3.1 business growth

why do some firms remain small?

• Operate in niche markets - not enough demand to grow, already profitable where they are, mass production not desirable or viable

• Barriers to entry - e.g. domination of market by large companies means small firms cannot offer competitive prices, therefore cannot enter new markets to grow

• Diseconomies of scale - negative impacts of large scale operations e.g. high costs if they grew too quickly, breakdown of communication and control due to increase in hierarchy and span of control = all lead to inefficiency and increased costs 

• Lack of finance - could be due to lack of personal funds from owner or bank not willing to lend

• More personalised service for consumers, focus on building relationships and loyalty

• Many small firms operate in mass markets with low barriers to entry

• Risk averse owners

why do some firms grow?

• to benefit from economies of scale i.e. lowered cost at a higher output

• owners and shareholders desire greater profit - profit maximisation

• profit can be reinvested

• desire for larger market share - stronger market power

• large firms often have easier access to finance at lower interest rates due to larger borrowing amount

• opportunities for product diversification - risk bearing economies as the risk from any singular area of the market is reduced 

• managerial objectives

what is divorce of ownership from control?

In small businesses, owners typically manage the firm. However, as firms grow, particularly into large companies (e.g., public limited companies), ownership (shareholders) becomes separate from control (managers/directors). Shareholders own the company, but hired managers make the day-to-day decisions.

This leads to the PRINCIPLE AGENT PROBLEM.

what is the principle agent problem?

This problem arises when the interests of the owner (principal) and the manager (agent) of a firm do not align, leading to conflicts.

• e.g. Shareholders want to maximise their profits, but workers want to maximise their salaries

• e.g. Shareholders want to maximise their profits, but managers may want to maximise the number of sales over the value of the sales

• Misaligned Incentives: Managers may prioritize personal gain over maximizing shareholder wealth e.g. CEOs receiving large bonuses even if company performance declines, leading to shareholders losing value.

• Risk Aversion: Managers may avoid taking risks that could benefit the firm but endanger their job security e.g. Managers may resist long-term investments in research and development due to the uncertainty involved.

• The problem is exacerbated by information gaps in that the agents have a lot more information than the owners and are often able to control the flow of that infromation

how can the principle agent problem be tackled?

Various mechanisms like performance-based pay, monitoring, and corporate governance are used to align interests.

• Stock options and bonuses tied to company performance can align the interests of managers and shareholders.

• Another way that Principals attempt to diminish the problem is by granting share options to managers. If managers are shareholders, then they will be likely to align their interests more with those of the owners

what is a public sector organisation?

Public sector organisations are owned, funded and controlled by the Government e.g. through taxation or government borrowing

Their goal is not profit maximisation but to provide a service. Primarily driven by providing public services, social welfare, or achieving government policy objectives (e.g., efficiency, equity, welfare maximisation, economic stability). Profit is not the main goal.

• There are a wide variety of government owned organisations in the UK

  • Corporations like the BBC and Channel 4

  • National services such as State Schools and National Health Service Trusts

  • Local services such as Transport for London

  • Civil service departments such as Defence, Police, Education

  • Regulatory bodies such as the General Dental Council

what are private sector organisations

Owned and controlled by private individuals and entities

Primary goal is profit maximisation

This often means the private sector is more efficient than the public sector, with higher levels of productivity and response to consumers - as they operate in a competitive market

Private sector organisations rely on investments, loans, and revenue

Types of ownership vary from sole traders, partnerships, private limited companies (Ltd), public limited companies (PLC), multinational corporations.

e.g. Amazon

what are profit organisations

Primary Objective: To generate a financial surplus (profit) for its owners or shareholders.

Distribution of Surplus: Profits are typically distributed to owners (e.g., as dividends to shareholders) or reinvested into the business for future growth.

Motivation: Driven by financial incentives and market competition.

Examples: All private sector firms (sole traders, partnerships, limited companies, etc.) are generally profit-seeking, though their objectives may sometimes deviate (e.g., sales maximisation, growth maximisation).

what are non-profit organisations

Primary Objective: To achieve a social, charitable, educational, or community-based mission, rather than generating profit for owners. Any surplus generated is reinvested to further their mission. Aim is to provide a service or meet a need e.g. for social impact, providing a public good, or other specific causes

Often funded by donations and grants

Exempt from direct taxes that profit organisations have to pay

Examples:

• charities like Oxfam

• social enterprises which are businesses that aim to address a social or environmental problem while operating commercially (e.g., a coffee shop employing homeless people)

• voluntary organisations such as community groups, sports clubs.

