Chapter 6: Corporate-Level Strategy

Chapter 6
Corporate-Level Strategy

Remember that in Chapters 4 and 5 the discussion centered on selecting and implementing a
business-level or competitive strategy - actions a firm should take to compete in a single
industry or product market - and the actions and responses that affect the competitive
dynamics of a single industry or product market.

In contrast, when a firm diversifies its operations by operating business in several industries,
corporate-level strategy becomes a primary focus. This means that a diversified firm has two
levels of strategy: business-level (or competitive) and corporate-level (or company-wide), the
latter of which entails selecting a strategy that focuses on the selection and management of a
mix of businesses.

Corporate-level strategies detail actions taken to gain a competitive advantage through the
selection and management of a mix of businesses competing in several industries or product
markets. Primary concerns of corporate-level strategy are:
 What businesses should the firm be in?
 How should the corporate office manage its group of businesses?
 How can the corporation as a whole add up to more than the sum of its business parts?

The ultimate measure of the value of a firm’s corporate-level strategy is that the businesses in
the firm’s portfolio are worth more under current management (and by following the firm’s
corporate-level strategy) than they would be under different ownership or management.

*Note
The unique organizational structure that is required by this strategy is discussed in
Chapter 11.

LEVELS OF DIVERSIFICATION

Diversified firms vary according to two factors:

 The level of diversification
 Connection or linkages between and among business units

Figure Note
Five levels of diversification are listed and each is defined in Figure 6.1. It is
recommended that you refer students to Figure 6.1 as you begin to discuss levels of
diversification in more detail.

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FIGURE 6.1
Levels and Types of Diversification

Figure 6.1 should be used as a reference point during your discussion of diversification
types. Students’ attention should be directed to inter-unit linkages depicted on the right side
of Figure 6.1.

Levels and types of diversification defined in Figure 6.1 and discussed in more detail in the
next sections of this chapter are:

Low levels of diversification:

 Single business
 Dominant business

Moderate to high levels of diversification:

 Related-constrained diversification
 Related-linked diversification (mixed related and unrelated)

Very high levels of diversification:

 Unrelated diversification

LOW LEVELS OF DIVERSIFICATION

Firms that follow single- or dominant-business strategies have low levels of diversification.
A single business is a firm where more than 95 percent of its revenues are generated by the
dominant business. Firms such as the Wrigley Co. are examples of single-business firms.
Wrigley Co. has dominated the global gum-related industry as the largest manufacturer of
chewing gum, specialty gums, and gum bases. Its brands, Doublemint, Spearmint, and Juicy
Fruit, led the market.

*Note
Wrigley has chosen to focus its attention on its historic (since 1915) core business. It
competes effectively (and successfully) against large diversified firms, including RJR
Nabisco (Beechnut and Carefree) and Warner-Lambert (Trident and Dentyne).
Focusing on its core business has enabled Wrigley’s top-level managers to maintain
strategic control of the business. As a result, Wrigley maintains a clear, strategic
focus and is highly competitive in its core business (though it is beginning to
diversify somewhat in recent years).

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A dominant business is a firm that generates between 70 and 95 percent of its sales within a
single business area.

*Note
UPS is an example of a dominant business firm because, although 22 percent of
revenue comes from international operations, it generates 60 percent of its revenue
from its US package delivery service.

Moderate and High Levels of Diversification

A related-diversified firm is one that earns at least 30 percent of its revenues from sources
outside the dominant business and whose units are related to each other - e.g., by the sharing
of resources and by product, technological, and distribution linkages.

Related-constrained firms also earn at least 30 percent of their revenues from the dominant
business, and all business units share product, technological, and distribution linkages, as
illustrated in Figure 6.1. Kodak, Procter & Gamble, and Campbell’s Soup Company are
related-constrained firms.

Related linked (mixed related and unrelated) firms, such as Campbell Soup and P&G,
generate at least 30 percent of their total revenues from the dominant business, but there are
few linkages between key value-creating activities.

