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4 Cost Leadership CHALLENGE QUESTIONS 4.1. Ryanair, Wal-Mart, Timex, Casio, and Hyundai are all cited as examples of firms pursuing cost leadership strategies, but these firms make substantial investments in advertising, which seems more likely to be associated with a product differentiation strategy. Are these firms really pursuing a cost leadership strategy or are they pursuing a product differentiation strategy by emphasizing their lower costs? Yes. There is an element of both business level strategies in the actions of these companies. However, there would be little point in their advertising if they did not vigorously pursue cost leadership strategies. These firms need to generate large sales volumes to fully exploit their low per unit cost structure. Keep in mind that their advertising is not just for their intended customers. Their advertising is an important signal to competitors as well. As such, it is an important part of their cost leadership strategies. 4.2. When economies of scale exist, firms with large volumes of production will have lower costs than firms with smaller volumes of production. The realization of these economies of scale, however, is far from automatic. What actions can firms take to ensure that they realize whatever economies of scale are created by their volume of production? First, such firms must sell their productive output. Without sales revenue, economies of scale are of little benefit. Second, such firms must carefully manage the distribution of their output. Economies of scale could be outweighed by high storage and distribution costs if firms incur significant carrying costs for finished product inventories. Third, such firms must be careful not to extend lenient credit terms that have the effect of making the firm a lending institution. Customers must be given incentives to pay on time and/or be charged an interest rate high enough to ensure that the firm’s economies of scale are not cancelled out by the cost of carrying accounts receivable. Finally, firms should adopt organizational control policies that encourage employees to be vigilant in controlling costs and looking for ways to reduce costs even further. 4.3. Firms engage in an activity called “forward pricing” when they establish, during the early stages of the learning-curve, a price for their products that is lower than their actual costs, in anticipation of lower costs later on, after significant learning has occurred. Under what conditions, if any, does forward pricing make sense? Forward pricing makes sense when firms have some basis for accurate prediction of learning curve effects on costs. For example, if the firm has had prior experience with a similar product, then forward pricing can be undertaken with some confidence. It should be noted that firms engaging in forward pricing are signaling to would-be competitors that costs are going to fall such that it may not make sense to even try to compete. 4.4. When firms do engage in “forward pricing,” what risks, if any, do they face? The most obvious risk firms face when forward pricing is that their estimate of future costs will be wrong. If actual costs come in above the estimate, the firm is in the position of either accepting smaller margins than expected or raising prices—neither of which is desirable. Another risk is that competitors may be able to achieve a lower cost, in which case the focal firm would appear to have been charging an excessive price, which may hurt sales. 4.5. One way of thinking about organizing to implement cost leadership strategies is that firms that pursue this strategy should be highly centralized, have high levels of direct supervision, and keep employee wages to an absolute minimum. Another approach is to decentralize decision-making authority—to ensure that individuals who know the most about reducing cost make decisions about how to reduce costs. This, in turn, would imply less direct supervision and somewhat higher levels of employee wages. Why is this? A more decentralized approach typically means that employees have more autonomy and receive higher wages because more is expected of such employees as compared to employees that are expected only to carry out instructions. 4.6. Which of the two approaches used to implement cost leadership strategies seems more reasonable? Either of these approaches can be reasonable depending on the product type, production processes, conditions faced by the firm, the available labor pool, etc. 4.7. Under what conditions would the two different approaches for implementing cost leadership strategies make more or less sense? A more centralized approach would make sense with a more standardized product, a more simple or codified production process, and a rather unskilled labor force. On the other hand, a decentralized approach would make more sense when the product requires modification, the production process is complex and/or tacit, and when a relatively skilled labor force is available. Problem Set 4.8. The economies of scale curve in Figure 4.1 can be represented algebraically in the equation: Average costs = a + bQ + cQ2; where Q is the quantity produced by a firm, and a, b, and c are coefficients that are estimated from industry data. For example, it has been shown that the economies of scale curve for savings and loan companies in the U.S. is: Average costs = 2.38 - .615A + .54A2, where A is a savings and loan’s total assets. Using this equation, what is the optimal size of a savings and loan? (Hint: Plug in different values of A and calculate Average costs. The lowest possible Average costs is the optimal size for a savings and loan). 