What is the shape of the relationship between the level of diversification and performance quizlet?

Financial Economies

Financial Economies = resulting from restructuring & using internal capital markets
- a source of value creation in a diversification strategy

Restructuring = process of reorganizing & divesting business units and activities to refocus a company to leverage its core competencies more fully

Boston Consulting GROUP (BCG) growth-share metric = corporation viewed as a portfolio of business units
- horizontal axis: relative market share
- vertical axis: speed of market growth
- 4 categories: dog, cash cow, star, question mark (horizontal axis) and speed of market growth (vertical axis)

Strategy Formulation

Strategy Formulation: where & how to compete

1. Business Strategy = how to compete in a single product market
- differentiation
- cost-leadership
- blue ocean (if trade-offs can be reconciled)

2. Corporate Strategy = where to compete overall

Corporate Strategy

Corporate Strategy = the decisions that the leaders make & the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously; formulated to guide continued growth
- done by the CEO
- PURPOSE OF CORPORATE STRATEGY = GROWTH

- any corporate strategy must align with the firms business strategy

- strategy determines WHERE to compete

- strategy determines the boundaries of the firm along 3 dimensions

3 Dimensions of Corporate Strategy

1. Vertical Integration
- in what stages of the industry value chain should the firm participate? (value chain is turning raw materials into finished goods)

2. Diversification
- what range of products/ services should the firm offer and which not to offer?

3. Geographic Scope
- where should the firm compete: regional, national, or global markets?

5 Reasons Firms need to Grow
(Corporate Strategy → Growth)

1. Increase Profits
- higher return for shareholder
- higher stock market valuation (determined by expected future revenue)

2. Lower Costs
- grow in order to achieve economies of scale
- must achieve minimum efficient scale (MES)

3. Increase Market Power
- grow to increase market share with their market power → M&A

4. Reduce Risk
- grow to diversify product/service portfolio by competing in different industries
- grow to achieve "economies of scope"

5. Motivate Management
- grow to afford career opportunities and professional development for employees
- beware of agency problem

corporate strategic decisions & guiding strategic management concepts

fundamental corporate strategic decisions: where to compete in terms of industry value chain, products & services, and geography

strategic decisions guided by the underlying strategic management concepts:
1) Core Competencies
- unique strengths that allow a firm differentiate its product/service

2) Economies of Scale
- average cost per unit decreases as output increases

3) Economies of Scope
- use the same resource to produce 2 or more different products

4) Transaction Costs
- all costs associated with an economic exchange
- is it cost effective for firm to grow through vertical integration of diversification?

Boundaries of a Firm:
Transaction Cost Economies

Transaction Cost Economics = theoretical framework to explain and predict the boundaries of the firm - helps leaders decide what activities to do in-house vs. what products/services to obtain from external market

→ WHICH IS CENTRAL TO FORMULATING a corporate strategy that's more likely to lead a competitive advantage

- key insight of transaction cost economics is that different institutional arrangements (markets vs. firms) have different costs attached

Transaction Costs

Transaction Costs = ALL internal + external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or market

1. Internal Transaction Costs = costs pertaining to organizing an economic exchange within a firm:
- cost of recruiting / retaining employees
- paying salaries and benefits
- setting up a shop floor
- providing office space and computers
- administrative costs

2. External Transaction Costs
- cost of searching for a firm / individual in market with whom to contract → negotiating, monitoring, enforcing contract

Firms vs. Markets: advantages & disadvantages matrix

market = outsourcing
firm = in-house making

Firms vs. Markets: 4 Firm Advantages

1. "command-and-control" decisions

2. "Coordination of highly complex tasks" through specialization of labor

3. "transaction-specific investments"

4. "Community of Knowledge"

Firms vs. Markets: 3 Firm Disadvantages

1. Administrative Costs

2. Low-Powered Incentives
- such as hourly wages & salaries (these are less attractive motivators than the entrepreneurial opportunities / rewards that can come in the open market)

3. Principal-Agent Problem = where an agent performs an activity on behalf of their own interests

Firms vs. Markets: 2 Market Advantages

1. High Powered Incentives
- instead of working as a salaried engineer for an existing firm, an individual can start a new venture offering specialized software

