Roth5_Ch8_W20_VIDivers.pptxChapter 8
Corporate Strategy: Vertical Integration and Diversification
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The AFI Strategy Framework
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Learning Objectives
Define corporate strategy and describe the three dimensions along which it is assessed.
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 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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Case Study - Amazon
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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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Amazon’s Corporate Strategy
Originally was an online book seller:
Started in a garage in a Seattle suburb.
Then entered strategic alliances to expand products offered.
Is now a widely diversified technology company.
Amazon has diversified:
Prime Air uses drones to drop off packages.
Amazon Campus, co-branded University websites.
Electronics such as Echo, Alexa.
Continues to innovate:
In a competitive battle with Apple, Facebook, Alphabet, Walmart, and Alibaba.
2017 acquisition of Whole Foods.
Streaming content.
Amazon Web Services.
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What’s next?
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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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Corporate Strategy
The decisions and goal-directed actions that leaders make to address the quest for competitive advantage while competing in multiple markets and industries simultaneously…whew!
It answers the question: where to compete?
It addressed the 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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Three Dimensions of Corporate Strategy
Vertical integration, (where in the value chain should the company participate)
Diversification, (what range of products/services offered)
Geographic scope, (regional, national, international)
Underlying concepts that guide these:
Core Competencies – unique strengths that differentiate and create value
Economies of Scale - avg cost per unit decreases
Economies of Scope – savings producing two or more outputs
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).
Core Competencies (Ch4):
Economies of Scale (Ch6):
Economies of Scope (Ch6)
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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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Transaction Costs
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In many ways, we face make-or-buy decisions all the time and choose based on our often unexpressed understanding of the trade-offs. “I will stop to buy fast food on the way home from school because I want to spend my time at home making study cards for my upcoming exam.” In essence, “It is a better use of my time and resources to buy my dinner vs. buying the groceries and making my dinner for this one task, (studying), which will produce a better outcome, (exam score).
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Make or Buy?
If Cin-house < Cmarket…then vertically integrate (make) by owning production of the needed inputs or the channels for the distribution of outputs.
If firms are more efficient in organizing economic activity than the markets, which rely on contracts from many independent players, firms should vertically integrate.
If Cin-house > Cmarket…then outsource, (buy).
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Google does mostly in house due to 1. captured costs, 2. economies of scale and 3. IP protection.
Ford outsources its tires and windshields because it can determine the quality better and more cost efficiently vs. making them in-house.
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Alternatives on the Make-or-Buy Continuum
Exhibit 8.4
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This just illustrates how involved you are in the make or buy continuum:
Short-term contacts: Competitive bidding process: RFP, Less than one-year term, Lower prices = cost advantages
Strategic alliances: Facilitate investment without administrative costs, Ex: Short term contracts, (somewhat risky as there is no buy-in for long term performance), Long-term contacts, (franchising or licensing) and equity alliances or joint ventures, (construction projects)
Parent–subsidiary relationship: Most integrated alternative, Parent companies have command and control, Ex: GM owns Opel and Vauxhall in Europe
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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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Full Vertical Integration:
Owns forests, mills, and distribution to retailers
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Ford created subsidiaries that produced glass, rubber and metal to ensure supply. Ford helped eliminate shortages or stoppages in materials by owning the plants that produced. They feed the manufacturer to make a product.
Disney opened their own retail stores to capture revenues from merchandise sales.
“Disney designed” to create value added stores to help capture more revenues from the tie in promos and merchandise-retail They feed the consumer from the parent.
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
Access the text alternate for slide image.
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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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1. Raw materials, (chemicals, ceramics, metals, oil for plastic are commodities). Commodity businesses such as Dupont, BASF, Kyocera and Exxon Mobile, respectively.
2. Intermediate goods/Components such as integrated circuits, displays, touchscreens, cameras and batteries are provided by ARM Holdings, Jabil Circuit, Intel, LG, Altek and BYD
3. OEM’s such as Flextronics and Foxconn assemble the phones under contract from Consumer Electronics firms such as Nokia, Motorola, Samsung and Apple.
