CHAPTER
8
Corporate Strategy:
Vertical Integration
and Diversification
By Cecilia, Christine, and Savanna
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Part 2 Strategy Formulation
Christine
8-2
Refocusing GE: A Future of Clean-Tech
ChapterCase 8
and Health Care?
• Jeffrey Immelt appointed CEO of GE Sept. 7th 2001




Environmental Change (e.g., 9/11 and Global Financial Crises)
GE’s stock price fell by 84% over 17 months
Loss of shareholder value of $378 billion
Lost AAA credit rating
• Refocus on green economy and health care industries
 Sold majority stake in NBC Universal to Comcast
 Listed for sale its appliance unit
 Two strategic initiatives put into play
• ecomagination: solar energy, hybrid locomotives, fuel cells,
efficient lighting…etc (this generates $25 billion annually in
revenues)
• healthymagination: increase quality and access to health
care at a lower cost
Christine
8-3
Refocusing GE: A Future of Clean-Tech
ChapterCase 8 and Health Care?
GE’s Changing Product Scope
Source: Author’s depiction of data in GE annual reports.
Christine
8-4
Refocusing GE: A Future of Clean-Tech
ChapterCase 8
and Health Care?
GE’s Changing Geographic Scope
Source: Author’s depiction of data in GE annual reports.
Christine
8-5
What Is Corporate Strategy?
• Corporate strategy
 Quest for competitive advantage when competing in multiple
industries

Ex: Jeffrey Immelt’s initiative in clean-tech and health care industries
• Corporate strategy concerns the scope of the firm
 Industry value chain
 Products and services
 Geography
Christine
8-6
What Is Corporate Strategy? (cont'd)
• Three dimensions that determine the boundaries
of the firm . . .
 vertical integration - the stages of the industry value
chain
 horizontal integration and diversification – the
range of products and services the firm should offer
 global strategy - where in the world to compete
Christine
8-7
EXHIBIT 8.1
Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
Christine
8-8
What Is Corporate Strategy? (cont'd)
• Economies of scale
 The average per-unit cost decreases as its output
increases (the larger the market share, the lower the costs)

Ex: Anheuser-Busch Inbev largest global brewer
• Economies of scope
 Savings that come from producing two or more
outputs or providing different services at less cost

Ex: Amazon range of products & services
• Transaction cost
 The cost associated with economic exchange

Christine
"Make or buy" decision
8-9
Transaction Cost Economics and Scope of the Firm
• Transaction cost economics
 Explains and predicts the scope of the firm
 Scope
Gain & sustain competitive advantage
 Formulating corporate strategy

 In-house vs external market
 Institutional arrangements
SAV
8-12
Transaction Cost Economics and Scope of the Firm
• Transaction costs
 Costs associated with economic exchanges
Firm OR markets
 Ex: negotiating and enforcing contracts

• Administrative costs
 Organizing an exchange within a hierarchy
Recruiting & training
 Paying salaries and benefits
 Providing supplies

SAV
11
Firms vs. Markets: Make or Buy
• In-house (make)? Or externally (to buy)?
• If Cin-house < Cmarket, then the firm should vertically
integrate
 Own input production or distribution outputs
 Ex: Microsoft hires programmers
 Both distinct advantages and disadvantages
SAV
8-13
EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets
SAV
8-14
Firms vs. Markets: Make or Buy?
• Disadvantage of “make” in-house
 Principal – agent problem

owner = principal, manager = agent
 Personal interests
• Disadvantage of “buy” from markets
 Search cost
 Opportunism
 Incomplete contracting
 Enforce legal contracts
SAV
8-15
Firms vs. Markets: Make or Buy?
• Information asymmetries
 Uneven level of knowledge

Akerlof – “Lemons problem” for used cars
SAV
15
Alternatives of the Make or Buy Continuum
• Short-term contacts
 Competitive bidding process
 < One-year term
 Lower prices cost advantages
• Strategic alliances
 Facilitate investment without administrative costs
Long-term contacts
– Licensing & franchising
 Joint ventures
– Hulu
 Equity alliances
– Toyota & Orocobre

