choosing corporate scope 1

Choosing Corporate ScopeChoosing Corporate Scope

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Choosing Corporate ScopeChoosing Corporate ScopeBut we must now refer to one question about systems in general, and about organization systems in particular, the answer to which is of fundamental importance.

I refer to the question as to whether the whole is more than the sum of the parts . . .

whether there emerge from the system properties which are not inherent in the parts.

—Chester Barnard, The Functions Of The Executive (1938), p. 79

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Quite a few groups / companies are conglomerates and manufacture /market a variety of diverse range of products /services

Eg P & G, GEGodrej, Tatas, Videocon, Birlas

Choosing Corporate ScopeChoosing Corporate Scope It is planned to examine: the logic that underlies

choices of corporate scope◦ Dimensions of scope horizontal scope

in which industries to compete

vertical scope make own inputs – forward / backward integration Holdup-Contracting : shifting from a transaction based

relationship to long term contracts - outsourcing

geographic scope where to compete

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Choosing Corporate ScopeChoosing Corporate ScopeResearch suggests that effect of common corporate ownership on the operating performance of businesses is significant but

smaller than “within industry” differences in performance that operate at business level and

Differences in average performance at the industry level

However corporate strategy cannot be ignored because:1. Corporate-level effects on performance are not

negligible2. Inferences to be drawn from such estimates remain

controversial3. Focus on operating performance used to isolate

corporate efects miss out on some potential mechanism for corporate value addition 5


Corporate strategy cannot be ignored

Corporate effects on performance represent:◦ lower bounds on the strategic headroom

afforded by corporate strategy ◦ wide gap between best and average

practices

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Evolution of corporate strategy Evolution of corporate strategy practices practices Portfolio planning techniques continued to hold

through the 1970s and 1980’s e.g. GE’s # 1 or #2 or out (market share axis of the growth –share matrix)–analysis showed that related diversifiers outperformed the unrelated ones

portfolio of strategic business units (SBUs) -influenced by liberalisation of U.S. financial markets (1980s), financial innovations (junk bonds), domestic deregulation, intensified foreign competition

Specialist consulting firms promoted “value-based management” and heavy use of financial measures of performance

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Evolution of corporate strategy Evolution of corporate strategy practices practices

1990s- Economic Value Added (EVA)Prahalad and Hamel - core competencies - attacked

SBU-level foundations of portfolio planning. No single SBU feels responsible for maintainin a viable position in core products or competencies that cross business boundaries; competencies are not shared across SBUs anjd opportunities for growth are missed. Recommended corporate wide strategic architecture for competence building.Successful organisation of the future would be the one s that shifted their focus from SBUs to core competencies, because these formed the foundation of future growth.

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Evolution of corporate strategy Evolution of corporate strategy practicespractices

Bain and Company Survey (2002)

◦25 most popular management tools used7

core competences ranked 11th

strategic planning ranked 1st

economic value-added analysis ranked 21st

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Focusing on core competences also was doubted It is a feel good exercise that no one failsEvery company can can identify an activity that it

does better than other activities and claim that as core competence

The definition of core competence should not be be based on “internal assessment of which activity of all its activities the company performs best, it should be a harsh external assessment of what it does better than competitors.-distinctive competence”e.g. Sears, Roebuck and Co. acquired Coldwell,

banker, largest real-estate brokerage firm in U.S. and Dean Witter, Reynolds, major securities broker

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◦ Sears acquisitions added to insurance and consumer credit card businesses. It was expected that it would leverage

expertise in data processing credit-card relationships with tens of millions of consumers trust in the eyes of many customers10

◦ Cross-selling efforts stalled -reluctance to share customer lists

◦ Sears’ executives failed to address weakening position in the retail business fiercely competitive industry threat of Wal-Mart’s rise

◦ Struggle to mitigate hostile takeover (1988)

◦ Exit financial services scope (1992)11

Two Tests applied to horizontal Two Tests applied to horizontal corporate strategycorporate strategyThe ‘Better-Off” test

◦ whether a particular set of business units should be working together as a broad scope

