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Chapter 8 Corporate Strategy: Vertical Integration and Diversification

Chapter 8 Corporate Strategy: Vertical Integration and Diversification. The AFI Strategy Framework. Jump to Appendix 1 long image description. Chapter 8 Outline (1 of 2). 8.1 What is Corporate Strategy? Why Firms Need to Grow Three Dimensions of Corporate Strategy

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Chapter 8 Corporate Strategy: Vertical Integration and Diversification

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  1. Chapter 8Corporate Strategy: Vertical Integration and Diversification

  2. The AFI Strategy Framework Jump to Appendix 1 long image description

  3. Chapter 8 Outline (1 of 2) 8.1 What is Corporate Strategy? • Why Firms Need to Grow • Three Dimensions of Corporate Strategy 8.2 The Boundaries of the Firm • Firms vs. Markets: Make or Buy? • Alternatives on the Make-or-Buy Continuum 8.3 Vertical Integration along the Industry Value Chain • Types of Vertical Integration • Benefits and Risks of Vertical Integration • When Does Vertical Integration Make Sense? • Alternatives to Vertical Integration

  4. Chapter 8 Outline (2 of 2) 8.4 Corporate Diversification: Expanding Beyond a Single Market • Types of Corporate Diversification • Leveraging Core Competencies for Corporate Diversification • Corporate Diversification and Firm Performance 8.5 Implications for the Strategist

  5. Learning Objectives (1 of 2) 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.

  6. Learning Objectives (2 of 2) 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.

  7. What Is Corporate Strategy?

  8. Corporate Strategy • The decisions & actions taken to gain & sustain competitive advantage in several industries and markets simultaneously • Addresses where to compete along three dimensions: • Products and services • Industry value chain • Geography (regional, national, or global markets)

  9. Questions That Executives Ask to Determine Corporate Strategy • In what stages of the industry value chain should we participate? • Related to the topic of vertical integration • What range of products and services should the we offer? • Related to the topic of diversification • Where should we compete geographically? • Related to the topic of geographic scope

  10. Why Firms Need to Grow • Increase profits • Lower costs • Increase market power • Reduce risk • Motivate management

  11. Three Dimensions of Corporate Strategy • Core Competencies (Chapter 4) • Economies of Scale (Chapter 6) • Economies of Scope (Chapter 6) • Transaction Costs • Determine whether it is cost effective to: • Vertically integrate • Diversify

  12. The Boundaries of the Firm

  13. Exhibit 8.2 Transaction Cost Economies • Helps explain & predict boundaries of the firm • Helps managers decide • Which activities to perform in-house • Services & products to obtain from the external market Jump to Appendix 2 long image description

  14. Transaction Costs • Costs associated with an economic exchange • Can be within or external to a firm • External transaction costs • Searching for a firm individual to contract with • Negotiating, monitoring, and enforcing the contract • Internal transaction costs • Recruiting and retaining employees • Paying salaries and benefits • Setting up a shop floor • Providing office space and computers, etc.

  15. Firms Vs. Markets: Make Or Buy? • If Cin-house < Cmarket, vertically integrate • Own production of the inputs or • Own output distribution channels • When firms are more efficient than the market, vertically integrate • Example: Google in-house programmers

  16. Exhibit 8.3 Organizing Economic Activity: Firms vs. Markets Jump to Appendix 3 long image description

  17. Alternatives on the Make-or-buy Continuum (1 of 2) • Short Term Contracts • Strategic Alliances • Long term contracts • Licensing • Franchising • Equity alliances • Joint Ventures • Parent-Subsidiary Relationships

  18. Exhibit 8.4 Alternatives on the Make-or-buy Continuum (2 of 2)

  19. Strategy Highlight 8.1 Is Coke Becoming a Monster? • The demand for Coke / Pepsi is falling. • Replaced by water & energy drinks • Coca Cola formed an alliance with Monster. • $2B for a 16.7% stake in the company • Why not an acquisition? • Several wrongful death suits • They can benefit from explosive growth. • They can protect their wholesome image & brand.

