CHAPTER 8 Corporate Strategy Vertical Integration and Diversification

CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

What Is Corporate Strategy? • Corporate strategy Ø Quest for competitive advantage when competing in multiple industries v Ex: Jeffrey Immelt’s initiative in clean-tech and health care industries • Corporate strategy concerns the scope of the firm Ø Industry value chain Ø Products and services Ø Geography 7– 2 8 -2

What Is Corporate Strategy? (cont'd) • Economies of scale Ø Average per-unit cost decreases as its output increases v Ex: Anheuser-Busch Inbev largest global brewer • Economies of scope Ø Savings that come from producing more outputs or providing different services at less cost v Ex: Amazon range of products & services • Transaction cost Ø The cost associated with economic exchange v "Make or buy" decision 7– 3 8 -3

Firms vs. Markets: Make or Buy • Should a firm do things in-house (to make)? Or obtain externally (to buy)? • If Cin-house < Cmarket, then the firm should vertically integrate Ø Ex: Microsoft hires programmers to write code in-house rather than contracting out Ø Firms and markets have distinct advantages and disadvantages (see Exhibit 8. 2) 1– 4 8 -4

EXHIBIT 8. 2 Organizing Economic Activity: Firm vs. Markets 1– 5 8 -5

Firms vs. Markets: Make or Buy? • Disadvantage of “make” in-house Ø Principal – agent problem v owner = principal, manager = agent Ø Agent pursues his/her own interests • Disadvantage of “buy” from markets Ø Search cost Ø Opportunism Ø Incomplete contracting Ø Enforce legal contracts • Information asymmetries Ø One party is more informed than others v Akerlof – “Lemons problem” for used cars 1– 6 8 -6

Repurchasing • Pepsi. Co Ø Bottle distributors Ø Gain merchandising control • GM Ø Purchased a minority stake in Delphi Automotive LLC v Ensuring supply • Boeing Ø Aggressively outsources parts Ø Purchased a 50% stake in a joint venture that supplies parts for 787 Dreamliner jet (Worthen, B. , Tuna, C. , & Scheck, J. 2009) 1– 7 8 -7

EXHIBIT 8. 3 Alternatives along the Make or Buy Continuum 1– 8 8 -8

Vertical Integration along the Industry Value Chain • In what stages of the industry value chain should the firm participate? • Vertical integration Ø Ownership of its inputs, production, & outputs in the value chain Ø Horizontal value chain v Internal, firm-level value chains (Chapter 4) • Vertical value chain Ø Industry-level integration from upstream to downstream v Examples: cell phone industry value chain • Many different industries and firms 1– 9 8 -9

EXHIBIT 8. 4 Backward and Forward Vertical Integration along an Industry Value Chain 1– 10 8 -10

Types of Vertical Integration • Full vertical integration Ø Ex: Weyerhaeuser • Owns forests, mills, and distribution to retailers • Backward vertical integration Ø Ex: HTC’s backward integration into design of phones • Forward vertical integration Ø Ex: HTC’s forward integration into sales & branding • Not all industry value chain stages are equally profitable Ø Zara – primarily designs in-house & partners for speedy new fashions delivered to stores 1– 11 8 -11

EXHIBIT 8. 5 HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry 1– 12 8 -12

Benefits and Risks of Vertical Integration • Benefits of vertical integration Ø Securing critical supplies Ø Lowering costs Ø Improving quality Ø Facilitating scheduling and planning Ø Facilitating investments in specialized assets v Ex: HTC started as OEM & expanded to fully integrated 1– 13 8 -13

Strategic health system development • Vertical integration in managed health care Ø Shared information – improved quality & facilitating scheduling and planning Ø Hospital and Physician alliance against insurance companies - lowering costs Ø Specialists - Facilitating investments in specialized assets (Nauert, R. C. , 2002) 1– 14 8 -14

Risks of Vertical Integration • Increasing costs Ø Internal suppliers lose incentives to compete • Reducing quality Ø Single captured customer can slow experience effects • Reducing flexibility Ø Slow to respond to changes in technology or demand • Increasing the potential for legal repercussions Ø FTC carefully reviewed Pepsi plans to buy bottlers 1– 15 8 -15

Alternatives to Vertical Integration • Taper integration Ø Backward integrated but also relies on outside market firms for supplies OR Ø Forward integrated but also relies on outside market firms for some of its distribution • Strategic outsourcing Ø Moving value chain activities outside the firm's boundaries v Ex: EDS and People. Soft provide HR services to many firms that choose to outsource it. 8 -16