4.9. The learning curve depicted in Figure 4.2 can be represented algebraically in the following equation: Average time to produce x units = ax-β, where x is the total number of units produced by a firm in its history, a is the amount of time it took a firm to produce its first unit, and β is a coefficient that describes the rate of learning in a firm. Suppose it takes a team of workers 45 hours to assemble their first product (a = 45) and 40.5 hours to assemble their second product. When a firm doubles its production (in this case, from one to two units) and cuts its production time (in this case from 45 hours to 40.5 hours), learning is said to have occurred (in this case 40.5/45 or 90% learning curve). The β for a 90% learning curve is .3219. Thus, this firm’s learning curve is: Average time to produce x units = 45x-.3219. What is the average amount of time it will take this firm to produce 6 products? (Hint: Simply plug “6” in for “X” in the equation and solve). What is the total time it took this firm to produce these 6 products? (Hint: Simply multiply the number of units produced “6” by the average time it will take to produce these 6 products). What is the average time it will take this firm to produce five products? What is the total time it will take this firm to produce five products? So, what is the total time it will take this firm to produce its sixth product? (Hint: Subtract the total time needed to produce five products from the total time needed to produce six products). Suppose a new firm is going to start producing these same products. Assuming this new firm doesn’t learn anything from established firms, what will the cost disadvantage for this new firm be when it assembles its first product? (Hint: Compare the costs of the experienced firm’s sixth product with the cost of the new firm’s first product). Answer 4.8 Assume the following Savings & Loans Assets (Bank 1 = 75,000,000; Bank 2 = 135,000,000; Bank 3 = 137,350,000; Bank 4 = 156,000,000). Average Costs Bank 1: = 2.38 - .615(S&L 1) + .54(S&L 1)2 Average Costs Bank 1: = 2.38 - .615(S&L 2) + .54(S&L 2)2 Average Costs Bank 1: = 2.38 - .615(S&L 3) + .54(S&L 3)2 Average Costs Bank 1: = 2.38 - .615(S&L 4) + .54(S&L 4)2 Answer 4.9 The constant for a 90% learning curve is log2 = -.152 Average amount of time to product 6 products = 59.08 minutes Total time for this firm to product these 6 products 5.9 hours Average time to produce 5 products: = 57.47 minutes Total time to produce 5 products: = 4.78 hours Total time to produce its sixth product = 1.12 hours 5 Product Differentiation CHALLENGE QUESTIONS 5.1. Although cost leadership is, perhaps, less relevant for firms pursuing product differentiation, costs are not totally irrelevant. What advice about costs would you give a firm pursuing a product differentiation strategy? Although costs are important, concern about costs should never be allowed to erode the base of differentiation in any way. Lower costs will improve profit margins, but if customers begin to lose their preference for a differentiated product, above normal profits will quickly disappear. For example, if customers were to find out that Rolex had begun using lower quality jewels in an effort to reduce costs the prices Rolex is able to charge would likely begin to fall. 5.2. Product features are often the focus of product differentiation efforts. Yet product features are among the easiest-to-imitate bases of product differentiation and thus among the least likely bases of product differentiation to be a source of sustained competitive advantage. This appears paradoxical. How can you resolve this paradox? The resource-based view predicts that the most common resource, in this case, product features, is not likely to produce a sustained competitive advantage. Many firms are able to realize temporary competitive advantages based on product features, but most product features are quickly imitated. The fact that product features are so often the focus of differentiation strategies suggests that many managers do not fully understand the implications of imitation. 5.3. What are the strengths and weaknesses of using regression analysis and hedonic prices to describe the bases of product differentiation? The strength of using regression analysis and hedonic prices is that the hedonic price of specific product features can be calculated because the researcher can compare a product with a specific feature to a product without that feature. This would allow a firm to price its products accordingly. The main weakness of using regression analysis is that the bases of differentiation, other than product features, are very difficult to measure. In a sense, there is no control group if the base of differentiation happens to be something like product complexity or reputation. A researcher may have a very difficult time determining the actual base of differentiation. 