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7/27/2019 Chap008 - Revised
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8CHAPTER
McGraw-Hill/Irwin Copyright 2013 by The McGraw-H il l Companies, I nc. All ri ghts reserved.
Corporate Strategy:
Vertical Integration
and Diversification
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Part 2 Strategy Formulation
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LO 8-1 Define corporate-level strategy, and describe the three dimensionsalong which it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economicactivity.
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 differentdiversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,and when it does not.
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Chapter Case 8 Refocusing GE: A Future ofClean-Tech and Health Care?
Jeffrey Immelt appointed CEO of GE Sept. 7th
2001
Environmental Change (e.g., 9/11 and Global Financial Crises)
GEs 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 cellsetc.
Healthymagination: increase quality and access to health care
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Chapter Case 8Refocusing GE: A Future of
Clean-Tech and Health Care?
GEs Changing Product Scope
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Chapter Case 8Refocusing GE: A Future of
Clean-Tech and Health Care?
GEs Changing Geographic Scope
Source: Authors depiction of data in GE annual reports.
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What Is Corporate Strategy?
Corporate strategy
Corporate strategy is the way a company creates value through theconfiguration and coordination of its multi-market activities
Quest for competitive advantage when competing in multiple industries
Example: Jeffrey Immelts initiative in clean-tech and health care industries
Corporate strategy concerns the scope of the firm
Industry value chain
Products and services
Geography
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What Is Corporate Strategy?
Three key dimensions:
What stages of industry value chain and degrees ofvert ical integrat ion
What range of products and services and degrees ofho rizon tal integrat ionand diversi f icat ion
Where in the world to compete and global strategy
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EXHIBIT 8.1 Three Dimensions of Corporate Strategy
Scope of the f irmdetermines boundaries along these 3 dimensions.
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LO 8-1 Define corporate-level strategy, and describe the three dimensions alongwhich 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 differentdiversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,and when it does not.
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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 costsCosts pertaining to organizing an exchange within a
hierarchy Ex: recruiting & training employees
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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 vert ical ly integrate
Ex: Microsoft hires programmers to write codein-house rather than contracting out
Firms and markets have distinct advantages and
disadvantages (see Exhibit 8.2)
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EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets
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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 AkerlofLemons problem for used cars
Receiving Noble prize in Economics
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EXHIBIT 8.3 Alternatives along the Make or Buy Continuum
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STRATEGY HIGHLIGHT 8.1 Toyota Locks Up Lithiumfor 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 topower 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
http://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=cse7/27/2019 Chap008 - Revised
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LO 8-1 Define corporate-level strategy, and describe the three dimensions alongwhich it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economicactivity.
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 differentdiversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,and when it does not.
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Vertical Integration alongthe Industry Value Chain
In what stages of the industry value chainshould the firm participate?
Vertical integration
Ownership of its inputs, production, and
outputs in the value chainHorizontal value chain
Internal, firm-level value chains (Chapter 4)
Vertical value chain
Industry-level integration from upstream todownstream Examples: cell phone industry value chain
Many different industries and firms
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EXHIBIT 8.4 Backward and Forward Vertical Integrationalong an Industry Value Chain
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Types of Vertical Integration
Full vertical integration
Ex: Weyerhaeuser Owns forests, mills, and distribution to retailers
Backward vertical integration
Ex: HTCs backward integration into design of phones
Forward vertical integration
Ex: HTCs forward integration into sales & branding
Not all industry value chain stages are equal lyprof i table
Zara primarily designs in-house & partners for speedynew fashions delivered to stores
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EXHIBIT 8.5HTCs Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
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LO 8-1 Define corporate-level strategy, and describe the three dimensions alongwhich it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economicactivity.
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 differentdiversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive advantage,and when it does not.
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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
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Benefits of Vertical Integration
Specialized assets
Assets that have significantly more value in theirintendeduse than in their next best use
Types of specialized assets Site specificity
Co-located such as coal plant andelectric utility
Physical asset specificity
Bottling machinery
Human asset specificity
Mastering procedures of a particular organization
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Managerial Eco. - Rutgers University 6-13
Optimal Input Procurement
Substantial
specialized
investments
relative to
contracting costs?
Spot ExchangeNo
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Yes
Contract
No
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STRATEGY HIGHLIGHT 8.2 Back to the Future:
PepsiCos Forward Integration
PepsiCo acquired bottlers in 2009Gain 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
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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
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Alternatives to Vertical Integration
Taper integration Backward integrated but also relies on outside market firms
for suppliesOR
Forward integrated but also relies on outside market firmsfor some of its distribution
Strategic outsourcing
Moving value chain activities outside the firm's boundaries
Example: EDS and PeopleSoft provide HR services to many firmsthat choose to outsource it.
