MGT 496, Chapter 8

What are the two types of vertical integration?

-Backward integration -Forward integration

What are the three types of strategic alliances?

-Long-term contracts (licensing, franchising) -Equity Alliances -Joint Ventures

What are the alternatives on the Make-or-Buy Continuum?

-Short term contracts -Strategic Alliances (long-term contracts, licensing, franchising; equity alliances; joint ventures -Parent-subsidiary relationship

What is a short-term contract?

.Firms send out RFPs to several companies and accept competitive bids for contracts awarded with short duration, generally less than a year.

What two types of cost are entailed in a related-diversification strategy?

1. Coordination Costs 2. Influence Costs

What are the four strategic management concepts underlying vertical integration, diversification, and geographic competition?

1. Core competencies 2. Economies of scale 3. Economies of scope 4. Transaction costs

Two important dangers of vertical integration.

1. Flexibility to quickly make changes to your business 2. Focus - the more activities a firm conducts, the harder it is to be world-class in those activities.

What three questions must executives answer to determine their 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)?

What are the two different generic business strategies that firms can pursue their quest for competitive advantage?

1. Increase differentiation (while containing cost) 2. Lower costs (while maintaining differentiation).

Name two alternatives to vertical integration

1. Taper integration 2. Strategic outsourcing

What are the 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 over 3. The geographic scope - where to compete.

Why do firms need to grow?

1. To increase profits 2. To lower costs -firms need to achieve minimum efficient scale to take out the lowest-cost position. 3. To increase market power 4. To reduce risk - diversify products and services 5. To motivate management

Corporate strategy determines the boundaries of the firm along what three dimensions?

1. Vertical integration (along the industry value chain) 2. Diversification (of products and services 3. Geographic scope (regional, national or global markets)

What two variables did Richard Rumelt look at when he developed a classification scheme that identifies four main types of diversification?

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

What are coordination costs?

A function of the number, size, and types of businesses that are linked.

What is information asymmetry?

A situation in which one party is more informed than another because of the possession of private information. Often sellers have better information than buyers.

What is a Diversification Discount?

A situation in which the stock price of highly diversified firms is valued at less than the sum of their individual business units.

What is a diversification premium?

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

What are 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. Insights gained from transaction cost economics help managers decide what activities to do in-house vs. what services and products to obtain form the external market. •Explains the scope of the firm •Make or buy decision

Why can a higher degree of vertical integration lead to reduced flexibility?

Commitment to fully integrated business models/technologies.

Unique strengths embedded deep within a firm. They allow a firm to differentiate its products and services from those of its rivals, creating higher or comparable value at lower cost.

Core Competencies

What is a Related-Diversification Strategy?

Corporate strategy in which a firm derives less than 70% of its revenues from a single business activity and obtains revenues from other lines of business that are linked to the primary business activity.

What is an Unrelated Diversification Strategy?

Corporate strategy in which a firm derives less than 70% of its revenues from a single business and there are few, if any, linkages among its businesses.

What is Geographic Diversification Strategy?

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

What are internal transaction costs?

Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs. (i.e., 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). They include costs associated with coordinating activity between different business units of the same corporation. They tend to increase with organizational size and complexity.

What do firms that pursue unrelated diversification experience in the stock market?

Diversification Discount

What are human-asset specificity specialized assets?

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.

According to the resource-based view of the firm, what are a firm's boundaries delineated by?

Its knowledge bases and core competencies. Activities that draw on what the firm knows how to do well should be done in-house, while non-core activities (i.e., payroll) can be outsourced.

What is a diversified company?

One that competes in several different markets simultaneously.

What is a Dominant-Business Firm?

One that derives between 70 and 95% of its revenues from a single business, but it pursues at least one other business activity that accounts for the remainder of the revenue.

What is a Single-Business Firm?

One that derives more than 95% of its revenues from one business.

What is a non-diversified company?

