UNIT 5: CORPORATE STRATEGY AND METHODS OF DEVELOPMENT

1. What is corporate strategy?

Strategy formulation centers around the key questions of where and how to compete. Business
strategy concerns the question of how to compete in a single product market. As discussed in
unit 4 the two generic business strategies that firms can pursue their quest for competitive
advantage are to increase differentiation (while containing cost) or lower costs (while
maintaining differentiation).

As firms grow, they are frequently expanding their business activities through seeking new
markets both by offering new products and services and by competing in different
geographies.

Corporate strategy comprises the decisions that leaders make and the goal-directed actions it
takes in the quest for competitive advantage in several industries and markets simultaneously.
It provides answers to the key question of where to compete.

Corporate strategy determines the boundaries of the firm along three dimensions:

Vertical integration (along the industry value chain), diversification (of products and services),
and geographic scope (regional, national, or global markets).

Executives must determine their corporate strategy by answering three questions:

1. In what stages of the industry value chain should the company participate (vertical

integration)? The industry value chain describes the transformation of raw materials

into finished goods and services along distinct vertical stages.

2. What range of products and services should the company offer (diversification)?

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3. Where should the company compete geographically in terms of regional, national, or
international markets (geographic scope)?

2. Vertical integration along the industry value chain

The first key question when formulating corporate strategy is: In what stages of the industry
value chain should the firm participate? Deciding whether to make or buy the various activities
in the industry value chain involves the concept of 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.

The degree of vertical integration tends to correspond to the number of industry value chain
stages in which a firm directly participates.

Backward vertical integration: Owning inputs of the value chain

Forward vertical integration: Owning activities closer to the customer

The figure depicts a generic industry value chain. Industry value chains are also called vertical
value chains because they depict the transformation of raw materials into finished goods and
services along distinct vertical stages.

Each stage of the vertical value chain typically represents a distinct industry in which a number
of different firms are competing. This is also why the expansion of a firm up or down the
vertical industry value chain is called vertical integration.

Vertical value chain of a cellphone:

Stage 1. The raw materials to make your cell phone, such as chemicals, ceramics, metals, oil
for plastic, and so on, are commodities. In each of these commodity businesses are different
companies, such as DuPont (U.S.), BASF (Germany), Kyocera (Japan), and ExxonMobil (U.S.).

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Stage 2. Intermediate goods and components such as integrated circuits, displays,
touchscreens, cameras, and batteries are provided by firms such as ARM Holdings (UK), Jabil
Circuit (U.S.), Intel (U.S.), LG Display (Korea), Altek (Taiwan), and BYD (China).

Stage 3. Final assembly and Manufacturing. Original equipment manufacturing firms (OEMs)
such as Flextronics (Singapore) or Foxconn (China) typically assemble cell phones under
contract for consumer electronics and telecommunications companies such as Apple (United
states); Samsung and LG (BOTH South Korea), Huawei and Oppo Electronisc (Both china) and
others.

Stages 4 and 5. Marketing and sales. to get wireless data and voice service, you pick a service
provider such as AT&T, Sprint, T-Mobile, or Verizon in the United States; América Móvil in
Mexico; Oi in Brazil; Orange in France; T-Mobile or Vodafone in Germany; NTT Docomo in
Japan; Airtel in India; or China Mobile in China, among others.

Along the industry value chain, firms pursue varying degrees of vertical integration in their
corporate strategy. Some firms participate in only one or a few stages of the industry value
chain, while others comprise many if not all stages. In this figure, note HTC’s transformation
from a no-name OEM (original equipment manufacturing firms) manufacturer in stage 2 of the
value chain to a player in the design, manufacture, and sale of smartphones (stages 1 and 3). It
now offers a lineup of innovative and high-performance smartphones under the HTC label.
Firms regularly start out as OEMs and then vertically integrate along the value chain in either a
backward and/or forward direction. Over time, HTC was able to upgrade its capabilities from
merely manufacturing smartphones to also designing products. In doing so, HTC engaged in
backward vertical integration—moving ownership of activities upstream to the originating
inputs of the value chain. Moreover, by moving downstream into sales and increasing its
branding activities, HTC has also engaged in forward vertical integration—moving ownership of
activities closer to the end customer.

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The transaction cost economics explains and predicts the boundaries of the firm and can help
managers decide what activities to do in-house versus what services and products to obtain
from the external market.

