Foundations of Strategy Chapter 7: Corporate Strategy Sienna Rucker, Jordan Myers, Nick Thomas, Jayson Davidson, Phoenix Delcueto

Corporate strategy The scope of the firm Key concepts for analysing firm scope Diversification Vertical integration Managing the corporate portfolio

Where a firm competes Product scope Vertical scope Geographical scope Product scope: how diversified is the company in products offered, Vertical scope: supply chain, invovment vs oursourcing Geographical scope: how many countries do you operate,

Fluor scope Product scope Vertical scope Geographical scope Construction for industrial Mining and metal project / plant management Government projects energy Vertical scope Extensive supply chain and logistics Geographical scope 100 countries

The Scope of the firm Narrow or broad Vertical integration Supply chain activities Changes over time Fluor has moved back toward core capability of construction. One of our original jobs that we had outsourced, but are now doing again, this is vertical integration of the supply chain. If a company is highly vertically integrated they would be involved in whole supply chain,

Key Concepts for Analyzing Firm Scope •Key concepts for analyzing a firm’s decisions and scope overtime: •Economies of Scope •Transaction Costs •Costs of Corporate Complexity Firms Reduce their scope because they perceive it to be in their best interest which is pretty straight forward. Changing the firm’s boundaries create value for shareholders either by increasing revenue or reducing cost. 3 concepts that are key to analyzing corporate strategic decisions and shifts in the scope of firm’s activities overtime: Economies of Scope, Transaction Costs, and Costs of Corporate Complexity. These concepts help with understanding value creation and destruction in multi-business firms. So to go into them a little more

Economies of Scale vs. Scope •Refer to the reduction in average costs that result from an increase in the output of a single product. •Economies of Scope: •Are cost economies from increasing the output of multiple products. Economies of Scale: Refer to the reduction in average costs that result from an increase in the output of a single product. Economies of Scope: Are cost economies from increasing the output of multiple products. Economies of scope exist when using a resource across multiple activities uses less of that resource than when the activities are carried out independently. Economies of scope and economies of scale are two different economic concepts used to help cut a company's cost. Economies of scope focuses on the average total cost of production of a variety of good, whereas economies of scale focuses on the cost advantage that arises when there is a higher level of production of one good. The theory of economies of scope states that the average total cost of a company's production decreases when there is an increasing variety of goods produced. Economies of scope give a cost advantage to a company when it produces a complementary variety of products while focusing on its core competencies. For example, company ABC is the leading desktop computer producer in the industry. Company ABC wants to increase its product line and remodels its manufacturing building to produce a variety of electronic devices, such as laptops, tablets and phones. Since the cost of operating the manufacturing building is spread out across a variety of products, the average total cost of production decreases. The costs of producing each electronic device in another building would be greater than just using a single manufacturing building to produce multiple products. Conversely, economies of scale offer a cost advantage when there is an increased output of a good or service. Economies of scale arise due to the inverse relationship between the average cost per unit and output level. Economies of scale focus on the output level of one product, whereas economies of scope focus on the variety of products offered. The nature of economies of scope varies between different types of resources and capabilities.

Economies of Scope •Tangible Resources •Distribution networks •Information Technology Systems •Sales Forces •Research Laboratories •Intangible Resources •Brands •Corporate Reputation •Technology •Organizational Capabilities The nature of economies of scope varies between different types of resources and capabilities. These different resources capabilities are: Tangible resources: offer economies of scope by eliminating duplication between businesses through creating a single shared facility. The greater the fixed costs is, the greater the associated economies of scope are likely to be. Flour: engineers, contractors, fabrication facilities. Intangible Resources - offer economies of scope from the ability to extend them to additional businesses at low marginal cost. Exploiting a strong brand across additional products is called brand extension. Starbucks has extended its brand to ice cream, packaged cold drinks, home espresso machines. Flour-patents, trade secrets, contracts, customer relationships Organizational Capabilities-economies result from the ability to transfer capabilities between businesses within the diversified company. Flour- Blueprint Approval System which is referred to as Change Management. Basically what the Change Management system does is allow an all encompassing way for engineers to communicate with the contractors who are doing the building. So the engineer sends the plans to the contractor to build. In case you don’t know, there are almost always going to be change orders in the construction industry in general. So what this program allows for is the contractor to make changes, but when he does this program highlights the changes and sends them back to the engineer to get his stamp of approval before the plans can actually be put in place. Previously this process was a lot more tedious, and could lead to the engineer not catching all of the changes.

