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7 Corporate Diversification WHAT IS CORPORATE DIVERSIFICATION? The previous chapter provided an introduction to corporate strategy by describing various issues that a firm faces in the area of vertical integration. Diversification continues the topic of corporate strategy by focusing on two specific types of actions: Product diversification – when a firm operates in multiple industries simultaneously, and Geographic market diversification – when a firm operates in multiple geographic markets simultaneously. Slide 7-2 This slide provides a good segue to this chapter by pointing out that both vertical integration and diversification are corporate level strategies. You should begin the lecture by pointing out that virtually all of the 500 largest firms in the United States and the 500 largest firms in the world are diversified, either along product lines or geographically, or both. It is also important to point out that, while diversification appears to be the norm in the corporate world, the jury is still out as far as the performance of diversified firm goes. Not all diversification moves create economic value. ► Example: Beatrice Companies Since its founding as a regional dairy company in 1891, Beatrice Companies grew to be a $12.5 billion diversified producer of a variety of products— ranging from grocery products to chemicals—by 1985. A succession of CEOs had propelled the company through a series of acquisitions to diversify the company’s activities. As a diversified company, previous leaders ran Beatrice as a decentralized operation and made no attempt to coordinate activities among the businesses. When James Dutt became CEO in 1979, he decided on an aggressive strategy of corporate marketing and attempted to create synergy among the business units. This proved to be an extremely difficult task and the company ran into financial problems. A leveraged buy out firm, Kohlberg Kravis Roberts (KKR) acquired Beatrice and sold it piece by piece. Diversification proved not to be a value creating strategy for Beatrice largely because the management was never able to exploit potential synergies between divisions. This example helps to illustrate the importance of implementation issues in the context of diversification strategies. (Collis and Stuart, Beatrice Companies, 1985, Harvard Business School Case) Slide 7-3 Use this slide to remind students of the logic of corporate level strategy. Emphasize that the logic applies to diversification strategies as well as vertical integration. Carefully explain that a sound diversification strategy will result in synergies between divisions that create value that could not be created by independently owned firms. Thus, shareholders may realize value through a sound diversification strategy that they couldn’t realize by diversifying their individual investment portfolios. Slide 7-4 This is a useful slide to show students at this point in the lecture. It points out the critical difference between vertical integration and diversification. TYPES OF CORPORATE DIVERSIFICATION When a firm chooses to diversify, it faces a decision as to how related the new business(es) is(are) to the existing businesses of the firm. When Charles Bluhdorn was CEO of a company called Gulf+Western in the 1950s, he diversified into a host of industries: motion pictures (Paramount Pictures, the makers of The Godfather, Chinatown, and other movies), clothing, cigars, zinc mines, auto parts, and sugar, among others! In contrast, a company such as Cooper Industries is more careful in diversifying into related industries. Define Corporate Diversification and Describe Five Types Of Corporate Diversification Slide 7-5 Use this slide to help students see that diversification may be a matter of entering different product markets and/or entering different geographic markets. This will help to establish a framework for thinking about diversification. We can identify five types of diversification: Single-business Dominant-business Related-constrained Related-linked Unrelated Slide 7-6 This slide will help you introduce the five types of diversification in a visual fashion. Students may have difficulty memorizing the revenue percentages that define each type. It is important to stress that the percentages help underscore how dependent the single-business and dominant-business firms are on one industry. Slide 7-7 This is a useful slide to show students at this point as it clarifies the various diversification possibilities for firms. Limited Corporate Diversification A single-business firm is technically not diversified because it gets 95 percent or more of its total revenues from one business. Delta Airlines is an example of a single-business firm. Its 2013 annual report states that in each of the last four fiscal years, passenger revenues accounted for 92 percent of total revenues, while cargo revenues provided the rest (Delta Airlines Annual Report, 2013). A dominant-business firm is different in that it has moved beyond a complete focus on one business by obtaining revenues from other businesses. However, as the definition in Figure 7.1 indicates, it is still largely dependent upon one industry. Important Point: While single-business and dominant-business firms are listed in Figure 7.1 as two of the five types of diversification, these firms are not leveraging their resources and capabilities beyond a single product or market. Strategic analysis