Strategic Management week 5 Discussion

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chapter 8 Diversification Strategies

Arthur A. Thompson The University of Alabama

An e-book published and distributed by McGraw Hill Education

Sixth Edition of Strategy: Core Concepts and Analytical Approaches (2020-2021). Arthur A. Thompson, The University of Alabama. Published and distributed by McGraw Hill Education. Image of globe comprised of puzzle pieces with several pieces dislodged and scattered below the globe. Chapter 5 The Five Generic Competitive Strategy Options: Which One to Employ

“I think our biggest achievement to date has been bringing back to life an inherent Disney synergy that enables each part of our business to draw from, build upon, and bolster the others.”

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Michael Eisner, former CEO, Walt Disney Company

“Fit between a parent and its businesses is a two-edged sword: A good fit can create value; a bad one can destroy it.”

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Andrew Campbell, Michael Gould, and Marcus Alexander

“Make winners out of every business in your company. Don’t carry losers.”

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Jack Welch, former CEO, General Electric

Learning Objectives

Understand when to diversify and how to test whether a move to diversify into a new business is sound.

Learn the strategic difference between related and unrelated diversification strategies.

Gain an understanding of the pros and cons of related diversification strategies.

Gain an understanding of the pros and cons of unrelated diversification strategies.

Gain command of the analytical approaches to evaluating a company’s diversification strategy.

Become familiar with a diversified company’s principal strategic options after it has diversified.

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What Does Crafting a Diversification Strategy Entail?

When and Why Diversification Makes Good Strategic Sense

Choosing the Diversification Path: Related versus Unrelated Businesses

The Case for Diversifying into Related Businesses

The Case for Diversifying into Unrelated Businesses

Evaluating a Diversified Company’s Strategy—The Six Analytical Steps

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Chapter 8 Roadmap

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What Is Meant by “Diversification”?

A firm is diversified when it operates in two or more lines of business that are in distinctly different industries

Diversification complicates the strategy-making task because it requires:

Assessing the multiple industry environments of a collection of individual businesses

Developing a separate business strategy for each industry arena (or line of business) in which the diversified firm operates

Devising a companywide (or corporate) strategy for improving the attractiveness and performance of the company’s overall business lineup and for making a rational whole out of its diversified collection of individual businesses and individual business strategies

What Does Crafting a Diversification Strategy Entail?

Strategy-making in a diversified firm requires:

Picking new industries to enter and deciding whether to enter the industry by start-up, acquisition, or a joint venture or strategic alliance with another firm

Pursuing opportunities to leverage cross-business value chain relationships and strategic fits into competitive advantage

Evaluating the growth and profitability prospects for each business, establishing investment priorities for each business, and then using these priorities to steer corporate resources to individual businesses

Initiating actions to boost the combined performance of the corporation’s collection of businesses

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FIGURE 8.1 Identifying a Diversified Company’s Strategy

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When to Consider Diversifying

There’s no urgency for a single-business firm to diversify into other businesses so long as it has ample opportunities for growth and profitability in its present industry

But it is risky for a single-business firm to continue to remain in one industry when, for whatever reason, its long-term prospects for continued good performance start to dim

A single-business firm becomes a prime candidate for diversifying when:

Conditions in its present industry turn sour and are expected to be long-lasting

There are opportunities to expand into industries whose technologies and products complement its present business

Its current competencies and capabilities are key success factors and valuable competitive assets for competing in another business

Diversifying into closely related businesses will reduce its costs

It has a powerful and well-known brand name that can be transferred to the products of other businesses and help drive the sales and profits of such businesses to higher levels

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A firm can diversify:

Into closely-related or totally-unrelated businesses

Its present revenue and earning base to a small extent or to a major extent

Into a one or two large new businesses or a greater number of small ones

By acquiring an existing firm in a business/industry it wants to enter

By forming a new startup subsidiary in a promising industry

By forming joint ventures with other firms to enter new businesses

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Diversification Possibilities

Core Concept

Creating added long-term value for shareholder via diversification requires building a multibusiness firm where the whole is greater than the sum of its parts—such 1 + 1 = 3 effects across different businesses are called synergy.

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Will Diversification Produce Added Long-Term Value for Shareholders?

The Cost-of-Entry Test

The Industry Attractiveness Test

The Better-Off Test

Diversifying in Ways That Build Long-Term Value for Shareholders

To produce added long-term economic value for shareholders, diversifying must pass three tests:

Industry Attractiveness Test

Industry conditions must be conducive to good profitability

Cost-of-Entry Test

High cost of entering cannot spoil the profit opportunities

Better-Off Test

Diversifying must offer potential for the firm’s businesses to perform better together under a single corporate umbrella than they would perform as independent stand-alone businesses

Moves to Diversify into a New Business Should Pass Three Tests

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Why The “Better-Off” Test Is So Important

Creating added long-term value for shareholders via diversification requires building a multi-business firm where the whole is greater than the sum of its parts.

