Business Policy Review Guide: Ch. 6-11 – Vertical Integration, Diversification, & More

Posted on Sep 5, 2024 in Economy

Business Policy Chapters 6-11 Review Guide

Chapter 6: Vertical Integration

Understanding the Supply Chain and Vertical Integration

The supply chain and how forward and backward vertical integration are accomplished:

• Backward Integration: Moving closer to the source of raw materials.
• Forward Integration: Moving closer to the end customer.
• Vertical Integration: Integration across the supply chain.

When and Why to Vertically Integrate

When does it make sense to vertically integrate? Why?

Integration makes sense when the focal firm can capture more value than a market exchange provides.

Imitability of Vertical Integration

When is a strategy of vertical integration difficult for competitors to imitate?

Form vs. Function

• The form is typically not difficult to imitate.
• The function may be costly to imitate if:
  • Integrated resources possess resource combinations that are the result of:
    • Historical uniqueness
    • Causal ambiguity
    • Social complexity
  • Capital requirements are prohibitive.
  • Strategic alliances may be a substitute for vertical integration.

Oversight and Implementation of Vertical Integration

What controls are used to successfully oversee and implement forms of vertical integration?

Goal: Focus management attention on achieving value chain economies.

• Budget
• Board Committees
  • Provide oversight and direction to functional managers.
  • Help ensure that strategic direction is maintained.
• Compensation
  • Individual: Salary; bonuses for individual performance.
  • Group (to support capabilities): Bonuses for group performance.
  • Group (to support flexibility): Stock options for performance.

Summary of Vertical Integration

Vertical integration:

• Makes sense when value chain economies can be created and captured.
• Allows a firm to leverage capabilities.
• May be a response to the threat of opportunism/uncertainty.
• Is important if considering international expansion.
• Can be costly (ownership is expensive; integrate only when benefits outweigh the costs of integration).

Chapter 7: Corporate Diversification

Types of Diversification

Know the differences among product diversification, (geographic) market diversification, and product-market diversification:

• Product Diversification: Firms diversifying by producing a new product (e.g., a car company that also produces bikes).
• Geographic Market Diversification: A firm selling its product(s) in multiple markets across the world.
• Product-Market Diversification: A combination of product and geographic market diversification.

Levels of Diversification

Understand that various levels of diversification exist (e.g., limited, related, and unrelated) and know the specific types of diversification that exist within each level:

• Limited Diversification
  • Single-Business Diversification: 95 percent or more of firm revenues comes from a single business.
  • Dominant-Business Diversification: Between 70 and 95 percent of firm revenues comes from a single business.
• Related Diversification
  • Related-Constrained Diversification: Less than 70 percent of firm revenues comes from a single business, and different businesses share numerous links and common attributes.
  • Related-Linked Diversification: Less than 70 percent of firm revenues comes from a single business, and different businesses share only a few links and common attributes or different links and common attributes.
• Unrelated Diversification: Less than 70 percent of firm revenues comes from a single business, and there are few, if any, links or common attributes among businesses.

Value of Corporate Diversification

When is corporate diversification valuable to the firm?

Two Criteria:

1. Do economies of scope exist?
2. Does a cost advantage exist?

Economies of Scope and Corporate Diversification

How are economies of scope created through corporate diversification? Know all 4 categories (e.g., operational scope, financial scope, etc.) and how to implement each in the context of a firm:

Economies of scope should create a synergy.

Synergy: Will enhance the overall value of the business units for the firm.

Operational Scope

• Shared Activities: Exploiting efficiencies by sharing business activities.

• Core Competencies: Complex sets of resources and capabilities that link different businesses in a firm through knowledge and experience (core capabilities; what a firm does exceptionally well).

Financial Scope

• Capital Allocation
  • In an internal capital market, the businesses of a firm compete for corporate capital.
  • Premise: Insiders can allocate capital more efficiently than external capital markets.
• Risk Reduction
  • Risk level of cash flow in a diversified firm is lower than risk in undiversified firms.
• Tax Advantages
  • Losses in one business can offset losses in another.
  • When payments on debt are tax deductible, debt capacity can be increased.

Anticompetitive Actions

• Multipoint Competition and Exploiting Market Power
• Tacit Collusion: When firms work together to reduce competitive forces to a mutually beneficial level.
• Market Power: Using profits in one business to compete in another (e.g., predatory pricing; firms acquiring competition).