One that focuses on a single market

This category of SBUs on the BCG Growth-Share Matrix includes SBUs that hold a high market share in a fast-growing market. Their earnings are high and either stable or growing.

Star

What is restructuring?

The process of reorganizing and divesting business units and activities to refocus a company in order to leverage its core competencies more fully.

What are economies of scope?

The savings that come from producing two (or more) outputs or providing different services at less cost than producing each individual, through using the same resources and technology.

What is the diversification-performance relationship?

There is an inverted, U-shaped relationship between the type of diversification and overall firm performance.

What is the rationale behind related diversification?

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.

What must diversification do to enhance firm performance?

•Provide economies of scale, which reduces costs •Exploit economies of scope, which increases value •Reduce costs and increase value

What is Corporate Strategy?

"Where to complete in the industry value chain." 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. It provides answers to the key question of where to compete. It must align with and strengthen the firm's business strategy, whether it is differentiation, cost-leadership, or blue-ocean strategy.

What is the critical challenge in corporate strategy?

Determining the boundaries of the firm so that it is more likely to gain and sustain a competitive advantage.

What is Product-Market Diversification Strategy?

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

What are the two variations of related diversification strategy?

1. Related-Constrained Diversification 2. Related-Linked Diversification

What is a Conglomerate?

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

What is the 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. All four categories shape the firm's corporate strategy.

What is Related-Constrained Diversification?

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. A firm follows a related-constrained diversification strategy when it derives less than 70% of its revenues from a single business activity and obtains revenues from other lines of business related to the primary business activity.

What is Related-Linked Diversification?

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

What is a credible commitment?

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

What is a strategic alliance?

A voluntary arrangement between firms that involves the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services. These can facilitate investments in transaction-specific assets without encountering internal transaction costs.

What are transaction costs?

All internal and external costs associated with an economic exchange. They enable managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification.

What is Diversification?

An increase in the variety of products and services a firm offers or markets and the geographic regions in which it competes.

How do internal transaction costs play into the make or buy decision?

As long as the internal transaction costs are less than the external one, it makes sense to bring the activity into the firm. If it costs more to do it in-house than in the market, then buy it in the market. It's more than just a price-tag... its economic value created. Value is the benefit that consumers get for a product or service. Doing something in-house is called vertical integration.

What are the three "Cs" and two "Fs" of vertical integration?

Capabilities Coordination Control Flexibility Focus

This category of SBUs on the BCG Growth-Share Matrix represent SBUs that compete in a low-growth market but hold a considerable market share. Their earnings and cash flows are high and stable.

Cash Cow

What is 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.

What is the main reason to vertically integrate?

Failure of vertical markets

What levels of diversification are associated with lower overall firm performance?

High and low levels of diversification.

What levels of diversification are associated with higher firm performance?

Moderate levels of diversification.

What is Strategic Outsourcing?

Moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain. Outsourcing outside the home country is called offshoring.

The most-integrate alternative to performing an activity within one's own corporate family.

Parent-Subsidiary Relationship. The corporate parent owns the subsidiary and can direct it via command and control.

What is the key insight of transaction cost economies?

That different institutional arrangements - markets vs. firms - have different costs attached.

What do findings suggest about the success of vertical integration?

That when a company vertically integrates two or more steps away from its core competency, it fails two-thirds of the time.

What is Vertical Integration?

The firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs. It can be measured by a firm's value added: What percentage of a firm's sales is generated within the firm's boundaries. The degree of vertical integration tends to correspond to the number of industry value chain stages in which a firm directly participates.

What are the benefits of short-term contracts?

They allow longer planning period than individual market transactions and buying firm can often demand lower prices due to competitive bid process.

What is an Industry Value Chain? (Also called Vertical Value Chain)

They depict the transformation of raw materials into finish goods and services along distinct vertical stages, typically each stage represents a distinct industry in which a number of different firms are competing. This is why expansion up or down the chain is called "vertical" integration. This defines the vertical boundaries of the firm.

