Foundation of Strategy
Chapter 7
Ian Goldberg
Nathan Smith
Michael Medford
Cameron Rice
Scope of the Firm
• Ask self, “What business are we in?”
• Starting point of strategy
• Basis for defining firm’s identity
• Corporate strategic decisions involve the breadth of
the firm’s product range (product scope) and the
extent of its involvement in the industry value chain
(vertical scope)
Scope of the Firm
• Many firms define their business via mission/vision
statements
• Some define their business with a focus exclusively on a
narrow part of the supply chain, others extend over many
supply chain activities
• Shell: “to engage efficiently, responsibly and profitably in oil,
oil products, gas, chemicals, and other selected businesses”
• McDonald’s: “to be the world’s beswt quick service
restaurant chain”
• JC Penney’s: “To drive Sales and Profit growth by ensuring
our Customers and our Associates always know they’re first
in our Stores by what We do!”
Trends
• The scope of a firm’s business is likely to change
over time
• Companies diversify offerings
• Microsoft went from supplying operating systems to
providing application and networking software
• JC Penney went from providing month-long specials
cutting prices by 20-30%, to permanently marking
down a large chunk of its merchandise by the same
price
Economies of Scope
• Cost economies from increasing the output of multiple
products
• Depends of the different types of resources and
capabilities
• Tangible resources (distribution networks, information
technology systems, sales forces, and research labs) – offer Eof-S by eliminating duplication between businesses through
creating a single shared facility
• Intangible Resources (brands, corporate reputation) – create
E-of-S by extending to additional businesses at a marginal
cost
Economies of Scope
• Brand Extension- exploiting a strong brand across
additional products
• Starbucks selling ice cream, packaged cold drinks,
audio CDs/books
• Organizational Capabilities- result from ability to
transfer capabilities between businesses within the
diversified company (can be replicated in a new
business at a fraction of the cost
Economies of Scope:
JCPenney
• Started off as a moderately priced department store
and by identifying target market as middle-class
($30,000-$80,000)
• Changed their focus to middle aged women (35-54)
and to offer dressy casual clothing items
• JCP changed focus from general public and middle
class to upper-middle/lower-upper
The Market
• A capitalist economy comprised of two forms of economic
organization
• Market Mechanism
• Administrative Mechanism
• Market Mechanism- where individuals/firms are guided by
market prices and make independent decisions to buy/sell
goods & services
• Administrative Mechanism- where decisions concerning
production and resouce allocation are made by managers
• Example, versus hiring a specialist firm to build a new house,
you can hire a general buileder, a plumber, an electrician, a
joiner and painter
Transaction Costs
• Costs determine which particular activities are
undertaken by a firm
• Markets are not free, costs include:
• Purchase/sales costs, contractual costs, costs to monitor and
ensure that the other party is fulfiling its side of the contract,
enforcement costs of arbitration/litigation
• During 20th century, companies grew in size and scope,
absorbing more transaction costs
• Major factor encouraging firms to extend their boundaries
was fall in administrative costs
• Technology was major source of falling admin. costs
Transaction Costs: JCPenney
• Large retailers such as JCP contract with a large
range of suppliers
• If we identify the supply chain arrangements that
support JCP’s provision of clothing to its stores, we
can identify the source of many different transaction
costs
Transaction Costs: JCPenney
• In order to ensure that its stores receive regular
supplies of good quality clothes, JCP must, forgoing
transaction costs:
• Bargain with selected suppliers to est. prices, quality,
standards, and other detailed aspects of the supply
arrangements
• Draw up a legal contract
• Monitor the supplier to mae sure that what is delivered
meets the terms of the agreements
• Enforce the contract and seek damages if the chosen
supplier defaults on the part of the contract
The Costs of Corporate
Complexity
• Corporate Complexity
• Additional business activities  Economies of scope
• Organizational Complexity
• Managing different businesses requires different
capabilities
• Different strategic planning systems
• Different approaches to human resource management
Tesco Corporate Complexity
• Grocery Retailer  Purchasing & Merchandising
• Diversification into non-food products
• Introduced clothing line  seamless
• Diversification into Financial Services
• Requires new competencies
• Not able to overcome
3 Concepts
• Economies of Scope
• Transaction costs
• Cost of managing complexity
Diversification
• Diversification
• Expansion of an existing firm into another product line
or field of operation
• Unrelated & Related
Unrelated Diversification
• Takes place when the additional product line is very
different from the firm’s core business
• Food processing company makes medical devices
Related Diversification
• Occurs when a firm expands into a similar field of
operation
• Ex: Car manufacturer extends product to trucks or
buses
• Also known as concentric diversification
• Greater potential benefits
Horizontal Diversification
• Involves the firm moving into the same stage of
production
• Unrelated to current products
• Sephora
Vertical Diversification
• Occurs when a firm undertakes successive stages in
the production of a good or service
Benefits & Cost of
Diversification
• Motives for diversification
•
•
•
•
Growth
Risk Reduction
Value Creation
Exploiting Economies of Scope
Motives for Diversification
• Growth
• Low growth industries diversify
• Exxon diversified into copper & coal mining
• Nabisco diversified from a tobacco company into
consumer products
Motives for Diversification
• Risk Reduction
• Don’t put all of your eggs in one basket
• Beneficiaries:
• Managers  Stable Profits = Job Security
Motives for Diversification
• Value Creation
• Primary Source
• Exploiting linkages between different businesses
• Sublicensing
• Are transaction costs worth the value?