The “Best-Alternative” test◦ whether the set must be jointly owned to maximize

the amount of value created and captured◦ These tests are useful whether one is one is

considering the addition of a business unit to broaden horizontal scope or

◦ Thinking about divesting a unit to narrow scope, or,

◦ Deciding how to manage an existing portfolio of businesses portfolio 12

The possible third testThe possible third testBest parent test: the appropriate benchmark

for value creation is not what would happen without a corporate parent, but what the best available parent would achieve

The Good parent test : even if a proposed opportunity to expand scope apparently satisfies the earlier two tests, it is worth asking whether your company is particularly is particularly well placed to observe or act on the opportunities identified before you actually move to capitalise on it.

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The “Better-Off” TestThe “Better-Off” Test

To pass, an expansion in horizontal scope must enable a corporation’s business units to create and capture more value together than they could as separate, single-business entities unrelated to one another.

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The “Better-Off” TestThe “Better-Off” TestIndustry attractiveness

◦ broad horizon scope can improve industry structure by mitigating five

forces may provide opportunity to migrate out of a

structurally poor industry into a more attractive setting e.g. Nokia getting out of several industries (rubber, electricity generation, cables etc) into mobiles

Competitive advantage◦ improve position within an industry by creating value

increase the gap between price and costsCost effects

◦ shared cost economies15

The “Better-Off” TestThe “Better-Off” TestWillingness-to-pay/price effects

Benefits◦one-stop shopping◦cross-promotion◦umbrella brandingDifficulties◦conflict, cooperation, coordination◦mixed motives◦cognitive conflicts◦reputational risks

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The “Better-Off” TestThe “Better-Off” TestDuel effects

◦superior internal resource markets transfer mechanisms skills and capabilities

◦cross-business learning and innovation

Risk considerations

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The “Better-Off” TestThe “Better-Off” TestEffects of Horizontal Diversification on Competitive Advantage

-Availability of market / inter-firm alternatives- Typical breadth versus depth trade-off- Internal/inside-the-box biases- Antitrust laws/political backlash

- Superior internal resource markets/transfer mechanisms

- Other superior skills and capabilities

- Cross-business learning/innovation

- Size-based political influence

Dual Effects

• Compromise• Coordination- Mixed motives- Cognitive conflicts- Reputational risk

- One-stop shop/one-vendor sales and support

- Cross-promotion/cross-selling- Umbrella branding- Bundling, particularly of complements

Willingness-to- Pay/Price Effects

Diseconomies of scale or scope-Costs of• Conflict/politicking

Shared cost economies across businesses

• -Shared activities• -Shared resources

Cost Effects

Limits Levers for Value Creation

Component

The “Best-Alternative” The “Best-Alternative” TestTest

The ‘Better-Off” test focuses on corporate added value (value addition)

The “Best-Alternative” test◦ common ownership is not the only option◦ business units may choose to remain independently

owned (value appropriation) partnered strategic alliances long-term contracts

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The “Best-Alternative” The “Best-Alternative” TestTest

Transactions Costs and Ownership◦contractual complexity and incompleteness◦unclear property rights◦poor enforcement of contracts and property

rights◦relationship-specific or co-specialized

resources

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The “Best-Alternative” The “Best-Alternative” TestTestModels of Corporate

Management◦dominant-business corporations◦related-business corporations◦unrelated-business corporations

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The “Best-Alternative” TestThe “Best-Alternative” Test

SingleBusiness

Firms

Dominant- Business

Corporations

Related-Business

Corporations

Unrelated-Business

Corporations

Holding Company (portfolio

management)

Specialized Nature of Common

Resources

Generic

Activity / Resource Sharing

Coordination mechanisms

Resource/ Skill transfer

Operating Control systems

Financial

Large Cross-Business Management

Function Small

Models of Corporate Management

Increasing Horizontal Scope

An Application:An Application: Merrill Lynch’s Merrill Lynch’s Analysis Analysis of the AOL Time Warner of the AOL Time Warner MergerMergerAnnouncing moves that broaden

scope◦publicizes “synergies” between

sister units◦many synergy claims are logically

flawed highlighted by better-off tests best-alternative tests

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An Application: Merrill Lynch’s Analysis of the AOL Time Warner MergerAn Application: Merrill Lynch’s Analysis of the AOL Time Warner Merger Exhibit 6.3 highlights potential synergies from the AOL Time Warner Merger (in millions of

US $)

Source: Stephen P. Bradley and Erin E. Sullivan, “AOL Time Warner, Inc.,” (Harvard Business School Case no. 702-421, Boston, MA, 2002), p. 23.

