STRAT 390 Midterm #1

Competitive Level Strategy should ask:

1. How do we compete in this market today?

2. What activity choices will allow us to have

competitive advantage?

3. How will we compete in this market in the future?

Corporate Level Strategy should ask:

1. In which markets should we compete today and in the

future?

2. How does our ownership of a business ensure its

competitiveness today and in the future?

3. How do we organize to maximize corporate advantage?

A company creates corporate advantage when:

It improves the average competitiveness of the individual business units, meaning it helps the business units create and capture more value.

Scope:

Which business units should be a part of a single

company to maximize corporate advantage?

Organizational design:

How do organizations manage to achieve corporate advantage? What interorganizational strategies like

M&A do we need to adopt to achieve the strategic scope?

Technology, Innovation, Platforms, and Artificial Intelligence:

How can companies gain corporate advantage using these more advanced business models?

Horizontal Scope

How wide a range of products does the firm supply?

Related vs unrelated

Vertical Scope

What range of vertically linked activities does the firm encompass?

Upstream vs. downstream

Global Scope

What is the geographical spread of the firm's activities?

Local vs global

How diversification can create value:

Portfolio Management/ Resource Allocation, Restructuring, Synergies

Portfolio Management/ Resource Allocation

This requires the firm to have an informational advantage over the market (external investors)

Restructuring

Improve the performance of individual businesses without necessarily exploiting the linkages between them. This requires the firm to be able to add value in a way that

individual businesses could not do on their own

Synergies

Improve the performance of the portfolio by exploiting linkages across businesses (synergies)

For corporate strategy to create shareholder value, it must meet these tests:

1. Attractiveness Test: Industry must be attractive (potentially)

2. Cost of Entry Test : Future profits must justify cost of entry

3. Better-Off Test: The company needs to be better off with the new business. That is, the new business needs to help the company create value

4. Ownership Test: The businesses have to perform better under common management than they could perform operating as independent stand-alone enterprises!

Corporate strategy creates corporate advantage when two conditions hold:

1. There exist cost benefits through economies of scope or revenue benefits through cross selling to create synergy across the businesses = Better Off

2. It must be less costly for managers to realize these economies of scope than for outside equity holders on their own = Ownership

The "Better Off" Test:

How does owning a new business or keeping an existing

business help your company create value? In terms of diversification, why would you want to add the new business or expand? In terms of scope reduction, does it still make sense to own the existing business?

cross-selling benefits

Diversification can create value by increasing willingness to pay

Economies of scope

Shared activities and other sources of scope economies

The Ownership Test:

Do you have to own a business to

create value from it?

If you're considering an acquisition, would you be better

off writing a contract to get the inputs you need without

ownership? Do you actually have to own it within the

corporate portfolio?

Or, if you're considering a divestiture, would you do

better transacting with an existing business separately

with a contract instead of owning it?

Costs incurred by ownership of multiple businesses:

Cost of headquarters facilities and personnel

E.g., C-suite for corporate center

Cost of coordination

Trying to coordinate takes lots of time and it is hard for a company to have the necessary expertise to do it well

Cost of distraction

Diversified companies often waste resources on doomed products

Cost of social comparison

Employees working on different functions/products are often treated differently

Business Strategy is

about competitive advantage within an industry

- How do we compete in this market?

- What choices will grant us a competitive advantage?

- How will we compete in this market in the future?

Corporate Strategy is

doing this across several businesses

- In which markets should we compete today and in the future? (diversification)

- How does our ownership of business ensure its competitive today and in the

future? (vertical/global integration and horizontal diversification)

- How do we organize to maximize corporate advantage?

Economies of scope

exist when using a

resource across multiple activities uses less of

that resource than when the activities are

carried out independently. Economies of scope

exist for similar reasons as economies of scale.

• The key difference is that economies of scale

relate to cost economies from increasing

output of a single product; economies of scope

are cost economies from increasing output of

multiple products

Related diversification (Horizontal Scope)

enables a firm to benefit

from (leverage and exploit) horizontal relationships

across different businesses.

• Enjoy greater revenues through cross selling

(demand side economies of scope)

• Reduce costs by exploiting supply side economies

of scope

7 Powers asks in the context of diversification is: does the firm's entry into a new market bring a Power with it, or does it simply bring capital and management attention that any competitor could match?

