1. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li1 Lecture #16: Diversification and the Scope of the Firm Competitive Advantage from Diversification Scope of the Firm Recent Trends OUTLINE

2. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li2 Diversification Decisions: The Basic Issues Is the industry to be entered more attractive than the firm’s existing business? Can the firm establish a competitive advantage within the industry to be entered?

3. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li3 Motives for Diversification GROWTH To escape stagnant or declining industries (tobacco, oil, defense) RISK SPREADING To reduce variance of profit flows PROFIT To create shareholder value

4. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li4 Competitive Advantage from Diversification Share tangible resources (research labs, distribution systems) across businesses Share intangible resources (brands, technology) Transfer functional capabilities Apply general management capabilities to multiple businesses Internal capital and labor markets Superior access to information ECONOMIES OF SCOPE INTERNAL TRANSACTION S

5. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li5 Diversification and Performance: Empirical Evidence Empirical evidence inconclusive-- No consistent findings on impact of diversification on profitability Some evidence that high levels of diversification are detrimental to profitability 1 2 3 4 5 6 index of product diversity 3 2 1 return on net assets (%)

6. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li6 Relatedness in Diversification Operational Relatedness-- synergies from sharing resources across businesses (common distribution facilities, brands, joint R&D) Strategic Relatedness-- synergies at the corporate level from ability to apply general management capabilities to different businesses.

7. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li7 The Functions of Corporate Management Decisions over diversification, divestment, and allocating resources between businesses. --Assisting business strategy formulation --Monitoring and controlling performance of the businesses Sharing and transferring resources and capabilities Managing linkages between companies Guidance and control of individual businesses Managing the Corporate Portfolio

8. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li8 Diversification and Shareholder Value: Porter’s Three Essential Tests If diversification is to create shareholder value, it must meet three tests: 1. The Attractiveness Test: Diversification must be directed towards actual or potentially-attractive industries 2. The Cost of Entry Test: The cost of entry must be lower than future profits 3. The Better-Off Test: The new unit must gain competitive advantage from its link with the firm, or vice-versa (i.e. synergy must be present)

9. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li9 Transactions Costs and the Scope of the Firm The Costs and Benefits of Vertical Integration Recent Trends Vertical Integration and The Scope of the Firm

10. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li10 Transactions Costs and the Scope of the Firm Which is more efficient ? VERTICAL PRODUCT GEOGRAPHICAL AREAS SINGLE V 1 P 1 P 2 P 3 A 1 A 2 A 3 FIRM V 2 V 3 SEVERAL V 1 P 1 P 2 P 3 A 1 A 2 A 3 SPECIALIZED V 2 FIRMS V 3 Common Issue--- What are TRANSACTION COSTS of markets compared with administrative costs of the firm?

11. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li11 The Costs and Benefits of Vertical Integration: BENEFITS Technical economies from integrating processes e.g. iron and steel production Superior coordination Avoids transactions costs of market contracts from: -- small numbers of firms -- transaction-specific investments -- opportunism and strategic misrepresentation -- taxes and regulations on market transactions

12. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li12 The Costs and Benefits of Vertical Integration: COSTS Differences in optimal scale of operations Inhibits development of and exploitation of core competencies Limits flexibility in responding to changes in technology, customer preferences, etc. Compounding of risk

13. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li13 Recent Trends in Vertical Relationships From competitive contracting to supplier partnerships, e.g. in autos From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services) Diffusion of franchising Technology partnerships (e.g. IBM- Apple; Canon- HP) Inter-firm networks General conclusion:- boundaries between firms and markets becoming increasingly blurred

14. Fall 2000MGTO321 (L1, L2) -- Dr. JT Li14 Recent Trends: Reinventing GE Initiatives by Jack Welch: Delayering --- from 9 or 10 layers of hierarchy to 4 or 5, decentralize decisions. Reformulating strategic planning --- from formal, document-intensive analysis to direct face-to-face discussions. Redefining the role of HQ --- from checker, inquisitor, and authority to facilitator, helper, and supporter. HQ as a facilitator --- Create the “boundaryless corporation” where innovations and ideas flow. HQ as change agent --- Driving force for continual organizational change (e.g. “workout”).