Module 5 - Horizontal Links and Moves
5.2
The Diversification Game
The ‘conglomerate’ corporate strategy is characterised by diversification into new and unrelated
business.
Diversification is both a direction and a method. It is a direction because the firm expands along
particular horizontal lines and a method because the firm exploits these opportunities through internal
organisation rather than through agreements with other firms.
5.2.1
Horizontal Directions in the Diversification Game
Diversification game seen from firm 3’s perspective:
Market
Helmets
Trousers
Jackets
Handbags
Umbrellas
1
2
3
4
5
6
7
8
9
10
Motor cycle Motor cycle Motor cycle Accessories Accessories
Technology Carbon-fire
Leather
Leather
Leather
Plastics/metals
The question is how Firm 3 should choose. Three rules which may help:
Rule 1: Competitive advantage: Each player must seek competitive advantage over the other. In our
simple game we assume particular moves may enhance competitive advantage in one of two ways;
the move must help shift at least one demand curve or one cost curve in a way that adds value to the
firms activity. Diversified firms do not compete; only their individual business units do. If diversification
is to have benefits it must be in terms of a positive impact of the ability of at least one of its businesses
to compete in the market place.
Rule 2: Only one move at a time: It is expensive to diversify at all levels
Rule 3: Fair play: Here fair play is interpreted to mean that a particular move does not allow a firm to
achieve a dominant position that would allow them to exercise monopoly control over customer or
suppliers.
Each move has different implication for competitive advantage.
Firm 3 merging or acquiring firm 8 – the specialisation shown below
The value chain and gains from specialisation:
sales force
trucks
Distribution
D
marketing development
market research
advertisement
Marketing
M
plant
equipment
labour force
Production
P
research
development
R&D
Firm 3
R&D
mergers with...
Firm 8
Partial links between the value chains in the case of both helmet and handbag moves:
D
M
D
M
D
M
D
M
P
R&D
P
R&D
P
R&D
P
R&D
Firm 3 plus Firm 6
The MC market
Firm 3 plus Firm 9
Leather technology
= Marketing and distribution linkages
= Technological linkages
Good fits between both value chains in the case of jackets to trousers:
D
M
D
M
P
R&D
P
R&D
Firm 3 plus Firm 7
Leather MC garments
Leather technology
The MC market
Strong linkages throughout the value chain in the case of specialisation:
D
M
D
M
P
R&D
P
R&D
Firm 3 plus Firm 8
Leather MC jackets
Leather technology
The MC market
Jackets to umbrellas a conglomerate type move generate no real linkages:
D
M
D
M
P
R&D
P
R&D
Firm 3 plus Firm 10
Jackets and umbrellas
5.2.2
Preferred Moves in the Diversification Game
What to prefer? The firm should specialise as far as possible if it is seeking competitive advantage.
There are four main reasons for this:
1. Resource effects. Specialise if you can; if you have to diversify, stay as close to home as
possible and try to avoid unrelated diversification as long as related alternative exists.
2. Market power considerations. If the firm is seeking more control over its market, the
specialisation option is clearly the most direct and powerful route to achieve this.
3. Allergic reactions. Firms can display an adverse reaction to new activities that are unrelated
or loosely related to its existing competencies. Failure of synergy in corporate expansion,
Michael Porter - it is often what firm knows rather than what they do not know that can be the
problem.
4. Rivals’ valuation. For example firm 4 value firm ten more than our firm 3.
5.2.3
Methods of Expansion in the Diversification Game
Why should the firm choose expansion by diversification as a method of expansion opportunities
rather than making some agreements with the firms to share resources?
Market power is one example. You may not trust your partner. Resource effects may be achieved by
co-operation as well as by diversification. The reason why firms diversify in some case is the
transaction cost associated by co-operation. The opportunity cost is also a reason for going the
conglomerate way.
5.3
Why Diversify?
5.3.1
Market Power
There are many ways that power could be exercised by diversification, but each tends to come down
to the increased share of the firm in particular markets.
How diversification can aid control of markets and technologies:
The MC market link
Helmets
D
M
Trousers
D
M
Jackets
D
M
Handbags
D
M
P
R&D
P
R&D
P
R&D
P
R&D
Leather technology link
5.3.2
Synergy
If resources can be shared across value chains for different businesses they may give rise to cost
savings described as synergy in strategic management and economics. If the businesses are
effectively the same these resource affects are described as economies of scale. There can be two
sources of gains in such cases:

Indivisibilities – Resources tend to come in lumps – a factory, a truck, a machine, an
economist, etc. If you where to cut each of these resources in two physically, they would not
be able to do their job any more. The fuller the use that can be made of these indivisible
lumps, the lower will the cost to the firm of using these resources.

