ESSAY QUESTIONS

Vertical Integration
1. Explain the difference between vertical and horizontal integration and provide two local
examples of each. Identify two advantages and two disadvantages of a corporation
choosing either approach
Vertical integration is a strategy used by a company to gain control over its suppliers or
distributors in order to increase the firm’s power in the marketplace, reduce transaction
costs and secure supplies or distribution channels.
Horizontal – firm acquires or merges with a competitor in the same industry. Example - a
company competing in raw materials industry and buys another company in the same
industry rather than trying to expand to intermediate goods industry.
Advantages:
- Lower costs due to eliminated market transaction costs;
- Improved quality of supplies;
- Critical resources can be acquired through VI;
- Improved coordination in supply chain;
- Greater market share;
- Secured distribution channels;
- Facilitates investment in specialized assets (site, physical-assets and human-assets);
- New competencies.
Disadvantages:
- Higher costs if the company is incapable of managing new activities efficiently;
- The ownership of supply and distribution channels may lead to lower quality
products and reduced efficiency because of the lack of competition;
- Increased bureaucracy and higher investments leads to reduced flexibility;
- Higher potential for legal repercussion due to size (An organization may become a
monopoly);
- New competencies may clash with old ones and lead to competitive disadvantage.

2. Define vertical integration and distinguish between forward vertical integration and
backward vertical integration. Discuss the circumstances under which a firm should use
vertical integration as a corporate level strategy.
Vertical integration is a corporate strategy. A firm's level of vertical integration is simply the
number of steps in this value chain that a firm accomplishes within its boundaries. More
vertically integrated firms accomplish more stages of the value chain within their boundaries
than less vertically integrated firms. Less vertically integrated firms accomplish fewer stages
of the value chain within their boundaries than more vertically integrated firms. A firm
engages in backward vertical integration when it incorporates more stages of the value
chain within its boundaries and those stages bring a firm closer to the beginning of the value
chain, i.e., closer to gaining access to raw materials. A firm engages in forward vertical
integration when it incorporates more stages of the value chain within its boundaries and
those stages bring a firm closer to the end of the value chain, i.e., closer to interacting
directly with final customers.
When to vertically integrate – (At least 5 of the following)
- Firm’s current suppliers are unreliable, expensive or cannot supply the required
inputs.
- There are only few small suppliers but many competitors in the industry.
- The industry is expanding rapidly.
- The prices of inputs are unstable.
- Suppliers earn high profit margins.
- Few quality distributors are available in the industry.
- Distributors or retailers have high profit margins.
- Distributors are very expensive, unreliable or unable to meet firm’s distribution
needs.
- The industry is expected to grow significantly.
- There are benefits of stable production and distribution.
- The company has enough resources and capabilities to manage the new business.

Diversification
3. Describe how diversified firms can use activity sharing and transfer of core competencies
to create value. Use examples in your answer.
In related diversification, a firm seeks to exploit economies of scope between its business
units. Economies of scope are cost savings created by transferring some of its capabilities
and competencies developed in another business to a new business. Firms create value
through economies of scope two ways: the sharing of activities (operational relatedness)
and the transferring of core competencies (corporate relatedness). Both primary and
support activities may be shared, including marketing and production. This activity sharing
can result in cost reductions and improve financial returns. The sharing of core
competencies allows the firm to create value two ways: 1) it eliminates the need for the
second unit to allocate resources to develop the competence, and 2) transferring intangible
resources internally makes it hard for competitors to understand and to imitate the
resource.
Examples **
 4. The resource of the firm may only permit diversification that is value neutral rather than
value creating. Outline and explain the incentives for a firm to pursue a value-neutral
diversification.

Diversification strategies are sometimes used with value-neutral rather than value-creating
objectives in mind. Incentives to diversify come from both the external environment and a firm’s
internal environment. External incentives include antitrust regulations and tax laws. Internal
incentives include low performance, uncertain future cash flows, and the pursuit of synergy and
reduction of risk for the firm.
Antitrust Regulation and Tax Laws - Antitrust laws prohibiting mergers that created increased
market power (via either vertical or horizontal integration)
Some research shows that low returns are related to greater levels of diversification. If “high
performance eliminates the need for greater diversification,” then low performance may provide
an incentive for diversification.
Uncertain Future Cash Flows - As a firm’s product line matures or is threatened, diversification
may be an important defensive strategy. Small firms and companies in mature or maturing
industries sometimes find it necessary to diversify for long-term survival.
Synergy and Firm Risk Reduction - Diversified firms pursuing economies of scope often have
investments that are too inflexible to realize synergy between business units. As a result, a
number of problems may arise. Synergy exists when the value created by business units working
together exceeds the value that those same units create working independently.