Unrelated-diversified (or highly diversified) firms do not share resources or linkages. Firms
that pursue unrelated diversification strategies - often known as conglomerates - include
United Technologies, Samsung, and Textron.

Though there are more unrelated diversified firms in the US than in most other countries,
conglomerates (firms following unrelated diversification strategies) dominate the private
sector economy in Latin America and in several emerging economies (such as China, South
Korea, and India).

*Note
Many firms that have at one time pursued unrelated diversification strategies are
restructuring to focus on a less diversified mix of businesses, a move that may reflect:
 An inability to manage high levels of diversification
 Recognition that a lower level of diversification would improve the match between
the firm’s core competencies and environmental opportunities and threats

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REASONS FOR DIVERSIFICATION

*Note
The content of this section of the chapter generally is limited to a discussion of Table
6.1, which provides some of the reasons that firms implement diversification
strategies. The various value-related motives for diversification are discussed in more
detail in the remainder of the chapter as specific diversification strategies are
discussed.

Firms may implement diversification strategies to enhance or increase the strategic

competitiveness of the overall organization, and thus the value of the firm increases.

Value can be created through either related or unrelated diversification if the strategies
enable the firm’s mix of businesses to increase revenues and/or decrease costs when
implementing business-level strategies.

Firms may implement diversification strategies that are either value neutral or result in
devaluation of the firm. They may attempt to diversify:
 To neutralize a competitor’s market power
 To reduce managers’ employment risk (i.e., risk of the CEO being unemployed when a
dominant-business firm fails as compared to this risk when a single business fails when it
is only one part of a diversified firm)
 To increase managerial compensation because of the positive relationships between
diversification, firm size, and compensation

Table Note
Reasons or motives for implementing diversification strategies are presented in Table
6.1. They are discussed in the following chapter sections.

TABLE 6.1
Reasons for Diversification

Firms follow diversification strategies for many reasons. These can be grouped into three
broad sets of motives:

Motives to create value:

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 Economies of scope (related diversification) through activity-sharing and the transfer

of core competencies
 Market power motives (related diversification) by vertical integration or blocking
competitors via multipoint competition
 Financial economies motives (unrelated diversification) to improve efficiency of
capital allocation through an internal capital market or by restructuring the portfolio
of businesses

Motives that are value-neutral with respect to strategic competitiveness are used to:
 avoid violations of antitrust regulations
 take advantage of tax incentives
 overcome low performance
 reduce the uncertainty of future cash flows
 reduce overall firm risk
 exploit tangible resources
 exploit intangible resources

Managerial or value-reducing motives are used to:

 diversify managerial employment risk
 increase managerial compensation

Figure Note
As illustrated in Figure 6.2, firms seek to create value by sharing activities and
transferring skills or corporate core competencies.

FIGURE 6.2
Value-Creating Strategies of Diversification: Operational and Corporate Relatedness

Firms seek to create value from economies of scope through two basic kinds of operational
economies: sharing activities and transferring skills (corporate core competencies). However,
the levels of the two will lead to different corporate strategies with different advantages
associated with each.

Combinations of Economies Resulting Strategy Economies for Advantage

High operational/ Vertical integration Market power

Low corporate
Low operational/ Unrelated diversification Financial economies
Low corporate
High operational/ Both operational and
Rare capability and can create

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High corporate relatedness diseconomies of scope

High operational/ Related-linked Economies of scope
High corporate diversification

VALUE-CREATING DIVERSIFICATION:
RELATED CONSTRAINED AND RELATED LINKED DIVERSIFICATION

Firms implement related diversification strategies in order to achieve and exploit economies
of scope and build a competitive advantage by building on existing resources, capabilities,
and core competencies.

For firms that operate in multiple industries or product markets, economies of scope
represent cost savings attributed to entering an additional business and sharing activities or
using capabilities and core competencies developed in another business that can be
transferred to a new business without significant additional costs.

The difference between activity sharing and core competence sharing is based on how
different resources are used jointly to create economies of scope:
 To create economies of scope, tangible resources such as plant and equipment or other
business-unit physical assets often must be shared. Less tangible resources, such as
manufacturing know-how, also can be shared.
 Know-how transferred between separate activities with no physical or tangible resource
involved is a transfer of a corporate-level core competence, not an operational sharing of
activities.

