1. © Ram Mudambi, Temple University and University of Reading, 2006. Lecture 7 Corporate Strategy: Vertical Integration, Diversification, and Strategic Alliances BA 951 Policy Formulation and Administration

2. © Ram Mudambi, Temple University and University of Reading, 2006. 9-2 Outline  Organizing the firm  Transaction costs analysis  Vertical integration - VI  Types of VI  Creating value through VI  Outsourcing  Diversification  Related and unrelated diversification  Entering new markets

3. © Ram Mudambi, Temple University and University of Reading, 2006. 9-3 The Value Chain UpstreamDownstream

4. © Ram Mudambi, Temple University and University of Reading, 2006. 9-4 The Boundaries of the Firm – 1 Organizational Form Hierarchies ‘Visible Hand’ – Alfred Chandler Markets ‘Invisible Hand’ – Adam Smith ContractsSpot MarketsVertical Integration

5. © Ram Mudambi, Temple University and University of Reading, 2006. 9-5 Firm Organization – A simple view STAGE 1 Upstream STAGE 2 Downstream Firm 1Market transactions Firm 2 Intra-firm transactions VALUE CHAIN

6. © Ram Mudambi, Temple University and University of Reading, 2006. 9-6 Stages in the Raw-Material-to-Consumer Value Chain in the Personal Computer Industry End userDistributionAssembly Intermediate manufacturer Raw materials Examples: Dow Chemical Union Carbide Kyocera Examples: Intel Seagate Micron Examples: Apple Compaq Dell Gateway Examples: Computer World Office Max Staples IBM

7. © Ram Mudambi, Temple University and University of Reading, 2006. 9-7 The Boundaries of the Firm – 2 Spot Markets  When the buyer and seller of an input meet, exchange, and then go their separate ways Contracts  A legal document that creates an extended relationship between a buyer and a seller Vertical Integration  When a firm shuns other suppliers and chooses to produce an input internally

8. © Ram Mudambi, Temple University and University of Reading, 2006. 9-8 Transaction Costs – 1 The costs of using the market mechanism Coordination costs  Process C & C (inventories, information) Costs based on asymmetric information  Policing costs  Bargaining costs

9. © Ram Mudambi, Temple University and University of Reading, 2006. 9-9 Transaction Costs – 2 Asymmetric Information Policing costs: Moral hazard & adverse selection  Effort; Quality; Property rights; Restrictive agreements Bargaining costs  Asset specificity and hold-up  New products and processes  Economies of scope

10. © Ram Mudambi, Temple University and University of Reading, 2006. 9-10 Optimal Firm Organization Substantial specialized investments relative to contracting costs? Spot Exchange No Complex contracting environment relative to costs of integration? Yes Vertical Integration Yes Contract No

11. © Ram Mudambi, Temple University and University of Reading, 2006. 9-11 Vertical Integration: Forward, backward, full, partial PARTIAL INTEGRATION FULL INTEGRATION

12. © Ram Mudambi, Temple University and University of Reading, 2006. 9-12 Vertical Integration Greater attraction of VI when  Thin markets; TSAs necessary; Demand uncertainty Difficulty of monitoring/writing contracts  VI  Limited information; Environmental uncertainty Taxes/regulations on market contracts  VI to circumvent taxes/regulations VI difficult when  Scale differential in stages; Strategic dissimilarities in resources/capabilities/success factors

13. © Ram Mudambi, Temple University and University of Reading, 2006. 9-13 Creating Value Through Vertical Integration Advantages of a vertical integration strategy:  Builds entry barriers to new competitors by denying them inputs and customers.  Facilitates investment in efficiency-enhancing assets that solve internal mutual dependence problems.  Protects product quality through control of input quality and distribution and service of outputs.  Improves internal scheduling (e.g., JIT inventory systems) responses to changes in demand.

14. © Ram Mudambi, Temple University and University of Reading, 2006. 9-14 Creating Value Through Vertical Integration Disadvantages of vertical integration  Cost disadvantages of internal supply purchasing.  Remaining tied to obsolescent technology.  Aligning input and output capacities with uncertainty in market demand is difficult for integrated companies.

15. © Ram Mudambi, Temple University and University of Reading, 2006. 9-15 Bureaucratic Costs and the Limits of Vertical Integration The costs of running an organization rise with integration due to:  The lack of an incentive for internal suppliers to reduce their operating costs.  The lack of strategic flexibility in times of changing technology or uncertain demand. Bureaucratic costs reduce the value of vertical integration.

16. © Ram Mudambi, Temple University and University of Reading, 2006. 9-16 Designing Vertical Relationships Degree of Commitment LowHigh Formal Low High Spot Markets Informal relationships Long Term Contracts Agency Franchises Partnerships Joint ventures VI

17. © Ram Mudambi, Temple University and University of Reading, 2006. 9-17 Alternatives to Vertical Integration: Cooperative Relationships and Strategic Outsourcing Short-term contracts and competitive bidding  Strong competitors attempt to control supplier costs with minimal-length contracts. Poor treatment of suppliers raises competitor input costs. Strategic alliances and long-term contracting  Long-term contracts foster cooperative relationships.  Alliances reduce the need for vertical integration.