SAV
8-16
STRATEGY HIGHLIGHT 8.1
Toyota Locks Up Lithium for
Car Batteries
• World demand for lithium-ion batteries for cars
Grow from $278 million in ‘09 to $25 billion in 2014
• Toyota wants to secure long-term supply of lithium to power
its hybrid fleet
• Orocobre holds exploration rights to a large salt-lake area
Upfront investment to extract of lithium is very high
• Should Orocobre make the investment to supply Toyota?
To encourage investment, Toyota took an equity position
China Rare Earth Video
SAV
1–18
8-18
Alternatives of the Make or Buy Continuum
• Parent – subsidiary relationship
 Most integrated alternative
 Parent has command and control

Ex: GM owns Opel and Vauxhall in Europe
SAV
18
Vertical Integration along the Industry
Value Chain
• In what stages of the industry value chain should
the firm participate?
• Vertical integration
 Ownership of its inputs, production, & outputs in the
value chain
• Horizontal value chain

Transform inputs into outputs, with activities ranging from
basic R&D to customer service.
CECILIA
8-19
Vertical Integration along the Industry
Value Chain
• Vertical value chain (Industry)
 Industry-level integration run from upstream to
downstream

Examples: cell phone industry value chain
• Many different industries and firms
• Horizontal value chain (Internal, firm
level)

Run Horizontally
CECILIA
8-20
EXHIBIT 8.4 Backward and Forward Vertical Integration along an
Industry Value Chain
CECILIA
8-21
Example: of Vertical Integration is “Cell phone”
Stage 1:
Raw Materials
Chemicals, ceramics, metals, oil, and so
on.
-DuPont (U.S.), ExxonMobil (U.S.), others.
Stage 2:
Intermediate
goods
Components
Integrated circuits, displays, touch screens,
cameras, and batteries.
-Jabil Circuit (U.S.), Intel (U.S.), others.
Stage 3:
Manufacturing
Final Assembly
Stage 4:
Marketing
Sales
Stage 5:
Flextronics (Singapore) or Foxconn (China),
others.
Telecommunications companies like Ericsson
(Sweden), Motorola (U.S.), Nokia (Finland),
others.
To get wireless data and voice service.
CECILIA
Types of Vertical Integration
• Full vertical integration
 Ex: Weyerhaeuser
• Owns forests, mills, and distribution to
retailers
The company's operations are divided into three
major business segments:
1- Timberlands — Growing and harvesting trees in
renewable cycles.
2- Wood Products — Manufacturing and distribution
of building materials for homes and other structures.
3- Cellulose Fiber — Research and development,
manufacturing and distribution of pulp products.
CECILIA
8-23
Types of Vertical Integration
• Backward vertical integration
-Moving ownership of activities upstream to the
originating (inputs) point of the value chain.
• Forward vertical integration
 By moving downstream into sales and
increasing its branding activities.
 Moving ownership of activities closer to the
end (customer) point of the value chain.
CECILIA
8-24
Types of Vertical Integration
• Not all industry value chain stages are equally
profitable
 Zara – Vertically Disintegrated—
*Primarily designs in-house & partners for speedy new
fashions delivered to stores
CECILIA
8-25
EXHIBIT 8.5
HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
CECILIA
8-26
Benefits of Vertical Integration
• Specialized assets
 Assets that have significantly more value in their
intended use than in their next best use
• Types of specialized assets
 Site specificity