- External transaction costs: When companies transact in the open market

The costs of searching for a firm or an individual with whom to contract

Negotiating, monitoring, and enforcing the contract.

- Internal transaction costs: Occur within the firm as well

The costs of recruiting and retaining employees; paying salaries and benefits; setting up a shop
floor; providing office space and computers; and organizing, monitoring, and supervising work.

They also include administrative costs associated with coordinating economic activity between
different business units of the same corporation such as transfer pricing for input factors, and
between business units and corporate headquarters including important decisions pertaining
to resource allocation, among others.

Internal transaction costs tend to increase with organizational size and complexity.

BENEFITS OF VERTICAL INTEGRATION

● Reducing transaction costs which are those arising from contracting with outside suppliers
or customers.

● Facilitating investments in specialized assets. They can come in two forms:

Physical-asset specificity—assets whose physical and engineering properties are designed to

satisfy a particular customer, example, the case of winery that has a many brands of wine,
unique equipment such as molds and a specific process is required to produce the different
and trademarket bottle shapes.

Human-asset specificity— investments made in human capital to acquire unique knowledge

and skills, such as mastering the routines and procedures of a specific organization, which are
not transferable to a different employer ( case of HTC).

● Improving quality by entering industries at other stages of the value-added chain, a

company can often enhance the quality of the products in its core business and strengthen its
differentiation advantage.

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● Facilitating scheduling and planning and creation of a community of knowledge.

● Securing critical supplies and distribution channels this may be an important aspect when
the bargaining power of customers or suppliers imposes harsh conditions for the firm or
generates uncertainty in procurement or marketing.

RISKS OF VERTICAL INTEGRATION

● Increasing costs In-house suppliers tend to have higher cost structures because they are
not exposed to market competition. Knowing there will always be a buyer for their
products reduces their incentives to lower costs. Also, suppliers in the open market,
because they serve a much larger market, can achieve economies of scale that elude in-
house suppliers (Example of GM)

● Reducing quality because a higher degree of vertical integration also can reduce the
incentive to increase quality or come up with innovative new products. Moreover, given
their larger scale and greater exposure to more customers, external suppliers often can
reap higher learning effects, and so develop unique capabilities or quality improvements.

● Reducing flexibility especially when faced with changes in the external environment such
as fluctuations in demand and technological change. When technology is changing fast,
vertical integration may lock a company into an old, inefficient technology and prevent it
from changing to a new one that would strengthen its business model.

● Demand unpredictability because the demand for products wildly fluctuates and is
unpredictable. Thus, vertical integration can be risky when demand is unpredictable
because it is hard to manage the volume or flow of products along the value-added chain.

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3. Corporate diversification: Expanding beyond a single market
Vertical Integration: In what stages of the industry value chain should the firm participate?

Corporate Diversification: A firm that engages in diversification increases the variety of

products and services it offers or markets and the geographic regions in which it
competes.

A non-diversified company focuses on a single market, whereas a diversified company

competes in several different markets simultaneously.

- Product Diversification: A firm that is active in several different product markets.

What range of products and services should the firm offer? Why do some companies compete
in a single product market, while others compete in several different product markets?

- Geographic Diversification: A firm that is active in several different countries

Where should the firm compete in terms of regional, national, or international markets?

- Product-market Diversification: A company that pursues both a product and a geographic

diversification strategy.

To understand the different types and degrees of corporate diversification, Richard Rumelt
developed a helpful classification scheme that identifies four main types of diversification by
looking at the percentage of revenue from the dominant or primary business.

Just knowing the percentage of revenue of the dominant business immediately, four main
types of business diversification are identified:

1. SINGLE BUSINESS

A single-business firm derives more than 95% of its revenues from one business.

Google, Kellogg’s

2. DOMINANT BUSINESS

A dominant-business firm derives between 70 - 95% of its revenues from a single business, but
it pursues at least one other business activity that accounts for the remainder of revenue.

Nestle

3. RELATED DIVERSIFICATION

A firm follows a related diversification strategy when it 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.

The rationale behind related diversification is to benefit from economies of scale and scope:
These multi-business firms can pool and share resources as well as leverage competencies
across different business lines.

Two types of related diversification are evident:

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Related constrained diversification: They need to be related through common resources,
capabilities, and competencies.

Nike

Related linked diversification: Only some businesses share competencies.

