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Chapter 8

Corporate Strategy: Vertical Integration and Diversification

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Learning Objectives 1-9

Define corporate strategy and describe the three dimensions along which it is assessed.

Explain why firms need to grow, and evaluate different growth motives.

Describe and evaluate different options firms have to organize economic activity.

Describe the two types of vertical integration along the industry value chain: backward and forward vertical integration.

Identify and evaluate benefits and risks of vertical integration.

Describe and examine alternatives to vertical integration.

Describe and evaluate different types of corporate diversification.

Apply the core competence-market matrix to derive different diversification strategies.

Explain when a diversification strategy creates a competitive advantage and when it does not.

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Corporate Strategy

The decisions that leaders make.

Goal-directed actions that they take in the quest for competitive advantage.

Boundaries of the firm:

Vertical integration.

Diversification.

Geographic scope.

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Vertical integration: In what stages of the industry value chain should the company participate? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages.

Diversification: What range of products and services should the company offer?

Geographic scope: Where should the company compete geographically in terms of regional, national, or international markets?

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Why Firms Need to Grow

To increase profits and shareholder returns.

To lower costs and achieve economies of scale.

To increase market power.

To reduce risk through diversification.

To motivate management.

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Increase profits – results in shareholder returns.

Lower costs – growth enables efficiency.

Increase market power – fewer competitors, more bargaining power, higher profitability.

Reduce risk – low performance in one SBU can be compensated by another.

Motivate management – job security.

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Three Dimensions of Corporate Strategy

Vertical integration.

Diversification.

Geographic scope.

Underlying concepts that guide these:

Core Competencies (Chapter 4).

Economies of Scale (Chapter 6).

Economies of Scope (Chapter 6).

Transaction Costs: cost effectiveness of vertical integration vs. diversification.

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The Chapter Case discusses Amazon’s diversification over time. Bezos also decided to customize certain country-specific websites despite the instant global reach of ecommerce firms. With this strategic decision, he decided where to compete globally in terms of different geographies beyond the United States. In short, Bezos determined where Amazon competes geographically (question 3).

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Transaction Costs

Associated with an economic exchange.

External transaction costs:

Searching for contractors.

Negotiating, monitoring, and enforcing contracts.

Internal transaction costs:

Recruiting and retaining employees.

Setting up a shop floor.

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Internal transaction costs include costs pertaining to organizing an economic exchange within a firm—for example, 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. Internal transaction costs also include administrative costs associated with coordinating economic activity between different business units of the same corporation such as transfer pricing for input factors, and between business units and corporate headquarters including important decisions pertaining to resource allocation, among others. Internal transaction costs tend to increase with organizational size and complexity.

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Internal and External Transaction Costs

Exhibit 8.2

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Make or Buy?

If Costsin-house < Costsmarket,

Vertically integrate.

Own production of the inputs.

Or own output distribution channels.

If Costsmarket < Costsin-house,

The firm should consider purchasing instead.

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Organizing Economic Activity: Firms vs. Markets

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The Principal-Agent Problem

A major disadvantage of organizing economic activity within firms.

Principal – the owner of the firm.

Goal: create shareholder value.

Agent – manager or employee.

Should act on behalf of the principal.

Problem:

Agents pursue their own interests (corporate jets, golf outings, expensive hotels).

One Solution:

Stock options to make agents owners.

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Information Asymmetry

A situation in which:

One party is more informed than another,

Due to the possession of private information.

Can result in the crowding out of desirable goods and services by inferior ones.

Examples: used cars, e-commerce, mortgage backed securities, R&D projects.

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Alternatives on the Make-or-Buy Continuum

Exhibit 8.4

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Vertical Integration

The ownership of inputs or distribution channels.

“What percentage of a firm’s sales is generated within the firm’s boundaries?”

Backward Vertical Integration:

Owning inputs of the value chain.

Forward Vertical Integration:

Owning activities closer to the customer.

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The degree of vertical integration tends to correspond to the number of industry value chain stages in which a firm directly participates.

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Backward and Forward Vertical Integration along an Industry Value Chain

Exhibit 8.5

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The Vertical Value Chain of Your Cell Phone

Raw materials:

Chemicals, ceramics, metals, oil for plastic.

Intermediate goods and components:

Integrated circuits, displays, touchscreens, cameras, and batteries.

Final Assembly and manufacturing:

Assembly.

Marketing, sales, after-sales service and support:

Pick a service provider.