for such firms would deal primarily with business-level strategies discussed in Chapters 4 and 5. Related Corporate Diversification When multiple lines of business are linked in a firm, the firm is pursuing a strategy of related diversification. Such a firm is conscious of leveraging its resources and capabilities beyond a single product or market into those businesses that are related to their current activities. Important Point: Students may ask the professor to be specific in defining “relatedness” in a related diversification. Students should be told not to be too hung up on this issue at this point for two reasons: one is that this issue is explored further in the upcoming sections. The second, and probably, the more important point is that there is no standard definition of this term in the corporate world. Firms may justify the relatedness of their businesses on various grounds. At this point it is important to go back to Figure 7.1. Related diversification can happen in two ways: Related-constrained – when all the businesses in which a firm operates share a significant number of inputs, production technologies, distribution channels, similar customers, etc. Related-linked – when the different businesses that a single firm pursues are linked on only a couple of dimensions, or if different sets of businesses are linked along very different dimensions. Examples help in understanding the critical difference between related-constrained and related-linked types of diversification. Bic, the French Company, produces products such as disposable razors, cigarette lighters, and pens. The company pursues a related-constrained diversification strategy because all their products share significant commonalities in the areas of plastic injection molding, retail distribution, and brand name. Newell Rubbermaid is a good example of a related-linked firm. After Newell Company acquired Rubbermaid, the company is organized into five segments: cleaning and organization; home and family; home fashions; office products; and tools and hardware. All five segments share common distribution channels – supermarkets (such as Wal-Mart) and office supply stores (Staples, Office Depot, etc.). The products are sold under various brand names (Sharpie, Levolor) and do not typically share common technology or inputs across segments. The Disney example in the text is an interesting one and you can use it to show how firms evolve on the diversification path. Disney was a related-constrained firm till about the early 1990s. The company had evolved from a single-business to a dominant-business to a diversified firm under the leadership of Michael Eisner and his predecessors. When Disney started making movies for mature audiences and acquired ABC television, it moved into a more related-linked mode. Unrelated Corporate Diversification An unrelated diversified firm (called a conglomerate) owns businesses in its portfolio that share few, if any, common attributes. The management approach in such firms is to regard each business as a stand-alone entity. Unrelated diversified firms (such as Berkshire Hathaway) make every effort to erect walls around each business so that the performance of each unit can be independently measured and controlled. Interestingly, conglomerates were very much in vogue in the 1960s and 1970s, as the earlier example of Gulf +Western points out. At one point, ITT owned 250 or more unrelated businesses! Teaching Points • Use the examples given above to demonstrate that there are recognizable examples of the differences between related and unrelated diversification. • Briefly explain that unrelated diversification (conglomerates) appear to have fallen out of favor in recent decades because of relatively poor performance. • Stress the difference between related-constrained and related-linked diversification using examples and the graphic in Figure 7.1. • Point out that relatedness usually refers to product relatedness. However, related-linked diversification can refer more to the underlying processes, raw inputs, or technologies behind seemingly unrelated products (petroleum-based plastics and injection molding may be used to make very unrelated products). THE VALUE OF CORPORATE DIVERSIFICATION Strategic actions are aimed at creating value for the organization. Therefore, it is important to look at the value creation rationale of diversification. Specify The Two Conditions That A Corporate Diversification Strategy Must Meet In Order To Create Value Diversification moves create value when: economies of scope exist among the multiple businesses in the organization, and exploiting these scope economies can be done more efficiently by the firm than by shareholders on their own. Slide 7-8 Quickly show this slide to remind students that a diversification strategy is likely to produce competitive advantage only if it meets the VRIO criteria referred to throughout the course. The general discussion on value creation in diversification sets the stage for the next important pasture for you – outlining the key elements of economies of scope. What are Valuable Economies of Scope? It is important to define economies of scope first and clarify what it means with the help of examples. At this point, students have been exposed to the more commonly used economies of scale. Since scope economies are at the heart of successful diversification moves, its definition is vital. Slide 7-9 Use this slide to emphasize the two important