CH-9-10 Corporate-Level Strategy: Horizontal Integration, Vertical Integration, and Strategic Outsourcing – Strategic Management: Theory: An Integrated Approach : Book Guide

This Document Contains Chapters 9 to 10 CHAPTER 9 Corporate-Level Strategy: Horizontal Integration, Vertical Integration, and Strategic Outsourcing Synopsis of Chapter This chapter and Chapter 10 concern corporate-level strategy. This chapter focuses on the different strategic choices that companies make with regard to horizontal and vertical integration. In particular, we consider the arguments for and against horizontal and vertical integration and examine cooperative relationships such as strategic outsourcing as alternatives. Successful corporate strategy adds value by enabling the company to perform one or more of the value creation functions at a lower cost or in a way that allows differentiation and brings a premium price. For a company to be successful its corporate strategy must assist in the process of establishing a distinctive competency at the business level. To a certain extent, this view conflicts with the received wisdom of the strategic management literature. It is often claimed that a company’s corporate-level strategy sets the context for its business level strategy. Our position is that if a corporate level strategy is to succeed, the reverse should be the case. That is, the process of establishing a sustainable competitive advantage at the business level defines the set of appropriate corporate-level strategies. Another theme stressed in the chapter is that the existence of bureaucratic diseconomies implies a fundamental limit to the profitable pursuit of horizontal and vertical integration. As companies become more diversified or vertically integrated top management begins to lose control leading to the dissipation rather than the creation of value. A final theme of this chapter is that strategic alliances and strategic outsourcing are often viable alternatives to horizontal and vertical integration. That is, these strategies can achieve many of the same benefits without encountering the same bureaucratic costs. Learning Objectives 1. Discuss how corporate-level strategy can be used to strengthen a company’s business model and business-level strategies. 2. Define horizontal integration and discuss the primary advantages and disadvantages associated with this corporate-level strategy. 3. Explain the difference between a company’s internal value chain and the industry value chain. 4. Describe why, and under what conditions, cooperative relationships such as strategic alliances and outsourcing may become a substitute for vertical integration. Opening Case Outsourcing and Vertical Integration at Apple Apple’s management had concluded that overseas factories provided superior scale, flexibility, diligence, and access to industrial skills—“Made in the U.S.A.” just did not make sense for Apple anymore. “Foxconn City,” a complex where the iPhone is assembled, has 230,000 employees, many of whom work 6 days a week and up to 12 hours a day. It is owned by Foxconn Technology, which has dozens of factories in Asia, Eastern Europe, Mexico, and Brazil. It is estimated that Foxconn assembles 40% of the world’s consumer electronics, and boasts a customer list that includes Amazon, Dell, Hewlett-Packard, Motorola, Nintendo, Nokia, Samsung, and Sony, in addition to Apple. Foxconn can hire thousands of engineers overnight and put them up in dorms—something no American firm could do. Moreover, China’s advantage was not only in assembly; it offered advantages across the entire supply chain. Apple’s strategy of paying upfront for both the technology and capacity enabled it to induce its suppliers to make specialized investments in technologies that were well beyond the industry standard, and to hold excess capacity that would enable rapid scaling. The net result is that Apple ends up with superior flexibility and technological sophistication that its competitors cannot match. Seeming to acknowledge the advantages of Apple’s strategy of controlling device design and production, Microsoft announced on June 18, 2012, that it too would design and produce its own tablet, the Surface. It also launched its own chain of dedicated Microsoft retail stores that looked remark- ably similar to Apple stores. Teaching Note: This case illustrates how Apple’s decision to outsource the assembling of iPhone has given Apple superior flexibility and technological sophistication that its competitors cannot match. Apple’s competitors are launching retail chains similar to Apple stores. Ask your students to come up with points on how Apple’s competitors could match Apple’s success through outsourcing and vertical integration. Lecture Outline I. Overview The overriding goal of managers is to maximize the value of a company for its shareholders. In general, corporate-level strategy involves choices strategic managers must make: deciding in which businesses and industries a company should compete; selecting which value creation activities it should perform in those businesses; and determining how it should enter, consolidate, or exit businesses or industries to maximize long-term profitability. The principal goal of corporate-level strategy is to enable a company to sustain or promote its competitive advantage and profitability in its present business—and in any new businesses or industries that it chooses to enter. Horizontal integration, vertical integration, and strategic outsourcing are three corporate level strategies that are primarily directed toward improving a company’s competitive advantage and profitability in its current business or industry. II. Corporate-Level Strategy and the Multibusiness Model The choice of corporate-level strategies is the final part of the strategy-formulation process. Corporate-level strategies drive a company’s business model over time and determine which types of business-and functional-level strategies managers will choose to maximize long-term profitability. Strategic managers develop a business model and strategies that use their company’s distinctive competencies to strive for a cost-leadership position and/or to differentiate its products. To increase profitability, a corporate-level strategy should enable a company or one or more of its business divisions or units to perform value-chain functional activities at a lower cost and/or in a way that results in increased differentiation. Only when it selects the appropriate corporate-level strategies can a company choose the pricing option that will allow it to maximize profitability. When a company decides to expand into new industries, it must construct its business model at two levels: •It must develop a business model and strategies for each business unit or division in every industry in which it competes. •It must develop a higher-level multibusiness model that justifies its entry into different businesses and industries. III. Horizontal Integration: Single-Industry Corporate Strategy Staying within one industry allows a company to focus all of its managerial, financial, technological, and functional resources and capabilities on competing successfully on one area. A second advantage of staying within a single industry is that a company “sticks to the knitting,” meaning that it stays focused on what it knows and does best. Even when a company stays in one industry, sustaining a successful business model over time can be difficult because of changing conditions in the environment, such as advances in technology that allow new competitors into the market, or because of changing customer needs. A focus on corporate-level strategy can help managers anticipate future trends and then change their business models to position their companies to compete successfully in a changing environment. Strategic managers must not become so committed to improving their company’s existing product lines that they fail to recognize new product opportunities and threats. Horizontal integration is the process of acquiring or merging with industry competitors to achieve the competitive advantages that arise from a large scale and scope of operations. An acquisition occurs when one company uses its capital resources, such as stock, debt, or cash, to purchase another company, and a merger is an agreement between equals to pool their operations and create a new entity. A. Benefits of Horizontal Integration: Profitability increases when horizontal integration: •Lowers the cost structure •Increases product differentiation •Leverages a competitive advantage more broadly •Reduces rivalry within the industry •Increases bargaining power over suppliers and buyers 1. Lower Cost Structure Horizontal integration can lower a company’s cost structure because it creates increasing economies of scale. Achieving economies of scale is especially important in industries with a high-fixed-costs structure. A company can also lower its cost structure when horizontal integration allows it to reduce the duplication of resources between two companies. 2. Increased Product Differentiation Horizontal integration may also increase profitability when it increases product differentiation, for example, by increasing the flow of innovative new products that a company’s sales force can sell to customers at premium prices. Horizontal integration may also increase differentiation when it allows a company to combine the product lines of merged companies so that it can offer customers a wider range of products that can be bundled together. Product bundling involves offering customers the opportunity to purchase a range of products at a single combined price. Another way to increase product differentiation is through cross-selling, which is when a company takes advantage of or “leverages” its established relationship with customers by way of acquiring additional product lines or categories that it can sell to customers. In this way, a company increases differentiation because it can provide a “total solution” and satisfy all of a customer’s specific needs. 9.1 Strategy in Action Larry Ellison Wants Oracle to Become the Biggest and the Best This case describes Oracle’s strategy to become the leader in corporate applications software. Oracle has acquired numerous companies to build competencies in the corporate market. This strategy allows the company access to cutting edge applications as well as new cohorts of customers. Oracle’s CEO, Larry Ellison, has invested heavily to acquire more than 20 leading suppliers of corporate software and hardware. Oracle expects several competitive advantages to result from its use of acquisitions to pursue the corporate strategy of horizontal integration: bundling the best software applications of the acquired companies, access to thousands of new customers, and consolidation of the corporate software industry. Oracle has become the second-largest supplier of corporate software and is better positioned to compete with leader SAP. Teaching Note: The Oracle case illustrates the use of corporate strategy to identify: •Which businesses and industries a company should compete in. •Which value creation activities to perform in those businesses. •How it should enter or leave businesses to maximize long-term profitability. Oracle has used horizontal integration to increase the size and competitiveness of the company. Ask students to discuss in detail how this business model has benefitted the company. 3. Leveraging a Competitive Advantage More Broadly For firms that have resources or capabilities that could be valuably deployed across multiple market segments or geographies, horizontal integration may offer opportunities to become more profitable. Focus On: Wal-Mart Wal-Mart’s Expansion into Other Retail Formats In 2013, Wal-Mart was the largest firm in the world, with sales of $469.2 billion, more than 10,000 stores worldwide, and employing 2.2 million people. However, as the U.S. discount retail market was mature (where Wal-Mart earned 70% of its revenues), it looked for other opportunities to apply its exceptional retailing power and expertise. In the United States it had expanded into supercenters (that sold groceries in addition to general merchandise) and even-lower-priced warehouse store formats (sam’s club), both of which were doing well. Wal-Mart had invested relatively early in advanced information technology: it adopted radio frequency identification (RFID) tagging well ahead of its competitors, and satellites tracked inventory in real time. Wal-Mart knew where each item of inventory was at all times and when it had sold, enabling it to simultaneously minimize its inventory holding costs while optimizing the inventory mix in each store. As a result, it had higher sales per square foot and inventory turnover than either target or Kmart. Wal-Mart began to pursue other types of expansion opportunities. It expanded into smaller-format neighborhood stores, international stores (many of which were existing chains that were acquired), and was considering getting into organic foods and trendy fashions. While expansion into contiguous geographic regions (e.g., Canada and Mexico) had gone well, its success at overseas expansions was spottier. Teaching Note: Wal-Mart’s success was its ability to identify opportunities to apply its exceptional retailing power and expertise. It expanded into supercenters and even lower-priced warehouse stores. Wal-Mart adopted radio frequency identification (RFID) tagging well ahead of its competitors and satellites tracked inventory in real time Wal-Mart began to pursue other types of expansion opportunities. It expanded into smaller-format neighborhood stores and international stores. Ask your students to identify why Wal-Mart was not as successful in foreign countries as it was in the United States. 4. Reduced Industry Rivalry Horizontal integration can help to reduce industry rivalry in two ways: •Acquiring or merging with a competitor helps to eliminate excess capacity in an industry, which triggers price wars. •By reducing the number of competitors in an industry, horizontal integration often makes it easier to implement tacit price coordination between rivals or coordination reached without communication. 