Transaction Costs •Market Mechanism ‘Invisible Hand’ •Administrative Mechanism ‘Visible Hand’ Two forms of economic organization Market mechanism- where individuals and firms, guided by market prices, make independent decisions to buy and sell goods and services. Administrative-where decisions concerning production and resource allocation are made by managers and imposed through hierarchies. Market Mechanism was characterized by 18th century philosopher Adam Smith, as the ‘invisible hand’ because it coordinating role does not require conscious planning. He referred to Administrative Mechanism as the ‘visible hand’ because coordination involves active planning Transaction Costs: making a purchase or sale involves search costs, the costs of negotiating and drawing up a contract, the costs of monitoring to ensure that the other party’s side of the contract is being fulfilled and the enforcement costs of arbitration or litigation should a dispute arise. If the transaction costs associated with organizing across markets are greater than the administrative costs of organizing within firms, we can expect the coordination of productive activity to be internalized within firms.

Vertical Scope •Which is more efficient? •Answer: •3 independent companies, or •3 stages of production within a single company •Answer: •Internalizing business transactions imposes its own costs or… ex. Fluor is in the mining industry: 3 independent companies- one to mine, one to refine, one to roll into steel sheets Or in the instance of Fluor each of the stages of production are within in the single company, those resources are then used in different industries, like air ducts on construction jobs. During most of the 20th century most companies grew in size and scope, absorbing transactions that had previously taken place across markets. This shifted during the 1980’s and 90’s the trend increased corporate scope was reversed. Although large companies continued to expand internationally, the dominant trends of the past three decades were ‘downsizing’ and ‘refocusing’ During the 21st century, the costs of administration within large, complex firms as traditional management systems have struggled to become more flexible and responsive.

The Costs of Corporate Complexity •Engaging in more arenas of business involves greater organizational complexity. •Can you manage the balancing act? Engaging in more arenas of business involves greater organizational complexity because managing different businesses usually requires different organizational capabilities. So the question you have to ask is: Can you manage the balancing act? Can you vertically integrate, but not take on too many additional costs?

Diversification is Fun! “The expansion of an existing firm into another product line or field of operation.” Related/Concentric Expands into a similar field Unrelated/Conglomerate Additional product line very different from core business Horizontal Diversification Same stage of production Vertical Diversification Successive stages in the productive of a good or service Related Car manufacturer goes to trucks/buses Unrelated food-processing to medical devices h/v discussed later on in chapter HD: the company adds new products or services that are often technologically or commercially unrelated to current products but that may appeal to current customers. This strategy tends to increase the firm's dependence on certain market segments VD: talk about later on

Benefits and Costs of Diversification Growth “Prisoners of their industry” Stagnant or declining industries Risk Reduction “Don’t put all your eggs in one basket.” Stable profit earnings, job security Value Creation Exploiting linkages between different businesses Operational and strategic links These are the most commonly mentioned benefits when talking about diversification

Benefits and Costs of Diversification Cont. Exploiting Economies of Scope Using brand name or trade mark to link the business Internal Capital Markets Avoid costs of using the external capital market Better access to info Internal Labour Markets Transfer employees throughout corporation Detailed info on the competencies of its employees

When does diversification create value? Attractiveness test Structurally attractive or capable of being made attractive Insufficient on its own The Cost-of-Entry test Must not capitalise all future profits Barriers to entry Corporate venture vs. acquire an established company The Better-off test Competitive advantage Unattractive industry but low cost of entry (fragmented industry) Attrac. And cost of entry can cancel each other out So most important is better off? Corporate venture = go through all barriers Acquire - very costly Fragmented - hairdressing

