CHAPTER

8
Corporate Strategy:
Vertical Integration
and Diversification

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Part 2 Strategy Formulation

8–2
LO 8-1 Define corporate-level strategy, and describe the three dimensions
along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.

8–3
 Chapter Case 8
Refocusing GE: A Future of
Clean-Tech and Health Care?

• Jeffrey Immelt appointed CEO of GE Sept. 7th 2001

 Environmental Change (e.g., 9/11 and Global Financial Crises)

 GE’s stock price fell by 84%

 Lost AAA credit rating

• Refocus on green economy and health care industries

 Sold majority stake in NBC Universal to Comcast

• “Ecomagination”: solar energy, hybrid locomotives, fuel cells…etc.

• “Healthymagination”: increase quality and access to health care

8–4
Chapter Case 8 Refocusing GE: A Future of
Clean-Tech and Health Care?

GE’s Changing Product Scope

Chapter Case 8 Refocusing GE: A Future of
Clean-Tech and Health Care?

GE’s Changing Geographic Scope

Source: Author’s depiction of data in GE annual reports. 8–6

 What Is Corporate Strategy?

• Corporate strategy
 Corporate strategy is the way a company creates value through the
configuration and coordination of its multi-market activities
 Quest for competitive advantage when competing in multiple industries

 Example: Jeffrey Immelt’s initiative in clean-tech and health care industries

• Corporate strategy concerns the scope of the firm

 Industry value chain

 Products and services

 Geography

8–7
EXHIBIT 8.1 Three Dimensions of Corporate Strategy

Scope of the firm determines boundaries along these 3 dimensions.

8–8
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize
economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.

8–9
Transaction Cost Economics and Scope of the Firm
• Transaction cost economics
 Explains and predicts the scope of the firm
 "Market vs. firms" have differential costs

• Transaction costs
 Costs associated with economic exchanges
 Either in the firm OR in the markets
 Ex: negotiating and enforcing contracts

• Administrative costs
 Costs pertaining to organizing an exchange within a
hierarchy
 Ex: recruiting & training employees
8–10
 Firms vs. Markets: Make or Buy

• Should a firm do things in-house (to make)? Or obtain

externally (to buy)?

• If Cin-house < Cmarket, then the firm should vertically integrate

 Ex: Microsoft hires programmers to write code

in-house rather than contracting out

 Firms and markets have distinct advantages and

disadvantages (see Exhibit 8.2)

8–11
EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets

8–12
 Firms vs. Markets: Make or Buy?
• Disadvantage of “make” in-house
 Principal – agent problem
 owner = principal, manager = agent
 Agent pursues his/her own interests
• Disadvantage of “buy” from markets
 Search cost
 Opportunism
 Incomplete contacting
 Enforce legal contacts
• Information asymmetries
 One party is more informed than others
 Akerlof – “Lemons problem” for used cars
– Receiving Noble prize in Economics 
EXHIBIT 8.3 Alternatives along the Make or Buy Continuum

8–14
STRATEGY
STRATEGY HIGHLIGHT
HIGHLIGHT 8.1
8.1 Toyota Locks Up Lithium
for Car Batteries

• World demand for lithium-ion batteries for cars

 Grow from $278 million in ‘09 to $25 billion in 2014

• Toyota wants to secure long-term supply of lithium to

power its hybrid fleet

• Orocobre holds exploration rights to a large salt-lake area

 Upfront investment to extract of lithium is very high

• Should Orocobre make the investment to supply Toyota?

 To encourage investment, Toyota took an
equity position

1–15
China Rare Earth Video
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value
chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.

8–16
EXHIBIT 8.4
Backward and Forward Vertical Integration
along an Industry Value Chain

8–17
 Types of Vertical Integration

• Full vertical integration

 Ex: Weyerhaeuser
• Owns forests, mills, and distribution to retailers

• Backward vertical integration

 Ex: HTC’s backward integration into design of phones

• Forward vertical integration

 Ex: HTC’s forward integration into sales & branding

• Not all industry value chain stages are equally

profitable
 Zara – primarily designs in-house & partners for speedy
new fashions delivered to stores
8–18
EXHIBIT 8.5 HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry

8–19
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.

8–20
 Vertical Integration
Professor Oliver Williamson of University of California at
Berkeley has made clear that In order to avoid confusion on
the vertical coordination problem it is important for the
manager to separate two distinct issues:

Issue #1: What is the objective for vertical coordination?

Or put differently, what efficiencies, risk sharing, or market
power advantages are being sought?

