Managerial Economics II Business Strategy Lecture 18 Diversification
Managerial Economics II: Business Strategy Lecture 18: Diversification II Professor Wolfolds Cornell University Dyson School of Applied Economics and Management March 30 th, 2017 Cornell Business
Logistics 1. Problem Sets are available for pick-up at the end of class 2. Remember to check the updated syllabus on Piazza 3. Any questions?
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
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 (Four? ) 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) 4. (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, or Long term contracts? )
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
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?
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!)
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
Muddiest Question: § Compare relative costs: transaction vs. administrative costs If don’t diversify: transaction costs § § Hire external labor Raise external capital Purchase resources So, transaction costs in this case are the costs of undergoing these transactions (from hiring costs, interest rate, research costs, etc. ) If do diversify: administrative costs § Literally, the additional costs of having to administer the diversified business § Culture, organizational, performance management
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Class Objectives § In general, you should be able to: – – – List types of globalization Consider effects of globalization on Five Forces Use Porter’s National Diamond to consider country’s comparative advantages List costs/benefits of globlization Identify elements of the CAGE Framework to consider country distance § If I give you a company, you should be able to: – Suggest how a company may want to break up the value chain by country – Suggest how a company may want to enter into a new international market § Samsung and Starbucks Examples – Identify how and why they are globalized
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Class Objectives § In general, you should be able to: – – – List types of globalization Consider effects of globalization on Five Forces Use Porter’s National Diamond to consider country’s comparative advantages List costs/benefits of globalization Identify elements of the CAGE Framework to consider country distance § If I give you a company, you should be able to: – Suggest how a company may want to break up the value chain by country – Suggest how a company may want to enter into a new international market
Modes of Overseas Market Entry • Exporting • Licensing • Strategic alliances • Foreign direct investment • Build local subsidiary 1. Is the firm’s competitive advantage based on countryspecific resources? 2. Is the product tradable? 3. Does the firm have Increasing resources/capabilities to involvement establish competitive advantage in overseas market? 4. Can firm appropriate returns from resources? 5. Are high transaction costs involved?
Types of Industry Internationalization
Effect of Globalization on 5 Forces PROFITABILITY • Other things remaining equal, internationalization tends to reduce an industry’s margins and return on capital COMPETITION • Increased intensity of competition INDUSTRY STRUCTURE § Lower entry barriers into national markets § Increased industry rivalry —lower seller concentration —greater diversity of competitors § Increased buyer power —buyers have more potential suppliers to choose from
Strategy-as-Link
Porter’s National Diamond 1. FACTOR CONDITIONS: “Home grown” resources/capabilities more important than natural endowments 2. RELATED AND SUPPORTING INDUSTRIES: Key role of “industry clusters” 3. DEMAND CONDITIONS: Discerning domestic customers drive quality & innovation 4. STRATEGY, STRUCTURE, RIVALRY: E. g. domestic rivalry drives upgrading
Comparative Advantage
International Location Decisions § Where to locate activity X? 1) The optimal location of activity X (use Porter’s Diamond) - Cost and availability of inputs - Government incentives/penalties - Internal resources/capabilities of the firm in particular locations 2) The importance of links between activity X and other activities of the firm - Firm’s business strategy (cost vs. differentiation advantage) - Coordination benefits from co-locating activities
Costs/Benefits of Globalization
CAGE Framework
How to use the CAGE framework? § Higher cultural distance more likely to not globalize; pursue partnerships; multi-domestic approach § Higher administrative distance more likely to not globalize; pursue partnerships § Higher geographical distance more likely to not globalize; use multi-domestic approach § Higher economic distance more likely to not globalize; break up value chain
Globalization/Vertical Integration
Class Objectives § In general, you should be able to: – List types of globalization § § Exporting, licensing, strategic partnerships, direct investment, local subsidiary Global strategy vs. multi-domestic strategy – Consider effects of globalization on Five Forces § Increasing rivalry, threat of entry, bargaining power of byers – Use Porter’s National Diamond to consider country’s comparative advantages § Factor conditions, related industries, demand conditions, strategy/rivalry – List costs/benefits of globalization § § Pros: Scale, arbitrage, learning Cons: transportation/communication costs, differences in customer needs, infrastructure differences – Identify elements of the CAGE Framework to consider country distance § Cultural, Administrative, Geographic, and Economic Differences world isn’t a single market § If I give you a company, you should be able to: – Suggest how a company may want to break up the value chain by country § e. g Apple: outsource most parts of the i. Phone, considering costs/advantage by country – Suggest how a company may want to enter into a new international market § Consider reliance on country advantages, ability to trade or license, whether resources/capabilities would generate competitive advantage
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Samsung Article Spend a few minutes and discuss with your neighbors: 1) What industries is Samsung considering diversifying into? 2) How does Samsung utilize South Korea’s competitive advantage? 3) How do South Korea and the U. S. compare for CAGE? 4) What approach are they considering when diversifying?