EXHIBIT 8. 6 Taper Integration along the Industry Value Chain Outside suppliers could also be off-shored when they are not located in the home country 8 -17

Corporate Diversification: Expanding Beyond a Single Market • Degrees of diversification Ø Range of products and services a firm should offer v Ex: Pepsi. Co also owns Lay's & Quaker Oats. • Diversification strategies: Ø Product diversification v Active in several different product categories Ø Geographic diversification v Active in several different countries Ø Product – market diversification v Active in a range of both product and countries 8 -18

Types of Corporate Diversification • Single business v Google • Dominant business v Microsoft • Related diversification Ø Related constrained v Exxon. Mobil Ø Related linked v Disney • Unrelated diversification v GE 8 -19

EXHIBIT 8. 7 Different Types of Diversification 8 -20

Richard Rumelt - UCLA • Business world – diversification is done to sustain top-line growth. • Companies begin thinking about diversification when growth has leveled-out and opportunities for expansion within their own business has subsided. (Lovallo & Mendonca, 2007) 7– 21

Leveraging Core Competencies for Corporate Diversification • Core competence Ø Unique skills and strengths Ø Allows firms to increase the value of product/service Ø Lowers the cost • Examples: Walmart – global supply chain v Infosys – low-cost global delivery system v • The core competence – market matrix Ø Provides guidance to executives on how to diversify in order to achieve continued growth 8 -22

EXHIBIT 8. 8 The Core Competence – Market Matrix Pepsi - Gatorade Bo. A - NCNB Salesforce. com Bo. A - Merrill Lynch 8 -23

Organizational Capabilities • Examples: marketing skill, distribution skills, human resources skill at top and middle management. Ø Heart of a companies value – firms seek businesses that are a good match for their capabilities. Ø Linked to diversification Ø When a business declines, should you liquidate your organizational capabilities or transfer them into a new business? (Matsusaka, 2001) 7– 24

EXHIBIT 8. 9 The Diversification-Performance Relationship 8 -25

Corporate Diversification • How does diversification enhance performance? Ø Economies of scale lower the cost Ø Economies of scope increase the value Ø Reduce cost and increase value simultaneously 8 -26

Corporate Diversification • Restructuring Ø Process of reorganizing and divesting business units Ø To refocus a company to leverage its core competencies • Boston Consulting Group growth-share matrix Ø Dogs Ø Cash cows Ø Stars Ø Question marks 8 -27

EXHIBIT 8. 11 BCG Matrix 8 -28

Corporate Diversification • Internal capital markets Ø Source of value creation in a diversification strategy Ø Allows conglomerate to do a more efficient job of allocating capital • Coordination cost Ø A function of number, size, and types of businesses linked to one another • Influence cost Ø Political maneuvering by managers to influence capital and resource allocation • Bandwagon effects Ø Firms copying moves of industry rivals 8 -29

Chapter Eight Conclusion • Corporate-level strategy • Options for firms to organize economic activity. . • Two types of vertical integration – backward and forward • Benefits and risks of vertical integration • Alternatives to vertical integration • Different types of corporate diversification • Core competence-market matrix for different diversification strategies. • Diversification strategy – competitive advantage or not 1– 30

References Lovalla, D. P. & Mendonca, L. T. (2007) Strategies strategist: An Interview with Richard Remult. Strategy, The Mc. Kinsey Quaterly, August 2007. Retrieved from http: //www. mckinsey. it/storage/first/uploadfile/attach/139924/file/stst 07. pdf Matsusaka, J. G. (2001). Corporate diversification, value maximization, and organizational capabilities. Journal of Business, 2001, 74 (3), 409 -431. Retrieved from http: //citeseerx. ist. psu. edu/viewdoc/download? doi=10. 1. 1. 122. 5464&rep=rep 1&type =pdf Nauert, R. C. (2002). Strategic health system development and managed care delivery. of Health Care Finance, 29(2), 5 -17. Retrieved from http: //search. proquest. com/docview/235180431? accountid=28644 Journal Worthen, B. , Tuna, C. , & Scheck, J. (2009, Nov 30). Companies more prone to go 'vertical'. Wall Street Journal. Retrieved from http: //search. proquest. com/docview/399140920? accountid=28644 1– 31