5. Increased Bargaining Power: Some companies use horizontal integration because it allows them to obtain bargaining power over suppliers or buyers and increase their profitability at the expense of suppliers or buyers. By consolidating the industry through horizontal integration, a company becomes a much larger buyer of suppliers’ products and uses this as leverage to bargain down the price it pays for its inputs, thereby lowering its cost structure. When a company has greater ability to raise prices to buyers or bargain down the price paid for inputs, it has obtained increased market power. B. Problems with Horizontal Integration Although horizontal integration can strengthen a company’s business model in several ways, there are problems, limitations, and dangers associated with pursuing this corporate-level strategy. Implementing a horizontal integration strategy is not an easy task for managers. There are several reasons why mergers and acquisitions may fail to result in higher profitability: •Problems associated with merging very different company cultures. •High management turnover in the acquired company when the acquisition is a hostile one. •A tendency of managers to overestimate the potential benefits from a merger or acquisition and underestimate the problems involved in merging their operations. When a company uses horizontal integration to become a dominant industry competitor, in an attempt to keep using the strategy to continue to grow business, the company comes into conflict with the Federal Trade Commission (FTC), the government agency responsible for enforcing antitrust laws. Antitrust authorities are concerned about the potential for abuse of market power; more competition is generally better for consumers than less competition. IV. Vertical Integration: Entering New Industries to Strengthen the “Core” Business Model A company pursuing a strategy of vertical integration expands its operations either backward into an industry that produces inputs for the company’s products (backward vertical integration) or forward into an industry that uses, distributes, or sells the company’s products (forward vertical integration). There are four main stages in a typical raw-materials-to-consumer value-added chain: raw materials, component parts manufacturing, final assembly, and retail. For a company based in the assembly stage, backward integration involves moving into component parts manufacturing and raw materials production. Forward integration involves movement into distribution and sales (retail). Figure 9.1: Stages in the Raw-Materials-to-Consumer Value-Added Chain Figure 9.2: The Raw-Materials-to-Customer Value-Added Chain in the PC Industry At each stage in the chain, value is added to the product, meaning that a company at one stage takes the product produced in the previous stage and transforms it in some way so that it is worth more to a company at the next stage in the chain and, ultimately, to the customer. It is important to note that each stage of the value-added chain is a separate industry or industries in which many different companies are competing. A. Increasing Profitability through Vertical Integration Vertical integration increases product differentiation, lowers costs, or reduces industry competition when it: •Facilitates investments in efficiency-enhancing specialized assets. •Protects product quality. •Results in improved scheduling. 1. Facilitating Investments in Specialized Assets A specialized asset is an asset that is designed to perform a specific task and whose value is significantly reduced in its next best use. The asset may be a piece of equipment that has a firm-specific use or the knowhow or skills that a company or employees have acquired through training and experience. Companies invest in specialized assets because these assets allow them to lower their cost structure or to better differentiate their products, which facilitates premium pricing. Specialized assets can help a company achieve a competitive advantage at the business level. Just as a company invests in specialized assets in its own industry to build competitive advantage, it is often necessary that suppliers invest in specialized assets to produce the inputs that a specific company needs. For example, supposing that Ford has developed a unique energy-saving electrical engine system that will dramatically increase fuel efficiency and differentiate Ford’s cars from those of its rivals, giving it a major competitive advantage. Ford must decide whether to make the system in-house (vertical integration) or contract with a supplier such as a specialist out- sourcing manufacturer to make the new engine system. The supplier might reason that once it has made the investment, it will become dependent on Ford for business because Ford is the only possible customer for the electrical engine made by this specialized equipment. The problem is a lack of trust— neither Ford nor the supplier can trust the other to operate fairly in this situation. The lack of trust arises from the risk of holdup—that is, being taken advantage of by a trading partner after the investment in specialized assets has been made. Often such firms practice tapered integration, whereby the firm makes some of the input and buys some of the input. Purchasing part or most of its needs for a given input from suppliers enables the firm to tap the advantages of the market (e.g., being able to choose from more suppliers that are competing to improve quality or lower the cost of the product). At the same time, meeting some of its needs for the input through internal production improves the firm’s bargaining power by reducing its likelihood of holdup by a supplier. 9.2 Strategy in Action Specialized Assets and Vertical Integration in the Aluminum Industry Aluminum refineries are designed to refine bauxite ore and produce aluminum. Refinery designs are very specialized—each factory must be designed for a particular type of ore, which is produced only at one or a few bauxite mines. Using a different type of ore would raise production costs by 50%. Therefore, the value of the aluminum company’s investment is dependent on the price it must pay the bauxite company. Recognizing this, once the aluminum company has made the investment in a new refinery, the bauxite company can raise prices to hold up the refiner. The aluminum company can reduce this risk by purchasing the bauxite supplier. Vertical integration, by eliminating the risk of holdup, makes the specialized investment worthwhile. Teaching Note: The case reports that over 90% of aluminum refiners own the bauxite mine. Ask students to consider whether there are any other effective methods of reducing holdup. If so, what are they? If not, why not? 2. Enhancing Product Quality By entering industries at other stages of the value-added chain, a company can often enhance the quality of the products in its core business and strengthen its differentiation advantage. By enhancing product quality, vertical integration enables a company to become a differentiated player in its core business, leading to more pricing options. 3. Improved Scheduling Sometimes important strategic advantages can be obtained when vertical integration makes it quicker, easier, and more cost-effective to plan, co-ordinate, and schedule the transfer of a product, such as raw materials or component parts, between adjacent stages of the value-added chain. This can be particularly important in companies trying to realize the benefits of just-in-time (JIT) inventory systems. B. Problems with Vertical Integration Vertical integration can often be used to strengthen a company’s business model and increase profitability. However, vertical integration has some disadvantages which include: •Increasing cost structure •Disadvantages that arise when technology is changing fast •Disadvantages that arise when demand is unpredictable Sometimes these disadvantages are so great that vertical integration, rather than increasing profitability, may actually reduce it—in which case a company engages in vertical disintegration and exits industries adjacent to its core industry in the industry value chain. 1. Increasing Cost Structure Although vertical integration is often undertaken to lower a company’s cost structure, it can raise costs if a company makes mistakes, such as continuing purchasing inputs from company-owned suppliers when low-cost external sources of supply exist. Company-owned or “in-house” suppliers might have high operating costs relative to independent suppliers because they know that they can always sell their output to other parts of the company. The fact that they do not have to compete for orders with independent, outside suppliers reduces their incentive to look for new ways to minimize operating costs or increase component quality. In-house suppliers simply pass on cost increases to the divisions in the form of higher transfer prices, the prices one division of a company charges other divisions for its products. The term bureaucratic costs refers to the costs of solving the transaction difficulties that arise from managerial inefficiencies and the need to manage the handoffs or exchanges between business units to promote increased differentiation, or to lower a company’s cost structure. 2. Technological Change When technology is changing fast, vertical integration may lock a company into an old, inefficient technology and prevent it from changing to a new one that would strengthen its business model. Vertical integration can pose a serious disadvantage when it prevents a company from adopting new technology, or changing its suppliers or its distribution systems to match the requirements of changing technology. 3. Demand Unpredictability Vertical integration can be risky when demand is unpredictable because it is hard to manage the volume or flow of products along the value-added chain. V. Alternatives to Vertical Integration: Cooperative Relationships Companies have found that they can realize the gains associated with vertical integration without having to bear the associated bureaucratic costs if they enter into long term cooperative relationships with companies in industries along the value-added chain, also known as quasi integration. A. Short-Term Contracts and Competitive Bidding Many companies use short-term contracts that last for a year or less to establish the price and conditions under which they will purchase raw materials or components from suppliers or sell their final products to distributors or retailers. A classic example is the carmaker that uses a competitive bidding strategy, in which independent component suppliers compete to be chosen to supply a particular component, such as brakes, made to agreed-upon specifications, at the lowest price. Short-term contracting does not result in specialized investments that are required to realize differentiation and cost advantages because it signals a lack of long term commitment to its suppliers. This is not a problem when there is minimal need for cooperation, and specialized assets are not required to improve scheduling, or enhance product quality, or reduce cost. This is not a problem when there is minimal need for cooperation, and specialized assets are not required to improve scheduling, enhance product quality, or reduce costs. In this case, competitive bidding may be optimal. However, when there is a need for cooperation, something that is becoming increasingly significant today, the use of short-term contracts and competitive bidding can be a serious drawback. B. Strategic Alliances and Long-Term Contracting Unlike short-term contracts, strategic alliances between buyers and suppliers are long-term, cooperative relationships; both companies agree to make specialized investments and work jointly to find ways to lower costs or increase product quality so that they both gain from their relationship. A strategic alliance becomes a substitute for vertical integration because it creates a relatively stable long-term partnership that allows both companies to obtain the same kinds of benefits that result from vertical integration. However, it also avoids the problems (bureaucratic costs) that arise from managerial inefficiencies that result when a company owns its own suppliers, such as those that arise because of a lack of incentives, or when a company becomes locked into an old technology even when technology is rapidly changing. 9.3 Strategy in Action Apple, Samsung, and Nokia Battle in the Smartphone Market For several years, Apple had formed a strategic alliance with Samsung to make the proprietary chips it uses in its iPhones and iPads, which are based on the designs of British chip company ARM Holdings, the company that dominates the smartphone chip industry. In 2011, Apple decided that its alliance with Samsung had allowed that company to imitate the designs of its smartphones and tablet computers and it sued Samsung, arguing that it had infringed on Apple’s patents and specialized knowledge. The alliance between the two companies quickly dissolved as Samsung countersued Apple, arguing that Apple had infringed upon Samsung’s own patented designs, and analysts expect Apple to turn to another company to make its chips in the future. At the same time, Nokia claimed that Apple had violated its patents and this had allowed it to innovate the iPhone so quickly. Apple countersued Nokia, arguing that Nokia had violated its patents, in particular the touchscreen technology for which it is now so well known. In June 2011, however, Apple agreed to settle with Nokia and to pay Nokia billions of dollars for the right to license its patents and use its technology. Teaching Note: This case demonstrates how a company can form strategic alliances but that they may result in long-term disadvantage. Remind students of the importance of examining the value chain for opportunities for integration. Ask students what might have prevented this stream of litigation? Assign students other companies to examine for vertical integration ideas. C. Building Long-Term Cooperative Relationships There are several strategies companies can adopt to promote the success of a long-term cooperative relationship and lessen the chance that one company will renege on its agreement and cheat the other. One strategy is for the company that makes the specialized investment to demand a hostage from its partner. Another is to establish a credible commitment from both companies that will result in a trusting, long-term relationship. 