Get wireless data and voice service.

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HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry

Exhibit 8.6

Access the text alternate for slide image.

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Benefits of Vertical Integration

Lowering costs.

Improving quality.

Facilitating scheduling and planning.

Facilitating investments in specialized assets:

Co-located assets, unique equipment, human capital.

Securing critical supplies and distribution channels.

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Specialized assets have a high opportunity cost: They have significantly more value in their intended use than in their next-best use. They can come in several forms:

▪ Site specificity—assets required to be co-located, such as the equipment necessary for mining bauxite and aluminum smelting.

▪ Physical-asset specificity—assets whose physical and engineering properties are designed to satisfy a particular customer. Examples include the bottling machinery for E&J Gallo. Given the many brands of wine offered by E&J Gallo, unique equipment, such as molds and a specific production process, is required to produce the different and trademarked bottle shapes.

▪ Human-asset specificity—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.

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Risks of Vertical Integration

Increasing costs.

Reducing quality.

Reducing flexibility.

Increasing the potential for legal repercussions.

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Amazon, featured in the Chapter Case, is facing potential legal repercussions because of its increasing scale and scope. Amazon now accounts for roughly one-half of all internet retail spending in the United States. In addition, with AWS, physical retail stores, and drone deliveries, Amazon is increasingly becoming a fully vertically integrated enterprise. Many argue that Amazon is much like a utility, providing the backbone for internet commerce, both in the business-to-consumer (B2C) as well as in the business-to-business (B2B) space. This paints a future picture in which rivals are depending more and more on Amazon’s products and services to conduct their own business. Amazon’s tremendous scale and scope can bring it increasingly into conflict with governments. Antitrust enforcers such as the Department of Justice might train their sights on Amazon.

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When Does Vertical Integration Make Sense?

When there are issues with raw materials.

Example: Henry Ford ran mining operations.

To enhance the customer experience.

Eliminate annoyances and poor interfaces.

Vertical market failure: when transactions are too risky or costly.

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In the early days of automobile manufacturing, Ford Motor Co. was frustrated by shortages of raw materials and the limited delivery of parts suppliers. In response, Henry Ford decided to own the whole supply chain, so his company soon ran mining operations, rubber plantations, freighters, blast furnaces, glassworks, and its own parts manufacturer.

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Alternatives to Vertical Integration

Taper Integration:

Backward or forward integrated.

Plus reliance on outside firms such as suppliers or distributors.

Strategic Outsourcing:

Moving internal value chain activities.

To other firms.

Example: HR management system.

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Taper integration has several benefits:

â–ª It exposes in-house suppliers and distributors to market competition so that performance comparisons are possible. Rather than hollowing out its competencies by relying too much on outsourcing, taper integration allows a firm to retain and fine-tune its competencies in upstream and downstream value chain activities.

▪ Taper integration also enhances a firm’s flexibility. For example, when adjusting to fluctuations in demand, a firm could cut back on the finished goods it delivers to external retailers while continuing to stock its own stores.

â–ª Using taper integration, firms can combine internal and external knowledge, possibly paving the path for innovation.

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Taper Integration along the Industry Value Chain

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Types of Diversification

Product Diversification:

Increase in variety of products / services.

Active in several product markets.

Geographic Diversification:

Increase in variety of markets / geographic regions.

Regional, national, or international markets.

Product-Market Diversification:

Product and geographic diversification.

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Coca-Cola, for example, focuses on soft drinks and thus on a single product market. Its archrival PepsiCo competes directly with Coca-Cola by selling a wide variety of soft drinks and other beverages, and also offering different types of chips such as Lay’s, Doritos, and Cheetos, as well as Quaker Oats products such as oatmeal and granola bars. Although PepsiCo is more diversified than Coca-Cola, it has reduced its level of diversification in recent years.

product–market diversification strategy

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

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Types of Corporate Diversification

Single business: low level of diversification.

Dominant business: additional business activity pursued.

Related diversification:

Constrained: all businesses share competencies.

Linked: some businesses share competencies.

Unrelated diversification (conglomerate): no businesses share competencies.

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Examples of the four main types of diversification:

Single business – Coca-Cola, Google, Facebook

Dominant business – Harley Davidson, Nestle, UPS

Related diversification – Related Constrained: ExxonMobile, Nike; Related Linked: Amazon, Disney

Unrelated diversification: (conglomerate) – Berkshire Hathaway

A related-diversification strategy entails two types of costs: coordination and influence costs. Coordination costs are a function of the number, size, and types of businesses that are linked. Influence costs occur due to political maneuvering by managers to influence capital and resource allocation and the resulting inefficiencies stemming from suboptimal allocation of scarce resource.