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EXHIBIT 8.6 Taper Integration along the Industry Value Chain
Outside suppliers couldalso be off-shoredwhenthey are not located in thehome country
Ri k i d ki i
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Risks in undertaking cooperative
agreements or strategic alliances
Adverse selection Partners misrepresent skills, ability and other
resources
Moral Hazard Partners provide lower quality skills and
abilities than they had promised
Holdup Partners exploit the transaction specific
investment made by others in the alliance
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Corporate Diversification:Expanding Beyond a Single Market
Degrees of diversification
Range of products and services a firm should offerEx: PepsiCo also owns Lay's & Quaker Oats.
Diversification strategies:
Product diversificationActive in several different product categories
Geographic diversificationActive in several different countries
Product market diversificationActive in a range ofbothproduct and countries
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EXHIBIT 8.7 Different Types of Corporate Diversification
E M bil Di ifi i
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STRATEGY HIGHLIGHT 8.3 ExxonMobil Diversifies intoNatural 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
http://video.nytimes.com/video/2009/12/14/business/energy-environment/1247466126026/exxon-mobil-will-buy-xto-energy.html?scp=1&sq=exxon%20xto&st=csehttp://video.nytimes.com/video/2009/12/14/business/energy-environment/1247466126026/exxon-mobil-will-buy-xto-energy.html?scp=1&sq=exxon%20xto&st=cse7/27/2019 Chap008 - Revised
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LO 8-1 Define corporate-level strategy, and describe the three dimensions alongwhich it is assessed.
LO 8-2 Describe and evaluate different options firms have to organize economicactivity.
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 differentdiversification strategies.
LO 8-8 Explain when a diversification strategy creates a competitive
advantage, and when it does not.
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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 ScopeLeveraging Brand-Name
(e.g., Haagen-Dazs to chocolate candy)
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Leveraging Core Competencies forCorporate Diversification
Core competenceUnique skills and strengthsAllows firms to increase the value of product/service Lowers the cost
Examples:Wal-mart global supply chain Infosys low-cost global delivery system
The core competence market matrix Provides guidance to executives on how to diversify
in order to achieve continued growth
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EXHIBIT 8.8 The Core Competence Market Matrix
BoA - NCNB BoA - Merrill Lynch
Pepsi - Gatorade Salesforce.com
http://www.salesforce.com/http://www.salesforce.com/7/27/2019 Chap008 - Revised
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Other Motivations For Diversification
Motivations that are Value neutral:
Diversification motivated by poor economic performancein current businesses.
Motivations that Devaluate:
Agency problem
Managerial capitalism (empire building)Maximize management compensation
Sales Growth maximization Professor William Baumol
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Diversification
Issue #1: When there is a reduction in managerial
(employment) risk, then there is upside anddownside effects for stockholders:
On the upside, managers will be more willing to learn
firm-specific skills that will improve the productivityand long-run success of the company (to the benefitof stockholders).
On the downside, top-level managers mayhave the economic incentive to diversify toa point that is detrimental to stockholders.
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Diversification
Issue #2: There may be no economic value to
stockholders in diversification moves sincestockholders are free to diversify by holding aportfolio of stocks. No one has shown thatinvestors pay a premium for diversified firms --in fact, discounts are common.
A classic example is Kaiser Industries that was dissolvedas a holding company because its diversificationapparently subtracted from its economic value.
Kaiser Industries main assets: (1) Kaiser Steel; (2) KaiserAluminum; and (3) Kaiser Cement were independentcompanies 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.
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Corporate Diversification
Diversification discount Stock price of diversified firms is less
Diversification premium
Stock price of diversified firms is greater
Will diversification increase performance?
The Diversification-Performance Relationship
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EXHIBIT 8.9The Diversification-Performance Relationship
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8 11 BCG Mat i
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EXHIBIT 8.11 BCG Matrix
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Corporate Diversification
Internal capital markets
Source of value creation in a diversification strategyAllows conglomerate to do a more efficient job of
allocating capital
Coordination cost
A function of number, size, and types of businesseslinked to one another
Influence cost
Political maneuvering by managers to influencecapital and resource allocation
Bandwagon effects
Firms copying moves of industry rivals
Oracle Corporate Strategy: Combining
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EXHIBIT 8.12Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
Problems inProblems inProblems in
Reasons forReasons for
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Ch7-3
Problems inAchieving Success
Problems inProblems inAchieving SuccessAchieving Success
IntegrationIntegration
difficultiesdifficulties
InadequateInadequateevaluation of targetevaluation of target
Too muchToo much
diversificationdiversification
Large orLarge or
extraordinary debtextraordinary debt
Inability toInability toachieve synergyachieve synergy
Managers overlyManagers overlyfocused on acquisitionsfocused on acquisitions
Too largeToo large
IncreasedIncreased
market powermarket power
OvercomeOvercomeentry barriersentry barriers
Lower riskLower risk
compared to developingcompared to developingnew productsnew products
Cost of newCost of new
product developmentproduct development
Increased speedIncreased speedto marketto market
IncreasedIncreaseddiversificationdiversification
Avoid excessiveAvoid excessivecompetitioncompetition
AcquisitionsAcquisitions
Reasons forReasons forAcquisitionsAcquisitions
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S t i bl C titi Ad t
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Sustainable Competitive Advantage
Trying to gain sustainable competitive advantage via
mergers and acquisitions puts us right up against theefficient market wall:
If an industry is generally known to be highly profitable,
there will be many firms bidding on the assets already inthe market. Generally the discounted value of futurecash flows will be impounded in the price that theacquirer pays. Thus, the acquirer is expected to
make only a competitive rate of return on investment.
