STRATEGIC MANAGEMENT

Lecture 10
Corporate Strategy: Vertical Integration
and Diversification
What Is Corporate Strategy?
• Corporate strategy comprises the decisions that
senior management makes and the goal-directed
actions it takes in the quest for competitive
advantage in several industries and markets
simultaneously.
• It provides answers to the key question of where to
compete.
• Corporate strategy determines the boundaries of the
firm along three dimensions/scopes:
 Vertical integration (along the industry value chain),
 Diversification (of products and services)
 Geographic scope (regional, national, or global markets).
WHY FIRMS NEED TO GROW
• 1. Increase profits: Profitable growth helps
business give ROIs to shareholders.
• 2. Lower costs: Larger firms means
economies of scale.
• 3. Increase market power: increased
market share leads to market power.
• 4. Reduce risk: failure risk is reduced by
diversification in different industries.
 What Is Corporate Strategy? (cont'd)

• Economies of scale
 Average per-unit cost decreases as its output
increases. Larger market share, therefore, often leads
to lower costs.
• Economies of scope
 Economies of scope is an economic concept that
the unit cost to produce a product will decline as the
variety of products increases.
 Ex: Amazon range of products & services.
• Transaction cost
 The cost associated with economic exchange
 "Make or buy" decision

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The Boundaries of the Firm
• Transaction costs are all internal and external
costs associated with an economic exchange,
whether it takes place within the boundaries of a
firm or in markets.
• external transaction costs: Costs of searching
for a firm or an individual with whom to contract,
and then negotiating, monitoring, and enforcing
the contract.
• internal transaction costs: Costs pertaining to
organizing an economic exchange within a
hierarchy; also called administrative costs.
FIRMS VS. MARKETS: MAKE OR BUY?

• Transaction cost economics allows us to explain

which activities a firm should pursue in-house
(“make”) versus which goods and services to
obtain externally (“buy”).
• If Cost of pursuing an activity in-house is less than Cost
of transacting for that activity in market, then the firm
should vertically integrate
 Ex: Microsoft hires programmers to write code
in-house rather than contracting out
Organizing Economic Activity: Firm vs. Markets

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 Firms vs. Markets: Make or Buy?
• Disadvantage of “make” in-house
 Principal – agent problem
 Agent(e.g. manager) pursues his/her own interests rather
than owners interest
 Involve agent to buy stocks one way to reduce this issue
• Disadvantage of “buy” from markets
 Search cost e.g. find reliable suppliers, distributors etc.
 Opportunism by other parties
 Incomplete contracting
 Enforce legal contracts is time consuming and costly
• Information asymmetries
 One party is more informed than others
 E.g. Suppliers are more knowledgeable about products
and services or market demand than the company 8-8
EXHIBIT 8.3 Alternatives along the Make or Buy Continuum

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ALTERNATIVES ON THE MAKE-OR-BUY
CONTINUUM
• The “make” and “buy” choices from markets to
firms, anchor each end of a continuum as
depicted.
• SHORT-TERM CONTRACTS: When engaging
in a firm sends out short-term contracting, to
several companies, which initiates competitive
bidding for requests for proposals contracts to
be awarded with a short duration, generally less
than one year.
ALTERNATIVES ON THE MAKE-OR-BUY
CONTINUUM
STRATEGIC ALLIANCES
• Voluntary arrangements between firms that involve
the sharing of knowledge, resources, and
capabilities with the intent of developing processes,
products, or services.
 Long term contracts: same as short term but the
duration is greater than a year.
 Franchising: long-term contract where the owner
licenses its operations—along with its products, branding,
and knowledge—in exchange for a franchise fee
 Joint venture: which is another special form of strategic
alliance, two or more partners create and jointly own a
new organization
Vertical Integration along the Industry Value
Chain
• Vertical integration: The firm’s ownership of its
production of needed inputs or of the channels by
which it distributes its outputs.
• Industry Value Chain: depicts the transformation
of raw materials into finished goods and services
along distinct vertical stages.
• Each stage of the chain shows a distinct industry
in which a number of different firms are
competing.
• This is also why the expansion of a firm up or
down the vertical industry value chain is called
vertical integration.
EXHIBIT 8.4 Backward and Forward Vertical Integration along an
Industry Value Chain

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Industry Value Chain- Cell Phone Example
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

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Types of Vertical Integration
Backward vertical integration:
• Changes in an industry value chain that
involve moving ownership of activities
upstream to the originating (inputs) point
of the value chain.
Forward vertical integration
• Changes in an industry value chain that
involve moving ownership of activities
closer to the end (customer) point of the
value chain.
 HTC’s Backward and Forward Integration along the
EXHIBIT 8.5
Industry Value Chain in the Smartphone Industry

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Benefits of Vertical Integration

• Benefits of vertical integration:

 Securing critical supplies and distribution
channels

 Lowering costs through economies of scale

 Improving quality

 Facilitating scheduling and planning: for

demand

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Example
• In 2009, PepsiCo forwardly
integrated by buying its bottlers in
order to obtain more control over its
quality, pricing, distribution, and in-
store display.
• Coca-Cola responded with its own
forward integration move and
purchased its bottlers for $12 billion
• By owning the bottlers, both
companies can deliver all products
through one channel, thus lowering
the overall cost of distribution.
 Risks of Vertical Integration

