Ch 8. Corporate Strategy: Vertical Integration & Differentiation
Underlying strategic management concepts that guide vertical integration, diversification, and geographic competition
-Core competencies -Economies of Scale -Economies of Scope -Transaction Costs
Licensing
A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property.
Diversification
An increase in the variety of products and services a firm offers or markets and the geographic regions in which it competes.
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. Moving from marketing to manufacturing to design. Backward vertical integration is often undertaken to overcome the threat of opportunism and in securing key raw materials.
Internal Transaction costs
Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs.
Long-Term Contracts
Duration generally greater than one year, help facilitate transaction-specific investments -Licensing -Franchising
Unrelated Diversification Strategy
Corporate strategy in which a firm derives less than 70 percent of its revenues from a single business activity and there are few, if any, linkages among its businesses.
Geographic diversification strategy
Corporate strategy in which a firm is active in several different countries.
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 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.
Strategic Outsourcing
Moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain.
Economies of Scale
Occur when a firm's average cost per unit decreases as its output increases (as discussed in Chapter 6). Anheuser-Busch InBev, the largest global brewer (producer of brands such as Budweiser, Bud Light, Stella Artois, and Beck's), reaps significant economies of scale. Given its size, it is able to spread its fixed costs over the millions of gallons of beer it brews each year, in addition to the significant buyer power its large market share affords. Larger market share, therefore, often leads to lower costs.
Strategic Alliances
Voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services to lead to competitive advantage. Advantage: the buying firm can often demand lower prices due to the competitive bidding process. Drawback: firms responding to the RFP have no incentive to make any transaction-specific investments (e.g., buy new machinery to improve product quality) due to the short duration of the contract.
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. From marketing to after-sales service and support.
Product-market diversification strategy
Corporate strategy in which a firm is active in several different product markets and several different countries.
Related Diversification Strategy
Corporate strategy in which a firm derives less than70 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.
Parent-Subsidiary Relationship
The parent-subsidiary relationship des- cribes the most-integrated alternative to performing an activity within one's own corpo- rate family. The corporate parent owns the subsidiary and can direct it via command and control.
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. ■ The principal-agent problem.
The advantages of organizing economic activity within 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.
Dominant Business
A dominant-business firm derives between 70 and 95 percent of its revenues from a single business, but it pursues at least one other business activity.
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. Vertical integration along the industry value chain can also facilitate investments in these Making the specialized investment opens up the threat of opportunism by one of the partners
Core Competence-Market Matrix
A framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets.
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; addresses where to compete along three dimensions: products and services, industry value chain, and geography (regional, national or global markets).
Economies of Scope
The savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology (as discussed in Chapter 6). Leveraging its online retailing expertise, for example, Amazon benefits from economies of scope: It 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.
The disadvantages of organizing economic activity in markets
■ Search costs. 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 at all 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 ■ 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 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.
Conglomerate
A company that combines two or more strategic business units under one overarching corporation; follows an unrelated diversification strategy.
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(divest or harvest), cash cow(invest), star(invest to cow), and question mark(invest to star), 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; the franchisee in turn pays an up-front buy-in lump sum and a percentage of revenues.
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 outside- market firms for some of its distribution.
Product Diversification Strategy
Corporate strategy in which a firm is active in several different product markets.
Transaction Costs
All internal and external costs associated with an economic exchange, whether within a firm or in a market. The concept is developed in transaction cost economics,
Short-term contracts
Firm sends out requests for proposals (RFPs) to several companies, which initiates competitive bid- ding for contracts to be awarded with a short duration, generally less than one year.
Firms vs. Markets
Firms and markets are different institutional arrangements for organizing economic activity, and have their own distinct advantages and disadvantages. When firms are more efficient in organizing economic activity than are markets, which rely on contracts among many independent actors, firms should vertically integrate.
Joint Venture
Organizational form in which two or more partners create and jointly own a new organization.
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
Situation in which their stock price is valued at greater than the sum of their individual business units. Firms that pursue unrelated diversification are often unable to create additional value
Principal-Agent Problem
Situationin which an agent performing activities on behalf of a principal pursues his or her own interests. Example: a manager may pursue own interests such as job security and managerial perks (e.g., corporate jets and golf outings) that conflict with the principal's goals—in particular, creating shareholder value
information asymmetries
Situations in which one party is more informed than another, because of the possession of private information.
Vertical Integration
The firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs. Benefits: ■ Securing critical supplies and distribution channels ■ Lowering costs ■ Improving quality ■ Facilitating scheduling and planning ■ Facilitating investments in specialized assets Risks: ■Increasing costs ■Reducing quality ■Reducing flexibility ■Increasing the potential for legal repercussions
Core Competencies
Unique strengths embedded deep within a firm; 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. -According to the resource-based view of the firm, a firm's boundaries are delineated by its knowledge bases and competencies. Activities that draw on what the firm knows how to do well (e.g., Honda's core competency in small, highly reliable engines, or 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. In this perspective, the internally held knowledge underlying a core competency determines a firm's boundaries.
Equity Alliances
a partner- ship in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock, and thus making an equity investment. The taking of equity tends to signal greater commitment to the partnership.
transaction cost economics
a strategic management framework, and enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification. This implies taking on greater ownership of the production of needed inputs or of the channels by which it distributes its outputs, or adding business units that offer new products and services.
The advantages of organizing economic activity in 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.