1. Corporate Strategy: Vertical Integration and Diversification

2. Part 2 Strategy Formulation
© 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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3. LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
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4. ChapterCase 8 Refocusing GE: A Future of Clean-Tech and Health Care?
Jeffrey Immelt appointed CEO of GE Sept. 7th 2001
Environmental Change (e.g., 9/11 and Global Financial Crises)
GE’s stock price fell by 84%
Lost AAA credit rating
Refocus on green economy and health care industries
Sold majority stake in NBC Universal to Comcast
ecomagination: solar energy, hybrid locomotives, fuel cells…etc.
healthymagination: increase quality and access to health care
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5. GE’s Changing Product Scope
Refocusing GE: A Future of Clean-Tech
and Health Care?
ChapterCase 8
GE’s Changing Product Scope
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Source: Author’s depiction of data in GE annual reports.

6. GE’s Changing Geographic Scope
Refocusing GE: A Future of Clean-Tech
and Health Care?
ChapterCase 8
GE’s Changing Geographic Scope
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Source: Author’s depiction of data in GE annual reports.

7. What Is Corporate Strategy?
Quest for competitive advantage when competing in multiple industries
Ex: Jeffrey Immelt’s initiative in clean-tech and health care industries
Corporate strategy concerns the scope of the firm
Industry value chain
Products and services
Geography
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8. What Is Corporate Strategy? (cont'd)
Three dimensions
What stages of industry value chain and degrees of vertical integration
What range of products and services and degrees of horizontal integration and diversification
Where in the world to compete and global strategy
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9. Three Dimensions of Corporate Strategy
EXHIBIT 8.1
Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
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10. What Is Corporate Strategy? (cont'd)
Economies of scale
Average per-unit cost decreases as its output increases
Ex: Anheuser-Busch Inbev largest global brewer
Economies of scope
Savings that come from producing more outputs or providing different services at less cost
Ex: Amazon range of products & services
Transaction cost
The cost associated with economic exchange
"Make or buy" decision
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11. LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
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12. Transaction Cost Economics and Scope of the Firm
Explains and predicts the scope of the firm
"Market vs. firms" have differential costs
Transaction costs
Costs associated with economic exchanges
Either in the firm OR in the markets
Ex: negotiating and enforcing contracts
Administrative costs
Costs pertaining to organizing an exchange within a hierarchy
Ex: recruiting & training employees
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13. Firms vs. Markets: Make or Buy
Should a firm do things in-house (to make)? Or obtain externally (to buy)?
If Cin-house < Cmarket, then the firm should vertically integrate
Ex: Microsoft hires programmers to write code
in-house rather than contracting out
Firms and markets have distinct advantages and disadvantages (see Exhibit 8.2)
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14. Organizing Economic Activity: Firm vs. Markets
EXHIBIT 8.2
Organizing Economic Activity: Firm vs. Markets
INSTRUCTOR: An Interactive video activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.2.
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15. Firms vs. Markets: Make or Buy?
Disadvantage of “make” in-house
Principal – agent problem
owner = principal, manager = agent
Agent pursues his/her own interests
Disadvantage of “buy” from markets
Search cost
Opportunism
Incomplete contracting
Enforce legal contracts
Information asymmetries
One party is more informed than others
Akerlof – “Lemons problem” for used cars
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16. Alternatives of the Make or Buy Continuum
Short-term contacts
Competitive bidding process
Less than one-year term
Lower prices  cost advantages
Strategic alliances
Facilitate investment without administrative costs
Ex: Long-term contacts, equity alliances, joint ventures
Parent – subsidiary relationship
Most integrated alternative
Parent companies have command and control
Ex: GM owns Opel and Vauxhall in Europe
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17. Alternatives along the Make or Buy Continuum
EXHIBIT 8.3
Alternatives along the Make or Buy Continuum
INSTRUCTOR: An Interactive video activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.2.
