Competing for Advantage

Competing for Advantage
PART III CREATING COMPETITIVE ADVANTAGE Chapter 8 Corporate-Level Strategy

The Strategic Management Process
Figure 1.6: The Strategic Management Process – A logical approach for responding to 21st century competitive challenges. Provides an outline of the content of the textbook by each chapter. Creating Competitive Advantage Business-level strategy – competitive advantages the firm will use to effectively compete in specific product markets Competitive rivalry and dynamics – analysis of competitor actions and responses is relevant input for selecting and using specific strategies Cooperative strategy – an important trend of forming partnerships to share and develop competitive resources Corporate-level strategy – concerns the businesses in which the company intends to compete and the allocation of resources in diversified organizations Acquisition and restructuring strategies – primary means used by diversified firms to create corporate-level competitive advantages International strategy – significant sources of value creation and above-average returns

Corporate-Level Strategy
Key Terms Corporate-level strategy Specifies actions a firm takes to gain a competitive advantage by selecting and managing a portfolio of businesses that compete in different product markets or industries Corporate-Level Strategy – A diversification strategy (introduced in Chapter 7) allows a firm to use its knowledge, skills, and resources to pursue opportunities for value creation in new business areas, seeking to develop new capabilities and acquire new resources while doing so. Discussion points: Like a firm’s business-level and cooperative strategies, corporate-level strategies are intended to help a firm create value which leads to high performance. Some suggest that few corporate-level strategies actually create value. A corporate-level strategy’s value is ultimately determined by the degree to which the businesses in the portfolio are worth more under the management of the company than they would be under any other ownership. One way to measure the success of a corporate-level strategy is to determine whether the aggregate returns across all of a firm’s business units exceed what those returns would be without the overall corporate strategy.

Five Elements of Strategy
Figure 2.4: Five Elements that Identify a Firm’s Strategy – revisited from Chapter 2 Corporate-level strategy answers the question regarding arenas: In what product markets and businesses should the firm compete and how should corporate headquarters manage those businesses? Discussion points: Defining the business arenas – critical starting point for strategic planning and management Commonly used growth vehicles – internal development, joint ventures, licensing, franchising, and acquisitions Differentiators – help a firm determine how it is expected to win customers in the marketplace Staging – the timing of strategy and the sequence of moves the firm will take to carry it out (increasingly important because of the speed of change in the competitive environment) Economic logic – pulls together all of the above elements and focuses on achieving above-average financial returns

Product Diversification
Primary form of corporate-level strategy Concerns scope of industries and markets Defines approach to buying, creating, and selling businesses Intends to reduce variability in profitability Comes with development and monitoring costs Product Diversification – the primary form of corporate-level strategy Discussion points: It is concerned with the scope of the industries and markets in which the firm competes. It defines how managers should buy, create, and sell different businesses to match the firm’s skills and strengths with opportunities in the external environment. By generating earnings from several different business units, it is expected to reduce variability in the firm's profitability. There is a cost to developing and monitoring a diversification strategy, which must be balanced with the benefits of establishing an ideal portfolio of businesses. CEOs and their top management team are ultimately responsible for determining the ideal portfolio of businesses for the firm.

Levels and Types of Diversification
Figure 8.1: Levels and Types of Diversification – Diversified firms vary according to their level of diversification and the degree of connections between and among their businesses. Figure 8.1 defines five categories of diversification. Discussion points: A firm is related through its diversification when there are several links between its business units. The more links among businesses, the more constrained is the relatedness of diversification. Unrelatedness refers to the absence of direct links between businesses. Firms using each type of diversification strategy constantly adjust the mix in their portfolio of businesses as well as decisions about how to manage their businesses. In what ways might the firm share related links between business units? Shared products or services Shared technologies Shared distribution channels

Low Levels of Diversification
Key Terms Single business strategy Corporate-level strategy in which the firm generates 95% or more of its sales revenue from its core business area Dominant business diversification strategy Corporate-level strategy in which the firm generates between 70% and 95% of its total sales revenue within a single business area Low Levels of Diversification – Two types of strategy are used by firms pursuing low levels of diversification. Example of single business strategy: Medifast Example of dominant business diversification strategy: UPS

Moderate Levels of Diversification
Key Terms Related diversification strategy Corporate-level strategy in which the firm generates more than 30% of its sales revenue outside a dominant business and whose businesses are related to each other in some manner Related constrained diversification strategy Related diversification strategy characterized by direct links between the firm's business units Related linked diversification strategy Related diversification strategy characterized by only a few links between the firm’s business units Moderate Levels of Diversification – Two types of strategy are used by firms pursuing moderate levels of diversification. Discussion points: A related constrained firm shares a number of resources and activities among its businesses. Examples: The Campbell Soup Company, P&G, and Merck & Co. A diversified company that has a portfolio of businesses with only a few links between them is combining related and unrelated approaches and is using the related linked diversification strategy. Examples: J&J and GE Compared with related constrained firms, related linked firms share fewer resources and assets among their businesses, instead concentrating on transferring knowledge and competencies among the businesses.