Motives for Diversification
• Exploiting Economies of Scope
• Disney licenses the Donald Duck trademark to
Florida’s Natural Growers (Orange Juice)
• If resources can be traded/licensed out for value
• Not necessary to enter another business to find value
Internal Capital Markets
Diversified Firm
Advantage
Disadvantage
• Corporate headquarters
allocates capital between
different businesses
• Failure to transfer cash
from worst prospects to best
prospects
• Can avoid using external
capital market
(debt/equity deals)
• Better access to
information on financial
data
Internal Labor Markets
• Ability of diversified companies to transfer
employees
• Cost of hiring:
• Advertising
• Interviewing
• ‘Head-hunting’ agencies
When does diversification
create value?
• Michael Porter proposes three ‘essential tests’ to see
if diversification creates value
• The Attractiveness Test
• The Cost-of-entry Test
• The Better-off Test
The Attractiveness Test
• The industries chosen for diversification must be
structurally attractive or capable of being made
attractive
• Theory insufficient on its own
Cost-of-entry Test
• The cost of entry must not capitalize all the future
profits
• Sometimes cost of entry may counteract attractiveness
The Better-Off Test
• Either the new unit must gain competitive advantage
from its link with the corporation, or vice versa
• Addresses basic issue of competitive advantage
• In most diversification decisions, it is the ‘better-off
test’ that dominates
Diversification & Performance
• Empirical Research into diversification has 2 issues:
• How do diversified firms perform relative to specialized
firms?
• Does related diversification outperform unrelated
diversification?
Vertical Integration
• A firms ownership of vertically related activities
• Indicated by the ratio of a firm’s value added to to its
sales revenue
• The more a firm makes rather than buys, the lower its costs
are relative to sales revenue
Vertical Integration
• Backward
• Firm acquires ownership & control over production of
inputs
• Forward
• Firm acquires ownership & control over activities
previously undertaken by customers
Bilateral Monopolies
• Each steel strip producer is tied to its adjacent steel
producer
• Single supplier negotiates with single buyer
• All depends on bargaining power
• Once moved from competitive market to individual
buyers and sellers that are locked in bilateral
relationships, efficiencies of the market system are
lost
Bilateral Monopolies
• Invest in equipment that is specific to needs of other
party
• Built to match the other party’s plant
• Depends on availability of other party’s complementary
facilities
• Gives the opportunity to “hold up” the other
• Transaction-specific investments can result in transaction
costs arising
• Contracts may not cover everything
Incentive problem
• Vertical integration changes the incentives between
vertically related businesses
• Buyer and Seller
• Profit incentive makes buyer motivated to get best deal
• Seller motivated to pursue efficiency and service to retain
buyer (high-powered incentives)
• Creating stronger performance incentives is to open internal
divisions to external competition
• Create shared service organizations where internal suppliers
compete with external suppliers of the same services
Vertical Integration
• Neither good or bad, it all depends
• Variety of relationships between buyers and sellers
• Classified in relation to two characteristics
• Extent to which buyer and seller commit resources to
the relationship
• The formality of the relationship
Different Types of Vertical
Relationship
Different Types of Vertical
Relationship
• Spot contracts
• Immediate sale and delivery of commodities
• Long-term contracts
• Commitment to undertake agreed activity over several
periods of time
• Franchising
• Contract agreement between owner of business system
and franchiser that permits the franchisee to produce
and market their product
Recent Vertical Integration
Trends
• Massive shift from arm’s-length supplier
relationships to long-term collaboration with fewer
suppliers
• Arm’s-Length: buyers and sellers are independent and
have no relationship to each other, act in their own self
interest
• Outsourcing
• Involves not just individual components and services,
but whole chunks of the value chain
Portfolio Planning
• GE/McKinsey matrix
• Attractiveness and competitive advantage
Portfolio Planning
• Boston Consulting Group’s growth-share matrix
• Rate of market growth and relative market share
Portfolio Planning
• Ashridge portfolio display
• Value creating potential of business (subjective)
JCPenney
• Stock has currently dropped 23 percent this year, 44
percent in 2012
• Currently revamping pricing strategy from high-low
to everyday low
• Eliminating coupons and creating clearance sales
• Pension officials want to know more about longterm plan for turning around JCPenney fashion lines
• Cutting jobs to trim costs
Corporate Strategy
• The key roll of corporate strategy is about deciding
in which businesses to engage.
• These strategies are among the most important
business decisions top managers will make.
• Mistakes can be costly both financially and
strategically.
Corporate Strategy
• Historically the successful businesses are those that
change their product lines, acquire new resources
and developing capabilities in line with market
opportunities.
• Long-term adaption to the market conditions is
through diversification is likely to be more successful
if it is based on a sound strategic analysis.
Corporate Strategy
• Having determined the potential for diversification
or vertical integration to add value, the challenge is
then how to manage multi-business firm to extract
this potential value.
• This is were Portfolio Planning has become the
dominant way for managers to make sense of the
complexity and to develop a plan of consistency.