SCALE ECONOMIES Reduction of unit costs as volume increases

NETWORK ECONOMIES Value grows with user base

COUNTER-POSITIONING New / unique business model

SWITCHING COSTS High cost for users to leave

BRANDING Durable consumer belief in value

CORNERED RESOURCE Exclusive access to key inputs

PROCESS EXPERTISE Embedded organizational activities delivering superior output

Unrelated diversification:

A firm entering a business that has little interaction with other businesses of a firm

• Two often used bad rationales:

• Risk reduction. E.g., median CEO's salary about 2x expense ratio of index funds

• Attractive industry: firm needs competitive advantage in the new market

No economic rationale

value chain

is a sequence of activities that transform raw materials into

finished products

Vertical Integration

is firm's ownership and control of multiple vertical stages in the supply of a product

Vertical integration (MAKE decision) integrates activities within the firm Outsourcing (BUY decision): buy from the market

Downstream integration:

moving ownership of activities forward in the value chain (closer to the end consumer)

Upstream integration:

Moving ownership of activities backward along the

value chain (towards the inputs of the value chain)

Efficient Market Hypothesis

≈

Efficient Market Hypothesis

The "market" is considered more efficient than an individual firm, as market prices tend to reflect all available information rapidly, while a single company may have less access to complete information and could be subject to internal inefficiencies.

Three key points to this theory:

Information aggregation

Efficiency

Price discovery

Information aggregation:

a market aggregates information from many

participants, leading to a more accurate reflection of overall value compared to a single firm's perspective

Efficiency

In a competitive market, firms are pressured to operate efficiently to stay competitive, which contributes to overall market efficiency

Market firms can achieve economies of scale that in-house

departments producing only for their own needs cannot

Price discovery:

market prices adjust quickly to new information, making it hard for any single entity to consistently exploit market inefficiencies

Coase theorem

There are two types of costs:

-The market has transaction costs: the cost of negotiating, monitoring and enforcing the contract

-Vertical integration (buy) has coordination/ administrative costs: the cost of coordinating and administrating the activities within the hierarchy

To choose between make or buy firms compare transaction costs and coordination costs:

-If transaction costs < coordination costs → market

-If transaction costs > coordination costs → vertical integration

Coase theorem: application

Better Off Test: For a specific set of transactions, is the firm better off conducting transactions in the market or using the hierarchy of the firm?

-Are there technical economies from the physical integration of processes?

-What are the comparative cost of transacting in the market versus the cost of internalizing the same set of transactions?

Ownership test: For a specific set of transactions,

-Can complete contracts be written cost effectively?

-Is close coordination required among transacting parties?

Contracts

Contracts list the set of tasks that each contracting party expects the other to perform. They also list specific remedies in the event that one party does not meet its obligations

• Contracts are not always effective in preventing shirking.

The effectiveness depends on

• The completeness of the contract

• The available body of contract law

• In addition, contracts can be broken:

• Cost of monitoring

• Cost of enforcement (taking the other party to court)

Transaction costs arise from 3 behaviors (3)

OPPORTUNISM

When there is asymmetric information, some people take

advantage of others (dishonesty)

BOUNDED RATIONALITY

Limited memory and decision-making ability. More

information than you can handle

UNCERTAINTY

Of transaction or the environment such that it is difficult to

measure performance

Transaction costs are higher when...

ASSET SPECIFICITY

Transaction specific investments are very difficult in a market relationships. The investment changes bargaining power dynamics

NEED FOR SIGNIFICANT COORDINATION

The cost of managing the information with third parties is

higher than within the firm. (Though with technology it can be lowered)

Asset specificity

is the extent to which the value of an asset is decreased

or lost when it is utilized outside of a certain context (transaction).

• In short: the value of that asset is much greater in that transaction than in other transactions

• An asset with a high level of specificity has use in only certain transactions or for certain purposes → more likely in vertical integration

• An asset with low specificity has multiple uses and purposes → more likely in a market transaction

Make or buy decision:

Make

Good

• Easier to control

• Easier to coordinate

• Better shared knowledge

Bad

Administrative costs

• Low-powered incentives

• Principal - agent problem

Buy

Good

• High-powered incentives

• More flexibility

Bad

• Search & information costs

• Bargaining costs

• Contract enforcement costs

firms compare transaction costs and coordination costs:

• If transaction costs < coordination costs → market

• If transaction costs > coordination costs → vertical integration

Coordination Costs

Coordination costs, or cost of the hierarchy (=costs of the firm), are the costs associated with activities that are not directly productive but are engaged in only as a consequence of the need to coordinate production among the parties in the transaction.