criteria that must be met in order for a diversification strategy to create value. Define The Concept Of “Economies of Scope” And Identify Eight Potential Economies Of Scope A Diversified Firm Might Try To Exploit Economies of scope exist in a firm when the value of the products or services it sells increases as a function of the number of businesses that the firm operates in. Economies of scope increase firm revenues, and/or decrease its costs compared to what would be the case if these economies of scope were not exploited. A firm using a common brand name across a wide variety of products (umbrella branding) is pursuing economies of scope. The value of all products sharing the brand name increases when a new and successful product is introduced in the market. Also, the cost of introducing the new product is less (and chances of its success greater) because it can “piggy-back” on the already established brand name. Slide 7-10 This slide demonstrates the idea of economies of scope by comparing the value of three businesses under independent ownership to the value of the same three businesses under common ownership. The size of the two ‘value’ ovals is intended to be indicative of the difference in the amount of value created. Use this slide to further explain how a shareholder could realize more value through corporate diversification strategy than through an investment diversification strategy. Of course, this logic only holds if there truly are economies of scope to be exploited in the corporate strategy. There are four types of economies of scope: operational economies of scope financial economies of scope anticompetitive economies of scope employee and stakeholder incentives for diversification Slide 7-11 Use this slide to briefly introduce students to the four types of economies of scope. Operational Economies of Scope Such economies of scope take one of two forms: shared activities and spreading core competencies. Important Point: Economies of scope will be valuable only if they are strategically relevant. This is especially true of the operational economies discussed below. A core competency in one market may or may not be strategically relevant in other markets. In fact, trying to exploit an economy of scope that is not strategically relevant will usually result in a competitive disadvantage. Slide 7-12 Use this slide to provide an overview of the two types of operational economies of scope. Stress the critical importance of strategic relevance. The examples of Frito-Lay and Orbitz should resonate well with students because these are companies familiar to them. Frito-Lay entered the trucking business by transporting freight for other companies on return trips. Frito-Lay realized that it made no sense to have trucks returning empty from delivery runs. Orbitz has spread its competencies to several different areas of the travel industry: air travel, hotels, car rental, etc. Sharing Activities. The value-chain model introduced in Chapter 3 may be used to explain how firms can look to share activities among their businesses. Economies of scope exist because the cost of an activity is now borne by multiple businesses. Table 7.2 in the text provides a number of possibilities for sharing activities in the value chain. The key is to reduce the cost of an activity for a business by having that business share the activity (and its costs) with other businesses. Volume purchasing from common suppliers, common warehousing of inventory, and common distribution channels are examples. From a revenue enhancement point-of-view, “product bundles” (created as a result of sharing among businesses) may appeal to customers because the value of such bundles may be greater than the value of each product bought separately. Economies of scope allow a firm to explore the possibility of becoming a “one-stop” shop for the customer. As students get into the notion of economies of scope and see the myriad possibilities such economies bring to organizations, you may want to step back and sound a note of caution. It is important to underscore three important limits to activity sharing: substantial organizational issues such as excess bureaucracy, inefficiency, and organizational gridlock can make managing relationships among businesses counterproductive, sharing activities may limit the ability of a particular business to meet its specific customers’ needs, and finally, while sharing can be a benefit because of the “piggy-back” effect, the reverse can also happen. Poor reputation of one business can affect another business. Spreading Core Competencies. Firms can also create value through diversification by spreading core competencies that are generating competitive advantage in one business to other businesses. 