Sustainable Competitive Advantage
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Sustainable Competitive Advantage
And the situation may actually beworse, given the phenomenon of thewinners curse.
The most optimistic bidder usually over-estimates the true value of the firm:
Quaker Oats, in late 1994, purchasedSnapple Beverage Company for $1.7 billion.
Many analysts calculated that Quaker Oatspaid about $1 billion too much for Snapple.In 1997, Quaker Oats sold Snapple for $300million.
Sustainable Competitive Advantage
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Sustainable Competitive Advantage
Under what scenarios can the bidder do well?
Luck
Asymmetric Information
This eliminates the competitive bidding premiseimplicit in the efficient market hypothesis
Specific-synergies(co-specialized assets) betweenthe bidder and the target.
Once again this eliminates the competitivebidding premise of the efficient market
hypothesis.
Take-Away Concepts
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LO 8-1 Define corporate-level strategy, and describe the three dimensionsalong which it is assessed.
While business strategy addresses how to compete, corporate strategyaddresses where to compete.
Corporate strategy concerns the scope of the firm along threedimensions: (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 mustsupport and strengthen a firms strategic position regardless of whether itis a differentiation, cost leadership, or integration strategy.
Take-Away Concepts
Take-Away Concepts
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LO 8-2 Describe and evaluate different options firms have to organizeeconomic activity.
Transaction cost economics help managers decide what activities to doin-house (make) versus what services and products to obtain from theexternal market (buy).
When the costs to pursue an activity in-house are less than the costs oftransacting in the market (Cin-house, Cmarket), then the firm should vertically
integrate. In the resource-based view of the firm, a firms 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 parentsubsidiary relationships .
Take Away Concepts
Take-Away Concepts
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LO 8-3 Describe two types of vertical integration along the industry valuechain: backward and forward vertical integration.
Vertical integration denotes a firms value addedwhat percentage of afirms sales is generated by the firm within its boundaries .
Industry value chains (vertical value chains) depict the transformation ofraw materials into finished goods and services. Each stage typicallyrepresents a distinct industry in which a number of different firms arecompeting .
Backward vertical integration involves moving ownership of activitiesupstream nearer to the originating (inputs) point of the industry valuechain .
Forward vertical integration involves moving ownership of activitiescloser to the end (customer) point of the value chain.
Take Away Concepts
Take-Away Concepts
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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, andfacilitating 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 thespecific corporate-level strategy.
LO 8-5 Describe and examine alternatives to vertical integration.
Taper integration is a strategy in which a firm is backwardly integratedbut also relies on outside market firms for some of its supplies, and/or isforwardly integrated but also relies on outside market firms for some if itsdistribution.
Strategic outsourcing involves moving one or more value chain activitiesoutside the firms boundaries to other firms in the industry value chain.Off-shoring is the outsourcing of activities outside the home country.
Take Away Concepts
Take-Away Concepts
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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 itsrevenues from a single business, but pursues at least one other businessactivity.
A firm follows a related diversification strategy when it derives less than70 percent of its revenues from a single business activity, but obtainsrevenues from other lines of business that are linked to the primarybusiness activity. Choices within a related diversification strategy can berelated-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
Take-Away Concepts
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LO 8-7 Apply the core competencemarket matrix to derive differentdiversification strategies.
When applying an existing/new dimension to core competencies andmarkets, four quadrants emerge, as depicted in Exhibit 8.8.
The lower-left quadrant combines existing core competencies with existingmarkets. Here, managers need to come up with ideas of how to leverageexisting core competencies to improve their current market position.
The lower-right quadrant combines existing core competencies with newmarket opportunities. Here, managers need to think about how to redeployand recombine existing core competencies to compete in future markets.
The upper-left quadrant combines new core competencies with existingmarket opportunities. Here, managers must come up with strategicinitiatives of how to build new core competencies to protect and extend thefirms current market position .
The upper-right quadrant combines new core competencies with newmarket opportunities. This is likely the most challenging diversificationstrategy because it requires building new core competencies to create andcompete in future markets.
Take Away Concepts
Take-Away Concepts
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Take Away Concepts
LO 8-8 Explain when a diversification strategy creates a competitiveadvantage, and when it does not.
The diversification-performance relationship is a function of theunderlying type of diversification.
The relationship between the type of diversification and overall firmperformance 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). Theindividual SBUs are evaluated according to relative market share andspeed of market growth, and plotted into one of four categories (dog,cash cow, star, and question mark). Each category warrants a differentinvestment strategy.
Both low levels and high levels of diversification are generally associatedwith lower overall performance, while moderate levels of diversificationare associated with higher firm performance.