4..Wireless carriers are the final piece as service providers to enable the cell phone to work.
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Benefits and Risk of Vertical Integration
Benefits:
Securing critical supplies
Lowering costs & improving quality
Facilitating investments in specialized assets
Risks:
Increasing costs & reducing quality
Reducing flexibility
Increasing the potential for legal repercussions
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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.
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…Unfortunately, he did not own the railroad to ship it!
China tries to close the market on rare earth materials as they become more and more important for electronics.
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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:
▪ 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.
▪ Using taper integration, firms can combine internal and external knowledge, possibly paving the path for innovation.
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Vertical Integration in Entertainment
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Frozen all inhouse with Disney, (movie, theme parks, merchandise, live theatre
HP: Warner Bros, Electronic Arts games, Comcast theme park, licenses for Mattel, Lego, Hasbro.
Diversification and Geographic Scope
Diversification is one of the strategies pursued by firms wishing to grow in newer markets and by launching newer products…
…Diversification addresses what range of products/services are to be offered
…Geographic scope determines where we are going to market those products/services; regional, national or international.
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Diversification at Disney
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What is Disney’s Geographic Scope?
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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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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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Diversification: Tale of two companies
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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. Used to own TacoBell/KFC/PizzaHut.
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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 (BNSF, Heinz, Geico, Sees Candies, DQ)
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
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.
Nations Bank CC was selecting, acquiring and integrating commercial banks to grow geographically
BofA leveraged CC of acquiring and moving into wealth management.
Coke competed with Pepsi’s Gatorade, (75% markshare)…tried with Powerade, (17) and moved into Body Armor (3+)
Salesforce leveraged leading CRM cloud based into PaaS to allow people to build own platforms.
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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 process of reorganizing and divesting business units and activities to help refocus a company and leverage core competencies more fully:
GE, (General Electric), exited TV, Appliances and Electronics and moved more into services.
InBev sold Busch Gardens and SeaWorld to focus on core business of beverages/beer.
Verizon sold off landline business to focus on Wireless.
Wall Street loves “restructuring” as it means layoffs, which equate to financial savings.
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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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Boston Consulting Group Matrix A tool to determine growth vs. market share
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. 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.
SBUs identified as dogs are relatively easy to identify: They are the underperforming businesses. Dogs hold a small market share in a low-growth market; they have low and unstable earnings or negative cash flows. The strategic recommendations are either to divest the business or to harvest it.
Cash cows are SBUs that compete in a low-growth market but hold considerable market share. Their earnings and cash flows are high and stable. The recommendation is to invest enough into cash cows to hold their current position and to avoid having them turn into dogs.
Stars hold a high market share in a fast-growing market. Their earnings are high and either stable or growing. The recommendation is to invest sufficient resources to hold the star’s position or even increase investments for future growth.
Question marks: It is not clear whether they will turn into dogs or stars. Their earnings are low and unstable, but they might be growing. The cash flow is negative. Ideally, corporate executives want to invest in question marks to increase their relative market share so they turn into stars.
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BCG in real life…
In small groups, identify the BCG model for the Apple product portfolio:
Macbook
iPhone
iPad
iPod
Watch
Apple TV
iTunes
Apple Music
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Apple Products
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Apple TV
iTunes
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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.
As of 2018, the company operates through the following segments: aviation, healthcare, power, renewable energy, digital industry, additive manufacturing, venture capital and finance, lighting, and oil and gas. GE was once a power house but is now retrenching. Formerly the poster child for diversification.
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The Diversification-Performance Relationship
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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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Does Diversification Lead to Superior Performance?
The critical question to ask…are the individual businesses worth more under the company’s management than if each were managed in separate firms? (history says…“not much”)
Diversification is like sex…attractions are obvious, often irresistible, yet the experience is often disappointing.
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Many times the reason for diversification is not related to improving the business, but more into CEO ego or “me-too” beliefs that everyone else is doing it, so I don’t want to get left behind.
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Team Exercise???
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