Vertical integration is going backward on an industry's value chain

LECTURE NOTES #5

Chapter 7. Strategy Formulation: Corporate Strategy

Corporate strategy deals with three key issues:

* Directional strategy: The firm's overall orientation toward growth, stability, or entrenchment;

* Portfolio strategy: The industries or markets in which the firm compete through its products and business units; and

* Parenting strategy: The manner in which management coordinates activities and transfers resources and cultivates capabilities among product lines and business units.

I. Directional Strategy

(a) Growth Strategies:

Growth strategies expand the company's activities. Growth is a very attractive strategy for two reasons: the growing flow of revenue increases corporate potential and flexibility in business operations, and a growing firm offers more opportunities for advancement, promotion, and interesting jobs. There are two basic growth strategies: concentration on the current product line(s) in one industry, and diversification into other product lines in other industries.

(1) Concentration: If a company’s current product lines have real growth potential, concentration of resources on those product lines could be a good strategy. The basic concentration strategies are vertical growth and horizontal growth. Vertical growth can be achieved by taking over a function previously provided by external suppliers or distributors so that the company grows by making its own supplies and or by distributing its own products. The growth is achieved either internally by expanding current operations or externally by acquisitions. Vertical growth results in vertical integration: a firm operates vertically in multiple locations on an industry’s value chain, from extracting raw materials to manufacturing to retailing. Backward integration is going backward on an industry’s value-chain (suppliers), and forward integration is going forward on an industry’s value-chain (distributors). Vertical integration is more efficient than purchasing goods and services in the markets when the transaction costs are not expensive, but if the latter is too expensive, outsourcing would be more profitable. The degree of vertical integration: full integration, taper integration (less than half of own supplies), quasi-integration (buying 20% stocks), and long-term contract (outsourcing). Horizontal growth can be achieved by expanding its products into other geographic locations and or by increasing the range of products and services in the market. Horizontal growth results in horizontal integration: the same firm operates in multiple geographic locations at the same point on an industry’s value-chain. The government regulations usually prohibit foreign ownership of a domestic airline for national security reasons, which restricts horizontal integration in the airline industry.

(2) Diversification: When an industry consolidates and becomes mature, most of the surviving firms have reached the limits of growth using vertical and horizontal growth strategies. In this case, the firms diversify into different industries if they want to continue to grow. Two basic diversification strategies are concentric and conglomerate. Concentric Diversification: by focusing on the characteristics of its competitiveness, the company uses the strengths as its means of diversification. The synergy explains that two businesses will generate more profits together than they operate separately. Conglomerate Diversification: If the current industry is unattractive, the firm diversifies into an industry unrelated to its current one without common thread.

(3) International Entry Options: growth has international implications. Most popular options for international entry are: exporting, licensing, franchising, joint ventures, acquisitions, green-field development (building its own manufacturing plant and distribution system), production sharing, turnkey operations (contracts for the construction of operating facilities in exchange for a fee), Build-Operate-Transfer, and management contracts.

(4) Controversies in directional growth strategies: Is vertical growth better than horizontal growth? Which diversification strategy is better than others? Is internal growth better than external one? And what can improve acquisition performance? There are numerous surveys and studies for different growth strategies: which strategy is more profitable in the long run?

(b) Stability Strategies:

Stability strategies make no change to the company's current activities. A corporation may choose stability over growth by continuing its current activities without any significant change in direction.

(1) Pause/Proceed-with-Caution Strategy attempts only incremental improvement until changes of environmental situation;

(2) No-Change Strategy is a decision to do nothing new that is a choice to continue current operations and policies for the foreseeable future; and

(3) Profit Strategy is an attempt to stabilize profits when a company’s sales are declining by reducing investment and short-term discretionary expenditures.

(c) Retrenchment Strategies:

Retrenchment strategies reduce the company's level of activities. If a company has a weak competitive position in some or all of its product lines resulting in poor performance, it chooses retrenchment strategies which include turnaround strategy, captive company strategy, sell-out strategy, and bankruptcy or liquidation strategy.

