The following slides are derived and slightly modified

from the ones developed for Chapter 8 of the book

entitled Strategic Management: Concepts & Cases
by Frank T. Rothaermel (2013)

Copyright 2013 by The McGraw-Hill Companies, Inc.

What Is Corporate Strategy?

Corporate strategy
Corporate strategy is the way a company creates value through the

configuration and coordination of its multi-market activities

Quest for competitive advantage when competing in multiple industries

Example: Jeffrey Immelts initiative in clean-tech and health care industries

Corporate strategy concerns the scope of the firm

Industry value chain
Products and services
Geography

What Is Corporate Strategy?

Three key dimensions:
What stages of industry value chain and degrees of

vertical integration
What range of products and services and degrees of

horizontal integration and diversification

Where in the world to compete and global strategy

Three Dimensions of Corporate Strategy

Scope of the firm determines boundaries along these 3 dimensions.

Source: Rothaermel, 2013:203.

Transaction Cost Economics and Scope of

the Firm
Transaction cost economics
Explains and predicts the scope of the firm
"Market vs. firms" have differential costs

Transaction costs
Costs associated with economic exchanges
Either in the firm OR in the markets
Ex: negotiating and enforcing contracts

Administrative costs
Costs pertaining to organizing an exchange within a

hierarchy

Ex: recruiting & training employees

Firms vs. Markets: Make or Buy

Should a firm do things in-house (to make)? Or obtain
externally (to buy)?
If Cin-house < Cmarket, then the firm should vertically integrate
Ex: Microsoft hires programmers to write code

in-house rather than contracting out

Firms and markets have distinct advantages and

disadvantages

Organizing Economic Activity: Firm vs.

Markets

Source: Rothaermel, 2013:205.

Firms vs. Markets: Make or Buy?

Disadvantage of make in-house
Principal agent problem

owner = principal, manager = agent

Agent pursues his/her own interests

Disadvantage of buy from markets

Search cost
Opportunism
Incomplete contacting
Enforce legal contacts

Information asymmetries
One party is more informed than others

Akerlof Lemons problem for used cars

Receiving Noble prize in Economics

Alternatives along the Make or Buy Continuum

Source: Rothaermel, 2013:207.

Vertical Integration along

the Industry Value Chain
In what stages of the industry value chain
should the firm participate?
Vertical integration
Ownership of its inputs, production, and

outputs in the value chain

Horizontal value chain

Internal, firm-level value chains

Vertical value chain

Industry-level integration from upstream to

downstream

Examples: cell phone industry value chain

Many different industries and firms

Backward and Forward Vertical Integration

along an Industry Value Chain

Source: Rothaermel, 2013:210.

Selecting Between Vertical Integration and Contracting Options

Start here

(1)
Innovation requires access
to complementary assets
for commercial success

Yes

No

(2)
Complementary
assets
specialized

No

Contract
for access

No

Contract
for access

No

Contract
for access

No

Contract
for access

Yes

Contract
for access

Yes
(3)
Appropriability
regime weak

Commercialize immediately

Yes
(4)
Specialized
asset critical
Yes
(5)
Cash position
OK
Yes

Integrate

No

(6)
Imitators/ competitors
better positioned

Source: Adapted by Hax & Majluf, 1991:143 from David J. Teece, ed. (1987), The Competitive Challenge, The Center for Research in Management, School of Business Administration, University of California, Berkeley.

Benefits and Costs of Using the Market

Benefits
Market firms can achieve economies of scale that in-house departments
producing only for their own needs cannot.
Market firms are subject to the discipline of the market and must be efficient
and innovative to survive. Overall corporate success may hide the inefficiencies and lack of innovativeness of in-house departments.

Costs
Coordination of production flows through the vertical chain may be compromised when an activity is purchased from an independent market firm
rather than performed in-house.
Private information may be leaked when an activity is performed by an independent market firm.
There may be costs of transacting with independent market firms that can
be avoided by performing the activity in-house.
Source: Besanko, et al., 2013:101.