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18. Toyota Locks Up Lithium for Car Batteries
STRATEGY HIGHLIGHT 8.1
Toyota Locks Up Lithium for Car Batteries
World demand for lithium-ion batteries for cars
Grow from $278 million in ‘09 to $25 billion in 2014
Toyota wants to secure long-term supply of lithium to power its hybrid fleet
Orocobre holds exploration rights to a large salt-lake area
Upfront investment to extract of lithium is very high
Should Orocobre make the investment to supply Toyota?
To encourage investment, Toyota took an equity position
INSTRUCTOR: A 6-minute video on China’s vital role in the supply of global rare earth metals. In fall of 2010, China restricted exports of the materials. The video was produced by The New York Times in November 2010.
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China Rare Earth Video
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19. LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
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20. Vertical Integration along the Industry Value Chain
In what stages of the industry value chain should the firm participate?
Vertical integration
Ownership of its inputs, production, & outputs in the value chain
Horizontal value chain
Internal, firm-level value chains (Chapter 4)
Vertical value chain
Industry-level integration from upstream to downstream
Examples: cell phone industry value chain
Many different industries and firms
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21. Backward and Forward Vertical Integration along an Industry Value Chain
EXHIBIT 8.4
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.3 & 8.4 on types and advantages of vertical integration.
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22. Types of Vertical Integration
Full vertical integration
Ex: Weyerhaeuser
Owns forests, mills, and distribution to retailers
Backward vertical integration
Ex: HTC’s backward integration into design of phones
Forward vertical integration
Ex: HTC’s forward integration into sales & branding
Not all industry value chain stages are equally profitable
Zara – primarily designs in-house & partners for speedy new fashions delivered to stores
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23. HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry
EXHIBIT 8.5
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.3 & 8.4 on types and advantages of vertical integration.
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24. LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
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25. Benefits and Risks of Vertical Integration
Benefits of vertical integration
Securing critical supplies
Lowering costs
Improving quality
Facilitating scheduling and planning
Facilitating investments in specialized assets
Ex: HTC started as OEM & expanded to fully integrated
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26. PepsiCo acquired bottlers in 2009
STRATEGY HIGHLIGHT 8.2
Back to the Future: PepsiCo’s Forward Integration
PepsiCo acquired bottlers in 2009
Gain control over quality, pricing, distribution, and in-store display.
Reversed a 1999 decision to sell off Pepsi bottlers
Goal now is faster innovative products launched
Forward integration
Enhance flexibility and improve decision making
Cost saving and interdependence
Coca-Cola did the same: forward integration with bottlers
INSTRUCTOR: The textbook DVD has an eight-minute audio clip from The Economist on Pepsi’s diversification of foods and the integration of its bottlers.
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27. Benefits of Vertical Integration
Specialized assets
Assets that have significantly more value in their intended use than in their next best use
Types of specialized assets
Site specificity
Co-located such as mining equipment
Physical asset specificity
Bottling machinery
Human asset specificity
Mastering procedures of a particular organization
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28. Risks of Vertical Integration
Increasing costs
Internal suppliers lose incentives to compete
Reducing quality
Single captured customer can slow experience effects
Reducing flexibility
Slow to respond to changes in technology or demand
Increasing the potential for legal repercussions
FTC carefully reviewed Pepsi plans to buy bottlers
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29. Alternatives to Vertical Integration
Taper integration
Backward integrated but also relies on outside market firms for supplies OR
Forward integrated but also relies on outside market firms for some of its distribution
Strategic outsourcing
Moving value chain activities outside the firm's boundaries
Ex: EDS and PeopleSoft provide HR services to many firms that choose to outsource it.
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30. EXHIBIT 8.6 Taper Integration along the Industry Value Chain
Outside suppliers could
also be off-shored when
they are not located in the
home country
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31. Corporate Diversification: Expanding Beyond a Single Market
Degrees of diversification
Range of products and services a firm should offer
Ex: PepsiCo also owns Lay's & Quaker Oats.
Diversification strategies:
Product diversification
Active in several different product categories
Geographic diversification
Active in several different countries
Product – market diversification
Active in a range of both product and countries
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32. Types of Corporate Diversification
Single business
Google
Dominant business
Microsoft
Related diversification
Related constrained
ExxonMobil
Related linked
Disney
Unrelated diversification GE
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33. Different Types of Diversification
EXHIBIT 8.7
Different Types of Diversification
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34. Small Group Exercise 1
Agriculture is one of the largest global industries
In the U.S. and many other countries, farmers often struggle to turn a profit given the variances of weather and commodity prices.