• public sector bodies like the NHS providing healthcare

what is organic business growth

Organic growth is the process of a business expanding its operations internally, relying on its own resources and increasing sales and revenue gradually over time. This can include expanding into new markets, introducing new products or services, and increasing market share.

what is vertical integration?

Vertical integration involves a company expanding its operations either upstream (backward) or downstream (forward) in the supply chain. Backward integration means acquiring suppliers or producers, while forward integration involves acquiring distribution channels or retailers.

When a firm merge with or takes over another firm that is at a different stage of the same production process or supply chain

The aim of vertical integration is often to gain greater control over the supply chain, reduce costs, enhance quality control, or secure vital inputs or distribution channels.

what is horizontal integration

Horizontal integration occurs when a company acquires or merges with competitors or businesses in the same industry. This strategy aims to increase market share and reduce competition by consolidating similar businesses.

One company combines with another that operates at the same level in the value chain in a particular industry.

Three ways:

• Merging with another company - In this approach to horizontal integration, two separate companies come together to create a newly combined organisation. In some cases, the individual brands remain intact while sharing common operations and resources; in other cases, one brand is absorbed by another. Mergers often occur among companies offering similar products or services that have relatively equal positions in the market.

• Acquiring another company: A horizontal integration may also involve one company purchasing and taking over the operations of another company. The acquiring company assumes control of the purchased company, integrating staff and other resources as needed. Business leaders will often pursue horizontal integration by acquisition to procure an advantage in the marketplace.

• Expanding internally: Companies may also achieve horizontal integration by strategically deploying capital in-house to expand their own presence at the same level of the value chain.

Examples:

Failure: 2015: Heinz’s merger with Kraft Foods The horizontal integration of Kraft Foods and Heinz, in a deal valued at $46 billion, created one of the largest food companies in the world. But the results were less than stellar. As a 2019 New York Times article pointed out, the post-merger company faced slumping sales, shareholder lawsuits, layoffs and questions about its accounting practises.

Success: 2012: The Facebook (Meta) acquisition of Instagram The rationale behind Facebook’s billion-dollar acquisition of photo-sharing social media platform Instagram is a tale as old as business: Instagram was becoming a competitive threat. The company paid a high price to neutralise the competition, but the strategy has reaped rewards. In 2022, Instagram was responsible for 41.5% of Facebook’s revenues, as its ad revenues outpaced those of Facebook, which were in decline.

what is external business growth

External growth refers to growth achieved by merging with or taking over another business.

what is forward vertical integration?

Forward vertical integration occurs when a firm merge with or takes over a firm that is at a later stage of the production process or supply chain, moving closer to the final consumer. Essentially, the firm acquires one of its distributors or retailers.

Example: In addition to backward integration, Apple also famously engaged in forward integration by opening its own Apple Stores worldwide.

• Explanation: This allowed Apple to control the entire customer experience, from product display and sales to Genius Bar support. It ensured that its premium products were sold in an environment that reflected their brand value and allowed for direct customer feedback and relationship building.

what is backward vertical integration

Backward vertical integration occurs when a firm merges with or takes over a firm that is at an earlier stage of the production process or supply chain. Essentially, the firm acquires one of its suppliers.

Example:

1. Nestlé: The global food and beverage giant has engaged in backward integration by owning and operating cocoa farms in some regions, or by having very close direct relationships with farming cooperatives.

   • Explanation: For a company like Nestlé, securing a consistent supply of key agricultural raw materials like cocoa beans, and ensuring their quality and ethical sourcing, is crucial for its various chocolate and food products. Direct control or strong ties mitigate risks in the supply chain.

what are reasons for forward vertical integration

Reasons for Forward Integration:

• Control over Distribution: Ensures that the product reaches the end consumer effectively, is displayed correctly, and is sold under the firm's desired conditions. Prevents issues with independent distributors prioritizing competitors' products.

• Enhanced Customer Experience: Allows the firm to directly control the sales environment and customer service, aligning it with the brand image and ensuring a consistent experience.

• Direct Access to Customer Data: Owning retail channels provides invaluable direct feedback and data on customer preferences, buying habits, and market trends, which can inform product development and marketing strategies.

• Increased Profit Margins: By cutting out intermediaries (wholesalers, retailers), the firm captures the profit margin that these entities would otherwise take, potentially increasing overall profitability.

