Retrenching to a narrower diversification base

CHAPTER 8 Corporate Strategy Diversification and the Multibusiness Company

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This chapter moves up one level in the strategy-making hierarchy, from strategy making in a single-business enterprise to strategy making in a diversified multibusiness enterprise. Because a diversified company is a collection of individual businesses, the strategy-making task is more complicated.

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Learning Objectives

This Chapter Will Help You Understand:

When and how business diversification can enhance shareholder value.

How cross-business strategic fit can contribute to each business’s competitive advantage.

The merits and risks of unrelated diversification strategies.

The analytic tools for evaluating a company’s diversification strategy.

What four main corporate strategy options a diversified company uses to improve company performance.

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In the first portion of this chapter, we describe what crafting a diversification strategy entails, when and why diversification makes good strategic sense, the various approaches to diversifying a company’s business lineup, and the pros and cons of related versus unrelated diversification strategies. The second part of the chapter looks at how to evaluate the attractiveness of a diversified company’s business lineup, how to decide whether it has a good diversification strategy, and the strategic options for improving a diversified company’s future performance.

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What Does Crafting a Diversification Strategy Entail?

STEP DESCRIPTION
Step 1 Picking new industries to enter and deciding on the means of entry
Step 2 Pursuing opportunities to leverage cross-business value chain relationships and strategic fit into competitive advantage
Step 3 Establishing investment priorities and steering corporate resources into the most attractive business units
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The task of crafting a diversified company’s overall corporate strategy falls squarely in the lap of top-level executives and involves three distinct steps.

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Strategic Diversification Options

Sticking closely with the existing business lineup and pursuing opportunities presented by these businesses

Broadening the current scope of diversification by entering additional industries

Retrenching to a narrower scope of diversification by divesting poorly performing businesses

Broadly restructuring the entire firm by divesting some businesses and acquiring others to put a whole new face on the firm’s business lineup

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The demanding and time-consuming nature of these four tasks explains why corporate executives generally refrain from becoming immersed in the details of crafting and executing business-level strategies. Rather, the normal procedure is to delegate lead responsibility for business strategy to the heads of each business, giving them the latitude to develop strategies suited to the particular industry environment in which their business operates, and holding them accountable for producing good financial and strategic results.

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When to Consider Diversifying

A firm should consider diversifying when:

Growth opportunities are limited as its principal markets reach their maturity and buyer demand is either stagnating or set to decline.

Changing industry conditions—new technologies, inroads being made by substitute products, fast-shifting buyer preferences, or intensifying competition—are undermining the firm’s competitive position.

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As long as a company has plentiful opportunities for profitable growth in its present industry, there is no urgency to pursue diversification. But growth opportunities are often limited in mature industries and markets where buyer demand is flat or declining. In addition, changing industry conditions—new technologies, inroads being made by substitute products, fast-shifting buyer preferences, or intensifying competition— can undermine a company’s ability to deliver ongoing gains in revenues and profits.

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How Much Diversification?

Deciding how wide-ranging diversification should be

Diversify into closely related businesses or into totally unrelated businesses?

Diversify present revenue and earnings base to a small or major extent?

Move into one or two large new businesses or a greater number of small ones?

Acquire an existing company?

Start up a new business from scratch?

Form a joint venture with one or more companies to enter new businesses?

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The decision to diversify presents wide-ranging possibilities. A company can diversify into closely related businesses or into totally unrelated businesses. It can diversify its present revenue and earnings base to a small or major extent. It can move into one or two large new businesses or a greater number of small ones. It can achieve diversification by acquiring an existing company, starting up a new business from scratch, or forming a joint venture with one or more companies to enter new businesses. In every case, however, the decision to diversify must start with a strong economic justification for doing so.

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Opportunity for Diversifying

Strategic diversification possibilities

Expand into businesses whose technologies and products complement present business(es).

Employ current resources and capabilities as valuable competitive assets in other businesses.

Reduce overall internal costs by cross-business sharing or transfers of resources and capabilities.

Extend a strong brand name to the products of other acquired businesses to help drive up sales and profits of those businesses.

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In every case, however, the decision to diversify must start with a strong economic justification.