(1) Turnaround Strategy: If a corporation’s problems are pervasive but not yet critical, this is a useful strategy. The first phase is contraction to stop the bleeding, and the second phase is consolidation to reduce unnecessary overhead and to make functional activities cost-justified.

(2) Captive Company Strategy: If the company cannot apply a turnaround strategy, it gives up independence in exchange for security. The management should search for an angel to be a captive company.

(3) Sell-Out /Divestment Strategy: If the management has no choice but to sell out the company. If the company has multiple business lines and it chooses to sell off a division with low growth potential, this is called divestment.

(4) Bankruptcy /Liquidation Strategy: Bankruptcy involves giving up management of the firm to the courts in return for some settlement of the company’s obligations. Liquidation is the termination of a firm.

II. Portfolio Strategy

In portfolio analysis, the top management views its product lines and business units as a series of investments from which it expects a profitable return. The product lines /business units form a portfolio of investments that top management must constantly juggle to ensure the best return on the company’s invested money. The popular portfolio approaches are the BCG Growth-Share Matrix and GE Business Screen.

(a) BCG Growth-Share Matrix:

The BBG (Boston Consulting Group) developed the simplest way of a company’s portfolio of investments. As shown in Figure 1, each of a corporation’s product lines or business units is plotted on a matrix according to both the growth rate of the industry in which it competes and its relative market share. The relative competitive position of a unit is defined as its market share in the industry divided by that of the largest other competitor. In this sense, a relative market share above 1.0 belongs to the market leader. The business growth rate is the percentage of market growth: the percentage by which sales of a particular business unit have increased. A growing market is attractive if other things are equal, so the relative competitive position is set at 1.5 times in the Figure 1: the left of 1.5x is in the high competitive position and the right is in the low competitive position. In the high position, “Stars” represents high growth rates (more than 10 percent) and “Cash Cow” does low growth rate (less than 10 percent); and in the low position, “Question Marks” represent high growth rates and “Dogs” do low growth rates. The area of the circle represents the relative significance of each business unit or product line to the corporation in terms of assets used or sales generated. As a product moves through its life cycle, it is categorized into one of four types for funding decisions. @ Question Marks are

Figure 1. BCG Growth-Share Matrix

Business

Growth Rate

(Percentage of

Market Growth)

10

0

Stars

Question Mark

o

O

Cash Cow

Dogs

o

O

10x 1.5x 1.0x 0.5x 0.1x

Relative Competitive Position (Market Share)

Source: Wheelen and Hunger, Strategic Management and Business Policy, 180.

new products with the potential for success, but they need a lot of cash for development, which fund is taken from more mature products. @ Stars are market leaders that are typically at the peak of their product life cycle and are usually able to generate enough cash to maintain their high share of the market. If their growth rates are declining, Stars became Cash Cows. @ Cash Cows bring more money than is needed to maintain their market share. In this declining stage of their life cycle, these products are milled for cash that will be invested in new question marks. @ Dogs have low market share and do not have the potential to bring in much cash, so that Dogs should be either sold off or managed carefully for the small amount of cash they can generate.

(b) GE Business Screen:

The individual product lines or business units are identified by a letter and plotted at circles on the GE Business Screen. The area of each circle is in proportion to the size of the industry in terms of sales (Omitted). The attractiveness of an industry can be assessed in many different ways (other than using the growth rate). @ Select criteria to rate the industry for each product line or business unit. Assess overall industry attractiveness for each product line or business unit on a scale from 1 (very unattractive) to 5 (very attractive). @Select the key factors needed for success in each product line or business unit. Assess business strength or competitive position for each product line or business unit on a scale of 1 (very weak) to 5 (very strong). @ Plot them on a matrix as shown in Figure 2. @ Plot the firm’s future portfolio, assuming that present corporate and business strategies remain unchanged. Is there a performance gap between projected and desired portfolios? If so, the gap should serve as a stimulus to seriously review the corporation’s current mission, objectives, strategies, and policies. Finally, the advantages of portfolio analysis are in that the top management evaluates individual product line of business unit, but that it is difficult to define product/market segments and real judgment is based on subjective judgment. In other words, industrial attractiveness and business strength are not scientifically accurate so that critical decisions for investment can be illusive. Campbell, Goold, and Alexander developed this strategy.[footnoteRef:1] [1: Michael Goold, Andrew Campbell, and Marcus Alexander, Corporate-Level Strategy: Creating Value in the Multibusiness Company, Hoboken, NJ: Wiley & Sons, Inc., 1994.]