Suppose Firm A diversifies by purchasing Firm B in another industry.

If A and B’s consolidated future profits are no greater than what each could have earned on its own, then A’s diversification produces a 1 + 1 = 2 result that does not create added value because A’s shareholders could have achieved the same 1 + 1 = 2 result by merely purchasing stock in B.

Rule

Diversification does not produce added long-term value for shareholders unless it produces a 1 + 1 = 3 effect where the firm’s different businesses perform better together than they would as independent enterprises.

Related Diversification

Involves diversifying into businesses whose value chains possess competitively valuable “strategic fits” with the value chain(s) of the firm’s present business(es)

Unrelated Diversification

Involves diversifying into businesses having no competitively valuable value chain match-ups or strategic fits with the value chain(s) of the firm’s present business(es)

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Choosing the Diversification Path: Related versus Unrelated Businesses

FIGURE 8.2 The Three Fundamental Strategy Alternatives for Pursuing Diversification

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Core Concept

Strategic fit exists when the value chains of different businesses present opportunities for cross-business resource transfer, lower costs through combining the performance of related value chain activities, cross-business use of a potent brand name, and/or cross-business collaboration to build new or stronger competitive capabilities.

Capturing such opportunities puts sister businesses in position to perform better financially together as parts of one firm than as independent enterprises, thus producing 1 + 1 = 3 benefits that boost shareholder value.

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What makes related diversification an attractive strategy is the opportunity to convert cross-business strategic fits into competitive advantage over business rivals with operations lacking comparable strategic fit benefits.

The greater the relatedness among a diversified firm’s sister businesses, the bigger a firm’s window for converting strategic fits into competitive advantage via:

Transferring competitively valuable resources and capabilities from one business to enhance the competitiveness and performance of a sister business.

Combining the related value chain activities of separate businesses into a single operation to achieve lower costs

Exploiting cross-business use of a well-known and competitively potent brand name

Cross-business collaboration to create altogether new competitively valuable resources and capabilities

The Case for Diversifying into Related Businesses

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FIGURE 8.3 Related Businesses Possess Related Value Chain Activities and Competitively Valuable Cross-Business Strategic Fits

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Core Concept

Economies of scope stem from successful managerial efforts to capture cost-saving strategic fits along the value chains of related businesses.

Economies of scope can be achieved only if a diversified firm operates in two or more related businesses with cost-related strategic fits in one or more value chain activities.

Often these cost-saving efficiencies are captured by combining the cost-related value chain activities of related businesses into a single, more cost-efficient operation.

When economies of scope exist, sister businesses can be operated more cost-efficiently as part of the same firm than they could operate as stand-alone businesses.

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Economies of scope are achieved by capturing cost-saving strategic fits along the value chains of related businesses; examples of such cost-saving efficiencies include:

Production-related strategic fits that enable two or more related businesses to use the same manufacturing facility to perform their production activities (using a single plant is likely to be more cost-effective than having multiple plants) and/or

Distribution-related strategic fits that enable two or more related businesses to share use of the same distribution centers (utilizing a common distribution centers is cheaper than having separate distribution centers for each business) and/or

Sales- and customer-related strategic fits that enable two or more related businesses to use a common sales force to sell their products to customers (a single sales force is more cost-efficient than having separate sales forces) and/or

The ability of two or more related businesses to share use of the same administrative infrastructure and thus spread admin costs over a bigger sales volume and revenue base

Economies of scale are cost savings that occur because a large-scale operation is more cost-efficient than a small-scale operation

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Economies of Scope Are Different from Economies of Scale

The greater the cost-savings associated with cost-related strategic fits among the value chains of sister businesses, the greater the potential for a related diversification strategy to yield a low-cost competitive advantage over

Undiversified competitors

Competitors whose own diversification efforts do not offer equivalent cost-saving benefits

Why Achieving Economies of Scope in Related Businesses Is Competitively Valuable

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Diversified firms having sister businesses with multiple strategic fits among their value chain activities have a larger opportunity for cross-business resource transfer, cost reduction, cross-business use of a respected and potent brand name, and/or cross-business collaboration to:

Enhance the overall competitive strength of the various sister firms

Boost the profitability and performance of the firm’s collection of related businesses

Achieve a competitive advantage over rivals whose own operations do not offer equivalent strategic fit benefits

Such strategic-fit benefits can be substantial and capturing them are what enables a firm pursuing related diversification to achieve 1 + 1 = 3 financial performance and enhanced shareholder value.