Some Make-or-Buy Fallacies

1. Firms should make an asset, rather than buy it, if the asset is a source of
competitive advantage for that firm.
2. Firms should buy, rather than make, to avoid the costs of making the product.
3. Firms should make, rather than buy, to avoid paying a profit margin to independent firms. (This fallacy is often expressed this way: Our firm should
backward integrate to capture the profit of our suppliers for ourselves.)
4. Firms should make, rather than buy, because a vertically integrated producer
will be able to avoid paying high market prices for the input during periods of
peak demand or scarce supply. (This fallacy is often expressed this way: By
vertically integrating, we obtain the input at cost, thereby insuring ourselves
against the risk of high input prices.)
5. Firms should make, rather than buy, to tie up a distribution channel. They
will gain market share at the expense of rivals. This claim has merit on some
occasions, but it used to justify acquisitions on many other occasions when
it lacks merit.
Source: Besanko, et al., 2013:102.

Types of Vertical Integration

Full vertical integration
Ex: Weyerhaeuser
Owns forests, mills, and distribution to retailers

Backward vertical integration

Ex: HTCs backward integration into design of phones

Forward vertical integration

Ex: HTCs forward integration into sales & branding

Not all industry value chain stages are equally

profitable
Zara primarily designs in-house & partners for speedy

new fashions delivered to stores

HTCs Backward and Forward Integration along the

Industry Value Chain in the Smartphone Industry

Source: Rothaermel, 2013:211.

Vertical integration =

Value added i - (net incomei + income taxes i )

Salesi - (net income i + income taxes i )

where
vertical intrgration i
value addedi
net incomei
income taxesi
salesi

Source: Barney, 2011:272.

=
=
=
=
=

the level of vertical integration for firmi

the level of value added for firmi
the level of net income for firmi
firms income taxesi
firms salesi

Vertical Integration
Professor Oliver Williamson of University of California at
Berkeley has made clear that In order to avoid confusion on
the vertical coordination problem it is important for the
manager to separate two distinct issues:
Issue #1: What is the objective for vertical coordination?
Or put differently, what efficiencies, risk sharing, or market
power advantages are being sought?
Issue #2: What organizational form (e.g., vertical
contracts, equity joint ventures, mergers & acquisitions)
best achieves the desired objective(s)?

Benefits of Vertical Integration

Benefits of vertical integration
Market power
Entry barriers
Down-stream price maintenance
Up-stream power over prices

Securing critical supplies

Lowering costs (efficiency)
Improving quality
Facilitating scheduling and planning
Facilitating investments in specialized assets

Ex: HTC started as OEM & expanded to fully integrated

Benefits of Vertical Integration

Specialized assets
Assets that have significantly more value in their

intended use than in their next best use

Types of specialized assets

Site specificity

Co-located such as coal plant and

electric utility

Physical asset specificity

Bottling machinery

Human asset specificity

Mastering procedures of a particular organization

Optimal Input Procurement

Substantial
specialized
investments
relative to
contracting costs?

No

Yes

No
Contract
Managerial Eco. - Rutgers University

Spot Exchange

Complex contracting
environment relative to
costs of integration?

Yes
Vertical
Integration
6-13

Risks of Vertical Integration

Increasing costs
Internal suppliers lose incentives to compete

Reducing quality
Single captured customer can slow experience effects

Reducing flexibility
Slow to respond to changes in technology or demand

Increasing the potential for legal repercussions

FTC carefully reviewed Pepsi plans to buy bottlers

Alternatives to Vertical Integration

Taper integration
Backward integrated but also relies on outside market firms

for supplies
OR
Forward integrated but also relies on outside market firms

for some of its distribution

Strategic outsourcing
Moving value chain activities outside the firm's boundaries

Example: EDS and PeopleSoft provide HR services to many firms

that choose to outsource it.

Taper Integration along the Industry Value

Chain

Outside suppliers could

also be off-shored when
they are not located in the
home country

Source: Rothaermel, 2013:215.

Risks in undertaking cooperative

agreements or strategic alliances

Adverse selection

Moral Hazard

Partners misrepresent skills, ability and other

resources
Partners provide lower quality skills and
abilities than they had promised

Holdup

Partners exploit the transaction specific

investment made by others in the alliance

Corporate Diversification:
Expanding Beyond a Single Market
Degrees of diversification
Range of products and services a firm should offer
Ex: PepsiCo also owns Lay's & Quaker Oats.

Diversification strategies:
Product diversification

Active in several different product categories

Geographic diversification

Active in several different countries

Product market diversification

Active in a range of both product and countries

Assigning Diversification Categories

SR = Specialization Ratio
(Proportion of a firms revenues
derived from its largest single business)
RR = Related Ratio
(Proportion of a firms revenues derived
from its largest single group of related businesses)
VR = Vertical Ratio
(Proportion of a firms revenues that arise from all
by products, intermediate products, and end products
of a vertically integrated sequence of processing
activities)
Yes

Single
Business

Yes

Is
SR 0.95
?
No

Dominant-Vertical

Yes

Is
VR 0.7
?
No

Is
RR ( SR+1)
?