3M has a core competency in the broad field of adhesives; Honda in designing high performance engines; Johnson & Johnson in marketing health care products to consumers. Each of these firms has spread their core competencies to multiple businesses. For example, Honda’s engines are used in automobiles, motorcycles, outboard boat motors, lawn mowers, generators, and power tools such as hedge and weed trimmers. This is a good time to introduce the concept of “free cash flow” and how it comes into play in the area of diversification. Cash left after funding all positive net present value projects represents “free cash flow” – cash without any encumbrance. For example, Apple was recently sitting on a cash horde in excess of $100 billion – cash that the company had no use for! Firms, rightly or wrongly, generally embark on a diversification spree when confronted with free cash flow. Diversification motivated merely by the desire to put free cash flow to work is unlikely to generate competitive advantage. On the other hand, diversification intended to share activities and/or spread core competencies is much more likely to result in competitive advantage. Important Point: The process of developing and leveraging a company’s core competency should not be thought of as always being a matter of careful and deliberate effort. Sometimes a firm’s core competencies are examples of the emergent (versus deliberate) strategies described in Chapter 1. Serendipity may play a large role in some cases. As in the case of economies of scope, the limits to core competencies must also be pointed out. How the firm is organized may very well either unleash these competencies or keep these competencies hidden and unexploited. The second limitation stems from the largely intangible nature of core competencies. The notion of “dominant logic” allows managers to use a common template to think about strategy across different businesses. In some cases, this “dominant logic” may be stretched so far that core competencies become “invented competencies.” Jack Welch, the former CEO of GE, once declared that managing the aircraft engine business and the television business are the same because both require negotiating for large sums of money. While television stars such as Jim Parsons and Kaley Cuoco (both of “The Big Bang Theory”), demand exorbitant sums of money, this commonality may be too small to regard the two businesses as having a common dominant logic! Also, the core competency sometimes may only be tangentially important to a particular business. While this competency can be leveraged in the other business, it may not lead to significant cost savings or substantial increased revenues. Diversification to Exploit Financial Economies of Scope The impetus for the conglomerate boom of the 1960s and 1970s were essentially the various financial motivations that underpin diversification. Three financial advantages of diversification were identified. They were: capital allocation efficiency risk reduction tax advantages It is important for you to describe what these advantages are and also to point out the limitations in such incentives. Internal Capital Markets. A diversified firm owns a portfolio of businesses. This creates an internal capital market in which the CEO and corporate headquarters staff allocate capital to the various divisions. This is similar to the external capital market where companies compete for equity funding. A potential efficiency gain from internal capital markets stems from the better quality of information available to the firm to make investment decisions. Owning a business gives a diversified firm access to detailed and accurate information about the actual performance of the business, its true future prospects, etc. Important Point: An internal capital market may be less efficient than external markets due to escalating commitment to a failing cause. This occurs when a doomed project continues to receive capital allocations because the project is the ‘pet’ of an influential manager. Slide 7-13 Emphasize that the argument for efficiency rests on the notion of superior information being available to managers within an internal capital market. Be sure to point out that the involvement of inside managers can also have its downside: escalating commitment. Hanson Trust, PLC had a successful history of putting together a conglomerate of unrelated businesses and using financial metrics and controls to efficiently operate those businesses. They would buy a diversified firm, sell off the businesses that did not fit in the Hanson Trust portfolio and allow the remaining division managers a high degree of autonomy in running the businesses. As long as the managers met the financial objectives of the firm, they were able to continue operating relatively autonomously. Discussion & Activity Divide the class into two groups. Assign one group to argue for the benefits of an internal capital market. Assign the other group to argue for the benefits of using external capital markets. Tell students to focus on the issue of the quality of information. Try to steer the debate toward a focus on the quality of information available in each type of capital market and the importance of such information. As the debate begins be sure to tell students that both types of markets have access to information that is unavailable in the other type of market. Students should begin to recognize that each market type has its merits. Two advantages of internal capital markets that should emerge are: Businesses have an incentive to downplay or even not report any negative information about their performance and prospects (as an aside, look at the difference in information provided by a firm in its annual report sent to investors and the 10-K that a firm is forced to file with the SEC). Decision makers in internal capital markets are more likely to have access to negative information that may be important in capital allocation decisions. Businesses may also choose to downplay positive information for fear of imitation. Internal markets allow businesses to keep proprietary information proprietary. Two advantages of external capital markets that