CHAPTER 7: CORPORATE STRATEGYFoundations of Strategy

Team 4

Scope [the range of product and marketing activities the firm undertakes]• Product Scope

• how specialized the firm is in terms of the range of products it supplies

• Vertical Scope • the range of vertically linked activities the firm encompasses

• Geographical Scope • the geographical spread of activities for the firm

Tesco• Global grocery and general merchandise retailer

headquartered in London• 3rd largest retailer in the world• Over 472,000 employees with 4,811 stores in 14 countries

Tesco• Founded by Jack Cohen in 1919• Market stall in the East End of London• Labels from tea shipments from T.E. Stockwell• TES + CO• Acquisitions in 1950’s and 1960’s• “piling it high and selling it cheap”

Tesco• Downmarket image, low price, middling quality• Consumers want better quality and more sophistication by

the 1970’s Jack Cohen steps down• Leslie Porter and Ian McLaurin take over, introduce:

• Tesco Extra (out of town hypermarkets)• Tesco Express (neighborhood convenience stores)• New systems and technology

• Appeal to a wider range of market segments and expand the company through acquisition

Tesco• First UK supermarket to introduce loyalty cards with its

“Clubcard” and points system• Gives Tesco valuable information about who you are and

what you buy for their database• Segment customer base more accurately and target promotions

and cross selling

Tesco• Terry Leahy took over in 1997 and though the company

was doing good, realized they were reaching limits• Added online non-food retail in 1998 through joint venture

with Grattan, a mail order company• Online grocery delivery, discount clothing, electronics,

DVDs• Tesco Direct, a printed catalougue, everything in house

(pictures, publishing)

Tesco• Diversification into personal finances• Tesco Personal Finance

• 50-50 banking joint venture with the Royal Bank of Scotland• Credit cards, savings accounts, insurance

• Sheer size of market and knowledge of shoppers personally through the Tesco database

• Had capital requirement necessary for a banking license• Customers are already familiar with Tesco• Synergy and innovation

Tesco• During 2008 financial crisis, they acquired RBS’s shares

in Tesco Personal Finance to become a wholly owned subsidiary of Tesco

• Customer disillusionment with traditional banks led the way for alternative financial service providers

Tesco• Pulling back from this ambitious plan• Different core competencies from store and bank• Need to develop differently• Customers reluctant to switch financial providers, too

complicated and daunting• Customers may view Tesco with disdain, if it does certain

bank acts (such as repossessing a house)

Tesco• Trading profits up 13%• Customer accounts across all products at 6.2 million• Watch to see how far Tesco can extend its product

portfolio

The scope of the firm• “What business are we in?”

• Starting point of strategy and basis for deciding firm’s identity• Range of scope

• Scope of a firm’s business is likely to change over time• Ex: Phillip Morris, now Altria Group• Ex: Microsoft

• Vertical integration • Now, trend is outsourcing and de-integration• Ex: Pharmaceutical companies

Key concepts for analyzing firm scope

• Firm’s extend or reduce their scope because they perceive this to be in the firm’s best interest

• Economies of scale• Reduction in average costs that result from an increase in the

output of a single product

• Economies of scope• Cost economies from increasing the output of multiple products• Creates potential for multi-business firms to gain cost advantages

over more specialized business

Key concepts for analyzing firm scope

• Tangible resources• Distribution networks, info technology systems, sales force, labs• Offer economies of scope by eliminating duplication between

businesses through creating a single shared facility• Ex: cable TV companies and telephone companies

• Shared services organizations

• Intangible resources• Brands, reputation, technology• Offer economies of scope from the ability to extend them to

additional businesses at low marginal cost• Ex: Starbucks

• Brand extension

Key concepts for analyzing firm scope

• Organizational capabilities• Transfer capabilities between businesses within the diversified

company• Once developed, can typically be replicated in a new business at a

fraction of the cost of the initial creation• General management capabilities are very important

• Ex: General Electric

Transaction Costs• Market Mechanism

• Administrative Mechanism

• Examples• search costs, cost of negotiating and drawing up a contract, the

cost of monitoring the other party’s side of the contract

The Scope of a Firm:Specialization vs. Integration• Single Integrated Firm

• Vertical Scope• Product Scope• Geographical Scope

• Several Specialized Firms

• “ The dominant trends of the past three decades were ‘downsizing’ and ‘refocusing’, as large industrial companies reduced both their product scope through focusing on their core businesses and their vertical scope through outsourcing.”