Yes

Dominant-Unrelated

No

No
Dominat-Constrained
or
Dominant-Linked

Is
SR 0.7
?

Yes

Related-Constrained
or
Related-Linked

Is
RR 0.7
?
No
Unrelated Business
or
Conglomerate

Source: Rumelt:1986:30

Strategic Classes Defined in Terms of the Specialization Ratio and the Related Ratio

Unrelated
Business
0.7

Related
Business

DominantUnrelated
Dominant
Business

Single
Business
1.0

0.95

1.0
0.7

Specialization Ratio

Source: Rumelt:1986:31

0.0

Related Ratio

0.0

Different Types of Corporate Diversification

Source: Rothaermel, 2013:217.

Motivations For Diversification

Value Enhancing Motives:
Increase market power

Multi-point competition

R&D and new product development

Developing New Competencies (Stretching)
Transferring Core Competencies (Leveraging)
Utilizing

excess capacity (e.g., in distribution)

Economies of Scope
Leveraging Brand-Name
(e.g., Haagen-Dazs to
chocolate candy)

Leveraging Core Competencies for

Corporate Diversification
Core competence
Unique skills and strengths
Allows firms to increase the value of product/service
Lowers the cost

Examples:
Wal-mart

global supply chain

Infosys low-cost global delivery system

The core competence market matrix

Provides guidance to executives on how to diversify in

order to achieve continued growth

Does Diversification Create or Destroy Value?

As stated by Saloner, Shepard and Podolny (2001:359,361)

in the 1980s and 1990s

In the 1980s and 1990s

Stick-to-your-knitting view gained ground;
In the business world, the new mantra has been focus and building on core strengths;
In the academic world of corporate finance, diversification was more likely to destroy
than to add value.
In strategic management, adding value through diversification is difficult. Corporate can add
value only if there are significant strategic spillovers among the business. (Saloner, Shepard and
Podolny, 2001:361; cf. also Ramanujam & Varadarajan, 1989:530-534; Ensign, 1998:662-663)

Related diversification does potentially create value!

Operational economies of scope
shared activities
core competencies
Financial economies of scope
internal capital allocation
Anticompetitive economies of scope
multipoint competition
exploiting market share
(Cf. Barney, 2011:306)

Attention !

Strategy, Interdependence and Economic Benefits

Strategy

Interdependence

Economic Benefits

Unrelated diversification

Pooled

Internal capital market

Vertical integration

Sequential pooled

Economies of integration
Internal capital market

Related diversification

Reciprocal
sequential pooled

Economies of scope
Economies of integration
Internal capital market

Source: Jones & Hill, 1988:163

BC u = a D
BC v = b d + c (D - 1)
BC r = d D + e { (D2 - D)}
Thus, BC r > BC v > BC u
Where BC
D
a,b,c,d,e

= Bureaucratic costs
= Number of divisions within the firm
= Constants.

Source: Jones & Hill, 1988:164-165

The Core Competence Market Matrix

Pepsi - Gatorade

BoA - NCNB

Salesforce.com

BoA - Merrill Lynch

Source: Adapted by Rothaermel, 2013:219 from G. Hamel and C.K. Prahalad (1984), Competing for the Future , Boston, MA: Harvard
Business School Press.

Other Motivations For Diversification

Motivations that are Value neutral:
Diversification motivated by poor economic performance

in current businesses.

Motivations that Devaluate:

Agency problem
Managerial capitalism (empire building)
Maximize management compensation
Sales Growth maximization

Professor William Baumol

Diversification
Issue #1: When there is a reduction in managerial
(employment) risk, then there is upside and
downside effects for stockholders:
On the upside, managers will be more willing to learn

firm-specific skills that will improve the productivity

and long-run success of the company (to the benefit
of stockholders).

On the downside, top-level managers may

have the economic incentive to diversify to

a point that is detrimental to stockholders.

Diversification
Issue #2: There may be no economic value to
stockholders in diversification moves since
stockholders are free to diversify by holding a
portfolio of stocks. No one has shown that
investors pay a premium for diversified firms -in fact, discounts are common.
A classic example is Kaiser Industries that was dissolved

as a holding company because its diversification

apparently subtracted from its economic value.