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Building Shareholder Value: The Ultimate Justification for Diversifying

Testing Whether Diversification Will Add Long-Term Value for Shareholders

The industry attractiveness test

The cost-of-entry test

The better-off test

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Diversification must do more for a company than simply spread its business risk across various industries. In principle, diversification cannot be considered wise or justifiable unless it results in added long-term economic value for shareholders—value that shareholders cannot capture on their own by purchasing stock in companies in different industries or investing in mutual funds to spread their investments across several industries. A move to diversify into a new business stands little chance of building shareholder value without passing the three Tests of Corporate Advantage.

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Three Tests for Building Shareholder Value through Diversification

The attractiveness test

Are the industry’s profits and return on investment as good or better than present business(es)?

The cost of entry test

Is the cost of overcoming entry barriers so great as to cause delay or reduce the potential for profitability?

The better-off test

How much synergy (stronger overall performance) will be gained by diversifying into the industry?

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To add shareholder value, diversification into a new business must pass the three tests of corporate advantage:

The industry attractiveness test

The cost of entry test

The better-off test

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Better Performance through Synergy

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Creating added value for shareholders via diversification requires building a multibusiness company in which the whole is greater than the sum of its parts; such 1 + 1= 3 effects are called synergy.

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FIGURE 8.2 Three Strategy Options for Pursuing Diversification

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Figure 8.2 shows the range of alternatives for companies pursuing diversification.

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Approaches to Diversifying the Business Lineup

Existing business acquisition

Internal new venture (start-up)

Joint venture

Diversifying into New Business

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The means of entering new businesses can take any of three forms: acquisition, internal startup, or joint ventures with other companies.

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Diversification by Acquisition of an Existing Business

Advantages:

Quick entry into an industry

Barriers to entry avoided

Access to complementary resources and capabilities

Disadvantages:

Cost of acquisition—whether to pay a premium for a successful firm or seek a bargain in a struggling firm

Underestimating costs for integrating acquired firm

Overestimating the acquisition’s potential to deliver added shareholder value

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Acquisition is a popular means of diversifying into another industry. Not only is it quicker than trying to launch a new operation, but it also offers an effective way to hurdle such entry barriers.

An acquisition premium, or control premium, is the amount by which the price offered exceeds the pre-acquisition market value of the target company.

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Entering a New Line of Business through Internal Development

Advantages of new venture development

Avoids pitfalls and uncertain costs of acquisition

Allows entry into a new or emerging industry where there are no available acquisition candidates

Disadvantages of corporate intrapreneurship

Must overcome industry entry barriers

Requires extensive investments in developing production capacities and competitive capabilities

May fail due to internal organizational resistance to change and innovation

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Achieving diversification through internal development involves starting a new business subsidiary from scratch. Internal development has become an increasingly important way for companies to diversify.

Corporate venturing, or new venture development, is the process of developing new businesses as an outgrowth of a firm’s established business operations. It is also referred to as corporate entrepreneurship or intrapreneurship since it requires entrepreneurial-like qualities within a larger enterprise.

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When to Engage in Internal Development

Low resistance of incumbent firms to market entry

Ample time to develop and launch business

Availability of in-house skills and resources

Cost of acquisition higher than internal entry

Added capacity affects supply and demand balance

Factors Favoring Internal Development

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Generally, internal development of a new business has appeal only when (1) the parent company already has in-house most of the resources and capabilities it needs to piece together a new business and compete effectively; (2) there is ample time to launch the business; (3) the internal cost of entry is lower than the cost of entry via acquisition; (4) adding new production capacity will not adversely impact the supply– demand balance in the industry; and (5) incumbent firms are likely to be slow or ineffective in responding to a new entrant’s efforts to crack the market.

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Using Joint Ventures to Achieve Diversification

Joint ventures are advantageous when diversification opportunities:

Are too large, complex, uneconomical, or risky for one firm to pursue alone.

Require a broader range of competencies and know-how than a firm possesses or can develop quickly.

Are located in a foreign country that requires local partner participation or ownership.

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Entering a new business via a joint venture can be useful in at least three types of situations.

First, a joint venture is a good vehicle for pursuing an opportunity that is too complex, uneconomical, or risky for one company to pursue alone.

Second, joint ventures make sense when the opportunities in a new industry require a broader range of competencies and know-how than a company can marshal on its own.

Third, companies sometimes use joint ventures to diversify into a new industry when the diversification move entails having operations in a foreign country.

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Risks of Diversification by Joint Venture

Joint ventures have the potential for developing serious drawbacks due to:

Conflicting objectives and expectations of venture partners.

Disagreements among or between venture partners over how best to operate the venture.

Cultural clashes among and between the partners.

