1. Strategic Management Strategic Choices: Diversification Mohammad Najjar, PhD Management Science 1

2. Strategic Management Process MissionObjectives External Analysis Internal Analysis Strategic Choice Strategy Implementation Competitive Advantage Business Level Strategy Corporate Level Strategy How to Position a Business in the Market? Which Businesses to Enter?

3. Strategic Management Process MissionObjectives External Analysis Internal Analysis Strategic Choice Strategy Implementation Competitive Advantage Corporate Level Strategy Which Businesses to Enter? Vertical Integration Diversification

4. Corporate Level Strategies: Diversification and Integration A sound diversification or integration strategies will result in synergies between businesses that create value that could not be created by independently owned firms. Thus, shareholders may realize value through a sound diversification/integration strategy that they couldn’t realize elsewhere

5. Corporate Level Strategies: Diversification and Integration Integration Diversification Customer Distribution Focal Firm Supplier Raw Materials Forward Backward Current Businesses No Links Many Links Unrelated Related Other Businesses Other Businesses

6. Corporate Level Strategies: Diversification Product Diversification: Geographic Market Diversification: Product-Market Diversification operating in multiple industries operating in multiple geographic markets operating in multiple industries in multiple geographic markets Types of Corporate Diversification in General

7. Corporate Level Strategies: Diversification Limited Diversification Related Diversification Unrelated Diversification single business: > 95% of sales in single business dominant business: 70% to 95% in single business related-constrained: all businesses related on most dimensions related-linked: some businesses related on some dimensions businesses are not related At a more specific level…

8. Corporate Level Strategies: Diversification

9. Corporate Level Strategies: Diversification Possibilities: dominant-business in one or multiple geographic areas single-business in one or multiple geographic area related-constrained in one or multiple geographic areas related-linked in one or multiple geographic areas unrelated in one or multiple geographic areas Note: relatedness usually refers to products or processes

10. Corporate Level Strategies: Diversification Diversification create value if: 1)There is some economy of scope: exist in a firm when the value of the products or services it sells increases as a function of the number of businesses that firm operates in. >> economy of scale create value by: -- reducing cost -- increasing revenues 2)equity holders create more value in corporate diversification than through portfolio investing, 3) or must create value that outside equity holders cannot create on their own

11. Corporate Level Strategies: Diversification e.g. A firm using a common brand name across a wide variety of products (umbrella branding) is pursuing economies of scope. The value of all products sharing the brand name increases when a new and successful product is introduced in the market. Also, the cost of introducing the new product is less (and chances of its success greater) because it can “piggy-back” on the already established brand name.

12. Corporate Level Strategies: Diversification Business X Business Y Business Z Independent: equity holder could buy shares of each firm Value Business X Business Y Business Z Focal Firm Value ++ Economies Of Scope Combined: equity holder buys shares in one firm

13. Corporate Level Strategies: Diversification Economies of Scope can be divided into: Operational Financial

14. Corporate Level Strategies: Diversification Operational Economies of Scope Sharing Activities exploiting efficiencies of sharing business activities, economies of scope exist because the cost of an activity is now borne by multiple businesses, see next slide Volume purchasing from common suppliers, common warehousing of inventory, and common distribution channels are examples. Note: while sharing can be a benefit because of the “reputation” effect, the reverse can also happen. Poor reputation of one business can affect another business.

16. Corporate Level Strategies: Diversification Operational Economies of Scope Spreading Core Competencies exploiting core competencies in other businesses, firms can also create value through diversification by spreading core competencies that are generating competitive advantage in one business to other businesses. Honda’s engines are used in automobiles, motorcycles, outboard boat motors, lawn mowers, generators, and power tools such as hedge and weed trimmers

17. Corporate Level Strategies: Diversification Financial Economies of Scope Internal Capital Market insiders can allocate capital across divisions more efficiently than the external capital market works only if managers have better information: Decision makers in internal capital markets are more likely to have access to negative information that may be important in capital allocation decisions. may suffer from escalating commitment: An internal capital market may be less efficient than external markets due to escalating commitment to a failing cause. External markets largely avoid the issue of escalating commitment.