Co-located such as mining equipment
 Physical asset specificity

Bottling machinery – different shapes, unique molds
 Human asset specificity

Christine
Mastering procedures of a particular organization – not meant
to be transferred elsewhere
8-27
Risks of Vertical Integration
• Increasing costs
 Internal suppliers lose incentives to compete – always a buyer
for their products
• Reducing quality
 Single captured customer can slow experience effects – external
suppliers gain higher learning to develop quality products
• Reducing flexibility
 Slow to respond to changes in technology or demand – steel
industry went bankrupt
• Increasing the potential for legal repercussions
 FTC carefully reviewed Pepsi plans to buy bottlers – vertical
integration needs to be carefully considered
Christine
8-28
Alternatives to Vertical Integration
• Taper integration orchestrates value activities
 Backward integrated but also relies on outside
market firms for supplies
OR
 Forward integrated but also relies on outside market
firms for some of its distribution
• Strategic outsourcing
 Moving one or more internal value chain activities
outside the firm's boundaries


Christine
Ex: EDS and PeopleSoft provide HR services to many firms
that choose to outsource it
Another example – support staff in schools
8-29
EXHIBIT 8.6 Taper Integration along the Industry Value Chain
Outside suppliers could
also be off-shored when
they are not located in the
home country
Christine
8-30
Corporate Diversification: Expanding Beyond a
Single Market
• Degrees of diversification
 Range of products and services a firm should offer

Ex: PepsiCo also owns Lay's & Quaker Oats; Coca Cola only
specializes in beverages
• Diversification strategies:
 Product diversification

Active in several different product categories
 Geographic diversification

Active in several different countries
 Product – market diversification

Christine
Active in a range of both product and countries
8-31
Types of Corporate Diversification
• Single business

Google – 95% or more from one business
• Dominant business

Microsoft – 70 – 95% from single business, also XBox
• Related diversification
 Related constrained

ExxonMobil – trying to move into another area
 Related linked

Disney – active in a wide array of business activities
• Unrelated diversification

Christine
GE – less than 70% comes from a single business; they are all
over the place with jet engines, household appliances, TV
shows, etc
8-32
EXHIBIT 8.7
Christine
Different Types of Diversification
8-33
Leveraging Core Competencies for
Corporate Diversification
• Core competencies
 Unique skills and strengths
 Increase perceived value/lower production costs
• Examples:
Walmart – global supply chain
 Apple - Integration and user experience
 Infosys – low-cost global delivery system

• The core competence – market matrix
 Guidance to diversification strategies

Leading to growth
SAV
8-37
EXHIBIT 8.8 The Core Competence – Market Matrix
Pepsi - Gatorade
BoA - NCNB
Salesforce.com
BoA - Merrill Lynch
SAV
8-38
Corporate Diversification
• Diversification discount
 Stock price lowers
• Diversification premium
 Stock price is greater
SAV
8-39
Corporate Diversification (cont'd)
• How does diversification enhance performance?
 Economies of scale lower the cost
 Economies of scope increase the value
 Reduce cost and increase value simultaneously
SAV
8-41
EXHIBIT 8.10
Vertical Integration and Diversification:
Sources of Value Creation and Costs
SAV
8-42
Corporate Diversification (cont'd)
• Restructuring
 Reorganizing and divesting business units
 Refocus and leverage core competencies
• Boston Consulting Group growth-share matrix
 Dogs

Low-performing
 Cash cows

Low growth/considerable market share
 Stars

High market share/fast growing market
 Question marks

Unclear transformation
SAV
8-43
EXHIBIT 8.11 BCG Matrix
SAV
8-44
Corporate Diversification (cont'd)
• Internal capital markets
 Value creation in diversification strategy
 Efficient allocating of capital
• Coordination cost
 A function of number, size, and types of businesses
linked to one another
• Influence cost
 Political maneuvering by managers to influence capital
and resource allocation
• Bandwagon effects
 Firms copying moves of industry rivals
SAV
8-45
Corporate Strategy: Combining Vertical
Integration and Diversification
• Firms’ corporate strategy
 Level of integration on value chain
AND
 Level of diversification
Ex: Oracle earned $23B in 2009
 Enterprise software is core competency
– Backward integration – Sun Microsystems
– Forward integration – PeopleSoft
 Diversification at Oracle:
– Related – IP management bought Sophoi
– Unrelated – ID theft bought Bharosa