CASES

VERTICAL INTEGRATION
Blue Star – Vertical Integration
Blue Star is a Portuguese packaging company, which was founded in 1965 as a metallic
packaging manufacturer. Blue Star gradually widened its product and activity portfolio through
vertical integration of the packaging value chain. Founded as a decorative-cans-producer for
industrial products, Blue Star integrated lithography (in 1970), the production of aerosol
containers (1972), the manufacturing of plastic components (1973), contract filling of aerosol
cans (1975), production of plastic containers (1982), contract filling of liquids (1983), and, in
1984, the production of metallic containers for food products. Thus, vertical integration allows
Blue Star to offer a full service that corresponds to the outsourcing needs of selected products
and activities of client firms.
In 1975, Blue Star established a partnership with the multinational Johnson Wax (JW), and, in
1993, acquired Johnson Wax's Spanish contract‐filling subsidiary in Valdemoro. More recently,
Blue Star advanced its internationalization strategy with a greenfield operation in Poland.
The metal packaging industry is very heterogeneous, with significant variations in the final
product, and where standardization in some segments co‐exists with differentiation in others.
Blue Star’s distinctiveness is built on a high level of vertical integration. Although there are
numerous manufacturers of metal packaging and plastic components, and contract fillers, there is
no other firm (at least in the EU) that carries such a wide array of activities of the packaging
value chain in house: from lithography to distribution.
Questions:
1. What is Blue Star’s vertical integration strategy? Justify your answer.
(5 marks)
A firm’s level of vertical integration is simply the number of steps in this
value chain that a firm accomplishes within its boundaries. Firms that are more
vertically integrated accomplish more stages of the value chain within their
boundaries than firms that are less vertically integrated
Backward
Forward

2. What are the risks associated with Blue Star’s vertical integration strategy?
(9 marks)
Risks in Vertical Integration
- Established distribution channels may be adversely affected
- Unprofitable outcome
- Obsolescence due to new technologies
- Higher cost due to lower volume
- Unforeseen labour issues
- Lack of continued focus on the original business
- If acquisition is a commodity, not having lowest costs
- Unsatisfactory return on capital

3. Define transaction-specific investments. What of the integrated activities along Blue

Star’s value chain would require a transaction-specific investment? Justify your answer.
(6 marks)
A transaction-specific investment is any investment in an exchange that has significantly
more value in the current exchange than it does in alternative exchanges. High levels of such
investments suggest the need for vertical integration; low levels of such investments
suggest that vertically integrating this exchange is not necessary.

- production of plastic containers

 - contract filling of aerosol cans
- contract filling of liquids

Luke Lobsters’ Vertical Integration

Luke’s Lobster is a fast-casual restaurant group with 29 domestic locations and 13 international
locations in Japan and Taiwan. Established in 2009, with one lobster shack, Luke’s Lobster has
been growing at a rapid pace since its first month in business. The runaway success of this
company has been attributed to their commitment to vertical integration: the relatively
uncommon practice of a single company overseeing multiple stages of production of goods - in
this case, the fishing, processing, and delivering of lobster, followed by its preparation and sale
at restaurant locations. Having a direct hand in where his lobsters come from has allowed Holden
to practice respectful stewardship of the seas and strict quality and environmental controls on his
entire operation, something that has earned Luke’s Lobster a B Corporation certification.
At the company’s processing facility in Saco, Maine, approximately 32,000 pounds of lobster are
cooked and prepared each day. Different parts of the lobster — claws, knuckles, bodies, legs and
tails — are separated, weighed and grouped into batches according to size. The lobster is then
divided into quarter-pound servings, bagged, packed and transported.
By the time the meat arrives at each of the 29 shacks across the country, it has been cut to
perfection, divided into equal proportions and prepared for consumption. This highly
orchestrated process helps Luke’s Lobster ensure quality and cost-control at each of the
company’s shacks, minimizing the type of disorder that slowed the company down in its early
days when it was buying lobsters from externa l suppliers.
The lobster shack has grown into a global food brand. Today, Luke’s Lobster has 29 “shacks”
across the U.S., a seven-location licensing deal in Japan, a single-shack licensing deal in Taiwan,
a traveling food truck, a deal selling lobster tails to Whole Foods and several partnerships with
small food businesses. The company generated approximately $30 million in sales in 2017 and
employs just under 500 people.
Questions:

1. What type of vertical integration did Luke Lobsters implement? Justify your answer.
(5 marks)
Backward vertical integration
A firm engages in backward vertical integration when it incorporates more stages of
the value chain within its boundaries and those stages bring it closer to the beginning
of the value chain, that is, closer to gaining access to raw materials.
Luke’s Lobster started out with the lobster shack that just sells the final product but
then backward vertically integrated into fishing, processing & delivery.
 2. What are the risks associated with Luke Lobsters’ type of vertical integration? (9 marks)
a) Higher costs if the company is incapable of managing new activities efficiently;
b) The ownership of supply and distribution channels may lead to lower quality
products and reduced efficiency because of the lack of competition;
c) Increased bureaucracy and higher investments leads to reduced flexibility;
d) Higher potential for legal repercussion due to size (An organization may
become a monopoly);
e) New competencies may clash with old ones and lead to competitive
disadvantage.