18. Corporate Level Strategies: Diversification Financial Economies of Scope Risk Reduction Diversification is often justified on the grounds of risk reduction. The argument is that the riskiness of the cash flows of diversified firms is lower than the riskiness of the cash flows of undiversified firms. Firms that diversify to reduce risk will have relatively stable returns over time. However, risk reduction can be captured by equity holders through investment diversification e.g. General Electric, for example, is successful in “smoothing” out its earnings (that is, no significant ups and downs in reported profits) because of its involvement in various businesses.

19. Corporate Level Strategies: Diversification >> most of the economies of scope cannot be realized by equity holders on their own. Insufficient information and lack of complementary activities are the key reasons. >> In fact, risk reduction is the only type of economies of scope that equity holders can do more efficiently on their own

20. Corporate Level Strategies: Diversification Diversification per se is not rare However, the underlying economies of scope may be rare e.g. acquisitions for diversification are not uncommon, what may be rare is a specific economy of scope as the driving force behind a diversification move

21. Corporate Level Strategies: Diversification Imitation/Duplication of Economies of Scope Less Costly-to-DuplicateCostly-to-Duplicate Risk Reduction Shared Activities Core Competencies Internal Capital Allocation (codified/tangible)(tacit/intangible) In general, economies of scope based upon tangible resources (sharing R&D) are usually relatively easy to duplicate. In other words, if Procter and Gamble acquired Gillette to exploit economies of scope based upon shared R&D, Colgate-Palmolive can do the same. Scope economies based on intangible resources – particularly those based on tacit collective knowledge are much more difficult to imitate. The realization of capital allocation economies of scope require sophisticated information processing capabilities.

22. Corporate Level Strategies: Diversification Substitution of Economies of Scope Internal Development Strategic Alliances start a new business under the corporate whole find a partner with the desired complementary assets Competitors may use these strategies to arrive at a position of diversification without buying another firm less costly than acquiring a firm

23. Corporate Level Strategies: Diversification and Implementation Information Processing Requirements as organizations become larger and more complex, information processing requirements exceed individual capacity bounded rationality: people have a limit on their capacity to handle information. organizational structure divides information processing into manageable blocks, allowing managers to make satisficing decisions

24. Corporate Level Strategies: Diversification and Implementation Strategic Planning Corporate Finance Corporate R&D Corporate Marketing Production Finance EngineeringAccounting Human Resources Division Sales & Marketing Senior Executive (CEO, CFO, COO) Corporate Human Resources Board of Directors

25. Corporate Level Strategies: Diversification and Implementation Chairman of the Board (monitoring) Chief Executive Officer (strategy formulation) Chief Operating Officer (strategy implementation) Chairman CEO COO Chairman CEO COO Chairman CEO COO Chairman CEO COO One PersonTwo PeopleThree People

26. Corporate Level Strategies: Diversification and Implementation Information Filtering information about the divisions’ businesses is filtered as it rises to the senior executive As information flows up through the organization from the divisions there is a summarizing and filtering process. The idea is that the information flowing up through the organization is the best and most necessary for decision making at the next level. Each manager should have that information which allows for the best decision making at that level. Too much information can become counterproductive as it exceeds the bounded rationality of managers.

27. Corporate Level Strategies: Diversification and Implementation ProductionFinance Engineering Division Human Resources Sales & Marketing ProductionFinance Engineering Shared Activities Cost Centers Profit Centers

28. Corporate Level Strategies: Diversification and Implementation Shared activities as cost centers: This means that the shared activity has a budget and is evaluated on how well it can manage its budget. The cost of the shared activity is usually allocated to the divisions that use the services of the shared activity. When the cost of obtaining the service from the shared activity is less than what it would cost the division to get the activity in the external market, true economies of scope result. Divisions would be motivated to use the services of the shared activity. On the other hand, if the cost of obtaining the service from the shared activity is greater than what it would cost the division to get it in the external market, there are no real economies of scope for this activity. In this case, there is no economic incentive for the division to use the services of the shared activity.

29. Corporate Level Strategies: Diversification and Implementation In order to promote efficiency, there is a growing tendency to regard shared activities as profit centers and evaluate them as such. In such cases, the shared activity “bills” its internal customers on a cost plus profit basis. Such firms also typically do not require their divisions to use the services of the shared activity. In other words, if they can find a cheaper vendor of the service outside, they are encouraged to use it. This creates a sense of competition for the shared activity and forces it to become more efficient.