Strategic Fit and Competitive Advantage: The Keys to Added Profitability and Gains in Shareholder Value

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Unrelated diversification strategies involve

Entering any industry and operating any business where there is opportunity to realize consistently good financial results

No deliberate effort to diversify into businesses with strategic fits

Acquiring an established company rather than forming a start-up subsidiary or collaborating in a joint venture to get into a new business

Making acquisitions that can pass both the industry attractiveness and cost-of-entry tests and that have good prospects for above-average financial performance

The Case for Diversifying into Unrelated Businesses

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Core Concept

The basic premise of unrelated diversification is that any firm or business that can be acquired on good financial terms and that has satisfactory growth and earnings potential represents a good acquisition and a good business opportunity.

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FIGURE 8.4 Unrelated Businesses Have Unrelated Value Chains and No Cross-Business Strategic Fits

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What Is Appealing about Unrelated Diversification?

Business risk is scattered over a set of truly diverse industries.

The firm’s financial resources are employed to maximum advantage by:

Investing in whatever industries offer the best profit prospects (as opposed to considering only opportunities in industries with related value chain activities)

Diverting cash flows from its businesses with low growth and profit prospects to acquiring and expanding firms with higher growth and profit potentials

When managers are exceptionally astute at spotting bargain-priced firms with big upside profit potential, shareholder wealth is enhanced by:

Buying distressed businesses at low prices, turning their operations around quickly with cash infusions and managerial know-how from the parent firm

Then either riding the crest of the profit increases generated by newly-turned around businesses or else enjoying the capital gains of selling a once-distressed business for an amount far above its purchase price

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Enhancing shareholder value via unrelated diversification requires:

Acquiring companies in any industry with growth and earnings prospects that can satisfy the industry attractiveness test and/or acquiring undervalued or underperforming businesses that present appealing opportunities for being overhauled in ways that will result in big gains in profitability. Both types of acquisitions raise the chances of passing the attractiveness test and the better-off test.

Being disciplined enough to acquire companies at prices sufficiently low to pass the cost of entry test.

Developing and nurturing outstanding corporate parenting capabilities (successful deployment of such capabilities also raises the chance of enhancing business unit performance enough to yield 1 + 1 = 3 results and thus pass the better-off test).

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The Pathway to Enhancing Shareholder Value via Unrelated Diversification

Core Concept

A diversified company has a parenting advantage when it has superior corporate parenting capabilities relative to other diversified companies and thus can boost the combined performance of its individual businesses through

Close oversight and timely advice from corporate executives with first-rate business acumen and

Corporate parent contributions of needed resources/capabilities

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Utilize the business acumen of certain corporate executives in identifying undervalued or underperforming companies and then further rely on the skills and expertise of these or other corporate executives in pinpointing achievable ways that the operations of such companies can be overhauled and streamlined to produce dramatic increases in profitability.

Utilize the bargaining skills of corporate executives to successfully negotiate a low price and other favorable terms in acquiring any new business the corporate parent decides to enter (thereby helping satisfy the cost-of-entry test)

Utilize the skills and business acumen of corporate executives to do such a superior job of overseeing, guiding, and otherwise parenting the firm’s business subsidiaries that the subsidiaries perform at a higher level than they would otherwise be able to do as a stand-alone enterprise (thus satisfying the better-off test)

Astutely allocating financial resources across the company’s businesses by shifting funds from businesses with excess cash to cash-short businesses with appealing growth opportunities and/or using the corporation’s financial strength and credit rating to supply needed funds to individual businesses.

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Strong Corporate Parenting Capabilities That Can Help Build Shareholder Value

The Two Big Drawbacks of Unrelated Diversification

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Limited Competitive Advantage Potential

Demanding Managerial Requirements

Likely outcome is 1 + 1 = 2, rather than desired 1 + 1 = 3!

