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Vertical Integration Foundations of Strategy Ch. 7 Corporate Strategy Kalie Marchington Jacey Guest Luke Burkett Team 3 Section 2 Company: Amazon Review - Corporate Strategy is concerned with where a firm competes - Business Strategy is concerned with how a firm competes in a particular area of business Scope of the firm - Product Scope- How specialized the firm is in terms of the range of products it supplies (Amazon has a large variety of products offered including food) - Vertical Scope- The range of vertically linked activities the firm encompasses - Geographical Scope- The geographical spread of activities of the firm Narrowing Tesco’s Corporate Scope - Share price declined by 40% in four years - ‘Piling it high and selling it cheap’ - Repositioned the emphasis on quality rather than low prices - In the 1990s Tesco became the first UK supermarket with loyalty cards - Terry Leahy transformed it into a diversified, international retailer - Expanded online and into banking The scope of the firm - What business are we in? - Three dimensions of a firm's scope : product range, presence along the industry value chain, and geographical markets in which it will compete - Amazon's mission and vision statement like many others is broad - Change overtime Vertical Integration - A firm's extension of its activities into the preceding stages of the production process, seen as a way of improving coordination and reducing risk - Recently towards outsourcing and de-integration - Amazon uses vertical integration by using its scale Key concepts for analysing firm scope - Economies of scope- Cost economies that arise from increasing the output of multiple products - Transaction costs- Finding a supplier or buyer entails search costs, making an agreement involves negotiating, drawing up a contract, monitoring that what was promised and is being delivered and if necessary, enforcing the contract through arbitration or litigation - The costs of corporate complexity- Extending the boundaries of the firm can eliminate the transaction costs of the market, but internalizing business transaction imposes its own costs Transaction costs and the scope of the firm Defining Diversification Diversification- The expansion of an existing firm into another product line or field of operation Related diversification- Occurs when a firm expands into a similar field of operation Unrelated diversification- Takes place when the additional product line is very different from the firm's core business The benefits and Costs of Diversification - Growth- Stagnant and declining industries makes diversification an appealing prospect for managers - Risk reduction- The rationale for diversifying to reduce risk is captured by the familiar advice ‘Don’t put all your eggs in one basket’ The benefits and Costs of Diversification ● Value creation: Porters’ essential Tests ○ The attractiveness test ○ The cost of entry test ■ Acquire an established player ■ Establish a new venture Ex. Amazon acquiring Whole Foods ○ The better off test → either the new unit must gain competitive advantage from its link to to corporation or vice versa The benefits and Costs of Diversification ● Exploiting economies of scope ○ Tangible resources → offer economies of scope by creating a single shared facility and eliminating duplication between businesses Ex. British Gas→ a publicly owned gas utility ○ Shared service organizations → supply common administrative and technical services to the organization ○ Intangible resources → offer economies of scope from the ability to extend them to additional businesses at a low marginal cost ■ Brand extension Ex. Starbucks ○ Organizational Capabilities Transaction costs of markets vs. the costs of corporate complexity ● Licensing the use of the resource to another company ○ Starbucks and Pepsi ○ Airports lease space to restaurants and retailers ● But sometimes the transactions costs might be much higher ○ Virgin ● Two key resources ○ Finance ○ Labour ■ Finance → a diversified firm represents an internal capital market (the corporate headquarters allocated funds to different businesses through capital expenditure) ■ Advantages of this: 1. Diversified firms avoid costs of issuing new debt and equity 2. They have better access to information on financial prospects of their different businesses ■ Disadvantages of this: often politicized (turf wars and ego building) Transaction costs of markets vs. the costs of corporate complexity ● Specialized companies → high hiring and firing costs (advertising, interviewing, and headhunting agencies) ● Internal labour market → its pool of employees within the company ● Diversified companies → have advantages when they hire from their own internal labour market ○ Broader set of career opportunities → higher calibre employees ○ Gain information on employees on performance by observing them in different job roles Amazon vs Competitors Amazon Diversification Amazon vs Ebay ● Books ● Ebay is a marketplace that helps ● Electronics (Kindle, Amazon third party buyers and sellers Fire) make transactions ● Amazon Studios (TV show and ● Amazon is also a retailer movie streaming service) ● Grocery Store products ● Clothing ● Pharmaceuticals Does Diversification enhance Corporate Performance How do diversified firms perform relative to specialized firms? Does related diversification outperform unrelated diversification? ● Related diversification offers greater potential benefits than unrelated, but managing these linkages also creates greater management complexity Vertical Integration ● Firm’s ownership of vertically related activities ● Ratio of its value added to its sales revenue ● Backward or Forward ● Full or Partial The Benefits and Costs ● Benefits ○ Offers cost savings from the physical integration of processes ■ Ex. linking two stages of production at a single location ■ Steel production and then rolling the steel into a sheet ○ Eliminates certain transaction costs ● Costs ○ May restrict a company’s ability to benefit from scale economies ○ Reduce flexibility ○ Increase risk Transaction Costs in Vertical Exchanges Market contracts are a result of: ● Low transaction costs ● Many buyers and sellers ● Readily available information ● Buyers and suppliers switching costs are low Vertical integration: ● Bilateral monopolies (each steel strip producer is tied to a steel producer) ● Single supplier and single buyer (depends on bargaining power) ● No market price Vertical Integration ● Differences in Optimal Scale Between Different Stages of Production - ● The Incentive Problem - A vertically integrated organization may experience this type of problem by having low incentive for helping its own workers. A way to prevent this is to have external businesses compete with the internal business to increase efficiency. ● Flexibility - A vertically integrated organization is slow to respond to the market climate and cannot make adjustments as quickly as a market transaction type organization. A way that vertical organizations make up for this is their system-wide flexibility. They are better able to make changes across the whole system quicker than market transaction organizations. ● Compounding Risk - A vertically integrated organization has compounded its risk by being vertical. Since it is producing its own products in house, It cannot easily switch to producing different products that it needs in case its needs change. Assessing Vertical Integration Vertical Integration can be good or bad. It depends. If the organization will benefit from the advantages of Vertical Integration, then there is no reason to outsource. Amazon is one of the best examples of vertical integration as an internet retailer. By doing this, Amazon is able to make huge profits. Different Types of Vertical Relationships Long-Term Contracts - An organization may use long-term contracts to reduce the price of a good that it needs and will need in the future. This type of relationship is hard to predict. If demand rises sharply, long-term contracts may be too restrictive to handle this. Vendor Partnerships - An organization may use this to reduce the cost of purchasing materials. This type of relationship is dependent on the vendor and may exist without a contract at all. Franchising - An organization does this by entering into a contract with a licensee that operates a certain area for the organization. This brings together the brand, marketing capabilities, and business systems of the large organization with the entrepreneurship and local knowledge of smaller firms. Trends in Vertical Integration Vertical Integration can be used to better the supplier-buyer relationship. This can be done by investing in the supplier or buyer. This will cause each business to depend on each other in order to achieve a profit. An opposite trend in the market is an organization that completely outsources its production or service. These organizations can become virtual organizations because of this. It simply coordinates the activities of its suppliers to the completion of its product or service. GE/McKinsey Matrix This matrix uses the key strategic variables from each business in a multi business organization to determine their potential for profit. The matrix can be used to: ● Allocate resources between businesses on the basis of each business’s market attractiveness and competitive position. ● Formulating business unit strategy - by comparing the strategic positioning of different businesses, opportunities for repositioning can be identified. ● Analysing portfolio balance - a single display of all the company’s
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