Specialisation – Expansion of the firm may permit increased specialisation of resources
which in turn can lead to enhanced value for the combined firm.
Economics have traditionally focused at the level of individual products –like a jacket or a helmet –
and looked at cost and price considerations in the respective cases.
Strategic management focuses instead at the level of the individual firm and looks at the resource
questions that matter at this level. The bigger and the more diversified the firm, the less likely that
economies from sharing tangible resources such as plant and equipment are going to be important at
the level of corporate strategy, and the more likely that intangible resources such as managerial
capabilities are going to be of relevance.
5.3.3
User Gains
Diversification can also help generate competitive advantage for the diversifier by providing benefits
for the user. These gains tend to be reflected in one of two main ways:
 Cost advantage: e.g. one stop shopping with the convenience of one supplier of M/C goods
to retailers rather than three.

5.3.4
Differentiation: e.g. enhanced compatibility of products, with M/C jackets, trousers and
helmets in matching styles
Internal Markets
The diversified firm is in a position to create internal markets such as internal labour markets, internal
markets for R&D know-how or know-how in general, and so on. The form of transaction cost depends
on the case in point, but the advantages of internal markets over external markets are generally
regarded as having tree major sources:
 Asymmetric information – managers inside the firm will generally have access to more and
better information about the potential trade than outside individuals and organisations.

Control of opportunistic behaviour is easier from the inside

Divisionalisation gains - The growth of the diversified firm has been seen by some as
creating possible efficiency gains in terms of organisational structure. Instead of organising the
firm around functions in what has been termed a Unitary form or U-form structure, the firm
could now be organised around divisions in a Multi-divisional or M-form structure.
The major advantages that M-form structures have been identified as having over the U
structures for the large diversified firm include:
o The creation of profit centres to aid assessment and comparison of performance
o Putting together resources that have the most need to co-ordinate their activities into
natural units
o The separation of strategy formulation management responsibilities at headquarters
level in the firm from the functional responsibilities at divisional level
The disadvantages in substituting external markets with internal markets, especially in terms of
principal-agent problems in which the shareholders are the principal and management are the agents:
 Opaque performance – A problem with creating an internal market is that it reduces the
transparency of performance since the performance of divisions may be concealed within
consolidated accounts at he level of the firm

Lock-in – One of the great virtues of the market mechanism is its flexibility. Opportunity cost
considerations mean that assets have negative value in their present use, the market
mechanism provides very effective devices for reallocating assets to their best uses. Internal
markets can be stickier. For instance, one product can be dependent on the other, otherwise it
won’t be profitable.

‘Not invented here’ syndrome – Divisions may place more value on ideas developed by
themselves and less on ideas developed elsewhere, even if these ideas have been developed
by other divisions within the same company.
One of the most widely considered markets in the context of the diversified firm has been the internal
capital market. By throwing corporate boundaries around the various businesses operated by the
conglomerate, it was argued that this would allow the firm to avoid the transaction costs associated
with the blunter and less sensitive instrument of the external capital market, these firms remained
independent, smaller and more specialised.
Conglomerate could exploit advantages in terms of information, control and divisionalisation from
treating the firm as a mini-capital market.
If it works well for conglomerates it work even better for related diversification. The internal capital
market justification for the conglomerate is a justification of the conglomerate as a method. Essentially
it says that in certain circumstances internal markets are more efficient than external markets, so if you
have to choose between the conglomerate and a series of independent firms, you might be better of
with a conglomerate.
Diversification and creation of internal markets:
Helmets
D
M
P
R&D
Jackets
D
M
Handbags
D
M
P
R&D
P
R&D
The related diversifier
can exploit a variety of
linkages in its internal
markets
The conglomerate
strategy exploits only
financial linkages in its
internal market
DIV 1
DIV 2
DIV 3
Organisational structure
for the related diversifier
to help create internal
capital markets
Similar (divisionalised)
organisational structure
for the conglomerate
Umbrellas
D
M
Helmets
D
M
Fast food
D
M
P
R&D
P
R&D
P
R&D
5.3.5
H.Q
H.Q
DIV 1
DIV 2
DIV 3
Growth
One frequently cited argument for diversification runs as follows: because of separation of ownership
and control asymmetric information, there is typically a principal-agent problem with manager having
some discretion over pursuing their objectives at the expense of owners objectives.
Owners would normally wish to maximise profits, but managers wish the firm to grow. Therefore,
managers may choose diversification for growth – that may be why conglomerates grows.
5.3.6
Risk and uncertainty
Diversification can reduce risk in many contexts. If the management of a single-business firm is
worried about its dependence on the fortunes of one business it might consider diversifying into other
business to spread risk. There are two sets of problems as follows:
 Opportunity cost of diversification – Diversification moves the firm away from its core
business and competencies. It may turn out to be a mistake once opportunity cost
considerations is taken into account. There may be cheaper ways to dealing with risks.