What companies create a diversification premium?

Those that pursue related diversification.

What is the strategic recommendation concerning SBUs in the Cash Cow category of the BCG Growth-Share Matrix?

To invest enough into cash cows to hold their current position and to avoid having them turn into dogs.

What is the strategic recommendation for Question Mark category of the BCG Growth-Share Matrix?

To invest in them to increase their relative market share so they turn into stars. Question Marks are likely to turn into dogs as the overall market growth slows. In this case, executives would want to harvest the cash flow or divest the SBU.

A stand-alone organization created and jointly owned by two or more parent companies. Both contribute equity and make a long-term commitment, which facilitates transaction-specific investments.

What is a Joint Venture?

What are economics of scale?

When a firm's average cost per unit decreases as its output increases, by the spreading of fixed costs over increased production.

When does a corporate diversification strategy enhance firm performance?

When its value creation is greater than the costs it incurs.

When should a firm vertically integrate by owning production of the needed inputs or channels for the distribution of outputs?

When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market.

What is Vertical Market Failure?

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

This category of SBUs on the BCG Growth-Share Matrix represents SBUs in which it is not clear whether they will turn in to dogs or stars. Their earnings are low and unstable. Cash flow is negative.

Question Marks

What is the strategic recommendation concerning SBUs in the Star Category of the BCG Growth-Share Matrix?

To invest sufficient resources to hold the star's position or even increase investments for future growth. Stars may turn in to cash cows in situations where the market in which the SBU is situated shows that reaching the maturity stage of the industry life cycle.

Two reasons backward vertical integration is often undertaken.

To overcome threat of opportunism and to secure key raw materials.

What is the critical question to ask when evaluating the performance of diversified companies?

Whether the individual businesses are worth more under the company's management than if each were managed individually.

When can an unrelated diversification strategy be advantageous?

In an emerging market.

What are the advantages of 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.

What are the three general diversification strategies?

1. Product diversification strategy 2. Geographic diversification strategy 3. Product-market diversification strategy

A partnership in which at least one partner takes partial ownership in the other partner by buying stock or assets (in private companies). Taking of equity signals greater commitment to the partnership.

Equity Alliance

What are the drawbacks of short-term contracts?

Firms responding to the bid have no incentive to make any transaction-specific investments (i.e., buy new machinery to improve product quality).

What are the two types of transactions costs?

Internal and external

What are the four main types of diversification?

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

What is Product Diversification Strategy?

A corporate strategy in which a firm is active in several different product markets

What is the Core Competence-Market Matrix?

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

What is 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.

What are site-specificity specialized assets?

Assets required to be co-located, such as the equipment necessary for mining bauxite and aluminum smelting.

What are physical-asset specificity specialized assets?

Assets whose physical and engineering properties are designed to satisfy a particular customer, such as bottling machinery for Coca-Cola and PepsiCo.

Why does corporate strategy need to be dynamic over time?

Because a firm's external environment never remains constant over time.

Why can an unrelated diversification strategy be advantageous in an emerging market?

Because it allows the conglomerate to overcome institutional weaknesses in emerging economies, such as a lack of a functional capital market.

Why does the unrelated diversification strategy help firms gain and sustain a 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.

What is 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.

What are external transaction costs?

Cost of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract: •Time •Contracts (i.e., drawing up contracts, enforcing them and licensing) and Legal Fees •Shipping Costs/Logistics •Search costs (sometimes you have to do a lot more research if you're looking for suppliers... you care about quality, price, you need to get a quote, you need to make sure the product works.

What are influence costs?

Costs that occur due to political maneuvering by managers to influence capital and resource allocation and the resulting inefficiencies stemming from suboptimal allocation of scarce resources.

This category of SBU on the BCG Growth-Share matrix represents underperforming businesses. They hold a small market share in a low-growth market; they have low and unstable earnings, combined with neutral or negative cash flows.