1. Hostage Taking Hostage taking is essentially a means of guaranteeing that each partner will keep its side of the bargain. The cooperative relationship between Boeing and Northrop Grumman illustrates this type of situation. The companies are mutually dependent; each company holds a hostage—the specialized investment the other has made. Thus, Boeing is unlikely to renege on any pricing agreements with Northrop because it knows that Northrop would respond the same way. 2. Credible Commitments A credible commitment is a believable promise or pledge to support the development of a long-term relationship between companies. For example, by publicly committing itself to a long-term contract and putting some money into the chip development process, IBM made a credible commitment that it would continue to purchase chips from GE. When a company violates a credible commitment with its partners, the results can be dramatic. 9.4 Strategy in Action Ebay’s Changing Commitment to Its Sellers Since its founding in 1995, eBay has always cultivated good relationships with the millions of sellers that advertise their goods for sale on its website. In order to improve the buyer experience, eBay implemented major changes in policy, primarily, in fee structure and feedback. All of which negatively impacted the sellers. Revolts and boycotts, on the part of sellers, proved that eBay’s level of commitment to sellers had fallen dramatically. As a result, eBay reversed course with eliminating several fee increases, revamped the feedback system. However, the old “community relationship” had been destroyed. Teaching Note: This case demonstrates how a company should find ways to maintain cooperative relationships. Ask students what eBay, specifically, could have done to be aware of seller feelings? 3. Maintaining Market Discipline Just as a company pursuing vertical integration faces the problem that its company-owned suppliers might become inefficient, a company that forms a strategic alliance with an independent component supplier runs the risk that its alliance partner might become inefficient over time, resulting in higher component costs or lower quality. A company holds two strong cards over its supplier partner. •All contracts, including long-term contracts, are periodically renegotiated, usually every 3 to 5 years, so the supplier knows that if it fails to live up to its commitments, its partner may refuse to renew the contract. •Many companies that form long term relationships with suppliers use parallel sourcing policies—they enter into a long-term contract with at least two suppliers for the same component. This arrangement protects a company against a supplier that adopts an uncooperative attitude because the supplier knows that if it fails to comply with the agreement, the company can switch all its business to its other supplier partner. VI. Strategic Outsourcing Vertical integration and strategic alliances are alternative ways of managing the value chain across industries to strengthen a company’s core business model. Strategic outsourcing is the decision to allow one or more of a company’s value-chain activities or functions to be performed by independent specialist companies that focus all their skills and knowledge on just one kind of activity. When a company chooses to outsource a value-chain activity, it is choosing to focus on a fewer number of value-creation activities to strengthen its business model. There has been a clear move among many companies to outsource activities that managers regard as being “noncore” or “nonstrategic,” meaning they are not a source of a company’s distinctive competencies and competitive advantage. The vast majority of companies outsource manufacturing or some other value-chain activity to domestic or overseas companies today; some estimates are that over 60% of all global product manufacturing is outsourced to manufacturing specialists because of pressures to reduce costs. These products are made under contract at low-cost, global locations by contract manufacturers that specialize in low-cost assembly—and many problems can arise as a result 9.5 Strategy in Action Apple Tries to Protect its New Products and the Workers Who Make Them Apple’s PCs and mobile computing devices are assembled by huge specialists outsourcing companies abroad. In the interest of secrecy, Apple has retaliated with litigation and company secrecy policies. Many of their outsourcing contracts include confidentiality clauses with penalties for security breaches. Appearing rather restrictive to employees regarding secrecy, Apple has been criticized and contradictory in their approach to employee/employment policies. Unethical employee treatment on the part of their outsourcer partners forced Apple to terminate some contracts. These circumstances beg the questions: Which rules does Apple spend the most time and effort to develop and enforce? Which rules does it regard as being most important—the rules that protect the secrecy of its products, or the rules that protect the rights of the workers who make those products? Teaching Note: This case demonstrates how a company can outsource its operations and protect such aspects as secrecy but fail in selecting outsource partners that enhance the image of the company. Ask students what Apple should have done in this situation? Companies engage in strategic outsourcing to strengthen their business models and increase their profitability. The process of strategic outsourcing typically begins with strategic managers identifying the value-chain activities that form the basis of a company’s competitive advantage; these are obviously kept within the company to protect them from competitors. Managers then systematically review the noncore functions to assess whether independent companies that specialize in those activities can perform them more effectively and efficiently. Because these companies specialize in particular activities, they can perform them in ways that lower costs or improve differentiation. If managers decide there are differentiation or cost advantages, these activities are outsourced to those specialists. Figure 9.3: Strategic Outsourcing of Primary Value Creation Functions The term virtual corporation has been coined to describe companies that have pursued extensive strategic outsourcing. A. Benefits of Outsourcing Strategic outsourcing has several advantages. It can help a company to lower its cost structure, increase product differentiation, and focus on the distinctive competencies that are vital to its long-term competitive advantage and profitability. 1. Lower Cost Structure Outsourcing will reduce costs when the price that must be paid to a specialist company to perform a particular value-chain activity is less than what it would cost the company to internally perform that activity in-house. 2. Enhanced Differentiation A company may also be able to differentiate its final products better by outsourcing certain noncore activity to specialists. For this to occur, the quality of the activity performed by specialists must be greater than if that same activity was performed by the company. 3. Focus on the Core Business A final advantage of strategic outsourcing is that it allows managers to focus their energies and their company’s resources on performing those core activities that have the most potential to create value and competitive advantage. B. Risks of Outsourcing There are also risks associated with strategic outsourcing, risks such as holdup and the possible loss of important information when an activity is outsourced. 1. Holdup In the context of outsourcing, holdup refers to risk that a company will become too dependent upon a specialist provider of an outsourced activity and that the specialist will use this fact to raise prices beyond some previously agreed-upon rate. As with strategic alliances, the risk of holdup can be reduced by outsourcing to several suppliers and pursuing a parallel sourcing policy. 2. Increased Competition As firms employ contract manufacturers for production, they help to build an industry-wide resource that lowers the barriers to entry in that industry. In industries that have efficient and high-quality contract manufacturers, large firms may find that their size no longer affords them protection against competitive pressure; their high investments in fixed assets can become a constraint rather than a source of advantage. 3. Loss of Information and Forfeited Learning Opportunities A company that is not careful can lose important competitive information when it outsources an activity. A firm that manufactures its own products also gains knowledge about how to improve their design in order to lower the costs of manufacturing or produce more reliable products. Thus, a firm that forfeits the development of manufacturing knowledge could unintentionally forfeit opportunities for improving its capabilities in product design. The firm risks becoming “hollow.” Teaching Note: Ethical Dilemma This question should be used to question whether a proposed merger interferes with FTC antitrust guidelines, creates unfair competition, or would otherwise be monopolistic. The instructor should use this as a homework assignment to allow students to research two or three companies whose mergers have presented concerns at the FTC level. As part of the assignment, then ask the students to conclude their research with the answer to “what criteria they would use to make the determination”? Answers to Discussion Questions 1. Under what conditions might horizontal integration be inconsistent with the goal of maximizing profitability? Horizontal integration is not consistent with maximizing stockholder wealth when implementation problems override value creation. Implementation will be difficult if prospective targets have organizational cultures or business practices that differ sharply from those of the acquiring firm. When a firm already dominates its industry, it may not be possible to maximize profitability by merger or acquisition due to antitrust law enforcement. Finally, if a company is pursuing horizontal integration for any other reasons (such as management ego or to ward off a rival) than to increase differentiation and improve cost structure, then it will be inconsistent with profit maximization goals. 2. What is the difference between a company’s internal value chain and the industry value chain? What is the relationship between vertical integration and the industry value chain? A value chain runs across industries, and embedded within that are the value chains of companies within each industry. A company pursuing a strategy of vertical integration expands its operations either backward into an industry that produces inputs for the company’s products or forward into an industry that uses, distributes, or sells the company’s products. To enter an industry, it may establish its own operations and build the value chain needed to compete effectively in that industry; or it may acquire a company that is already in the industry. 3. Why was it profitable for GM and Ford to integrate backward into component-parts manufacturing in the past, and why are both companies now buying more of their parts from outside suppliers? Back in the 1920s, when Ford and GM originally began to vertically integrate backward there were two main reasons for doing so. First, the component supply industry was not well developed, so automakers had to manufacture some parts themselves. Second, they wanted to achieve tight coordination between adjacent stages of production to lower their production costs. By the 1980s, however, conditions had changed. A lack of competitive pressures led to internal suppliers becoming inefficient (the bureaucratic costs were high). Also, unionization made in-house suppliers’ labor expenses too high. Furthermore, capacity reductions meant that both companies were experiencing excess capacity at in-house suppliers. Also, Japanese auto companies had shown that entering into long-term contractual relationships with component suppliers was a viable low-cost alternative to formal vertical integration. 4. What value creation activities should a company outsource to independent suppliers? What are the risks involved in outsourcing these activities? Companies should consider strategic outsourcing of functions that do not form the basis of its competitive advantage. Thus, universities may outsource food preparation, but a restaurant should not. Companies should outsource when there are a number of independent suppliers that can provide the activities more efficiently or more effectively than the firm can. Many companies outsource functions such as janitorial services, payroll, or temp hiring. Companies should outsource when there is a low risk of the firm becoming too dependent on its supplier. The high number of suppliers for corporate legal counsel makes it unlikely that the firm would become overly dependent on any one supplier. Risks of outsourcing include loss of ability to learn from that activity and loss of the opportunity to transform that activity into a distinctive competence. A further drawback of outsourcing is that the company may become too dependent upon a particular supplier. Another concern is that, in its enthusiasm for strategic outsourcing, a company might go too far and outsource value creation activities that are central to the maintenance of its competitive advantage. 