Professional Documents
Culture Documents
8: Corporate Strategy: Vertical integration
and diversification
8.1 What is corporate strategy?
What does strategy formulation center around?
Strategy formulation centers around the key questions of where and how to compete.
When do managers have to formulate a corporate strategy?
Managers have to formulate a corporate strategy as the firm grows and expands its business
activities through seeking out new markets both by offering new products and services and by
competing in different geographies.
What does a corporate strategy have to be in order for a firm to gain and sustain competitive
advantage?
To gain a sustain a competitive advantage, a corporate strategy must align with and
strengthen a firm’s business strategy, whether it is differentiation, cost leadership, or an
integration strategy.
What is corporate strategy?
Corporate strategy comprises the decisions that senior management makes and the
goaldirected actions it takes in the quest for competitive advantage in several industries and
markets simultaneously.
To which question does the corporate strategy provide the answers to?
Corporate strategy provides answers to the key question of “Where to compete?”.
What does corporate strategy determine?
Corporate strategy determines the boundaries of the firm along 3 dimensions:
Industry value chain
Products and services
Geography (regional, national, or global markets)
What do executives have to decide?
Executives must decide:
In what stages of the industry value chain to participate (this determines the firm’s vertical
integration)
What range of products and services to offer (this determines the firm’s level of
diversification)
Where to compete in terms of regional, national, or international markets (this determines
the firm’s geographic scope)
Where does the responsibility of corporate strategy rest?
The responsibility of corporate strategy rests with the CEO.
What are the fundamental corporate strategy decisions?
The fundamental corporate strategy decisions are:
Where to compete in terms of industry value chain
Where to compete in terms of products and services
Where to compete in terms of geography
What are the underlying strategic management concepts that guide the discussion of vertical
integration, diversification, and geographic competition?
The underlying strategic management concepts that guide the discussion of vertical
integration, diversification, and geographic competition are:
Core competencies: they are unique strengths embedded deep within a firm.
Economies of scale: they occur when a firm’s average cost per unit decreases as its
output increases.
Economies of scope: they are the savings that come from producing 2 or more
outputs or providing different services at less cost than producing each individually.
Transaction costs: they are costs associated with an economic exchange.
8.2 The boundaries of a firm:
What’s the critical challenge in corporate strategy?
The critical challenge in corporate strategy is determining the boundaries of the firm so that it
is more likely to gain and sustain competitive advantage.
What is the transaction cost economics framework?
The transaction cost economics framework explains and predicts the boundaries of the firm.
What do insights gained from transaction cost economics help managers with?
Insights gained from transaction cost economics help managers decide what activities to do
inhouse versus what services and products to obtain from the external market.
What is the key insight of the transaction cost economics?
The key insight of transaction cost economics is that different institutional arrangements
(markets vs firms) have different costs attached.
What are the transaction costs?
Transaction costs are all internal and external costs associated with an economic exchange,
whether it takes place within the boundaries of a firm or in markets.
What do total costs of transacting consist of?
The total costs of transacting consist of external and internal transaction costs.
What are external transaction costs and when are they incurred?
External costs are the costs of searching for a firm or an individual with whom to contract, and
then negotiating, monitoring, and enforcing the contract.
External transaction costs occur when companies transact in the open market.
What are internal transaction costs and when are they incurred?
Internal transaction costs include costs pertaining to organizing an economic exchange within
a firm (the costs of recruiting and retaining employees for example).
Internal transaction costs occur within the firm.
FIRMS VS MARKETS: MAKE OR BUY?
When should firms vertically integrate?
Firms should vertically integrate when the costs of pursuing an activity inhouse are less than
the costs of transacting for that activity in the market.
Firms would vertically integrate by owning production of the needed inputs or channels for the
distribution of outputs.
Advantages and disadvantages of firms and markets organizing economic activity?
What is the principalagent problem?
The principalagent problem is a situation in which an agent performing activities on behalf of
a principle pursues his/her own interests.
What are information asymmetries?
Information asymmetries are situations in which one party is more informed than the other
because of the possession of private information.