High Levels of Diversification
Key Terms Unrelated diversification strategy Corporate-level strategy for highly diversified firms in which there are no well- defined relationships between business units High Levels of Diversification – Highly diversified firms have no well-defined relationships between their businesses. These types of firms are also known as conglomerates. Examples: United Technologies, Textron, and Samsung

Relationship between Diversification and Performance
Figure 8.2: Curvilinear Relationship between Diversification and Performance – Research evidence suggests a curvilinear relationship exists between diversification levels and firm performance. Discussion points: Lower performance is expected for dominant business and unrelated business strategies. This chapter covers why a diversification strategy that involves a portfolio of closely related firms is likely to be higher performing than other types of diversification strategies. It is important to note two caveats to this pattern of diversification and performance. Some firms are successful with each type of diversification strategy. Some research suggests that all diversification leads to trade-offs and a certain level of suboptimization.

Reasons for Diversification
Table 8.1: Reasons for Diversification – Table 8.1 lists many of the reasons firms use a corporate-level diversification strategy and serves as an outline for much of the rest of this chapter. Discussion points: Value-creating diversification Most often corporate-level managers use a diversification strategy in an attempt to improve the firm’s overall performance. Value is created when the strategy allows a company’s business units to increase revenues or reduce costs. Related strategies seek to gain economies or market power. Unrelated strategies seek financial benefits. Value-neutral diversification In this case, the strategy does not necessarily guide the firm toward any particular type of value-creation. The prevailing logic of diversification suggests that the firm should diversify into additional markets when it has excess resources, capabilities, and core competencies with multiple uses. Although these factors might push a firm toward diversification, hopefully managers will actually pursue a type of diversification that will add value to the firm. Value-reducing diversification Diversification may actually increase costs or reduce a firm’s revenue and total value. These situations tend to be driven by the personal motivations of managers who are guiding the firm’s diversification strategy. Examples: Reduced employment risk, increased compensation, and empire building (see Slide 50) What are some value-neutral reasons for diversifying? Government-induced stimuli such as antitrust regulation and tax laws Concerns about low performance, uncertainty of future cash flows, or other types of business risk To take advantage of tangible or intangible resources the firm possesses that would facilitate diversification

Value-Creating Strategies of Diversification
Figure 8.3: Value-Creating Strategies of Diversification – two ways diversification strategies can create value: - Operational relatedness: sharing activities - Corporate relatedness: transferring knowledge, skills, or core competencies Discussion points: The study of these independent relatedness dimensions highlights the importance of resources and key competencies in strategic decisions. The vertical dimension of Figure 8.3 indicates sharing activities (operational relatedness). The horizontal dimension depicts corporate capabilities for transferring knowledge (corporate relatedness). Firms with a strong capability in managing operational synergy, especially in sharing assets between its businesses, fall in the upper left quadrant. This quadrant also represents vertical sharing of assets through vertical integration. The lower right quadrant represents a highly developed corporate capability for transferring a skill or skills across businesses. This capability is located primarily in the corporate office. The use of either operational relatedness or corporate relatedness is based on a knowledge asset that the firm can either share or transfer. Unrelated diversification is also shown in Figure 8.3 in the lower left quadrant. The unrelated diversification strategy creates value through financial economies rather than through either operational relatedness or corporate relatedness among business units. The upper right quadrant represents a rare capability of achieving both operational and corporate relatedness simultaneously, which can inadvertently create diseconomies of scope. (Refer to Slide 33 for further discussion.)

Diversification and the Multidivisional Structure
Key Terms Multidivisional structure (M-form) Organizational structure which ties together several operating divisions, each representing a separate business or profit center to which responsibility for daily operations and business-unit strategy is delegated Diversification and the Multidivisional Structure – The multidivisional organizational structure is used to support implementation of multi-business strategies. (Recall from Chapter 5.) Discussion points: Each division in the corporation represents a distinct, self-contained business with its own business-level structure. The M-form ties all of those divisions together. Diversification is a dominant corporate-level strategy in the global economy, so the M-form organizational structure is used extensively throughout the world. Proper use of the M-form in a diversified firm can lead to value creation.

Original Benefits of the M-form
It enabled corporate officers to more accurately monitor the performance of each business, which simplified the problem of control. It facilitated comparisons between divisions, which improved the resource allocation process. It stimulated managers of poorly performing divisions to look for ways of improving performance. Original Benefits of the M-form – The M-form was an innovative response to coordination and control problems that surfaced during the 1920s in the functional structures then used by large firms such as DuPont and General Motors. As initially designed, the M-form was thought to have these three major benefits. Discussion points: Active monitoring of performance through the M-form increases the likelihood that decisions made by managers heading individual units will be in the shareholders’ best interests. The M-form may be used to support implementation of both related and unrelated diversification strategies. This structure helps firms successfully manage the many demands of diversification, including those related to processing vast amounts of information.

