Strategic Management – Corporate Strategy: Vertical Integration & Diversification

Learning Objectives

• Recognize nine focal aims of Chapter 8:
  • Define corporate strategy; detail the three boundary dimensions.
  • Rationalize why firms pursue growth; contrast profit, risk-spreading, cost, power, and managerial-motivation logics.
  • Compare governance modes used to organize economic activity (markets, hierarchies, hybrids).
  • Distinguish backward vs. forward vertical integration along the industry value chain.
  • Weigh benefits and risks of vertical integration.
  • Catalogue viable substitutes to vertical integration (taper integration, outsourcing, alliances, etc.).
  • Classify major diversification forms (product, geographic, product-market).
  • Apply the Core-Competence × Market matrix to derive strategies.
  • Judge when diversification yields or destroys competitive advantage.

Foundations of Corporate Strategy

• Definition: goal-directed, top-management decisions that establish firm boundaries to secure competitive advantage.
• Boundary decisions fall along three axes:
  • Vertical integration – ownership of upstream inputs or downstream distribution.
  • Diversification – breadth of products/services or industries.
  • Geographic scope – location spread of sales & operations (regional → global).
• Underlying analytical lenses:
  • Core competencies (Ch. 4) – unique, hard-to-imitate resource bundles.
  • Economies of scale – \text{AC}=\frac{TC}{Q} declines as output Q rises.
  • Economies of scope – cost savings across multiple outputs.
  • Transaction-cost economics – compare \text{Costs}{\text{in-house}} vs. \text{Costs}{\text{market}}.

Growth Imperatives

• Firms expand to …
  • Raise profits & shareholder returns.
  • Drive down unit costs via scale.
  • Increase market power (bargaining, pricing, entry deterrence).
  • Diversify the earnings stream, reducing firm-specific risk.
  • Provide managerial motivation (career prospects, prestige, compensation tied to size).

Transaction-Cost Economics (TCE)

• Transaction costs = all costs of economic exchange beyond price.
  • External (market): search, negotiate, monitor, enforce.
  • Internal (hierarchy): recruit, train, coordinate, administrative overhead, plant setup.
• Decision logic:
  • If \text{Costs}{\text{in-house}}
  • If \text{Costs}{\text{market}}
• Diagram recap (Exhibit 8.2): circles for Firm A & B show internal arrows; external arrow denotes market transaction costs.

Organizing Activity: Hierarchy vs. Market (Exhibit 8.3)

• Hierarchy (Firm) advantages: command/control, coordination, protect transaction-specific assets, “community of knowledge.”
• Hierarchy disadvantages: administrative costs, weaker incentives, principal-agent issues.
• Market advantages: high-powered incentives, flexibility.
• Market disadvantages: search & negotiating costs, opportunistic hold-up, incomplete contracts, enforcement difficulty.

Principal-Agent Problem

• Separation of ownership (principal) and control (agent) generates moral hazard – agents may pursue private benefits (jets, golf).
• Mitigation: align incentives via stock options, performance pay.

Information Asymmetry

• One side holds private info → adverse selection & moral hazard.
• Leads to “market for lemons” outcome; examples: used cars, e-commerce fraud, opaque R&D projects.

Make-or-Buy Continuum (Exhibit 8.4)

• Governance modes ranked by integration:
  • Pure market (arm’s-length, short-term contracts).
  • Long-term contracts (licensing, franchising).
  • Equity alliances.
  • Joint ventures.
  • Parent–subsidiary (full ownership).
  • In-house “make.”
• Hybrids combine property rights, control, and incentive structures to balance flexibility vs. coordination.

Vertical Integration

Definitions

• Vertical integration ratio: % of revenue generated inside firm boundaries.
• Backward: ownership moves upstream toward raw materials.
• Forward: ownership moves downstream toward end customer.

Industry Value-Chain Illustration (Exhibit 8.5)

1. Raw materials → 2. Components/intermediates → 3. Assembly & manufacturing → 4. Marketing & sales → 5. After-sales service.

• Upstream Stages 1–2 = backward; downstream 4–5 = forward.

