1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 8 Corporate Strategy: Vertical Integration and Diversification

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3. 8-3  Corporate strategy determines the firm’s boundaries along three dimensions: 1.Industry value chain 2.Range of products and services 3.Where to compete: geography  Key strategic management concepts used here: Core competencies – unique strengths Economies of scale – average cost per unit decreases Economies of scope – savings producing two (or more) outputs Transaction costs – all internal and external costs associated with an economic exchange 8.1 What Is Corporate Strategy? CORPORATE-LEVEL STRATEGY

4. 8-4  Explains and predicts the scope of the firm "Market vs. firms" have differential costs  External transaction costs Costs associated with economic exchanges Ex: negotiating and enforcing contracts  Internal transaction costs Costs pertaining to organizing an exchange within a firm Ex: recruiting & training employees 8.2 The Boundaries of the Firm TRANSACTION COST ECONOMIES

5. 8-5 Exhibit 8.1 Internal and External Transaction Costs

6. 8-6  If C in-house < C market, then vertically integrate (make) Ex: Google hires programmers to write code in-house rather than contracting out.  Disadvantage of “make” in-house Principal–agent problem owner = principal, manager = agent  Disadvantage of “buy” from markets Search cost Opportunism Information asymmetries  These decisions determine the firm’s boundaries. Firms vs. Markets: Make or Buy? FIRST CORPORATE STRATEGY QUESTION

7. 8-7  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 Alternatives on the Make-or-Buy Continuum

8. 8-8 Exhibit 8.3 Alternatives on the Make-or-Buy Continuum

9. 8-9 Strategy Highlight 8.1 Toyota Locks Up Lithium for Car Batteries  World demand for lithium-ion batteries for cars Grew from $278 million in ‘09 to $25 billion in 2014  Toyota wants to secure long-term supply to power its hybrid fleet of over 5 million hybrids sold.  Orocobre holds rights to a large lithium deposit. Upfront investment to extract of lithium is very high.  To encourage investment, Toyota invested $120 million in an equity position. Toyota Locks Up Lithium for Car Batteries  World demand for lithium-ion batteries for cars Grew from $278 million in ‘09 to $25 billion in 2014  Toyota wants to secure long-term supply to power its hybrid fleet of over 5 million hybrids sold.  Orocobre holds rights to a large lithium deposit. Upfront investment to extract of lithium is very high.  To encourage investment, Toyota invested $120 million in an equity position.

10. 8-10  In what stages of the industry value chain should the firm participate?  Vertical integration Ownership of its inputs, production, & outputs in the value chain Vertical value chain Industry-level integration from upstream to downstream Examples: cell phone industry value chain Many different industries and firms 8.3 Vertical Integration along the Industry Value Chain

11. 8-11 Exhibit 8.4 Backward and Forward Vertical Integration along an Industry Value Chain

12. 8-12  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. Apple – designs in-house software and hardware but partners for manufacturing Porter’s five forces (Chapter 3) useful tool here Types of Vertical Integration

13. 8-13  Securing critical supplies  Lowering costs & improving quality  Facilitating investments in specialized assets  Increasing costs & reducing quality  Reducing flexibility  Increasing the potential for legal repercussions Benefits and Risks of Vertical Integration SOME BENEFITS OF VERTICAL INTEGRATION SOME RISKS OF VERTICAL INTEGRATION

14. 8-14  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: PeopleSoft, EDS, and Perot Systems provide HR services to many firms that choose to outsource it. Alternatives to Vertical Integration

15. 8-15  Degrees of diversification Range of products and services a firm should offer Ex: PepsiCo also owns Lay's & Quaker Oats, but sold off KFC Differences in corporate strategy between KFC & Chick-fil-A  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 products and countries 8.4 Corporate Diversification: Expanding Beyond a Single Market SECOND CORPORATE STRATEGY QUESTION