Samsung Article § What industries is Samsung considering diversifying into? – Solar panels, LED lighting, electric-vehicle batteries, medical devices, and biotech drugs § How does Samsung utilize South Korea’s competitive advantage? – “Fast follower” strategy: allow others to do initial innovation, and then buy technology and quickly grow it § Fits because South Korea not an expert in innovation, but has cheap financing/government guarantee helps them grow quickly – “Management by crisis”: works perhaps because of war recovery – Relatively closer to developing world than U. S. , but still industrialized aims products at both major IT firms/Western consumers and at poor countries – High volume manufacturing with low defect rates: somewhat lower wages, but also higher technological capability § How do South Korea and the U. S. compare for CAGE? – Cultural: different language, norms; Administrative: different government systems/involvement; geographic: far!; economic: somewhat different incomes (about double hourly compensation for U. S. workers) § What approach are they considering when diversifying? – Solar panels: domestic and industrial use; LED: already has a capability from TV market, will sell abroad – Electric-vehicle batteries: partnered with Bosch (German); medical devices: purchased a company
Class Objectives § Samsung and Starbucks Examples – Identify how/if they are globalized – Samsung: mostly globalized through exports § Competitive advantage heavily relies on country-specific advantages (culture, government) § Products are tradable § Strategy relates to these country advantages: fast follower; management by crisis; high volume manufacturing with low defects § Do plan to have some partnerships: but will they work? Culture likely not compatible?
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Starbucks Example § Watch this video and consider: 1) How does Starbucks globalize? Why? 2) What are the costs/benefits of offering specialized offerings in different countries?
Class Objectives § Samsung and Starbucks Examples – Identify how/if they are globalized – Samsung: mostly globalized through exports § Competitive advantage heavily relies on country-specific advantages (culture, government) § Products are tradable § Strategy relates to these country advantages: fast follower; management by crisis; high volume manufacturing with low defects § Do plan to have some partnerships: but will they work? Culture likely not compatible? – Starbucks: mostly globalized through subsidiaries § Competitive advantage relies on firm-specific advantages § Products are generally not tradable (hot coffee!) § Transaction costs are high: more about Starbucks experience than just Frappuccino recipe (versus Mc. Donald’s which can license!) § Brand is big part of competitive advantage, and can be leveraged in other countries
Class Agenda 1. Muddiest question from last class 2. Class Objectives 3. Globalization Background 4. Samsung Article 5. Starbucks Example 6. Q&A
Class Objectives § In general, you should be able to: – List types of globalization § § – Consider effects of globalization on Five Forces § – Factor conditions, related industries, demand conditions, strategy/rivalry List costs/benefits of globalization § § – Increasing rivalry, threat of entry, bargaining power of byers Use Porter’s National Diamond to consider country’s comparative advantages § – Exporting, licensing, strategic partnerships, direct investment, local subsidiary Global strategy vs. multi-domestic strategy Pros: Scale, arbitrage, learning Cons: transportation/communication costs, differences in customer needs, infrastructure differences Identify elements of the CAGE Framework to consider country distance § Cultural, Administrative, Geographic, and Economic Differences world isn’t a single market § If I give you a company, you should be able to: – Suggest how a company may want to break up the value chain by country § – e. g Apple: outsource most parts of the i. Phone, considering costs/advantage by country Suggest how a company may want to enter into a new international market § Consider reliance on country advantages, ability to trade or license, whether resources/capabilities would generate competitive advantage § Samsung and Starbucks Examples – Identify how/if they are globalized: Samsung exports, Starbucks opens subsidiaries, Mc. Donalds licenses
Q&A § Any questions? § Fill out muddiest card and leave here if anything was confusing today!
End of Lecture: § Happy Spring Break! § Next Tuesday: Toyota Case – “Toyota Manufacturing, U. S. A. , Inc. ” – * Available in HBR Course Packet § Assignments: – Reading Questions #10 due Next Tuesday** – ** Will be e-mailed next week
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