Cell-Phone Value Chain Example

• Raw inputs: chemicals, metals, oil-derived plastics.
• Intermediates: ICs, screens, batteries.
• Assembly/manufacturing.
• Marketing & carrier service bundles.

HTC Case (Exhibit 8.6)

• Backward integration to design (Stage 1) and partial manufacturing.
• Forward integration via branded marketing/sales and alliances with carriers for after-sales support.

Benefits

• Lower cost structure (scale, eliminate supplier margins).
• Quality improvement via in-house control.
• Better scheduling & planning (synchronized throughput).
• Safeguard & exploit specialized assets:
  • Co-location, idiosyncratic equipment, firm-specific human capital.
• Secure critical inputs/distribution (reduce bargaining hazards).

Risks

• Higher fixed costs (capacity duplication).
• Quality erosion if non-core competence.
• Reduced strategic flexibility (asset specificity, exit barriers).
• Antitrust / legal scrutiny for foreclosure.

When to Integrate

• Volatile or scarce raw material supply (e.g., Ford’s iron mines).
• Need to enhance user experience by removing channel frictions.
• Presence of vertical market failure: transactions too risky/costly.

Alternatives

• Taper integration: mix of internal production with external suppliers/distributors (Exhibit 8.7).
• Strategic outsourcing: relocate entire value-chain activities to partners (e.g., HRIS vendors).

Diversification Strategy

Basic Types

• Product diversification: variety of offerings.
• Geographic diversification: variety of locations.
• Product-market diversification: simultaneous breadth.

Corporate Diversification Categories

1. Single Business (> 95 % revenue one activity).
2. Dominant Business (70–95 % one activity, plus others).
3. Related Diversification
   • Related constrained – all businesses share common competencies/resources.
   • Related linked – some businesses share, others independent.
4. Unrelated Diversification (Conglomerate) – no shared competencies.

Core Competence × Market Matrix (Exhibit 8.9)

• Quadrants:
  • Existing core × existing market – leverage to defend/extend.
  • New core × existing market – build competencies to protect base.
  • Existing core × new market – redeploy to future arenas.
  • New core × new market – “mega-opportunities.”

Diversification–Performance Relationship (Exhibit 8.11)

• Inverted-U: Moderate related diversification maximizes performance; single & unrelated extremes underperform.

How Diversification Adds Value

• Economies of scale (cost synergy across SBUs).
• Economies of scope (shared R&D, marketing, distribution).
• Joint cost/value effects ⇒ higher V - C spread.
• Risk pooling of cash flows.
• Internal capital markets: reallocate funds cheaper than external if firm has superior information, lower flotation costs.
  • Must offset coordination & influence costs.

Restructuring & Portfolio Management

• Corporate HQ can create value by reorganizing, divesting, or acquiring SBUs to sharpen focus & exploit core competencies.
• Boston Consulting Group (BCG) Growth-Share Matrix (Exhibit 8.13):
  • Star (high growth, high share): invest for growth.
  • Question Mark (high growth, low share): build or divest.
  • Cash Cow (low growth, high share): milk cash; fund others.
  • Dog (low growth, low share): harvest/divest.

Ethical, Philosophical & Practical Implications

• Vertical foreclosure vs. consumer welfare; regulators watch integrated giants (e.g., big tech).
• Diversification can protect jobs in declining units but may destroy shareholder value—raises stewardship vs. agency debate.
• Outsourcing may hurt communities/workers; presses leaders to weigh cost savings against social responsibility.

Key Equations & Decision Rules

• Integration rule: \text{If}\;\text{Costs}{\text{in-house}}
• Economies of scale: AC=\frac{TC}{Q}; declining AC with larger Q.
• Learning curve (implicit): Cn = C1 n^{-b} where b>0 captures learning.

Integrated Study Tips

• Map every SBU/product to BCG cells; check resource sharing.
• Draw your firm’s value chain; mark stages with make/buy & evaluate risks.
• Use the core competence matrix to brainstorm growth options.
• Apply inverted-U logic: ask whether diversification level is “too little” or “too much.”
• Monitor transaction costs constantly; shifts in technology or regulation can flip the make-buy calculus.