Amazon (the only common thing is the distribution channel)

REASONS FOR RELATED DIVERSIFICATION

● Transferring competencies

Involves transferring knowledge and capabilities from one business to another, thereby
exploiting the interrelations between old and new activities in order to obtain sustainable
competitive advantages that formerly did not exist or transfer competitive advantage to the
new activities for a lower cost than if they had been created directly. The specific areas in
which resources are usually shared tend to be as follows. manufacturing, marketing, materials
management, or research and development (R&D).

Companies that base their diversification strategy on transferring competencies tend to

acquire new businesses related to their existing business activities because of commonalities
between one or more of their value-chain functions. A commonality is some kind of skill or
attribute that, when it is shared or used by two or more business units, allows both businesses
to operate more effectively and efficiently and create more value for customers.

● Sharing Resources and Capabilities

A second way in which two or more business units that operate in different industries can
increase a diversified company’s profitability is when the shared resources and capabilities
results in economies of scope, or synergies. Economies of scope arise when one or more of a
diversified company’s business units are able to realize cost-saving or differentiation synergies
because they can more effectively pool, share, and utilize expensive resources or capabilities,
such as skilled people, equipment, manufacturing facilities, distribution channels, advertising
campaigns, and R&D laboratories.

● Using Product Bundling

In the search for new ways to differentiate products, more and more companies are entering
into industries that provide customers with new products that are connected or related to
their existing products. This allows a company to expand the range of products it produces in
order to be able to satisfy customers’ needs for a complete package of related products.

RISKS OF RELATED DIVERSIFICATION

● Cost of coordination due to the greater effort in organizational coordination

The greater the number of businesses units in a company’s portfolio, the more difficult it is for
corporate managers to maintain control over their multibusiness models over time.

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● Cost of compromising

The generation of synergies calls for commitments and obligations whereby when the various
business have shared resources, none of them can be managed separately.

4. UNRELATED DIVERSIFICATION: THE CONGLOMERATE

A firm follows an unrelated diversification strategy when less than 70% of its revenues
comes from a single business and there are few, if any, linkages among its businesses. A
company that combines two or more strategic business units under one overarching
corporation and follows an unrelated diversification strategy is called a conglomerate.

Samsung (entering into travel, medical industry)

REASONS FOR UNRELATED DIVERSIFICATION

● Reduction in the firm’s overall risk

When businesses are unrelated to each other, the risks of fluctuations in profits tends to
decrease.

● In search for higher earnings

Unrelated diversification to seek investment opportunities in emerging sectors in order to

improve its overall performance.

● Better assignment of financial resources

RISKS OF UNRELATED DIVERSIFICATION

● Lack of knowledge and specific competences on the new activity

● The dispersion of interests that may arise withing the firm itself due to the broad diversity of
activities may compromise a firm’s traditional business.

● The difficulties of managing and coordinating a series of loosely interrelated activities may
make a conglomerate firm almost unmanageable.

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4. Methods of development. Strategic alliances and Mergers and Acquisitions
Corporate executives have three options at their disposal to drive firm growth:

- organic growth through internal development (Build)

- external growth through alliances (Borrow)

- external growth through acquisitions (Buy)

Strategic alliances are voluntary arrangements between firms that involve the sharing of
knowledge, resources, and capabilities to develop processes, products, or services.

Strategic alliances may join complementary parts of a firm’s value chain, such as R&D and
marketing, or they may focus on joining the same value chain activities. Strategic alliances are
attractive because they enable firms to achieve goals faster and at lower costs than going it
alone. Firms enter strategic alliances to:

- enter new markets (in terms of products/services or geography)

- hedge against uncertainty

- access critical complementary assets (marketing, manufacturing, after sales service) in order
to complete the value chain

Strategic alliances can be governed by:

● NON-EQUITY ALLIANCES. non-equity Alliance Partnership based on contracts between firms.

The most frequent forms of non-equity alliances are franchising, subcontracting, and licensing

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agreements. As suggested by their names, these contractual agreements are vertical strategic
alliances, connecting different parts of the industry value chain.