SAV
8-46
EXHIBIT 8.12
Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
SAV
8-47
Take-Away Concepts - Review
LO 8-1
Define corporate-level strategy, and describe the three dimensions along which it is assessed.
While business strategy addresses “how to
compete,” corporate strategy addresses “where to
compete”.
Corporate strategy concerns the scope of the firm
along three dimensions:
(1)vertical integration (along the industry value
chain);
(2)horizontal integration (diversification); and
(3)geographic scope (global strategy).
CECILIA
Take-Away Concepts - Review
LO 8-2
Describe and evaluate different options firms have to organize economic activity.
 Transaction cost economics help managers decide
what activities to do in-house (“make”) versus what
services and products to obtain from the external market
(“buy”).
 When the costs to pursue an activity in-house are
less than the costs of transacting in the market (Cin-house<
Cmarket), then the firm should vertically integrate.
 Moving from less integrated to more fully integrated
forms of transacting, alternatives include:
*short-term contracts,
*strategic alliances (including long-term contracts,
equity alliances, and joint ventures), and
*parent–subsidiary relationships .
CECILIA
Take-Away Concepts - Review
LO 8-3
Describe two types of vertical integration along the industry value chain: backward and forward vertical integration.
 Industry value chains (vertical value chains)
depict the transformation of raw materials into
finished goods and services. Each stage
typically represents a distinct industry in which a
number of different firms are competing .
 Backward vertical integration involves moving
ownership of activities upstream nearer to the
originating (inputs) point of the industry value
chain .
 Forward vertical integration involves moving
ownership of activities closer to the end
(customer) point of the value chain.
CECILIA
Take-Away Concepts - Review
LO 8-4
Identify and evaluate benefits and risks of vertical integration.
 Benefits of vertical integration include:
*securing critical supplies,
*lowering costs,
*improving quality,
*facilitating scheduling and planning, and
*facilitating investments in specialized assets.
 Risks of vertical integration include:
*increasing costs,
*reducing quality,
*reducing flexibility, and
*increasing the potential for legal
repercussions.
CECILIA
Take-Away Concepts - Review
LO 8-4
Identify and evaluate benefits and risks of vertical integration.
 Vertical integration contributes to
competitive advantage if the incremental
value created is greater than the
incremental costs of the specific
corporate-level strategy.
CECILIA
Take-Away Concepts - Review
LO 8-6 Diversification
An increase in the variety of products or markets
in which to compete.
There are various general diversification
strategies:
*Product Diversification Strategy.
*Geographic Diversification Strategy.
*Product-Market Diversification Strategy.
CECILIA
To gain & sustain competitive advantage,
any corporate strategy must support and
strengthen a firm’s strategic position
regardless of whether it is a differentiation,
cost leadership, or integration strategy.
1–50
MINI CASE 8-Core Competencies:
From Circuit City to CarMax
• Early 1990s, executives look for new ways to utilize core
competencies in other markets
• Leverage retail competency and improve customer buying
experience
• Launch CarMax in 1993
 Buy Trade-Ins at Blue Book value, even if you don’t buy
 Buying used car=root canal experience
 First store right by Circuit City Headquarters
 125 point inspection and detailing
 No haggle pricing, 5 day returns
 Thousands of cars for sale at any time
 100 Best companies to work for
 100 locations, employ 13,500 people, sell 350,000 cars, revenue $8
billion
7–51
MINI CASE 8-Core Competencies:
From Circuit City to CarMax
1. Do you judge CarMax to be successful? Why or why
not?
2. What type of diversification strategy is Circuit City’s
CarMax business venture?
3. Looking at core competence-market matrix in Exhibit
8.8, does circuit City’s CarMax diversification fall
neatly into one of the four quadrants? Why or why
not?
7–52
MINI CASE 8-Core Competencies:
From Circuit City to CarMax
4. Was CarMax a good strategic move for Circuit
City? Why or why not?
5. In 2002, Circuit City sold off CarMax, which
trades on the NYSE under KMX. Was this a good
decision by Circuit City’s top management team?
Why or why not?
7–53
Questions?
7–54