Transaction Costs at Tesco• Grocery retailer

• What transaction costs would a grocery retailer have?• Search for potential suppliers• Bargaining with these suppliers• Drawing up a legal contract• Monitor the suppliers’ performance• Enforce the contract and seek damages if need be

• What role does time play in the transaction costs of a company?

The Costs of Corporate of Corporate Complexity

• Organizational Complexity

• Three concepts • Economies of scope• Transaction cost of managing complexity• Provide important insights into corporate strategic decisions and

we next use these ideas to explore strategic decisions with regard to product scope and vertical scope

Diversification• The expansion of an existing firm into another product line

or field of operation

• Related (Concentric) or Unrelated (Conglomerate)

• Horizontal diversification

• Vertical diversification

The Benefits and Costs of Diversification

• Why do companies strive to diversify?• Growth• Risk reduction• Value creation

Exploiting Economies of Scope• Licensing

• Branding

• Franchising

Internal Capital Markets• The corporate allocating of capital between the different

businesses through the capital expenditures budget

• By maintaining a balance portfolio of cash-generating and cash-using businesses, diversified firms can avoid the costs of using the external capital market, including the margin between borrowing and lending the heavy costs of issuing new debt and equity

Internal Labor Markets• A diversified corporation has a pool of employees and can

respond to the specific needs of any one business through transfer from elsewhere within the corporation

• As college students, we look for the entry-level position which we can use as a springboard. Diversified companies such as Siemens, General Electric, Unilever, and Nestle are high sought after due to the immense opportunity to have an enriched career

When does diversification create value?

The attractiveness test• The industries chosen for diversification must be structurally

attractive or capable of being made attractive

• The Cost-of-Entry test• The cost of entry must not capitalize all the future profit

• The Better-Off test• Either the new unit must gain competitive advantage from its link

with the corporation, or vice versa

The attractiveness and cost-of-entry tests

• A key feature of Porters’ essential test is that the industry attractiveness is sufficient on its own

• Pharmaceuticals, corporate legal services, and defense contracting offer above-average profitability precisely because of barriers to entry

• The only ways to enter are to acquire and established player or establish a new corporate venture

The better-off test• Addresses the basic issue of competitive advantage

• If two businesses producing different products are brought together under the ownership and control of a single enterprise, is there any reason why they should become any more profitable?

• In most diversification decisions, it is the better-off test that dominates

Diversification and Performance • High levels of diversification associated with low

profitability • Diversification is good when exhausted growth has

occurred and emerge external opportunities • Moderately diversified companies more profitable than

specialized firms doesn’t necessarily mean they are more profitable but maybe firms diversify their cash flow investments

• Companies who diversify seem to have more profitability (a good happy medium seems to be the answer; take in what you can handle)

Related and Unrelated Diversification• Diversification in related industries should be more

profitable than justification into unrelated industries.• Several factors may be confusing the relationship

1. Related diversification offers greater potential benefits than unrelated diversification which creates greater management complexity.

2. Distinction between “related” and “unrelated” is not always clear, it may depend upon the strategy and characteristics of individual firms.

Recent Trends in Diversification• Conglomerate firms are highly diversified companies created from

multiple, unrelated acquisitions and have almost disappeared as a distinctive corporate form.

• The divestment trend among large US companies meant that between 1980 and 1990, the average index of diversification for the Fortune 500 declined from one 1.00 to 0.67.

• Highly diversified business groups dominate the industrial sectors of many emerging companies.

• There are also signs that diversification may be making a come back in advanced industrial nations.• In the technology sector, digitisation is tending to break down conventional market

boundaries.• Complementarities are becoming more important between different products

• As the rate at which technologies and products become obsolete increases and competitive advantages in core businesses erodes, so firms are finding it desirable to create “growth options” in other industries.

Defining vertical integration• Definition; a firms ownership vertically related activities

• the extent of vertical integration is indicated by the ratio of a firms value added to its sales revenue

• Vertical integration can be:• Backward: where the firm acquires ownership and control over the

production of its own inputs.• Forward: Where the firm acquires ownership and control of

activities previously undertaken by it customers.