Administrative costs in vertical integration

low-powered incentives

coordination costs

loss of flexibility

compounding risk

Low/high power incentives

Market: high-powered incentives

• Skin in the game, economic incentives determine the market transactions.

• Vertical integration: these incentives become low-powered, weaker

• Agents in the organization are more protected

• Shirking by managers and workers and the administrative controls to deter it (agency problem)

• Internal suppliers can lose incentives to compete (raising costs, lowering quality) -because they have a guaranteed supply

• Less exposure to the market can slow learning and experience effects

Coordination costs

Vertical integration involves managing businesses in very different industries and coordinating costs are associated with managing different stages of the value chain / system

Loss of flexibility

• When the environment is highly uncertain or changing, the market allows for greater flexibility and enables rapid response compared to a system wide coordinated response at a vertically integrated firm

• By integrating, organizations can be slow to respond to changes in technology or demand (Schumpeterian shocks)

Compounding risk

• When the environment is highly uncertain or changing, business risk compounds for a vertically integrated firm

Global Scope vs local responsiveness trade off

Cater to more people or appeal more to less peoples

Global scope along the value chain (advantages)

• A firm can internationalize to access a larger market

• But it can also internationalize to access resources and capabilities:

• From cheaper labor

• To raw materials

• To capabilities: to learn from an industry

Global scope costs

• Liability of foreignness: additional costs of doing business in an unfamiliar cultural and economic environment, and of coordinating across geographic distances

• Loss of reputation: achieving cost savings by globalizing the value chain can lead to losing reputation, when foreign governments or foreign business partners do not enforce working conditions or spouse different values

• Loss of intellectual property: intellectual property laws are very similar across countries due to international treaties, but enforcement varies widely. From copies of trademarks to patent infringement.

Where to enter?

To assess competitive and corporate advantage, the first step is to understand where to enter -and this requires understanding the characteristics of the target country and how they differ from the home country

There are two main ways used to assess these differences

• PESTEL - creating a profile for each country based on a series of factors. The analysis does not depend on the home country of the firm internationalizing.

• CAGE -which studies differences between the home and foreign country, and so it depends on both home and foreign country.

CAGE

CULTURAL distance

ADMINISTRATIVE distance

GEOGRAPHIC distance

ECONOMIC distance

Cultural distance

CULTURAL distance increases with

• Different languages, ethnicities, religions, social norms

• Lack of connecting ethnic /social networks

Industries most affected

• High linguistic content (TV, publishing)

• High cultural content (food, wine, music)

Administrative / political distance

ADMINISTRATIVE / POLITICAL distance increases with

• Absence of shared political or monetary association

• Political hostility

• Weak legal and financial institutions

Industries most affected

• Industries viewed by government as

strategically important (e.g. energy,

defense, telecom)

Geographic

GEOGRAPHIC distance increases with

• Lack of common border, or transportation or

communication links

• Physical remoteness

Industries most affected

• Products with low value-to-weight (cement) or value-to-volume (furniture)

• Industries sensitive to long-shipping times (e.g., produce)

Economic

ECONOMIC distance increases with

• Different consumer incomes

• Differences in resources

• Different information or knowledge

Industries most affected

• Products with income elastic demand (luxuries)

• Labor intensive products (clothing)

Advantages in a global context

Differences across countries create advantages for some countries/ firms

COUNTRY advantage (country specific)

- Input access (raw materials, labor)

- Regulations (taxes, subsidies)

COMPETITIVE advantage (business specific)

- Increasing WTP

- Cost reduction

CORPORATE advantage (multi-business advantages)

- Scale and scope benefits

- Proprietary assets (IP, knowledge)

- Customer needs / preferences

- competition

Choosing Global Scope: Better Off

• Does the presence of the corporation in a given geographic market

improve the total competitive advantage of business units over and

above what they would achieve on their own?

Choosing Global Scope: Ownership test

• Does ownership of the business unit in a geographic market produce

greater competitive advantage than an alternative arrangement would

produce?

