Foundation of Strategy

Chapter 7

Ian GoldbergNathan Smith

Michael MedfordCameron 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 E-of-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 MarketsDiversified Firm

Advantage

• Corporate headquarters allocates capital between different businesses

• Can avoid using external capital market (debt/equity deals)

• Better access to information on financial data

Disadvantage

• Failure to transfer cash from worst prospects to best prospects

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 long-term 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.