Incentives (to Diversify)

• Managerial Compensation
  • Compensation typically tied to firm size.
  • Incentivizes managers to increase firm size (number of employees, sales, etc.).
  • Larger scope = more compensation.
  • More firms basing compensation on stock price and performance.

Imitability of Economies of Scope

Which types of economies of scope are easier/more difficult to imitate?

Summary of Corporate Diversification

Diversification can occur in several forms.

Economies of scope can be developed through operational scopes, financial scopes, anticompetitive actions, and incentives.

Economies of scope should create a synergy.

Firms should pursue corporate diversification only if careful analysis shows a competitive advantage is likely.

Chapter 8: Organizing to Implement Corporate Diversification

Organizational Structure for Diversification

Which structure is most appropriate for corporate diversification?

Firms must organize appropriately to realize the full value of economies of scope.

As firms grow (becoming more complex), information processing requirements exceed individual capacity.

Organizational structure divides information from processing into manageable blocks (functional units).

Multidivisional (M-Form) Structure: Divides owners and managers; interests of owners/managers may diverge.

• Best organizational structure to leverage a diversification strategy.
• Several critical components: Board of directors, institutional investors, senior executive, division general managers, etc.

Functions within the M-Form Structure

Know the function of each level within the firm:

Owners

• Historically, large diversified firms had equity owned by numerous (millions) of individual investors.
• Institutional owners are becoming more common (59% of all equity in the US; 69% in the top 1000 firms).
  • Institutional owners can be:
    • Mutual funds
    • Insurance companies
    • Other groups of investors

Board of Directors

• Responsibilities: Monitor decision-making in the firm; ensure decisions are consistent with the interests of outside equity holders.
• Make-up: Typically consists of 10-15 individuals from the firm’s TMT and external individuals (outsiders usually outnumber).
  • All senior managers report to the board.
  • Sub-committees: Audit, finance, personnel/compensation, etc.

Senior Executive

• Two Responsibilities in an M-Form:
  1. Strategy formulation
  2. Strategy implementation
• Office of the President:
  • Chairman
  • CEO (formulation)
  • COO (implementation)

Division General Manager

• Responsible for managing the day-to-day business.
• Have strategic formulation and implementation responsibilities.
• Oversee multiple functional managers.
• Compete for corporate capital; exploit corporate economies of scope.

Managerial Controls in a Diversification Strategy

What managerial controls are used in a corporate diversification strategy?

Managerial controls include:

• Evaluating performance across divisions.
• Allocating capital across divisions.
• Transferring intermediate products between divisions.

Summary of Organizing for Diversification

The best organizational structure to leverage a diversification strategy is the multidivisional (M-Form) structure.

The M-form has several critical components:

• Board of directors
• Institutional investors
• Senior executive
• Division general managers
• Managerial controls
  • Evaluating performance across divisions
  • Allocating capital across divisions
  • Transferring intermediate products between divisions

Chapter 9: Strategic Alliances

Types of Strategic Alliances

What are the 3 types of strategic alliances?

Strategic Alliance: A cooperative effort between two or more independent firms to develop, manufacture, or sell products/services.

• Nonequity Alliance: Cooperation between firms is managed directly through contracts, without cross-equity holdings or an independent firm being created.
• Equity Alliance: Cooperative contracts are supplemented by equity investments by one partner in the other partner. Sometimes their investments are reciprocated.
• Joint Venture: Cooperating firms form an independent firm in which they invest. Profits from this independent firm compensate partners for this investment.

Value Creation in Strategic Alliances

How is value created in a strategic alliance?

Value Creation

• Improve Current Operations
  • Helping firms improve the performance of their current operations.
  • Exploiting economies of scale.
  • Learning from competitors.
  • Managing risk and sharing costs.
  • Creating a competitive environment favorable to superior performance.
  • Facilitating the development of technology standards.
  • Facilitating tacit collusion.
• Facilitate Entry and Exit
  • Low-cost entry into new industries and new industry segments.
  • Low-cost exit from industries and industry segments.
  • Managing uncertainty.
  • Low-cost entry into new markets.
• Shape Competitive Environment
  • Facilitating technology standards.
    • Partners may agree on a standard and avoid a battle for the industry standard.
  • Facilitating tacit collusion.
    • Partners communicate within an alliance in subtle, legal ways.
    • Similar communication between outside competitors may be illegal (e.g., pricing, production).
• Facilitate Entry and Exit
  • Low-cost entry into new industries.
    • Partner provides instant access and legitimacy.
  • Low-cost exit from industries.
    • Partner is an informed buyer.
  • Managing uncertainty.
    • Alliances serve as “real options.”