Unrelated Diversification Strategy

A widely diverse collection of unrelated businesses makes it harder for top executives to:

Discern good acquisitions from bad ones

Have in-depth knowledge about each of the businesses

Hard to judge soundness of strategic proposals of business-unit managers

Hard to select capable managers to manage the diverse requirements of each business

Hard to know what to do if a business stumbles

Avoid big mistakes

Misjudging competitive forces, impact of driving forces, and identification of key success factors

Discovering that problems of an acquired business will require more time and resources to correct than expected

Being too optimistic about a newly acquired firm’s future prospects

It is wise to avoid casting a wide net in pursing unrelated diversification—experience shows diversifying into a few unrelated businesses often results in better overall firm performance than diversifying into many unrelated businesses

The Demanding Managerial Requirements Are a Serious Issue

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Unrelated diversification’s lack of cross-business strategic fits reduces its competitive advantage potential to what each separate business can generate on its own

With no ability to capture cross-business strategic fits, it takes very astute management for the consolidated performance of an unrelated group of businesses to reach 1 + 1 = 3 outcome levels

Given the demanding requirements it takes to successfully manage a collection of unrelated businesses, pursuing a strategy of unrelated diversification is chancy and unreliable—it is far tougher than it might seem to achieve 1 + 1 = 3 results.

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Limited Competitive Advantage Potential Is a Major Shortcoming

Unrelated Diversification Strategies Often Result in “Ho-Hum” Performance

Without the added competitive advantage potential that cross-business strategic fit (and perhaps superior parenting) provides, it is hard for the consolidated performance of an unrelated group of businesses to be any better than the sum of what the individual business units could achieve if they were independent.

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Strategy

Lesson

There are significant challenges in building long-term shareholder value via a strategy of unrelated diversification—1 + 1 = 2 outcomes (or worse) are far more likely than 1 + 1 = 3 outcomes.

CONCLUSION: Relying solely on the expertise of corporate executives to astutely manage a set of unrelated businesses is a much weaker foundation for enhancing shareholder value than is a strategy of related diversification (where successful capture of strategic fits enhances competitive strength, boosts profitability, and offers potential competitive advantage—outcomes that raise the chances of 1 + 1 = 3 results for shareholders).

A strategy of unrelated diversification is a riskier and more problematic approach to diversifying than is a strategy of related diversification.

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Related versus Unrelated Diversification Strategies

The business make-up of diversified firms varies considerably:

Dominant-business firms: Have one major core firm that accounts for 50-80 percent of total revenues, with several small related or unrelated firms accounting for the remainder of total revenues

Narrowly diversified firms: Have a few (2-5) related or unrelated businesses

Broadly diversified firms: Have a wide-ranging collection of either related or unrelated businesses or a mixture of both

Diversified firms: have diversified into unrelated areas with a collection of related firms within each area—thus giving them a portfolio of several unrelated groups of related firms

Combination Related-Unrelated Diversification Strategies

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Step 1: Assess long-term attractiveness of each industry in which the firm has a business

Step 2: Assess competitive strength of each of the firm’s business units

Step 3: Evaluate competitive advantage potential of cross-business strategic fits among the various business units

Step 4: Check whether firm’s resources fit requirements of its present businesses

Step 5: Rank performance prospects of businesses and determine priority for resource allocation

Step 6: Craft new strategic moves to improve overall company performance

Evaluating and Improving a Diversified Firm’s Strategy: The Six Steps

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Step 1: Assessing Industry Attractiveness

How attractive are the various industries into which the firm has diversified?

Does each industry represent a good industry to be in?

Which industries are most attractive and which are least attractive?

How appealing is the whole group of industries in which the firm has businesses?

The more attractive the industries (both individually and as a group) a diversified firm is in, the better its prospects for good long-term performance.

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Market size and projected growth

Intensity of industry competition

Emerging opportunities and threats

Presence of cross-industry strategic fits

Resource requirements

Seasonal and cyclical factors

Social, political, regulatory, and environmental factors

Industry profitability

Industry uncertainty and business risk

Factors to Consider in Calculating Industry Attractiveness Scores

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Once industry attractiveness measures are selected, quantitative attractiveness scores are calculated by:

Assigning importance weights to each industry attractiveness measure (the measures are unlikely to be equally important)

Sum of weights must equal 1.0

Rating each industry on each attractiveness measure, using a scale of 1 to 10 (where 1 = very unattractive, 5 = average attractiveness, and 10 = very attractive)

Multiplying the importance weight by the assigned attractiveness rating to obtain a weighted attractiveness score

Summing the weighted ratings for each industry to obtain an overall weighted industry attractiveness score

Calculating Attractiveness Scores for Each Industry

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TABLE 8.1 Calculating Weighted Industry Attractiveness Scores

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[Rating scale: 1 = Very unattractive to company; 10 = Very attractive to company]

Industries with a score below 5.0 do not pass the attractiveness test

The group of industries into which the firm has diversified grows decidedly less attractive as the number of industries with scores below 5.0 increases (especially if those industries with low scores account for a sizable fraction of the diversified firm’s revenues)

If a firm’s industry attractiveness scores are all above 5.0, the industry group in which it operates is attractive as a whole