ALTERNATIVES ON THE MAKEORBUY CONTINUUM
1. Short term contracts:
What are short term contracts?
When engaging in short term contracts, a firm sends out requests for proposal (RFPs) to
several companies, which initiates competitive bidding for contracts to be awarded with a
short duration, generally less than one year.
What are the benefits of short term contracts?
The benefits of short term contracts:
they allow a somewhat longer planning period than individual market transactions
the buying firm can often demand lower prices due to the competitive bidding process.
What is the drawback of short term contracts?
The drawback of short term contracts is that firms responding to the RFP have no incentive to
make any transactionspecific investments due to the short duration of the contract.
2. Strategic alliances:
What are strategic alliances?
Strategic alliances are voluntary agreements between firms that involve the sharing of
knowledge, resources, and capabilities with the intent of developing processes, products, or
services to lead to competitive advantage.
What is the benefit of strategic alliances?
Strategic alliances can facilitate investments in transactionspecific assets without
encountering the internal transaction costs involved in owning firms in various stages of the
industry value chain.
What are some forms of strategic alliances?
Longterm contracts:
Long term are a form of strategic alliance and they are contracts that work much like
shortterm contracts but with a duration generally greater than one year. Long term contracts
help overcome the drawback of short term contracts concerning the lack of incentive of firms
to make transactionspecific investments.
A form of longterm contracts includes franchising whereby a franchisor grants a franchisee
the right to use the franchisor’s trademark and business processes to offer goods and
services that carry the franchisor’s brand name; the franchisee in turn pays an
upfrontbuyinlump sum and a percentage of revenue.
Equity Alliances:
Equity alliances are another form of strategic alliances and they involve a partnership in which
at least one partner takes partial ownership in the other partner: a partner purchases an
ownership share by buying stock, and thus making an equity investment.
A type of equity alliance includes a credible commitment which is a longterm strategic
decision that is both difficult and costly to reverse.
Joint venture:
A joint venture is another form of strategic alliance in which two or more partners create and
jointly own a new venture.
3. Parentsubsidiary relationship:
What is parentsubsidiary relationship?
The partsubsidiary relationship describes the most integrated alternative to performing an
activity within one’s own corporate family. The corporate parent owns the subsidiary and can
direct it via command and control.
8.3 Vertical integration along the industry value chain
What is the 1st key question managers ask when formulating corporate strategy?
The 1st key question managers ask when formulating corporate strategy is: “In what stages of
the industry value chain should the firm participate?”.
What is vertical integration?
Vertical integration is the firm’s ownership of its production of needed inputs or of the
channels by which it distributes its outputs.
How can vertical integration be measured?
Vertical integration can be measured by a firm’s value added: what percentage of a firm’s
sales is generated within the firm’s boundaries.
What does the degree of vertical integration tend to correspond to?
The degree of vertical integration tends to correspond to the number of industry value chain
stages in which a firm directly participates.
What is industry value chain?
Industry value chain is the representation of the transformation of raw materials into finished
goods and services along distinct vertical stages, each of which typically represents a distinct
industry in which a number of different firms are competing.
What does each stage of the vertical value chain represent?
Each stage of the vertical value chain represents a distinct industry in which a number of
different firms are competing.
What defines the vertical boundaries of a firm?
The boundaries of a firm are determined by their corporate strategy by which the firm decides
where in the industry value chain to participate.
TYPES OF VERTICAL INTEGRATION
Backward integration: it involves moving ownership of activities upstream to the originating
inputs of the value chain.
Forward integration: it involves moving ownership of activities closer to the end customer.
Degrees on integration:
Fully vertically integrated: when all activities are conducted within the boundaries of the firm.
Vertically disintegrated with a low degree of vertical integration: When firms focus only on
one or a few stages of the industry value chain.
→ Not all industry value chain stages are equally profitable.
BENEFITS AND RISKS OF VERTICAL INTEGRATION
Benefits of vertical integration:
Securing critical supplies and distribution channels
Lowering costs
Effectively planning and responding to changes in demand
Increasing operational efficiency
Controlling prices, quality, and distribution
Improving quality
Facilitating scheduling and planning
Facilitating investments in specialized assets (specialized assets are unique with high
opportunity cost, they have significantly more value in their intended use than in their
nextbestuse).