Organizational Controls
Key Terms Organizational controls Management tool which indicates how to compare actual results with expected results and suggests corrective actions to take when the difference between actual and expected results is unacceptable Strategic controls Subjective criteria intended to verify that the firm is using appropriate strategies for the conditions in the external environment and given the company's competitive advantages Financial controls Objective criteria used to measure firm performance against previously established quantitative standards Organizational Controls – an important aspect of the M-form Discussion points: Organizational controls Guide the use of strategy Firms rely on two types: strategic and financial Strategic controls Deal with the content of strategic actions rather than their outcomes Examine the fit between what the firm might do (as suggested by opportunities in its external environment) and what it can do (as indicated by its competitive advantages) (see Chapters 2 and 4) Effective strategic controls help the firm understand what it takes to be successful, to set appropriate strategic goals, and to monitor goal achievement Demand rich and frequent communications between top managers responsible for evaluating overall firm performance and those with primary responsibility for implementing the firm’s strategies in its divisions Used when there is a corporate-wide emphasis on sharing among business units Require corporate-level managers to understand each of their businesses very well, which is most likely when the businesses are related Difficult to use with extensive diversification Financial controls Emphasized to evaluate the performance of business units in unrelated diversified firms Include accounting-based measures Examples: RoI, RoA, and economic value-added Used when activities and capabilities are not being shared among business units

Variations of the M-form
Cooperative Strategic business-unit (SBU) Competitive Variations of the M-form Discussion points: The cooperative form of the multidivisional structure is used for related diversification strategies. The strategic business-unit (SBU) form of the multidivisional structure is used for related diversification strategies. The competitive form of the multidivisional structure is used for unrelated diversification strategies.

Related Diversification
Key Terms Economies of scope Cost savings that the firm creates by successfully transferring some of its capabilities and competencies that were developed in one of its businesses to another of its businesses Synergy Conditions that exist when the value created by business units working together exceeds the value those same units create working independently Related Diversification – This type of strategy builds upon or extends the company’s resources, capabilities, or core competencies to create value. An option for firms operating in multiple industries or product markets, the objective is to develop and exploit economies of scope between business units. Operational and corporate relatedness determine how resources are jointly used to create economies of scope. (Refer to Slide 12 or Figure 8.3.)

Operational Relatedness: Sharing Activities
Positive Outcomes: Increased Value Creation Improved Financial Returns Reduced Risk Challenges: Linked Outcomes Conflict Between Divisions Coordination Costs Operational Relatedness: Sharing Activities – Firms create operational relatedness by sharing either value chain activities or support functions (see discussion in Chapter 4). Sharing activities is quite common, especially among related constrained firms. Several issues affect the degree to which activity sharing creates positive outcomes. Discussion points: Firms expect activity sharing among units to result in increased value creation and improved financial returns. Research has revealed that firms with more related units have lower levels of risk. Building appropriate coordination mechanisms can contribute to successful creation of economies of scope. Example: Information systems More attractive results are obtained through activity sharing when facilitated by a strong corporate office. Coordination challenges must be effectively managed. Activity sharing can be risky because business-unit ties create links between outcomes. Example: Falling demand for one product can reduce revenues that cover the fixed costs of operating a shared facility Organizational conflict between divisions can interfere with success. Example: Managers may perceive and resent disproportionate sharing of gains Managing interdependencies between related businesses increases coordination costs. Synergy only improves performance if the benefits are greater than the costs. Despite additional costs, research shows that related diversification can create value. Example: Horizontal acquisitions in the banking industry

The Cooperative Form of the Multidivisional Structure
Key Terms Cooperative form Organizational structure using horizontal integration to bring about interdivisional cooperation Using the Cooperative Form of the Multidivisional Structure to Implement the Related Constrained Strategy – involves the formation of divisions around products or markets

Cooperative Form of the Multidivisional Structure
Figure 8.4: Cooperative Form of the Multidivisional Structure for Implementation of a Related Constrained Strategy – This figure uses product divisions to represent the cooperative form of the M-form, although market divisions could also be used. Discussion points: All of the divisions share one or more corporate strengths. Examples: Production competencies, marketing competencies, and channel dominance Interdivisional sharing of competencies helps the firm create economies of scope. Interdivisional sharing depends on cooperation. Increasingly, it is important that the links include both intangible resources (such as knowledge) and tangible resources (such as facilities and equipment). (Resources are discussed in more detail in the notes for Slide 49.)

