Week 5 Flashcards
Vertical integration
When a firm takes over ownership of its production, of its inputs, or of the channels it uses to distribute its output.
Diversification
Variety of products a firm offers, or the markets/geographic locations it competes in.
Corporate strategy
Diversification and Vertical Integration are part of corporate strategy.
Corporate strategy involves the decisions that leaders make and the goal-directed actions they take to gain competitive advantage in several industries/markets.
Business strategy on the other hand focuses on how to compete in a single product market.
3 dimensions of corporate strategy that managers need to decide on
- Vertical integration (which stages of the value chain should the firm participate in?);
- Diversification (what range of products and services should the firm provide?);
- Geographic scope (where should the firm compete geographically?).
Outcome of a firm’s corporate strategy
A large outcome for a firm’s corporate strategy is usually growth.
Firms grow for a number of reasons. These include: increased profits, lowered costs (as larger companies have more economies of scale), increased market power, reduced risk (due to diversified product portfolios), and a more motivated management.
However, businesses can also fail because they grow in the wrong way: too fast, too soon, or based on shaky assumptions about the future. In addition, some firms do not want to grow. For example, small family businesses who currently have convenience and stability might think that growth is not in their best interest.
Core competencies
Core competencies are unique strengths embedded deep within a company. They also allow firms to differentiate their products and create higher value, or have lower costs than competitors.
Core competencies and activities a firm does well should be done in-house. Therefore, according to the resource-based view, a firm’s internally held knowledge and core competencies determine its boundaries.
Economies of scale
When a company’s average cost per unit decreases as the output increases.
Economies of scope
Savings that come from producing two (or more) outputs at less cost than producing each individually, through using the same resources or technology
Transaction costs
These are all the internal and external costs associated with an economic exchange.
Transaction costs show that different institutional arrangements (such as markets vs. firms) have different costs attached to certain resources.
2 types of transaction costs
- External transaction costs are associated with the market and include things like enforcing contracts.
- Internal transaction costs are associated with the firm and include things like costs of recruiting, or paying salaries and benefits. Internal costs tend to increase when organizational size or complexity increases.
Make or buy decisions
Transaction cost economics is a theoretical framework that can be used to explain or predict firm boundaries.
Examining transaction costs enables managers to see if it is cost-effective for the firm to expand boundaries via diversification or vertical integration. In other words, transaction costs help a firm to make ‘make or buy’ decisions.
When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market, firms should vertically integrate.
Determining firm boundaries in a way that creates a sustainable competitive advantage, guided by transaction costs, is therefore a key challenge in corporate strategy.
Advantage of organizing economic activity within the firm
Ability to make command-and-control decisions among clear hierarchical lines.
It also allows for the coordination of highly complex tasks and specialized division of labour.
A company can also make transaction-specific investments that are highly valuable within a firm but are of little use to the external market.
An example of a transaction-specific investment would be a special machine that the firm only uses for the products of one buyer. Lastly, firms can create a community of knowledge.
Disadvantages of organizing economic activity within the firm
Disadvantages include administrative costs because of bureaucracy, the low-power of incentives such as hourly wages and salaries, and the principal-agent problem. You likely have heard of the principal-agent problem before.
An agent (or manager) performs activities on behalf of the principal (or owner/shareholder). However, the manager is likely to pursue their own interests.
Because separation of ownership and control is mandatory in public firms, the principal-agent problem is inevitable. Manager goals, such as job security, might therefore interfere with principal goals, like shareholder value.
Advantage of organising economic activity through markets
Firstly, markets have high-powered incentives, which can be powerful motivators.
Entrepreneurs can start their own venture and capture more profit than they would by being employed at a firm. For example, being acquired or doing an IPO (initial public offering) are known as liquidity events that provide enough money for life.
Markets also have increased flexibility - transacting in the market allows comparison of prices.
Disadvantages of organising economic activity through markets
The disadvantages include search costs, as a firm has to look for reliable suppliers. Firms also have to look out for opportunism by other parties - as partner firms may be wholly self-interested.
Another threat is incomplete contracting. All contracts are incomplete because they cannot fully include all future contingencies (and certain aspects like quality are hard to specify). This means that even with a contract, you never have full control over your dealings with the partner.
Another thing to look out for in markets is information asymmetry. This is when one party in a deal has more information than the other. Often, sellers have more information than buyers, which can lead to a crowding out of all “good” products.
Alternatives on the make-or-buy continuum
- Short-term contracts. With these, the firm sends requests for proposals (RFPs) to several companies, which initiates competitive bidding for contracts.
This allows for a longer planning period than individual market transactions and lower prices due to competitive bidding. However, firms have no incentive to make transaction-specific investments since the contracts are short. - Strategic alliances. These are voluntary arrangements between firms involving the sharing of knowledge, resources, and capabilities with the intent to develop processes or products. Alliances can facilitate investments in transaction-specific assets, without the transaction costs associated with owning firms in different stages of the industry value chain.