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The Core Competence–Market Matrix

Exhibit 8.9

Source:. Adapted from G. Hamel and C.K. Prahalad (1994), Competing for the Future (Boston: Harvard Business School Press).

Access the text alternate for slide image.

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To survive and prosper, companies need to grow. This mantra holds especially true for publicly owned companies because they create shareholder value through profitable growth. Strategic leaders respond to this relentless growth imperative by leveraging their existing core competencies to find future growth opportunities. Gary Hamel and C.K. Prahalad advanced the core competence–market matrix, depicted in Exhibit 8.9, as a way to guide managerial decisions in regard to diversification strategies. The first task for managers is to identify their existing core competencies and understand the firm’s current market situation. When applying an existing or new dimension to core competencies and markets, four quadrants emerge, each with distinct strategic implications.

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The Diversification-Performance Relationship

Exhibit 8.11

Source:. Adapted from L.E. Palich, L.B. Cardinal, and C.C. Miller (2001), “Curvilinearity in the diversification-performance linkage: An examination of over three decades of research,” Strategic Management Journal 21: 155–174..

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High and low levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance. This implies that companies that focus on a single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation. Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies into adjacent markets.

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How Diversification Can Enhance Firm Performance

Provides economies of scale (reduces costs).

Exploits economies of scope (increases value).

Reduces costs and increase value.

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Restructuring

Reorganizing and divesting business units and activities.

Helps refocus a company.

Helps leverage core competencies more fully.

Helpful restructuring tool: BCG growth-share matrix.

Guides portfolio planning.

Each category warrants a different strategy.

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Corporate executives can restructure the portfolio of their firm’s businesses, much like an investor can change a portfolio of stocks.

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Restructuring the Corporate Portfolio: The Boston Consulting Group Growth–Share Matrix

Exhibit 8.13

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Corporate executives can restructure the portfolio of their firm’s businesses, much like an investor can change a portfolio of stocks. One helpful tool to guide corporate portfolio planning is the Boston Consulting Group (BCG) growth–share matrix. This matrix locates the firm’s individual SBUs in two dimensions:

Relative market share (horizontal axis).

Speed of market growth (vertical axis).

The firm plots its SBUs into one of four categories in the matrix: dog, cash cow, star, and question mark. Each category warrants a different investment strategy. All four categories shape the firm’s corporate strategy.

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Internal Capital Markets

Can be a source of value creation in diversification strategy.

A way to allocate capital at a lower cost, if more efficient than external markets.

A related-diversification strategy can enhance corporate performance.

Consider coordination and influence costs.

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Coordination costs are a function of the number, size, and types of businesses that are linked. Influence costs occur due to political maneuvering by managers to influence capital and resource allocation and the resulting inefficiencies stemming from suboptimal allocation of scarce resources.

Until recently, GE Capital brought in close to $70 billion in annual revenues and generated more than half of GE’s profits.  In combination with GE’s triple-A debt rating, having access to such a large finance arm allowed GE to benefit from a lower cost of capital, which in turn was a source of value creation in itself. In 2009, at the height of the global financial crises, GE lost its AAA debt rating. The lower debt rating and the smaller finance unit are likely to result in a higher cost of capital, and thus a potential loss in value creation through internal capital markets. GE subsequently sold its GE Capital business unit.

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End of Main Content

© 2019 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.

No reproduction or further distribution permitted without the prior written consent of McGraw Hill.

Because learning changes everything.®

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Accessibility Content: Text Alternatives for Images

© McGraw Hill

Internal and External Transaction Costs Text Alternate

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The image has two circles, Firm A and Firm B, and shows the respective internal transactions costs within Firm A and Firm B via an arrow inside each circle. This image also shows the external transaction costs that occur when Firm A and Firm B do business with one another, with an arrow pointing externally from the circles under a title called “Market.”