Owners may spread their risks by diversifying their portfolios
The important issue in each case is to identify which, if any, problems are caused with volatile sales
this may be solution to reduce risk:
 Liquid assets (assets that may be quickly realised by the firm) – firm could set aside funds for
dips

Short-term finance – the firm may not even have to keep a fund in the form of liquid assets if
presenting the variation for a bank. They get short-term credit

Stockholding – Keep the production on the same level

Insurance – it may be possible to transfer the risk to insurance company

Long-term contracts is a way the firm could pass on the risk of variability,

Vertical integration can be a way to reduce risks and guarantee sales.
None of these solutions is free. Another risk is if a rival come up with improved technology and our
sales goes down. A strategic bomb is shown. When external threats hit a firm they may not focus just
on individual businesses, but on particular linkages. For example, if Firm 3 merged with Firm 8 above
it will be able to extract gains from marketing/distribution and technological linkages.
The linkages that can help generate enhanced value when the environment is relatively stable can
also pose a source of joint weakness when the environment begins to throw up nasty threats. For
example, if the M/C business begins to decline, then both jackets and trousers could be attacked
along the M/C market linkage. If a rival develops an improved synthetic substitute for leather, then
both jackets and trousers can be attacked along the shared technological linkage.
Corporate diversification can help provide a basis for defending the firm against unpleasant surprises
such as technological innovation by its competitors. However, there are further questions we can ask
of this strategy; it is not going to be let off so easily:

Why not specialise until you are forced to change to another business? – Diversification
usually takes time and costs a lot, so when it has to it may be the worst timing

If some corporate diversification is designed to safeguard managerial jobs, can this
also be in interest of owners? It can be on very special occasion for instance where the
alternative would be bankruptcy or an alternative to loosing the best and necessary resources.

If risks such as technological innovation by competitors are often one off surprises,
how can management know in advance when they should diversify? – This is impossible
to answer- Good strategic management may find indications or warnings
On the face of it, conglomerate diversification offers the most obvious way of anticipating threats to the
viability of individual businesses.
5.4
Forms of Diversification
Firms diversify for a number of reasons. These include market power, resource effect, user gains,
creation of internal markets, growth motives and dealing with the possibility of attacks on the viability
of individual businesses. Most motives suggest that the firm should stay as close to home as possible.
Related link strategy (Richard Rumelt Harvard Business School) is when firms simultaneously exploit
the gains from the linkages between businesses together with risk-spreading benefits of multiple
markets and multiple technologies that the conglomerate strategy offers.
New game:
Helmets
MC Audio
equipment
Jackets
12
6
Saddles
3
Handbags
Umbrellas
11
15
14
Fast food
13
9
10
16
Market
Motor cycle Motor cycle Motor cycle Horse riding Accessories Accessories Restaurant
Plastics/
Technology Carbon-fire Electronic
Leather
Leather
Leather
Retailing
metals
Some moves Firm 3 can make in game 2
MC jackets pursues market-based diversification, exploiting selling and distribution linkages:
Helmets
D
M
P
R&D
Jackets
D
M
Audio
D
M
P
R&D
P
R&D
Here MC jackets becomes a conglomerate, moving into new markets and technologies:
Umbrellas
D
M
Jackets
D
M
Fast food
D
M
P
R&D
P
R&D
P
R&D
Technology based diversification MC jackets exploits production and R&D competencies:
Handbags
D
M
Jackets
D
M
Saddles
D
M
P
R&D
P
R&D
P
R&D
The related-linked strategy; here MC jackets exploits different linkages in its moves:
Helmets
D
M
P
R&D
Jackets
D
M
Handbags
D
M
P
R&D
P
R&D
The most important attacks in real life corporate battles tend to be the following:
 Innovation in from of new products or processes
 Change in consumer tastes
 Change in government restriction

