, Sprint, T-Mobile, Verizon, etc

ORDER of diversification strategy success

Single Business (LOW) Dominant Business (MED) Related Diversification (HIGH) Unrelated Diversification (LOW)

Corporate executives CAN restructure the portfolio of their firm's businesses, much like an investor can change a portfolio of stocks.

TRUE

When the costs of pursuing an activity in-house are LESS than the costs of transacting for that activity in the market (C in-house < C market), then the firm should ...

VERTICALLY INTEGRATE (owning production of the needed inputs or the channels for the distribution of outputs) Ex: google in-house programmers

Strategic Alliances - umbrella term that includes...

Voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services. - umbrella term that denotes different hybrid organizational forms—among them, long-term contracts, equity alliances, and joint ventures.

Equity Alliance

a partnership in which at least one partner takes partial ownership in the other partner. - form of strategic alliance - 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 - example: Coca-Cola formed an equity alliance with energy-drink maker Monster

conglomerate

company combines 2+ business units under one overarching corporation (unrelated diversification)

Transaction cost economics - explains/predicts... - insights help managers.. - this is accomplished by...

explains and predicts the BOUNDARIES of the firm Insights gained from transaction cost economics help managers decide what activities to do IN-HOUSE (make) vs. what services and products to obtain from the EXTERNAL market (buy). This is accomplished through the analysis of the firm's external and internal environments.

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. "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 2/3rds of the time!

(3) Types of "general" Diversification

1. product diversification strategy - active in several different product markets 2. geographic diversification strategy - active in several different countries 3. product—market diversification strategy - pursues both a product and a geographic diversification strategy simultaneously

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 (each of which warrants a different investment strategy): 1. dog 2. cash cow 3. star 4. question mark

(4) Options to Formulate Corporate Strategy via Core Competencies

(Core Competence Strategic Matrix) 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. *see slide 49*

(4) Risks of Vertical Integration

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

(5) Benefits of Vertical Integration

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

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

Types of CORPORATE/"business" Diversification determined by: 1. % of revenue from dominant business 2. relationship of core competencies

1. Single Business - 95% of revenue from one business - single business leverage its competencies 2. Dominant Business - dominant and minor businesses share competencies "RELATED DIVERSIFICATION" 3. Related-Constrained - businesses SHARE competencies - EX: Exxon, J&J, Nike 4. Related-Linked - SOME businesses share competencies - ex: Amazon, Disney, GE "UNRELATED" 5. Unrelated Diversification (conglomerate) - businesses share few, if any, competencies

(2) Alternatives to Vertical Integration

1. Taper 2. Strategic Outsourcing ** alternatives to vertical integration that provide similar benefits without the accompanying risks

executives make important choices along THREE dimensions that determine the boundaries of the firm

1. The degree of vertical integration—in what stages of the industry value chain to participate. 2. The type of diversification—what range of products and services to offer. 3. The geographic scope—where to compete

(2) types of Long-term contracts

1. licensing 2. franchising ** willing to invest in "transaction-specific investments, last longer than a year (unlike short-term contracts **

Licensing

A form of "long-term" contracting in the MANUFACTURING sector that enables firms to commercialize intellectual property such as a patent The first biotechnology drug to reach the market, Humulin (human insulin), was developed by Genentech and commercialized by Eli Lilly based on a licensing agreement.

Core Competence Strategic Matrix

A framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets - provides guidance to executives on how to diversify in order to achieve continued growth ** The 1st task for managers is to identify their existing core competencies and understand the firm's current market situation.

Credible Commitment

A long-term strategic decision that is both difficult and costly to reverse - Coca-Cola made Monster a credible commitment

Joint Venture

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

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 ** 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

Principal-Agent Problem

Situation in which an agent performing activities on behalf of a principal pursues his or her OWN interests. - 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. - 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.

Diversification Discount

Situation in which the stock price of highly diversified firms is valued at LESS than the sum of their individual business units. - GE has experienced this for the last decade - unrelated diversification tends to lead to this

Diversification Premium

Situation in which the stock price of related diversification firms is valued at greater than the sum of their individual business units. - At the most basic level, a corporate diversification strategy enhances firm performance when its value creation is greater than the costs it incurs.

(4) Dimensions of Corporate Strategy

Strategic management concepts that will guide our discussion of vertical integration, diversification, and geographic competition are: 1. core competencies 2. economies of scale 3. economies of scope 4. transaction costs

"related diversification" (either related-constrained or related-linked such as in the Nike and adidas example) is most likely to lead to superior performance because it taps into multiple sources of value creation (economies of scale and scope; financial economies).

TRUE

Since a firm's external environment never remains constant over time, corporate strategy needs to be dynamic over time

TRUE

VERTICAL INTEGRATION - measured by...

The firm's ownership of its production of needed inputs or the channels by which it distributes it outputs measured by "value added": the percent of sales that is generated WITHIN the firms boundaries ** degree of vertical integration corresponds to the # of industry value chain stages it participates

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.