• Vertical integration may be full or partial.

The Benefits & Cost of Vertical Integration

• For most of the 20th century, the prevailing wisdom was that vertical integration was generally beneficial because it allowed superior coordination and reduced risk.

• There has been a change of opinion during the last 25 years that outsourcing enhances flexibility and allows firms to focus on their core competencies.

• On the positive side, vertical integration can produce cost savings due to the physical integration of processes, eliminate certain transaction cost and facilitate transaction specific investments.

• On the negative side, vertical integration may restrict a firms ability to benefit from scale economies and may reduce flexibility and increase risk.

Technical Economies from the Physical Integration of Processes• Analysis of the benefits of vertical integration has

traditionally emphasized the technical economies of vertical integration; cost savings that arise from the physical integration of processes.

Transaction Costs in Vertical Exchanges

• Where a single supplier negotiates with a single buyer, there is no market price; it all depends on relative bargaining power.• Such bargaining is likely to be costly; the mutual dependency of the two

parties is likely to give rise opportunism and strategic misrepresentation as each company seeks to both enhance and exploit it bargaining power at the expense of the other.

• The more technically complex the integrated circuit and hence the greater the need for the designer and fabricator to invest in technical collaboration and adapt processes to the needs of the other, the better the relative performance of integrated producers.

The Incentive Problem• High Powered incentives: Where a market interface exists

between a buyer and a seller, profit incentives insure that the buyer is motivated to secure the most best possible deal and the seller is motivated to pursue efficiency and service in order to attract and retain the buyer.

• One approach to creating stronger performance incentives within vertically integrated companies is to open internal divisions to external competition.

Flexibility • Where the required flexibility is rapid responsiveness to

uncertain demand, there may be advantages in market transactions.

• Vertical integration may also be disadvantages in responding quickly to new product development opportunities that require new combinations of technically capabilities.

• Where system-wide flexibility is required vertical integration may allow for speed and coordination in achieving simultaneous adjustment throughout the vertical chain.

Compounding Risk• To the extent to the vertical integration ties a company to

its internal suppliers, vertical integration represents a compounding of risk insofar as problems at any one stage of production threaten production and profitability at all other stages.

Designing Vertical Relationships• Vertical business relationships exist when two people

interact that are on different positional levels within an organization. 

• These relationships often involve an employee relating to his direct supervisor. It can also involve relationships that stretch across two or more levels of hierarchy within the organization. 

Different Types of Vertical Relationships

• Long Term Contracts:• Series of transactions over a period of time and specify the terms

and responsibilities for each party.

• Spot Contracts:• Market transactions or normal purchases

• Relational Contracts:• A contract whose effect is based upon a relationship

of trust between the parties.

• Franchise:• A Contractual agreement between the owner of a business system

and a trademark.

Vertical integration vs. Outsourcing• Throughout the years companies have done less

outsourcing and more vertical integration.

• Companies in essence have “maxed out” on outsourcing

• Vertical integration allows more control and less risk.

Dominating the supply chain

Managing the corporate portfolio

• Opportunities exist to create value through diversification or vertical integration

• “How do we manage a multi-business firm in ways that generate as much value as possible?”

Portfolio Planning

• Represent graphically the individual businesses of a multi-business company in terms of key strategic variables that determine their potential for profit

• Relate to attractiveness of their market and competitive advantage in that market

GE/McKinsey matrix• Industry attractiveness axis combines market size, growth

rate, profitability, international potential• Business unit competitive advantage combines market

share, return on sales relative to competitors; and relative position with regard to quality, technology, manufacturing, distribution, marketing, and cost

Boston Consulting Group’s growth-share matrix

• Uses single indicator as a proxy for each of these dimensions: industry attractiveness is measured by rate of market growth, competitive advantage by relative market share

• Simplicity is both limitation and usefulness

The Ashridge portfolio display• The value-created potential of a business within a

company’s business portfolio depends not just on the characteristics of the business, but also on the characteristics of the parent

• Focus on fit between business and parent company

Portfolio Planning Models• Portfolio planning models can aid managers to make

sense of the complexity and to start to develop a degree of consistency in the firm’s activities to produce coherence and fit

Questions???