• Stronger Brand Presence: Direct interaction with consumers can build stronger brand loyalty and recognition.

what are reasons for backward vertical integration

Reasons for Backward Integration:

• Secure Supply of Inputs: Ensures a reliable and consistent supply of raw materials or components, reducing reliance on external suppliers who might face disruptions or sudden price increases.

• Cost Reduction: By bringing production in-house, the firm might eliminate the profit margins charged by independent suppliers, potentially leading to lower unit costs. It can also gain from economies of scale if its demand is large enough.

• Quality Control: Allows the firm to monitor and control the quality of inputs more directly, ensuring they meet specific standards for the final product.

• Intellectual Property Protection: For highly specialised or sensitive components, backward integration can prevent critical information or technology from leaking to competitors.

what are the pros and cons of organic growth

Advantages:

• Sustainable and controlled expansion.

• Lower financial risk as it relies on internal resources.

• Builds on existing strengths and expertise.

Disadvantages:

• Slower growth compared to other strategies.

• Limited in terms of rapid market capture.

• Requires time and patience to see substantial results.

what are the pros and cons of vertical integration

Advantages:

• Increased control over the supply chain.

• Cost efficiencies through elimination of middlemen.

• Better coordination and quality control.

Disadvantages:

• High upfront costs for acquisitions.

• Potential for increased risk if the integrated supply chain faces challenges.

• Regulatory scrutiny and antitrust concerns.

what are the pros and cons of horizontal integration

Benefits:

• reduced competition

• increased market share/power

• increased customer base

• revenue growth

• improved efficiency - reduce overall costs by sharing resources

• Greater product and service differentiation - A company may integrate with another business that sells different or complementary products or services

• Access to new markets - One company may merge with or acquire another company that operates in a different market

• potential for economies of scale

Challenges:

• Integration challenges, such as cultural differences or leadership clashes

• May divert management’s attention from core operations.

• Reduced flexibility - As organisations grow larger, they can become less adaptable to changes in the marketplace, decreased ability to innovate

• Failed expectations - The anticipated benefits of horizontal integration may not always materialise, and overhyped economies of scales may not deliver the predicted savings for the integrated organisation. In the worst-case scenario, a failed horizontal integration can destroy value for the organisations involved.

• Regulatory and legal issues. While the purpose of horizontal integration is sometimes to absorb competition, widespread industry consolidation can lead to monopolistic behaviours, like price gouging and limited choices for consumers.

what is conglomerate integration

Conglomerate integration involves a company diversifying its operations by acquiring businesses in unrelated industries. This strategy is often used to spread risk and take advantage of opportunities in different markets.

what are the pros and cons of conglomerate integration

Advantages:

• Diversification of risk across different industries.

• Capitalizing on unrelated opportunities.

• Potential for higher returns in diverse markets.

Disadvantages:

• Complexity in managing unrelated businesses.

• Limited synergies between diverse operations.

• Difficulty in achieving economies of scale.

what is horizontal alliance

It is possible for a company to achieve some of the benefits of horizontal integration without merging with or acquiring another company. A horizontal alliance among companies operating at the same level within an industry value chain, also known as horizontal cooperation, can also enable businesses to team up in mutually beneficial ways.

With a horizontal alliance, companies set up a strategic contract with each other to collaborate on some level, but, unlike horizontal integration, each participant continues to operate as an independent company. Companies in a horizontal alliance work together to improve their position in the marketplace, for example, by uniting to provide complementary products or services to customers; pursuing economies of scale in a certain aspect of business, like logistics or distribution; or collaborating on developing or setting standards for an innovative new product.

what are constraints on business growth

• Size of the Market: The size and growth potential of the target market can limit a business's expansion. If the market is small or saturated, it may be challenging to achieve substantial growth.

• Access to Finance: Availability of capital, including loans, investments, and access to equity, is crucial for growth. Limited access to finance can hinder expansion plans.

• Owner Objectives: The goals and risk tolerance of business owners or shareholders can impact growth decisions. Some may prioritize steady, sustainable growth, while others may seek rapid expansion.

• Regulation: Government regulations and industry-specific rules can either facilitate or hinder growth. Regulatory compliance costs and restrictions can affect a business's ability to expand.

Extra:

• Competition: Intense competition in an industry can make it challenging to gain market share and grow. Established competitors can also limit pricing power and market access.

• Technology and Innovation: Staying competitive often requires investment in technology and innovation. A lack of access to cutting-edge technology can hinder growth potential.

• Resource Constraints: Limitations in terms of human resources, production capacity, or infrastructure can constrain a company's ability to meet increased demand or expand into new markets.