5. What steps would you recommend that a company take to build mutually beneficial long-term cooperative relationships with its suppliers? The main objective in building long-term stable relationships must be the establishment of mutual trust. Therefore, the company should consider actions such as the creation of liaison roles in both the firm and the supplier, with an emphasis on open, friendly communication. The firm should ensure that all parties are aware of the opportunities for mutual benefit, and then design a system that rewards innovations and suggestions. The firm must then follow through in investigating and responding to suggestions and appropriately rewarding those responsible for any resulting improvements. The other important consideration is to ensure that the supplier does not exploit the relationship for its exclusive benefit. This can be accomplished by creating a hostage through mutual investment in specialized assets. Credible commitments, periodic contract renegotiation, and parallel sourcing policies can also be used to ensure equity in the relationship. Practicing Strategic Management Small-Group Exercise: Comparing Vertical Integration Strategies Students are asked to break into small groups and read a short case about Quantum Corporation and Seagate Technologies. They are then asked to describe the costs and benefits of a vertical integration strategy, as illustrated in the case. The students also should recommend a strategy for firms in the computer disk drive industry. Teaching Note: Quantum uses a vertical integration approach to the manufacture of disk drives, which gives the firm control over proprietary technology and product quality and enables better coordination between steps as well. However, the firm faces high bureaucratic costs from that coordination, high operating costs due to lack of competitive pressures, and risks of technological obsolescence. Seagate outsources mass market production to an overseas supplier, which reduces costs and allows the company to focus on what it does best, which is R&D. However, Seagate risks loss of control over scheduling and costs and also risks losing its proprietary technology. Strategy Sign-On Article File 9 Students should find an example of a company whose vertical integration or diversification strategy appears to have dissipated rather than created value. They should determine why this has happened and what the company should do to rectify the situation. Teaching Note: Students should examine companies that have undergone a recent merger or acquisition to find good candidates for this exercise. The students can evaluate the success of a merger or acquisition by looking at profitability before and after the merger. If this proves difficult, another, perhaps easier, way to examine performance is to look at stock price over time. If the stock price declines after the merger, then the market values the merged companies less. Investors can be wrong about a firm’s future performance, however, so use stock valuation cautiously. Strategic Management Project: Module 9 This module requires students to assess the horizontal and vertical integration strategy being pursued by the companies of their choice. With the information at their disposal, students must answer the questions and perform the tasks listed: 1. Has your company ever pursued a horizontal integration strategy? What was the strategic reason for pursuing this strategy? 2. How vertically integrated is your company? In what stages of the industry value chain does it operate? 3. Assess the potential for your company to increase profitability through vertical integration. In reaching your assessment, also consider the bureaucratic costs of managing vertical integration. 4. On the basis of your assessment in question 3, do you think your company should (a) outsource some operations that are currently performed in-house or (b) bring some operations in-house that are currently outsourced? Justify your recommendations. 5. Is your company involved in any long-term cooperative relationships with suppliers or buyers? If so, how are these relationships structured? Do you think that these relationships add value to the company? Why or why not? 6. Is there any potential for your company to enter into (additional) long-term cooperative relationships with suppliers or buyers? If so, how might these relationships be structured? Teaching Note: Students will be able to find information about a company’s recent merger and acquisition activity by examining its website. An organization chart will show the current levels of integration. The remaining questions are opinion questions, and students should be encouraged to look closely at the material in this chapter for help in answering them. In the General Task, students should readily find examples of firms that are using strategic outsourcing. They may not be able to find detailed financial information about the costs and benefits of the outsourcing, so allow them to answer this question in general or speculative terms. CLOSING CASE The Rapid Consolidation of the U.S. Airline Industry This case details the U.S. airline industry pathway to consolidation. In 2008, at the height of competition, the airline industry was faced with rising oil prices, financial recession, decreases in demand, especially among business travelers, and resulting financial losses. With bankruptcies abounding, merger requests, expanded route requests, and the need to reduce cost structures, government intervention became present. With government approval, horizontal integration took place in the airline industry. The shakeout revealed that Southwest had rapidly expanded its route structure and made powerful acquisitions to become one of the largest U.S. carriers by 2011. As a low cost strategy provider, where will Southwest rank in the years ahead? And what consolidations will take place to narrow the number of airlines operating? Teaching Note: This case illustrates how horizontal integration changed the airline industry along with how Southwest’s corporate strategy was used to increase company and industry profitability. Southwest used its corporate strategy to identify 1) which businesses and industries a company should compete in now and in the future, 2) which value creation activities it should perform in those businesses, and 3) how it should enter or leave businesses or industries to maximize its long-run profitability. Answers to Case Discussion Questions 1. How does consolidation improve airlines’ revenues? How might it improve their costs? Industry consolidation makes it easier for carriers to announce changes such as charging for a second checked bag or the right to be seated first, all of which provide airlines with additional sources of revenue. Airlines can improve their costs by slashing the number of flights they offer, mothballing hundreds of older planes, laying off thousands of employees, and instituting new surcharges for fuel, baggage, and even for carrying pets onboard. 2. Are there any disadvantages to the airlines of consolidating? Airlines rapidly consolidating can lead to conflict with the Federal Trade Commission (FTC), the government agency responsible for enforcing antitrust laws. Antitrust authorities are concerned about the potential for abuse of market power; more competition is generally better for consumers than less competition. The FTC is concerned when a few companies within one industry try to make acquisitions that will allow them to raise consumer prices above the level that would exist in a more competitive situation, and thus abuse their market power. The FTC also wishes to prevent dominant companies from using their market power to crush potential competitors, for example, by cutting prices when a new competitor enters the industry and forcing the competitor out of business, then raising prices after the threatening company has been eliminated. Because of these concerns, any merger or acquisition the FTC perceives as creating too much consolidation, and the potential for future abuse of market power, may, for antitrust reasons, be blocked. 3. Why do you think Southwest Airlines is (on average) the most profitable of the U.S. airlines? Should it attempt to integrate with other airlines? Why or why not? Southwest always pursued a cost-leadership strategy and so had been able to withstand falling ticket prices and rising costs better than the older, more established airlines. Southwest served most major U.S. cities, and its managers also saw an opportunity to expand market share and simultaneously keep its cost structure low by acquiring one of its low-cost rivals, Air Tran Holdings, owner of AirTran Airways. AirTran offered low-cost passenger transportation to almost 70 cities, mainly in the United States and the Caribbean. Like Southwest Airlines, it operated an all-Boeing fleet, facilitating its integration with Southwest’s operations (Southwest’s use of only Boeing 737s was said to be a major source of efficiencies, for example, by reducing parts inventory requirements and increasing pilot flexibility). The revenues of the combined companies reached $17.1 billion in 2012, roughly half the size of the world’s largest airlines. This example suggests that Southwest Airlines should integrate with other airlines. cHAPTER 10 Corporate-Level Strategy: Related and Unrelated Diversification Synopsis of Chapter This chapter continues the discussion of corporate strategy that was begun in Chapter 9. Diversification into more than one business is the corporate-level strategy for growth. The corporation is treated as a portfolio of investments, and diversification is seen as a way of further leveraging the firm’s distinctive competencies. The role of diversification in increasing firm profitability, through transferring or leveraging competencies, sharing resources and capabilities, product bundling, or leveraging general organizational competencies, is also discussed. Next, the chapter deals with related and unrelated diversification and the advantages and disadvantages of each strategy. The limits of diversification are also described, including an extensive treatment of bureaucratic costs. The chapter continues with a discussion of how best to choose related or unrelated strategies. The remainder of the chapter describes three entry strategies for diversification—internal new ventures, acquisitions, and joint ventures. In each section, the benefits and challenges of that entry strategy are listed, along with suggestions about how to increase the chances of a successful implementation of that strategy. Finally, diversification’s opposite, restructuring, is introduced and discussed. Learning Objectives 1. Differentiate between multibusiness models based on related and unrelated diversification. 2. Explain the five primary ways in which diversification can increase company profitability. 3. Discuss the conditions that lead managers to pursue related diversification versus unrelated diversification and explain why some companies pursue both strategies. 4. Describe three methods companies use to enter new industries—internal new venturing, acquisitions, and joint ventures—and discuss the advantages and disadvantages associated with each of these methods. Opening Case Citigroup: The Opportunities and Risks of Diversification In 2013, Citigroup was a $90.1 billion diversified financial services firm known around the world. However, its history had not always been smooth. From the late 1990s through 2010, the company’s diversification moves, and its role in the mortgage crisis, combined to bring the company to its knees. Citigroup traces its history all the way back to 1812, and by 1929, it was the largest commercial bank in the world. The bank’s capital resources and its trusted brand name enabled it to successfully diversify into a range of consumer banking services. The highly innovative company was, for example, the first to introduce savings accounts with compound interest, unsecured personal loans, checking accounts, and 24-hour ATMs, among other things. The merger of Citicorp and Travelers happened due to the rise of a new concept of “financial supermarket.” This merger created a $140 billion firm with assets of $700 billion. Renamed Citigroup, it was now the largest financial services organization in the world. Unfortunately, at almost exactly the same time, the Internet rendered the bricks-and-mortar financial supermarket obsolete—the best deals were to be found at the financial supermarket on the Web. To make matters worse, rather than cross-selling, the different divisions of Citi and Travelers began battling each other to protect their turf. To boost earnings, Citi began investing in subprime loans, whose risk was camouflaged by bundling them into mortgage-backed securities known as collateralized debt obligations (CDOs). Trouble began brewing before even Citi knew the scale of risk it had undertaken. Loose lending policies had resulted in a large number of poor-quality mortgages, the vast majority of which had adjustable-rate mortgages. This combined with a steep decline in housing prices that made it next to impossible for homebuyers to refinance their mortgages as their interest rates climbed—their homes were now worth less than what they owed. A lawsuit by Citi’s shareholders in 2006 accused the company of using a “CDO-related quasi-Ponzi scheme” to falsely give the appearance that it had a healthy asset base and conceal the true risks the company was facing. Soon the company was posting billions in losses and its stock price fell to the lowest it had been in a decade. To Lynn Turner, a former chief accountant with the Securities and Exchange Commission, Citi’s crisis was no surprise. The amalgamation of businesses had created conflicts of interest, and Citi’s managers lacked the ability to accurately gauge the risk of the exotic financial instruments that were proliferating. While the U.S. government kept the bank from failing with a $45 billion bailout, Citigroup began reducing its workforce, and selling off everything it could, dismantling its financial supermarket. It also restructured itself into two operating units—Citicorp for retail and institutional client business, and Citi Holdings for its brokerage and asset management. In 2010, Citigroup finally returned to profitability. It repaid its U.S. government loans, and its managers and the investment community breathed a sigh of relief, optimistic that the worst was over. In 2012, Citi posted $71 billion in revenues and $7.5 billion in net income. Teaching Note: The saga of Citi clearly shows that having a very large and complex organization had made it more difficult to provide sufficient, and effective, oversight within the firm. Citibank’s reputation, brand name, expertise, and capital had enabled it to profitably expand both its product and geographic scope. However, overestimates of synergies led the firm to diversify into activities that strayed from its key strengths in consumer retail banking. Furthermore, as it became increasingly diversified, it became difficult for managers to provide adequate oversight within the organization. Problems, including conflicts of interest and underestimates of the risk of its assets, grew without being detected. Discuss with your students how diversification can create, and destroy, value. Lecture Outline I. Overview This chapter continues to discuss both the challenges and opportunities created by corporate-level strategies of related and unrelated diversification. It examines the