Forms of specialized assets:
Site specificity: assets are required to be colocated.
Physical asset specificity: assets whose physical and engineering properties are designed to
satisfy a particular customer.
Humanasset specificity: investments made in human capital to acquire unique knowledge
and skills.
Risks of vertical integration:
Increasing costs (knowing that there will always be a buyer for their products since they are
not exposed to market competition, lowers firms’ incentives to reduce costs)
Reducing quality (knowing that there will always be a buyer for their products since they are
not exposed to market competition, can also reduce the incentive to improve quality or come
up with innovative new products)
Reducing flexibility especially when firms are faced with changes in the external environment
Increasing the potential for legal repercussions
ALTERNATIVES TO VERTICAL INTEGRATION
1. Taper integration:
What is taper integration?
Taper integration is a way of orchestrating value activities in which a firm is backwardly
integrated, but it also relies on outsidemarket firms for some of it suppliers, and/or is
forwardly integrated but also relies on outsidemarkets firms for some of its distribution.
What are the benefits of taper integration?
It exposes inhouse suppliers and distributors to market competition so that performance
comparisons are possible.
It enhances a firm’s flexibility.
It allows firms to combine internal and external knowledge, possibly having the path for
innovation.
2. Strategic outsourcing:
What is strategic outsourcing?
Strategic outsourcing involves moving one or more internal value chain activities outside the
firm’s boundaries to other firms in the industry value chain.
8.4 Corporate diversification: expanding beyond a single market
What are the 2nd and 3rd questions managers ask when formulating corporate strategy?
→ The 2nd question managers ask when formulating corporate strategy relates to the firm’s
degree of diversification: “What range of products and services should the firm offer?”.
→ The 3rd question managers ask when formulating corporate strategy concerns where to
compete in terms of regional, national or international markets. This determines the firm’s
geographic focus.
What does a firm that engages in diversification do?
A firm that engages in diversification increases the variety of products and services it offers or
market and the geographic regions in which it competes.
What does a nondiversified company focus on?
A nondiversified company focuses on a singlemarket.
What does a diversified company focus on?
A diversified company focuses on competing in several different markets simultaneously.
What are the general diversification strategies?
Product diversification strategy: A firm that is active in several different product markets.
Geographic diversification strategy: A firm that is active in several different countries.
Productmarket diversification strategy: A company that pursues both a product and a
geographic diversification strategy.
TYPES OF CORPORATE DIVERSIFICATION
1. Singlebusiness: A firm that derives 95% or more of its revenues from one business.
2. Dominant business: A firm that derives between 70% and 95% of its revenues from a single
business, but it pursues at least one other business activity. The dominant business shares
competencies in products, services, technology, or distribution.
3. Related diversification strategy: A firm that derives less than 70% of its revenues from a
single business activity and obtains revenues from other lines of business linked to the
primary business activity.
→ There are 2 types of related diversification strategy:
Relatedconstrained diversification: When business executives consider business
opportunities only where they can leverage their existing competencies and resources.
Relatedlinked diversification: When executives consider new business activities that
share only a limited number of linkages with their existing business.
4. Unrelated diversification strategy: A firm that derives less than 70% of its revenues
from a single business, and there are a few, if any, linkages among its businesses.
What is a conglomerate?
A conglomerate is a company that combines 2 or more strategic business units under
one overarching corporation and follows an unrelated diversification strategy.
LEVERAGING CORE COMPETENCIES FOR CORPORATE DIVERSIFICATION
What is the core competencemarket matrix?
The core competencemarket matrix is a framework that guides corporate diversification
strategy by analyzing possible combinations of existing/new core competencies and
existing/new markets.
CORPORATE DIVERSIFICATION AND FIRM PERFORMANCE
When does corporate diversification enhance firm performance?
Corporate diversification enhances firm performance when its value creation is greater than
the costs it incurs.
When are firms unable to create additional value?