2. Increased Flexibility
- you can compare prices among different providers

Firms vs. Markets: 4 Market Disadvantages

1. Search Costs

2. Opportunism by other Parties
opportunism = self-interest seeking behavior
- this is when the supplier knows you need this product, so they take advantage of the opportunity and make the price so high

3. Incomplete Contracting
- hard to specify expectations, performance, outcomes
- Risk of "information asymmetry" = one party is more informed than another because of the possession of private information (buyer beware)
→ info asymmetry can lead to the crowding out of desirable goods/services by inferior ones

4. Enforcement of Contracts
- difficult, costly, time consuming

Alteratives on the Make-or-Buy Continuum (3 alteratives to firm vs. market)

1. Short-Term Contracts (closest to buy; less integrated)

2. Strategic Alliances
- Long-Term Contracts (licensing, franchising)
- Equity Alliances
- Joint Ventures

3. Parent-Subsidiary Relationship (cloest to make; more integrated)

Alternatives: 1) Short-Term Contracts

ST Contract = firm sends out RFP (request for proposals) to a few companies, this initiates competitive bidding for contracts to be awarded with short duration (<1yr)

Benefit → the buying firm can demand lower prices because of competitive bidding

Drawback → company's responding to RFP have no incentive to make any "transaction-specific investments" (buying a new machine to improve product quality) due to short term duration

Alternatives: 2) Strategic Alliances

Strategic Alliances = voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services

- let a firm gain transaction-specific assets without encountering internal transaction costs with vertical integration

1) Long-Term Contracts
- Licensing
- Franchising

2) Equity Alliances

3) Joint Venture

Alternatives: Strategic Alliances
→ LONG-TERM CONTRACTS

Long-Term Contracts = facilitate transaction-specific investments

- Licensing = a form of long term contracting in the manufacturing sector that enables firms to commercialize intellectual property such as a patent.

- Franchising = a form of long-term contract in the service industry where franchisor grants franchisee the right to use the trademark, business processes, and brand name

Alternatives: Strategic Alliances
→ EQUITY ALLIANCES

Equity Alliances = a partnership where at least one partner takes partial ownership in the other partner

- partner purchases ownership through buying a stock

- signals commitment

- one gains more information with this alliance*

- an equity investment is making a "credible commitment" = a long-term strategic decision that is difficult and costly to reverse

Alternatives: Strategic Alliances
→ JOINT VENTURE

Joint Venture = a stand-along organization is created and jointly owned by 2 or more parent companies

- partners contribute equally, so it is a long-term commitment
- facilitates transaction-specific investments

Alternatives: 3) Parent-Subsidiary Relationship

parent-subsidiary = the most-integrated alternative to performing an activity within one's own corporate family

- corporate parent owns the subsidiary and can direct it via command and control
- transaction costs may arise due to political turd battles
- how centralized vs. decentralized in subsidiary unit

When to vertically integrate? (firm produce instead of market)

1st corporate strategy question: in what stages of the industry value chain should the firm participate?

- cost of pursuing activity in-house < cost of activity in market

- firms should vertically integrate when the firm is more efficient in organizing economic activity than the markets which rely on contracts

Vertical Integration

Vertical Integration = the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs

- solidifies vertical boundaries; firm must decide where in the industry value chain to compete

Measurement of Vertical Integration: measured by a firm's value added, aka. what percent of a firms sales is generated within the firm's boundaries?

Industry Value Chain / Vertical Value Chain

Industry Value Chain = transforming raw materials into finished goods, along distinct vertical stages → each of which represents a distinct industry in which many firms are competing

a firms degree of vertical integration = number of industry value chain stages in which a firm directly participates
- participating in different levels helps a firm achieve economies of scope

Vertical Integration: 2 TYPES

Changes in an Industry Value Chain:

1. Backward Vertical Integration = moves ownership of activities upstream to the originating point of the value chain (inputs/raw materials)

2. Forward Vertical Integration = moves ownership of activities closer to the end customer

Vertical Integration: 4 BENEFITS (both types)