16. 8-16  Single-business firm derives >95% from one business Google revenues from online search  Dominant-business firm 70% to 95% from one business Harley-Davidson yields 10% revenues from clothing  Related diversification strategy <70% from one business Related-constrained – leverage current competencies ExxonMobil strategic move into natural gas Related-linked – share only limited links to current business Amazon move into cloud computing, Kindle tablets, & video streaming  Unrelated diversification <70% and few if any links among businesses (a conglomerate) GE, LG, Tata Types of Corporate Diversification

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18. 8-18  Core competence Unique skills and strengths Allows firms to increase the value of product/service Lowers the cost  Examples of core competencies are: Walmart − globally distributed supply chain at low cost Infosys − high-quality/low-cost IT services  The core competence – market matrix Provides guidance to executives on how to diversify in order to achieve continued growth Leveraging Core Competencies for Corporate Diversification

19. 8-19  Does corporate 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?  Research finds an inverted U-shaped relationship Type of diversification Overall firm performance Corporate Diversification and Firm Performance

20. 8-20 Exhibit 8.9 The Diversification- Performance Relationship

21. 8-21  The process of reorganizing and divesting business units such as GE in ChapterCase 8 InBev sold Busch Gardens and SeaWorld to focus on core.  Boston Consulting Group (BCG) growth-share matrix Build market share with stars and question marks. Hold market share with cash cows. Harvest (milk) as much short-term cash as possible. Divest a dog business unit. RESTRUCTURING

22. 8-22 Exhibit 8.11 Restructuring the Corporate Portfolio: The Boston Consulting Group Growth-Share Matrix

23. 8-23 8.5 Implications for the Strategist  Effective corporate strategy helps to gain and sustain a competitive advantage.  Corporate strategy needs to be dynamic over time. GE CEO Jeffrey Immelt formulated a new corporate strategy in clean-tech and health care. (ChapterCase 8) Strategic positions of Nike and adidas another example adidas founded in 1924 focused on athletic shoes  Integrated manufacturing model Globalization led adidas to less integration and wider sports apparel  2013 − 40% shoes, 50% apparel, 10% equipment Nike started in 1978 as a vertically disintegrated firm.

24. 8-24 Take-Away Concepts  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 integration strategy. LO 8-1 Define corporate strategy and describe the three dimensions along which it is assessed.

25. 8-25 Take-Away Concepts  Transaction cost economics help managers decide what activities to do in-house (“make”) versus 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, then the firm should vertically integrate.  Principal–agent problems and information asymmetries can lead to market failures.  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.  Moving from less integrated to more fully integrated forms of transacting, alternatives include short-term contracts, strategic alliances, and parent–subsidiary relationships LO 8-2 Describe and evaluate different options firms have to organize economic activity.

26. 8-26 Take-Away Concepts LO 8-3 Describe the two types of vertical integration along the industry value chain: backward and forward vertical integration.

27. 8-27 Take-Away Concepts LO 8-4 Identify and evaluate benefits and risks of vertical integration.

28. 8-28 Take-Away Concepts LO 8-5 Describe and examine alternatives to vertical integration.

29. 8-29 Take-Away Concepts  A single-business firm derives 95% or more of its revenues from one business.  A dominant-business firm derives between 70 and 95% 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% of its revenues from a single business activity, but obtains revenues from other businesses linked to the primary business activity. (related-constrained or related-linked)  A firm follows an unrelated diversification strategy when less than 70% of its revenues come from a single business, and there are few, if any, linkages among its businesses LO 8-6 Describe and evaluate different types of corporate diversification.

30. 8-30 Take-Away Concepts  When applying an existing/new dimension to core competencies and markets, four quadrants emerge, depicted in Exhibit 8.8.  The lower-left quadrant combines existing core competencies with existing markets. Consider 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. Consider 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. Consider 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 LO 8-7 Apply the core competence– market matrix to derive different diversification strategies.

31. 8-31 Take-Away Concepts  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).  Unrelated diversification often results in a diversification discount: the stock price of such highly diversified firms is valued at less than the sum of their individual business units.  Related diversification often results in a diversification premium: the stock price of related-diversification firms is valued at greater than the sum of their individual business units.  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 the speed of market growth, and are plotted using 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. LO 8-8 Explain when a diversification strategy creates a competitive advantage and when it does not.

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