5.4. Chamberlin used the term “monopolistic competition” to describe firms pursuing a product differentiation strategy in a competitive industry. However, it is usually the case that firms that operate in monopolies are less efficient and less competitive than firms that operate in more competitive settings (see Chapter 3). Would this same problem exist for firms operating in a ‘monopolistic competition” context? No because firms still face competitive pressures. Over time, there will be downward pressure on prices as imitation occurs. There will be upward pressure on costs as the price of inputs is bid up once their value becomes known. Above normal profits will eventually be eroded in monopolistic competition. 5.5. Implementing a product differentiation strategy seems to require just the right mix of control and creativity. How do you know if a firm has the right mix? It is impossible to know if the firm has exactly the right (optimal) mix. However, it is possible to know if the mix is dramatically out of balance. Policy guidelines can be examined to see if managers have a reasonable amount of latitude in decision-making. Also, compensation policies can be examined to see what incentives and disincentives managers have to be creative. 5.6. Is it possible to evaluate the mix of control and creativity when implementing a product differentiation strategy before problems associated with being out of balance manifest themselves? If yes, how? If not, why not? As indicated in the answer to the question above, the key here is in using organizational policies as well as compensation practices to prevent problems. The first works on control, while the second could be set up to enhance creativity. 5.7. A firm with a highly differentiated product can increase the volume of its sales. Increased sales volumes can enable a firm to reduce its costs. High volumes with low costs can lead a firm to have very high profits, some of which the firm can use to invest in further differentiating its products. What advice would you give a firm whose competition is enjoying this product differentiation and cost leadership advantage? Two possibilities exist. You could try to serve a different market. Look for customers that do not have a strong preference for your competitor’s product and focus on serving them with a different base of differentiation. You could also develop a new differentiated product based on a different base of differentiation that will cause your competitor’s customers to prefer your product. You are not likely to win a cost war until you develop a strong following among some set of customers for your own differentiated product. Problem Set 5.8. For each of the listed products, describe at least two ways they are differentiated. a. Ben & Jerry’s Ice Cream b. The Hummer H2 c. The X-Games d. The movies “Animal House” and “Caddyshack” e. Fredrick’s of Hollywood f. Taco Bell 5.9. Which, if any of these bases of product differentiation in the previous question are likely to be sources of sustained competitive advantage, and why? 5.10. Suppose you obtained the following regression results, where the starred (*) coefficients are statistically significant. What could you say about the bases of product differentiation in this market? (Hint: A regression coefficient is statistically significant when it is so large that its effect is very unlikely to have emerged by chance). House Price = $125,000* + $15,000* (More than 3 bedrooms) + 18,000* (More than 3,500 sq. ft) + $150 (has plumbing) + $180 (has lawn) + $17,000* (Lot larger than ½ acre) How much would you expect to pay for a 4 bedroom, 3800 square foot house on a one-acre lot? How much for a 4 bedroom, 2700 square foot house on a ¼ acre lot? Do these results say anything about the sustainability of competitive advantages in this market? 5.11. Which of the following management controls and compensation policies are consistent with implementing cost leadership? With product differentiation? With both cost leadership and product differentiation? With neither cost leadership nor product differentiation? a. Firm-wide stock options b. Compensation that rewards each function for meeting its own objectives separately c. A detailed financial budget plan d. A document that describes, in detail, how the innovation process will unfold in a firm e. A policy that reduces the compensation of a manager that introduces a product that fails in the market f. A policy that reduces the compensation of a manager that introduces several precuts that fail in the market g. The creation of a purchasing council to discuss how different business units can reduce their costs. 5.12. Identify three industries/markets that have the volume/profit relationship described in Figure 5.2. Which firms in this industry are implementing cost leadership strategies? Which are implementing product differentiation strategies? Are there any firms “stuck in the middle?” If yes, who are they? If no, why not? Are there any firms implementing both cost leadership and product differentiation strategies? If yes, who? If no, why not? Answer 5.8 a. Ben & Jerry’s – Product features; Consumer marketing b. The Hummer H2 – Product features; Product reputation c. The X-Games – Product complexity; Consumer marketing d. “Animal House” and “Caddy Shack” – Timing of product introduction; Consumer marketing e. Fredrick’s of Hollywood – Product features; Product reputation f. Taco Bell – Product features; Location Answer 5.9 To determine which bases of product differentiation