Issue #2: What organizational form (e.g., vertical

contracts, equity joint ventures, mergers & acquisitions)
best achieves the desired objective(s)?
 Benefits of Vertical Integration
• Benefits of vertical integration

 Market power
• Entry barriers
• Down-stream price maintenance
• Up-stream power over prices

 Securing critical supplies

 Lowering costs (efficiency)

 Improving quality

 Facilitating scheduling and planning

 Facilitating investments in specialized assets

 Ex: HTC started as OEM & expanded to fully integrated

8–22
 Benefits of Vertical Integration

• Specialized assets
 Assets that have significantly more value in their
intended use than in their next best use

• Types of specialized assets

 Site specificity
 Co-located such as coal plant and
electric utility 
 Physical asset specificity
 Bottling machinery
 Human asset specificity
 Mastering procedures of a particular organization
8–23
 Optimal Input Procurement

Spot Exchange
No
Substantial
specialized
investments
relative to Yes Complex contracting
contracting costs? environment relative to
costs of integration?

No Yes

Vertical
Contract Integration

Managerial Eco. - Rutgers University 6-13

 STRATEGY
STRATEGY HIGHLIGHT
HIGHLIGHT 8.2
8.2 Back to the Future:
PepsiCo’s Forward Integration

• PepsiCo acquired bottlers in 2009

 Gain control over quality, pricing, distribution, and
in-store display.
 Reversed a 1999 decision to sell off Pepsi bottlers
 Goal now is faster innovative products launched

• Forward integration

 Enhance flexibility and improve decision making

 Cost saving and interdependence

• Coca-Cola did the same: forward integration with bottlers

1–25
8–25
 Risks of Vertical Integration
• Increasing costs
 Internal suppliers lose incentives to compete

• Reducing quality
 Single captured customer can slow experience effects

• Reducing flexibility
 Slow to respond to changes in technology or demand

• Increasing the potential for legal repercussions

 FTC carefully reviewed Pepsi plans to buy bottlers

8–26
 Alternatives to Vertical Integration
• Taper integration
 Backward integrated but also relies on outside market firms
for supplies
OR
 Forward integrated but also relies on outside market firms
for some of its distribution

• Strategic outsourcing
 Moving value chain activities outside the firm's boundaries

 Example: EDS and PeopleSoft provide HR services to

many firms that choose to outsource it.
8–27
EXHIBIT 8.6 Taper Integration along the Industry Value Chain

Outside suppliers could

also be off-shored when
they are not located in the
home country
Risks in undertaking cooperative
agreements or strategic alliances

 Adverse selection
 Partners misrepresent skills, ability and other
resources
 Moral Hazard
 Partners provide lower quality skills and
abilities than they had promised
 Holdup
 Partners exploit the transaction specific
investment made by others in the alliance

8–29
Corporate Diversification:
Expanding Beyond a Single Market

• Degrees of diversification
 Range of products and services a firm should offer
 Ex: PepsiCo also owns Lay's & Quaker Oats.

• Diversification strategies:
 Product diversification
 Active in several different product categories
 Geographic diversification
 Active in several different countries
 Product – market diversification
 Active in a range of both product and countries

8–30
EXHIBIT 8.7 Different Types of Corporate Diversification

8–31
 STRATEGY
STRATEGY HIGHLIGHT
HIGHLIGHT 8.3
8.3
ExxonMobil Diversifies into
Natural Gas
• ExxonMobil earned highest profit in its history in 2008
 Majority of profits come from petroleum-based products.
• Environmental change toward clean energy
 ExxonMobil must react to the change.
 ExxonMobil to focus on clean energy: natural gas.
• ExxonMobil acquired XTO Energy
 Leverage core competence in exploration and
commercialization of energy sources into natural gas.
 85% today fossil fuels
 Exxon is largest producer of natural gas on the planet.

Exxon XTO video 1–32

8–32
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive
advantage, and when it does not.

8–33
 Motivations For Diversification

• Value Enhancing Motives:

 Increase market power

 Multi-point competition
 R&D and new product development
 Developing New Competencies (Stretching)
 Transferring Core Competencies (Leveraging)

 Utilizing
excess capacity (e.g., in distribution)
 Economies of Scope
 Leveraging Brand-Name
(e.g., Haagen-Dazs to chocolate
candy)
8–34
 Leveraging Core Competencies for
Corporate Diversification
• Core competence
 Unique skills and strengths
 Allows firms to increase the value of product/service
 Lowers the cost

• Examples:
 Wal-mart – global supply chain
 Infosys – low-cost global delivery system

• The core competence – market matrix

 Provides guidance to executives on how to diversify
in order to achieve continued growth

8–35
EXHIBIT 8.8 The Core Competence – Market Matrix

Pepsi - Gatorade Salesforce.com

BoA - NCNB BoA - Merrill Lynch

8–36
 Other Motivations For Diversification

• Motivations that are “Value neutral”:

 Diversification motivated by poor economic performance

in current businesses.