Dog

What is the strategic recommendation concerning SBUs in the Dog category of the BCG Growth-Share Matrix?

Either to divest the business or to harvest it. This implies stopping investment in the business and squeezing out as much cash flow as possible before shutting it or selling it.

What is a community of knowledge?

Employees within the firm have ongoing relationships, exchanging ideas and working closely together to solve problems.

A long-term contract in which a franchiser 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.

Franchising

What is the principal-agent problem?

How do you get the agent to act on behalf of the principle without self-interests? A situation in which an agent performing activities on behalf of a principal pursues his or her own interests. It is a major disadvantage of organizing economic activity within firms, as opposed to within markets. Some options include, stock incentives, pay for performance.

When can Internal Capital Markets 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.

What is the first key question when formulating corporate strategy?

In what stages of the industry value chain should the firm participate? Deciding whether to make or buy the various activities in the industry chain involves the concept of vertical integration.

A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property.

Licensing

What is a long-term contract?

Like short-term, but longer than one year. They help overcome the incentive to make transaction-specific investments.

Although many managers provide input, the responsibility for corporate strategy ultimately rests with who?

The CEO.

What underlies the three questions that executives must answer to determine their corporate strategy?

The desire/need for growth.

What is the first task for managers in the Core Competence-Market Matrix?

To identify their existing core competencies and understand the firm's current market situation.

What are 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.

What are core competencies?

Unique strengths embedded deep within a firm that allow companies to increase the perceived value of their product and service offerings and/or lower the cost to produce them.

What are the disadvantages of organizing economic activity within firms?

•Administrative costs because of necessary bureaucracy •Low-powered incentives, such as hourly wages and salaries. •The principle-agent problem

Three primary reasons companies vertically integrate:

•Capabilities (can you be one of the best in the world a doing it? If not, consider outsourcing) •Coordination (are you better able to coordinate the activity with other business activities in the firm. To what extend will be improve our ability to coordinator our business activities by doing this ourself? •Control (to what extend will be gain control over a valuable step in the value chain by conducting this activity ourself? You want to control assets or inputs that are customized to each other.

What are other potential benefits to firm performance when following a diversification strategy?

•Financial economies resulting from restructuring •Using internal capital markets

What are the advantages of markets?

•High-powered incentives (a successful entrepreneur can make potentially enough money to provide financial security for life) •Increased flexibility (offering price and service comparisons among many different providers)

What are the risks of vertical integration?

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

What are the benefits of taper integration?

•It exposes in-house suppliers and distributors to market competition so that performance comparisons are possible. It allows firms to retain and fine-tune its competencies in upstream and downstream value chain activities. •It enhances a firm's flexibility •Firms that use taper integration can combine internal and external knowledge, possibly paving the path for innovation.

Why can a higher degree of vertical integration lead to increasing costs?

•Less competition •Larger market/economies of scale •Increased administrative costs •Knowledge that there will always be a buyer reduces incentive to lower costs and improve quality or innovate.

What are the benefits of vertical integration?

•Lowering costs •Improving quality •Facilitating scheduling and planning •Facilitating investments in specialized assets •Securing critical suppliers and distribution channels Vertical integration along the industry value chain can also facilitate investments to specialized assets.

What are the disadvantages of markets?

•Search costs. On a very fundamental level, search costs are the biggest disadvantage of transacting in markets rather than owning the various production and distribution activities (i.e., 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. Or to find suppliers when the specific products and services are not offered by firms currently in the market. •Opportunism by other parties (self-interest seeking with guile). •Incomplete contracting (not all future contingencies can be anticipated, and it is difficult to specify expectations or measure performance and outcomes. •Enforcement of contracts. It is difficult, costly, and time-consuming to enforce legal contracts Legal exposure is one of the major hazards in using markets rather than integrating an activity within a firm's hierarchy. •Information Asymmetries