Figure 2. General Electric’s Business Screen

Industry

Attractiveness

High

Medium

Low

Winners

Winners

Question

Marks

Winners

Average Businesses

Losers

Profit

Producers

Losers

Losers

Business Strength Strong Average Weak

Competitive Position

Source: Source: Wheelen and Hunger, Strategic Management and Business Policy, 182.

III. Parenting Strategy

The Portfolio Analysis primarily views matters financially, regarding business units and product lines as separate and independent investments. In contrast, corporate parenting views a corporation in terms of resources and capabilities that can be used to build business unit value as well as generate synergies across business units. Corporate parenting generates corporate strategy by focusing on the core competencies of the parent corporation and on the value created from the relationship between the parent and its businesses. In the form of corporate headquarters, parent has a great of power in this relationship. If there is a good fit between the parent’s skills and resources and opportunities of the business units, the corporation is likely to create value. If there is not a good fit, the corporation is likely to destroy value. The primary job of corporate headquarters is, therefore, to obtain synergy among the business units by providing needed resources to units, transferring skills and capabilities among the units, and coordinating the activities of shared unit functions to attain economies of scope (as in centralized purchasing). Modern company’s market value stems from intangible assets such as organizational knowledge and capabilities.

There are three analytical steps. (1) Examine each business unit (or target firm, in the case of acquisition) in terms of its strategic factors. one popular approach is to establish centers of excellence throughout a corporation. A center of excellence is an organizational unit that embodies a set of capabilities that has been explicitly recognized by the firm as an important source of value creation, with the intention that these capabilities be leveraged by and/or disseminated to other part of the firm. (2) Examine each business unit (or target firm) in terms of areas in which performance can be improved. These are the parenting opportunities. For example, two business units might be able to gain economies of scale by combining their sales forces. In another instance, a unit may have good, but not great, manufacturing and logistical skills. A parenting company having world-class expertise in these areas could improve that unit’s performance. (3) Analyze how well the parent corporation fits with the business unit (or target firm). Corporate headquarters must be aware of its own strengths and weaknesses in terms of resources, skills, and capabilities. To do this, the corporate parent must ask whether it has the characteristic that fit the parenting opportunities in each business unit.

On the other hand, A Horizontal Strategy is a corporate strategy that cuts across business unit boundaries to build synergy across business units and to improve the competitive position of one or more business units. In multipoint competition, large multi-business corporations compete against other large multi-business firms in a number of markets: a number of business units compete with each other. Multipoint competition and the resulting use of horizontal strategy may actually slow the development of hyper-competition in an industry. An attack on a market leader’s position could result in a response in another market, which leads to mutual forbearance in which managers behave more conservatively toward multi-market rivals, so that competitive rivalry is reduced: live and let live replace strong competitive rivalry, and corporations expand into more markets through strategic alliance.

In sum, corporate strategy deals with three key issues: first (directional strategy), the firm moves toward growth, stability, or retrenchment; second (portfolio strategy), the firm competes through its products and business units in industries and markets; third (parenting strategy), the management coordinates activities, transfers resources, and cultivates capabilities among product lines and business units. The growth of computers and internet communications made firms rethink what industries should be in the future. As Amazon.com became successful in book sales through the internet, it diversified its sales to so many sectors. In the very beginning, internet companies tried to attract more subscribers to provide internet service, but as soon as appropriate number of customers were secured, they started to sell various items like other retail companies with expanding of advertisement.

(End of the Lecture Notes)