different kinds of multibusiness models upon which related and unrelated diversification are based. Then, it discusses three different ways companies can implement a diversification strategy—internal new ventures, acquisitions, and joint ventures. By the end of this chapter, students will understand the advantages and disadvantages associated with strategic managers’ decisions to diversify and enter new markets and industries. II. Increasing Profitability Through Diversification Diversification is the process of entering new industries, distinct from a company’s core or original industry, to make new kinds of products that can be sold profitably to customers in these new industries. A multibusiness model based on diversification aims to find ways to use a company’s existing strategies and distinctive competencies to make products that are highly valued by customers in the new industries it enters. A diversified company is one that makes and sells products in two or more different or distinct industries. A diversification strategy should enable a company or its individual business units to perform one or more of the value-chain functions (1) at a lower cost, (2) in a way that allows for differentiation and gives the company pricing options, or (3) in a way that helps the company to manage industry rivalry better—in order to increase profitability. The managers of most companies often consider diversification when they are generating free cash flow, that is, cash in excess of that required to fund new investments in the company’s current business and meet existing debt commitments. For diversification to be value creating, a company’s return on investing free cash flow to pursue diversification opportunities, that is, its future return on invested capital (ROIC) must exceed the value shareholders would reap by returning the cash to them. There are five primary ways in which pursuing a multibusiness model based on diversification can increase company profitability. Diversification can increase profitability when strategic managers: • Transfer competencies between business units in different industries • Leverage competencies to create business units in new industries • Share resources between business units to realize synergies or economies of scope • Use product bundling • Utilize general organizational competencies that increase the performance of all a company’s business units A. Transferring Competencies Transferring competencies involves taking a distinctive competency developed by a business unit in one industry and implanting it in a business unit operating in another industry. Companies that base their diversification strategy on transferring competencies aim to use one or more of their existing distinctive competencies in a value-chain activity to significantly strengthen the business model of the acquired business unit or company. Figure 10.1: Transfer of Competencies at Philip Morris Companies that base their diversification strategy on transferring competencies tend to acquire new businesses related to their existing business activities because of commonalities between one or more of their value-chain functions. A commonality is some kind of skill or attribute that, when it is shared or used by two or more business units, allows both businesses to operate more effectively and efficiently and create more value for customers. In general competency transfers increase profitability when they either: • Lower the cost structure of one or more of a diversified company’s business units • Enable one or more of its business units to better differentiate their products For competency transfers to increase profitability, the competencies transferred must involve value-chain activities that become an important source of a specific business unit’s competitive advantage in the future. In other words, the distinctive competency being transferred must have real strategic value. B. Leveraging Competencies to Create a New Business Firms can also leverage their competencies by using them to develop a new business in a different industry. The multibusiness model is based on the premise that the set of distinctive competencies that are the source of a company’s competitive advantage in one industry might be applied to create a differentiation or cost-based competitive advantage for a new business unit or division in a different industry. C. Sharing Resources and Capabilities A third way in which two or more business units that operate in different industries can increase a diversified company’s profitability is when the shared resources and capabilities results in economies of scope, or synergies. Economies of scope arise when one or more of a diversified company’s business units are able to realize cost-saving or differentiation synergies because they can more effectively pool, share, and utilize expensive resources or capabilities, such as skilled people, equipment, manufacturing facilities, distribution channels, advertising campaigns, and R&D laboratories. There are two major sources of these cost reductions: • When companies can share resources or capabilities across business units, it lowers their cost structure compared to a company that operates in only one industry and bears the full costs of developing resources and capabilities. Figure 10.2: Sharing Resources at Procter & Gamble • Diversification to obtain economies of scope is possible only when there are significant commonalities between one or more of the value-chain functions in a company’s different business units or divisions that result in synergies that increase profitability. o In addition, managers must be aware that the costs of coordination necessary to achieve synergies or economies of scope within a company may sometimes be higher than the value that can be created by such a strategy. D. Using Product Bundling In the search for new ways to differentiate products, more and more companies are entering into industries that provide customers with new products that are connected or related to their existing products. This allows a company to expand the range of products it produces in order to be able to satisfy customers’ needs for a complete package of related products. Just as manufacturing companies strive to reduce the number of their component suppliers to reduce costs and increase quality, final customers want to obtain the convenience and reduced price of a bundle of related products. It is important to note here that product bundling often does not require joint ownership. For product bundling to serve as a justification for diversification, there must be a strong need for coordination between the producers of the different products that cannot be overcome through market contracts. E. Utilizing General Organizational Competencies General organizational competencies transcend individual functions or business units and are found at the top or corporate level of a multibusiness company. Typically, general organizational competencies are the result of the skills of a company’s top managers and functional experts. Three kinds of general organizational competencies help a company increase its performance and profitability—entrepreneurial capabilities, organizational design capabilities, and strategic capabilities. 1. Entrepreneurial Capabilities A company that generates significant excess cash flow can take advantage of it only if its managers are able to identify new opportunities and act on them to create a stream of new and improved products, in its current industry and in new industries. Such a company is able to promote entrepreneurship because it has an organizational culture that stimulates managers to act entrepreneurially. It is important to note that to promote entrepreneurship, a company must: • Encourage managers to take risks • Give managers the time and resources to pursue novel ideas • Not punish managers when a new idea fails • Make sure that the company’s free cash flow is not wasted in pursuing too many risky new ventures that have a low probability of generating a profitable return on investment 2. Capabilities in Organizational Design Organizational design skills are a result of manager’s ability to create a structure, culture, and control systems that motivate and coordinate employees to perform at a high level. Organizational design is a major factor that influences a company’s entrepreneurial capabilities; it is also an important determinant of a company’s ability to create the functional competencies that give it a competitive advantage. Effective organizational structure and controls create incentives that encourage business-unit (divisional) managers to maximize the efficiency and effectiveness of their units. To profit from pursuing the corporate-level strategy of diversification, a company must be able to continuously manage and change its structure and culture to motivate and coordinate its employees to work at a high level and develop the resources and capabilities upon which its competitive advantage depends. The ever-present need to align a company’s structure with its strategy is a complex, never-ending task, and only top managers with superior organizational design skills can do it. 3. Superior Strategic Management Capabilities For diversification to increase profitability, a company’s top managers must possess the intangible, hard-to-define governance skills that are required to manage different business units in a way that enables these units to perform better than they would if they were independent companies. These governance skills are a rare and valuable capability. An especially important governance skill in a diversified company is the ability to diagnose the underlying source of the problems of a poorly performing business unit, and then to understand how to proceed to solve those problems. This might involve recommending new strategies to the existing top managers of the unit or knowing when to replace them with a new management team that is better able to fix the problems. Related to strategic management skills is the ability of the top managers of a diversified company to identify inefficient and poorly managed companies in other industries and then to acquire and restructure them to improve their performance—and thus the profitability of the total corporation. This is known as a turnaround strategy. There are several ways to improve the performance of the acquired company: • The top managers of the acquired company are replaced with a more aggressive top management team. • The new top management team sells off expensive assets; it also terminates managers and employees to reduce the cost structure. • The new management team works to devise new strategies to improve the performance of the operations of the acquired business and improve its efficiency, quality, innovativeness, and customer responsiveness. • To motivate the new top-management team and the other employees of the acquired company to work toward such goals, a company-wide pay-for-performance bonus system linked to profitability is introduced to reward employees at all levels for their hard work. • The acquiring company often establishes “stretch” goals for employees at all levels; these are challenging, hard-to-obtain goals that force employees at all levels to work to increase the company’s efficiency and effectiveness. • The members of the new top-management team clearly understand that if they fail to increase their division’s performance and meet these stretch goals within some agreed-upon amount of time, they will be replaced. 10.1 Strategy in Action: United Technologies Has an “ACE” in its Pocket United Technologies is a conglomerate that owns many diverse businesses. How is it that this company can continue to justify its multibusiness model in a time when many other conglomerates have been broken up? The CEO George David claims that he has created a unique and sophisticated model that adds value across the set of diverse companies. David started his career at UTC with Otis Elevator, where he had responsibility for Japanese operations. While there he witnessed the results of the use of Japanese “process” techniques to correct problems with a new elevator. When he became CEO of UTC he decided that the best way to increase UTC’s financial performance was to improve efficiency and quality in all of its businesses. UTC developed a TQM system called ACE—Achieving Competitive Excellence. The use of these “process disciplines” has increased performance of all UTC companies. Teaching Note: UTC has a multibusiness model that: • Allows each business to pursue its own industry specific business model • Supplies each division with corporate support in the form of its ACE system • Uses the financial power of the corporate entity to make acquisitions and divestitures to improve the companies’ performance UTC illustrates the elements of a corporate strategy and the value that it can provide to unrelated businesses under a corporate umbrella. III. Two Types of Diversification The two corporate strategies of related diversification and unrelated diversification can be distinguished by how they attempt to realize the profit-enhancing benefits of diversification. A. Related Diversification Related diversification is a corporate-level strategy based on the goal of establishing a business unit (division) in a new industry that is related to a company’s existing business units by some form of commonality or linkage between the value-chain functions of the existing and new business units. The goal of this strategy is to obtain the benefits from transferring competencies, leveraging competencies, sharing resources, and bundling products. The multibusiness model of related diversification is based on taking advantage of strong technological, manufacturing, marketing, and sales commonalities between new and existing business units that can be successfully “tweaked” or modified to increase the competitive advantage of one or more business units. Figure 10.3 illustrates the commonalities or linkages possible among the different functions of three different business units or divisions. One more advantage of related diversification is that it can also allow a company to use any general organizational competency it possesses to increase the overall performance of all its different industry divisions. Figure 10.3: Commonalities between the Value Chains of Three Business Units B. Unrelated Diversification