Strategy - Chapter 8 Corporate Strategy: Vertical Integration and Diversification What is corporate level strategy?

Corporate level strategy involves the decisions that senior management makes and the actions it takes in the quest for competitive advantage in several industries and markets simultaneously. (For example, Immelt's clean tech and health care industries) When formulating corporate strategy, managers must clarify the firm's focus on specific product and geographic markets. (industry value chain) Corporate strategy concerns the scope of the firm which determines the boundaries of the firm along three dimensions: industry value chain, product and services and geography. To determine these boundaries, executives must decide: o In what stages of industrial value chain (transformation of raw materials into finished goods and services along distinct vertical stages) to participate. This decision determines the firm's vertical integrator o What range of products and services the firm should offer. This decision determines the firm's horizontal integration or diversification. o Where in the world to compete. This decision determines the firm's global strategy. Vertical

Geographical

Horizontal The underlying strategic management concepts that will guide our discussion of the vertical, horizontal and geographic scope of the firm are economies of scale and scope, and transaction costs. Economies of scale occurs when a firm's average cost per unit decreases as its output increases. Economies of scope, in turn, are the savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, through using the same sources and technology. (Amazon) Second underlying strategic management that will guide the discussion is transaction costs, which are all costs associated with economic exchange. Transaction cost economics explain the choice firms make concerning their scope. This strategic management framework enables managers to answer the question of whether it is cost effective for the firm to grow its scope by taking on greater ownership of

production of needed inputs or of the channels by which it distributes its outputs (vertical integration). Transaction Cost Economies and the Scope of the Firm Transaction cost economics explains and predicts the scope of the firm, which is central to formulating a corporate level strategy. Insights gained from transaction cost economics help managers decide what activities to do in house versus what services and products to obtain from the external market. The key insight of transactional cost economics is that different institutional arrangements markets vs firms - have different costs attached. Transaction costs are all costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets. When companies transact in the open market, they incur the costs of searching for an economic agent with whom to contract, negotiate, monitor.etc. Transaction costs can occur within the firm as well. Considered administrative costs, they include costs pertaining to organizing an economic exchange within a hierarchy. For instance, the cost of recruiting and retaining employees, paying salaries and benefits, setting up shop floor, etc. Administrative costs also include costs associated with coordinating economic activity between different business units within the same corporation. Administrative costs tend to increase with organizational size and complexity.

Firms vs Markets - Make or Buy? In some cases, cost of using the market (such as search sots, negotiating and enforcing) may be higher than integrating the activity within a single firm and coordinating it through an organizational hierarchy. When cost of in house < cost of market, then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs; when firms are more efficient in organizing activity than on markets, then firms should vertically integrate For example, Microsoft's own programmers.

Resource based view of the firm provides an alternative aspect on the make or buy decision. Rather than being determined by transaction costs, a firm's boundaries are delineated by its knowledge based competencies. Core competencies should be done in house, non core should be outsourced.

Alternatives to the Make or Buy Continuum These can also be mere contractual agreements. Moving from transacting in the market (buy) to full integration (make), alternatives includes contracts and strategic alliances Short Term Contracts o Request for proposals (RFP - sent out by firms) o Competitive bidding for contracts, generally less than 1 year o Benefit to this approach lies in the fact that it allows somewhat longer planning period than individual market transactions; buying firms can demand loner prices due to the competitive bidding process o Drawback is that firms responding to the RFP have no incentive to make any transaction specific investments (new machinery to improve product quality) Strategic Alliances o Strategic alliances are voluntary arrangements between firms that involve the sharing of knowledge, resources and capabilities with the intent of developing processes, products or services together. o Facilitate investments in transaction specific assets without encountering the administrative costs involved in owning firms in various stages of the industry value chain. Denotes different hybrid organizational forms, LT contracts, equity alliances and joint ventures. A key vehicle to execute a firm's corporate strategy.