Dissolution of the venture when one of the venture partners decides to go their own way.

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Partnering with another company has significant drawbacks due to the potential for conflicting objectives, disagreements over how to best operate the venture, culture clashes, and so on. Joint ventures are generally the least durable of the entry options, usually lasting only until the partners decide to go their own ways.

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Choosing a Mode of Market Entry

The question of The question
The Question of Critical Resources and Capabilities Does the firm have the resources and capabilities for internal development?
The Question of Entry Barriers Are there entry barriers to overcome?
The Question of Speed Is speed crucial to the firm’s chances for successful entry?
The Question of Comparative Cost Which is the least costly mode of entry, given the firm’s objectives?
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The choice of how best to enter a new business—whether through internal development, acquisition, or joint venture—depends on the answers to four important questions. Transaction costs are the costs of completing a business agreement or deal, not including the price of the actual deal. They can include the costs of searching for an attractive target, the costs of evaluating its worth, bargaining costs, and the costs of completing the transaction.

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Choosing the Diversification Path: Related versus Unrelated Businesses

Which Diversification Path to Pursue?

Related Businesses

Unrelated Businesses

Both Related and Unrelated Businesses

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Once a company decides to diversify, it faces the choice of whether to diversify into related businesses, unrelated businesses, or some mix of both.

Related businesses possess competitively valuable cross-business value chain and resource matchups.

Unrelated businesses have dissimilar value chains and resource requirements, with no competitively important cross-business relationships at the value chain level.

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Diversification into Related Businesses

Strategic fit opportunities

Transferring specialized expertise, technological know-how, or other resources and capabilities from one business’s value chain to another’s

Sharing costs by combining the related value chain activities of different businesses into a single operation

Exploiting common use of a well-known brand name

Sharing other resources (besides brands) that support corresponding value chain activities across businesses

Engaging in cross-business collaboration and knowledge sharing to create new competitively valuable resources and capabilities

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Strategic fit exists whenever one or more activities constituting the value chains of different businesses are sufficiently similar in present opportunities for cross-business sharing or transferring of the resources and capabilities that enable these activities.

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Pursuing Related Diversification

Generalized resources and capabilities:

Can be deployed widely across a broad range of industry and business types.

Can be leveraged in both unrelated and related diversification situations.

Specialized resources and capabilities:

Have very specific applications which restrict their use to a narrow range of industry and business types.

Can typically be leveraged only in related diversification situations.

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The resources and capabilities that are leveraged in related diversification are specialized resources and capabilities that have very specific applications; their use is restricted to a limited range of business contexts in which these applications are competitively relevant. Because they are adapted for particular applications, to have value, specialized resources and capabilities must be utilized by particular types of businesses operating in specific kinds of industries; they have limited utility outside this designated range of industry and business applications. This is in contrast to general resources and capabilities (such as general management capabilities, human resource management capabilities, and general accounting services), which can be applied usefully across a wide range of industry and business types.

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FIGURE 8.1 Related Businesses Provide Opportunities to Benefit from Competitively Valuable Strategic Fit.

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Figure 8.1 illustrates the range of opportunities to share and/or transfer specialized resources and capabilities among the value chain activities of related businesses. It is important to recognize that even though general resources and capabilities may be shared by multiple business units, such resource sharing alone cannot form the backbone of a strategy keyed to related diversification.

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Identifying Cross-Business Strategic Fits along the Value Chain

Potential Cross-Business Fits

Sales and marketing activities

R&D technology activities

Supply chain activities

Manufacturing-related activities

Distribution-related activities

Customer service activities

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Cross-business strategic fit can exist anywhere along the value chain—in R&D and technology activities, in supply chain activities and relationships with suppliers, in manufacturing, in sales and marketing, in distribution activities, or in customer service activities.

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Strategic Fit, Economies of Scope, and Competitive Advantage

Using economies of scope to convert strategic fit into competitive advantage can entail:

Transferring specialized and generalized skills or knowledge

Combining related value chain activities to achieve lower costs

Leveraging brand names and other differentiation resources

Using cross-business collaboration and knowledge sharing

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The greater the cross-business economies associated with resource sharing and transfer, the greater the potential for a related diversification strategy to give individual businesses of a multibusiness enterprise a cost advantage over their rivals.

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Economies of Scope Differ from Economies of Scale

Economies of scope

Are cost reductions that flow from cross-business resource sharing in the activities of the multiple businesses of a firm.