Integrating Mechanisms of the Cooperative Form of the Multidivisional Structure
Centralization Standardization Formalization Integrating Mechanisms of the Cooperative Form of the Multidivisional Structure – Different characteristics of structure (refer to Chapter 5) are used as integrating mechanisms to facilitate interdivisional cooperation in the cooperative form. Discussion points: Centralization – of some organizational functions at the corporate level allows the linking of activities among divisions Work completed in these centralized functions is managed by the firm’s central office with the purpose of exploiting common strengths among divisions by sharing competencies. Examples: HR management, R&D, marketing, and finance Standardization – involves adoption of uniform processes and procedures Formalization – of the firm’s rules and procedures

Success Factors of the Cooperative Form of the Multidivisional Structure
Information processing among divisions Strategic controls Reward systems Managerial commitment levels Success Factors of the Cooperative Form of the Multidivisional Structure Discussion points: Success is influenced by how well information is processed among divisions. Cooperation among divisions implies a loss of managerial autonomy, and division managers may not readily commit themselves to the type of integrative information-processing activities that this structure demands. Success relies on the use of strategic controls. Divisional managers’ performance can be evaluated at least partly on the basis of how well they have facilitated interdivisional cooperative efforts. Success can be impacted by the use of proper reward systems. Using reward systems that emphasize overall company performance, besides financial outcomes achieved by individual divisions, helps overcome problems associated with the cooperative form. Success can be influenced by managerial commitment levels (which can soften the response to some lost managerial autonomy). Coordination among divisions sometimes results in an unequal flow of positive outcomes to divisional managers. A high level of managerial commitment can overcome perceived imbalances in benefits from the sharing of corporate competencies.

Corporate Relatedness: Transferring Core Competencies
Key Terms Corporate-level core competencies Complex sets of resources and capabilities that link different businesses, primarily through managerial and technological knowledge, experience, and expertise Corporate Relatedness: Transferring of Core Competencies – Over time, the firm’s intangible resources become the foundation of its core competencies.

Corporate Relatedness: Transferring Core Competencies
Elimination of duplicate efforts Resource intangibility Corporate Relatedness: Transferring of Core Competencies Discussion points: Related linked firms (see Figure 8.3) often transfer competencies across businesses, thereby creating value in at least two ways. Because the expense of developing a competence has been incurred in one unit, transferring it to a second business unit eliminates the need for the second unit to allocate resources to develop the competence. Intangible resources are difficult for competitors to understand and imitate; therefore, the unit receiving a transferred competence often gains an immediate competitive advantage over its rivals. Examples: Cargill and Catholic Health Initiatives

The Strategic Business-Unit Form of the Multidivisional Structure
Key Terms Strategic business-unit form Form of multidivisional organization structure with three levels used to support the implementation of a diversification strategy Using the Strategic Business-Unit Form of the Multidivisional Structure to Implement the Related Linked Strategy – involves the formation of strategic business units (SBU's)

Three Levels of the SBU Form
Corporate headquarters Strategic business units Divisions within each SBU Three Levels of the SBU Form Example: GE

SBU Form of the Multidivisional Structure
Figure 8.5: SBU Form of the Multidivisional Structure for Implementation of a Related Linked Strategy Discussion points: Divisions within each SBU share product or market competencies to develop economies of scope and possibly economies of scale. The divisions of one SBU have little in common with the divisions of the other SBUs. Each SBU is a profit center that is controlled and evaluated by the headquarters office. Both financial and strategic controls are necessary, but for different reasons. Financial controls are more vital to the headquarters’ evaluation of each SBU. Strategic controls are critical when the heads of SBUs evaluate their divisions’ performance. Strategic controls are also critical to the headquarters’ efforts to determine whether the company has chosen an effective portfolio of businesses and whether those businesses are being effectively managed. There is need for strategic systems that promote exploration to identify new products and markets and mechanisms to spur actions that exploit current product lines and markets. One way to facilitate the transfer of competencies is to move key people into new management positions, but this can be complicated by human resource tendencies. Business-unit managers of older divisions may be reluctant to transfer key people who have accumulated knowledge and experience critical to that unit’s success. Key people may not want to transfer, especially if the transfer involves relocation to a distant location or a different country. Top-level managers from the transferring division may interfere with transferring competencies meant to fulfill the firm’s diversification objectives.

Market Power through Related Diversification
Multimarket Competition Vertical Integration Market Power through Related Diversification – In addition to previously-discussed objectives, related diversification strategies can also be used to gain market power.