should emerge are: • Businesses vying for capital in an external market are forced to compete with a wide variety of other firms. This places a market discipline on such businesses. • External markets largely avoid the issue of escalating commitment. ► Example: Escalating Commitment to Heaven’s Gate In his richly detailed book, former United Artists’ executive, Steven Bach explains how the studio’s high profile movie, “Heaven’s Gate,” by Oscar winner Michael Cimino, went out of control financially because the executives kept investing more and more money in the movie in the hope that improbably it would somehow turn into a masterpiece. The final cost of the movie was in excess of $100 million and it yielded a box office return of less than $10 million as critics savaged it and audiences ignored it. (Steven Bach, Final Cut: Dreams and Disasters in the Making of Heaven’s Gate; Newmarket Press, 1999.) Risk Reduction. Diversification is often justified on the grounds of risk reduction. The argument is that the riskiness of the cash flows of diversified firms is lower than the riskiness of the cash flows of undiversified firms. Firms that diversify to reduce risk will have relatively stable returns over time. General Electric, for example, is successful in “smoothing” out its earnings (that is, no significant ups and downs in reported profits) because of its involvement in various businesses. Slide 7-14 Point out that diversification may lower overall risk for a firm and therefore lower the risk for individual shareholders. However, individual shareholders could more efficiently lower the risk of their own portfolios by simply diversifying in the market themselves. Head Ski was founded when Howard Head developed the first metal laminated snow ski. Through a series of acquisitions Head is now a Dutch company that owns the following brands: Head Skis, Tyrolia (ski bindings), Penn (tennis products), and Mares and Dacor (diving equipment). This diversification strategy has spread the risk of Head across several very different sporting goods businesses. Tax Advantages. Diversified firms may also benefit from tax advantages. Losses in one business can offset profits in others, thereby reducing the firm’s overall tax liability. Because of less variance in cash flows, a diversified firm can also take on more debt to finance its operations. Interest payments can be used to reduce tax obligations. Important Point: Tax advantages of diversification can be especially important in the international context. Because of differing tax rates across borders, firms can locate businesses in areas with lower tax rates and then try to recognize most of their income in those areas. Ireland aggressively advertises its tax advantages in an effort to get foreign businesses to locate operations in Ireland. Slide 7-15 Explain that firms have some latitude in allocating costs and recognizing revenue across divisions. Point out that a U.S. firm could locate a manufacturing plant in Ireland and set a high price for the output from that plant as the product is sold to other divisions within the firm. Thus, more profit would be recognized in Ireland where the income tax rate is lower than in the U.S. Diversification to Exploit Anticompetitive Economies of Scope Diversification helps a firm reduce competitive threats. Two activities that help a firm do this are: multipoint competition to facilitate mutual forbearance and tacit collusion, and exploiting market power. Slide 7-16 Use this slide to introduce multipoint competition and market power as potential economies of scope. Dallas/Ft. Worth is the major hub for American Airlines. Atlanta is the major hub for Delta Airlines. Yet both airlines compete in both cities. American knows that anything it might do in the Atlanta market would likely result in a response from Delta in the Dallas/Ft. Worth market. Both airlines understand that mutual forbearance in these markets makes sense. You have to help students understand two important concepts here: mutual forbearance and tacit collusion. Examples should help drive home these concepts. When two or more diversified firms simultaneously compete in multiple markets, multipoint competition exists. Procter and Gamble and Unilever compete in both the personal care (soaps, shampoos, etc.) and detergent markets. General Motors and Ford compete in both the U.S. and European markets. The word “tacit” means “unwritten.” Tacit collusion occurs when firms cooperate (without a written agreement) to reduce rivalry below the level expected under perfect competition. The potential loss that each firm may experience in some of its businesses must be compared to the potential gain that each might obtain if it exploits competitive advantage in other of its businesses. In simple terms, firms might come to the conclusion that it does not make sense for them to compete aggressively in one business with a competitor because that competitor might hurt them in a different business. What is likely to result is that both firms decide not to compete with each other. This is mutual forbearance. Movie studios practice this quite often in announcing release dates for their important films. When a firm announces, for example, a release date for its summer blockbuster, other firms may decide not to compete by releasing their film on that date for fear of retaliation in a different encounter. It is important to stress, though, that mutual forbearance does not always