Economies of scale

Accrue when unit costs are reduced due to the increased output of larger-size operations of a firm.

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Economies of scope are cost reductions that flow from operating the same essential activities in multiple businesses (a larger scope of operation).

Economies of scale accrue from the lower variable costs of outputs from a larger-size operation.

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From Strategic Fit to Competitive Advantage, Added Profitability, and Gains in Shareholder Value

Capturing the cross-business strategic-fit benefits of related diversification

Builds more shareholder value than owning a stock portfolio

Only possible via a strategy of related diversification

Yields value in the application of specialized resource and capabilities

Requires that management take internal actions to realize them

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Diversifying into related businesses where competitively valuable strategic-fit benefits can be captured puts a firm’s businesses in position to perform better financially as part of the firm than they could have performed as independent enterprises, thus, providing a clear avenue for boosting shareholder value and satisfying the better-off test.

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The Effects of Cross-Business Fit

Fit builds more value than owning a stock portfolio of firms in different industries.

Strategic-fit benefits are possible only via related diversification.

The stronger the fit, the greater its effect on the firm’s competitive advantages.

Fit fosters the spreading of competitively valuable resources and capabilities specialized to certain applications and that have value only in specific types of industries and businesses.

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Capturing the benefits of strategic fit along the value chains of its related businesses gives a diversified company a clear path to achieving competitive advantage over undiversified competitors and competitors whose own diversification efforts don’t offer equivalent strategic-fit benefits. Such competitive advantage potential provides a company with a dependable basis for earning profits and a return on investment that exceeds what the company’s businesses could earn as stand-alone enterprises.

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The Kraft-Heinz Merger: Pursuing the Benefits of Cross-Business Strategic Fit

Why did Kraft choose to seek a merger with Heinz rather than starting its own food products subsidiary?

What are the anticipated results of the merger?

To what extent is decentralization required when seeking cross-business strategic fit?

What should Kraft-Heinz do to ensure the continued success of its related diversification strategy?

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Illustration Capsule 8.1 describes the merger of Kraft Foods Group, Inc. with the H. J. Heinz Holding Corporation, in pursuit of the strategic-fit benefits of a related diversification strategy.

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Diversification into Unrelated Businesses

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Achieving cross-business strategic fit is not a motivation for unrelated diversification. Companies that pursue a strategy of unrelated diversification often exhibit a willingness to diversify into any business in any industry where senior managers see an opportunity to realize consistently good financial results.

With an unrelated diversification strategy, company managers spend much time and effort screening acquisition candidates and evaluating the pros and cons of keeping or divesting existing businesses using the criteria listed in this slide

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Building Shareholder Value via Unrelated Diversification

Type Details
Astute corporate parenting by management Provide leadership, oversight, expertise, and guidance Provide generalized or parenting resources that lower operating costs and increase SBU efficiencies
Cross-business allocation of financial resources Serve as an internal capital market Allocate surplus cash flows from businesses to fund the capital requirements of other businesses
Acquiring and restructuring undervalued companies Acquire weakly performing firms at bargain prices Use turnaround capabilities to restructure them to increase their performance and profitability
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Corporate parenting is the role that a diversified corporation plays in nurturing its component businesses through the provision of:

Top management expertise

Disciplined control

Financial resources

Other types of generalized resources and capabilities such as long-term planning systems, business development skills, management development processes, and incentive systems

A diversified firm has a parenting advantage when it is more able than other firms to boost the combined performance of its individual businesses through high-level guidance, general oversight, and other corporate-level contributions.

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The Path to Greater Shareholder Value through Unrelated Diversification

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For a strategy of unrelated diversification to produce company-wide financial results above and beyond what the businesses could generate operating as stand-alone entities, corporate executives must do three things to pass the three tests of corporate advantage:

Diversify into industries where the businesses can produce consistently good earnings and returns on investment (to satisfy the industry-attractiveness test).

Negotiate favorable acquisition prices (to satisfy the cost of entry test).

Do a superior job of corporate parenting via high-level managerial oversight and resource sharing, financial resource allocation and portfolio management, and/or the restructuring of underperforming businesses (to satisfy the better-off test).

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The Drawbacks of Unrelated Diversification

Monitoring and maintaining the parenting advantage

Demanding Managerial Requirements

Possible lack of cross-business strategic-fit benefits

Pursuing an Unrelated Diversification Strategy

Limited Competitive Advantage Potential

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Unrelated diversification strategies have two important negatives that undercut the pluses: very demanding managerial requirements and limited competitive advantage potential.

