Chapter 8: Corporate Strategy:

Vertical Integration and Diversification

1. What is corporate-level strategy?
Corporate-Level Strategy= The decision that senior management makes and the actions it
takes in the quest for competitive advantage in several industries and markets simultaneously;
addresses where to compete.

When formulating corporate strategy, managers must clarify the firm’s focus on specific product
and geographic markets. The responsibility for corporate strategy ultimately rests with the CEO.
To gain and sustain competitive advantage, any corporate strategy must align with and
strengthen a firm’s business strategy, whether it is differentiation, cost leadership, or integration
strategy.

Scope of the Firm= The boundaries of the firm along three dimensions: industry value chain,
products and services, and geography (regional, national, or global markets). To determine these
boundaries, executives must decide: (fundamental corporate strategic decisions)

 Vertical Integration= Determined by deciding in what stages of the industry value

chain to participate.

 Horizontal Integration/Diversification= Determined by deciding what range of

products and services the firm should offer

 Global Strategy= Determined by where in the world firm will compete.

The three dimensions create a space in which corporate executives most position the company
for competitive advantage. Underlying strategic management concepts that guide the
fundamental decisions: Economies of Scale and Scope, and Transaction Costs.

2. Transaction Cost Economics and the Scope of the Firm

Transaction Cost Economics= A theoretical framework in strategic management to explain and
predict the scope of the firm, which is central to formulating a corporate-level strategy that is
more likely to lead to competitive advantage. (Challenge in corporate-level strategy)
 Help managers decide what activities to do in-house (make) versus what services and
products to obtain from the external market (buy).
 Different institutional arrangements – markets vs firms – have different costs attached

Transaction Costs= All costs associated with an economic exchange, whether within a firm or in
markets.

Administrative Costs= All costs pertaining to organising an economic exchange within a

hierarchy, including recruiting and retaining employees, paying salaries and benefits, and setting
up business. They increase with organizational size and complexity.

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2.1 Firm vs. Markets: Make or Buy?
If Cin-house < Cmarket  firm should vertically integrate by
owning production of the needed inputs or the channels
for the distribution of outputs.

Adv and disadv in exhibit 8.2.

Principal-Agent Problem = Situation in which an agent

performing activities on behalf of a principal pursues his
or her own interest (ex: job security, managerial perks).
The interest of managers and shareholders diverge.
Overcome it by making managers owners through stock
options.

Liquidity Events= One of the most high-powered incentives of the open market: taking a new
venture through an initial public offering (IPO), or being acquired by an existing firm.

Opportunism= behaviour characterized by seeking self-interest with guile.

Incomplete Contracting = all contracts are incomplete to some extent, since not all future
contingencies can be anticipated at the time of contracting.

Information Asymmetries= Situations in which one party is more informed than another,
mostly due to the possession of private information.

Lemons Problem= Nobel Laureate George Akerlof: Information asymmetries can result in the
crowding out of desirable goods and services by inferior ones, can lead to perverse effects.

Resource-based view of the firm = provides an alternative perspective on the make-or buy
decision. The internally held knowledge determines a firm’s boundaries. Core-activities should
be done in house, and non-core should be outsourced.

2.2 Alternatives on the Make-or-Buy Continuum

Short-Term Contracts (a mere

contractual arrangement)
Firm send out request for proposal (RFPs)
to several companies, which initiates
competitive bidding for contracts to be
awarded with a short duration, generally
less than one year; lower price due to
competition, and no transaction-specific
investments from the RFP.

Strategic Alliances
Voluntary arrangements btw firms that involve the sharing of knowledge, resources, and
capabilities with the intent of developing processes, products, or services together. Facilitates
investments. Denotes different hybrid organisational forms:

 Long –Term Contracts: > 1 year: help facilitate transaction-specific investments

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  Licensing: A form of long-term contracting in the manufacturing sector that enables
firms to commercialise intellectual property.
 Franchising: A long-term contract in which a franchisor grants a franchisee the right
to use the franchisor’s trademark and business processes to offer goods and services that
carry the franchisor’s brand name; the franchisee in turn pays an p-front buy-in-lump
sum and a percentage of revenues.
‼ All contracts are incomplete which opens door for opportunism by one of the
contractual parties due ro diverging motivations and incentives.
 Equity Alliances: a partnership in which at least one partner takes partial ownership in
the other partner (greater commitment)
 credible commitment: A long-term strategic decision that is both difficult and costly to
reverse.
 Joint Ventures: Organisational form in which two or more partners create and jointly
own a new organisation. (long-term commitment & facilitate transaction-specific
investments)

Parent-Subsidiary Relationship
Describes the most-integrated alternative to performing an activity within one’s own corporate
family. The corporate parent owns the subsidiary and can direct it directly by command and
control. Transaction costs arise due to political turf battle (ex: capital budgeting process and
transfer prices)

3. Vertical Integration along the Industry Value Chain

In what stages of the value chain should the firm participate?

Vertical Integration= firm’s ownership of its production of needed inputs or of the channels by
which it distributes its output.
 Can be measured by a firm’s value added and corresponds to the # of industry value-chain
stages in which it directly participates

Industry Value Chain= Vertical value chain; Depiction of the transformation of raw materials
into finished goods and services along distinct vertical stages, each of which typically represents
a distinct industry in which a number of different firms are competing.
≠Internal value chain which runs horizontally

3.1 Types of Vertical Integration

Fully vertically integrated= all activities are conducted within the boundaries of the firm

Vertically disintegrated= firms that focus on only one or a limited few stages of the industry
value chain
 Not all industry value-chain stages are equally profitable
 The Logic behind the decisions can be explained by applying SCP and VRIO models.