There are 3 different types of strategic alliances
- Long-term contracts. These have a duration longer than a year and facilitate transaction-specific investments. Examples include licensing, which enables firms to commercialize a patent, and franchising, which is when a franchisor grants a franchisee the right to use the franchisor’s trademark and processes. For this right, the franchisee pays a lump sum to the franchisor and part of their revenue.
- Equity alliance. This is when one partner takes partial ownership of another partner. This equity investment means a greater commitment to the partnership and can allow one company to get an inside look into another company. One partner can also pressure another into lowering prices. Additionally, it could encourage the firm to make a credible commitment, which is a long-term strategic decision that is hard to reverse.
- Joint venture. This is when two or more partners create and jointly own a new organization. Once again, because this is a long-term commitment, the firm is more inclined to make transaction-specific investments.
The last option on the make-or-buy continuum
Parent-subsidiary relationship. This is when a corporate parent owns a subsidiary and can direct it via command and control.
Transaction costs can arise in this relationship due to political turf battles, such as certain departments claiming their services are more valuable than other departments. It could also cause conflict with the amount of centralization of subsidiaries.
Vertical integration along the industry value chain
Vertical integration can be measured by the value that a company adds. This can be seen by looking at the industry value chain, which depicts the transformation of raw materials into finished goods through different stages.
Each stage represents a distinct industry where numerous firms are competing. An example of a stage would be raw materials, or marketing and sales.
There are varying levels of vertical integration
Most firms only focus on a few stages or one stage in the chain. However, some firms are fully integrated. This means they control the whole value chain. This allows for economies of scale, which creates lower costs, more operational efficiency through coordination, and better quality control.
However, it also means that the firm has to deal with many competitors at every stage. Other firms have low integration. This is because not all the value chain stages are equally profitable.
We can split vertical integration into two type
- Backward integration involves moving ownership of activities upstream to the originating inputs of the value chain.
- Forward integration involves moving ownership of activities closer to the end customer.
Benefits of vertical integration
The benefits of vertical integration include lowering costs, improving quality, facilitating scheduling and planning, securing critical supplies and distribution channels, and facilitating investments in specialized assets.
Specialized assets are unique assets that have high opportunity costs, offering a lot more value in their intended use than in their next-best use. These high opportunity costs come from the threat of opportunism. To overcome this threat, companies can undertake backward vertical integration.
Different types of specialized assets
- Site specificity: the assets have to be co-located;
- Physical asset specificity: assets whose physical properties are designed to satisfy a certain customer;
- Human asset specificity: investments made in human capital to acquire unique knowledge
and skills. An example of this could be training employees to master the routines of the employer.
Risks of vertical integration
Risks of vertical integration include increasing costs (in-house suppliers have higher costs due to exposure to market competition), reduced knowledge, reduced flexibility, and the increasing potential for legal repercussions. For example, trade authorities might accuse you of monopolizing an industry.
Main reason to vertically integrate
The main reason to vertically integrate is due to the failure of vertical markets. Vertical market failure is when transactions within the industry value chain are too risky and alternatives to integration are too costly or too time-consuming.
Two alternatives to vertical integration
- Taper integration. This is when a firm is backwardly integrated but relies on the outside market for some of its supplies, or is forwardly integrated but relies on the outside market for some of its distribution. This exposes in-house suppliers to market competition, allows the firm to retain competencies, enhances firm flexibility, and allows firms to combine internal and external knowledge.
- Strategic outsourcing. This refers to moving one or more internal value chain activities outside firms’ boundaries, to other firms. Common examples include outsourcing HR, IT, financial services, and legal work. When outsourced activities occur outside the home country, it is called offshoring.
Corporate diversification: expanding beyond a single market
A non-diversified company is a company that focuses on a single market.
A diversified company competes in several different markets.
3 corporate diversification strategies
- Product diversification (several product markets)
- Geographic diversification (several countries)
- Product-market diversification (both product and geographic diversification)
4 types of corporate diversification
- Single business; low diversification, 95% or more of its revenues are made from one business. The one business leverages its competencies;
- Dominant business; low diversification, the firm derives 70-95% of revenues from a single business but pursues at least one other business activity. The dominant business shares competencies in products, services, technology and distribution with the other strategic business unit;
- Related diversification; the firm derives less than 70% of revenues from a single business activity and obtains revenue from other lines of business linked to its primary business activity. The businesses usually share some competencies;
- Unrelated diversification; the firm derives less than 70% of revenues from a single business, and there are very few competencies shared between businesses. A conglomerate follows an unrelated diversification strategy. This is a company that has combined two or more strategic business units under one overarching corporation.
Related diversification can also be split into two more variations
- Related-constrained diversification. This means that less than 70% of revenues come from a single business activity, and the rest is obtained from other lines related to the primary activity. However, the business only enters new opportunities when it can leverage existing competencies. Therefore, the choice of other business activities is “constrained” to related activities.