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Misguided Reasons for Pursuing Unrelated Diversification

Poor Rationales for Unrelated Diversification

Seeking a reduction of business investment risk

Pursuing rapid or continuous growth for its own sake

Seeking stabilization of earnings to avoid cyclical swings in businesses

Pursuing personal managerial motives

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Companies sometimes pursue unrelated diversification for reasons that are entirely misguided. Because unrelated diversification strategies at their best have only a limited potential for creating long-term economic value for shareholders, it is essential that managers not compound this problem by taking a misguided approach toward unrelated diversification, in pursuit of objectives that are more likely to destroy shareholder value than create it.

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Combination Related-Unrelated Diversification Strategies

Dominant-business enterprises

Narrowly diversified firms

Broadly diversified firms

Multibusiness enterprises

Related-Unrelated business portfolio combinations may be suitable for

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Combination related–unrelated diversification strategies have particular appeal for companies with a mix of valuable competitive assets, covering the spectrum from general to specialized resources and capabilities.

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Structures of Combination Related-Unrelated Diversified Firms

Dominant-business enterprises:

Have a major “core” firm that accounts for 50 to 80% of total revenues and a collection of small related or unrelated firms that accounts for the remainder.

Narrowly diversified firms:

Are comprised of a few related or unrelated businesses.

Broadly diversified firms:

Have a wide-ranging collection of related businesses, unrelated businesses, or a mixture of both.

Multibusiness enterprises:

Have a business portfolio consisting of several unrelated groups of related businesses.

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There’s ample room for companies to customize their diversification strategies to incorporate elements of both related and unrelated diversification, as may suit their own competitive asset profile and strategic vision. Combination related–unrelated diversification strategies have particular appeal for companies with a mix of valuable competitive assets, covering the spectrum from general to specialized resources and capabilities.

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Steps in Evaluating the Strategy of a Diversified Firm

Assess the attractiveness of the industries the firm has diversified into, both individually and as a group.

Assess the competitive strength of the firm’s business units within their respective industries.

Evaluate the extent of cross-business strategic fit along the value chains of the firm’s various business units.

Check whether the firm’s resources fit the requirements of its present business lineup.

Rank the performance prospects of the businesses from best to worst and determine resource allocation priorities.

Craft strategic moves to improve corporate performance.

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Strategic analysis of diversified companies builds on the concepts and methods used for single-business companies. The procedure for evaluating the pluses and minuses of a diversified company’s strategy and deciding what actions to take to improve the company’s performance involves six steps.

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Step 1: Evaluating Industry Attractiveness

How attractive are the industries in which the firm has business operations?

Does each industry represent a good market for the firm to be in?

Which industries are most attractive, and which are least attractive?

How appealing is the whole group of industries?

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A principal consideration in evaluating the caliber of a diversified company’s strategy is the attractiveness of the industries in which it has business operations. The more attractive the industries (both individually and as a group) that a diversified company is in, the better its prospects for good long-term performance.

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Calculating Industry-Attractiveness Scores: Key Measures

Market size and projected growth rate

The intensity of competition among market rivals

Emerging opportunities and threats

The presence of cross-industry strategic fit

Resource requirements

Social, political, regulatory, environmental factors

Industry profitability

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A simple and reliable analytic tool for gauging industry attractiveness involves calculating quantitative industry-attractiveness scores based on these measures.

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Calculating Industry Attractiveness from the Multibusiness Perspective

The question of cross-industry strategic fit

How well do the industry’s value chain and resource requirements match up with the value chain activities of other industries in which the firm has operations?

The question of resource requirements

Do the resource requirements for an industry match those of the parent firm or are they otherwise within the company’s reach?

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The more one industry’s value chain and resource requirements match up well with the value chain activities of other industries in which the company has operations, the more attractive the industry is to a firm pursuing related diversification. However, cross-industry strategic fit is not something that a company committed to a strategy of unrelated diversification considers when it is evaluating industry attractiveness.