are likely to be sources of sustained competitive advantage, it's important to consider their durability and ability to create customer value over the long term. Here's an analysis: • Brand Image and Reputation: A strong brand image and reputation can be a potent source of sustained competitive advantage. Brands like Apple, Coca-Cola, and Nike have built enduring reputations that resonate with customers, influencing their purchasing decisions and fostering loyalty. Maintaining a positive brand image requires consistent delivery of high-quality products, exceptional customer service, and effective marketing efforts. Competitors may find it challenging to replicate the emotional connection and trust that consumers have with established brands, making this a durable source of competitive advantage. • Product Quality and Reliability: Consistently delivering superior product quality and reliability can lead to a sustained competitive advantage. Customers value products that perform as expected and provide a reliable experience over time. Companies that invest in research and development, quality control processes, and continuous improvement initiatives can establish themselves as leaders in their industries. Achieving and maintaining a reputation for high-quality products can act as a barrier to entry for competitors and enhance customer loyalty, contributing to long-term success. • Innovation and Technological Leadership: Companies that innovate and lead in technology often enjoy sustained competitive advantages. Innovation can lead to the development of breakthrough products, services, or processes that set a company apart from its competitors. By continuously investing in research and development, staying ahead of emerging trends, and leveraging cutting-edge technologies, firms can maintain their leadership positions in their respective markets. Competitors may struggle to replicate the level of innovation and expertise demonstrated by industry pioneers, giving innovative companies a lasting edge. • Customer Service and Support: Providing exceptional customer service and support can be a source of sustained competitive advantage. Companies that prioritize customer satisfaction, responsiveness, and personalized assistance can differentiate themselves in crowded markets. Building strong relationships with customers, addressing their needs and concerns promptly, and going above and beyond to exceed their expectations can foster customer loyalty and advocacy. Competitors may find it challenging to match the level of service and support offered by companies that prioritize customer-centricity, giving them a lasting competitive advantage. In conclusion, brand image and reputation, product quality and reliability, innovation and technological leadership, and customer service and support are bases of product differentiation that are likely to provide sustained competitive advantage. These factors create value for customers, build loyalty, and act as barriers to entry for competitors, allowing companies to maintain their market positions over the long term. Answer 5.10 One could surmise that Pricing for housing is a function of # of bedrooms, size in sq. footage, and being located on a large lot. Therefore, differentiation is achieved based on product features, product customization, and location. Answer 5.11 a. firm-wide stock options – product differentiation b. functional based rewards – cost leadership c. detailed budget plan – cost leadership d. innovation – product differentiation e. compensation tied to performance – cost leadership; product differentiation f. compensation failed products – cost leadership g. purchasing council – cost leadership Answer 5.12 Public Utilities, Energy (i.e. gas & oil); Major League Baseball 6 Vertical Integration CHALLENGE QUESTIONS 6.1. Some firms have engaged in backward vertical integration strategies in order to appropriate the economic profits that would have been earned by suppliers selling to them. How is this motivation for backward vertical integration related to the opportunism logic for vertical integration described in this chapter? (Hint: Compare the competitive conditions under which firms may earn economic profits to the competitive conditions under which firms will be motivated to avoid opportunism through vertical integration.) Take the case of an auto manufacturer who is currently sourcing, say, rear-view mirrors from an outside supplier. It is clear to the manufacturer that the mirror supplier is making enormous profits in this transaction. Now, let’s say that the manufacturer is making a new type of vehicle that calls for a significantly new type of mirror. The mirror manufacturer has to make significant transaction-specific investment for this deal. The auto manufacturer is unlikely to get the mirror manufacturer to make the investment for fear of opportunistic behavior by the auto manufacturer. The auto manufacturer can now avoid opportunism and increase its profits by vertically integrating into making its own mirrors. However, the other explanations for vertical integration (capabilities and flexibility) must also be factored into this decision. 