Triple A framework: strategies for global value creation

Adaptation: Local responsiveness

Aggregation: Economies of scale

Arbitrage: exploiting differences

X axis - globalization of markets

Y axis - globalization of production

+ X = aggregation

- X = adaptation

+ y = arbitrage

Looks like upside down triangle

Arbitrage

Ex. Factor cost differences - locating

overseas to exploit lower prices of inputs in other countries

-Nike

Aggregation

Economies of scale (Aggregation) - selling in other countries can increase total number of units produced. This may give the opportunity for the firm to exploit economies of scale

Adaptation

Exploiting knowledge around the world (Adaptation) - allows the firm to adapt a product or a strategic capability (developed domestically in general) into a new market OR access ideas from other parts of the world. Companies seek to boost revenues and market share by maximizing their local relevance

Modes of entry: the investment-control continuum

Exporting: Lowest commitment

Licensing / Franchising: Low-moderate

Equity alliances / JVs: Moderate-high

Acquisition / Greenfield: Highest control

Exporting

Produce at home, sell abroad.

Oldest and lowest-commitment mode — often used to test whether a market is ready.

Strength: low investment, easy to reverse.

Limitation: little local control; exposed to tariffs and exchange rates.

Strategic alliances

Licensing: Grant rights to a local

firm for a fee/royalty

Franchising: License a whole business format — brand, process, standards

Joint ventures: Shared ownership of a new local entity.

Local control and capital, in exchange for sharing profits and know-how

Wholly-owned subsidiary

Acquisition: Buy an established local player — fast, but integration risk

Greenfield: Build from scratch — full control, slower and costlier

The entry tradeoff

MORE control & commitment

— Capture more value and protect IP

— Learn the market directly

— But: higher cost, harder to reverse

LESS commitment, more flexibility

— Speed and low capital

— Local partners bring market knowledge

— But: shared margin and weaker control

The integration-responsiveness framework

4 quadrants: X axis = pressure for local responsiveness

Y axis = pressure for cost reduction

Q1= TRANSNATIONAL

Q2= GLOBAL STANDARDIZATION

Q3= INTERNATIONAL

Q4= MULTIDOMESTIC

International strategy

Low cost pressure / low responsiveness

— Leverage home-based core competencies abroad

— Sell largely the same product, lightly changed

— Often the first step; relies on exporting/licensing

Watch for:

- Exposed to exchange rates and IP theft; little local fit.

Ex. Harley, Rolex

Multidomestic strategy

Low cost pressure / high responsiveness

— Maximize local responsiveness; be perceived as local

— Autonomous country units; common in food & drink

— Reduced scale and learning across regions

← Pernod Ricard

Now under integration pressure.

Ex. Nestle

Global-standardization strategy

HIGH cost pressure / low responsiveness

— Global division of labor at lowest cost

— Best-of-class capabilities wherever they sit

— Business-level strategy: cost leadership

Watch for:

A "race to the bottom" as wages rise; no local fit

Ex. Lenovo

Transnational strategy

HIGH cost pressure / HIGH responsiveness

— "Think global, act local" — both at once

— Run through a global matrix structure

— Echoes AAA: aggregation + adaptation together

Watch for:

The matrix is costly and hard to run — high failure rate

Ex. P&G

SPECIALIZATION raises productivity — but it creates two problems

COORDINATION: Getting people to work together:

Specialized, interdependent efforts have to be integrated

COOPERATION: The agency problem: people's goals

don't automatically line up with the firm's

Good organizational design does three things

1 Influences behavior: so people do what the organization needs

2 Routes information: so decision-makers have what they need

3 Allocates decision rights: to the people who will use them well

Put authority where it will be used well — with whoever holds the relevant knowledge and bears the consequences.

Centralize when the center knows best; push decisions down when local knowledge and speed matter.

Organizational structure: what it is

Organizational structure describes how an organization

allocates, coordinates, and supervises tasks to achieve its goals.

It is the firm's answer to the specialization-coordination-

cooperation problem

Types of organizational structures

SIMPLE

Owner / manager + employees

FUNCTIONAL (U-form)

Grouped by activity: R&D, Mfg, Sales, Mktg

DIVISIONAL (M-form)

Grouped by output: product or geography

Functional Structure

Structure Description: McDonald's operates with clear functional departments - Operations, Marketing, Finance, Human Resources, Supply Chain, and Technology -

each with specialized expertise reporting up through a hierarchical chain.