To be a strong performer, a diversified firm’s principal businesses should be in attractive industries—those with a good outlook for growth and above-average profitability

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Interpreting the Industry Attractiveness Scores

Doing an appraisal of each business unit’s competitive strength and market position in its industry

Reveals each unit’s chances for industry success

Provides a basis for ranking the units from competitively strongest to competitively weakest and sizing up the competitive strength of all the business units as a group

The procedure involves selecting a set of measures of competitive strength and calculating quantitative competitive strength scores using essentially the same methodology as was used to arrive at the industry attractiveness scores

Step 2: Assessing Business Unit Competitive Strength

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Relative market share

Costs relative to competitors

Ability to match or beat rivals on key product attributes

Ability to benefit from strategic fits with sister businesses

Ability to exercise bargaining leverage with key suppliers or customers

Brand image and reputation

Other competitively valuable resources and capabilities

Profitability relative to competitors

Potential Measures of Business-Unit Competitive Strength

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A firm’s relative market share is the ratio of its market share to its largest rival’s market share, with market share measured in unit volume, not dollars

If Firm A has a 15% market share and its largest rival has a 30% share, Firm A’s relative market share is 0.50

For a market-leader firm, relative market share equals its market share divided by the next largest rival’s market share

If Firm B has a market-leading share of 40% and its largest rival has 30%, Firm B’s relative market share is 1.33

Only market share leaders in their respective industries can have relative market shares greater than 1.0

The higher is a given business’s relative market share, the greater is its implied competitive strength

What Is “Relative Market Share” and How Is It Calculated?

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Strategic Insight

Using relative market share to measure competitive strength is analytically superior to using straight-percentage market share.

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The further a firm’s relative market share falls below 1.0, the weaker its competitive strength and market position vis-à-vis the industry leader.

For example: A firm with a 10% market share is in a weaker competitive market position

When the leader’s market share is 50% (in which case the firm’s relative market share is only 0.20)

as compared to when

The firm has a 10% market share and the market leader’s share is 12% (in which case the firm’s relative share is 0.83)

A firm with a relative market share of 0.83 is in a much stronger competitive position vis-à-vis the market leader than is a firm with a relative market share of 0.20.

Relative Market Share Signals Competitive Strength or Weakness

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Firms with a large industry-leading market share (greater than 1.0) are in a much stronger overall competitive position vis-à-vis their rivals.

A firm with a 30% market share has considerably more competitive strength when its next largest rival only has a market share of 10% (which means the leader’s relative market share is 3.0) as compared to when its next-largest rival has a market share of 25% (which means the leader’s relative market share is 1.2).

Relative Market Share Signals Competitive Strength or Weakness (continued)

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Relative market share is a very telling measure of a firm’s competitive strength vis-à-vis rival firms (and should typically be assigned a high importance weight in determining its competitive strength)

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Conclusions: Relative Market Share Versus Percentage Market Share

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Calculating Competitive Strength Scores

Competitive strength scores are calculated by:

Assigning importance weights to each competitive strength measure (measures are unlikely to be equally important)

Sum of weights must equal 1.0

Rating each business unit on each strength measure relative to its rivals, using a scale of 1 to 10 (where 1 = very weak, 5 = average or on a par, and 10 = very strong)

Multiplying the importance weight by the assigned strength rating to obtain a weighted score

Summing the weighted scores for each business unit to obtain a weighted overall competitive strength score

TABLE 8.2 Calculating Weighted Competitive Strength Scores for a Diversified Company’s Business Units

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[Rating scale: 1 = Very weak; 10 = Very strong]

Firms with ratings above 6.7 are typically strong market contenders

Higher scores are indicative of a diversified firm’s prospects for good financial performance (unless the units are in unattractive industries)

Firms with ratings in the 3.3 to 6.7 range have moderate competitive strength vis-à-vis rivals

Firms with ratings below 3.3 are in competitively weak market positions

As the number of business units in relatively weak competitive positions with scores below 5.0 increases, a diversified firm becomes less likely to be a strong performer, most especially when the combined revenues of these units account for a large percentage share of the firm’s total revenues

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Interpreting Competitive Strength Scores

The industry attractiveness scores (Table 8.1) and competitive strength scores (Table 8.2) can be used to portray the strategic positions of each business unit in a diversified firm (Figure 8.5).