Kaiser Industries main assets: (1) Kaiser Steel; (2) Kaiser

Aluminum; and (3) Kaiser Cement were independent
companies and the stock of each were publicly traded.
Kaiser Industries was selling at a discount which vanished
when Kaiser Industries revealed its plan to sell its holdings.

Corporate Diversification
Diversification discount
Stock price of diversified firms is less

Diversification premium
Stock price of diversified firms is greater

Will diversification increase performance?

The Diversification-Performance
Relationship

Source: Adapted by Rothaermel, 2013:221 from L.E. Palich, L.B. Cardinal, and C.C. Miller (2000), Curvilinearity in the DiversificationPerformance Linkage: An Examination of over Three Decades of Research, Strategic Management Journal 21:155-174.

Vertical Integration and

Diversification: Sources of Value
Creation and Costs

Source: Rothaermel, 2013:222.

BCG Matrix

Source: Rothaermel, 2013:223.

Knowledge Processes within the Organization

Knowledge
Generation
(Exploration)

Knowledge
Creation

Training
Knowledge
Acquisition

Knowledge
Integration
Knowledge
Sharing

Knowledge
Application
(Exploitation)

Research

Knowledge
Replication
Knowledge
Storage &
Organization

Recruitment
Intellectual property
licensing
Benchmarking

New product
development
Operations

Strategic planning
Communities of practice

Best practices transfer

On-the-job training

Databases
Standard operating practices

Knowledge
Measurement

Intellectual capital accounting

Competency modeling

Knowledge
Identification

Project reviews
Competency modeling

Corporate Diversification
Internal capital markets
Source of value creation in a diversification strategy
Allows conglomerate to do a more efficient job of

allocating capital

Coordination cost
A function of number, size, and types of businesses

linked to one another

Influence cost
Political maneuvering by managers to influence

capital and resource allocation

Bandwagon effects
Firms copying moves of industry rivals

Oracle Corporate Strategy:

Combining
Vertical Integration and
Diversification

Source: Rothaermel, 2013:225.

Problems in
Achieving Success

Reasons for
Acquisitions
Increased
market power

Integration
difficulties

Overcome
entry barriers

Inadequate
evaluation of target

Cost of new
product development

Large or
extraordinary debt

Increased speed
to market

Acquisitions

Inability to
achieve synergy

Lower risk
compared to developing
new products

Too much
diversification

Increased
diversification

Managers overly
focused on acquisitions

Avoid excessive
competition

Too large

Ch7-3

Attributes of Effective
Acquisitions
Attributes

Results

Complementary
Assets or Resources
Friendly
Acquisitions
Careful Selection
Process

Buying firms with assets that meet current

needs to build competitiveness
Friendly deals make integration go more
smoothly
Deliberate evaluation and negotiations are
more likely to lead to easy integration and
building synergies

Maintain Financial
Slack

Provide enough additional financial

resources so that profitable projects would
not be foregone
20

Sustainable Competitive Advantage

Trying to gain sustainable competitive advantage via
mergers and acquisitions puts us right up against the
efficient market wall:
If an industry is generally known to be highly profitable,

there will be many firms bidding on the assets already in

the market. Generally the discounted
value of future cash flows will be impounded in the price
that the acquirer pays. Thus, the acquirer is expected to
make only a competitive
rate of return on investment.

Sustainable Competitive Advantage

And the situation may actually be
worse, given the phenomenon of the
winners curse.
The most optimistic bidder usually over-

estimates the true value of the firm:

Quaker

Oats, in late 1994, purchased

Snapple Beverage Company for $1.7 billion.
Many analysts calculated that Quaker Oats
paid about $1 billion too much for Snapple.
In 1997, Quaker Oats sold Snapple for $300
million.

Sustainable Competitive Advantage

Under what scenarios can the bidder do well?
Luck
Asymmetric Information

This eliminates the competitive bidding premise

implicit in the efficient market hypothesis
Specific-synergies (co-specialized assets) between

the bidder and the target.

Once again this eliminates the competitive
bidding premise of the efficient market
hypothesis.

Take-Away Concepts
1

Define corporate-level strategy, and describe the three dimensions

along which it is assessed.

While business strategy addresses how to compete, corporate strategy

addresses where to compete.

Corporate strategy concerns the scope of the firm along three

dimensions: (1) vertical integration (along the industry value chain); (2)
horizontal integration (diversification); and (3) geographic scope (global
strategy).

