Managerial Economics II Business Strategy Lecture 17 Diversification

Managerial Economics II: Business Strategy Lecture 17: Diversification I Professor Wolfolds Cornell University Dyson School of Applied Economics and Management March 28 th, 2017 Cornell Business

Logistics 1. Problem Sets are available for pick-up at the end of class 2. New Syllabus is uploaded based on evaluation feedback: - Fewer readings/less text reading - Less review at beginning of class more time for Q&A at end of class - Please submit “muddiest” idea card at end of class if have one to review at beginning of next class - Addition of learning objectives at beginning/end of class - Increase discussion during class 3. Any questions?

Class Agenda 1. Class Objectives 2. Diversification Background 3. Volkswagen Article 4. Virgin Group Example 5. Q&A

Class Objectives § In general, you should be able to: – List factors that a company should consider when deciding whether or not to diversify (e. g. pros/cons of diversification) – List the determinants of relatedness of diversification § If I give you a company, you should be able to: – Suggest whether a new product/business would satisfy the “Essential Tests” for that company – Identify what resources/capabilities could be used to diversify § Volkswagen and Virgin Group – Identify how/if they are diversified – List resources/capabilities that they use to diversify – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus

Class Agenda 1. Class Objectives 2. Diversification Background 3. Volkswagen Article 4. Virgin Group Example 5. Q&A

Diversification Background Objectives § In general, you should be able to: – List factors that a company should consider when deciding whether or not to diversify (e. g. pros/cons of diversification) – List the determinants of relatedness of diversification § If I give you a company, you should be able to: – Suggest whether a new product/business would satisfy the “Essential Tests” for that company – Identify what resources/capabilities could be used to diversify

Motives for Diversification § Growth – The desire to escape stagnant or declining industries is a powerful motive for diversification (e. g. tobacco, oil, newspapers). – But, growth is in the interests of managers not shareholders

Motives for Diversification § Growth – The desire to escape stagnant or declining industries is a powerful motive for diversification (e. g. tobacco, oil, newspapers). – But, growth is in the interests of managers not shareholders § Risk Spreading – Diversification reduces the variance of profit flows – But, does not create value for shareholders

Motives for Diversification § Growth – The desire to escape stagnant or declining industries is a powerful motive for diversification (e. g. tobacco, oil, newspapers). – But, growth is in the interests of managers not shareholders § Risk Spreading – Diversification reduces the variance of profit flows – But, does not create value for shareholders § Value Creation – For diversification to create shareholder value, putting different businesses under common ownership must increase their total profitability

Porter’s Three Essential Tests For diversification to create shareholder value, it must meet three tests: 1. The Attractiveness Test: diversification must be directed towards attractive industries (or those with the potential to become attractive). 2. The Cost of Entry Test: the cost of entry must not capitalize all future profits. 3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa (i. e. some form of “synergy” must be present) - Profitability (Firm 1 + Firm 2) > Profitability (Firm 1) + Profitability (Firm 2)

Why Better-Off? § Economies of Scope: Definition – Cost savings from sharing of resources and capabilities – Many units of the same item is scale, while scope involves multiple products § Sub-additivity: C(X)<∑Ci(xi) – Production of goods x 1, x 2, …xn – C(X) = Cost of producing all n goods within a single firm – ∑i. Ci(xi) = Cost of producing the goods in n specialized firms

Why Better-Off? § Economies of Scope: Sources – Sharing tangible resources across multiple businesses § § Technology Distribution networks Information technology systems Sales/marketing force – Market power/bundling/predatory pricing

Why Better-Off? § Economies of Scope – Sharing tangible resources across multiple businesses – Market power/bundling/predatory pricing – Sharing intangible resources across multiple businesses § Brands § Intellectual Property

Why Better-Off? § Economies of Scope – Sharing tangible resources across multiple businesses – Market power/bundling/predatory pricing – Sharing intangible resources across multiple businesses § Brands § Intellectual Property – Transferring functional capabilities across businesses § Advertising/Promotion

Why Better-Off? § Economies of Scope – – – Sharing tangible resources across multiple businesses Market power/bundling/predatory pricing Sharing intangible resources across multiple businesses Transferring functional capabilities across businesses Applying common general management capabilities to different businesses § Economies from Internalizing Transactions – Economies of scope not a sufficient basis for diversification—must be supported by transaction costs in markets for resources § Compare relative costs: transaction costs vs. administrative costs (org. structure, incentives, culture) – Diversified firm can avoid external transactions by operating internal capital and labor markets – Diversified firm has better information on resource characteristics than external markets