Industry attractiveness scores are plotted on the vertical axis

Competitive strength scores are plotted on the horizontal axis

A nine-cell grid is created by dividing the vertical axis into three regions (high, medium, and low attractiveness) and the horizontal axis into three regions (strong, average, and weak competitive strength)

Each unit’s industry attractiveness and competitive strength scores determine its location on the matrix, shown as a circle or “bubble”

Size of each business unit’s bubble is scaled to represent the percentage of total corporate revenues that the business unit generates

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Using a Nine-Cell Matrix to Simultaneously Portray Industry Attractiveness and Competitive Strength

FIGURE 8.5 A Nine-Cell Industry Attractiveness–Competitive Strength Matrix

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Strategic Insight

The nine-cell attractiveness–strength matrix provides strong logic for fully funding the resource needs of competitively strong businesses in attractive industries, investing selectively in businesses with intermediate positions on the grid, and getting rid of competitively weak businesses in unattractive industries unless they generate sizable cash flows that can be redeployed elsewhere.

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Interpreting the Attractiveness-Strength Matrix

Locations of the business units on the attractiveness–strength matrix provide guidance in concentrating corporate resources and focusing strategic attention on units having the greatest competitive strength and positioned in highly attractive industries

Businesses in the three upper left cells merit top priority

Businesses in the three diagonal cells merit medium priority

Businesses in the three lower right merit the lowest priority and are candidates to be divested or else managed to produce maximum cash flows from operations

The greater the competitive value of cross-business strategic fits, the more competitively powerful is a firm’s related diversification strategy

Requires an evaluation of how much benefit a diversified firm can gain from value chain matchups that present opportunities to:

Reduce costs by combining the performance of certain activities and thereby capture economies of scope

Transfer skills, technology, or intellectual capital from one business to boost the performance of another business

Share the use of a corporate parent’s umbrella brand name or corporate reputation

Employ cross-business collaboration among sister businesses to create attractive new competitive capabilities that could lead to significant performance gains for one or more sister businesses

Step 3: Evaluating the Competitive Value of Cross-Business Strategic Fits (this step is bypassed for diversified firms with all unrelated businesses)

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Core Concepts

A company’s related diversification strategy derives its power in large part from the presence of competitively valuable strategic fits among its businesses and forceful company efforts to capture the benefits of these fits.

The greater the value of cross-business strategic fits in enhancing a firm’s performance in the marketplace or on the bottom line, the more competitively powerful is its strategy of related diversification.

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Step 4: Checking for Resource Fit

A diversified firm’s collection of businesses exhibit resource fit when

Each company business had adequate access to the resources and capabilities it needs to be competitively successful (these resources can either be internal to its own operations or supplied by its corporate parent)

The parent company has adequate financial resources and parenting capabilities to support its entire group of businesses without spreading itself too thin.

Core Concept

Resource fit concerns whether each company

business has adequate access to the resources

and capabilities needed to be competitively

successful and whether the corporate parent has

the financial means and parenting capabilities to

support its entire group of businesses.

There are two types of resource fit:

Financial resource fit

Nonfinancial resource fit (which includes managerial, administrative, and other parenting capabilities)

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Core Concept

Resource fit concerns whether each company business has adequate access to the resources needed to be competitively successful and whether the corporate parent has the financial means and parenting capabilities to support its entire group of businesses.

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Core Concepts

A cash hog business generates cash flows that are too small to fully fund its operations and growth; a cash hog business requires cash infusions to provide additional working capital and finance new capital investment.

A cash cow business generates cash flows over and above its internal requirements, thus providing a corporate parent with funds for investing in cash hog businesses, financing new acquisitions, or paying dividends.

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To remain financially healthy, a diversified firm must generate internal cash flows sufficient to fund its capital requirements, pay dividends, and meet its debt and financial obligations.

A cash hog business generates insufficient cash flows to fully fund its current needs for working capital and new capital investment.

A cash cow business generates surplus cash flows for use in investing in cash hog businesses, financing new acquisitions, or paying dividends

A diversified firm’s businesses exhibit good financial resource fit when the excess cash generated by its cash cow businesses is sufficient to fund the investment requirements of promising cash hog businesses, pay down its debt, pay dividends, and help pay for new acquisitions.

Financial Resource Fits: Cash Cows versus Cash Hogs

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What To Do with Cash Hog Businesses

Does it make good financial and strategic sense to keep pouring new money into a business that continually needs cash infusions?