Threats in Strategic Alliances

What are the threats managers should be aware of when engaging in strategic alliances?

Three Forms of Misappropriating Value:

• Adverse Selection: Misrepresenting the value of skills/abilities.
• Moral Hazard: Providing skills/abilities of lesser value than promised.
• Holdup: Exploiting the investment of partners; demanding higher returns than agreed.

Value, Rarity, Inimitability, and Organization of Alliances

When are strategic alliances valuable, rare, inimitable, and how are they organized?

Are Strategic Alliances Rare?

• As a form of economic exchange, NO!
• However, the sources of value creation within alliances may be rare.
  • Complementary resources à rare combination.

Are Strategic Alliances Costly to Imitate?

• As a form of organizing economic exchange, NO!
• However, the resource combinations created may be rare.
  • Social complexity
  • Causal ambiguity
  • Historical uniqueness

Organizing

Codified

Tacit

Summary of Strategic Alliances

Successful managers of strategic alliances will:

• Create alliances that produce gains from complementary resources.
• Identify the sources of value creation.
• Assess the challenges (threats) to value creation.
• Adopt the appropriate governance response(s) to address the challenges to value creation/allocation.

The largest challenges of alliances: Maximizing gains while minimizing the threat of cheating.

Chapter 10: Mergers & Acquisitions

Mergers vs. Acquisitions

What is the difference between mergers and acquisitions? Are they different?

• Mergers: Two firms combined on a relatively co-equal basis.
• Acquisitions: Purchase of one firm by another.
• Often used interchangeably even though they have very different meanings.

Related vs. Unrelated M&As

Related M&A Activities

• Vertical Merger: A firm acquires former suppliers or customers.
• Horizontal Merger: A firm acquires a former competitor.
• Product Extension Merger: A firm gains access to complementary products through an acquisition.
• Market Extension Merger: A firm gains access to complementary markets through an acquisition.

Unrelated M&A Activities

• Conglomerate Merger: There is no strategic relatedness between a bidding and a target firm.

Calculating Top Payment for Acquisitions

Know how to calculate the top payment that should be made for the acquisition of an unrelated and related acquisition:

Value: Unrelated

• Do M&As of Unrelated Firms Create Value?
  • Potential efficiencies from the internal capital market.
  • Managerial knowledge/restructuring.
  • If no synergy, value not likely.
• Current Market Value: Target = $10,000; Bidding = $15,000.
• Valuation: Sum – Bidding = Top payment for target.
• $25,000 – $15,000 = $10,000.

Value: Related

• Do M&As of Related Firms Create Value?
  • Value is expected due to synergies between divisions.
  • Economies of scale.
  • Economies of scope.
• Current Market Value: Target = $10,000; Bidding = $15,000.
• Valuation: Sum – Bidding = Top payment for target.
• $32,000 – $15,000 = $17,000.

Value Creation and Competitive Advantage in M&As

How is value created by using an M&A strategy? Do M&As create a sustained competitive advantage?

Do M&As Create Value? Research Shows…

• Acquiring Firm: On average, no value created for acquiring firms.
• Target Firm: On average, value increases by 25%.
• Related M&A activity creates more value than unrelated M&A activity.
• Value of target firm increases after M&A announced.

Why is M&A Activity so Prevalent if No (Limited) Value Created for Acquiring Firm?

Competitive Advantage

• Can an M&A Strategy Generate a Sustained Competitive Advantage?
  • Yes! But how?
    • Managers are good at recognizing and exploiting value-creating economies with other firms.
    • Managers are good at “doing deals” (negotiating).
    • Managers are good at both.

Bidding and Target Firm Considerations

What should bidding and target firms be aware of during the acquisition process?

Bidding Firm’s Perspective

• Search for rare economies.
• Limit information to other bidders.
• Limit information to the target.
• Avoid bidding wars.
• Close the deal quickly.
• Seek thinly traded markets.

Target Firm’s Perspective

• Seek information from bidders.
• Invite other bidders to join the bidding contest.
• Delay, but do not stop the acquisition.