A key to creating value through sharing essentially separate activities is to share know-how
or skills rather than physical or tangible resources.

Operational Relatedness: Sharing Activities

Because all of its businesses share product and technological and distribution linkages,
activity sharing is common among related-constrained diversified firms, such as Procter &
Gamble.

P&G’s paper towel and disposable diaper units can share many activities due to their
common characteristics:
 Each business uses paper products as a key input, so they are likely to share key facets of
procurement and inbound logistics, as well as primary manufacturing activities.

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 Because all three businesses produce consumer products that are sold in similar (if not the
same) outlets, they will likely share outbound logistics, distribution channels, and possibly
sales forces.

Firms also must recognize that although activity sharing is intended to reduce costs through
achieving economies of scope, there are incremental costs related to sharing activities (costs
that are created by sharing). These costs must be recognized and taken into account when
planning activity sharing or scope economies may not result.

Activity sharing can also result in new risks since closer linkages between business units
create tighter interrelationships and/or interdependencies. For example, if two business units
share production facilities and sales in one unit’s products decline to the point that revenues
no longer cover the costs of shared production, then each business unit’s ability to achieve
strategic competitiveness may be adversely affected.

Regardless of the risks that accompany activity sharing, research indicates that activity
sharing - or the potential for activity sharing - can increase the value of the firm. Some
findings are summarized here:
 Acquiring firms in the same industry - a horizontal acquisition - where sharing of
activities and resources is implemented results in improved performance and higher
returns to shareholders.
 Selling off units where resource sharing is a possible source of economies of scope results
in lower returns to shareholders than does selling off business units unrelated to the firm’s
core business.
 Firms with more related units have less risk.

CORPORATE RELATEDNESS: TRANSFERRING OF CORE COMPETENCIES

Over time, most firms develop intangible resources that can become a foundation for
corporate-level core competencies that are competitively valuable. In diversified firms, these
core competencies generally are made up of managerial and technical knowledge,
experiences, and expertise.

There are at least two ways the related linked diversification strategy helps firms create
value:
 Any costs related to developing the competence have already been incurred
 Competencies based on intangible resources, such as marketing know-how, are less visible
and therefore are more difficult for competitors to understand and imitate

*Note

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As an example, Philip Morris acquired Miller Brewing at a time when competition in

the brewing industry was focused on establishing efficient operations.
 Philip Morris used marketing competencies coming from the competitive cigarette
industry.
 No brewing firm used marketing capabilities as a source of competitive advantage.
 By transferring its marketing competence to Miller, Philip Morris introduced
marketing as a source of competitive advantage to the brewing industry.
 Because its primary competitor, Anheuser-Busch, was unable to develop the
capability to respond for several years, Miller’s strategic action (mostly effective
advertising campaigns) let Miller achieve a temporary competitive advantage and
earn above-average returns.

Other firms have focused on transferring a variety or resources/capabilities across businesses

in their control.
 Virgin has transferred its marketing skills across travel, cosmetics, music, drinks, and
other retail businesses.
 Thermo Electron has employed its entrepreneurial skills in starting up a number of new
ventures and maintaining a new venture network.
 Honda has developed and transferred across its businesses its expertise in small and now
larger engines for a number of vehicle types - from motorcycles and lawnmowers to its
range of automotive products.

One way that firms can facilitate the transfer of competencies between or among business
units is to move key personnel into new management positions in the receiving unit.
However, research suggests that transferring expertise often does not lead to performance
improvement.

*Note
Expertise transfers may be difficult or costly because of the following:
 A business-unit manager of an older division may be reluctant to transfer key
people who have accumulated knowledge and experience critical to the business
unit’s success.
 Managers able to facilitate the transfer of core competencies may come at a
premium.
 The key people involved may not want to transfer.
 The top-level managers from the transferring division may not want the
competencies transferred to a new division to fulfill the firm’s diversification
objectives.