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Calculating Industry-Attractiveness Scores

Evaluating Industry Attractiveness

Deciding on appropriate weights for industry attractiveness measures

Gaining sufficient knowledge of the industry to assign accurate and objective ratings

Whether to use different weights for different business units whenever the importance of strength measures differs significantly from business to business

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Each attractiveness measure is then assigned a weight reflecting its relative importance in determining an industry’s attractiveness, since not all attractiveness measures are equally important. The intensity of competition in an industry should nearly always carry a high weight (say, 0.20 to 0.30). Strategic-fit considerations should be assigned a high weight in the case of companies with related diversification strategies; but for companies with an unrelated diversification strategy, strategic fit with other industries may be dropped from the list of attractiveness measures altogether. The importance weights must add up to 1.

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TABLE 8.1 Calculating Weighted Industry-Attractiveness Scores

Aspects Importance weight Business A in Industry A Business A in Industry A Business B in Industry B Business B in Industry B Business C in Industry C Business C in Industry C
Competitive-Strength Measures Importance weight Business A in Industry A Strength Rating Business A in Industry A Weighted Score Business B in Industry B Strength Rating Business B in Industry B Weighted Score Business C in Industry C Strength Rating Business C in Industry C Weighted Score
Relative market share 0.15 10 1.50 2 0.30 6 0.90
Costs relative to competitor’s costs 0.20 7 1.40 4 0.80 5 1.00
Ability to march or beat rivals on key product attributes 0.05 9 0.45 5 0.25 8 0.40
Ability to benefit from strategic fit with other portfolio businesses 0.20 8 1.60 4 0.80 8 0.80
Bargaining leverage with suppliers/customers 0.05 9 0.45 2 0.10 6 0.30
Brand image and reputation 0.10 9 0.90 4 0.40 7 0.70
Competitively valuable capabilities 0.15 7 1.05 2 0.30 5 0.75
Profitability relative to competitors 0.10 5 0.50 2 0.20 4 0.40
Sum of importance weights 1.00 0 0 0 0 0 0
Weighted overall competitive strength scores N A N A Business A in Industry A weighted score 7.85 N A Business B in Industry B weighted score 3.15 N A Business C in Industry C weighted score 5.25
Rating scale: 1 equals very weak; 10 equals very strong.

Remember: The more intensely competitive an industry is, the lower the attractiveness rating for that industry!

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The sum of the weighted scores for all the attractiveness measures provides an overall industry-attractiveness score. The importance weights must add up to 1.

This procedure is illustrated in Table 8.1. Keep in mind here that the more intensely competitive an industry is, the lower the attractiveness rating for that industry.

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Step 2: Evaluating Business Unit Competitive Strength

Relative market share

Costs relative to competitors’ costs

Ability to match or beat rivals on key product attributes

Brand image and reputation

Other competitively valuable resources and capabilities

Benefits from strategic fit with firm’s other businesses

Bargaining leverage with key suppliers or customers

Profitability relative to competitors

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Relative market share is the ratio of a business unit’s market share to the market share of its largest industry rival as measured in unit volumes, not dollars. Using relative market share to measure competitive strength is analytically superior to using straight-percentage market share.

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TABLE 8.2 Calculating Weighted Competitive-Strength Scores for a Diversified Company’s Business Units

N A N A COMPETITIVE-STRENGTH ASSESSMENTS COMPETITIVE-STRENGTH ASSESSMENTS COMPETITIVE-STRENGTH ASSESSMENTS COMPETITIVE-STRENGTH ASSESSMENTS COMPETITIVE-STRENGTH ASSESSMENTS COMPETITIVE-STRENGTH ASSESSMENTS
N A N A Business A in Industry A Business A in Industry A Business B in Industry B Business B in Industry B Business C in Industry C Business C in Industry C
Competitive-Strength Measures Importance Weight Strength Rating* Weighted Score Strength Rating* Weighted Score Strength Rating* Weighted Score
Relative market share 0.15 10 1.50 2 0.30 6 0.90
Costs relative to competitors’ costs 0.20 7 1.40 4 0.80 5 1.00
Ability to match or beat rivals on key product attributes 0.05 9 0.45 5 0.25 8 0.40
Ability to benefit from strategic fit with sister businesses 0.20 8 1.60 4 0.80 8 0.80
Bargaining leverage with suppliers/customers 0.05 9 0.45 2 0.10 6 0.30
Brand image and reputation 0.10 9 0.90 4 0.40 7 0.70
Other valuable resources/capabilities 0.15 7 1.05 2 0.30 5 0.75
Profitability relative to competitors 0.10 5 0.50 2 0.20 4 0.40
Sum of importance weights 1.00 NA NA NA NA NA NA
Weighted overall competitive strength scores NA NA 7.85 NA 3.15 NA 5.25
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After settling on a set of competitive-strength measures that are well matched to the circumstances of the various business units, the company needs to assign weights indicating each measure’s importance. As in the assignment of weights to industry-attractiveness measures, the importance weights must add up to 1. Each business unit is then rated on each of the chosen strength measures, using a rating scale of 1 to 10 (where a high rating signifies competitive strength and a low rating signifies competitive weakness). If the available information is too limited to confidently assign a rating value to a business unit on a particular strength measure, it is usually best to use a score of 5—this avoids biasing the overall score either up or down. Weighted strength ratings are calculated by multiplying the business unit’s rating on each strength measure by the assigned weight. For example, a strength score of 6 times a weight of 0.15 gives a weighted strength rating of 0.90. The sum of the weighted ratings across all the strength measures provides a quantitative measure of a business unit’s overall competitive strength. Table 8.2 provides sample calculations of competitive-strength ratings for three businesses.