Unrelated diversification is a corporate-level strategy whereby firms own unrelated businesses and attempt to increase their value through an internal capital market, the use of general organizational competencies, or both. Company’s pursing this strategy are often called conglomerates, business organizations that operate in many diverse industries. An internal capital market refers to a situation whereby a corporate headquarters assesses the performance of business units and allocates money across them. Cash generated by units that are profitable but have poor investment opportunities within their business is used to cross-subsidize businesses that need cash and have strong promise for long-run profitability. The benefits of an internal capital market are limited, however, by the efficiency of the external capital market. If the external capital market were perfectly efficient, managers could not create additional value by cross-subsidizing businesses with internal cash. An internal capital market is, in essence, an arbitrage strategy where managers make money by making better investment decisions within the firm than the external capital market would. Often this is because managers have superior information than the external capital market. The amount of value that can be created through an internal capital market is thus directly proportional to the inefficiency of the external capital market. Companies pursuing a strategy of unrelated diversification have no intention of transferring or leveraging competencies between business units or sharing resources other than cash and general organizational competencies. If the strategic managers of conglomerates have the special skills needed to manage many companies in diverse industries, the strategy can result in superior performance and profitability; often they do not have these skills. IV. The Limits and Disadvantages of Diversification There are three principal reasons why a business model based on diversification may lead to a loss of competitive advantage——changes in the industry or inside a company that occur over time, diversification pursued for the wrong reasons, and excessive diversification that results in increasing bureaucratic costs. A. Changes in the Industry or Company To pursue diversification, top managers must have the ability to recognize profitable opportunities to enter new industries and to implement the strategies necessary to make diversification profitable. Over time, a company’s top management team often changes. When the managers who possess the hard-to-define skills leave, they often take their visions with them. A company’s new leaders may lack the competency or commitment necessary to pursue diversification successfully over time; thus, the cost structure of the diversified company increases and eliminates any gains the strategy may have produced. In addition, the environment often changes rapidly and unpredictably over time. When new technology blurs industry boundaries, it can destroy the source of a company’s competitive advantage. When a major technological change occurs in a company’s core business, the benefits it has previously achieved from transferring or leveraging distinctive competencies disappear. The company is then saddled with a collection of businesses that have all become poor performers in their respective industries because they are not based on the new technology. Thus, a major problem with diversification is that the future success of a business is hard to predict when this strategy is used. B. Diversification for the Wrong Reasons When managers decide to pursue diversification, they must have a clear vision of how their entry into new industries will allow them to create new products that provide more value for customers and increase their company’s profitability. Over time, however, a diversification strategy may result in falling profitability, but managers often refuse to recognize that their strategy is failing. In the past, for example, one widely used (and false) justification for diversification was that the strategy would allow a company to obtain the benefits of risk pooling. The idea behind risk pooling is that a company can reduce the risk of its revenues and profits rising and falling sharply (something that sharply lowers its stock price) if it acquires and operates companies in several industries that have different business cycles. However, this argument ignores two facts. • Stockholders can eliminate the risk inherent in holding an individual stock by diversifying their own portfolios, and they can do so at a much lower cost than a company can. • Research suggests that corporate diversification is not an effective way to pool risks because the business cycles of different industries are inherently difficult to predict, so it is likely that a diversified company will find that an economic downturn affects all its industries simultaneously. If this happens, the company’s profitability plunges. When a company’s core business is in trouble, another mistaken justification for diversification is that entry into new industries will rescue the core business and lead to long-term growth and profitability. In desperation, companies diversify for reasons of growth alone rather than to gain any well-thought-out strategic advantage. In fact, many studies suggest that too much diversification may reduce rather than improve company profitability. C. The Bureaucratic Costs of Diversification A major reason why diversification often fails to boost profitability is that very often the bureaucratic costs of diversification exceed the benefits created by the strategy (that is, the increased profit that results when a company makes and sells a wider range of differentiated products and/or lowers its cost structure). Bureaucratic costs are the costs associated with solving the transaction difficulties that arise between a company’s business units and between business units and corporate headquarters, as the company attempts to obtain the benefits from transferring, sharing, and leveraging competencies. They also include the costs associated with using general organizational competencies to solve managerial and functional inefficiencies. The level of bureaucratic costs in a diversified organization is a function of two factors—the number of business units in a company’s portfolio and the degree to which coordination is required between these different business units to realize the advantages of diversification. 1. Number of Businesses The greater the number of business units in a company’s portfolio, the more difficult it is for corporate managers to remain informed about the complexities of each business. Managers simply do not have the time to assess the business model of each unit. The inability of top managers in extensively diversified companies to maintain control over their multibusiness model over time often leads managers to base important resource allocation decisions only on the most superficial analysis of each business unit’s competitive position. Furthermore, because they are distant from the day-to-day operations of the business units, corporate managers may find that business unit managers try to hide information on poor performance to save their own jobs. As organizational problems increase; top managers must spend an enormous amount of time and effort to solve the problems. This increases bureaucratic costs and cancels out the profit-enhancing advantages of pursuing diversification. 2. Coordination among Businesses The amount of coordination required to realize value from a diversification strategy based on transferring, sharing, or leveraging competencies is a major source of bureaucratic costs. The bureaucratic mechanisms needed to oversee and mange this coordination and handoffs between units are a major source of these costs. A second source of bureaucratic costs arises from the enormous amount of managerial time and effort required to accurately measure the performance and unique profit contribution of a business unit that is transferring or sharing resources with another is also one of these costs. Figure 10.4: Coordination among Related Business Units In sum, although diversification can be a highly profitable strategy to pursue, it is also the most complex and difficult strategy to manage because it is based on a complex multibusiness model. Even when a company has pursued this strategy successfully in the past, changing conditions both in the industry environment and inside a company may quickly reduce the profit-creating advantages of pursuing this strategy. 10.2 Strategy in Action: How Bureaucratic Costs Rose Then Fell at Pfizer Pfizer grew to be the largest global pharmaceuticals company but had problems in innovating new blockbuster drugs. It realized leadership changes and created a detailed plan for changing the way Pfizer researchers made decisions. This ensured the best use for company resources and balanced talent and funds. Pfizer grew into a bureaucratic culture with increasing bureaucratic costs. Martin Mackay, in the top R&D seat, reduced management layers, laid off numerous managers, reduced committees, reduced bureaucratic rules scientists had to follow, and eliminated reporting. As a result, new work flow was created, conflict was reduced, and innovation occurred. Teaching Note: Pfizer’s ability to recognize and reduce its bureaucratic costs is the focus of the case. Have students examine other companies with profitability problems for bureaucratic cost concerns. Have students research the reasons for Pfizer’s growth with the purpose of examining diversification for the wrong reasons. V. Choosing a Strategy A. Related versus Unrelated Diversification Because related diversification involves more sharing of competencies, one might think it can boost profitability in more ways than unrelated diversification, and is therefore the better diversification strategy. Although it is true that related diversified companies can create value and profit in more ways than unrelated companies, they also have to bear higher bureaucratic costs to do so. These higher costs may cancel out the higher benefits, making the strategy no more profitable than one of unrelated diversification. The choice of strategy depends upon a comparison of the benefits of each strategy against the bureaucratic costs of pursuing it. It pays a company to pursue related diversification when: • The company’s competencies can be applied across a greater number of industries • The company has superior strategic capabilities that allow it to keep bureaucratic costs under close control—perhaps by encouraging entrepreneurship or by developing a value-creating organizational culture. Using the same logic, it pays a company to pursue unrelated diversification when: • Each business unit’s functional competencies have few useful applications across industries, but the company’s top managers are skilled at raising the profitability of poorly run businesses • The company’s managers use their superior strategic management competencies to improve the competitive advantage of their business units and keep bureaucratic costs under control B. The Web of Corporate-Level Strategy Although some companies may choose to pursue a strategy of related or unrelated diversification, there is nothing that stops them from pursuing both strategies at the same time. A company should pursue any and all strategies as long as strategic managers have weighed the advantages and disadvantages of those strategies and arrived at a multibusiness model that justifies them. Figure 10.5 illustrates how Sony developed a web of corporate strategies to compete in many industries—a program that proved a mistake and actually reduced its differentiation advantage and increased its cost structure in the 2000s. Figure 10.5: Sony’s Web of Corporate-Level Strategy 10.3 Strategy in Action: Sony’s “Gaijin” CEO is Changing the Company’s Strategies Once a trend-setter in innovation, Sony, faced agile global competitors and lost its leading competitive position. The decision-making process grew slower and operating costs increased. Welshman Stringer, gaijin, Sony’s CEO, moved toward reducing costs, increasing cooperation, and sharing resources and competencies to speed product development across divisions. In spite of Stringer’s bold moves in downsizing and promotions and focusing on commonalities between the company’s businesses, performance continued to decline. Stringer was forced to take more control over division business-level strategies and reorganization. By 2010, financial performances indicated that Stringer’s approach was a positive one. However, website hacking, increased consumer payouts, and decreases in revenue have surfaced to stifle Sony’s turnaround efforts. Sony continues to strive to meet competitive challenges. Teaching Note: Sony’s profitability has fallen dramatically because its multibusiness model let the company to diversify into too many industries, in each of which the focus was upon innovating high-quality products. As a result its cost structure increased so much it swallowed up all the profits its businesses were generating. Sony’s strategy of individual business unit autonomy also resulted in each unit pursuing its own goals at the expense of the company’s multibusiness model—which escalated bureaucratic costs and drained its profitability. Ask students what role commonalties would play in Sony’s lack of success for future successes? VI. Entering New Industries: Internal New Ventures A. The Attractions of Internal New Venturing Internal new venturing is typically used to implement corporate-level strategies when a company possesses one or more distinctive competencies in its core business model that can be leveraged or recombined to enter a new industry. Internal new venturing is the process of transferring resources to and creating a new business unit or division in a new industry. Internal venturing is used most by companies that have a business model based upon using their technology or design skills to innovate new kinds of products and enter related markets or industries. Thus, technology-based companies that pursue related diversification. A company may also use internal venturing to enter a newly emerging or embryonic industry—one in which no company has yet developed the competencies or business model to give it a dominant position in that industry. B. Pitfalls of New Ventures Three reasons are often put forward to explain the relatively high failure rate of internal new ventures—market entry on too small a scale, poor commercialization of the new-venture product, and poor corporate management of the new-venture division. 