1. Foundation of Strategy Chapter 7
Ian Goldberg
Nathan Smith
Michael Medford
Cameron Rice

2. Scope of the Firm Ask self, “What business are we in?”
Starting point of strategy
Basis for defining firm’s identity
Corporate strategic decisions involve the breadth of the firm’s product range (product scope) and the extent of its involvement in the industry value chain (vertical scope)

3. Scope of the Firm
Many firms define their business via mission/vision statements
Some define their business with a focus exclusively on a narrow part of the supply chain, others extend over many supply chain activities
Shell: “to engage efficiently, responsibly and profitably in oil, oil products, gas, chemicals, and other selected businesses”
McDonald’s: “to be the world’s beswt quick service restaurant chain”
JC Penney’s: “To drive Sales and Profit growth by ensuring our Customers and our Associates always know they’re first in our Stores by what We do!”

4. Trends The scope of a firm’s business is likely to change over time
Companies diversify offerings
Microsoft went from supplying operating systems to providing application and networking software
JC Penney went from providing month-long specials cutting prices by 20-30%, to permanently marking down a large chunk of its merchandise by the same price

5. Economies of Scope
Cost economies from increasing the output of multiple products
Depends of the different types of resources and capabilities
Tangible resources (distribution networks, information technology systems, sales forces, and research labs) – offer E- of-S by eliminating duplication between businesses through creating a single shared facility
Intangible Resources (brands, corporate reputation) – create E-of-S by extending to additional businesses at a marginal cost

6. Economies of Scope
Brand Extension- exploiting a strong brand across additional products
Starbucks selling ice cream, packaged cold drinks, audio CDs/books
Organizational Capabilities- result from ability to transfer capabilities between businesses within the diversified company (can be replicated in a new business at a fraction of the cost

7. Economies of Scope: JCPenney
Started off as a moderately priced department store and by identifying target market as middle-class ($30,000-$80,000)
Changed their focus to middle aged women (35-54) and to offer dressy casual clothing items
JCP changed focus from general public and middle class to upper-middle/lower-upper

8. The Market
A capitalist economy comprised of two forms of economic organization
Market Mechanism
Administrative Mechanism
Market Mechanism- where individuals/firms are guided by market prices and make independent decisions to buy/sell goods & services
Administrative Mechanism- where decisions concerning production and resouce allocation are made by managers
Example, versus hiring a specialist firm to build a new house, you can hire a general buileder, a plumber, an electrician, a joiner and painter

9. Transaction Costs
Costs determine which particular activities are undertaken by a firm
Markets are not free, costs include:
Purchase/sales costs, contractual costs, costs to monitor and ensure that the other party is fulfiling its side of the contract, enforcement costs of arbitration/litigation
During 20th century, companies grew in size and scope, absorbing more transaction costs
Major factor encouraging firms to extend their boundaries was fall in administrative costs
Technology was major source of falling admin. costs

10. Transaction Costs: JCPenney
Large retailers such as JCP contract with a large range of suppliers
If we identify the supply chain arrangements that support JCP’s provision of clothing to its stores, we can identify the source of many different transaction costs

11. Transaction Costs: JCPenney
In order to ensure that its stores receive regular supplies of good quality clothes, JCP must, forgoing transaction costs:
Bargain with selected suppliers to est. prices, quality, standards, and other detailed aspects of the supply arrangements
Draw up a legal contract
Monitor the supplier to mae sure that what is delivered meets the terms of the agreements
Enforce the contract and seek damages if the chosen supplier defaults on the part of the contract

12. The Costs of Corporate Complexity
Additional business activities  Economies of scope
Organizational Complexity
Managing different businesses requires different capabilities
Different strategic planning systems
Different approaches to human resource management
Xerox, kodak, phillips cannot maintain IT services  outsource

13. Tesco Corporate Complexity
Grocery Retailer  Purchasing & Merchandising
Diversification into non-food products
Introduced clothing line  seamless
Diversification into Financial Services
Requires new competencies
Not able to overcome

14. 3 Concepts Economies of Scope Transaction costs
Cost of managing complexity

15. Diversification Diversification Unrelated & Related
Expansion of an existing firm into another product line or field of operation
Unrelated & Related

16. Unrelated Diversification
Takes place when the additional product line is very different from the firm’s core business
Food processing company makes medical devices

17. Related Diversification
Occurs when a firm expands into a similar field of operation
Ex: Car manufacturer extends product to trucks or buses
Also known as concentric diversification
Greater potential benefits

18. Horizontal Diversification
Involves the firm moving into the same stage of production
Unrelated to current products
Sephora

19. Vertical Diversification
Occurs when a firm undertakes successive stages in the production of a good or service

20. Benefits & Cost of Diversification
Motives for diversification
Growth
Risk Reduction
Value Creation
Exploiting Economies of Scope

21. Motives for Diversification
Growth
Low growth industries diversify
Exxon diversified into copper & coal mining
Nabisco diversified from a tobacco company into consumer products

22. Motives for Diversification
Risk Reduction
Don’t put all of your eggs in one basket
Beneficiaries:
Managers  Stable Profits = Job Security

23. Motives for Diversification
Value Creation
Primary Source
Exploiting linkages between different businesses
Sublicensing
Are transaction costs worth the value?