happen. Dream works and Disney are aggressive in competing with each other. While these firms engage in multipoint competition (by focusing on the children’s as well as the adult moviegoers markets), each tries to outdo the other in releasing an important film on DVD when the other launches a movie in theaters! A diversified firm may exercise a degree of market power by having some businesses that are extremely profitable while other businesses may not be so. The firm may choose to cross-subsidize, i.e., use profits in one to subsidize the operations of others. This may take the form of predatory pricing (prices set at below cost) for a short period of time to drive competitors out. Firms could also exercise market power in their purchasing. Firm Size and Employee Incentives to Diversify In many firms, interestingly enough, compensation of top managers is tied to the sales of the firm (sales being a proxy for size) and not to its profits. Since managers typically behave according to how they are rewarded, they may grow the firm through diversification. By making large acquisitions, a diversified firm can grow substantially in a short period of time, resulting in senior managers earning higher incomes. In an effort to curb this kind of unprofitable growth, firms are now tying managerial compensation to economic performance and not to size. Such compensation methods are aimed at encouraging managers to make profitable diversification decisions – particularly those that exploit economies of scope. Slide 7-17 Use this slide to facilitate the discussion of how size-based compensation for managers could motivate diversification. Point out the difficulty of knowing whether or not managerialism is the reason for any given diversification strategy. Can Equity Holders Realize These Economies of Scope on their Own? Slide 7-18 Use this slide to introduce the efficiency criterion in evaluating diversification. Point out that most of the economies of scope you have discussed could not be achieved by individual shareholders diversifying in the market. Remind students that if a diversification move does not generate value that individual shareholders would be unable to achieve on their own, then the diversification strategy should probably not be adopted by the firm. Identify Which Of These Economies Of Scope A Firm’s Outside Equity Investors Are Able To Realize On Their Own At Low Cost As the class discusses various types of economies of scope, it is important to summarize all this discussion succinctly and relate it to the primary reasons for diversification indicated at the beginning of the chapter. While exploiting economies of scope is important, there must also be an efficiency criterion. It must be cheaper for the firm to exploit economies of scope than for equity holders to do it on their own. You should use Table 7.3 to take students through this discussion. It is clear from the table that most of the economies of scope cannot be realized by equity holders on their own. Insufficient information and lack of complementary activities are the key reasons. In fact, risk reduction is the only type of economies of scope that equity holders can do more efficiently on their own. You should also drive home the point that related diversification is more likely to be consistent with the interests of a firm’s equity holders than unrelated diversification. The reason is simple: as stated earlier, risk reduction is the one economy of scope that equity holders can duplicate on their own. And risk reduction is the only economy of scope that an unrelated diversified firm can try to realize. Empirical research seems to underscore this notion – related diversified firms outperform unrelated diversified firms. Teaching Points • Ensure that students understand what economies of scope are. Use examples to explain this concept. • Reiterate to students that scope economies are the economic underpinning of a successful related diversification strategy. • At the end of the discussion of all the types of economies of scope, use Tables 7.1 and 7.2 to summarize the discussion. • Point out that the acid test of a successful diversification based on economies of scope is whether these same economies can be obtained by equity holders on their own. • Ask students for examples of diversification they have read about in the business press and use the concepts in this chapter to examine the economic logic of these moves. CORPORATE DIVERSIFICATION AND SUSTAINED COMPETITIVE ADVANTAGE This is a good time to go back to the VRIO Framework and establish its connection with diversification. In order for diversification to be a source of sustained competitive advantage, it must not only be valuable but also rare and costly to imitate, and a firm must be organized (this aspect is dealt with in Chapter 8) to implement this strategy. The Rarity of Diversification Specify The Circumstances Under Which A Firm’s Diversification Strategy Will Be Rare The strategy of diversification is indeed not rare. Seldom does a day go by when The Wall Street Journal, for example, does not announce an acquisition aimed at diversification. While acquisitions for diversification are not uncommon, what may be rare is a specific economy of scope as the driving force behind a diversification move. Slide 7-19 Use this slide to reiterate what is meant by rareness in this context. The rareness is not in the strategy of diversification, but more specifically, in the type of