CORPORATE STRATEGYFOUNDATIONS OF STRATEGY

Team 5

OBJECTIVES

The scope of the firm Concepts for analyzing firm scope Diversification Vertical integration Managing the corporate portfolio

SCOPE OF THE FIRM

Range of product/market activities the firm undertakes Product scope- how specialized the firm is in terms

of the range of products it supplies. Ex. Coca Cola is engaged in a single industry sector.

Vertical Scope- the range of vertically linked activities the firm encompasses. Ex. Nike

Geographical scope- the geographical spread of activities for the firm. Whether a company operates globally or in a certain area.

What Business are we in? This question is the basis for defining the firm’s identity

KEY CONCEPTS FOR ANALYZING FIRM SCOPE

Change scope to continue to create value for shareholders Southwest during the 2008 recession

“With the weak domestic economy and unprecedented jet fuel prices, we are pleased to report our 69th consecutive quarter of profitability. Although we have prepared ourselves well for today's challenging environment and are proud of our ability to sustain profitability, we cannot stand still. We must continue to make the necessary adjustments to adapt to higher jet fuel prices and restore our profit margins."

3 concepts for analysis Economies of Scope Transaction Costs Costs of Corporate Complexity

ECONOMIES OF SCOPE

Put out more of multiple products to decrease unit cost or resource use

Good for multi-business firms to gain cost-advantage

Tangible Resources Intangible Resources Licensing

TRANSACTION COSTS

Costs associate with participating in a market

Market Mechanism Adam Smith “invisible hand”

Administrative Mechanism Alfred Chandler “visible hand” Decisions concerning production & resource

allocation are made by managers

COSTS OF CORPORATE COMPLEXITY

Incurring additional management costs Administrative costs may outweigh

potential cost savings Diverse businesses may require various

strategic planning to avoid profit loss

DIVERSIFICATION

Unrelated: takes place when the additional product line is different from the firm’s core business

AKA: Conglomerate Diversification

Related: occurs when a firm expands into a similar field of operation

AKA: Concentric Diversification

DIVERSIFICATION

Horizontal: the firm moves into the same stage of production

Vertical: occurs when a firm undertakes successive stages in the production of a good or service

MOTIVES FOR DIVERSIFICATION

Growth Risk Reduction Value Creation Exploiting Economies of Scope Internal Capital Markets Internal Labour Markets

Not all motives are consistent with the creation of shareholder value.

GROWTH

Without diversification, firms will remain stagnant.

Low-growth, cash flow-rich industries are susceptible to diversification.

Investments in diversification take away from shareholder returns.

RISK REDUCTION

Reduce risk by pooling profits from different businesses under one common owner.

Many incomes create stable profit earnings.

The primary beneficiaries tend to be managers because stable profits means job security.

VALUE CREATION

Value creation occurs through the exploitation of linkages between businesses.

Links can be operational, strategic, technical, etc.

To fully exploit the value creation of diversified activities, administrative costs should be low

EXPLOITING ECONOMIES OF SCOPE

Commonly done through the trading or licensing of a firm’s resource.

Easily traded resources do not require entry into new businesses.

INTERNAL CAPITAL MARKETS

Corporate headquarters will allocate capital through a capital expenditure budget.

Advantages:1. avoid costs associated with borrowing

cash or issuing equity2. Access to better internal financial

information than external.

INTERNAL LABOR MARKETS

Diversified companies have a pool of employees and can respond to specific labor needs with employee transfers.

Eliminates costs associated with hiring and firing people.

Detailed information on employee competencies can be collected and shared easily between businesses.

WHEN DOES DIVERSIFICATION CREATE VALUE?

Michael Porter’s three essential tests:

1. The attractiveness test2. The cost-of-entry test3. The better-off test

THE ATTRACTIVENESS TEST

The industries chosen for diversification must be structurally attractive or capable of being made attractive

Industry attractiveness is insufficient on its own.

THE COST-OF-ENTRY TEST

The cost of entry must not capitalize all the future profits.

Barriers to entry can counteract the attractiveness of an industry.

Acquisition or Corporate Venture are the two ways to enter an industry.

THE BETTER-OFF

The new unit must gain competitive advantage from its link with the corporation or vice versa.

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

DIVERSIFICATION AND PERFORMANCE

Empirical studies associate high levels of diversification with lower profitability.

There are benefits to moderate diversification - “a strategic sweet spot between focus and broader diversification.”

Findings reflect that turbulence of the business environment increase the costs of managing diversified companies.

RECENT TRENDS IN DIVERSIFICATION

Diversified companies have began divesting their non-core businesses.

Highly diversified business groups dominate many emerging countries: India, Thailand, Indonesia, Malaysia, etc.

Firms are beginning to acquire “growth options.”

VERTICAL INTEGRATION

Refers to a firm’s ownership of vertically related activities.

Vertical Integration can be backward or forward.

Vertical Integration can be either full or partial.

BENEFITS AND COSTS OF VERTICAL INTEGRATION

Strategies towards vertical integration have been shifting fashions.

Many of the coordination benefits traditionally associated with vertical integration can be achieved through collaboration between vertically related companies.

TRANSACTIONS COSTS IN VERTICAL EXCHANGES

The Incentive problem- Vertical Integration changes the incentives between vertically related businesses.

Flexibility- Both vertical integration and market transactions can claim advantage with regard to different types of flexibility.

DIFFERENT TYPES OF VERTICAL RELATIONSHIP

1. Vendor Partnerships2. Franchising Recent trends in vertical integration: Growing diversity of hybrid vertical

relationships A massive shift from arm’s length

supplier relationships to long-term collaboration with fewer suppliers.