Market Power through Multipoint Competition
Key Terms Market power Exists when a firm is able to price and sell its products above the existing competitive level or to reduce costs of value chain activities and support functions below the competitive level, or both Multimarket (or multipoint) competition Exists when two or more diversified firms simultaneously compete in the same product or geographic markets Market Power through Multipoint Competition Discussion points: Multipoint competition was introduced in Chapter 6 as a condition that influences competitive rivalry. Recall that competition in the same markets can reduce the likelihood of aggressive competitive action, a situation known as mutual forbearance. Example: Marriott and Hilton

Market Power through Vertical Integration
Key Terms Vertical integration Exists when a company produces its own inputs or owns its own source(s) of output distribution Taper integration Exists when a firm sources inputs externally from independent suppliers as well as internally within the boundaries of the firm, or disposes of its outputs through independent outlets in addition to company-owned distribution channels Market Power through Vertical Integration Discussion points: Vertical integration When a company produces its own inputs – backward integration When a company owns its own sources of output distribution – forward integration Example: Hanwha-SolarOne Taper integration Partial integration of operations Example: To match or neutralize another firm’s advantage by acquiring a distribution outlet similar to the rival’s

Sources of Market Power through Vertical Integration
Reduced operational costs Reduced market costs Improved product quality Protected technology (from imitation) Invaluable ties between assets Use of Vertical Integration to Gain Market Power – Vertical integration is often used in the firm’s core business to gain market power over or relative to rivals. Discussion points: Market power is gained as the firm develops the ability to save money on its operations, to avoid market costs, to improve product quality, and possibly to protect its technology from imitation by rivals. Market power is also created when firms have strong ties between their assets for which no market prices exist – where establishing a market price would result in high search and transaction costs, so firms vertically integrate rather than remain separate businesses. A cooperative M-form similar to that described in association with the related constrained firm supports a vertical integration strategy (see Figure 8.4 or Slide 20).

Limitations of Vertical Integration
Outside supplier may produce inputs at a lower cost. Bureaucratic costs may occur. Substantial investments may be required, which lessen flexibility. Changes in demand can create a capacity imbalance and coordination problems. Limitations of Vertical Integration – Although vertical integration can create value, especially through market power, it is not without risks and costs. Discussion points: Internal transactions from vertical integration may be expensive and reduce profitability relative to competitors. Bureaucratic costs may be present with vertical integration. Because vertical integration can require substantial investments in specific technologies, it may reduce the firm’s flexibility, especially when technology changes quickly. It may be necessary to sell a product outside of the firm as well as to the internal division to cover fixed costs or achieve economies to provide a good price to internal customers. Many manufacturing firms are reducing vertical integration as a means of gaining market power. Examples: Intel, Dell, Ford, and General Motors are developing independent supplier networks instead Example: Flextronics represents a new breed of large contract manufacturers leading the revolution in supply-chain management

Simultaneous Operational and Corporate Relatedness
“Diseconomies” of Scope or Competitive Advantage Simultaneous Operational Relatedness and Corporate Relatedness – Simultaneously creating economies of scope by sharing activities (operational relatedness) and transferring core competencies (corporate relatedness) may be difficult to achieve. (Refer to upper right quadrant in Figure 8.3 or on Slide 12.) Discussion points: If the costs associated with managing both types of relatedness exceed the benefits, then firms may experience what is called diseconomies of scope. The implications of this dual strategy: Managing two sources of information is very difficult. More process mechanisms to facilitate integration and coordination may be required. Success is likely to produce a sustainable competitive advantage as imitation becomes difficult. Example: Walt Disney Company

Process and Integrating Mechanisms
Frequent and direct contact between division managers Liaisons Temporary teams or task forces Formal integration departments Process and Integrating Mechanisms – More process mechanisms are required to facilitate the integration and coordination necessary to achieve simultaneous operational relatedness and corporate relatedness. Discussion points: Liaison roles could be established in each division to reduce the amount of time division managers spend integrating and coordinating their unit’s work with the work taking place in other divisions. Temporary teams or task forces may be formed around projects for which success depends on sharing competencies that are embedded within several divisions. Formal integration departments might be established in firms that frequently use temporary teams or task forces. Cooperative or SBU M-forms are most likely to be used to implement a dual strategy, depending on the degree of diversification (i.e., more diversification would likely require the SBU form). Ultimately, a matrix organization may evolve in firms implementing this dual strategy.

Simultaneous Operational and Corporate Relatedness
Key Terms Matrix organization Organizational structure in which a dual structure combines both functional specialization and business product or project specialization. Simultaneous Operational Relatedness and Corporate Relatedness

Unrelated Diversification
Key Terms Financial economies Cost savings realized through improved allocations of financial resources based on investments inside or outside the firm Unrelated Diversification

Financial Economies that Create Value
Efficient internal capital allocation Asset restructuring of purchased corporations Financial Economies that Create Value – Two types of financial economies can create value in an unrelated diversification strategy. Discussion points: Efficient internal capital allocations theoretically reduce total corporate risk by creating a portfolio of businesses with different risk profiles. In a market economy, capital markets are thought to efficiently allocate capital: Through investor ownership of shares of firm equity with high future cash-flow values. Through debt, as bondholders and financiers try to improve the value of their investments by taking stakes in businesses with high growth prospects. In large diversified firms, the corporate office distributes capital to business divisions to create value for the overall company. Restructuring the assets of purchased corporations can increase the profitability of their operations. As in the real estate business, buying assets at low prices, restructuring them, and selling them at a price exceeding their cost generates a positive return on the firm’s invested capital. Some conglomerates have pursued value creation through restructuring firms in this way. Today this strategy is most often pursued by private equity firms, which are like an unrelated diversified firm in that they have large portfolios of acquired businesses that they buy, restructure, and sell to another company or through a public offering.