Relatedness of Diversification § Resource Allocation – – Similar sizes of capital investment projects Similar time spans of investment projects Similar sources of risk Similar general management skills required for business unit managers § Strategy Formulation – Similar key success factors – Similar stages of the industry life cycle – Similar competitive positions occupied by each business within its industry § Performance Management/Control Variables – Targets defined in terms of similar performance variables – Similar time horizons for performance targets

Need-to-own test? § Does the firm need to own in order to benefit / profit from them? § Can the same value creation be achieved through • Licenses • Strategic alliances • Long term contracts

Diversification Background § In general, you should be able to: – List factors that a company should consider when deciding whether or not to diversify (e. g. pros/cons of diversification) § Costs vs. benefits of economies of scope/internalizing versus transaction costs – List the determinants of relatedness of diversification § Resource Allocation, Strategy Formulation, Performance Management § If I give you a company, you should be able to: – Suggest whether a new product/business would satisfy the “Essential Tests” for that company § Attractiveness, Cost-of-Entry, Better-Off – Identify what resources/capabilities could be used to diversify § Can the tangible/intangible/functional capabilities be shared? § Questions?

Class Agenda 1. Class Objectives 2. Diversification Background 3. Volkswagen Article 4. Virgin Group Example 5. Q&A

Volkswagen Objectives § Volkswagen and Virgin Group – Identify how/if they are diversified – List resources/capabilities that they use to diversify – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus

Volkswagen Group § What products/markets is Volkswagen diversified into? – Volkswagen Group: a large international corporation in charge of multiple car and truck brands, including Audi, SEAT, Lamborghini, Bentley, Bugatti, Scania, MAN, and Škoda § What resources/capabilities are they sharing? § What do we think about acquisition of Ducati and Porsche? Up! (the sub-subcompact car)? – The first Porsche car, the Porsche 64 of 1938, used many components from the Volkswagen Beetle. The 1948 Porsche 356 continued using many Volkswagen components, including a tuned engine, gearbox and suspension.

Volkswagen Grouo Share Price History: - September 11, 2015: 167. 95 - October 2, 2015: 92. 36 - Decline of 45% Why? - September 18, 2015 EPA issued a notice of violation of the Clean Air Act

Volkswagen Group

Volkswagen Objectives § Volkswagen Group – Identify how/if they are diversified § Products include various brands (Audi, Bentley, VW, etc. ), and types of cars (compact, sedan, SUV, truck) – List resources/capabilities that they use to diversify § § Modular strategy with base parts/design Sales force, engineers Distribution Brand – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus § Electric vehicles (Strategy 2026) § Perhaps sell Ducati? § Key: consider benefits AND costs of co-ownership! (e. g. brand damage affects all companies!)

Class Agenda 1. Class Objectives 2. Diversification Background 3. Volkswagen Article 4. Virgin Group Example 5. Q&A

Virgin Group Objectives § Volkswagen and Virgin Group – Identify how/if they are diversified – List resources/capabilities that they use to diversify – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus

Virgin Group § Watch this video and read the article to consider: 1) What industries is the Virgin Group in? 2) What are the resources/capabilities they are trying to leverage when they diversify? 3) What mistake did they make with Virgin Cola? 4) Are they making related or unrelated diversification choices?

Virgin Group Objectives § Virgin Group – Identify how/if they are diversified § Industries: records, trains, money, planes, commercial space travel…. – List resources/capabilities that they use to diversify § Resources: Richard Branson, brand § Capabilities: customer service – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus § Ignored “attractiveness test” in cola industry § Other nascent, customer-facing industries

Class Agenda 1. Class Objectives 2. Diversification Background 3. Volkswagen Article 4. Virgin Group Example 5. Q&A

Class Objectives § In general, you should be able to: – List factors that a company should consider when deciding whether or not to diversify (e. g. pros/cons of diversification) – List the determinants of relatedness of diversification § If I give you a company, you should be able to: – Suggest whether a new product/business would satisfy the “Essential Tests” for that company – Identify what resources/capabilities could be used to diversify § Volkswagen and Virgin Group – Identify how/if they are diversified – List resources/capabilities that they use to diversify – Consider other ways they might be able to diversify, or instances of “mistakes” in diversification and how they can refocus

Q&A § Any questions? § Fill out muddiest card and leave here if anything was confusing today!

End of Lecture: § Thursday: Diversification II – Globalization – Grant Chapter 12: “Global Strategy and the Multinational Corporation” – “Samsung: The Next Big Bet”* – * Posted on Piazza § Assignments: – Reading Questions #9 due Thursday** – ** Will be e-mailed this afternoon