6.2. You are about to purchase a used car. What kinds of threats do you face in this purchase? The principal threat that the buyer of a used car faces is with regards to the quality of the car. A new car comes with a warranty, while a used car (other than one bought from a dealer) bought from a private seller does not. There is also the price issue. It is possible to get an idea of the price of a new car by comparing various dealers’ price for a specific car. It is much more difficult for a used car because the comparable variables (number of years used, mileage, etc.) could be different. 6.3. You are about to purchase a used car. What can you do to protect yourself from the threats in this situation? If the buyer wants to protect himself/herself from the possibility of buying a lemon, the dealership route is more attractive because the dealer is likely to offer a limited warranty and there is somebody to go to and demand answers from if the car has problems. Not so in the case of the individual seller, who will offer no warranty and is not likely to answer questions after the sale. 6.4. How is buying a car like and unlike vertical integration decisions? One can buy a used car by transacting directly with a seller or by buying it from a dealer. Transacting directly with a seller requires the buyer to do a lot more work (in a sense vertically integrate) than the dealership route. The buyer has to get the car tested (at an independent repair shop) and get the paperwork done at the government office that deals with car registrations. The amount of time spent is greater as is the amount of responsibility undertaken by the buyer. 6.5. What are the competitive implications for firms if they assume that all potential exchange partners cannot be trusted? The principal option for such a firm is to vertically integrate into all activities of the value chain. This way they do not have to work with outside partners and thereby completely avoid the trust issue. The other option is to write ironclad contracts for lengthy periods of time. Such contracts cover every possible contingency so that the firm is protected from adverse actions of exchange partners. 6.6. Common conflicts between sales and manufacturing are mentioned in the text. What conflicts might exist between other functional areas? Consider the following pairings: research and development and manufacturing; finance and manufacturing; marketing and sales; accounting and everyone else? R&D may develop a product without any regard to the difficulties in the manufacturing process. For example, R&D may design a product with tremendously low tolerances for some of the components. This may be difficult to manufacture. Manufacturing may demand improvements in their plants or the construction of new plants to take care of capacity issues. Finance may balk at these proposals because organizational capital may be limited and there are other demands on it. Marketing and sales may have conflict over any of the 4 Ps – product, pricing, promotion, and place (distribution). As salespeople, they may want lower prices to meet their sales quotas and additional marketing; the marketing function may insist on sticking to their original marketing plan. Accountants are record keepers; they love paper trails because it protects them during audits. The other functions may not pay as much attention to records. Accountants may also insist on cutting costs and staying within budgets; the other functions may chafe at this close monitoring. The CEO can resolve these conflicts by stating clearly his/her expectations for each function and by promoting the well being of the organization as a whole as the paramount goal. Insisting on regular cross-functional meetings also helps. Finally, having liaisons that act as internal boundary spanners and coordinate activities between functions can help everybody see the same big picture. 6.7. What could a CEO do to help resolve the conflicts found between functional areas of the organization? The CEO can resolve these conflicts by stating clearly his/her expectations for each function and by promoting the well being of the organization as a whole as the paramount goal. Insisting on regular cross-functional meetings also helps. Finally, having liaisons that act as internal boundary spanners and coordinate activities between functions can help everybody see the same big picture. 6.8. Under what conditions would you accept a lower-paying job instead of a higher-paying job? One would accept a lower paying job over a higher paying job if the lower paying job has tremendous upside to it. In other words, if the job is more challenging and rewarding in a non-monetary way. Also, if the higher paying job requires the employee to invest a tremendous amount of time in learning skills specific to this employer (transaction-specific investment), the employee may fear opportunistic behavior by the employer in terms of future compensation. 6.9. What implications does your accepting a lower-paying job over a higher-paying one have for your potential employer’s compensation policy? The organization’s compensation policy must take these issues into consideration to attract capable employees. This means that HR has to work closely with the hiring unit in question to ensure that a lower-paying job has other non-monetary rewards. Problem Set 6.10. Which of the following two firms is more vertically integrated? How can you tell? a. Firm A has included manufacturing, sales, finance, and human resources within its boundaries and has outsourced legal and customer service. b. Firm B has included manufacturing, sales, legal, and customer service within its boundaries and has outsourced finance and human resources. 