  20. Vertical Integration along the Industry Value Chain

  21. Exhibit 8.5 A Vertical Value Chain The transformation of raw materials into finished goods and services along distinct vertical stages Jump to Appendix 5 long image description

  22. 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 • Original equipment manufacturing firms • Assembly of cell phones under contract • Service provider • AT&T, Sprint, T-Mobile, Verizon, etc.

  23. Types of Vertical Integration • Backward Vertical Integration • Moving ownership of activities upstream to the originating inputs of the value chain • Forward Vertical Integration • Moving ownership of activities closer to the end customer

  24. Exhibit 8.6 Forward and Backward Integration: The Smartphone Industry Jump to Appendix 6 long image description

  25. Benefits of Vertical Integration • Lowers costs • Improves quality • Facilitates scheduling and planning • Facilitates investments in specialized assets • Reference the next slide for more information • Secures critical supplies and distribution channels

  26. Specialized Assets • Unique assets with high opportunity cost: • They have significantly more value in their intended use than in their next-best use. • 3 Types: • Site specificity • Co-location requirements (Machine collaboration) • Physical asset specificity • Unique physical & engineering properties (Coca-Cola Bottle) • Human asset specificity • Investments made in human capital (knowledge & skills for a specific process)

  27. Risks of Vertical Integration • Increase in costs • Reduction in quality • Reduction in flexibility • Increase in the potential for legal repercussions

  28. When Does Vertical Integration Make Sense? • When there are shortages of raw materials • Ex. Henry Ford ran mining operations • To enhance the customer’s experience • Eliminate annoyances & poor interfaces

  29. Exhibit 8.7 Tapering Integration • An alternative to vertical integration • Involves either: • Backward integration & relying on others for supplies • Forward integration & relying on others for distribution Jump to Appendix 7 long image description

  30. Strategic Outsourcing • Moving one or more internal value chain activities outside the firm’s boundaries to other firms in the industry value chain • Example: Off-shoring • Most active sectors of off-shoring: • Banking & financial services • IT • Health Care

  31. Corporate Diversification: Expanding Beyond a Single Market

  32. Diversification • Increase in: • The variety of products / services a firm offers, or • The markets / geographic regions in which it competes • Can be targeted towards: • Products • Geography • Product-Market

  33. Four Main Types of Business Diversification • Single business • Single business leverages its competencies • Dominant business • Dominant & minor businesses share competencies • Related diversification • Related Constrained: all businesses share competencies • Related Linked: some businesses share competencies • Unrelated diversification (conglomerate) • No businesses share competencies

  34. Examples of the Four Main Types of Business 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

  35. Strategy Highlight 8.2 The Tata Group: Integration at the Corporate Level • A multinational conglomerate in Mumbai, India • Activities: tea, hospitality, steel, IT, communications, power, and automobiles • Tata Motors • Bought Jaguar and Range Rover from Ford (2008) • Created the Tata Nano a small, no-frills car • 50% cheaper than their next-lowest cost car • Pursue differentiation & low cost strategies simultaneously

  36. Exhibit 8.9 Leveraging Core Competencies For Corporate Diversification 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

  37. Exhibit 8.10 Corporate Diversification and Firm Performance • Does corporate diversification indeed lead to superior performance? • High and low levels of diversification = lower performance • Moderate levels of diversification = higher firm performance 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

  38. How Diversification Can Enhance Firm Performance • Provide economies of scale: reduces costs • Exploit economies of scope: increases value • Reduce costs and increase value

  39. Exhibit 8.11 Vertical Integration and Diversification: Sources of Value Creation and Costs Jump to Appendix 10 long image description

  40. Financial Economies of Scale Can Be Achieved Through Restructuring • Restructuring: • Reorganizing & divesting business units & activities • Refocuses a company on its core competencies • Executives can restructure the business portfolio. • Boston Consulting Group (BCG) growth-share matrix: • Helps guide portfolio planning • Each category warrants a different investment strategy.