Market Power

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Firms also may implement related diversification strategies in an attempt to gain market
power.
 Market power exists when a firm is able to sell its products at prices above the existing
competitive level or decrease the costs of its primary activities below the competitive
level, or both.
 Market power through diversification may be gained through multipoint competition, a
condition where two or more diversified firms compete in the same product areas or
geographic markets.

Firms also might gain market power by following a vertical integration strategy, which
exists when a company produces its own inputs (backward integration) or owns its own
distribution system (forward integration). A vertical integration strategy may be motivated by
a firm’s desire to strengthen its position in its core business relative to competitors by
increasing its market power.

Vertical integration enables a firm to increase market power by:

 Developing the ability to save on its operations
 Avoiding market costs
 Improving product quality
 Protecting its technology from imitation by rivals
 Having strong ties between their assets for which no market prices exist

Note
Establishing a market price would result in high search and transaction costs, so firms seek
to vertically integrate rather than remain separate businesses.

*Note
As an example of vertical integration, CVS, a Walgreen’s competitor, recently
merged with Caremark, a pharmaceutical benefits manager. This represents a vertical
move for CVS from a retail-only firm to broader-based health care. However, CVS
risks alienating Walgreen’s, which may then choose to align with another benefits
manager.

However, like other strategies that create value and aid the firm in achieving strategic
competitiveness, vertical integration may not be the perfect answer because of risks and costs
that accompany it.
 Outside suppliers may be able to provide inputs at a lower cost (and, possibly also of a
higher quality).

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 The costs of coordinating vertically integrated activities may exceed the value of the
control realized.
 Vertical integration may result in the firm losing strategic competitiveness if the internal
unit does not keep up with changes in technology.
 To vertically integrate, the firm may need to build a facility with capacity that exceeds the
ability of its internal units to absorb, forcing the selling unit to sell to outside users in
order to achieve scale economies.

Many manufacturing firms no longer pursue vertical integration. In fact, deintegration is the
focus of most manufacturing firms, such as Intel and Dell, and even among large automobile
companies, such as Ford and General Motors, as they develop independent supplier
networks. Solectron Corp., a contract manufacturer, represents a new breed of large contract
manufacturers that is helping to foster this revolution in supply-chain management. Such
firms often manage their customers’ entire product lines, and offer services ranging from
inventory management to delivery and after-sales service.

E-commerce allows vertical integration to turn into “virtual integration,” permitting closer
relationships with suppliers and customers through electronic means of integration. This lets
firms reduce transaction costs while boosting supply-chain management skills and tightening
inventory control.

Ericsson’s Substantial Market Power

Ericsson is the largest global manufacturer of mobile telecommunications networks

equipment (with 38 percent global market share in 2012). It has a presence in 108 countries
and their business unit support system provides charging and billing service for 1.6 billion
people. Ericsson has three primary businesses: business unit networks, business unit support
systems, and business unit global services. As these businesses are all related to some degree
it is clear that Ericsson is following a related-constrained diversification strategy. Ericsson is
facing formidable competition from Huawei and Samsung. To stay ahead of competitors
Ericsson makes ‘major’ investments in R&D to develop new technologies and products. It
estimates that 5G wireless, federated networked cloud services, and 3D visual
communications will be needed in the near future and it is positioning itself to be a leader in
all of these areas.

Simultaneous Operational and Corporate Relatedness

As Figure 6.2 suggests, some firms simultaneously seek operational and corporate
relatedness to create economies of scope. Because simultaneously managing two sources of
knowledge is very difficult, such efforts often fail, creating diseconomies of scope.