3. Luke Lobsters’ vertical integration ensured quality and cost control for the business.
Explain the threat of opportunism and two (2) ways in which suppliers could have
behaved opportunistic towards Luke Lobsters. (6 marks)

Opportunism exists when a firm is unfairly exploited in an exchange. Examples

of opportunism include when a party to an exchange expects a high level of quality
in a product it is purchasing, only to discover it has received a lower level of
quality than it expected; when a party to an exchange expects to receive a service
by a particular point in time and that service is delivered late (or early); and when
a party to an exchange expects to pay a price to complete this exchange and its
exchange partner demands a higher price than what was previously agreed.

1. Suppliers being late or slow delivery of raw materials to lobster shack (produce
stale/ not fresh)
2. Suppliers delivering grade B lobster when agreement was for grade A lobster
3. Suppliers charging more for the raw lobsters than was previously agreed

DIVERSIFICATION
Jewell Company Diversification
Jewell Company (JC) is a $2 billion diversified manufacturer and marketer of simple household
items, cookware, and hardware. In the early 1950s, JC’s business consisted solely of
manufactured curtain rods that were sold through hardware stores and retailers like Sears. Since
the 1960s however, the company has diversified extensively through acquisition into such
businesses as paintbrushes, writing pens, pots and pans, and hairbrushes.
Over 90 percent of its growth can be attributed to these many small acquisitions, whose
performance it improved tremendously through aggressive restructuring and its corporate
emphasis on cost-cutting and cost controls. While JC’s sixteen different lines of business may
appear quite different, they all share the common characteristics of being staple manufactured
items and sold primarily through volume retail channels like Wal-Mart, Target, and Kmart. JC
operates each line of business autonomously using separate manufacturing, R&D, and selling
responsibilities for each line. Commonalities between them are both internal (accounting
systems, product merchandising skills, and acquisition competency) and external (distribution
channel of volume retailers).
JC is presently contemplating the acquisition of Plastico, a $3 billion U.S.-based manufacturer of
flexible plastic products like trash cans, reheatable and freezable food containers, and a broad
range of other plastic storage containers designed for home and office use. While Plastico has
been highly innovative (over 80% of its growth has come from internal new product
development), it has had difficulty controlling costs and is losing ground against powerful
customers like Wal-Mart. JC believes that the market power it wields with retailers like Wal-
Mart will help it turn Plastico’s prospects around.
Questions:
1. What is the level and type of JC’s diversification strategy? Justify your answer. (6 marks)
Level - Moderate to high
Type - Related diversification
All of JC’s business operate in the same product market - household items, cookware,
and hardware which are staple manufactured items and sold primarily through
volume retail channels. The different businesses share activities like accounting
systems and distribution channels.

2. How might JC's diversification strategy result in economies of scope and market power?
(10 marks)

Economies of scope is achieve through the cost savings that the firm creates by
successfully sharing some of its resources and capabilities or transferring one or
more corporate-level core competencies that were developed in one of its
businesses to another of its businesses. Firms seek to create value from economies of
scope through two basic kinds of operational economies:

- sharing activities (operational relatedness) – JC’s businesses are similar and make it
practical to share accounting systems, product merchandising skills, distribution
channel of volume retailers. This allows the a cost saving for JC.

- transferring corporate-level core competencies (corporate relatedness) – Because

the businesses are related then competencies can be transferred from on company
to another.

3. Why would the acquisition of Plastico be good for JC? (4 marks)

JC has likely created some market power with respect to the large retailers so another staple
consumer product makes sense. JC can leverage its existing market presence, selling
contacts, distribution system, and merchandising skills for plastic consumer products as
well. And since Plastico is having trouble controlling its costs, JC can bring to it more
sophisticated financial management skills and accounting systems.

Practise Questions on Mergers & Acquisitions

4. Identify and explain the seven reasons firms engage in an acquisition strategy.

ANS:
(1) Increased market power. Market power allows a firm to sell its goods or services above
competitive levels or when the costs of its primary or support activities are below those
of its competitors. Market power is derived from the size of the firm and the firm’s
resources and capabilities to compete in the marketplace. Firms use horizontal, vertical,
and related acquisitions to increase their size and market power.

(2) Overcoming entry barriers. Firms can gain immediate access to a market by purchasing a
firm with an established product that has consumer loyalty. Acquiring firms can also
overcome economies of scale entry barriers through buying a firm that has already
successfully achieved economies of scale. In addition, acquisitions can often overcome
barriers to entry into international markets.