Some working farms are turning to tourism as an additional and complementary revenue source.
A study from the U.S. Census of Agriculture in 2007 found nearly 25,000 farms providing some level of agri-tourism and recreation services.
Small farms worldwide are participating in this trend by offering “pick your own” crops in season as well as a small bed-and-breakfast.
What other industries could benefit from diversifying into tourism & recreation?
INSTRUCTOR: This is a shortened version of Small Group Exercise 1 in the back of this chapter.
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35. ExxonMobil Diversifies into Natural Gas
STRATEGY HIGHLIGHT 8.3
ExxonMobil earned highest profit in its history in 2008
Majority of profits come from petroleum-based products.
Environmental change toward clean energy
ExxonMobil must react to the change.
ExxonMobil to focus on clean energy: natural gas.
ExxonMobil acquired XTO Energy
Leverage core competence in exploration and commercialization of energy sources into natural gas.
85% today fossil fuels
Exxon is largest producer of natural gas on the planet.
INSTRUCTOR: A 90-second video on Exxon’s purchase of XTO Energy. The video was produced by The New York Times in December 2009.
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Exxon XTO video 35

36. LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
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37. Leveraging Core Competencies for Corporate Diversification
Core competence
Unique skills and strengths
Allows firms to increase the value of product/service
Lowers the cost
Examples:
Walmart – global supply chain
Infosys – low-cost global delivery system
The core competence – market matrix
Provides guidance to executives on how to diversify in order to achieve continued growth
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38. The Core Competence – Market Matrix
EXHIBIT 8.8
The Core Competence – Market Matrix
Pepsi - Gatorade
Salesforce.com
BoA - NCNB
BoA - Merrill Lynch
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39. Corporate Diversification
Diversification discount
Stock price of diversified firms is less
Diversification premium
Stock price of diversified firms is greater
Will diversification increase performance?
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.8 on the appropriate context of diversification for competitive advantage.
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40. The Diversification-Performance Relationship
EXHIBIT 8.9
The Diversification-Performance Relationship
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.8 on the appropriate context of diversification for competitive advantage.
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41. Corporate Diversification (cont'd)
How does diversification enhance performance?
Economies of scale  lower the cost
Economies of scope  increase the value
Reduce cost and increase value simultaneously
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42. Vertical Integration and Diversification: Sources of Value Creation and Costs
EXHIBIT 8.10
INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.8 on the appropriate context of diversification for competitive advantage.
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43. Corporate Diversification (cont'd)
Restructuring
Process of reorganizing and divesting business units
To refocus a company to leverage its core competencies
Boston Consulting Group growth-share matrix
Dogs
Cash cows
Stars
Question marks
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44. EXHIBIT 8.11
BCG Matrix
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45. Corporate Diversification (cont'd)
Internal capital markets
Source of value creation in a diversification strategy
Allows conglomerate to do a more efficient job of allocating capital
Coordination cost
A function of number, size, and types of businesses linked to one another
Influence cost
Political maneuvering by managers to influence capital and resource allocation
Bandwagon effects
Firms copying moves of industry rivals
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46. Corporate Strategy: Combining Vertical Integration and Diversification
Firms’ corporate strategy
Concerns level of integration on value chain
AND
Level of diversification
Ex: Oracle earned $23B in 2009
Enterprise software is core competency
Backward integration – Sun Microsystems
Forward integration – PeopleSoft
Diversification at Oracle:
Related – IP management bought Sophoi
Unrelated – ID theft bought Bharosa
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47. Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
EXHIBIT 8.12
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48. CHAPTERCASE 8/ Consider This…
Where do ecomagination and healthymagination fit on the core competence – market matrix for GE?
Take either the energy or health care industry and draw the industry value chain. What areas of potential vertical integration should GE consider?
What related diversification would you suggest for GE in reference to its focus for the future?