• Motivations that “Devaluate”:

 Agency problem
 Managerial capitalism (“empire building”)
 Maximize management compensation
 Sales Growth maximization
 Professor William Baumol
 Diversification
• Issue #1: When there is a reduction in managerial
(employment) risk, then there is upside and
downside effects for stockholders:

 On the upside, managers will be more willing to learn

firm-specific skills that will improve the productivity
and long-run success of the company (to the benefit
of stockholders).

 On the downside, top-level managers may

have the economic incentive to diversify to
a point that is detrimental to stockholders.
 Diversification
• Issue #2: There may be no economic value to
stockholders in diversification moves since
stockholders are free to diversify by holding a
portfolio of stocks. No one has shown that
investors pay a premium for diversified firms --
in fact, discounts are common.

 A classic example is Kaiser Industries that was dissolved

as a holding company because its diversification
apparently subtracted from its economic value.

 Kaiser Industries main assets: (1) Kaiser Steel; (2) Kaiser

Aluminum; and (3) Kaiser Cement were independent
companies and the stock of each were publicly traded.
Kaiser Industries was selling at a discount which vanished
when Kaiser Industries revealed its plan to sell its holdings.
8–39
EXHIBIT 8.9 The Diversification-Performance Relationship
EXHIBIT 8.10 Vertical Integration and Diversification:
Sources of Value Creation and Costs

8–41
EXHIBIT 8.11 BCG Matrix

8–42
 Knowledge Processes within the Organization

Knowledge • Research
Creation
Knowledge
• Training
Generation • Recruitment
(“Exploration”) Knowledge • Intellectual property
Acquisition licensing
• Benchmarking

Knowledge • New product

development
Integration • Operations
Knowledge • Strategic planning
Sharing • Communities of practice

Knowledge • Best practices transfer

Knowledge Replication • On-the-job training
Application Knowledge
(“Exploitation”) • Databases
Storage & • Standard operating practices
Organization
Knowledge • Intellectual capital accounting
Measurement • Competency modeling

Knowledge • Project reviews

Identification • Competency modeling
 Corporate Diversification
• Internal capital markets
 Source of value creation in a diversification strategy
 Allows conglomerate to do a more efficient job of
allocating capital
• Coordination cost
 A function of number, size, and types of businesses
linked to one another
• Influence cost
 Political maneuvering by managers to influence
capital and resource allocation
• Bandwagon effects
 Firms copying moves of industry rivals
8–44
EXHIBIT 8.12 Oracle Corporate Strategy: Combining
Vertical Integration and Diversification

8–45
Reasons for Problems in
Acquisitions Achieving Success
Increased Integration
market power difficulties

Overcome Inadequate
entry barriers evaluation of target

Cost of new Large or

product development extraordinary debt

Increased speed Inability to

to market Acquisitions achieve synergy

Lower risk Too much

compared to developing diversification
new products

Increased Managers overly

diversification focused on acquisitions

Avoid excessive
competition Too large
Ch7-3
 Attributes of Effective
Acquisitions
Attributes Results
Complementary Buying firms with assets that meet current
Assets or Resources needs to build competitiveness
Friendly Friendly deals make integration go more
Acquisitions smoothly
Careful Selection Deliberate evaluation and negotiations are
Process more likely to lead to easy integration and
building synergies
Maintain Financial Provide enough additional financial
Slack resources so that profitable projects would
not be foregone 20
 Sustainable Competitive Advantage

• Trying to gain sustainable competitive advantage via

mergers and acquisitions puts us right up against the
“efficient market” wall:

 If an industry is generally known to be highly profitable,

there will be many firms bidding on the assets already in
the market. Generally the discounted
value of future cash flows will be impounded in the price
that the acquirer pays. Thus, the acquirer is expected to
make only a competitive
rate of return on investment.

8–48
 Sustainable Competitive Advantage

• And the situation may actually be

worse, given the phenomenon of the
winner’s curse.

 The most optimistic bidder usually over-

estimates the true value of the firm:

 Quaker Oats, in late 1994, purchased

Snapple Beverage Company for $1.7 billion.
Many analysts calculated that Quaker Oats
paid about $1 billion too much for Snapple.
In 1997, Quaker Oats sold Snapple for
$300 million.
 Sustainable Competitive Advantage

• Under what scenarios can the bidder do well?

 Luck

 Asymmetric Information
– This eliminates the competitive bidding premise
implicit in the “efficient market hypothesis”

 Specific-synergies (co-specialized assets) between

the bidder and the target.
– Once again this eliminates the competitive
bidding premise of the efficient market
hypothesis.