Firms that pursue an unrelated diversification are often unable to create additional value and
they experience a diversification discount.
What is a diversification discount?
A diversification discount is a situation in which the stock price of highly diversified firms is
valued at less than the sum of their individual business units.
When is an unrelated diversification strategy beneficial?
An unrelated diversification strategy is advantageous in emerging economies where they may
help firms gain and sustain competitive advantage because it allows conglomerates to
overcome institutional weaknesses.
When are firms able to create additional value?
Firms that pursue related diversification are more likely to improve their performance and they
create a diversification premium.
What is a diversification premium?
A diversification premium is a situation in which the stock price of relateddiversification firms
is valued at greater than the sum of their individual business units.
What are high and low levels of diversification associated with?
High and low levels of diversification are generally associated with lower overall firm
performance: Firms that focus on a single business as well as companies that pursue
unrelated diversification often fail to achieve additional value.
What are moderate levels of diversification associated with?
Moderate levels of diversification are associated with higher firm performance: Firms that
compete in single markets could potentially benefit from economies of scope by leveraging
their core competencies into adjacent markets.
What must diversification do to enhance firm performance?
For diversification to enhance firm performance it must do at least one of the following:
Provide economies of scale which reduces cost
Exploit economies of scope which increases value
Reduce costs and increase value
What can firms benefit from to enhance their firm performance?
Firms can benefit from financial economies to enhance their firm performance.
Financial economies include:
Restructuring
Using internal capital markets
RESTRUCTURING
What is restructuring?
Restructuring describes the process of recognizing and divesting business units and activities
to refocus a company in order to leverage its core competencies more fully.
How can corporate executives restructure the portfolio of their firm’s businesses?
Corporate executives can restructure the portfolio of their firm’s business by using the Boston
Consulting Group (BCG) growthshare matrix.
What is the Boston Consulting Group (BCG) growthshare matrix?
The Boston Consulting Group (BCG) growthshare matrix is a corporate planning tool in which
the corporation is viewed as a portfolio of business units, which are represented graphically
along relative market share (horizontal axis) and speed of market growth (vertical axis). SBUs
are plotted into 4 categories:
Dog
Cash cow
Star
Question mark
USING INTERNAL CAPITAL MARKETS
When can internal capital markets be a source of value creation?
Internal capital markets can be a source of value creation in a diversification strategy if the
conglomerate’s headquarters does a more efficient job of allocating capital through its
budgeting process than what could be achieved in external capital markets.
What is the benefit of internal capital markets?
Internal capital markets may allow the company to access capital at a lower cost.
DIVERSIFICATION STRATEGIES AND PERFORMANCE ENHANCEMENT
Which diversification strategies are most likely to enhance corporate performance?
A strategy of relatedconstrained or relatedlinked diversification is more likely to enhance
corporate performance than either a single or dominant level of diversification or an unrelated
level of diversification. The reason is that the sources of value creation include not only
restructuring, but also the potential benefits of economies of scope and scale. However, to
create additional value the benefits from these sources (restructuring and economies of scope
and scale) must outweigh their costs.
Which additional costs does a relateddiversification strategy entail?
A relateddiversification strategy entail 2 additional types of costs:
Coordination costs: they are a function of the number, size, and types of businesses
that are linked to one another.
Influence costs: they occur due to political maneuvering by managers to influence
capital and resource allocation and the resulting inefficiencies stemming from
suboptimal allocation of scarce resources.
8.5 Implications for the strategist
What does an effective corporate strategy do?
An effective corporate strategy increases a firm’s chances of gaining and sustaining as
competitive advantage.
Along which 3 dimensions do executives make important choices when formulating corporate
strategy?
When formulating corporate strategy, executives make important choices along 3 dimensions
that determine the boundaries of the firm:
The degree of vertical integration: in what stages of the industry value chain to participate
The type of diversification: what range of products and services to offer
The geographic scope: where to compete
→ Corporate strategy needs to be dynamic over time.
What do firms tend to do as they grow?
As they grow, firms tend to diversify and globalize to capture additional growth opportunities.