Resource depletion, an industry can simple begin to run out of raw material. Resource
depletion is likely to be a slow ticking bomb at worst with firms usually having plenty of time to
prepare for the worst.
How much damage can a simple bomb do? The answer depends on the pattern of linkage, not just
the extent of linkages.
Market bombs can be dangerous to firms that are diversified and market related. Technology bombs
can be dangerous for firms that are diversified and technological related. Technology and market
threats do not affect the firm as a whole if it is a conglomerate that’s one favour for the conglomerate.
Growth using related-linked strategy:
Helmets
D
M
P
R&D
Jackets
D
M
Handbags
D
M
Umbrellas
D
M
P
R&D
P
R&D
P
R&D
Related-linked expansion; now no more than two of the
firm's businesses are vulnerable to any threat to specific
competencies
By the figure above, a single bomb could only impact on two of its four businesses even if it were
aimed at a competence and not a single business.
This is a degree of insulation from external threat, which is almost as good as the conglomerate, and
indeed the more that the related-linked firm expands using this strategy, the closer it approximates the
degree of protection offered by conglomerates.
But it is not a conglomerate since every business is linked to every other and there is a solid level of
linkage exploited as we move through the strategy, just as in the case of the market-based and
technology-based diversifiers. This is a strategy that seems to enable management to exploit the
advantages of related diversification without incurring the dangers of exposure to a single external
threat.
The related-linked strategy is one of the unsung successes of corporate diversification. Rumelt’s study
found that it had been adopted by many of the most successful large firms in the US economy since
the nineteen-sixties.
Conglomerates usually do not exist for synergy, deep pocket, market power reasons, or to absorb the
risks to individual businesses. Anything the conglomerate can do in these respects, related to
diversification can match and improve on. Answers to the riddle of the conglomerate must lie
elsewhere and include the following:

The disguised related-link firm: many firms which appears to be conglomerates because of
the diversity of their businesses turn out on closer inspection to be related-linked firms rather
than genuine conglomerates.

Restructuring of related-linked firms: Related linked strategy can be fragile and it does not
take much to turn into a conglomerate, especially if the firm is under pressure to divest lossmaking businesses.
If a related-linked firm decides to divest
loss-making businesses that act as
connectors to the rest of the firm
D
M
D
M
D
M
D
M
D
M
P
R&D
P
R&D
P
R&D
P
R&D
P
R&D
...then it may turn itself into
a conglomerate by default
D
M
D
M
D
M
P
R&D
P
R&D
P
R&D
D
M
P
R&D

No alternatives: There are some industries which have faced external threats in the past for
which it has been difficult to find closely related products. Tobacco and petroleum are two
cases in point in which attempts to expand and escape from a threatened industrial base led
the firms into unrelated fields when value-enhancing related opportunities proved difficult to
find.

Rapid growth: Synergy takes time and patience to release. If the firm is seeking really fast
growth rates in the immediate time period and the capital market is willing to bankroll your
plans, then synergy is less important. Strategic planning can become dominated by availability
of acquisitions rather than how they fit existing businesses. This is how many acquisitive firms
in the past turned into conglomerate.

Path dependency: Restructuring, the absence of alternative and rapid growth may explain
why some firms become conglomerates but they do not help explain why they remain such.
One answer is the path dependency. The managing skills in the firm may be built on
managing unrelated businesses and shifting strategy involve a major change among top
management skills and substantial transaction costs in buying and selling business until the
new strategy is created.

Conglomerate focus: Management learn and adapt. They may not be able to change their
spot easily but they can do the next best thing – they can shuffle them around.
Downsizing and conglomerate persistence:
This conglomerate has been hit by
threats to two of its businesses...
D
M
D
M
D
M
D
M
D
M
P
R&D
P
R&D
P
R&D
P
R&D
P
R&D
...so it has divested these loss makers
and instructed the three ramaining
groups to diversify into related fields
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
D
M
P
R&D
Vertical integration is unlikely to be a successful long-term solution for a firm in a declining
industry.
Decline in unit cost with cumulative production is the definition of the learning curve