A franchise is a type of contract in which one firm-the franchiser-grants another-the

franchisee-the right to retail certain products or services within a specific geographical area
and under certain conditions in exchange for a direct or indirect financial consideration. The
franchiser transfers certain marketing rights that usually include a product Brand, rights that
usually include a product Brand, a trade name, and the design and layout of the franchisee´s
premises, while the latter owns the business and makes the necessary investments for its start-
up. (McDonald’s)

Subcontracting, whereby a firm-the contractor or principal commissions another

subcontractor or agent to undertake certain production activities or render certain services,
according to certain pre-arranged instructions, with the principal firm ultimately retaining all
financial liability. subcontracting favors vertical disintegration processes through the
outsourcing of those production or service operations that are not essential to a firm's value
chain, thereby striking a better balance between efficiency and flexibility.

Licensing agreements are contractual alliances in which the participants regularly exchange
codified knowledge.

Because of their contractual nature, non-equity alliances are flexible and easy to initiate and
terminate. However, because they can be temporary in nature, they also sometimes produce
weak ties between the alliance partners, which can result in a lack of trust and commitment.

● EQUITY ALLIANCES. Yet another form of strategic alliance is an equity alliance—a

partnership in which at least one partner takes partial ownership in the other partner. A
partner purchases an ownership share by buying stock or assets (in private companies), and
thus making an equity investment. The taking of equity tends to signal greater commitment to
the partnership.

Equity alliances tend to produce stronger ties and greater trust between partners than non-
equity alliances do. Equity alliances are frequently stepping-stones toward full integration of
the partner firms either through a merger or an acquisition. Essentially, they are often used as
a “try before you buy” strategic option. The downside of equity alliances is the amount of
investment that can be involved, as well as a possible lack of flexibility and speed in putting
together and reaping benefits from the partnership.

● JOINT VENTURES. Two or more partners create and jointly own a new organization. Since
the partners contribute equity to a joint venture, they make a long-term commitment, which
in turn facilitates transaction-specific investments. The advantages of joint ventures are the
strong ties, trust, and commitment that can result between the partners. However, they can
entail long negotiations and significant investments. If the alliance doesn’t work out as
expected, undoing the JV can take some time and involve considerable cost. A further risk is
that knowledge shared with the new partner could be misappropriated by opportunistic
behavior. Finally, any rewards from the collaboration must be shared between the partners.

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● MERGERS AND ACQUISITIONS. Mergers and acquisitions are, by definition, distinct from
each other. A merger describes the joining of two independent companies to form a combined
entity. Mergers tend to be friendly; in mergers, the two firms agree to join in order to create a
combined entity.

An acquisition describes the purchase or takeover of one company by another. Acquisitions

can be friendly or unfriendly. When a target firm does not want to be acquired, the acquisition
is considered a hostile takeover.

In contrast to vertical integration, which concerns the number of activities a firm participates
in up and down the industry value chain, horizontal integration is the process of merging with
a competitor at the same stage of the industry value chain.

There are three main benefits to a horizontal integration strategy:

1. REDUCTION IN COMPETITIVE INTENSITY. Looking through the lens of Porter’s five forces
model with a focus on rivalry among competitors (introduced in unit 3), horizontal integration
changes the underlying industry structure in favor of the surviving firms. Excess capacity is
taken out of the market, and competition tends to decrease as a consequence of horizontal
integration, assuming no new entrants. As a whole, the industry structure becomes more
consolidated and potentially more profitable. If the surviving firms find themselves in an
oligopolistic industry structure and maintain a focus on non-price competition (i.e., focus on
R&D spending, customer service, or advertising), the industry can indeed be quite profitable,
and rivalry would likely decrease among existing firms.

2. LOWER COSTS. Firms use horizontal integration to lower costs through economies of scale.
In industries that have high fixed costs, achieving economies of scale through large output is
critical in lowering costs.

3. INCREASED DIFFERENTIATION. Horizontal integration through M&A can help firms

strengthen their competitive positions by increasing the differentiation of their product and
service offerings.

Why do firms acquire other firms?

- TO GAIN ACCESS TO NEW MARKETS AND DISTRIBUTION CHANNELS. Firms may resort to
acquisitions when they need to overcome entry barriers into markets they are currently not
competing in or to access new distribution channels.

- TO GAIN ACCESS TO A NEW CAPABILITY OR COMPETENCY. Firms often resort to M&A to

obtain new capabilities or competencies.

- TO PREEMPT RIVALS. Sometimes firms may acquire promising startups not only to gain
access to a new capability or competency, but also to preempt rivals from doing so.

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