Types of Strategic Alliances Long term contracts o Works like short term contracts but with a generally greater duration o more incentive to make transaction specific investments Licensing A form of LT contracting in the manufacturing sector that enables firms to commercialize intellectual property

Franchising franchisee pays upfront to use franchisor's trademark, business processes to offer goods and services that carry the franchisor's brand name o Drawbacks of long term contacts; all contracts are incomplete to some extent; incomplete contracts open the door for opportunism by one of the contractual parties due to diverging motivation and incentives Equity Alliance o A partnership in which at least one partner takes partial ownership in the other partner. o A partner purchases an ownership share by buying stock (making an equity investment) o Making a credible commitment - Toyota & Orocobre Joint Venture o In a JV, two or more partners create and jointly own a new organization. o Long term commitment, facilitating transaction specific investments. Parent Subsidiary relationship o The parent subsidiary relationship describes the most integrated alternative to performing an activity within one's own corporate family; the corporate parent owns the subsidiary and can direct it via command and control. (Transaction costs arise due to political turf battles, Opel vs GM)

Vertical Integration along industrial value chain Vertical integration is the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs. Vertical integration 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 it directly participates. Industry level integration from upstream to downstream Firm level value chain runs horizontally.

Industry value chain: Depiction of the transformation of raw materials into finished goods and services along distinct vertical stages, each of which typically represents a distinct industry in which a number of different firms are competing

Determined by their corporate strategy, each firm decides where in the industry value chain to participate, and thus, vertical scope of the firm.

Types of Vertical Integration 1. Fully vertically integrated: All activities are conducted within the boundaries of the firm. Weyerhauser - Forests .... 100% value added 2. Vertically disintegrated: Firms that focus on only one or a limited few stages of industry value chain (Zara - outsource most of its manufacturing to Asia and Middle East) a. Not all industry value chain stages are equally profitable b. Logic behind the decision to integrate in novel ways can be explained by Structure Conduct Performance (SCP) and VRIO model. Overtime , HTC was able to upgrade its capabilities from merely manufacturing smart phones to also designing products. In doing so, HTC engaged in backward vertical integration - moving ownership of activities upstream to originating point of the value chain. By moving downstream into sales and increasing branding, HTC also engaged in forward vertical integration - moving ownership of activities closer to the end point of the value chain. HTC benefits from economies of scope through participating in different stages of the industry value chain, for instance, it is now able to share competencies in product design, manufacturing and sales while attempting to reduce transaction costs. Benefits of Risks and Vertical Integration Benefits of Vertical Integration Securing critical supplies Lowering costs Improving quality Facilitating scheduling and planning Facilitating investments in specialized assets Vertical integration can increase differentiation and reduce costs, thus strengthening a firm's strategic position as the gap between value creation and costs widening. Vertical integration along the industry value chain can also facilitate investments in specialized assets. Specialized assets have significantly more value in their intended use than in their next best use. (high opportunity cost) Specialized assets come in several forms: o Site specificity - Assets are required to be co-located, such as the equipment necessary for mining bauxite and aluminium smelting. o Physical asset specificity - Assets whose physical and engineering properties are designed to satisfy a particular customer, such as bottling machinery for Coca Cola. Since bottle have different shapes, they have unique moulds. o 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.

Risks of Vertical Integration Increasing Costs o In house supplies tend to have higher cost structure because they are not exposed to market competition o Suppliers in open market has competition and economies of scale thus lower costs. Reducing Quality o External suppliers can reap higher learning and experience effects to develop quality improvements Reducing Flexibility o when faced with changes in the external environment such as fluctuations in demand and technological changes, inability to quickly switch technologies Increasing the potential for legal repercussions o Concerns of monopoly; vertical integration has not gone unchallenged.

Alternatives to Vertical Integration 1. Taper Integration It is a way of orchestrating value activities in which a firm is backwardly integrated but it 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.

A firm sources intermediate goods and components from in house suppliers as well as from outside suppliers. In similar fashion, a firm sells its products through company owned retail outlets and through independent retailers. Taper integration has several benefits, it exposes in house supplies and distributors to market competition, so that performance comparisons are possible:

i. rather than hollowing out its competencies by relying too much on outsourcing, taper integration allows a firm to retain its competencies in manufacturing and retailing ii. Taper integration also enhances a firm's flexibility. (adjusting fluctuations to demand) iii. Firms can combine internal and external knowledge, paving path for innovation. 2. Strategic outsourcing involves moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain resource non core activities to companies who can leverage their deep competencies and produce scale effects Corporate Diversification: Expanding Beyond a Single Market Diversification - increasing the variety of products or markets in which to compete. Non diversified company focuses on a single market. General Diversification Strategies: o A firm that is active in several product markets is pursuing a product diversification strategy. o A firm that is active in several countries is pursuing a geographic diversification strategy. o A company that pursues both a product and a geographic diversification strategy simultaneously follows a product market diversification strategy.