6.11. What is the level of transaction specific investment for each firm in the following transactions? Who in these transactions is a greater risk of being taken unfair advantage of? a. Firm I has built a plant right next door to Firm II. Firm I’s plant is worth $5 million if it supplies Firm II. It is worth $200,000 if it does not supply Firm II. Firm II has three alternative suppliers. If it receives supplies from Firm I, it is worth $10 million. If it does not receive supplies from Firm I, it is worth $9.8 million. b. Firm A has just purchased a new computer system that is only available from Firm B. Firm A has redesigned its entire production process around this new computer system. The old production process is worth $1 million; the new process is worth $12 million. Firm B has several hundred customers for its new computer system. c. Firm Alpha, a fast food restaurant company, has a contract with Firm Beta, a movie studio. After negotiating with several other potential partners, Firm Alpha agreed to a contract that requires Firm Alpha to pay Firm Beta $5 million per year for the right to use characters from Firm Beta’s movies in its packaged meals for children. Demand for children’s movies has recently dropped. d. Firm I owns and runs a printing press. Firm J uses the services of a printing press. Historically, Firm I has sold its services to many customers. However, it was recently approached by Firm J to become its exclusive supplier of printing press services. Currently, Firm I is worth $1 million. If it became the sole supplier to Firm J, it would be worth $8 million. To complete this deal, Firm I would have to stop supplying its current customers and modify its machines to meet Firm J’s needs. No other firm needs the same services as Firm J. Before deciding to propose this arrangement with Firm I, Firm J contacted several other suppliers who said they would be willing to become a sole supplier for Firm J. 6.12. What recommendation would you make in each of these situations, vertical integration or not vertical integration and why? a. Firm A needs a new and unique technology for its product line. There are no substitute technologies. Should Firm A make this technology or buy it? b. Firm I has been selling its products through a distributor for some time. It has become the market share leader. Unfortunately, this distributor has not been able to keep up with the evolving technology and customers are complaining. There are no alternative distributors available. Should Firm I keep its current distributor or should it begin distribution on its own? c. Firm Alpha has manufactured its own products for years. Recently, however, one of these products has become more and more like a commodity. Several firms are now able to manufacture this product at the same price and quality as Firm Alpha. However, they do not have Firm Alpha’s brand name in the market place. Should Firm Alpha continue to manufacture this product or should it out-source it to one of these other firms? d. Firm I is convinced that a certain class of technologies holds real economic potential. However, it does not know, for sure, which particular version of this technology is going to dominate the market. There are eight competing versions of this technology currently, but ultimately, only one will dominate the market. Should Firm I invest in all eight of these technologies itself? Should it invest in just one of these technologies? Should it partner with other firms that are investing in these different technologies? Answer 6.10 Firm A appears to be more vertically integrated. Students should provide an analysis that examines the level of vertical integration from both a backward and forward perspective. In the backward vertical integration situation, the firm has integrated aspects of its value chain that are closer to the supplier side; in the forward vertical integration situation, the firm has integrated aspects of its value chain that are closer to its customers. Answer 6.11 a. The level of transaction specific investment is higher for Firm I than it is for Firm II. Firm I is the party that has a greater risk of being taken unfair advantage of. b. Firm A has the higher level of transaction specific investment. Firm B has the lower transaction specific investment given the many customers. Firm A has the greater risk. c. Due to the decrease in demand for children’s movies, it could be argued that Firm Beta has the higher level of transaction specific investment. d. Firm I clearly has the higher level of transaction specific investment risk. Firm I will be the exclusive supplier for Firm J and for no other firms. Firm J has already contacted other potential sources for its supplies. Answer 6.12 a. Firm A could consider vertically integrating by purchasing the technology. This would fall under “firm capabilities” where the technology is rare and costly to imitate. b. It could decide to forwardly integrate by developing distribution capabilities. However, the flexibility here is rather low (costs are high). One would have to weigh the relative “costs” associated with customer dissatisfaction and whether or not there are substitute products/services that its existing customers could pursue. c. If Firm Alpha continues to have strong presence in the market and holds the dominant market position, it should continue to manufacture the product with its own brand. There does not appear to be any cost advantage to outsourcing as the other firms have the same capabilities. d. It would probably be more cost effective to partner, in the short-term, with other firms that are investing in the different technologies. Note to Instructor: In each of the above cases, you may wish to ask students to provide a value-chain projection to support their analyses. 