24. Motives for Diversification
Exploiting Economies of Scope
Disney licenses the Donald Duck trademark to Florida’s Natural Growers (Orange Juice)
If resources can be traded/licensed out for value
Not necessary to enter another business to find value

25. Internal Capital Markets Diversified Firm
Advantage
Disadvantage
Corporate headquarters allocates capital between different businesses
Can avoid using external capital market (debt/equity deals)
Better access to information on financial data
Failure to transfer cash from worst prospects to best prospects

26. Internal Labor Markets
Ability of diversified companies to transfer employees
Cost of hiring:
Advertising
Interviewing
‘Head-hunting’ agencies

27. When does diversification create value?
Michael Porter proposes three ‘essential tests’ to see if diversification creates value
The Attractiveness Test
The Cost-of-entry Test
The Better-off Test

28. The Attractiveness Test
The industries chosen for diversification must be structurally attractive or capable of being made attractive
Theory insufficient on its own

29. Cost-of-entry Test
The cost of entry must not capitalize all the future profits
Sometimes cost of entry may counteract attractiveness

30. The Better-Off Test
Either the new unit must gain competitive advantage from its link with the corporation, or vice versa
Addresses basic issue of competitive advantage
In most diversification decisions, it is the ‘better-off test’ that dominates

31. Diversification & Performance
Empirical Research into diversification has 2 issues:
How do diversified firms perform relative to specialized firms?
Does related diversification outperform unrelated diversification?

32. Vertical Integration
A firms ownership of vertically related activities
Indicated by the ratio of a firm’s value added to to its sales revenue
The more a firm makes rather than buys, the lower its costs are relative to sales revenue

33. Vertical Integration Backward Forward
Firm acquires ownership & control over production of inputs
Forward
Firm acquires ownership & control over activities previously undertaken by customers

34. Bilateral Monopolies
Each steel strip producer is tied to its adjacent steel producer
Single supplier negotiates with single buyer
All depends on bargaining power
Once moved from competitive market to individual buyers and sellers that are locked in bilateral relationships, efficiencies of the market system are lost

35. Bilateral Monopolies
Invest in equipment that is specific to needs of other party
Built to match the other party’s plant
Depends on availability of other party’s complementary facilities
Gives the opportunity to “hold up” the other
Transaction-specific investments can result in transaction costs arising
Contracts may not cover everything

36. Incentive problem
Vertical integration changes the incentives between vertically related businesses
Buyer and Seller
Profit incentive makes buyer motivated to get best deal
Seller motivated to pursue efficiency and service to retain buyer (high-powered incentives)
Creating stronger performance incentives is to open internal divisions to external competition
Create shared service organizations where internal suppliers compete with external suppliers of the same services

37. Vertical Integration Neither good or bad, it all depends
Variety of relationships between buyers and sellers
Classified in relation to two characteristics
Extent to which buyer and seller commit resources to the relationship
The formality of the relationship

38. Different Types of Vertical Relationship

39. Different Types of Vertical Relationship
Spot contracts
Immediate sale and delivery of commodities
Long-term contracts
Commitment to undertake agreed activity over several periods of time
Franchising
Contract agreement between owner of business system and franchiser that permits the franchisee to produce and market their product

40. Recent Vertical Integration Trends
Massive shift from arm’s-length supplier relationships to long-term collaboration with fewer suppliers
Arm’s-Length: buyers and sellers are independent and have no relationship to each other, act in their own self interest
Outsourcing
Involves not just individual components and services, but whole chunks of the value chain

41. Portfolio Planning GE/McKinsey matrix
Attractiveness and competitive advantage

42. Portfolio Planning Boston Consulting Group’s growth-share matrix
Rate of market growth and relative market share

43. Portfolio Planning Ashridge portfolio display
Value creating potential of business (subjective)

44. JCPenney
Stock has currently dropped 23 percent this year, 44 percent in 2012
Currently revamping pricing strategy from high-low to everyday low
Eliminating coupons and creating clearance sales
Pension officials want to know more about long- term plan for turning around JCPenney fashion lines
Cutting jobs to trim costs

45. Corporate Strategy
The key roll of corporate strategy is about deciding in which businesses to engage.
These strategies are among the most important business decisions top managers will make.
Mistakes can be costly both financially and strategically.

46. Corporate Strategy
Historically the successful businesses are those that change their product lines, acquire new resources and developing capabilities in line with market opportunities.
Long-term adaption to the market conditions is through diversification is likely to be more successful if it is based on a sound strategic analysis.

47. Corporate Strategy
Having determined the potential for diversification or vertical integration to add value, the challenge is then how to manage multi-business firm to extract this potential value.
This is were Portfolio Planning has become the dominant way for managers to make sense of the complexity and to develop a plan of consistency.