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Organizing Economic Activity: Firms vs. Markets Text Alternate

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This image has a graphic of four squares, which list each of the following:

Firm Advantages:

Command and control (flat & hierarchical)

Coordination

Transaction specific investments

Community of knowledge

Firm Disadvantages:

Administrative costs

Low powered incentives

Principle agent problem

Market Advantages:

High powered incentives

Flexibility

Market Disadvantages:

Search costs

Opportunism (hold up)

Incomplete contracting (specifying and measuring performance, and information asymmetries)

Enforcement of contracts

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Alternatives on the Make-or-Buy Continuum Text Alternate

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Several alternative hybrid arrangements are available between these two extremes. Moving from transacting in the market (“buy”) to full integration (“make”), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent–subsidiary relationships. Long term contacts can include both licensing and franchising.

The make side of the graph requires more integration, and the buy side of the graph requires less integration.

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Backward and Forward Vertical Integration along an Industry Value Chain Text Alternate

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This image shows a downward facing series of arrows that moves from upstream activities (backward integration) toward upstream activities (forward integration).

The arrows move along the following sequence:

Stage 1 – Raw Materials

Stage 2 – Components and Intermediate Goods

Stage 3 – Final Assembly & Marketing

Stage 4 – Marketing and Sales

Stage 5 – After-Sales Service and Support

Near stage 1 includes more upstream industries and backward vertical integration, and near stage 5 includes more downstream industries and forward vertical integration.

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H T C’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry Text Alternate

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Backward Vertical Integration achieved through:

Stage 1, Design: Apple, Blackberry, Google, H T C, Huawei, L G, Samsung, Xiaomi

Stage 2, Manufacturing: Flextronics, Foxconn, H T C, Inventec, other O E M’s

Forward Vertical Integration achieved through:

Stage 3, Marketing and Sales: Apple, Google, H T C, Huawei, L G, Samsung, Xiaomi

Stage 4, After-Sales Service and Support: A T and T, Google (Project Fi), T Mobile, Verizon

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Taper Integration along the Industry Value Chain Text Alternate

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This image shows a series of boxes and interconnecting arrows. To the upper left side of the image, a box titled Outside Suppliers: Intermediate Goods and Components has an arrow pointing toward In-House Suppliers: Assembly and Manufacturing. The upper right side of the image has a box titled In-House Suppliers: Assembly and Manufacturing, which also points toward In-House Suppliers: Assembly and Manufacturing.

The In-House Suppliers: Assembly and Manufacturing box points toward two different boxes on the bottom of the image. One that says In-House Distributors: Retail and Service, and another that says Outside Distributors: Retail and Service.

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The Core Competence: Market Matrix Text Alternate

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This image shows four quadrants, each with distinct strategic implications, to be considered when applying an existing or new dimension to core competencies and markets:

The lower-left quadrant combines existing core competencies with existing markets. Here, managers must come up with ideas of how to leverage existing core competencies to improve the firm’s current market position.

The lower-right quadrant combines existing core competencies with new market opportunities. Here, managers must strategize about how to redeploy and recombine existing core competencies to compete in future markets.

The upper-left quadrant combines new core competencies with existing market opportunities. Here, managers must come up with strategic initiatives to build new core competencies to protect and extend the company’s current market position.

Finally, the upper-right quadrant combines new core competencies with new market opportunities. Hamel and Prahalad call this combination “mega- opportunities”—those that hold significant future-growth opportunities.

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The Diversification-Performance Relationship Text Alternate

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This image shows an inverted U shaped relationship between the type of diversification and overall firm performance. High and low levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance.

The x-axis of the image is titled Level of Diversification, and the y-axis is titled Performance. From the left to the right of the image are the words Single Business, Dominant Business, Related Diversification (related constrained or related linked), and Unrelated Diversification.

Both Single Business and Unrelated Diversification are at the lower ends of the inverted u, and Dominant Business and Related Diversification are at the higher ends of the inverted u.

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Restructuring the Corporate Portfolio: The Boston Consulting Group Growth, Share Matrix Text Alternate

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This image shows the B C G 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). S B U’s are plotted into four categories (dog, cash cow, star, and question mark), each of which warrants a different investment strategy.

High market growth and high market share = star. Earnings are high, stable or growing. Cash flow is neutral. The strategy is to hold or invest for growth.

High market growth and low market share = question mark. Earnings are low, unstable or growing. Cash flow is negative. The strategy is to increase market share or harvest / divest.

Low market growth and high market share = cash cow. Earnings are high and stable and cash flow is also high and stable. The strategy is to hold.

Low market growth and low market share = dog. Earnings are low and unstable and cash flow is neutral or negative. The strategy is to harvest or divest.

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