• Economic Conditions: Economic downturns, inflation, and currency fluctuations can impact a company's ability to grow profitably.

• Global Factors: International expansion may be constrained by geopolitical instability, trade barriers, and cultural differences.

• Environmental and Social Factors: Increasing attention to sustainability and social responsibility can influence growth strategies and investment decisions.

Successful businesses carefully assess these constraints and develop strategies to mitigate them to achieve sustainable growth.

what are reasons for a demerger

1. Strategic Focus: By separating different business units and shedding non-core assets, a company can concentrate on its core competencies and increase specialisation, and ensure efficient allocation of resources.
2. Unlocking shareholder value: Individual business units often become more attractive to investors as they can be individually evaluated, leading to higher valuations. This avoids conglomerate discount, which is when the market value of a large diversified company is less than the sum of its individual parts.
3. Enhanced Efficiency: Sometimes, large organisations become less efficient due to bureaucracy (hierarchal structures of power). Demergers can lead to streamlined operations and cost reduction.
4. Financial Performance: If a specific business unit is underperforming, a demerger can isolate the poor performance and allow the parent company to focus on improving it or divesting it entirely.
5. Market Pressure: A company might demerge to satisfy regulatory bodies or anti-trust authorities who deem the company's size or market power too dominant. Splitting up can prevent forced break-ups or allow a company to pursue a merger that would otherwise be blocked.
6. Risk Mitigation: By separating different business units, a company can isolate certain risks. This can be particularly important when one business unit poses a significant risk to the overall organization.

7. Tax Benefits: In some cases, demergers can offer tax advantages, such as tax-free spin-offs, that can benefit both the parent company and the spun-off entity.
8. Raising capital - A company might demerge a particular division or asset to generate cash to reduce corporate debt. It can be easier to raise capital for a specialised, standalone business than for a division within a large conglomerate, especially if that division's potential is obscured by the parent company's overall performance. The newly demerged company can seek investment directly, often at a higher valuation.

9. Managing Diverse Cultures / Conflicts of Interest

examples of demergers

In 2015, eBay demerged from its payment’s division, PayPal. The argument was that both companies would perform better as separate entities, focusing purely on their respective e-commerce and digital payments markets without the complexities of managing a conglomerate. eBay could focus on online retail, and PayPal on payment solutions, leading to more agile and competitive operations for both. PayPal’s potential was being hindered by ebay, and it was believed it could become a dominant online payment system rather than just for ebay transactions. Unlock greater shareholder value and focus on respective businesses.

Kraft Foods Inc. completed a significant demerger, splitting into two independent public companies: Kraft Foods Group (focusing on North American grocery products) and Mondelez International (focusing on global snacks and confectionery). This strategic move aimed to unlock shareholder value and allow each entity to pursue distinct growth strategies. The distinct business models and growth prospects of the snack division versus the grocery division were believed to be better appreciated by investors as separate entities, potentially leading to higher valuations for both. Allowed respective North American vs Global focus, providing a stable source of profit from NA and a chance for expansion and innovation from global.

For both, there were upfront costs e.g. legal fees, separations of resources

but benefits for consumers and the firm through increased efficiency and innovation etc

for workers - potential layoffs and change in company culture

what are the impacts of demergers

1. Businesses:

• Parent Company: The parent company may experience a positive impact in terms of increased focus, improved financial performance, and a higher stock price if the demerger is executed well.

• Spun-off Entity: The spun-off entity may have the opportunity to thrive independently, potentially attracting new investors and partners. However, it may also face challenges in establishing its operations and management.
  

2. Workers:

• Parent Company: Employees in the parent company may experience changes in their roles, responsibilities, and working conditions as a result of the demerger. This can create uncertainty and potentially lead to job cuts.

• Spun-off Entity: Workers in the spun-off entity may face similar uncertainties, but they may also benefit from the increased autonomy and focus of the new organisation.
  

3. Consumers:

• Parent Company: Consumers may or may not notice immediate changes, depending on the nature of the business units involved. If the parent company's focus is enhanced, it could potentially lead to better products or services in the long run.

• Spun-off Entity: Consumers of the spun-off entity might see changes in branding, customer service, and product offerings. These changes can be positive or negative, depending on the strategic direction of the spun-off entity.

4. Investors:

• Parent Company: Investors in the parent company may initially see changes in the stock price, but the long-term impact depends on the success of the demerger and the performance of the remaining business.

• Spun-off Entity: Investors in the spun-off entity can experience fluctuations in stock prices and may have different expectations regarding the new company's growth potential.