1. Lowering Costs

2. Improving Quality

3. Facilitating, Scheduling, and Planning

4. Facilitating Investments in "Specialized Assets"

Specialized Assets = unique assets with high opportunity costs → they have significant value in their intended use, rather than in their next-best use
i. Site Specificity
ii. Physical-Asset Specificity
iii. Human-Asset Specificity

- high opportunity costs because making the specialized investment opens up threat of opportunism by one of the partners
- often backward vertical integration is done to overcome the threat of opportunism and to secure raw materials
- normally if getting raw materials from someone in the market they KNOW you need it so they can raise prices bc they know you'll buy it

4 Vertical Integration: RISKS

1. Increasing Costs
- in-house suppliers have higher cost structures because they are not exposed to market competition

2. Reducing Quality
- fewer incentives to increase quality or create new innovative products due to lack of competition, not motivated

3. Reducing Flexibility
- especially when faced with challenges in the external environment like fluctuations in demand and technological change

4. Increasing the Potential for Legal Repercussions

When does Vertical Integration make sense?

main reason to vertically integrate → "failure of vertical markets"

Vertical Market Failure = when the markets along the industry value chain are too risky, and alternatives are too costly in time or money

2 Alternatives to Vertical Integration

2 alternatives to gain some benefits of vertical integration without the risks of full ownership of the supply chain

1. Taper Integration = a way of orchestrating value activities in which a firm is either:
- backwardly integrated, but it also relies on outside-market firms for some of its supplies and/or forwardly integrated, but also relies on out-market firms for some of its distribution

benefits = comparative performance to competitors enhances firm's flexibility, combines internal+external knowledge

2. Strategic Outsourcing = involves moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain
- you hire another company to be responsible for a business acitivity
- reduces firm's level of vertical integration
- firms outsource noncore activities like HR to leverage deep competencies and produce scale effects

3 Benefits of Taper Integration

- Comparative Performance: exposes in-house suppliers (backward) & distributors (forward) to market competition so that performance comparisons are possible → lets the firm fine-tune competencies

- Enhances Firm's Flexibility: able to adjust better to fluctuations in demand

- Innovation: firm combines internal & external knowledge

Corporate Diversification - expands beyond a single market

1) Vertical Integration: in what stages of the value chain should the firm participate?

2) Product Diversification: what range of products and services should the firm offer?
- do i want to compete in a single product market (only soft drinks) or do i want to diversify and compete in multiple product markets (soft drinks and chips)
- number of markets to compete in

3) Geographic Diversification: where should the firm compete in terms of regional, national or international market?
- do i want to just compete in local markets or do i want to compete beyond national boarders
- where to compete geographically

Corporate Strategy: Vertical Integration & Diversification

Diversification Makeup

Diversification → regards to questions about the # of markets to compete & where to compete geographically

- a non diversified company focuses on a single market
- a diversified company competes in several different markets simultaneously

Diversification & 3 diversification strategies

Diversification = an increase in the variety of products / services a firm offers or markets, and the geographic regions in which is competes
- non-diversified company focuses on single market

3 Diversification Strategies:
1) Product Diversification Strategy
- firm is active in several different product markets

2) Geographic Diversification Strategy
- firm is active in several different countries

3) Product-Market Diversification Strategy
- firm is active in several different product markets AND several different countries

4 main types of business diversification by 2 key variables

2 key variables for PRODUCT Markets (not geographic diversification)

1. the percentage of revenue from the dominant/ primary business
- Single Business
- Dominant Business

2. the relationship of the core competencies across the business
- Related Diversification
- Unrelated Diversification: the conglomerate

Business Diversification→ Single Business

- low levels of diversification
- 95% of revenue from one business
- remaining 5% is not significant to success

Business Diversification→ Dominant Business

- 70-90% of revenue from a single dominant business

- remainder of the revenue comes from another SBU in the firm (another business activity)

ex) Harley Davidson - 80% of revenue from selling motorcylces and the other 20% from side business like motercycle parts

Business Diversification→ Related Diversification

Related-Constrained Diversification = executives pursue ONLY businesses where they can apply resources & core competencies they already have available in the primary business
- less than 70% of revenue is derived from a single business activity & remainder from other related businesses
- connected triangle of main activity, to 2 other sources (all sharing resources/competencies)