• Increasing costs
 Internal suppliers lose incentives to compete
• Reducing quality
 Knowledge that there will always be a buyer can slow
innovativeness and competitiveness.
• Reducing strategic flexibility
 Slow to respond to changes in technology or demand
• Increasing the potential for legal repercussions
 FTC carefully reviewed Pepsi plans to buy bottlers

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Corporate Diversification: Expanding Beyond a
Single Market

• Degrees of diversification
 Range of products and services a firm should offer
 Ex: Coca Cola only has beverages focus is only on Cola.
PepsiCo also owns Lay's & Quaker Oats.
• Diversification strategies:
 Product diversification
 A firm is active in several different product markets
 Geographic diversification
 A firm is active in several different countries
 Product – market diversification
 A firm is active in a range of both product and countries

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 Types of Corporate Diversification
• Single business firm: derives more than
95% of its revenues from one business.
The remainder of less than 5 % of revenue
is insignificant to its success. E.g. Google
revenue 95% by online advertising
• Dominant business: derives between 70
and 95 percent of its revenues from a
single business, but it pursues at least one
other business activity that accounts for the
remainder of revenue
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 Types of Corporate Diversification
• Related diversification: corporate strategy in
which a firm derives less than 70 percent of its
revenues from a single business activity and
obtains revenues from other lines of business
that are linked to the primary business activity.
 e.g. Disney’s purchase of ABC is an example of
related diversification.
 Honda is best known for its cars and trucks, the
company actually started out in the motorcycle
business.

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 Types of Corporate Diversification
• Unrelated diversification:
• “Don’t put all your eggs in one basket”
• Corporate strategy in which a firm derives
less than 70 percent of its revenues from a
single business and there are few, if any,
linkages among its businesses.
 Harley-Davidson, for example, once tried to sell
Harley-branded bottled water.
 Starbucks tried to diversify into offering Starbucks-
branded furniture.

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EXHIBIT 8.7 Different Types of Diversification

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 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:
 Walmart – global supply chain

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CORPORATE DIVERSIFICATION AND FIRM
PERFORMANCE
• Corporate managers pursue diversification to
gain and sustain competitive advantage.
• High and low levels of diversification are
generally associated with lower overall
performance, while moderate levels of
diversification are associated with higher firm
performance.
• This implies that companies that focus on a
single business, as well as companies that
pursue unrelated diversification, often fail to
achieve additional value creation.
CORPORATE DIVERSIFICATION AND FIRM
PERFORMANCE
• Firms that pursue unrelated diversification are
often unable to create additional value. They
experience a diversification discount in the
stock market
• companies that pursue related diversification are
more likely to improve their performance. They
create a diversification premium.
EXHIBIT 8.9 The Diversification-Performance Relationship

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CORPORATE DIVERSIFICATION AND FIRM
PERFORMANCE
• For diversification to enhance firm performance,
it must do at least one of the following:
 Corporate Diversification
• Restructuring
 Process of reorganizing and divesting business units
 To refocus a company to leverage its core
competencies
• One helpful tool to guide corporate portfolio
planning is the Boston Consulting Group
(BCG) growth-share matrix.
• This matrix locates the firm’s individual SBUs in
two dimensions: relative market share
(horizontal axis) and speed of market growth
(vertical axis).
• Plots SBUs into 4 categories: Cash Cows,
Dogs, Star, Question Mark 8-31
EXHIBIT 8.11 BCG Matrix

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Dog
• SBUs identified as dogs are relatively easy to
identify: They are the underperforming
businesses.
• Dogs hold a small market share in a low-growth
market; they have low and unstable earnings,
combined with neutral or negative cash flows.
• The strategic recommendations are either to
divest the business or to harvest it.
• This implies stopping investment in the business
and squeezing out as much cash flow as
possible before shutting it or selling it.
Cash cows
• Cash cows, in contrast, are SBUs that compete
in a low-growth market but hold considerable
market share.
• Their earnings and cash flows are high and
stable. The strategic recommendation is to
invest enough into cash cows to hold their
current position and to avoid having them turn
into dogs (as indicated by the arrow).
Star
• A corporation’s star SBUs hold a high market
share in a fast-growing market. Their earnings
are high and either stable or growing.
• The recommendation for the corporate strategist
is to invest sufficient resources to hold the star’s
position or even increase investments for future
growth. As indicated by the arrow, stars may
turn into cash cows as the market in which the
SBU is situated slows after reaching the maturity
stage of the industry life cycle
Question Marks
• Some SBUs are question marks: It is not clear
whether they will turn into dogs or stars.
• Their earnings are low and unstable, but they
might be growing. The cash flow, however, is
negative. Ideally, corporate executives want to
invest in question marks to increase their
relative market share so they turn into stars.
• If market conditions change, however, or the
overall market growth slows, then a question-
mark SBU is likely to turn into a dog.
• In this case, executives would want to harvest
the cash flow or divest the SBU
Implications for the Strategist
• Since a firm’s external environment never
remains constant over time, corporate strategy
needs to be dynamic over time.
• An effective corporate strategy increases a
firm’s chances to gain and sustain a competitive
advantage.
• By formulating corporate strategy, executives
make important choices along three dimensions
that determine the boundaries of the firm: