CHAPTER
8
Corporate Strategy:
Vertical Integration
and Diversification
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Part 2 Strategy Formulation
LO 8-1 Define corporate-level strategy, and describe the three dimensions
along which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.
Chapter Case 8
Refocusing GE: A Future of
Clean-Tech 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%
 Lost AAA credit rating
• Refocus on green economy and health care industries
 Sold majority stake in NBC Universal to Comcast
• “Ecomagination”: solar energy, hybrid locomotives, fuel cells…etc.
• “Healthymagination”: increase quality and access to health care
Chapter Case 8
Refocusing GE: A Future of
Clean-Tech and Health Care?
GE’s Changing Product Scope
Chapter Case 8
Refocusing GE: A Future of
Clean-Tech and Health Care?
GE’s Changing Geographic Scope
Source: Author’s depiction of data in GE annual reports.
What Is Corporate Strategy?
• Corporate strategy
 Corporate strategy is the way a company creates value through the
configuration and coordination of its multi-market activities
 Quest for competitive advantage when competing in multiple industries

Example: 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
What Is Corporate Strategy?
• Three key dimensions:
 What stages of industry value chain and degrees of
vertical integration
 What range of products and services and degrees of
horizontal integration and diversification
 Where in the world to compete and global strategy
EXHIBIT 8.1
Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize
economic activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.
Transaction Cost Economics and Scope of the Firm
• Transaction cost economics
 Explains and predicts the scope of the firm
 "Market vs. firms" have differential costs
• Transaction costs
 Costs associated with economic exchanges
Either in the firm OR in the markets
 Ex: negotiating and enforcing contracts

• Administrative costs
 Costs pertaining to organizing an exchange within a
hierarchy

Ex: recruiting & training employees
Firms vs. Markets: Make or Buy
• Should a firm do things in-house (to make)? Or obtain
externally (to buy)?
• If Cin-house < Cmarket, then the firm should vertically integrate
 Ex: Microsoft hires programmers to write code
in-house rather than contracting out
 Firms and markets have distinct advantages and
disadvantages (see Exhibit 8.2)
EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets
Firms vs. Markets: Make or Buy?
• Disadvantage of “make” in-house
 Principal – agent problem

owner = principal, manager = agent
 Agent pursues his/her own interests
• Disadvantage of “buy” from markets
 Search cost
 Opportunism
 Incomplete contacting
 Enforce legal contacts
• Information asymmetries
 One party is more informed than others

Akerlof – “Lemons problem” for used cars
– Receiving Noble prize in Economics 
EXHIBIT 8.3 Alternatives along the Make or Buy Continuum
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
1–16
China Rare Earth Video
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value
chain: backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.
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, and
outputs in the value chain
 Horizontal value chain

Internal, firm-level value chains (Chapter 4)
• Vertical value chain
 Industry-level integration from upstream to
downstream

Examples: cell phone industry value chain
• Many different industries and firms
EXHIBIT 8.4
Backward and Forward Vertical Integration
along an Industry Value Chain
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
EXHIBIT 8.5
HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,
and when it does not.
Benefits of Vertical Integration
• Benefits of vertical integration
 Market power
• Entry barriers
• Down-stream price maintenance
• Up-stream power over prices
 Securing critical supplies
 Lowering costs (efficiency)
 Improving quality
 Facilitating scheduling and planning
 Facilitating investments in specialized assets

Ex: HTC started as OEM & expanded to fully integrated
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 coal plant and
electric utility 
 Physical asset specificity

Bottling machinery
 Human asset specificity

Mastering procedures of a particular organization
Optimal Input Procurement
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Managerial Eco. - Rutgers University
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
6-13
STRATEGY HIGHLIGHT 8.2
Back to the Future:
PepsiCo’s Forward Integration
• PepsiCo acquired bottlers in 2009
 Gain control over quality, pricing, distribution, and
in-store display.
Reversed a 1999 decision to sell off Pepsi bottlers
 Goal now is faster innovative products launched

• Forward integration
 Enhance flexibility and improve decision making
 Cost saving and interdependence
• Coca-Cola did the same: forward integration with bottlers
1–27
Risks of Vertical Integration
• Increasing costs
 Internal suppliers lose incentives to compete
• Reducing quality
 Single captured customer can slow experience effects
• Reducing flexibility
 Slow to respond to changes in technology or demand
• Increasing the potential for legal repercussions
 FTC carefully reviewed Pepsi plans to buy bottlers
Alternatives to Vertical Integration
• Taper integration
 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 value chain activities outside the firm's boundaries

Example: EDS and PeopleSoft provide HR services to many firms
that choose to outsource it.
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
Risks in undertaking cooperative
agreements or strategic alliances

Adverse selection


Moral Hazard


Partners misrepresent skills, ability and other
resources
Partners provide lower quality skills and
abilities than they had promised
Holdup

Partners exploit the transaction specific
investment made by others in the alliance
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.
• Diversification strategies:
 Product diversification

Active in several different product categories
 Geographic diversification

Active in several different countries
 Product – market diversification

Active in a range of both product and countries
EXHIBIT 8.7
Different Types of Corporate Diversification
STRATEGY HIGHLIGHT 8.3
ExxonMobil Diversifies into
Natural Gas
• ExxonMobil earned highest profit in its history in 2008
 Majority of profits come from petroleum-based products.
• Environmental change toward clean energy
 ExxonMobil must react to the change.
 ExxonMobil to focus on clean energy: natural gas.
• ExxonMobil acquired XTO Energy
 Leverage core competence in exploration and
commercialization of energy sources into natural gas.
 85% today fossil fuels

Exxon is largest producer of natural gas on the planet.
Exxon XTO video
1–34
LO 8-1 Define corporate-level strategy, and describe the three dimensions along
which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economic
activity.
LO 8-3 Describe two types of vertical integration along the industry value chain:
backward and forward vertical integration.
LO 8-4 Identify and evaluate benefits and risks of vertical integration.
LO 8-5 Describe and examine alternatives to vertical integration.
LO 8-6 Describe and evaluate different types of corporate diversification.
LO 8-7 Apply the core competence – market matrix to derive different
diversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive
advantage, and when it does not.
Motivations For Diversification
• Value Enhancing Motives:
 Increase market power

Multi-point competition
 R&D and new product development
 Developing New Competencies (Stretching)
 Transferring Core Competencies (Leveraging)
 Utilizing
excess capacity (e.g., in distribution)
 Economies of Scope
 Leveraging Brand-Name
(e.g., Haagen-Dazs to chocolate candy)
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:
– global supply chain
 Infosys – low-cost global delivery system
 Wal-mart
• The core competence – market matrix
 Provides guidance to executives on how to diversify
in order to achieve continued growth
EXHIBIT 8.8
The Core Competence – Market Matrix
Pepsi - Gatorade
BoA - NCNB
Salesforce.com
BoA - Merrill Lynch
Other Motivations For Diversification
• Motivations that are “Value neutral”:
 Diversification motivated by poor economic performance
in current businesses.
• Motivations that “Devaluate”:
 Agency problem
 Managerial capitalism (“empire building”)
 Maximize management compensation
 Sales Growth maximization

Professor William Baumol
Diversification
• Issue #1: When there is a reduction in managerial
(employment) risk, then there is upside and
downside effects for stockholders:
 On the upside, managers will be more willing to learn
firm-specific skills that will improve the productivity
and long-run success of the company (to the benefit
of stockholders).
 On the downside, top-level managers may
have the economic incentive to diversify to
a point that is detrimental to stockholders.
Diversification
• Issue #2: There may be no economic value to
stockholders in diversification moves since
stockholders are free to diversify by holding a
portfolio of stocks. No one has shown that
investors pay a premium for diversified firms -in fact, discounts are common.
 A classic example is Kaiser Industries that was dissolved
as a holding company because its diversification
apparently subtracted from its economic value.