Efficient Internal Capital Market Allocation
Corporate office distributes capital to business divisions Requires detailed and accurate information External sources of capital have imperfect information about the organization Minor corrections to capital allocations are possible Capital allocations can be based on specific criteria Efficient Internal Capital Market Allocation – Several advantages exist for firms with internal capital markets which fund investments and operations. Discussion points: Because corporate managers have access to more detailed and accurate information about the firm’s businesses, they should be expected to make distributions that result in gains exceeding those that would be made with capital allocated by the capital market. Compared with corporate office personnel, external investors have relatively limited access to internal information and can only estimate divisional performance and future business prospects. Information provided to capital markets through annual reports and other sources may not include negative information, but emphasize only positive prospects and outcomes. Even external shareholders who have access to information have no guarantee of full and complete disclosure. Because it has less accurate information, the external capital market may fail to allocate resources adequately to high-potential investments compared with corporate office investments. External sources of capital have limited ability to understand the dynamics within large organizations. In an internal capital market, the corporate office can fine-tune or correct its capital allocations, whereas intervention from outside the firm would involve significant changes or adjustments, such as bankruptcy or a change in the top management team.

The “Conglomerate Discount”
Stock markets value diversified manufacturing conglomerates at 20% less than the value of the sum of their parts. The discount applies despite economic influences. Only extraordinary manufacturers can defy it (for a while). The “Conglomerate Discount” – Research suggests that in efficient capital markets, the unrelated diversification strategy may be discounted. Discussion points: For years, stock markets have applied a conglomerate discount, valuing diversified manufacturing conglomerates an average of 20% less than the sum of their parts. The discount still applies, in good economic times and bad. Extraordinary manufacturers (like GE) can defy it for a while, but more ordinary ones (like Philips and Siemens) cannot. What is a potential reason for the conglomerate discount? The discount is likely caused by the fact that firms using an unrelated diversification strategy tend to substitute acquisitions for innovation over time. When too many resources are allocated to analyzing and completing acquisitions to further diversify, the firm neglects to allocate appropriate resources to nurture internal innovation.

The Downside of Unrelated Diversification
Attention and resources are focused on acquisitions rather than innovations. Conglomerates in developed countries have short life cycles. The Downside of Unrelated Diversification Discussion points: Despite these challenges, some firms still use it. Large diversified business groups are found in many European countries, where the number of firms using the conglomerate or unrelated diversification strategy has actually increased. Some research suggests that an unrelated diversification strategy may work better in developing economies. Example: Conglomerates continue to dominate private sectors in Latin America, China, Korea, and Taiwan Example: Typically family-controlled, these corporations also account for the greatest percentage of private firms in India Explain why unrelated diversification appears to be a more effective strategy in emerging economies than in developed nations. In developed economies, financial economies are more easily duplicated than are the gains derived from operational relatedness and corporate relatedness, which reduces the long-term competitive advantages of an unrelated diversification strategy. In emerging economies, managers may be more efficient at allocating capital where it can be put to good use than the financial markets in those countries, where the absence of a “soft infrastructure” (including effective financial intermediaries, sound regulations, and contract laws) supports and encourages use of the unrelated diversification strategy. In emerging economies, such as those in India and Chile, diversification increases the performance of firms affiliated with large diversified business groups.

Restructuring Strategy
Success usually calls for a focus on mature, low-technology businesses with more certain demand and less reliance on valuable human resources. Service businesses oriented toward clients are difficult to buy/sell because of their sales orientation and the mobility of sales people. Restructuring – Firms can create financial economies by buying, restructuring, and selling other companies' assets in the external market, but it requires an understanding of significant trade-offs. Discussion points: Because of the uncertainty of demand for high-technology products, decisions about resource allocation become too complex and create information-processing overload on small corporate staffs found in unrelated diversified firms. High-technology businesses also depend heavily on human resources, who may leave or demand higher pay and deplete the value of an acquired firm. Professional service businesses are particularly vulnerable to a loss in valued human resources triggered by an acquisition or a change in ownership. What types of professional service businesses are particularly vulnerable to the loss of valued human resources triggered by an acquisition or a change in ownership? Accounting Law Advertising Consulting Investment banking

The Competitive Form of the Multidivisional Structure
Key Terms Competitive form Organizational structure in which the firm's divisions are completely independent Using the Competitive Form of the Multidivisional Structure to Implement the Unrelated Diversification Strategy – involves the formation of independent divisions

Competitive Form of the Multidivisional Structure
Figure 8.6: Competitive Form of the Multidivisional Structure for Implementation of an Unrelated Strategy Discussion points: Unlike the divisions in the cooperative structure (see Figure 8.4 or Slide 20), the divisions that are part of the competitive structure do not share common corporate strengths. Because strengths aren’t shared in the competitive structure, integrating devices aren’t developed for the divisions to use. The efficient internal capital market that is the foundation for use of the unrelated diversification strategy requires organizational arrangements that emphasize divisional competition rather than cooperation.