Successes: Operational Excellence, Cost

Efficiency, Brand Uniformity, Deep Expertise

Challenges: Slow Innovation, Local

Adaptation, Cross-functional Coordination

Divisional Structure

Structure Description: P&G operates through five global business units (Baby, Feminine & Family Care; Health Care; Fabric & Home Care, etc.), each led by a CEO with complete

autonomy and profit/loss responsibility

• Successes: Market Responsiveness, Innovation Speed, Clear Accountability, Global-Local Balance

• Challenges: Resource Duplication, Internal Competition, Coordination Difficulties, Scale Inefficiencies:

Metrix Structure

Two reporting lines at once

Strength:

captures both economies of scale and local responsiveness.

Cost:

dual authority, conflict, and political complexity.

Structure Description: Unilever uses a matrix where employees report to both functional

managers (R&D, Marketing, Finance) and product/project managers (Foods, Personal Care,

Home Care, etc.), creating cross-functional project teams.

Successes: Innovation Excellence, Resource Optimization, Knowledge Sharing, Market Agility

Challenges: Role Confusion, Communication Complexity, Employee Stress, Slow Decision Making

The McKinsey 7-S framework

Strategy

Structure

Systems

Style

Skills

Shared Values

Staff

Move one S, and the others must move with it.

A new strategy that is not matched by structure, systems, staff, skills, style,

and shared values will stall.

Merger

The firms purchase a fraction of each other's assets

• Typically, they are not unfriendly ("merger of equals")

• One of the parent firms usually emerges as the dominant

management

Acquisition

A firm buys another firm's stock using any (or mix) of cash,

debt and equity

• Acquiring firm takes a controlling, majority or complete share

in target firm

• An acquisition can be friendly or hostile

• Mostly through an open tender by offering a premium over

the current stock price of the target firm

For whom do M&As create value?

On average, M&A activity creates value, but target firms capture it

Negative- Acquirer

On average, value destroyed (negative value)

Positive- Target

On average, value created (

Why lack of value capture?

Premium paid - for the deal to break even the acquired company must now do better than what the market had already priced into the shares

Faulty assumptions

a. Melding businesses is costless

b. Synergies will ride to the rescue

c. The target will improve operational weakness of the acquirer

What is the "social proof" effect?

One means we use to determine what is correct is to find out what other people think is correct. Applies especially to what constitutes correct behavior

In times of uncertainty, the natural tendency is to look around at the actions of others for clues

Motivation for M&A

1 To ensure survival

e.g. M&A activity among banks during the financial crisis

2 Free cash flow

Utilize excess cash generated instead of giving dividends or buying back stocks

3 Agency problems

Managers' desire for status and pecuniary benefits

4 Managerial hubris

Over-confidence that acquiring firm can manage the target firm's assets more efficiently

5 Potential for above normal profits

Some mergers and acquisitions have the potential to create value for both the acquirer and the target

Determinants of merger success

Strategic vision and fit

Due diligence

Pre-merger

planning

Post-merger

integration

Strategic vision and fit

Having a clear merger rationale that

• Articulates and focuses on long-term competitive advantage

• Designed for synergies in size, geography, people, or service

• Partners are the right choices to fulfill the strategic vision

Strategic Vision and Fit: The Investment Thesis

TYPE OF MERGER

1. The Overcapacity M&A

2. The Geographic Roll-up M&A

3. The Product or Market Extension M&A

4. M&A as R&D

Overcapacity M&A

strategic objective / investment thesis

eliminate overcapacity, gain market share, and create a

more efficient operation

The Geographic Roll-up M&A

strategic objective / investment thesis

expands geographically by buying many small units;

operating units remain local.

Common in fragmented industries

The Product or Market Extension M&A

strategic objective / investment thesis

Extend a company's product line or its international

coverage

M&A as R&D

strategic objective / investment thesis

Used in lieu of in-house R&D to build market position

quickly

synergies

In M&A, synergies are the additional value created

when two companies combine.

These synergies generally fall into three categories:

cost, revenue or other

Cost synergies

Aim to reduce or optimize costs by combining operations,

eliminating redundancies, and improving efficiency

Often realized more quickly than revenue synergies

Revenue synergies

Aim to increase the combined company's ability to generate

sales or reach new markets, focusing on top-line growth