Diversification Continued Diversification in Performance No systematic relationships between diversification and performance “Strategic sweet spot between focus and broader diversification” Association or causation Related and Unrelated Diversification Management complexity Recent Trends in Diversification Since 1980s, diversified companies are refocusing their business Conglomerate firms

Vertical Integration Vertical Integration refers to a firm’s ownership of vertically related activities The greater the extent to which a firm’s ownership extends over successive stages of the value chain for its product the greater its degree of vertical integration Extent of vertical integration is indicated by the ratio of a firm’s value added to its sales revenue Vertical Integration refers to a firm’s ownership of vertically related activities -The greater the extent to which a firm’s ownership extends over successive stages of the value chain for its product the greater its degree of vertical integration -Extent of vertical integration is indicated by the ratio of a firm’s value added to its sales revenue -So basically the more a firm makes rather than buys the lower are it’s cost of bought in goods and services relative to its final sales revenue

Types of Vertical Integration Backward Vertical Integration- when a firm acquires ownership and control over the production of its own inputs Forward Vertical Integration- when a firm acquires ownership and control of activities previously undertaken by customers Full Vertical Integration- When a firm has control and ownership over all inputs Partial Vertical Integration- When a firm has control and ownership over some but not all input processes Backward Vertical Integration- when a firm acquires ownership and control over the production of its own inputs Forward Vertical Integration- when a firm acquires ownership and control of activities previously undertaken by customers Full Vertical Integration- When a firm has control and ownership over all inputs Partial Vertical Integration- When a firm has control and ownership over some but not all input processes

Benefits and Costs of Vertical Integration Over last 25 years outsourcing has become more popular Enhances flexibility Allows firms to focus on their “core competencies” Vertical Integration can produce cost savings Due to physical integration transaction costs can be cut Vertical Integration may restrict a firm’s ability to benefit from scale economies Reduce flexibility Increase risk For most of the 20th century it was thought that vertical integration was generally beneficial because it allowed superior coordination and reduced risk Over last 25 years outsourcing has become more popular because it: Enhances flexibility Allows firms to focus on their “core competencies” Many benefits achieved through vertical integration can be achieved with collaboration Vertical Integration can produce cost savings Due to physical integration transaction costs can be cut PRODUCING STEEL CAN EXAMPLE STEEL to SHEET to CAN Vertical Integration may restrict a firm’s ability to benefit from scale economies Reduce flexibility Increase risk

Transaction Costs in Vertical Exchanges Benefits of vertical integration traditionally emphasized the cost savings that arise from physical integration Along a value curve it will make sense to vertically integrate in some areas but not in others Bilateral Monopoly Sometimes vertically integrating would be too technical Benefits of vertical integration traditionally emphasized the cost savings that arise from physical integration -Common ownership not always necessary. 2 related firms in same place will do - Steel to sheet okay sheet to can to technical Along a value curve it will make sense to vertically integrate in some areas but not in others When competitive market between two stages is impossible and the stages are dependent on each other vertical integration makes sense and creates a Bilateral Monopoly Sometimes vertically integrating would be too technical

The Incentive Problem Vertical Integration changes incentive between vertically related businesses Market interfaces between buyers and sellers create profit incentives High powered incentives Vertical Integration creates internal suppliers low powered incentives Opening internal divisions to external competition creates incentives in vertically integrated firms Vertical Integration changes incentive between vertically related businesses Market interfaces between buyers and sellers create profit incentives exist High powered incentives (very responsive) Vertical Integration creates internal suppliers and low powered incentives Not very responsive (doesn’t happen fast like fired or no bonuses) Opening internal divisions to external competition creates incentives in vertically integrated firms Shared service organizations where internal suppliers of corporate services compete with external suppliers of the same services