1. Scale of Entry Research suggests that large-scale entry into a new industry is often a critical precondition for the success of a new venture. In the short run, this means that a substantial capital investment must be made to support large-scale entry; thus, there is a risk of major losses if the new venture fails. Large-scale entrants rapidly realize scale economies, build brand loyalty, and gain access to distribution channels, all of which increase the probability of a new venture’s success. In contrast, small-scale entrants may find themselves handicapped by high costs due to a lack of scale economies, and a lack of market presence limits the entrant’s ability to build brand loyalty and gain access to distribution channels. These scale effects are particularly significant when a company is entering an established industry in which incumbent companies possess scale economies, brand loyalty, and access to distribution channels. Figure 10.6 plots the relationship between scale of entry and profitability over time for successful small-scale and large-scale ventures. The figure shows that successful small-scale entry is associated with lower initial losses, but in the long term, large-scale entry generates greater returns. However, because of the high costs and risks associated with large-scale entry, many companies make the mistake of choosing a small-scale entry strategy, which often means they fail to build the market share necessary for long-term success. Figure 10.6: Scale of Entry and Profitability 2. Commercialization Many internal new ventures are driven by the opportunity to use a new or advanced technology to make better products for customers and outperform competitors. But, to be commercially successful, the products under development must be tailored to meet the needs of customers. Many internal new ventures fail when a company ignores the needs of customers in a market. Thus, a new venture may fail because it is marketing a product based on technology for which there is no demand, or the company fails to correctly position or differentiate the product in the market to attract customers. 3. Poor Implementation Managing the new-venture process, and controlling the new-venture division, creates many difficult managerial and organizational problems. For example, one common mistake some companies make to try to increase their chances of introducing successful products is to establish too many different internal new-venture divisions at the same time. Another common mistake is when corporate managers fail to do the extensive advanced planning necessary to ensure that the new venture’s business model is sound and contains all the elements that will be needed later if it is to succeed. The failure to anticipate the time and costs involved in the new-venture process constitutes a further mistake. C. Guidelines for Successful Internal New Venturing To avoid the above pitfalls, a company should adopt a well-thought-out structured approach to manage internal new venturing. New venturing is based on R&D. It begins with exploratory research necessary to advance basic science and technology and development research to identify, develop, and perfect the commercial applications of a new technology. Companies can take a number of steps to ensure that good science ends up with good, commercially viable products: • Many companies must place the funding for research into the hands of business unit managers who have the skill or know-how to narrow down and then select the best set of research projects. • A company’s top managers must work with its R&D scientists to continually develop and improve the business model and strategies that guide their efforts and make sure all its scientists and engineers understand what they have to do to make it succeed. • A company must also foster close links between R&D and marketing to increase the probability that a new product will be a commercial success in the future. • A company should also foster close links between R&D and manufacturing to ensure that it has the ability to make a proposed new product in a cost-effective way. • A company should construct efficient-scale manufacturing facilities and give marketing a large budget to develop a future product campaign that will build market presence and brand loyalty quickly, and well in advance of that product’s introduction. VII. Entering New Industries: Acquisitions Acquisitions are the main vehicle that companies use to implement a horizontal integration strategy. They are also a principal way companies enter new industries to pursue vertical integration and diversification, so it is necessary to understand both the benefits and risks associated with using acquisitions to implement a corporate-level strategy. A. The Attraction of Acquisitions In general, acquisitions are used to pursue vertical integration or diversification when a company lacks the distinctive competencies necessary to compete in a new industry, so it uses its financial resources to purchase an established company that has those competencies. Entering a new industry through internal venturing is a relatively slow process; acquisition is a much quicker way for a company to establish a significant market presence. Acquisitions are often perceived as being less risky than internal new ventures because they involve less commercial uncertainty. Because of the risks of failure associated with internal new venturing, it is difficult to predict its future success and profitability. Acquisitions are an attractive way to enter an industry that is protected by high barriers to entry. When the entry barriers are high, it may be very difficult for a company to enter an industry through internal new venturing because it will have to construct large-scale manufacturing facilities and invest in a massive advertising campaign to establish brand loyalty—difficult goals that require huge capital expenditures. B. Acquisition Pitfalls Acquisitions have long been the most common method that companies use to pursue diversification. However, acquisitions may fail to raise the performance of the acquiring companies for four reasons: • Companies frequently experience management problems when they attempt to integrate a different company’s organizational structure and culture into their own • Companies often overestimate the potential economic benefits from an acquisition • Acquisitions tend to be so expensive that they do not increase future profitability • Companies are often negligent in screening their acquisition targets and fail to recognize important problems with their business models 1. Integrating the Acquired Company Once an acquisition has been made, the acquiring company has to integrate the acquired company and combine it with its own organizational structure and culture. Integration involves the adoption of common management and financial control systems, the joining together of operations from the acquired and the acquiring company, the establishment of bureaucratic mechanisms to share information and personnel, and the need to create a common culture. After an acquisition, many acquired companies experience high management turnover because their employees do not like the acquiring company’s way of operating—its structure and culture. Research suggests that the loss of management talent and expertise, and the damage from constant tension between the businesses, can materially harm the performance of the acquired unit. 2. Overestimating Economic Benefits Managers often overestimate the competitive advantages that will derive from the acquisition and so pay more for the acquired company than it is worth. One reason is that top managers typically overestimate their own personal general competencies to create valuable new products from an acquisition. The very fact that they have risen to the top of a company gives managers an exaggerated sense of their own capabilities, and a self-importance that distorts their strategic decision making. 3. The Expense of Acquisitions Perhaps the most important reason for the failure of acquisitions is that acquiring a company with stock that is publicly traded tends to be very expensive—and the expense of the acquisition can more than wipe out the value of the stream of future profits that are expected from the acquisition. One reason is that the top managers of a company that is “targeted” for acquisition are likely to resist any takeover attempt unless the acquiring company agrees to pay a substantial premium above its current market value. These premiums are often 30 to 50% above the usual value of a company’s stock. The reason why the acquiring company must pay such a high premium is that the stock price of the acquisition target increases enormously during the acquisition process as investors speculate on the final price the acquiring company will pay to capture it. In the case of a contested bidding contest, where two or more companies simultaneously bid to acquire the target company, its stock price may surge. 4. Inadequate Pre-acquisition Screening Researchers have discovered that one important reason for the failure of an acquisition is that managers make the decision to acquire other companies without thoroughly analyzing potential benefits and costs. In many cases, after an acquisition has been completed, many acquiring companies discover that instead of buying a well-managed business with a strong business model, they have purchased a troubled organization. C. Guidelines for Successful Acquisition To avoid the above pitfalls and make successful acquisitions, companies need to follow an approach to targeting and evaluating potential acquisitions that is based on four main steps—target identification and pre-acquisition screening, bidding strategy, integration, and learning from experience. 1. Identification and Screening Thorough pre-acquisition screening increases a company’s knowledge about a potential takeover target and lessens the risk of purchasing a problem company—one with a weak business model. It also leads to a more realistic assessment of the problems involved in executing a particular acquisition so that a company can plan how to integrate the new business and blend organizational structures and cultures. An acquiring company should select a set of top potential acquisition targets and evaluate each company using a set of criteria that focus on revealing: • Its financial position • Its distinctive competencies and competitive advantages • Changing industry boundaries • Its management capabilities • Its corporate culture Once a company has reduced the list of potential acquisition candidates to the most favored one or two, it needs to contact expert third parties, such as investment bankers. These companies’ business models are based on providing valuable insights about the attractiveness of a potential acquisition, and assessing current industry competitive conditions, and handling the many other issues surrounding an acquisition, such as how to select the optimal bidding strategy for acquiring the target company’s stock and keep the purchase price as low as possible. 2. Bidding Strategy The objective of the bidding strategy is to reduce the price that a company must pay for the target company. The most effective way a company can acquire another is to make a friendly takeover bid, which means the two companies decide upon an amicable way to merge the two companies, satisfying the needs of each company’s stockholders and top managers. A friendly takeover prevents speculators from bidding up stock prices. By contrast, in a hostile bidding environment, the price of the target company often gets bid up by speculators who expect that the offer price will be raised by the acquirer or by another company that might have a higher counteroffer. Another essential element of a good bidding strategy is timing. With good timing, a company can make a bargain purchase. 3. Integration Despite good screening and bidding, an acquisition will fail unless the acquiring company possesses the essential organizational design skills needed to integrate the acquired company into its operations, and quickly develop a viable multibusiness model. Integration should center upon the source of the potential strategic advantages of the acquisition. Integration should also involve steps to eliminate any duplication of facilities or functions. In addition, any unwanted business units of the acquired company should be divested. 