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A Bit of Disney History: A Mini-Case

By using operational relatedness and corporate relatedness, Disney made $3 billion

on the 150 products that were marketed with its movie, The Lion King. Sony’s Men
in Black was a super hit at the box office and earned $600 million, but box office and
video revenues were practically the entire success story. Disney was able to
accomplish its great success by sharing activities regarding The Lion King theme
within its movie, theme park, music, and retail products divisions, while at the same
time transferring knowledge into these same divisions, creating a music CD, Rhythm
of the Pride Lands, and producing a video, Simba’s Pride. In addition, there were
Lion King themes at Disney resorts and Animal Kingdom parks. However, it is
difficult for analysts from outside the firm to fully assess the value-creating potential
of the firm pursuing both operational relatedness and corporate relatedness. As such,
Disney’s assets as well as other media firms such as AOL Time Warner have been
discounted somewhat because “the biggest lingering questions is whether multiple
revenue streams will outpace multiple-platform overhead.”

UNRELATED DIVERSIFICATION

Firms implementing unrelated diversification strategies hope to create value by realizing

financial economies, which are cost savings realized through improved allocations of
financial resources based on investments inside or outside the firm.

Financial economies are realized through internal capital allocations (that are more efficient
than market-based allocations) and by purchasing other companies and then restructuring
their assets.

Efficient Internal Capital Market Allocation

Although capital generally is efficiently distributed in a market economy through the capital
markets, large diversified firms may be able to distribute capital more efficiently to divisions
and thus create value for the overall organization. This generally is possible because:
 Corporate offices have more detailed and accurate information on actual division
performance and future prospects.
 Investors have limited access to internal information and generally can only estimate
division performance.

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One implication of increased access to information is that the internal capital market may be
able to allocate resources between investment opportunities more accurately (and at more
adequate levels) than the external capital market. There are several reasons for this:
 Information disclosed to capital markets through annual reports may not fully disclose
negative information, reporting only positive prospects while meeting all regulatory
disclosure requirements.
 External capital sources have limited knowledge of what is taking place within large,
complex firms.
 While owners have access to information, full and complete disclosure is not guaranteed.
 An internal capital market may enable the firm to safeguard information related to its
sources of competitive advantage that otherwise might have to be disclosed. Through
disclosure, the information could become available to competitors who might use the
information to duplicate or imitate the firm’s sources of competitive advantage.

Other advantages of internal capital markets:

 Corrective actions may be more efficiently structured and underperforming management
can be more effectively disciplined through the internal capital market than through
external capital market mechanisms. Thus, the internal capital market is more capable of
taking specific, finely tuned corrective actions compared to the external market.
 If external intervention is required, only drastic alternatives generally are available, such
as forcing the firm into bankruptcy or forcing the removal of top-level managers.
 With an internal capital market, the corporate office can adjust managerial incentives or
can suggest strategic changes to make the desired corrections.

Research suggests that in efficient capital markets, the unrelated diversification strategy may
be discounted. Stock markets have applied what some have called a “conglomerate discount”
reflected in the valuation of diversified manufacturing conglomerates at 20 percent less, on
average, than the value of the sum of their parts.

The Achilles heel of the unrelated diversification strategy is that conglomerates in developed
economies have a short life cycle because financial economies are more easily duplicated
than are the gains derived from operational relatedness and corporate relatedness. This is less
of a problem in emerging economies, where the absence of a “soft infrastructure” (e.g.,
effective financial intermediaries, sound regulations, and contract laws) supports and
encourages use of the unrelated diversification strategy. In fact, in emerging economies such
as those in India and China, diversification increases performance of firms from large
diversified business groups.

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Restructuring of Assets

A restructuring approach to creating value in an unrelated diversified firm involves the

buying and selling of other companies (and their assets) in the external market.

Following the asset sale and layoffs, underperforming divisions (those acquired in the
purchase) are sold to other firms and remaining divisions are placed under strict budgetary
controls accompanied by the reporting of cash inflows and outflows to the corporate office.