Flexibility Where the required flexibility is rapid responsiveness to uncertain demand there are advantages in market transactions Where system wide flexibility is required vertical integration may allow for speed and coordination in achieving simultaneous adjustments throughout the vertical chain Where required flexibility is rapid responsiveness to uncertain demand there are advantages in market transactions Construction Industry Where system wide flexibility is required vertical integration may allow for speed and coordination in achieving simultaneous adjustments throughout the vertical chain Allows for super fast, highly responsive, design to distribution cycle

Designing Vertical Relationships Vertical relationships not limited to simple choice of make or buy The extent to which the buyer and seller commit resources to a relationship determine which relationship is appropriate Types of Vertical Relationships: Contracts Spot Contracts Long-Term Contracts Vendor Partnerships Franchises Vertical relationships not limited to simple choice of make or buy The extent to which the buyer and seller commit resources to a relationship determine which relationship is appropriate Types of Vertical Relationships: Contracts Spot Contracts Long-Term Contracts Vendor Partnerships Franchises

Spot Contracts Spot Contracts are transactions where there is no need for transactions specific investments by either party. One time transactions Many buyers and sellers in market Standard products Opportunism Spot Contracts are transactions where there is no need for transactions specific investments by either party. Many buyers and sellers in market Standard products Closer supplier-customer ties are needed One time transactions Opportunism

Long Term Contracts Long Term Contracts are agreements between firms that specify the terms and responsibilities of the firms for a series of transactions over a period of time Help avoid opportunism Provides security needed to make longer term investments Face problem of anticipating future circumstances Long Term Contracts are agreements between firms that specify the terms and responsibilities of the firms for a series of transactions over a period of time Help avoid opportunism Provides security needed to make longer term investments Face problem of anticipating future circumstances Too restrictive Too loose that allows opportunism and conflicting interpretation

Vendor Partnerships Vendor partnerships are close collaborative relationships companies have with their suppliers Based on trust and mutual understanding Helps avoid opportunism Provide security needed for transaction specific investments Vendor partnerships are close collaborative relationships companies have with their suppliers Based on trust and mutual understanding Collabortion between computer makers and computer components Helps avoid opportunism similarly to long term contracts Provide security needed for transaction specific investments (highest costs)

Franchise A franchise is a contractual agreement between the owner of a business system and a trademark that permits the franchisee to produce and market the franchiser’s product or service in a specified area Brings together the brand, marketing capabilities, and business systems of large corporations with entrepreneurship and local knowledge of small firms A franchise is a contractual agreement between the owner of a business system and a trademark that permits the franchisee to produce and market the franchiser’s product or service in a specified area Brings together the brand, marketing capabilities, and business systems of large corporations with entrepreneurship and local knowledge of small firms

Recent Trends in Vertical Integration Growth in diversity of hybrid vertical relationships Recent phenomenon from high-tech sectors Competitive tendering and multiple sourcing have been replaced by single-supplier arrangements. “There has been a shift in supplier relationships from arm’s length with many suppliers to long-term collaboration with fewer suppliers.”

Managing the Corporate Portfolio GE/McKinsey Matrix Allocating resources Formulating business unit strategy Analyze Portfolio Balance Set Performance Targets

Managing the Corporate Portfolio (cont.) BCG Growth-Share Matrix Matrix uses industry attractiveness and competitive position to compare the strategic strategic position of different businesses Simplicity: Pro & Con

Managing the Corporate Portfolio (cont.) Ashridge Portfolio Display Value-creating potential of a subsidiary business; dependent on characteristics of the business and parent company The focus is the fit between a business and its parent company Horizontal: parent’s potential for creating additional profit Vertical: potential for value destruction; mismatch between management needs and style

Summary Competition: Product, Geographical, & Vertical Scope Economics of Scale vs Scope Economies of scope provide cost savings from staring resources and capabilities Diversification Is Fun “Corporate Strategy is about deciding which businesses to engage and often represents some of the most important and difficult decisions management are likely to make.”

Questions?