Related-Linked Diversification = executives pursue various business opportunities that share only a limited number of linkages
- in a triangle, only 2 of the sides are connected: main business connected to another business and that other business is connected to a third
ex) amazon first only sold books and then they expanded into CDs and then they leveraged its online retailing capabilities into a wide array of product offerings

Business Diversification→ Unrelated Diversification

Conglomerate = a company that combines 2 or more strategic business units (SBUs) under one overarching corporation

- generates less than 70% of revenue from single business, and there are few if any linkages between businesses

4 Types of Product Diversification Chart

Leveraging Core Competencies for Diversification

core competencies = unique strengths embedded deep in a firm that allow a firm to increase perceived value of their product or lower the cost to produce them

core competence-market matrix is used to help managerial decisions in regard to diversification strategies:
1) new competencies, same market →

2) same competencies, same market → managers come up with new ideas on how to leverage existing core competencies to improve firms current market position

3) new competencies, new market → build new competencies to compete in future markets

4) same competencies, new market → leaders strategize about how to redeploy and recombine core competencies to compete in future markets

Corporate Diversification & Core Competencies

Core Competence-Market Matrix = a framework to guide corporate diversification strategy by analyzing possible combinations of existing/new core competencies and existing/new markets

4 Options to Formulate Corporate Strategy via Core Competencies:

1) leverage existing core competencies to improve current market position

2) build new core competencies to protect & expand current market position

3) redeploy & recombine existing core competencies to compete in markets of the future

4) build new core competencies to create and compete in markets of the future

Corporate Diversification & Firm Performance

"U-shape" relationship between the type of diversification and overall firm performance
- high & low diversification → low performance
- medium diversification → high performance

Firm Performance: unrelated vs. related diversification

A) Firm's pursuing "Unrelated Diversification" cannot create additional value

Diversification Discount = situation where the stock price of highly diversified firms is valued at LESS than the sum of their individual business units

B) Firm's pursuing "Related Diversification" can improve their performance:

Diversification Premium = the stock price of related-diversification firms is GREATER than the sum of their individual business units

How can diversification improve firm performance?

it must do at LEAST one of the following:

- provide economies of scale (reduces costs)

- exploit economies of scope (increases value)

- reduce costs AND increase value

Another Benefit to Firm Performance with a Diversification Strategy

Financial Economies which results from restructuring and using internal capital markets

Restructuring = reorganizing & divesting SBUs to refocus a firm to leverage core competencies more fully (decide how to reorganize with the BCG growth-share matrix)

Internal Capital Markets = if more efficient job og allocating capital through internal budgeting process than what could be achieved in external markets

Restructuring

Restructuring = process of reorganizing & divesting business units and activities to refocus a company to leverage its core competencies more fully

Boston Consulting GROUP (BCG) growth-share metric = corporation viewed as a portfolio of business units
- horizontal axis: relative market share
- vertical axis: speed of market growth
- 4 categories: dog, cash cow, star, question mark (horizontal axis) and speed of market growth (vertical axis)

star = high share, high growth
? = low share, high growth
cash cow = high share, low growth
dog = low share, low growth

Internal Capital Markets

Internal Capital Markets = a source of value creation if the conglomerate's headquarters does a more efficient job of allocating capital through its budgeting process than what could be achieved in external capital markets

- related diversification is more likely to enhance corporate performance

2 types of costs for related-diversification strategy:
1. Coordination Costs
2. Influence Costs

2 types of costs for related-diversification strategy:

1. Coordination Costs = this cost depends on the #, size, type of businesses that are LINKED

2. Influence Costs = political things with managers trying to allocate resources across SBUs and they dont do a good job of allocating scare resources

- due to political maneuvering by managers to influence capital and resource allocation, and the resulting inefficiencies stemming from suboptimal allocation of scarce resources

Corporate Strategy: sources of value creation & sources of costs

strategic leader must determine the degree of vertical integration, the type of diversification, and the geographic scope
- the corporate Strategy needs to be dynamic over time

What is the shape of the relationship between the level of diversification and performance?

What level of diversification leads to the highest levels of performance?

What is a related linked diversification strategy?

Which of the following are the types of general diversification strategies?