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CHAPTER 8

Corporate Strategy:

Vertical Integration

and Diversification

©ISerg/iStock/Getty Images RF

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The AFI Strategy Framework

Exhibit 1.3 Jump to Appendix 1 long image description

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Learning Objectives

LO 8-1 Define corporate strategy and describe the three dimensions along

which it is assessed.

LO 8-2 Explain why firms need to grow, and evaluate different growth

motives.

LO 8-3 Describe and evaluate different options firms have to organize

economic activity.

LO 8-3 Describe the two types of vertical integration along the industry

value chain: backward and forward vertical integration.

LO 8-5 Identify and evaluate benefits and risks of vertical integration.

LO 8-6 Describe and examine alternatives to vertical integration.

LO 8-7 Describe and evaluate different types of corporate diversification.

LO 8-8 Apply the core competence–market matrix to derive different

diversification strategies.

LO 8-9 Explain when a diversification strategy creates a competitive

advantage and when it does not.

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§8.1 What Is Corporate Strategy?

Corporate strategy comprises the decisions that

leaders make and the goal-directed actions they take in

the quest for competitive advantage in one or more

industries and markets simultaneously.

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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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Three Dimensions of Corporate Strategy

Three Dimensions of Corporate Strategy:

• 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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Underlying Concepts

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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§ 8.2 Internal and External Transaction Costs

Exhibit 8.2 Source: Rothaermel, 3e, p. 258, Ex. 8.2

Jump to Appendix 2 long image description

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Transaction Costs

Transaction cost economics provides useful theoretical

guidance to explain and predict the boundaries of the firm.

Transaction costs are all internal and external costs

associated with an economic exchange.

When companies transact in the open market, they incur

external transaction costs.

• Searching for contractors

• Negotiating, monitoring, and enforcing contracts

When companies transact internally, they incur internal

transaction costs.

• Recruiting and retaining employees

• Setting up a shop floor

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Firms versus Markets: Make Or Buy?

If Costsin-house < Costsmarket,

• The firm should 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 Advantages and Disadvantages

Exhibit 8.3 Jump to Appendix 3 long image description

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The Principal-Agent Problem

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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Alternatives on the Make-or-Buy Continuum 1

Exhibit 8.4 Jump to Appendix 4 long image description

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Alternatives on the Make-or-Buy Continuum 2

• Short Term Contracts: Firms send out a Request for Proposal (RFP),

competitive bidding ensues, the buying firm can often demand lower

prices.

• Strategic Alliances:

• Long-term contracts (licensing enables firms to commercialize

intellectual property, and franchising enables use of trademarks,

brands, and goods & services in exchange for a lump sum paid up-

front & a % of revenues);

• Equity alliances (one partner takes partial ownership of another

partner), and

• Joint Ventures (two or more partners jointly create & own a new

organization).

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Alternatives on the Make-or-Buy Continuum 3

• Parent-Subsidiary Relationships: the most integrated

alternative to performing work in-house. The corporate

parent owns the subsidiary and can direct it via command

and control. Common issue: political turf battles.

Strategy Highlight 8.1 describes how soft drink giant Coca-

Cola formed an equity alliance with energy-drink maker

Monster.

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§ 8.3 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

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 the

Industry Value Chain

Exhibit 8.5 Jump to Appendix 5 long image description

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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, cameras, and batteries

Original equipment manufacturing firms

• Assembly

After-Sales Service and Support

• AT&T, Sprint, T-Mobile, Verizon, etc.

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Forward and Backward Integration:

The Smartphone Industry

Exhibit 8.6 Jump to Appendix 6 long image description

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Benefits of Vertical Integration

Lowers costs

Improves quality

Facilitates scheduling and planning

Facilitates investments in specialized assets

• Co-located assets, unique equipment, human capital

Secures critical supplies and distribution channels

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Risks of Vertical Integration

Increase in costs

Reduction in quality

Reduction in flexibility

Increase in the potential for legal repercussions

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When Does Vertical Integration Make Sense?

When there are issues with raw materials

• Ex. Henry Ford ran mining operations

To enhance the customer experience

• Eliminate annoyances & poor interfaces

Vertical market failure

• When transactions are too risky or costly

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Alternatives to Vertical Integration

Taper Integration

• Backward or forward integrated

• Plus reliance on outside firms

Strategic Outsourcing

• Moving internal value chain activities

• To other firms

• Ex: HR management system

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Taper Integration Along the

Industry Value Chain

Exhibit 8.7

Jump to Appendix 7 long image description

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§8.4 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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Types of Corporate Diversification

1. Single Business/Concentrated Growth

• Low level of diversification

2. Dominant Business/Concentrated Growth

• Additional business activity pursued

3. Related/Concentric Diversification

A. Constrained: all businesses share competencies

B. Linked: some businesses share competencies

4. Unrelated/Conglomerate Diversification

• No businesses share competencies

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Leverage Core Competencies for Diversification

Exhibit 8.9

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

Jump to Appendix 8 long image description

Corporate Diversification and Firm Performance

Exhibit 8.10

SOURCE: Adapted from L.E. Palich, L.B. Cardinal, and C.C. Miller (2000), “Curvilinearity in the diversification-performance linkage: An examination of over three decades of research,” Strategic Management Journal 21: 155–174.

Jump to Appendix 9 long image description

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How Diversification Can Enhance

Firm Performance

Provides economies of scale

• This reduces costs

Exploits economies of scope

• This increases value

Reduces costs and increase value

Vertical Integration and Diversification: Sources

of Value Creation and Costs

Corporate

Strategy

Sources of Value Creation (V) Sources of Costs (C)

Vertical

Integration

• Can lower costs

• Can improve quality

• Can facilitate scheduling and

planning

• Facilitating investments in

specialized assets

• Securing critical supplies and

distribution channels

• Can increase costs

• Can reduce quality

• Can reduce flexibility

• Increasing potential for legal repercussions

Diversification

• Economies of scope

• Economies of scale

• Financial economies

• Restructuring

• Internal capital markets

• Coordination

• Influence costs

Unrelated

Diversification

• Financial economies

• Restructuring

• Internal capital markets

• Influence costs

Exhibit 8.11

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Restructuring/Turnaround

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

Boston Consulting Group (BCG)

Growth-share Matrix

Exhibit 8.12

Jump to Appendix 11 long image description

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Exit Strategies

• Harvest – Reinvestment no longer brings positive

results; firm is held until cash flows become negative

• Divestment

• Sale – Firm is sold as a “going concern” to another

company

• Spin-Off – Firm is “sold” by issuing stock to present

shareholders

• Liquidation – Assets of firm are liquidated for cash

• Chapter 7 Bankruptcy – Forced liquidation

Internal Capital Markets

A way to allocate capital at a lower cost

• If more efficient than external markets

A source of value creation in diversification strategy

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§ 8.5 Implications for Strategic Leaders

An effective corporate strategy increases a firm’s chances to

gain and sustain a competitive advantage. By formulating

corporate strategy, strategic leaders make important

choices along three dimensions that determine the

boundaries of the firm:

• The degree of vertical integration – in what stages of the

industry value chain to participate.

• The type of diversification – what range of products or

services to offer.

• The geographic scope – where to compete.