Strategic Options:

Invest in promising cash hogs to grow them into star businesses (strong, profitable market contenders)

Divest cash hogs with questionable promise (either because of low industry attractiveness or a weak competitive position)

Redeploy resources from divested cash hogs to better advantage elsewhere

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Why Cash Cow Businesses Are Valuable

The surplus cash flows that cash cow businesses generate can be used to:

Provide funds for investing in the firm’s promising cash hogs

Finance acquisitions

Pay corporate dividends and help fund other corporate activities

It makes good financial and strategic sense to keep cash cows in healthy condition so that they are able to:

Fortify and defend their market position

Preserve their cash-generating capabilities over the long term to provide an ongoing source of financial resources to deploy elsewhere

Other Financial Resource Fit Considerations

Two other financial considerations are pertinent in determining financial resource fit:

Do any of the company’s individual businesses not contribute adequately to achieving companywide performance targets?

Subpar profitability?

Slow or declining revenue growth?

A poor image with customers?

Does the company have adequate financial strength to fund its different businesses, pursue growth via new acquisitions, and maintain a healthy credit rating?

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Nonfinancial Resource Fits

A diversified firm must have a sufficiently large and talented pool of managerial, administrative, and resource capabilities to support all of its businesses.

Revealing an inadequacy of nonfinancial resources:

Is there any evidence indicating that any of the firm’s business units are resource deficient—either because needed resources and/or capabilities cannot be transferred in or shared with sister businesses or missing resources and/or capabilities cannot be supplied by the corporate parent?

Are the corporate parent’s resources and parenting capabilities poorly matched to the resource requirements of one or more businesses it has diversified into?

Are the firm’s nonfinancial resources and capabilities being stretched too thinly by the resource/capability requirements of one or more of its businesses?

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As a rule, business units with the brightest profit and growth prospects, attractive positions in the nine-cell matrix, and solid strategic and resource fits should receive top priority for allocation of corporate resources.

There may also be merit in considering each business’s past performance in arriving at resource allocation decisions

Sales and profit growth

Contribution to company earnings

Return on capital invested in business

Cash flows from operations

Medium priority should go to units with satisfactory prospects for growth and profitability (units in the diagonal cells and cash cow units in the lower-right cells of the attractiveness-strength matrix)

Step 5: Ranking the Performance Prospects of Business Units and Assigning a Priority for Resource Allocation

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For a firm to make the best use of its limited pool of resources, both financial and nonfinancial, top executives must be diligent in:

Steering resources to those businesses with the best opportunities and performance prospects

Allocating few, if any, additional resources to businesses with weak prospects

When a corporate parent has nonfinancial resources that particular business units will find uniquely valuable in strengthening their performance and/or accelerating their growth, allocating such resources to these business units should be automatic—they usually represent 1 + 1 = 3 opportunities that should not be missed.

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The Importance of Resource Allocation

FIGURE 8.6 The Chief Strategic and Financial Options for Allocating a Diversified Company’s Financial Resources

Strategic Options for Allocating Company Financial Resources

Invest in ways to strengthen or grow existing businesses

Make acquisitions to establish positions in new industries or to complement existing businesses

Fund long- range R&D ventures aimed at opening marketing opportunities in new or existing businesses

Financial Options for Allocating Company Financial Resources

Pay off existing long-term or short-term debt

Increase dividend payments to shareholders

Repurchase shares of the company’s common stock

Build cash reserves; invest in short-term securities

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Strategic options to improve a diversified firm’s overall performance fall into five broad categories of actions:

Sticking closely with the existing business lineup and pursuing the opportunities these businesses present

Broadening the firm’s business scope by making acquisitions in new industries

Divesting underperforming businesses and retrenching to a narrower base of business operations

Restructuring the firm’s business lineup and putting a whole new face on the firm’s business makeup

Pursuing multinational diversification and striving to globalize the operations of the firm’s business units

Step 6: Crafting New Strategic Moves to Improve Overall Corporate Performance

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This option is sensible when present businesses:

Offer attractive growth opportunities

Can be counted on to generate good earnings and cash flows

As long as the company’s set of existing businesses have good prospects for enhancing corporate performance and these businesses have good strategic and/or resource fits, then major changes in the company’s business mix are usually unnecessary.

Executives can concentrate their attention on

Getting the best performance from each of its businesses

Steering corporate resources into those areas of greatest potential and profitability

Identifying and pursuing good acquisition prospects

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Sticking with the Existing Business Lineup

Factors motivating firms to build positions in new related or unrelated industries:

Sluggish growth prospects for current business lineup

The potential for transferring resources and capabilities in existing businesses to newly-acquired related or complementary businesses

Rapidly changing conditions (either favorable or unfavorable) in one or more of a firm’s core businesses that make it desirable to expand into other industries

The presence of opportunities to acquire certain new businesses that will complement and strengthen the market position and competitive capabilities of one or more present businesses

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Broadening the Firm’s Business Scope

Retrenching to a narrower diversification base merits consideration when:

Resources are stretched too thin and overall performance can be improved by concentrating on building stronger positions in fewer core businesses and industries

Market conditions in a once-attractive business have badly deteriorated

A weakly-positioned business lacks cultural, strategic or resource fit, is a cash hog with poor long-term potential for a decent return on investment

An acquired business is simply not profitable—mistakes were made in foreseeing how a new line of business would actually evolve

Subpar performance in some business units raises questions of whether to divest them or keep them and attempt a turnaround

Certain businesses, despite adequate financial performance, have a culture that does not mesh well with the rest of the firm’s businesses

A useful guide to divesting a business subsidiary is to ask, “If we were not in this business today, would we want to get into it now?” When the answer is “no” or “probably not”, divestiture should be considered.

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Retrenching to a Narrower Diversification Base

Restructuring involves divesting some businesses and acquiring others to put a whole new face on a company’s business lineup

Restructuring makes sense when a firm’s financial performance is being weakened by:

Mismatches between the businesses it has diversified into and the parent firm’s resources and parenting capabilities

Too many businesses in slow-growth, declining, low-margin, or otherwise unattractive industries

Too many competitively weak businesses

The emergence of new technologies that threaten the survival of one or more important businesses

Ongoing declines in the market shares of one or more major business units that are falling prey to more market-savvy competitors

Excessive debt with interest costs that eat deeply into profitability

Ill-chosen acquisitions that have not lived up to expectations

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Restructuring a Firm’s Business Lineup

Offers two major avenues for growing revenues and profits:

Growth by entering additional businesses

Growth by extending the operations of existing businesses into additional country markets

Pursuing both growth avenues at the same time can provide a diversified firm with exceptional competitive advantage potential

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Pursuing Multinational Diversification

Using multinational diversification to pursue both growth avenues helps create competitive advantage in five ways:

Facilitating full capture of economies of scale and learning/experience curve effects and thus drive down unit costs by expanding sales to additional country markets

Diversifying into related businesses offering economies of scope arising from cost-saving strategic fits among related business units paves the ways for realizing a low-cost advantage over less diversified rivals

Transferring competitively valuable resources and capabilities both from one business unit to another and from one country to another

Enabling full leverage of a well-known and powerful brand name across both businesses and countries to gain marketing and advertising advantages over rivals with lesser-known brands

Using cross-business unit collaboration to develop and leverage competitively valuable resources and capabilities for one or more sister business in one or more countries

All five paths to competitive advantage can be pursued simultaneously when a company elects to pursue related multinational diversification.

Building Competitive Advantage through Multinational Diversification

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Core Concept

A strategy of multinational diversification into related businesses has more built-in potential for competitive advantage than any other diversification strategy because all five approaches to securing competitive advantage over rivals can be pursued simultaneously:

Increased capture of economies of scale

Increased capture of economies of scope

Cross-business and cross-country transfer of valuable resources/capabilities

Exploitation of a competitively powerful brand name

Cross-business collaboration to develop/leverage valuable new resources/capabilities for one or more sister businesses in one or more country markets

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Accessibility Content: Text Alternatives for Images

FIGURE 8.1 Identifying a Diversified Company’s Strategy, Text Alternate

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Questions to ask to determine a diversified company’s strategy:

Is the company’s diversification based narrowly in a few industries or broadly in many industries?

Are the businesses the company has diversified into related, unrelated or a mixture of both?

Is the scope of company operations mostly domestic, increasingly multinational, or global?

Any recent moves to strengthen the company’s positions in existing businesses?

Any recent moves to build positions in new industries?

Any recent moves to divest weak business units?

Any effort to capture the benefits of cross-business value chain relationships?

What is the company’s approach to allocating investment capital and resources across its present businesses?

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FIGURE 8.5 A Nine-Cell Industry Attractiveness–Competitive Strength Matrix, Text Alternate

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The x axis is competitive strength and or market position going from strong to average to weak. And the y axis is industry attractiveness, going from low to medium to high.

Three cells at the bottom. The bottom strong cell goes up to 6.7. The average to 3.3.

In the center of the y axis is medium, between 3.3 and 6.7.

Business A in Industry A sits at 7.85 on the Strong continuum and the High end of industry attractiveness. It is in the area for high priority for resource allocation.

Business C in Industry C sits in the middle of both y and x axis at 5.25 average competitive strength and or market position and 5.10 in industry attractiveness. It is in the area for medium priority for resource allocation.

Business B in Industry B sits at 2.95 on the x axis and 3.15 on the y axis. It is in the area for low priority for resource allocation.

Strategic Management week 5 Discussion

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