To gain & sustain competitive advantage, any corporate strategy must

support and strengthen a firms strategic position regardless of whether it
is a differentiation, cost leadership, or integration strategy.

Take-Away Concepts
2

Describe and evaluate different options firms have to organize

economic activity.

Transaction cost economics help managers decide what activities to do

in-house (make) versus what services and products to obtain from the
external market (buy).

When the costs to pursue an activity in-house are less than the costs of
transacting in the market (Cin-house, Cmarket), then the firm should vertically
integrate.

In the resource-based view of the firm, a firms boundaries are delineated

by its knowledge bases and competencies.

Moving from less integrated to more fully integrated forms of transacting,

alternatives include: short-term contracts, strategic alliances (including
long-term contracts, equity alliances, and joint ventures), and parent
subsidiary relationships .

Take-Away Concepts
3

Describe two types of vertical integration along the industry value

chain: backward and forward vertical integration.

Vertical integration denotes a firms value addedwhat percentage of a

firms sales is generated by the firm within its boundaries .

Industry value chains (vertical value chains) depict the transformation of

raw materials into finished goods and services. Each stage typically
represents a distinct industry in which a number of different firms are
competing .

Backward vertical integration involves moving ownership of activities

upstream nearer to the originating (inputs) point of the industry value
chain .

Forward vertical integration involves moving ownership of activities closer

to the end (customer) point of the value chain.

Take-Away Concepts
4

Identify and evaluate benefits and risks of vertical integration.

Benefits of vertical integration include: securing critical supplies, lowering

costs, improving quality, facilitating scheduling and planning, and
facilitating investments in specialized assets.

Risks of vertical integration include: increasing costs, reducing quality,

reducing flexibility, and increasing the potential for legal repercussions.

Vertical integration contributes to competitive advantage if the

incremental value created is greater than the incremental costs of the
specific corporate-level strategy.

Describe and examine alternatives to vertical integration.

Taper integration is a strategy in which a firm is backwardly integrated but

also relies on outside market firms for some of its supplies, and/or is
forwardly integrated but also relies on outside market firms for some if its
distribution.

Strategic outsourcing involves moving one or more value chain activities

outside the firms boundaries to other firms in the industry value chain.
Off-shoring is the outsourcing of activities outside the home country.

Take-Away Concepts
6

Describe and evaluate different types of corporate diversification.

A single-business firm derives 95 percent or more of its revenues from

one business.

A dominant-business firm derives between 70 and 95 percent of its

revenues from a single business, but pursues at least one other business
activity.

A firm follows a related diversification strategy when it derives less than

70 percent of its revenues from a single business activity, but obtains
revenues from other lines of business that are linked to the primary
business activity. Choices within a related diversification strategy can be
related-constrained or related-linked.

A firm follows an unrelated diversification strategy when less than 70

percent of its revenues come from a single business, and there are few, if
any, linkages among its businesses.

Take-Away Concepts
7

Apply the core competencemarket matrix to derive different

diversification strategies.

When applying an existing/new dimension to core competencies and

markets, four quadrants emerge, as depicted in The Core Competence
Market Matrix.

The lower-left quadrant combines existing core competencies with existing

markets. Here, managers need to come up with ideas of how to leverage
existing core competencies to improve their current market position.

The lower-right quadrant combines existing core competencies with new

market opportunities. Here, managers need to think about how to redeploy
and recombine existing core competencies to compete in future markets.

The upper-left quadrant combines new core competencies with existing

market opportunities. Here, managers must come up with strategic
initiatives of how to build new core competencies to protect and extend the
firms current market position .

The upper-right quadrant combines new core competencies with new

market opportunities. This is likely the most challenging diversification
strategy because it requires building new core competencies to create and
compete in future markets.

Take-Away Concepts
8

Explain when a diversification strategy creates a competitive

advantage, and when it does not.

The diversification-performance relationship is a function of the

underlying type of diversification.

The relationship between the type of diversification and overall firm

performance takes on the shape of an inverted U (see The Diversification Performance Relationship).

In the BCG matrix, the corporation is viewed as a portfolio of businesses,

much like a portfolio of stocks in finance. The individual SBUs are
evaluated according to relative market share and speed of market
growth, and plotted into one of four categories (dog, cash cow, star, and
question mark). Each category warrants a different investment strategy.

Both low levels and high levels of diversification are generally associated
with lower overall performance, while moderate levels of diversification
are associated with higher firm performance.