4. Learning from Experience Research suggests companies that acquire many companies over time become expert in this process, and can generate significant value from their experience of the acquisition process. Their past experience enables them to develop a “playbook,” a clever plan that they can follow to execute an acquisition most efficiently and effectively. VIII. Entering New Industries: Joint Ventures Joint ventures, where two or more companies agree to pool their resources to create new business, are most commonly used to enter an embryonic or growth industry. Suppose a company is contemplating creating a new-venture division in an embryonic industry; such a move involves substantial risks and costs because the company must make the huge investment necessary to develop the set of value-chain activities required to make and sell products in the new industry. In this situation, a joint venture frequently becomes the most appropriate method to enter a new industry because it allows a company to share the risks and costs associated with establishing a business unit in the new industry with another company. This is especially true when the companies share complementary skills or distinctive competencies because this increases the probability of a joint venture’s success. Although joint ventures usually benefit both partner companies, under some conditions they may result in problems: • Although a joint venture allows a company to share the risks and costs of developing a new business, it also requires that they share in the profits if it succeeds. • The joint-venture partners may have different business models or time horizons, and problems can arise if they start to come into conflict about how to run the joint venture; these kinds of problems can disintegrate a business and result in failure. • A company that enters into a joint venture runs the risk of giving away important company specific knowledge to its partner, which might then use the new knowledge to compete with its other partner in the future. IX. Restructuring Sometimes, companies need to exit industries to increase their profitability and split their existing businesses into separate, independent companies. Restructuring is the process of reorganizing and divesting business units and exiting industries to refocus upon a company’s core business and rebuild its distinctive competencies. A. Why Restructure? One main reason that diversified companies have restructured in recent years is that the stock market has valued their stock at a diversification discount, meaning that the stock of highly diversified companies is valued lower, relative to their earnings, than the stock of less-diversified companies. Investors see highly diversified companies as less attractive investments for four reasons: • Investors often feel these companies no longer have multibusiness models that justify their participation in many different industries. • The complexity of the financial statements of highly diversified enterprises disguises the performance of its individual business units. • Many investors have learned from experience that managers often have a tendency to pursue too much diversification or do it for the wrong reasons—their attempts to reduce profitability. • Innovations in strategic management have diminished the advantages of vertical integration or diversification. Teaching Note: Ethical Dilemma The instructor should discuss with the students the many examples in recent years of unethical financial reporting for personal gain. Use the examples to illustrate the five ways diversification is used to increase profitability—transferring and leveraging competences, sharing resources, product bundling, and the use of general managerial competencies. The instructor could use this opportunity to discuss the Sarbanes Oxley Act-its successes and failures as a control measure. Answers to Discussion Questions 1. When is a company likely to choose (a) related diversification and (b) unrelated diversification? Related diversification will be favored when there are significant commonalities between the two businesses. There will be commonalities identified throughout the value chain, and competencies will be transferred and leveraged. Companies will pursue related diversification when the benefits of resource sharing and skill transfer outweigh the costs of implementation. Finally, companies prefer related diversification when it can help them prevail in multipoint competition. Unrelated diversification will be favored when there are few, if any, functional competencies that can be transferred and leveraged in the new industry. The company’s strategy is to increase profitability throughout the organization, across all business units, and therefore only general organizational competencies are applied. Unrelated diversification requires skilled strategic management and strong organizational design. 2. What factors make it most likely that (a) acquisitions or (b) internal new venturing will be the preferred method to enter a new industry? Acquisitions tend to make the most sense when barriers to entry are high—that is, the costs of internal venturing are high. Second, acquisitions are preferred when the company is pursuing unrelated diversification because acquisitions provide instant access to an experienced management team, reducing learning costs. Third, acquisitions make more sense when the acquiring company is unwilling to accept the commitment of time, the development costs, and the risks of internal venturing. Internal new venturing makes sense in the opposite circumstances—that is when barriers to entry are low, when the industry to be entered is closely related to the company’s existing operations, and when the company does not need to move quickly. 3. Imagine that IBM has decided to diversify into the telecommunications business to provide online cloud computing data services and broadband access for businesses and individuals. What method would you recommend that IBM pursue to enter this industry? Why? Students’ answers will vary. They are required to demonstrate the knowledge of the pros and cons of acquisitions, relative to internal ventures and joint ventures, as alternative entry strategies. In reality, if IBM did decide to enter into the telecommunications business, it would probably use a combination of entry strategies. It might try to gain access to some critical competencies by: • Acquiring firms that possess those competencies • Entering into strategic alliances (joint ventures) with such firms In addition, the company might well use its own digital know-how to build the businesses. 4. Under which conditions are joint ventures a useful way to enter new industries? Joint ventures are useful in embryonic or growth industries because it allows a company to share the risks and costs associated with establishing a business unit in the new industry with another company. Also, joint ventures are useful when companies want to be involved in new product markets and want to share the costs and risks. 5. Identify Honeywell’s (www.honeywell.com) portfolio of businesses that can be found by exploring its Website. In how many different industries is Honeywell involved? Would you describe Honeywell as a related or unrelated diversification company? Has Honeywell’s diversification strategy increased profitability over time? Honeywell is involved in hundreds of businesses, focused on four major sectors—aerospace, automation and control systems, specialty materials, and transportation and power systems. Honeywell’s businesses are not purely related or unrelated. They share some common traits, such as a reliance on electronics and engineering know-how, but they also are unrelated in the customer segments they serve and the manufacturing technologies they use. By organizing their hundreds of products into just four sectors, Honeywell is able to offer a bundle of related products to customers within each segment. Across segments, Honeywell primarily benefits from reducing duplication in corporate functions, such as information systems. Honeywell’s size also leads to increased brand name reputation. Finally, Honeywell benefits to some extent from sharing knowledge across segments. Practicing Strategic Management Small-Group Exercise: Visiting General Electric Students are asked to break into groups of three to five students, and explore GE’s Website (www.ge.com) and answer the following questions. They are asked to appoint one member of the group as spokesperson who will communicate the group’s findings to the class: 1. Review GE’s portfolio of major businesses. Upon what multibusiness model is this portfolio of businesses based? How profitable has that model been in past? 2. Has GE’s multibusiness model been changing? Has its CEO, Jeffrey Immelt, announced any new strategic initiatives? 3. What kinds of changes would you make to its multibusiness model to boost its profitability? Teaching Note: GE is a global infrastructure, finance and media company taking on the world’s toughest challenges. GE is involved with appliances, healthcare, aviation, consumer electronics, electrical distribution, energy, financial services for businesses and consumers, rail, security, water, oil and gas, lighting, medical imaging, and media content. GE has initiatives in consulting services, and intelligent computer platforms. Suggestions for strategy will vary and should be analyzed in the context of value creation and the key drivers of profitability—product differentiation and control of cost structure. Strategy Sign-On Article File 10 Students should find an example of a diversified company that has made an acquisition that appears to have failed to create any value. Have them identify and critically evaluate the rationale that top management used to justify the acquisition when it was made. Students should also explain why the acquisition subsequently failed. Teaching Note: You may wish to identify some useful examples for students. Firms with failed acquisitions might include the railroad merger of Union Pacific and Southern Pacific, Quaker Oats’ acquisition of Snapple, AT&T’s acquisition of NCR, Sara Lee’s acquisitions of Coach leather goods and Electrolux vacuums, and so on. As they examine these or other cases of failed acquisitions, students will quickly realize that managers’ estimates of projected benefits can often be quite inaccurate, and they are often far too optimistic as they choose a partner, set a price, and attempt to integrate the firms after the acquisition. Strategic Management Project: Module 10 This module requires students to assess their company’s use of acquisitions, internal new ventures, and joint ventures as ways to enter a new business or restructure its portfolio of businesses. A. Your Company Has Entered a New Industry During the Past Decade 1. Pick one new industry that your company has entered during the past 10 years. 2. Identify the rationale for entering this industry. 3. Identify the strategy used to enter this industry. 4. Evaluate the rationale for using this particular entry strategy. Do you think that this was the best entry strategy to use? Why or why not? 5. Do you think that the addition of this business unit to the company increased or reduced profitability? Why? B. Your Company Has Restructured Its Corporate Portfolio During the Past Decade 1. Identify the rationale for pursuing a restructuring strategy. 2. Pick one industry from which your company has exited during the past 10 years. 3. Identify the strategy used to exit from this particular industry. Do you think that this was the best exit strategy to use? Why or why not? 4. In general, do you think that exiting from this industry has been in the company’s best interest? Teaching Note: Every large corporation will have a history of growth that will involve the use of one or more of these growth strategies, and most will have a history of restructuring attempts. Students should be encouraged to think about their responses and identify relationships. For example, if a firm is restructuring in order to respond to a failed acquisition, the acquired firm may be an attractive target for a corporate buyer, and thus the firm would probably use divestment, rather than harvest or liquidation strategies. Students may have trouble finding a firm that has undergone restructuring. You can recommend firms such as Kmart, Nortel, Lucent, Qwest, and Vivendi. From this exercise, they will gain further appreciation of the complexities and considerations that are necessary in planning a diversification or restructuring move. Closing Case VF Corp. Acquires Timberland to Realize the Benefits from Related Diversification In 2011, U.S.-based VF Corp., the global apparel and clothing maker, entered into a “transformative” acquisition of Timberland, the U.S.-based global footwear maker, which increased profitability and increased sales of other VF Corp. brands. VF’s acquisition created more value by offering an extended range of products, producing cost savings through functional production line sharing, and being able to differentiate its outdoor products. Ultimately, VF was looking for brand loyalty synergy among its products, thereby, creating the premier portfolio of outdoor brands with a global differentiated appeal. VF allows the managers of its brands and divisions autonomy in pursuing their own business level strategies to increase differentiated appeal but retains a centralized control to reduce costs organization-wide. While stock price of both companies have taken steep rises, achievement of their goals for the acquisition are yet to be determined.This case describes the goals of VF Corp.’s in their acquisition of Timberlake. Teaching Note: This case describes VF Corp’s acquisition strategies. Class discussion should center around the type of diversification used by VF and the pros and cons of related and unrelated diversification. You could also ask students to research other companies with multibusiness models. Have students reflect on what industry and environmental concerns VF should be conscious of and which of these factors might cause them to change their corporate strategy. Answers to Case Discussion Questions 1. What kinds of resources can likely be shared across different brands between an apparel maker and a footwear maker? What kinds of resources are unlikely to be shared? Students’ answers may vary. Some of them may say that resources that can be shared across different brands between an apparel maker and a footwear maker are customers, brand loyalty, distribution functions and channels resulting in synergies and cost savings. The resources that are not likely to be shared are profits. 2. How much does being a larger, more diversified apparel and footwear company increase VF Corp’s market power over its suppliers or customers? How could we assess how much this is worth? VF Corporation posted revenues of $9.4 billion and $10.9 billion while also showing an increase in net profit margin to 9.4% and 10.0% in 2011 and 2012, respectively as opposed to its sales in 2010 which had been $7.7 billion with a net income of $571 million, for a net profit margin of 7.4%. 3. If VF had increased its sales only by the amount of Timberland’s sales and had not reaped an increase in profitability, would you consider the acquisition successful? An acquisition can be considered successful only if it increases the sales and profitability of the acquiring firm. So, if VF Corp’s acquisition of Timberland had increased only its sales then the acquisition would be considered partially successful. 4. How might you compare VF’s increase in profits to the premium it paid for Timberland? VF paid a 40% premium while acquiring Timberland, which has been justified by the increase in profits and sales that are rapidly increasing touching 10% in the year 2012. By combining the products of the clothing and footwear division, VF could almost double profitability by increasing its global sales by at least 15%. Solution Manual for Strategic Management: Theory: An Integrated Approach Charles W. L. Hill, Gareth R. Jones, Melissa A. Schilling 9781285184494