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FIGURE 8.3 A Nine-Cell Industry-Attractiveness–Competitive-Strength Matrix

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The industry-attractiveness and business-strength scores can be used to portray the strategic positions of each business in a diversified company. Industry attractiveness is plotted on the vertical axis and competitive strength on the horizontal axis. A nine-cell grid emerges from dividing the vertical axis into three regions (high, medium, and low attractiveness) and the horizontal axis into three regions (strong, average, and weak competitive strength). As shown in Figure 8.3, scores of 6.7 or greater on a rating scale of 1 to 10 denote high industry attractiveness, scores of 3.3 to 6.7 denote medium attractiveness, and scores below 3.3 signal low attractiveness. Likewise, high competitive strength is defined as scores greater than 6.7, average strength as scores of 3.3 to 6.7, and low strength as scores below 3.3. Each business unit is plotted on the nine-cell matrix according to its overall attractiveness score and strength score, and then it is shown as a “bubble.” The size of each bubble is scaled to the percentage of revenues the business generates relative to total corporate revenues. The bubbles in Figure 8.3 were located on the grid using the three industry-attractiveness scores from Table 8.1 and the strength scores for the three business units in Table 8.2.

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Step 3: Determining the Competitive Value of Strategic Fit in Diversified Companies

Assessing the degree of strategic fit across its businesses is central to evaluating a company’s related diversification strategy.

The real test of a diversification strategy is what degree of competitive value can be generated from strategic fit.

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The greater the value of cross-business strategic fit in enhancing a firm’s performance in the marketplace or on the bottom line, the more competitively powerful is its strategy of related diversification. Without significant cross-business strategic fit and dedicated company efforts to capture the benefits, one must be skeptical about the potential for a diversified company’s businesses to perform better together than apart.

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FIGURE 8.4 Identifying the Competitive Advantage Potential of Cross-Business Strategic Fit

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Figure 8.4 illustrates the process of comparing the value chains of a company’s businesses and identifying opportunities to exploit competitively valuable cross-business strategic fit. A company pursuing related diversification exhibits resource fit when its businesses have matching specialized resource requirements along their value chains. A company pursuing unrelated diversification has resource fit when the parent company has adequate corporate resources (parenting and general resources) to support its businesses’ needs and to add value.

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Step 4: Checking for Good Resource Fit

Nonfinancial resource fit

Does the firm have (or can it develop) the specific resources and capabilities needed to be successful in each of its businesses?

Are the firm’s resources being stretched too thin by the resource requirements of one or more of its businesses?

Financial resource fit

State of the internal capital market

Using the portfolio approach:

Cash hogs need cash to develop.

Cash cows generate excess cash.

Star businesses are self-supporting.

Success sequence:

Cash hog to Star to Cash cow

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The businesses in a diversified company’s lineup need to exhibit good resource fit. In firms with a related diversification strategy, good resource fit exists when the firm’s businesses have well-matched specialized resource requirements at points along their value chains that are critical for the businesses’ market success. Matching resource requirements are important in related diversification because they facilitate resource sharing and low-cost resource transfer.

A portfolio approach to ensuring financial fit among a firm’s businesses is based on the fact that different businesses have different cash flow and investment characteristics.

A cash cow business generates cash flows over and above its internal requirements, thus providing a corporate parent with funds for investing in cash hog businesses, financing new acquisitions, or paying dividends.

A cash hog business generates cash flows that are too small to fully fund its operations and growth and requires cash infusions to provide additional working capital and finance new capital investment.