Tyco International: A Question of Ethics

Under former CEO Dennis L. Kozlowski, Tyco International, Ltd. excelled at
exploiting financial economies through restructuring. Tyco focused on two types of
acquisitions: platform, which represented new bases for future acquisitions, and add-
on, in markets where Tyco currently had a major presence. As with many unrelated
diversified firms, Tyco acquired mature product lines. However, completing large
numbers of complex transactions resulted in accounting practices that are not as
transparent as stakeholders now demand. In fact, many of Tyco’s top executives,
including Kozlowski, were arrested for fraud, and the new CEO, Edward Breen, has
been restructuring the firm’s businesses to overcome “the flagrant accounting, ethical,
and governance abuses of his predecessor.” Actions being taken in firms such as Tyco
suggest that firms creating value through financial economies are responding to the
demand for greater transparency in their practices. Responding in this manner will
provide the information the market needs to accurately estimate the value the
diversified firm is creating when using the unrelated diversification strategy.

Success in implementing unrelated diversification strategies usually requires that firms:

 Focus on firms in mature, low technology industries
 Avoid service businesses because of their client- or sales-orientation

VALUE-NEUTRAL DIVERSIFICATION: INCENTIVES AND RESOURCES

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As mentioned earlier, not all firms diversify to increase the value of the overall firm. Some
attempts at diversification are implemented to prevent the value of the firm from decreasing.

Incentives to Diversify

In most instances, managers have a choice regarding the level of diversification that their
firm should implement. In addition, both the external and internal environments are sources
of incentives or reasons that managers might use to justify diversification choices.

Antitrust Regulation and Tax Laws

In the 1960s and 1970s, government policies - in the form of antitrust enforcement and tax
laws - provided US firms with incentives to diversify the mix of businesses controlled by the
firm. Because of these policies, the vast majority of mergers during the period represented
unrelated diversification. They were classified as conglomerate mergers.

Conglomerate mergers (unrelated diversification) were encouraged in large part by the

Celler-Kefauver Act, which discouraged horizontal and vertical mergers. That is, federal
legislation (and enforcement by the US Department of Justice) discouraged market power
boosting via related diversification. As one measure of the effectiveness of official
“discouragement,” almost 80 percent of mergers during 1973–1977 were conglomerate
mergers.

During the 1980s, enforcement of antitrust laws slackened and firms chose to implement
horizontal merger strategies (or mergers with firms in the same [or a related] line of
business).

At the same time, investment bankers aggressively promoted merger and acquisition activity
to the extent that many acquisitions were classified as unfriendly or hostile takeovers.

Firms that had diversified (in an unrelated fashion) in the 1960s and 1970s began to
implement strategies to refocus their firms, and an era of restructuring began.

When firms generate more cash than they are able to profitably reinvest in the firm’s primary
activities, the excess funds, or “free cash flows,” should be returned to shareholders in the
form of dividends. However, during the 1960s and 1970s, dividends were taxed more heavily
than ordinary personal income. (Dividends are taxed twice: once when the firm pays taxes on
its operating income and a second time when net income is paid out to shareholders in the
form of dividends as shareholders pay a tax on dividends received at their personal income
tax rate.)

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In 1986, the perspective shifted once again, as the Tax Reform Act of 1986 reduced the top
personal income tax rate from 50 percent to 28 percent. Capital gains rules were changed so
that capital gains would be taxed at the ordinary personal income tax rate, and personal
interest deductibility was eliminated.

These changes in federal tax laws that affected individual tax rates for dividends and capital
gains (with the former decreasing and the latter increasing), have created an incentive for
shareholders to favor reduced levels of diversification (after 1986) unless funded by tax-
deductible debt.

The recent changes recommended by the Financial Accounting Standards Board (FASB),
regarding the elimination of the “pooling of interests” method for accounting for the acquired
firm’s assets and the elimination of the write-off for research and development in process,
reduce some of the incentives to make acquisitions, especially related acquisitions in high-
technology industries.

Although there was a loosening of federal regulations in the 1980s and a retightening in the
late 1990s, a number of industries have experienced increased merger activity due to
industry-specific deregulation activity, including banking, telecommunications, oil and gas,
and electric utilities.

Low Performance

When firms are able to earn above-average or superior returns in a single business, they have
little incentive to diversify (as previously discussed in the Wrigley Co. example).

However, low performance may provide an incentive for diversification as a low-performing

firm may become more risk seeking in an effort to improve overall firm performance.