Benefits of Internal Competition
Creates flexibility Challenges inertia Motivates employees Benefits of Internal Competition – Specific performance expectations and accountability for independent divisions stimulate internal competition for future resources in the competitive form of the multidivisional structure. Discussion points: Flexibility – Corporate headquarters can have divisions working on different technologies to identify those with the greatest future potential. Resources can then be allocated to the division that is working with the most promising technology to fuel the entire firm’s success. Change – Division heads know that future resource allocations are a product of excellent current performance as well as superior positioning of their division in terms of future performance. Motivation – The challenge of competing against internal peers can be as great as the challenge of competing against external marketplace competitors. The benefits of internal capital allocations or restructuring cannot be fully realized unless divisions are held accountable for their own independent performance.

HQ Role in the Competitive Form of the Multidivisional Structure
Maintains a distant relationship from divisions Primarily uses financial controls to monitor performance Focuses on cash flow, resource allocation, performance appraisal, and the legal aspects of acquisitions Headquarters’ Role in the Competitive Form of the Multidivisional Structure for Implementation of an Unrelated Strategy Discussion points: Maintains a distant relationship to avoid intervention in divisional affairs Audits operations Disciplines managers whose divisions perform poorly Uses organizational controls (primarily financial controls) to emphasize and support internal competition among separate divisions and to form the basis for allocating corporate capital based on division performance Uses strategic controls to set rate-of-return targets Uses financial controls to monitor divisional performance relative to those return targets Allocates cash flow on a competitive basis, rather than automatically returning cash to the division that produced it Focuses on performance appraisal, resource allocation, and legal aspects associated with acquisitions to verify that the firm’s portfolio of businesses will lead to financial success

Characteristics of Various Structural Forms
Structural Characteristics Cooperative M-Form SBU M-Form Competitive M-Form Type of Strategy Related- Constrained Related- Linked Unrelated Diversification Degree of Centralization Centralized at Corporate Office Partially Centralized in SBUs Decentralized to Divisions Characteristics of Various Structural Forms Use of Integrating Mechanisms Extensive Moderate Nonexistent

Characteristics of Various Structural Forms
Structural Characteristics Cooperative M-Form SBU M-Form Competitive M-Form Divisional Performance Appraisal Subjective Strategic Criteria Strategic & Financial Criteria Objective Financial Criteria Divisional Incentive Compensation Characteristics of Various Structural Forms Linked to Corporate Performance Linked to Corporate SBU & Division Performance Linked to Division Performance

Value-Neutral Incentives to Diversify
External Antitrust regulation Tax laws Internal Low performance Cash flow uncertainty Synergy Risk management Value-Neutral Diversification: Incentives and Resources – Firms sometimes select a diversification corporate strategy that is not designed to create value. Value-Neutral Incentives to Diversify – Both external and internal factors influence managerial decisions to diversify. Discussion points: Antitrust regulation Designed to reduce mergers that establish excessive market power Increasing scrutiny over current volume of merger and acquisition activity Commission created by the Antitrust Modernization Act of 2002 – examines existing antitrust laws and will impact diversification strategies of U.S. firms in years to come Tax laws Individual tax rates for capital gains and dividends – shareholder incentive to increase diversification before 1986, but deterrent after 1986 1986 Tax Reform Act – diminished some of the tax advantages of diversification through acquisitions Low performance Low returns related to increased levels of value-neutral diversification Manager willingness to take higher risks or unusual steps to improve performance Example: Seven Network Ltd. Uncertain future cash flows Defensive strategy sometimes employed as a product line matures or when long-term survival is threatened Example: PepsiCo Defensive strategy sometimes employed by small firms whose long-term survival is threatened Example: BGC Partners Inc. Synergy Realized by achieving economies of scope More likely when business units are highly related and managers integrate activities across the firm Risk management Increase risk of large-scale performance problems from greater relatedness and integration – synergy produces interdependence among business units, which reduces firm flexibility to respond to changing external conditions Difficulties in one area of the firm reverberate in another or across the entire firm in tightly-linked businesses Increased risk averse tendencies and behavior in managers – result in decisions which constrain sharing or diversifying activity

Resources and Diversification
Financial Resources Tangible Resources Intangible Resources Resources and Diversification – Sufficient resources are necessary for a firm to implement a diversification strategy. Although financial, intangible, and tangible resources can all facilitate successful diversification, they vary in their ability to create value. The degree to which resources are valuable, rare, costly to imitate, and nonsubstitutable (see Chapter 4) influence their ability to create value through diversification. Discussion points: Financial resources Free cash flows are a financial resource that may be used to diversify the firm. These types of financial resources tend to be highly visible to competitors and thus more imitable and less likely to create value over the long term. Intangible resources They tend to be more valuable because they are hard for competitors to recognize or imitate. Examples: Knowledge, skills, and relationships with stakeholders They tend to be more flexible. Excess capacity of intangible resources can often be used to diversify. Example: Excess capacity in a sales force may be used to sell similar products They can encourage even more diversification. Example: Tacit knowledge Tangible resources They tend to be less flexible assets. Excess capacity can often only be used for closely related products, especially those requiring highly similar manufacturing technologies. Example: Plant and equipment necessary to produce a good or service They may create resource interrelationships in production, marketing, procurement, and technology (activity sharing), which also reduces flexibility.

Managerial Motives to Diversify
Increased compensation Reduced employment risk Empire building Value-Reducing Diversification: Managerial Motives to Diversify – Motivations behind some managers' decisions to diversify are unrelated to value-neutral reasons (i.e., incentives and resources) and value-creating reasons (e.g., economies of scope). Discussion points: Desire for increased compensation for handling the complexities and difficulties of managing larger firms Belief that diversified firms will not be impacted by performance peaks and valleys that lead to job loss Pursuit of greater responsibility and self-importance Internal governance mechanisms – prevent behavior that is not in the best interests of the firm (discussed further on Slide 51 and extensively in Chapter 11)

Governance Mechanisms
Internal corporate governance External market for corporate control External market for managerial talent Manager reputation Governance Mechanisms – available to protect shareholder interests from self-interested managerial tendencies to diversify too much Discussion points: Internal governance mechanisms available to monitor manager decisions and ensure the best interests of the firm are being sought. Board of director vigilance Monitoring by owners Long-term oriented executive compensation When internal governance mechanisms are weak, the external market for corporate control may act as a disciplining force for top managers. Loss of adequate internal governance may result in poor performance, thereby triggering a threat of takeover. A takeover may improve efficiency by replacing ineffective managerial teams. If current managers feel vulnerable to this sort of discipline, they may pursue defensive tactics, known as poison pills, to fend off an acquisition and preserve their jobs. (Other defensive tactics are discussed in Chapter 11.) Example: The “golden parachute” A threat of external governance, although restraining managers, does not flawlessly control managerial motives for diversification. Managers’ desire to retain a strong reputation can reduce (self-check) their propensity to engage in self-serving behavior at the expense of the organization.

Summary Model - Relationship between Diversification and Performance
Figure 8.7: Summary Model of the Relationship between Diversification and Firm Performance – The level of diversification that can be expected to have the greatest positive effect on performance is based partly on how the interaction of value-creating influences, value-neutral influences, and value-reducing influences affects the adoption of particular diversification strategies. Discussion points: The greater the incentives and the more flexible the resources, the higher the level of expected diversification. Financial resources (the most flexible) should have a stronger relationship to the extent of diversification than either tangible or intangible resources. Tangible resources (the most inflexible) are useful primarily for related diversification. In summary: Diversification allows a firm to create value by productively using excess resources. Consistent with all strategies presented in Part III of the text, a diversification strategy can be expected to enhance performance only when the firm has the competitive advantages required to successfully use the strategy. For diversification strategies, the firm should possess the competitive advantages needed to form and manage an effective portfolio of businesses and to restructure that portfolio as necessary.

Ethical Question Assume that you overheard the following statement: “Those managing an unrelated diversified firm face far more difficult ethical challenges than do those managing a dominant business firm.” Based on your reading of this chapter, do you believe this statement true or false? Why?

Ethical Question Is it ethical for managers to diversify a firm rather than return excess earnings to shareholders? Provide reasoning to support your answer.

Ethical Question Are ethical issues associated with the use of strategic controls? With the use of financial controls? If so, what are they?

Ethical Question Are ethical issues involved in implementing the cooperative and competitive M-forms? If so, what are they? As a top-level manager, how would you deal with them?

Ethical Question What unethical practices might occur when a firm restructures the assets it has acquired through its diversification efforts? Explain.

Ethical Question Do you believe that ethical managers are unaffected by the managerial motives to diversify discussed in this chapter? If so, why? In addition, do you believe that ethical managers should help their peers learn how to avoid making diversification decisions on the basis of the managerial motives to diversify (e.g., increased compensation)? Why or why not?

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