Kaiser Industries main assets: (1) Kaiser Steel; (2) Kaiser
Aluminum; and (3) Kaiser Cement were independent
companies and the stock of each were publicly traded.
Kaiser Industries was selling at a discount which vanished
when Kaiser Industries revealed its plan to sell its holdings.
Corporate Diversification
• Diversification discount
 Stock price of diversified firms is less
• Diversification premium
 Stock price of diversified firms is greater
• Will diversification increase performance?
EXHIBIT 8.9
The Diversification-Performance Relationship
EXHIBIT 8.10
Vertical Integration and Diversification:
Sources of Value Creation and Costs
EXHIBIT 8.11
BCG Matrix
Corporate Diversification
• Internal capital markets
 Source of value creation in a diversification strategy
 Allows conglomerate to do a more efficient job of
allocating 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
EXHIBIT 8.12
Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
Problems in
Achieving Success
Reasons for
Acquisitions
Increased
market power
Integration
difficulties
Overcome
entry barriers
Inadequate
evaluation of target
Cost of new
product development
Large or
extraordinary debt
Increased speed
to market
Acquisitions
Inability to
achieve synergy
Lower risk
compared to developing
new products
Too much
diversification
Increased
diversification
Managers overly
focused on acquisitions
Avoid excessive
competition
Too large
Ch7-3
Sustainable Competitive Advantage
• Trying to gain sustainable competitive advantage via
mergers and acquisitions puts us right up against the
“efficient market” wall:
 If an industry is generally known to be highly profitable,
there will be many firms bidding on the assets already in
the market. Generally the discounted value of future
cash flows will be impounded in the price that the
acquirer pays. Thus, the acquirer is expected to
make only a competitive rate of return on investment.
Sustainable Competitive Advantage
• And the situation may actually be
worse, given the phenomenon of the
winner’s curse.
 The most optimistic bidder usually over-
estimates the true value of the firm:
 Quaker
Oats, in late 1994, purchased
Snapple Beverage Company for $1.7 billion.
Many analysts calculated that Quaker Oats
paid about $1 billion too much for Snapple.
In 1997, Quaker Oats sold Snapple for $300
million.
Sustainable Competitive Advantage
• Under what scenarios can the bidder do well?
 Luck
 Asymmetric Information
– This eliminates the competitive bidding premise
implicit in the “efficient market hypothesis”
 Specific-synergies (co-specialized assets) between
the bidder and the target.
– Once again this eliminates the competitive
bidding premise of the efficient market
hypothesis.
Take-Away Concepts
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).
 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.
Take-Away Concepts
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.
 In the resource-based view of the firm, a firm’s boundaries are delineated
by its knowledge bases and competencies.
 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 .
Take-Away Concepts
LO 8-3 Describe two types of vertical integration along the industry value
chain: backward and forward vertical integration.
 Vertical integration denotes a firm’s value added—what percentage of a
firm’s sales is generated by the firm within its boundaries .
 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.
Take-Away Concepts
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.
 Vertical integration contributes to competitive advantage if the
incremental value created is greater than the incremental costs of the
specific corporate-level strategy.
LO 8-5 Describe and examine alternatives to vertical integration.
 Taper integration is a strategy 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 if its
distribution.
 Strategic outsourcing involves moving one or more value chain activities
outside the firm’s boundaries to other firms in the industry value chain.
Off-shoring is the outsourcing of activities outside the home country.
Take-Away Concepts
LO 8-6 Describe and evaluate different types of corporate diversification.
 A single-business firm derives 95 percent or more of its revenues from
one business.
 A dominant-business firm derives between 70 and 95 percent of its
revenues from a single business, but pursues at least one other business
activity.
 A firm follows a related diversification strategy when it 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. Choices within a related diversification strategy can be
related-constrained or related-linked.
 A firm follows an unrelated diversification strategy when less than 70
percent of its revenues come from a single business, and there are few,
if any, linkages among its businesses.
Take-Away Concepts
LO 8-7 Apply the core competence–market matrix to derive different
diversification strategies.
 When applying an existing/new dimension to core competencies and
markets, four quadrants emerge, as depicted in Exhibit 8.8.
 The lower-left quadrant combines existing core competencies with existing
markets. Here, managers need to come up with ideas of how to leverage
existing core competencies to improve their current market position.
 The lower-right quadrant combines existing core competencies with new
market opportunities. Here, managers need to think about how to redeploy
and recombine existing core competencies to compete in future markets.
 The upper-left quadrant combines new core competencies with existing
market opportunities. Here, managers must come up with strategic
initiatives of how to build new core competencies to protect and extend the
firm’s current market position .
 The upper-right quadrant combines new core competencies with new
market opportunities. This is likely the most challenging diversification
strategy because it requires building new core competencies to create and
compete in future markets.
Take-Away Concepts
LO 8-8 Explain when a diversification strategy creates a competitive
advantage, and when it does not.
 The diversification-performance relationship is a function of the
underlying type of diversification.
 The relationship between the type of diversification and overall firm
performance takes on the shape of an inverted U (see Exhibit 8.9).
 In the BCG matrix, the corporation is viewed as a portfolio of businesses,
much like a portfolio of stocks in finance (see Exhibit 8.11). The
individual SBUs are evaluated according to relative market share and
speed of market growth, and plotted into one of four categories (dog,
cash cow, star, and question mark). Each category warrants a different
investment strategy.
 Both low levels and high levels of diversification are generally associated
with lower overall performance, while moderate levels of diversification
are associated with higher firm performance.