In response to low returns (or poor performance), firms often choose to seek greater levels of
diversification. At some point, however, poor performance slows the pace of diversification,
often resulting in restructuring divestitures of businesses to lower the level of firm
diversification.

Strategic Focus Coca-Cola’s Diversification to Deal with Its Reduced Growth in Soft
Drinks
Changing consumer tastes have caused The Coca-Cola Company to diversify its drink
offerings in order to combat falling revenue and profits, which dropped noticeable from 2013
to 2015. The company is responding to a consumer demand for “healthier, tastier, more

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unique and less mass market” products. Among its strategies, Coca-Cola launched its
“venture and emerging brands” (VEB) to cultivate relationships and ultimately to purchase
some of these small start-ups. Through this process, it now owns Fuse Tea, Zibo coconut
water, and the organic brand Honest Tea. It has also tinkered with other approaches such as
its Freestyle soda fountain machine “that offers more than 100 different drink choices; some,
such as Orange Coke, aren’t available in cans.” It now has these drink machines in fast food
chains such as Five Guys and Burger King. This approach has consistently raised drink sales
by double-digits every year, mostly because the volume is higher.

Figure Note
The relationship between level of performance and diversification (for firms that
already have diversified) is illustrated in Figure 6.3.

FIGURE 6.3
The Curvilinear Relationship Between Diversification and Performance

As Figure 6.3 illustrates, firms exhibiting low performance in their dominant businesses
often implement related-constrained diversification strategies that, to a certain point, result in
increased performance.

In search of even higher performance, related-diversified firms may continue to diversify, but
elect to acquire unrelated businesses.

When a firm’s core competencies do not create value in unrelated businesses, firm
performance decreases.

*Note
DaimlerChrysler had to deal with the challenges that were created partly by its failed
diversification efforts. The firm faced the task of reversing this strategy, which started
with the sale of its electronics operation, divesting a 34 percent stake in Cap Gemini
(a French software services company), and liquidating Fokker (a Dutch aircraft
manufacturer). The firm also eliminated a layer of upper-level executives and shaped
a culture of responsibility and entrepreneurship, with innovation (using cross-
functional project teams) as the force supporting the new culture.

Uncertain Future Cash Flows

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Firms also may implement diversification strategies when their products reach maturity (in
the product life cycle) or are threatened by external factors that the firm cannot overcome.
Thus, firms may view diversification as a survival strategy.

In the 1960s and 1970s, railroads diversified because of the threat from the trucking industry
to reduce demand for rail transportation.

Uncertainty can be derived from supply, demand, and distribution sources. For example, at
one time PepsiCo acquired Quaker Oats to fortify its growth with Gatorade and healthy
snacks, on the projection that these products would experience greater growth rates than
Pepsi’s soft drinks.

Synergy and Firm Risk Reduction

As you will recall from the discussion earlier in this chapter, firms that diversify in pursuit of
economies of scope take advantage of linkages between primary value-creating activities to
realize synergy from sharing.

Synergy exists when the value created by business units working together exceeds the value
the units create when working independently.

These linkages - and the inter-relatedness or interdependencies that result - produce joint
profitability between business units, and the flexibility of the firm to respond may be
constrained, increasing the risk of failure.

To eliminate this risk, firms may do one of two things:

 Operate in more certain environments to reduce the level of technological change and
choose not to pursue potentially profitable, yet unproven product lines
 Constrain or reduce the level of activity sharing, thus forgoing the potential benefits of
synergy

However, these decisions could lead to further diversification

 To diversify into industries where more certainty exists
 To additional, but unrelated diversification

Research suggests that a firm using a related diversification strategy is more careful in
bidding for new businesses, whereas a firm pursuing an unrelated diversification strategy
may be more likely to overprice its bid, because an unrelated bidder may not have full
information about the acquired firm. However, firms using either a related or an unrelated
diversification strategy must understand the consequences of paying large premiums.

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Resources and Diversification

In addition to having incentives to diversify, a firm also must possess the correct mix of
resources - tangible, intangible, or financial - that makes diversification feasible.