$403.3$590.0Total Revenue Upside

2.510.0Increased Warner Music sales using AOL platform

6.325.0MusicDownloads on early generation music devices

30.060.0

New AOL Premium Services2mm AOL subscriptions sign up for $5 increase Fee by year-end 2001 (for AOL TV, real time stock quotes, etc.)

12.525.0Incremental SubscriptionsNew subscriptions to AOL and magazines (through cross-promotion)

72.0120.0

Higher Broadband Penetration1mm more broadband subscriptions for TW relationships from AOL upgrades 500K average for year paying $20 more per month

120.0120.0More deals on AOL, ICQ through TW relationships

$160.0$200.0

Ad Sales Upside$200 of $600mm in estimated revenue upside at TW Online properties (CNN, CNNfn, CNNSI, Time, People, InStyle, Entertainment Weekly)

EBITDARevenuesRevenue Enhancement

$600.0 $600.0

25.025.0Reduced telecom/technology costs across AOL-Time Warner

25.025.0Reduced cost of member subscription and renewal

25.025.0Reduced cost of content purchased by AOL ($600mm over 4 years)

50.050.0Reduced customer support cost (in COGS)

50.050.0Overhead (Finance, Legal, HR)

125.0125.0Reduced spending on TW online initiatives (Entertaindom)

100.0100.0Sales & Marketing, Time Warner (movies and music)

$200.0$200.0Sales & Marketing, AOL (distribution of AOL software)

EBITDARevenuesCost Savings: Reduced Operating Expenses

Total Cost Savings

An Application:An Application: Merrill Lynch’s Merrill Lynch’s Analysis Analysis of the AOL Time Warner of the AOL Time Warner MergerMergerexplains the rationale behind

some of the synergies1. Sales & Marketing – AOL distribution2. Reduced Customer Support Cost3. Reduced Cost of Content Purchased by

AOL4. Advertising Sales Upside (Time Warner)5. Incremental Subscriptions

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An Application:An Application: Merrill Lynch’s Merrill Lynch’s Analysis Analysis of the AOL Time Warner of the AOL Time Warner MergerMergerLogical flaws

◦ mutually beneficial arrangements achieved via contracts sales and marking budget cuts

◦ assumed that additional business units can tap already-heavily-utilized resources with little or no additional investment

◦ opportunity costs of common ownership are ignored

◦ benefits that are supposed to make the jointly-owned units better off are counted twice often, once in each unit

◦ costs and difficulty of cross-unit coordination are ignored cross-unit coordination is assumed to be free

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SummarySummaryStakes and level of difficulty are high

◦when choosing range in which to compete

Corporate-level scope choices ◦overlay on business-unit strategies◦choices of scope are effective or

ineffective depending on the extent to which they

contribute to the success or failure of individual business units in their specific industries

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SummarySummaryBroad scope must pass two tests

1. breadth must bring together business units that are made better off by their union

2. joint ownership must capture the benefits of breadth better than alternate arrangements

arms’-length trade licensing strategic alliances joint ventures

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SummarySummaryExamples demonstrate enormous

power of corporate strategy to◦create value◦destroy value

Will see more examples of both◦given the complexities of scope

choices

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SummarySummaryManagers can improve odds of

value creation and capture◦ask whether SBU’s are better off

under same corporate umbrella separated coordinated by alternative outright

ownership

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Key TermsKey Termsbest-alternative testbetter-off testcorporate added valuecorporate strategygood parent

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choosing corporate scope 1

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