DEVELOPING STRATEGIES FOR COMPETITIVE ADVANTAGE

Session 8Diversification Strategy

Session 8Diversification Strategy

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• Introduction: The Basic Issues• The Trend over Time• Motives for Diversification

- Growth and Risk Reduction - Shareholder Value: Porter’s Essential Tests

• Competitive Advantage from Diversification• Diversification and Performance: Empirical Evidence• Relatedness in Diversification

Diversification StrategyDiversification Strategy

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OUTLINE

RETURN ON CAPITAL

> COST OF CAPITAL

INDUSTRY

ATTRACTIVENESS

COMPETITIVE

ADVANTAGE

Superior profit derives from two sources:

Diversification decisions involve these same two issues:

• How attractive is the sector to be entered?

• Can the firm achieve a competitive advantage?

The Basic Issues in Diversification DecisionsThe Basic Issues in Diversification Decisions

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• Business Strategy is concerned with how a firm computes within a particular market

• Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities

• The dimensions of scope are:– vertical scope– geographical scope– product scope

From Business Strategy to Corporate Strategy: the Scope of the Firm

From Business Strategy to Corporate Strategy: the Scope of the Firm

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P1 P2 P3 C1 C2 C3

VerticalScope

V1

V2

V3

P3P2P1 C3C2C1

V1

V2

V3

[A] SingleIntegrated Firm

[B] SeveralSpecialized Firms Linkedby Markets

In situation [A] businesses 1, 2 & 3 are integrated within a single firm.In situation [B] businesses 1, 2 & 3 are independent firms linked by markets.

Which situation is more efficient? Depends upon whether the administrative costs of the integrated firm are less than the transaction costs of markets?

ProductScope

Geographical Scope

Transactions Costs and the Scope of the Firm

Transactions Costs and the Scope of the Firm

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0

10

20

30

40

50

60

70

1949 1964 1974 1950 1970 1993

Single business

Dominant business

Related business

Unrelated business

United States United Kingdom%

Diversification Strategies of Large US and UK Companies During Late 20th Century

Diversification Strategies of Large US and UK Companies During Late 20th Century

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DEVELOPMENTSIN CORPORATE

STRATEGY

MANAGEMENT PRIORITIES

STRATEGY TOOLS & CONCEPTS

Quest for GrowthImproving perfo-rmance of widely diversified firms

Creating shareholder value

1960 1970 1980 1990 2000 2009

•Emergence of conglomerates

•Established firms diversify into related sectors

Emphasis on “related’ & “concentric” diversification

•Refocusing on core businesses •Divesting diversified businesses

•Financial analysis•Diffusion of M form structures •Creation of corporate planning depts.

•Economies of scope• Portfolio planning models• Capital asset pricing model

•Max. share-holder value

•Transaction cost analysis

•Core competence

•Dominant logic

•Competitive advantage through speed & flexibility•Growth

•Joint ventures and alliances•Focused Diversification to create growth options

•Dynamic capabilities

•Parenting advantage•Real options

Diversification: The Evolution of Strategic Thinking

Diversification: The Evolution of Strategic Thinking

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GROWTH --The desire to escape stagnant or declining industries a powerful motives for diversification (e.g. tobacco,

oil, newspapers). --But, growth satisfies managers not shareholders.

--Diversification in that seeks growth (esp. by acquisition) tends to destroy shareholder value

RISK --Diversification reduces variance of profit flowsSPREADING --But, doesn’t create value for shareholders—they can

hold diversified portfolios of securities. [Capital Asset Pricing Model shows that diversification lowers unsystematic risk not systematic risk].

VALUE --For diversification to create shareholder value, thenCREATION bringing putting different businesses under

common ownership must somehow increase their profitability.

Motives for DiversificationMotives for Diversification

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If diversification is to create shareholder value, it must meet three tests:

1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive).

2. The Cost of Entry Test : the cost of entry must not capitalize all future profits.

3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of “synergy” must be present)

Diversification and Shareholder Value: Porter’s Three Essential Tests

Diversification and Shareholder Value: Porter’s Three Essential Tests

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Competitive Advantage from Diversification(The “Better-Off” Test)

Competitive Advantage from Diversification(The “Better-Off” Test)

ECONOMIES OF

SCOPE

• Sharing tangible resources (research labs, distribution systems) across multiple businesses

• Sharing intangible resources (brands, technology) across multiple businesses

• Transferring functional capabilities (marketing, product development) across businesses

• Applying common general management capabilities to different businesses

ECONOMIESFROM

INTERNALIZINGTRANSACTIONS

• Economies of scope not a sufficient basis for diversification ----must be supported by transaction costs

• Diversified firm can avoid external transactions by operating internal capital and labor markets

• Diversified firm has better information on resource characteristics than external markets

Diversification: The Evolution of Strategic Thinking

Diversification: The Evolution of Strategic Thinking

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Economies of scope in diversification derive from

two types of relatedness:• Operational Relatedness-- synergies from sharing resources across

businesses (common distribution facilities, brands, joint R&D)• Strategic Relatedness-- synergies at the corporate level deriving

from the ability to apply common management capabilities to different businesses.

Problem of operational relatedness:

The benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.

Relatedness in DiversificationRelatedness in Diversification

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Corporate Management Tasks Determinants of Strategic Similarity

Resource allocation

Similar sizes of capital investment projects

Similar time spans of investment projects

Similar sources of risk

Similar general management skills required fo business unit managers

Strategy formulation

Similar key success factors

Similar stages of the industry life cycle

Similar competitive positions occupied by each business within its industry

Performance management and control

Targets defined in terms of similar performance variables

The Determinants of Strategic Relatedness Between Businesses

The Determinants of Strategic Relatedness Between Businesses

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