- Related-linked diversification, on the other hand, new business activities share only a limited number of linkages.
Examples of the different types of corporate diversification
We can also divide the corporate diversification into the following four types of businesses: single business, dominant business, related diversification, and unrelated diversification. In a single business, there is only a low level of diversification.
Examples of singles businesses are Coca-Cola, Google, and Facebook. In a dominant business, there are several types of business activities that are actively pursued. Examples of dominant businesses are Harley-Davidson, Nestle, and UPS. There are two types of related diversification: constrained and linked. When you have constrained related diversification, all the businesses share competencies, like ExxonMobil and Nike; whereas with linked related diversification, some businesses share competencies, like Amazon. If we look at unrelated diversification, no businesses share competencies. This type of diversification is mostly used in conglomerates.
Meaning of relatedness
Relatedness in diversification basically means the potential for sharing and passing resources and capabilities between businesses. So, if the operational relatedness is high, this indicates that there are a lot of similarities in activities such as manufacturing, marketing, and distribution.
If the corporate relatedness is high, this means that common general management capabilities and strategies can be used for different businesses.
Examples & more about unrelated diversification
Sometimes diversification needs to be unrelated. When we have unrelated diversification, this means that we diversify the businesses without strategic fit, meaningful value chain relationships, or unifying strategic themes.
The attitude is to undertake any business with which we think we can make a profit. We call these types of businesses conglomerates. An example of a conglomerate is Berkshire Hathaway Inc.
It is important that our corporate strategy stays dynamic over time. For example, if we take a look at Adidas, we see that in the hundred years they have been operating, they have changed from a lot of vertical integration with almost no diversification to a company with little vertical integration and a lot of diversification.
Leveraging core competencies for corporate diversification
Another matrix that can be used to see which strategy a firm should pursue given the markets it is entering and its core competencies is the core competence-market matrix.
4 parts of the core competence-market matrix
- Existing core competencies with existing markets; in which managers need to come up with ideas to leverage existing core competencies to improve its market position;
- Existing core competencies with new markets; in which managers must strategize about
how to redeploy and recombine existing core competencies to compete in future markets; - New core competencies with existing markets; in which managers must come up with strategic initiatives to build new core competencies to protect the company’s current
market position; - New core competencies with new markets; in which managers must build new core
competencies to create and compete in markets of the future.
How does diversification affect performance
Both high and low levels of diversification are associated with lower performance.
Moderate diversification, on the other hand, is associated with higher performance.
Firms that are highly diversified may have a diversification discount, meaning that their stock price is valued at less than the sum of their business units.
However, if firms perform related diversification, they might obtain a diversification premium, which is when the stock price of diversified firms is higher than the sum of individual business units.
In order for this to happen, the firm must either provide economies of scale to reduce costs, exploit economies of scope to increase value, or do both.
Potential benefits of corporate diversification
- Restructuring. This is the process of reorganizing and divesting business units and activities to refocus the company on leveraging its core competencies.
- Internal capital markets. This means firms can borrow money or redistribute funds through the firm instead of through banks or stock markets. Insiders often know better which business units provide the highest return, and internal capital may allow lower-cost capital.
- Economies of scope. We get economies of scope when we can use a resource for multiple activities, and we use less of that resource in total than when we would have executed the activities separately. We can get economies of scope through tangible resources by eliminating duplication, but also through intangible resources by extending these resources through extra businesses at a low cost.
- Parenting advantage. If we have a daughter company under a parent company, this parent company should add more value to the daughter company than any other potential parent company could.
Costs and disadvantages of corporate diversification
Lastly, firms should also be aware of the costs of diversification. One source of costs is coordination costs, which increase as the number, size, and types of businesses linked increase.
Another is influence costs, which arise from the political maneuvering by managers to influence resource allocation.
Boston Consulting Group’s growth-share matrix
An example of a matrix that shows how different firms should restructure is the Boston Consulting Group’s growth-share matrix. The two variables in the matrix are relative market share and speed of market growth.
The four categories are:
1. Dogs (low growth, low market share); these underperforming businesses should either be
divested or harvested;
- Cash cows (low growth, high market share); firms with high and stable cash flows that
should have enough investment to hold their current position; - Stars (high growth, high market share); firms with high and stable earnings that are growing. The firm should invest sufficient resources for the star to hold its position or increase investments for future growth;
- Question Mark (high growth, low market share); firms are not sure whether the opportunity
will turn into a dog or star, so they should invest based on a case by case basis.
Strategic Fit
Lastly, we look at strategic fit. We have a strategic fit when the value chain of different businesses offer opportunities for a cross-business resource transfer; combines the performance of related value chain activities or resource-sharing, resulting in lower costs; uses the potent brand name across multiple businesses; and collaborates among different businesses in order to get stronger competitive capabilities