However, remember that resources create value when they are rare, valuable, costly to
imitate, and non-substitutable. In other words, resources that do not have these
characteristics can be more easily duplicated (or acquired) by competitors. Thus, it may
not be possible to create value using such resources.

The excess capacity of tangible resources may be used to justify diversification, especially
when the firm sees opportunities for activity sharing. However, value-creation may be
possible only in related diversification. Remember, using tangible resources also creates
interrelationships through its activity linkages in production, marketing, procurement, and
technology, and these interdependencies often reduce firm flexibility and may, in fact,
increase the risk of failure.

Ideally, as discussed earlier, a firm’s intangible resources - because they are less visible and
less understood by competitors - should be used to facilitate and create value from
diversification.

VALUE-REDUCING DIVERSIFICATION:
MANAGERIAL MOTIVES TO DIVERSIFY

Some managers may be motivated to diversify their firms even if there are no incentives, and
a lack of resources can constrain inclinations toward diversification. Managers’ motives for
diversification include the following:
 Diversification may enable managers to reduce employment risk (the risks related to the
loss of their jobs or a reduction in compensation) because by diversifying the firm (i.e., by
adding a number of additional businesses), managers may be able to diversify their
employment risk, as long as profitability does not decline greatly as a result of the
diversification.
 Diversification allows managers to increase their compensation because of positive
correlations between diversification, firm size, and executive compensation (based on the
logic that large firms are more difficult to manage).

*Note

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Corporate governance is covered in much greater detail in Chapter 10. The discussion
in this chapter is introductory in nature.

If properly structured and used, governance structures - such as the firm’s board of directors,
performance monitoring, executive compensation limits, and the market for corporate control
- may provide the means to exert control over managers’ tendencies to over diversify because
of self-interest motives.

However, if a firm’s internal governance structure is not strong (or functions imperfectly);
managers may diversify the firm beyond the optimal level. As a result, the overall firm may
fail to earn average returns (illustrated by Figure 6.3).

When the internal governance structure fails to restrain managers from over diversifying (and
performance declines), external governance mechanisms, such as the takeover market, may
come into play.

In the takeover market (also known as the market for corporate control), improved levels of
diversification (and improved performance) are achieved by replacing incumbent or current
managers and restructuring the firm. However, managers may be able to avoid takeovers
through defensive tactics, such as golden parachutes, poison pills, greenmail, or increasing
the firm’s leverage ratio.

In spite of the preceding comments, most managers take positive strategic actions (such as
those related to diversification) that result in overall firm profitability and contribute to the
strategic competitiveness of the firm.

In addition to the internal and external governance mechanisms discussed, managers also
may be provided with incentives to limit firm diversification to optimal levels by a concern
for their personal reputations in the labor market and the related market for managerial talent
(also known as the market for managers).

One signal that the firm may be over diversified is when operating diversified businesses
reduces, rather than improves, the overall performance of the firm.

Figure Note
It is useful to note that two factors appearing in Figure 6.4 are discussed in greater
detail in future chapters. Governance structures in Chapter 10 and strategy
implementation is covered in Chapter 11. The overall relationship between reasons
for diversification, governance, and firm performance is provided in Figure 6.4.

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FIGURE 6.4
Summary Model of the Relationship Between Diversification and Firm Performance

As shown in Figure 6.4, a firm’s diversification strategy is determined by several inter-

related factors,
 Value-creating influences (economies of scope, market power, financial economics)
 Value-neutral influences (resources and incentives)
 Value-reducing influences (managerial motives to diversify)
 Internal governance
 Capital market intervention and the market for managerial talent

The relationship between diversification strategy and firm performance is moderated by:
 Capital market intervention and the market for managerial talent with which the
diversification strategy is implemented
As noted in this chapter, diversification strategies can be used to enhance a firm’s strategic
competitiveness and enable it to earn above-average returns. However, positive outcomes
from diversification are possible only when the firm achieves the appropriate level of
diversification, given its resources, capabilities, and core competencies, and taking into
account the external environmental opportunities and threats.

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