Chapter 7 Corporate Strategy

Learning objectives By the time you have completed this topic you will: be familiar with the concepts of economies of scope, transaction costs and the costs of managing complexity, and understand how these ideas help explain firm boundaries and shifts over time; understand the rationale behind multi-business activity and the potential benefits and costs of extending the horizontal or vertical scope of a firm; be able to evaluate the advantages and disadvantages of changing a firm’s scope and the different ways of exploiting opportunities for value creation; appreciate the trends in diversification and vertical integration over time and understand mergers, acquisitions and alliances; be familiar with the techniques of portfolio analysis and be able to apply them to corporate strategic decisions. Wiley Canada

Structure of the session the scope of the firm key concepts for analysing firm scope economies of scope transaction costs the costs of corporate complexity diversification vertical integration strategic manoeuvring managing the corporate portfolio Wiley Canada 3

Building an empire Empire Company Ltd. is based in Nova Scotia. Their subsidiary Sobeys owns or franchises over 1500 stores across Canada under the names Sobeys, IGA, Thrifty Foods, Foodland, Lawtons drug stores, and FreshCo. $17 billion sales, 47,000 employees Wiley Canada

Empire’s diversification strategy In previous decades, Empire acquired groceries, drug stores, industrial products, movie theaters, and real estate - product scope. Now Empire is concentrating on food retailing and real estate - geographic and vertical scope. In 2013, Empire purchased the Canadian Subsidiary of Safeway for $5.8 billion cash. Safeway had 213 stores, 199 pharmacies, 62 gas stations, 12 manufacturing facilities, and 4 distribution centres. Wiley Canada

The scope of the firm Product scope – How wide a range of products does the firm supply? Vertical scope – What range of vertically linked activities does the firm encompass? Geographical scope – What is the geographical spread of the firm’s activities? Does it compete locally or globally? Wiley Canada 6

Key concepts for analyzing firm scope Economies of scope: cost economies from spreading costs of over multiple products. Transaction costs: the costs of market transactions. When the costs of administering transactions within the firm are lower than the costs of market transactions, the firm grows in size and scope. The costs of corporate complexity: impose limits to the firm’s growth in size and scope. Wiley Canada

The scope of the firm: specialization vs. integration In the integrated firm there is an administrative interface between the different vertical units (V), product units (P), and country units (C). Where there is specialization, each unit is a separate firm linked by market interfaces. Which arrangement is more efficient depends upon economies of scope, transaction costs and costs of complexity. Wiley Canada

Transaction costs at Empire Most supermarkets are neither fully vertically integrated, nor wholly reliant on the open market. Empire chose a middle ground of long-term contractual relationships with a small number of suppliers. Wiley Canada

The benefits and costs of diversification Growth: A powerful motive for managers—but growth without profitability does not create value for shareholders. Growth through acquisition a major destroyer of shareholder value. Risk spreading: Diversification tends to reduce fluctuations in profits; but this does not necessarily create value for shareholders. Value creation: For diversification to create shareholder value it must exploit some linkage (“synergy”) between the different businesses, e.g., by: exploiting economies of scope, operating an efficient internal capability market, operating an internal labour market. Wiley Canada

When does diversification create value? Porter’s “three essential tests” The attractiveness test: The industries chosen for diversification must be structurally attractive or capable of being made attractive. The cost-of-entry test: The cost of entry must not capitalize all the future profits. The better-off test: Either the new unit must gain competitive advantage from its link with the corporation, or vice versa. Wiley Canada 11

Did Empire’s diversification create value? The attractiveness test: Western Canada is the fastest growing region. The cost-of-entry test: Acquisition of Safeway avoided “greenfield” costs and saved Empire $200 million per year. The better-off test: Empire sold 68 Safeway properties for $990 million. Wiley Canada

Diversification and performance How do diversified firms perform relative to specialized firms? Does related diversification outperform unrelated diversification? Wiley Canada

Diversification and performance In North America and Western Europe… When companies divest diversified businesses and concentrate on their core business, the result is typically increased profitability and higher stock valuation. Wiley Canada

Vertical integration: benefits and costs Sources of benefits technical economies from integrating processes avoids transactions costs in vertical exchanges; especially where there are: small numbers of firms, transaction-specific investments, limited information. superior coordination Sources of costs differences in optimal scale between different incentive problems limits flexibility—e.g., in responding to changes in demand and in technology. (however, may enhance system-wide flexibility) compounding of risk Wiley Canada

The vertical chain for steel cans Question: Why do market contracts predominate between some stages and vertical integration between others? Wiley Canada 16

Different types of vertical relationships Wiley Canada 17

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MANAGING THE CORPORATE PORTFOLIO The GE/McKinsey portfolio planning matrix THE GE/MCKINSEY PORTFOLIO PLANNING MATRIX Wiley Canada

Managing the corporate portfolio: the BCG growth-share matrix Wiley Canada

MANAGING THE CORPORATE PORTFOLIO: THE ASHRIDGE PORTFOLIO DISPLAY Source: Ashridge Strategic Management Centre Wiley Canada

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