(3) Reducing the cost of new product development and increasing speed to market.
Developing new products and ventures internally can be very costly and time consuming
without any guarantee of success. Acquiring firms with products new to the acquiring
firm avoids the risk and cost of internal innovation. In addition, acquisitions provide
more predictable returns on investments than internal new product development.
Acquisitions are a much quicker path than internal development to enter a new market,
and they are a means of gaining new capabilities for the acquiring firm.

(4) Lower risk compared to developing new products internally. Acquisitions are a means to
avoid internal ventures (and R&D investments), which many managers perceive to be
highly risky. However, substituting acquisitions for innovation may leave the acquiring
firm without the skills to innovate internally.
(5) Increased diversification. Firms can diversify their portfolio of business through
acquiring other firms. It is easier and quicker to buy firms with different product lines
than to develop new product lines independently.

(6) Reshaping the firm’s competitive scope. Firms can move more easily into new markets as
a way to decrease their dependence on a market or product line that has high levels of
competition.
 (7) Learning and developing new capabilities. By gaining access to new knowledge,
acquisitions can help companies gain capabilities and technologies they do not possess.
Acquisitions can reduce inertia and help a firm remain agile.

4. Describe the seven problems in achieving a successful acquisition.

ANS:
Acquisition strategies present many potential problems.

(1) Integration difficulties. It may be difficult to effectively integrate the acquiring and acquired
firms due to differences in corporate culture, financial and control systems, management styles,
and status of executives in the combined firms. Turnover of key personnel from the acquired
firm is particularly negative.

(2) Inadequate evaluation of target. Due diligence assesses where, when, and how management
can drive real performance gains through an acquisition. Acquirers that fail to perform effective
due diligence are likely to pay too much for the target firm.
(3) Large or extraordinary debt. Acquiring firms frequently incur high debt to finance the
acquisition. High debt may prevent the investment in activities such as research and
development, training of employees and marketing that are required for long-term success. High
debt also increases the risk of bankruptcy and can lead to downgrading of the firm’s credit rating.
(4) Inability to achieve synergy. Private synergy occurs when the acquiring and target firms’
assets are complementary in unique ways, making this synergy difficult for rivals to understand
and imitate. Private synergy is difficult to create. Transaction costs are incurred when firms seek
private synergy through acquisitions. Direct transaction costs include legal fees and investment
banker charges. Indirect transaction costs include managerial time to evaluate target firms, time
to complete negotiations, and the loss of key managers and employees following an acquisition.
Firms often underestimate the indirect transaction costs of an acquisition.
(5) Too much diversification. A high level of diversification can have a negative effect on the
firm’s long-term performance. For example, the scope created by diversification often causes
managers to rely on financial controls rather than strategic controls because the managers cannot
completely understand the business units’ objectives and strategies. The focus on financial
controls creates a short-term outlook among managers and they forego long-term investments.
Additionally, acquisitions can become a substitute for innovation, which can be negative in the
long run.
(6) Managers overly focused on acquisitions. Firms that become heavily involved in acquisition
activity often create an internal environment in which managers devote increasing amounts of
their time and energy to analyzing and completing additional acquisitions. This detracts from
other important activities, such as identifying and taking advantage of other opportunities and
interacting with importance external stakeholders. Moreover, during an acquisition, the managers
of the target firm are hesitant to make decisions with long-term consequences until the
negotiations are completed.
 (7) Growing too large. Acquisitions may lead to a combined firm that is too large, requiring
extensive use of bureaucratic controls. This leads to rigidity and lack of innovation, and can
negatively affect performance. Very large size may exceed the efficiencies gained from
economies of scale and the benefits of the additional market power that comes with size.

5. Describe how an acquisition program can result in managerial time and energy absorption.

ANS:
Typically, a substantial amount of managerial time and energy is required for acquisition
strategies if they are to contribute to a firm’s strategic competitiveness. Activities with which
managers become involved include those of searching for viable acquisition candidates,
completing effective due diligence processes, preparing for negotiations and managing the
integration process after the acquisition is completed. Company experience shows that
participating in and overseeing the acquisition activities can divert managerial attention from
other matters that are linked with long-term competitive success (e.g., identifying and acting on
other opportunities, interacting effectively with external stakeholders).

6. What are the attributes of a successful acquisition program?

ANS:
Acquisitions can contribute to a firm’s competitiveness if they have the following attributes:
(1) The acquired firm has assets or resources that are complementary to the acquiring firm’s core
business.
(2) The acquisition is friendly.
(3) The acquiring firm conducts effective due diligence to select target firms and evaluates the
target firm’s health (financial, cultural, and human resources).
(4) The acquiring firm has financial slack.
(5) The merged firm maintains low to moderate debt.
(6) The acquiring firm has sustained and consistent emphasis on R&D and innovation.
(7) The acquiring firm manages change well and is flexible and adaptable.