Types of Corporate Diversification Single business firm - 95% or more of its revenues from one business Dominant business firm - 70-95% of revenues from single business, but pursues at least one other business activity A firm follows a related diversification strategy when it derives less than 70% of its revenues from a single business but obtains revenues from other lines of business linked to the primary business activity. Related constraint - when executives consider business opportunities only where they can leverage their existing competencies and resources. o The choices of alternative business activities are limited or constrained by the fact that they need to be related through common resources, capabilities and activities. Related linked - when executives consider new business activities that share only a limited number of linkages (Disney) Firm follows an unrelated diversification strategy when less than 70% of its revenue come from a single business and there are few if any linkages among its business. Unrelated diversification can be advantageous as they help firms gain and sustain competitive advantage because it allows the conglomerate to become institutional weaknesses in emerging economies, such as lack of capital markets and well defined legal

systems and property rights.

Leveraging Core Competencies for Corporate Diversification Core Competence Unique skills and strengths Allows firms to increase value of product or service Lowers cost

Corporate Diversification Corporate managers pursue diversification to gain and sustain competitive advantage.

Whether individual businesses are worth more under the company's management than if each were managed individually. U shaped relationship between the type of diversification and overall firm performance. High and low levels of performance are generally associated with lower overall performance. Moderate levels of diversification are associated with higher firm performance.

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 benefit from economies of scope by leveraging their core competencies into adjacent markets. Firms that pursue unrelated diversification are often unable to create additional value and thus experience a diversification discount in stock market: the stock price of such highly diversified firms is valued at less than sum of their individual units. Companies that pursue related diversification are more likely to improve their performance and thus create a diversification premium: the stock price of related diversification firm is valued at greater than the sum of their individual business units For diversification to enhance performance, it must do at least one of the following: o Provide economies of scale to reduce cost o Exploit economies of scope and increase value o Increase value or reduce cost

Restructuring Restructuring describes the process of reorganizing and divesting business units to refocus on a company in order to leverage its core competencies more fully. Helpful tool to guide corporate portfolio planning is the BCG matrix.

Internal Capital Markets Internal capital markets can be a source of value creation in diversification strategy if the conglomerate's headquarters does a more efficient job of allocating capital through its budget process than what could be achieved in external capital markets. Corporate level managers are in position to discover which SBU will provide the highest return to invested capital. Internal capital markets may allow company to access capital at a lower cost o Lower cost of capital o 2009 - potential loss Strategy of related diversification is more likely to enhance corporate performance than either a single or dominant level of diversification on an unrelated level of diversification. o Need to create value and potentially benefit through economies of scale and scope. o Benefits > Cost Related diversification strategy entails two additional type of costs, coordination and influence costs. Coordination costs are a function of the number, size and types of businesses that are linked to one another. Influence costs occur due to political manoeuvring by managers to influence capital and resources allocation and resulting inefficiencies stemming from suboptimal allocation of scarce resources. In summary, related diversification is more likely to generate incremental value than unrelated diversification.

Why Difficult to Realize? Principal agent problem - interests of shareholders and managers diverge

Interdependent competitors in oligopolistic industry structures are forced to engage in diversification in response to moves by direct rivals. Bandwagon effect occurs - firms copying moves of industry rivals. There exists a U shaped relationship between the level of diversification and performance improvements. On average, related diversification is most likely to lead to superior performance because it taps into multiple sources of value creation. To achieve net positive effect on firm performance, however, related diversification must overcome additional sources of costs such as coordination costs and influence costs.

Corporate Strategy: Combining Vertical Integration and Diversification A firm's overall corporate strategy concerns both its level of integration along the vertical value chain and its level of diversification. (Oracle Example). In summary ,executives determine the scope of the firm in such a fashion a to enhance the firm's ability to gain and sustain a competitive advantage. To delineate the boundaries of the firm, executives must formulate corporate level strategy along 3 dimensions - vertical integration, horizontal integration and global scope.