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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.

3.2 Benefits and Risks of Vertical Integration

Benefits of Vertical Integration
 securing critical supplies
 lowering costs
 improving quality
 facilitating scheduling and planning
 Facilitating investments in specialized assets: Assets that have significantly more value in
their intended use than in their next-best use (high opportunity cost); they come in three
types: site specificity (co-location), physical asset specificity, and human asset specificity
(unique knowledge and skills)
 Why incur high opportunity costs? It opens up the threat of opportunism by one of the
partners. Backward integration undertaken to overcome it.
 can increase differentiation

Risks of Vertical Integration

 increasing costs due to no competition and no incentives to lower costs; organizational
complexity -> more administrative costs
 reducing quality -> less competition so no incentives to increase quality and innovate
 reducing flexibility to changes in the external environment
 increasing the potential for legal repercussions

3.3 Alternatives to Vertical Integration

Taper Integration= A way of orchestrating value activities in which a firm is backwardly
integrated but also relies on outside market firms for some of its supplies, and/or is forwardly
integrated but also relies on outside-market firms for some of its distribution.
Benefits:

 exposes in-house suppliers and distributors to market competition, so that

performance comparisons are possible
 allows a firm to retain its competencies in
manufacturing and retailing
 enhances firm’s flexibility
 can combine internal and external knowledge, possibly
leading to innovation

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Strategic Outsourcing
Strategic outsourcing= Moving one or more internal value chain activities outside the firm’s
boundaries to other firms in the industry value chain.

Off-shoring= outsourcing in another country

4. Corporate Diversification: Expanding beyond a Single Market

Diversification= An increase in the variety of products or markets in which to compete; turn to
it to achieve growth (not guaranteed)
Non-diversified: single market / Diversified: several different markets simultaneously

 Product Diversification Strategy= Corporate strategy in which a firm is active in several

different product markets.

 Geographic Diversification Strategy= Corporate strategy in which a firm is active in

several different countries.

 Product-Market Diversification Strategy= Corporate strategy in which a firm is active in

several different product markets and several different countries.

4.1 Types of Corporate Diversification

Related Diversification Strategy
Corporate strategy in which a firm derives less
than 70 percent of its revenues from a single
business activity but obtains revenues from
other lines of business that are linked to the
primary business activity. (Economies of scale and scope)

1. Related-constrained diversification: the

company need to be related through
common resources, capabilities, and
activities.
2. Related-linked diversification: only a
limited number of linkages

Unrelated Diversification Strategy

Corporate strategy in which a firm derives less than 70 percent of its revenues from a single
business activity and there are few, if any, linkages among its businesses.

 Can be advantageous as it helps firms gain and sustain competitive advantage because it
allows the conglomerate to overcome institutional weakness in emerging economies.
« mega opportunities », high challenge sport drinks
saleforces.com

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4.2 Leveraging Core Competencies for Corporate Diversification
Competitive adv can be based on core competencies,
which are unique skills and strengths that allow firms to
increase the perceived value of their product offerings
and/or lower the cost to produce them.

Core-competencies matrix – by Gary Hamel – guide

managers decisions on how to diversify in order to achieve
continued growth.

4.3 Corporate Diversification: superior

performance? Bank of America Bank of America-

investment and wealth management

Diversification Discount= Situation in which the stock price
of highly diversified firms is valued at less than the sum of their
individual business units.

Diversification Premium = Situation in which the stock price

of related-diversification firms is valued at greater than the
sum of their individual business units.

For Diversification to Enhance Firm Performance:

 Provide economies of scale, and
thus reduce cost
 Exploit economies of scope, and
thus increase value
 Reduce cost and increase value
 Restructuring
 Using internal capital markets

Restructuring
Process of reorganising and divesting
business units and activities to refocus a company in order to leverage its core competencies
more fully. Helpful guide:

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Boston Consulting Group (BCG) growth-share matrix= A corporate planning tool in which
the corporation is viewed as a portfolio of business units, which are represented graphically
along relative market share (horizontal axis) and speed of market growth (vertical axis). SBUs
are plotted into four categories (dog, cash, cow, star, and question mark), each of which
warrants a different investment strategy.

Internal Capital Markets

Internal Capital Markets: can be a source of value creation in a diversification strategy if the
conglomerate’s headquarters does a more efficient job of allocating capital through its budgeting
process than what could be achieved in external capital markets

Related-diversification strategy entails two additional types of costs:

- Coordination Costs: A function of the number, size, and types of businesses that are linked to
one another

- Influence Costs: occur due to political manoeuvring by managers to influence capital and
resource allocation and the resulting inefficiencies stemming from suboptimal allocation of
scare resources

Related diversification is more likely to generate incremental value than unrelated

diversification.

Diversification can create shareholder value in theory but it more difficult to realize in practice.
Why so much diversification? Principal-agent problem & interdependent competitors in
oligopolistic industry structures are forced to engage in diversification in response to moves by
direct rivals. Lead to:

Bandwagon Effects= Firms copying moves of industry rivals.

5. Corporate Strategy: Combining Vertical Integration and

Diversification
A firm’s overall corporate strategy concerns both its level of integration along the vertical value
chain and its level of diversification. Executives determine the scope of a firm in such a fashion
as to enhance the firm’s ability to gain and sustain competitive advantage. To delineate the
boundaries of the firm, executive must formulate corporate-level strategy along three impotant
dimensions: vertical integration, horizontal integration, and global scope. Vehicle to do so:
acquisition, alliances, and networks