18. © Ram Mudambi, Temple University and University of Reading, 2006. 9-18 Building Long-Term Cooperative Relationships Hostage taking  Both parties arrange to become mutually dependent on each other, fostering a cooperative relationship.  A believable commitment to support the long-term relationship (a credible commitment). Maintaining market discipline requires:  Periodic renegotiation of the contractual relationship.  Developing a parallel sourcing policy with two suppliers for critical inputs. Discourage opportunism Maintain dynamic efficiency Maintain dynamic efficiency

19. © Ram Mudambi, Temple University and University of Reading, 2006. 9-19 Hostages – creating trust in one-shot games*  Providing a hostage–  Providing a hostage –  Reduces the incentive for the trustee (hostage-giver) to abuse the trust  Reduces the cost of trust abuse to the trustor (hostage-taker)  Provides a signal of the trustee’s (hostage-giver) quality and intentions  However –  Ugly princess problems, etc. * Raub and Weesie (2000)

20. © Ram Mudambi, Temple University and University of Reading, 2006. 9-20 Strategic Outsourcing and the Virtual Corporation

21. © Ram Mudambi, Temple University and University of Reading, 2006. 9-21 Strategic Outsourcing Key to strategic outsourcing  Identifying the company’s basis of competitive advantage and value creation. Outsourcing advantages  Efficient subcontractors reduce overall costs.  Better product differentiation.  Allows for the concentration of available resources.  Firm becomes more flexible and responsive. Outsourcing disadvantages  Failure to learn from outsourced activity.  Too much dependence on a single supplier.  Danger of outsourcing value creation activities leading to competitive advantage.

22. © Ram Mudambi, Temple University and University of Reading, 2006. 9-22 Diversification Related diversification  Entry into new business activity based on shared commonalities in the components of the value chains of the firms – good strategic or resource fit  A strategy-driven approach to creating shareholder value Unrelated diversification Unrelated diversification  Entry into a new business area that has no obvious relationship with any area of the existing business.  A finance-driven approach to creating shareholder value

23. © Ram Mudambi, Temple University and University of Reading, 2006. 9-23 When to diversify? When it makes sense to diversify depends on  Growth potential in present business  Attractiveness of opportunities to transfer existing competencies to new businesses  Potential cost-saving opportunities to be realized by entering related businesses  Availability of adequate financial and organizational resources  Managerial expertise to cope with complexity of operating a multi-business enterprise

24. © Ram Mudambi, Temple University and University of Reading, 2006. 9-24 Why diversify?  To build shareholder value  Make 2 + 2 = 5  Diversification can increase shareholder value if it passes Porter’s three tests: 1.Attractiveness test 2. Cost of entry test 4 Must not capitalize all future profits 3. Better-off test 4 Combined unit must be better than the ones it replaces

25. © Ram Mudambi, Temple University and University of Reading, 2006. 9-25 Resource fit at Procter & Gamble Sharing resources

26. © Ram Mudambi, Temple University and University of Reading, 2006. 9-26 Strategic fit at Philip Morris Transferring competencies

27. © Ram Mudambi, Temple University and University of Reading, 2006. 9-27 Unrelated diversification  Entry into a new business area that has no obvious relationship with any area of the existing business.  A finance-driven approach to creating shareholder value

28. © Ram Mudambi, Temple University and University of Reading, 2006. 9-28 These capabilities help each business unit perform at a higher level than if it operated as an individual company: These capabilities help each business unit perform at a higher level than if it operated as an individual company: 1. Entrepreneurial capabilities – encourage risk taking while managing & limiting the amount of risk undertaken 2. Organizational design – create structure, culture, and control systems that motivate and coordinate employees 3. Superstrategic capabilities – effectively manage the managers of the business units and helping them think through strategic problems General organizational competencies are skills of a company’s top managers and functional experts that transcend individual functions or business units. These managerial skills are often not present, as they are rare and difficult to develop and put into action. Exploiting general organizational competencies

29. © Ram Mudambi, Temple University and University of Reading, 2006. 9-29 Finance-driven diversification often dissipates value Diversifying to pool risks Diversifying to pool risks  Stockholders can diversify their own portfolios at lower costs than the company can.  This represents an unproductive use of resources as profits can be returned to shareholders as dividends.  Research suggests that corporate diversification is not an effective way to pool risks. Diversifying to achieve greater growth Diversifying to achieve greater growth  Growth on its own does not create value.  Business cycles of different industries are inherently difficult to predict. Based on a large number of academic studies: Extensive diversification tends to reduce, rather than improve, company profitability.

30. © Ram Mudambi, Temple University and University of Reading, 2006. 9-30 Sony’s web of corporate-level diversification strategy

31. © Ram Mudambi, Temple University and University of Reading, 2006. 9-31 Summary  Corporate strategy – an application of Transactions Cost Economics (TCE)  The boundaries of the firm  The make-or-buy decision  The value chain and Vertical integration  Strategic outsourcing  Diversification