7 Corporate Diversification CHALLENGE QUESTIONS 7.1. One simple way to think about relatedness is to look at the products or services a firm manufactures. The more similar these products or services are, the more related is the firm’s diversification strategy. Why or why not would firms that exploit core competencies in their diversification strategies always produce products or services that are similar to each other? The Honda example can be used to see how core competencies are related to products. Honda has a core competency in making high performance engines. They have tremendous skills in engine design that encompasses a variety of related skills. Honda has used its engine design core competency to diversify into automobiles (from their original business of motorcycles), lawn movers, snow throwers, and off-road vehicles. While they all have the engine as the common part, they serve different markets. The key is not to look for similar products but products that will benefit from a core competency. 7.2. A firm implementing a diversification strategy has just acquired what it claims is a strategically related target firm but announces that it is not going to change this recently acquired firm in any way. Will this type of diversifying acquisition enable the firm to realize any valuable economies of scope that could not be duplicated by outside investors on their own? Why or why not? It is unlikely that this type of diversifying acquisition will help the firm exploit economies of scope that outside investors cannot do on their own. To exploit economies of scope, the newly acquired firm must be linked to the existing businesses in the acquiring firm’s portfolio. The chapter looked at a number of ways to obtain economies of scope –operational economies, financial economies, etc. Unless the newly acquired firm is connected to the rest of the organization (which would require making changes to it), the firm would not be able to realize economies of scope in a way that equity holders can do on their own. 7.3. One of the reasons why internal capital markets may be more efficient than external capital markets is that firms may not want to reveal full information about their sources of competitive advantage to external capital markets, in order to reduce the threat of competitive imitation. This suggests that external capital markets may systematically undervalue firms with competitive advantages that are subject to imitation. If you agree with this analysis, how could you trade on this information in your own investment activities? If I am convinced that external capital markets systematically undervalue such firms, then I would look to buy diversified firms rather than single-business or dominant-business firms for my portfolio. My argument would be that such companies know something that the external capital market doesn’t and that I can benefit from that. 7.4. If you do not agree with the above analysis, why not? This is unlikely to happen in practice for the simple reason that while a firm can seek to not share information about its sources of competitive advantage, the market will know the results of the company using its competitive advantage. For example, Wal-Mart’s core competency is in the area of logistics. There seems to be a strong element of causal ambiguity involved and Wal-Mart has been quite reticent to publicize the details of this competency. Yet, it is hard to say that Wal-Mart is an undervalued stock because the market sees the results of this core competency in the form of significantly higher profits than the industry average. While the process can be hidden, the results cannot. It is hard to trade on this information, unless the advantage is not yet captured in financial performance. 7.5. A particular firm is owned by members of a single family. Most of the wealth of this family is derived from the operations of this firm, and the family does not want to “go public” with the firm by selling its equity position to outside investors. Will this firm pursue a highly related diversification strategy or a somewhat less related diversification strategy? The economic logic of a diversification strategy rests on the assumption that certain economies of scope can be obtained more efficiently by a firm owning a number of businesses, than by equity holders acting on their own. The family firm will pursue a strategy of highly related diversification if the firm as a whole can get certain economies of scope that family members acting on their own cannot. However, family members may also want to minimize their risks because the majority of their portfolio is invested in this firm. If a strategy of highly related diversification positions the firm in certain product-market areas where the risks are high, the firm may decide on a somewhat less related diversification strategy. 