Professional Documents
Culture Documents
Continued...
Horizontal Diversification
Horizontal Scope
Business Area #1 Business Area #2 Business Area #3
Parts Activity
Activity #1
#1 Activity #1
Manufacturing Activity #2
Activity #2 Activity #2
Another way to think about “Business Area” = Firm owns/operates these steps in the value chain
is to think of each as a different “Product”
a3
a1+x1 a2+x2 a3 +x3
Assume:
• 1-3 = different divisions (e.g., GE: lightbulbs, jet engines,
healthcare (e.g., MRI Machines)
• a = value created if stand-alone businesses
• x = additional value created from operating businesses
within one firm (note that x may = 0 or be negative in value)
• C = cost (e.g., organizational, bureaucratic costs)
a3
a1+x1 a2+x2 a3 +x3
∑ xi > C HQ
Economies of Scale
Economies of Scope
Economies of Scale
Average Cost Curve
$/Unit $/Unit
AC AC
Quantity Quantity
MC ↓ Minimum
AC ↓ Efficient
Scale
• Truck
• Driver
• Fuel
Diseconomies of Scale
Spreading specialized resources too thin
• Sometimes successful individuals believe that having
achieved success in one venue they can duplicate it
elsewhere
“I alone can
fix• it!”
Restaurants
• TV Shows
• Cookbooks
Gordon Ramsay
Master Chef
Diseconomies of Scale
Bureaucracy
• “Red tape” and other barriers to getting things done
• Incentives within firms can be muted
• Information flow can be slow
• Departments fighting for scarce corporate resources
can work at cross-purposes
Economies of Scope
Economies of scope exist if the firm achieves
savings as it increases the variety of goods or
services it produces:
Example
Suppose:
Specialized Firm 1: C(5,0) = 150; C(10,0) = 320
Specialized Firm 2: C(0,50) = 100; C(0,100) = 210
Merged Firm: (C5,50) = 240; C(10,100) = 500
Does this production technology exhibit
economies of scope? Economies of scale?
Economies of scale:
C(5,0) = 150; C(10,0) = 320. Doubling output from 5
to 10 more than doubles cost, so no
Economies of scope:
C(5,50) = 240 < C(5,0) + C(0,50). Producing 5 of x
and 10 of y in merged firm < 150 + 100, so yes
Reasons to be Skeptical
Diversifying Shareholder’s Portfolios
• More easily done with lower cost by purchasing
diversified mutual funds
Identifying Undervalued Firms
• Requires that the market valuation of the target
firm is incorrect and that no other investors have
identified this fact
ABSTRACT
Acquiring-firm shareholders lost 12 cents around acquisition announcements per
dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001,
whereas they lost $7 billion in all of the 1980s, or 1.6 cents per dollar spent. The 1998
to 2001 aggregate dollar loss of acquiring-firm shareholders is so large because of a
small number of acquisitions with negative synergy gains by firms with extremely
high valuations. Without these acquisitions, the wealth of acquiring-firm sharehold-
ers would have increased. Firms that make these acquisitions with large dollar losses
perform poorly afterward.
757
The Ownership Test
• Must we own it to get benefits?
• What are the alternatives?
• Can contracts work?
• No one-size fits all formula
• Must explain reasons thoughtfully
Example 1:
Better Off Test
Costs (↓):
• Economies of Scope
• Infrastructure already exists to support bottling, distribution, and
marketing
• Costs spread out over more products
• Ordering high volumes of similar ingredients used in Coca-Cola
and Minute Maid concentrates
WTP (↑):
• Promotion and Bundling
• Coca-Cola already has shelf space
• Will expand product line for stores using Coca-Cola products
• Brand Recognition
• Customers are more willing to pay for products that have the
Coca-Cola brand name
Example 1:
Ownership Test
Costs (↓):
• Contracts
• Could contract with other firm to use Coke branding
on other product lines
• But can be expensive and taxing to have to renegotiate
a contract every couple of years
• Hold-up concerns
Other Considerations
• Bargaining Power
• With more variety in its product line Coca-Cola will
have more bargaining power when negotiating contracts
• Can market its brand as having more to offer than its
competitors
Example 2:
Better Off Test
Costs (↓):
• Parts Standardization
• Economies of scale and scope (spread R&D and
marketing costs over more units)
• Software standardization (iTunes, App Store)
WTP (↑):
• Compatibility among products
• Better customer service and support (Genius Bar)
• Enhance learning curve for consumer
Example: Current iPhone users don’t have to learn
how to use an iPad
Example 2:
Ownership Test
Costs (↓):
• Would lose some economies of scope in a contract
• With a contract to distribute an Android phone or Sony
MP3 player, Apple would not be able to spread some
centralized costs (like R&D) over those units
Other Considerations
• Avoid potential holdup from renegotiating contracts every
few years (e.g., if Apple were to distribute Android phones)
Merger Challenges
#1 #2
+
• Unwieldy“It’s
Corporate Structure
a dream deal… (2 Presidents)
creat[ing] the greatest
• Forced move from Boston to Cincy led the
consumer products company in world.”
to exits
• Cultural clashes
• Competing salesforces
Merger Challenges
Key Points
Key Points
Sources of economic efficiency
include:
Economies of Scale
• Arise due to “indivisibilities” and fixed
costs
• Most likely in capital intensive production
• Economies of Scope
• “Leveraging capabilities and resources”
Key Points
The more related the diversification,
the more likely that value will be
added:
• Similar technologies (same R&D lab,
different uses)
• Similar distribution channels
• Similar customer needs
• Similar “managerial logic” or expertise