  41. Exhibit 8.12 Boston Consulting Group (BCG) Growth-share Matrix Jump to Appendix 11 long image description

  42. Implications for the Strategist

  43. Executives Make Important Choices Along Three Dimensions • Degree of vertical integration: the stages of the industry value chain to participate in • Type of diversification: the range of products and services to offer • The geographic scope: where to compete

  44. Exhibit 8.13 Dynamic Corporate Strategy: Nike vs. Adidas Jump to Appendix 12 long image description

  45. Chapter 8 Summary

  46. Take Away Concepts (1 of 9) LO 8-1 Define corporate strategy and describe the three dimensions along which it is assessed. • Corporate strategy addresses “where to compete.” Business strategy addresses “how to compete.” • Corporate strategy concerns the boundaries of the firm along three dimensions: (1) industry value chain, (2) products and services, and (3) geography (regional, national, or global markets). • To gain and sustain competitive advantage, any corporate strategy must support and strengthen a firm’s strategic position, regardless of whether it is a differentiation, cost-leadership, or blue ocean strategy.

  47. Take Away Concepts (2 of 9) LO 8-2 Explain why firms need to grow, and evaluate different growth motives. • Firm growth is motivated by the following: • increasing profits, • lowering costs, • increasing market power, • reducing risk, and • managerial motives • Not all growth motives are equally valuable. Increasing profits and lowering expenses are clearly related to enhancing a firm’s competitive advantage. • Increasing market power can also contribute to a greater competitive advantage, but can also result in legal repercussions such as anti-trust law suits. • Growing to reduced risk has fallen out of favor with investors, who argue that they are in a better position to diversify their stock portfolio in comparison to a corporation with a number of unrelated strategic business units. • Managerial motives such as increasing company perks and job security are not legitimate reasons why a firm needs to grow.

  48. Take Away Concepts (3 of 9) LO 8-3 Describe and evaluate different options firms have to organize economic activity. • Transaction cost economics help managers decide what activities to do in-house (“make”) versus what services and products to obtain from the external market (“buy”). • When the costs to pursue an activity in-house are less than the costs of transacting in the market (Cin-house < Cmarket), then the firm should vertically integrate. • Principal–agent problems and information asymmetries can lead to market failures, and thus situations where internalizing the activity is preferred. • A principal–agent problem arises when an agent, performing activities on behalf of a principal, pursues his or her own interests. • Information asymmetries arise when one party is more informed than another because of the possession of private information. • Moving from less integrated to more fully integrated forms of transacting, alternatives include short-term contracts, strategic alliances (including long-term contracts, equity alliances, and joint ventures), and parent–subsidiary relationships.

  49. Take Away Concepts (4 of 9) LO 8-4 Describe the two types of vertical integration along the industry value chain: backward and forward vertical integration. • Vertical integration denotes a firm’s addition of value—what percentage of a firm’s sales is generated by the firm within its boundaries. • Industry value chains (vertical value chains) depict the transformation of raw materials into finished goods and services. Each stage typically represents a distinct industry in which a number of different firms compete. • Backward vertical integration involves moving ownership of activities upstream nearer to the originating (inputs) point of the industry value chain. • Forward vertical integration involves moving ownership of activities closer to the end (customer) point of the value chain.

  50. Take Away Concepts (5 of 9) LO 8-5 Identify and evaluate benefits and risks of vertical integration. • Benefits of vertical integration include securing critical supplies and distribution channels, lowering costs, improving quality, facilitating scheduling and planning, and facilitating investments in specialized assets. • Risks of vertical integration include increasing costs, reducing quality, reducing flexibility, and increasing the potential for legal repercussions.

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