Implementation Issues

• Cultural Differences
  • High levels of integration require greater cultural blending.
  • Cultural blending is a matter of:
    • Combining elements of both cultures.
    • Replacing one culture with the other.
  • Integration may be very costly, often unanticipated.
  • Integrating efficiency may be a source of competitive advantage.

Summary of Mergers & Acquisitions

M&A strategies can be applied to vertical and horizontal diversification.

The M&A strategy should satisfy the logic of corporate-level strategy.

M&A activity can create economic value at the announcement, but value is usually captured by the target firm.

M&As can create value over the long-term for the acquiring firm (if integration of firms is successful).

Chapter 11: International Strategies

International Strategies and Implementation

What are international strategies and how are they implemented?

Firms operating in multiple countries simultaneously are pursuing an international strategy.

Firms can:

• Vertically/horizontally integrate.
• Implement M&As.
• Form strategic alliances.
• … across national borders to enhance competitive advantage.

Economies of Scope in International Markets

What are the 5 sources of economies of scope in international markets? Be sure you are able to apply each economy of scope within the context of a firm.

Potential Sources of Economies of Scope in International Markets

• To Gain Access to New Customers for Current Products or Services (Access to New Customers)
  • To Increase Revenue:
    • Nondomestic customers must be willing to buy.
      • Many firms have made mistakes in adapting products to local standards.
    • Products/services must address the needs, wants, and preferences of customers as well as (or better) than alternatives.
    • Nondomestic customers must be able to buy.
      • Inadequate (or unavailable) distribution channels.
      • Trade barriers.
      • Insufficient wealth.
  • Product Life Cycle: A product or service can be at different stages in different countries.
• To Gain Access to Low-Cost Factors of Production (Low-Cost Factors of Production)
  • By expanding internationally, firms can gain access to low-cost factors of production:
    • Raw materials
    • Natural resources
    • Labor
      • China, Mexico, and Vietnam have inexpensive and highly productive labor.
    • Technology
      • Japanese firms have partnered internationally to gain technology insights.
• To Develop New Core Competencies (Develop New Core Competencies)
  • By expanding internationally, firms can refine and develop new core competencies through learning.
    • Intent to learn.
    • Culture of learning and innovation.
    • Transparency of business partner(s).
    • Trust between partners.
    • Receptivity to learning.
    • Ability to change the firm (unlearn past habits/routines).
• To Leverage Current Core Competencies in New Ways (Leverage Core Competencies in New Ways)
  • By expanding internationally, firms can use core competencies in new ways not possible in a domestic market.
    • Honda leveraged its core competency of design and manufacturing of power trains. Expanded beyond Japan and sells numerous products (lawnmowers of various sizes) in the United States and beyond.
• To Manage Corporate Risk (Manage Corporate Risk)
  • Equity holders can manage risk without diversification.
  • Two Qualifications:
    • Barriers to diversification may exist for individual equity holders and not for international firms.
    • In private firms, owners can maintain control and manage risk without “cashing out.”

Local Responsiveness vs. International Integration

Organizing International Business Operations

How do firms organize international business operations?

Rarity

• International strategies are becoming less rare.
  • Free trade agreements.
  • Technology (transportation, communication).
  • Development of international standards (technological, accounting).
• Rarity can exist.
  • A wide variety of opportunities available.
  • Firms build an international strategy of VIRO resources.

Inimitability

• Will firms try to duplicate valuable and rare strategies?
• Will firms be able to duplicate valuable and rare strategies?
• Substitutes: Strategic alliances, M&As.

Organizing

• Firms organize international business operations in several ways:

Organizational Structures for International Strategy

What organization structures are appropriate for organizing when pursuing an international strategy (based on high/low pressures of local responsiveness and pressure for cost reduction)?

• Decentralized Federation: Strategic and operational decisions are delegated to divisions/country companies.
• Coordinated Federation: Operational decisions are delegated to divisions/country companies; strategic decisions are retained at corporate headquarters.
• Centralized Hub: Strategic and operational decisions are retained at corporate headquarters.
• Transnational Structure: Strategic and operational decisions are delegated to those operational entities that maximize responsiveness to local conditions and international integration.

Summary of International Strategies

International strategies are a special type of diversification strategy.

Firms can gain a competitive advantage through the use of 5 types of international economies of scope.

Firms must evaluate local responsiveness vs. international integration and organize appropriately.

Organizing strategies are important for success.