scope economies sought. The Imitability of Diversification Indicate Which Of The Economies Of Scope Identified In This Chapter Are More Likely To Be Subject To Low-Cost Imitation and Which Are Less Likely To Be Subject To Low-Cost Imitation The imitability of a corporate diversification strategy depends upon the economy of scope that is the focal point of the strategy. Core competencies and multipoint competition are obvious examples of costly-to-duplicate economies of scope, while tax advantages and risk reduction are typically less costly-to-duplicate economies of scope. In general, economies of scope based upon tangible resources (sharing R&D, sales force, etc.) are usually relatively easy to duplicate. In other words, if Procter and Gamble acquired Gillette to exploit economies of scope based upon shared sales force, for example, Colgate-Palmolive can do the same. Scope economies based on intangible resources – particularly those based on tacit collective knowledge are much more difficult to imitate. The realization of capital allocation economies of scope requires sophisticated information processing capabilities. Similarly, multipoint competition requires considerable coordination skills. Finally, to exploit market power, the firm first of all must have market power advantage. In short, imitability is not the same across the board; rather it depends upon the resources involved. Slide 7-20 Use this slide to point out which types of economies of scope are costly to imitate and which ones are not. The asterisk is used to call attention to the fact that the sharing of activities may prove to be costly-to-imitate if the underlying relationships meet the VRIO criteria. Identify Two Potential Substitutes For Corporate Diversification Instead of leveraging scope economies across businesses, a firm may decide to grow and develop each of its businesses separately. It can replicate the success in one business to another, rather than look across businesses to leverage common activities. Strategic alliances are another substitute for growth through diversification. Instead of looking to share activities across two of its own businesses in the area of R&D or marketing, the firm can enter into a marketing partnership with another firm. Slide 7-21 This slide indicates that internal development and strategic alliances may be used to substitute for diversification by acquisition. In this sense, internal development, strategic alliances, and acquisitions can all be viewed as alternate modes of entry into a diversified position. By looking at diversification from the perspective of rarity and imitability, you can bring home the point that a firm’s diversification strategy must have the goal of helping the firm obtain a sustainable competitive advantage. This not only makes a case for careful deliberation from the firm’s point-of-view, it also informs students that the VRIO Framework is applicable in a variety of strategic situations. Teaching Points • Reiterate the importance of using the VRIO Framework to evaluate the strategy of diversification. • Encourage students to look for the rarity and imitability of the underlying economy of scope, rather than the rarity and imitability of the “form” of diversification. • Emphasize the point that the relationships that lead to an economy of scope are likely to be the determining factor in whether or not a diversification strategy is rare and costly-to-imitate. • Use Table 7.4 to identify the less costly-to-imitate economies of scope and the more costly-to-imitate economies of scope. SUMMARY OF DIVERSIFICATION STRATEGY Slide 7-22 This slide can be used to remind students that diversification is a key element of a firm’s corporate strategy. As such, any diversification strategy should satisfy the logic of corporate level strategy. Specifically, a diversification strategy should result in economies of scope that can only be obtained by corporate diversification. Corporate strategy underscores the boundaries of a firm. It aims to answer the question: what business(es) should we be in? Such a focus helps tie the concept of diversification addressed in this chapter with the previous chapter’s discussion of vertical integration. While diversification is a commonplace occurrence in the business world, as evidenced by the plethora of such announcements, there has to be logic in a firm’s pursuit of diversification. Economies of scope is the underlying logic behind diversification. But, that’s not enough – there has to be an efficiency focus, too. That is, diversification must create value that outside equity holders cannot create through their individual investment decisions. After going over this chapter, students should have a good understanding of the concept of economies of scope and how it is tied to the VRIO Framework. Slide 7-23 Use this slide to leave students with a solid reminder of the concept of economies of scope. Emphasize the point that economies of scope, just like other strategy concepts, are likely to result in competitive advantage only if they meet the VRIO criteria. There is no sense in pursuing a diversification strategy if it does not result in a competitive advantage to the firm. After diversifying by acquiring Time Warner, AOL was unable to obtain the economies of scope that motivated the combination in the first place. AOL Time Warner lost billions of dollars in market value because of this. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041