How do GE’s corporate-level strategic initiatives of energy, health care, and globalization reinforce each other? How might they generate conflicts in the company?
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49. Take-Away Concepts
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed.
While business strategy addresses “how to compete,” corporate strategy addresses “where to compete.
Corporate strategy concerns the scope of the firm along three dimensions: (1) vertical integration (along the industry value chain); (2) horizontal integration (diversification); and (3) geographic scope (global strategy).
To gain & 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 integration strategy.
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50. Take-Away Concepts (cont’d)
LO 8-2 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.
In the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and competencies.
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 .
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51. Take-Away Concepts (cont’d)
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
Vertical integration denotes a firm’s value added—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 are competing .
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.
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52. Take-Away Concepts (cont’d)
LO Identify and evaluate benefits and risks of vertical integration.
Benefits of vertical integration include: securing critical supplies, 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.
Vertical integration contributes to competitive advantage if the incremental value created is greater than the incremental costs of the specific corporate-level strategy.
LO 8-5 Describe and examine alternatives to vertical integration.
Taper integration is a strategy in which a firm is backwardly integrated but also relies on outside market firms for some of its supplies, and/or is forwardly integrated but also relies on outside market firms for some if its distribution.
Strategic outsourcing involves moving one or more value chain activities outside the firm’s boundaries to other firms in the industry value chain. Off-shoring is the outsourcing of activities outside the home country.
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53. Take-Away Concepts (cont’d)
LO 8-6 Describe and evaluate different types of corporate diversification.
A single-business firm derives 95 percent or more of its revenues from one business.
A dominant-business firm derives between 70 and 95 percent of its revenues from a single business, but pursues at least one other business activity.
A firm follows a related diversification strategy when it derives less than 70 percent of its revenues from a single business activity, but obtains revenues from other lines of business that are linked to the primary business activity. Choices within a related diversification strategy can be related-constrained or related-linked.
A firm follows an unrelated diversification strategy when less than 70 percent of its revenues come from a single business, and there are few, if any, linkages among its businesses.
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54. Take-Away Concepts (cont’d)
LO 8-7 Apply the core competence–market matrix to derive different diversification strategies.
When applying an existing/new dimension to core competencies and markets, four quadrants emerge, as depicted in Exhibit 8.8.
The lower-left quadrant combines existing core competencies with existing markets. Here, managers need to come up with ideas of how to leverage existing core competencies to improve their current market position.
The lower-right quadrant combines existing core competencies with new market opportunities. Here, managers need to think about how to redeploy and recombine existing core competencies to compete in future markets.
The upper-left quadrant combines new core competencies with existing market opportunities. Here, managers must come up with strategic initiatives of how to build new core competencies to protect and extend the firm’s current market position .
The upper-right quadrant combines new core competencies with new market opportunities. This is likely the most challenging diversification strategy because it requires building new core competencies to create and compete in future markets.
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55. Take-Away Concepts (cont’d)
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not.
The diversification-performance relationship is a function of the underlying type of diversification.
The relationship between the type of diversification and overall firm performance takes on the shape of an inverted U (see Exhibit 8.9).
In the BCG matrix, the corporation is viewed as a portfolio of businesses, much like a portfolio of stocks in finance (see Exhibit 8.11). The individual SBUs are evaluated according to relative market share and speed of market growth, and plotted into one of four categories (dog, cash cow, star, and question mark). Each category warrants a different investment strategy.
Both low levels and high levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance.
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56. Backward vertical integration
Administrative costs
Backward vertical integration
Boston Consulting Group (BCG) growth-share matrix
Corporate-level strategy (corporate strategy)
Credible commitment
Diversification
Diversification discount
Diversification premium
Forward vertical integration
Franchising
Geographic diversification strategy
Industry value chain
Information asymmetries
Joint venture
Licensing
Principal–agent problem
Product diversification strategy
Product–market diversification strategy
Related diversification strategy
Scope of the firm
Specialized assets
Strategic outsourcing
Taper integration
Transaction cost economics
Transaction costs
Unrelated diversification strategy
Vertical integration
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