7.6. Under what conditions will a related diversification strategy not be a source of competitive advantage for a firm? The key to value creation in a related diversification strategy is to exploit economies of scope more efficiently than what is possible by equity holders acting on their own. The related diversified firm succeeds because it has a competitive advantage based on scope economies. If the related diversified firm does not exploit economies of scope then it will not have a competitive advantage. It is possible that the relatedness is based on relatively loose links among the businesses such that there is no great possibility of economies of scope. Problem Set 7.7. Visit the corporate websites for the following firms. How would you characterize the corporate strategies of these companies? Are they following a strategy of limited diversification, related diversification, or unrelated diversification? a. Exxon-Mobil b. Google c. General Motors d. Jet Blue e. Citigroup f. Electronic Arts g. IBM h. Dell i. Berkshire Hathaway 7.8. Consider the following list of strategies. In your view, which are examples of potential economies of scope underlying a corporate diversification strategy? For those strategies that are an economy of scope, which economy of scope are they? For those strategies that are not an economy of scope, why aren’t they? a. The Coca-Cola Corp. replaces its old diet cola drink (Tab) with a new diet cola drink called Diet Coke. b. Apple Computer introduces an iPod MP3 Player with a larger memory. c. PepsiCo distributes Lay’s Potato Chips to the same stores where it sells Pepsi. d. K-Mart extends its licensing arrangement with Martha Stewart for four years. e. Wal-Mart uses the same distribution system to supply its Wal-Mart stores, its Wal-Mart Super Centers (Wal-Mart stores with grocery stores in them), and its Sam’s Club. f. Head Ski Company introduces a line of tennis rackets. g. General Electric borrows money from Bank of America at 3% interest and then makes capital available to its jet engine subsidiary at 8% interest. h. McDonald’s acquires Boston Market and Chipotle (two restaurants where many customers sit at the restaurant to eat their meals). i. A venture capital firm invests in a firm in the biotechnology industry and a firm in the entertainment industry. j. Another venture capital firm invests in two firms in the biotechnology industry. 7.9. Consider the following facts. The standard deviation of the cash flows associated with Business I is 0.8. The larger this standard deviation, the riskier a business’s future cash flows are likely to be. The standard deviation of the cash flows associated with Business II is 1.3. So Business II is riskier than Business I. Finally, the correlation between the cash flows for these two businesses over time is -0.8. This means that when Business I is up, Business II tends to be down, and vice versa. Suppose one firm owns both of these businesses. a. Assuming that Business I constitutes 40% of this firm’s revenues, and Business II constitutes 60% of its revenues, calculate the riskiness of this firm’s total revenues using the equation provided. b. Given this result, does it make sense for this firm to own both Business I and Business II? Why or why not? Answer 7.7 a. Exxon-Mobil – www.exxonmobil.com – related corporate diversification b. Google – www.google.com – limited corporate diversification c. General Motors – www.gm.com – related corporate diversification d. Jet Blue – www.jetblue.com – limited corporate diversification e. Citigroup – www.citigroup.com – related corporate diversification f. Electronic Arts – www.ea.com – limited corporate diversification g. IBM – www.ibm.com – related corporate diversification (could make a case for “limited.”) h. Dell – www.dell.com – limited corporate diversification i. Berkshire Hathaway – www.berkshirehathaway.com – unrelated corporate diversification Answer 7.8 (Note: Broad economies of scope categorization given. Students may provide more specific and focused answers within each broad category). a. Coca-Cola & Diet Coke – Operational economies of scope b. Apple Computer & iPod MP3 – Operational economies of scope c. PepsiCo & Lays Potato Chips distribution – Operational economies of scope d. K-Mart & Martha Stewart – Financial economies of scope e. Wal-Mart distribution – Operational economies of scope & Multi-point competition f. Head Ski Company – Operational economies of scope g. GE & Bank of America – Financial economies of scope (internal capital allocation) h. McDonalds acquires Boston Market – Anticompetitive economies of scope i. Venture capital investment in biotech – Financial economies of scope j. Venture capital investment in two biotech firms – Financial economies of scope & anticompetitive economies of scope Answer 7.9 a. The overall standard deviation for Business I and Business 2 is .56. b. b. It probably makes sense for the firm to own both Business I and Business II as the standard deviation is an indicator of “riskiness,” in that it takes into consideration the entire set of values (i.e. profitability and loss) for both firms. It appears that the level of riskiness when combined is actually less than either of the two businesses taken separately. Solution Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
