Key_Terms_of_Strategic_Management/Key_Terms_in_Strategic_Management
Creating Competitive Advantages
There are two perspectives of leadership:
the romantic view of leadership, and the external view of leadership. The implicit assumption of the romantic view of leadership is that the leader is the key to the (lack of) organizational success. In the external view of leadership, focus is on external factors that influence the success of an organization. Neither of these perspectives is entirely correct, but both have to be acknowledged in strategic management.
Strategic management consists of the actions, decisions, and analyses (these processes are highly interdependent and often don’t occur in a sequential fashion) a firm undertakes in order to achieve a sustainable competitive advantage.
Sustainable competitive advantage is possible only by performing different activities from rivals or performing similar activities in different ways. Performing similar activities better than rivals is called operational effectiveness.
Furthermore, strategic management has four main attributes:
• It is conducted at overall, firm-level organizational goals and objectives;
• It includes multiple stakeholders in the making of decisions;
• It requires managers to have both short-term and long-term perspectives;
• It involves the recognition of trade-offs between effectiveness and efficiency.
Some authors have developed the concept of ambidexterity. Ambidexterity encompasses the manager’s challenge to both align resources to take advantage of existing product markets (which is referred to as exploitation) as well as actively explore a new opportunity (which is referred to as exploration).
Organizational decisions that are determined only by analysis constitute the intended strategy of a firm. The final realized strategy of an organization is strategy in which organizational decisions are both determined by analysis, unforeseen environmental develop-ments, unanticipated resource constraints, and/or changes in managerial preferences.
As mentioned earlier, the three core processes of strategic management are analyses, decisions, and actions. Strategy analysis consists of the work that needs to be done in order to effectively formulate (decide on) and implement strategies (actions). Strategy formulation is developed at different levels: business-level strategy (how to compete in a given business) and corporate-level strategy (what business to compete in, and how to achieve synergy). Lastly, strategy implementation involves ensuring proper strategic controls and organizational designs.
The overall purpose of a corporation is to maximize the long-term return to the owners (shareholders). Corporate governance is the relationship among various participants in determining the direction and performance of corporations. The primary participants in corporate governance are the shareholders, the management, and the board of directors.
There are two opposing ways of looking at the role of stakeholder management. In the zero-sum perspective, stakeholders compete for the resources of the organization: the gain of one stakeholder is the loss of other stakeholders. The stakeholder symbiosis perspective recognizes that stakeholders are dependent upon each other for their success and well-being.
Social responsibility is the expectation that businesses or individuals will try to improve the overall welfare of society. Many companies are now measuring what has been called a triple bottom line, which involves assessing financial, social, and environmental performance.
Stakeholders are organizations, groups, and individuals who have a stake in the success of an organization, including owners, employees, etc.
Effectiveness means tailoring actions to the needs of an organization.
Efficiency refers to performing actions at a low cost relative to a benchmark.
As mentioned earlier, organizations must strive toward common goals and objectives. Firms express priorities best through stated goals and objectives that form a hierarchy of goals, which include the organization’s vision, mission, and strategic objectives. At the top, we find those organizational goals that are less specific yet able to evoke powerful and compelling mental images (a vision), and at the bottom we find the organizational goals that are more specific and measurable (the mission statement and strategic objectives)
A company’s mission statement is a set of organizational goals that include both the purpose of the organization, its scope of operations, and the basis of its competitive advantage.
Finally, strategic objectives are a set of organizational goals that are used to operationalize the mission statement and that are specific and cover a well-defined time frame. For strategic objectives to be meaningful, they must be measurable, specific, appropriate, realistic, and timely.
Analyzing the External Environment of the Firm
Environmental scanning involves surveillance of a firm’s external environment to predict environmental changes and detect changes that are already under way. Environmental monitoring tracks the evolution of trends, sequences of events, or streams of activities. Finally, competitive intelligence aids firms in defining and understanding their industry and identifying rivals’ strengths and weaknesses.
These three processes are the fundamental of environmental forecasting, which refers to the development of plausible projections about the direction, scope, and intensity of environmental change. A danger of forecasting is that managers can underestimate or overestimate uncertainty, which results in decisions that neither take advantage of opportunities nor defend against threats. A more in-depth approach to forecasting is scenario analysis, which involves experts’ detailed assessments of societal trends, economics, politics, technology, or other dimensions of the external environment.
A basic technique for analyzing firm and industry conditions is SWOT analysis. SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. The strengths and weaknesses portion refers to internal conditions of the firm; threats and opportunities are environmental conditions external to the firm. The basic idea of SWOT analysis is that a firm’s strategy must:
• Build on its strengths;
• Try to remedy or avoid the weaknesses;
• Take advantage of the opportunities;
• Protect the firm from the threats.
The SWOT approach is very popular for a number of reasons. It forces managers to simultaneously consider internal and external factors; it encourages firms to be proactive, not reactive; finally, its conceptual simplicity is achieved without sacrificing analytical rigor.
The general environment consists of factors external to an industry, and usually beyond a firm’s control that affect a firm’s strategy. The general environment is divided into six segments. These are demographic, sociocultural, political/legal, technological, economical, and global. Key trends and events are listed below.
The demographic segment includes elements such as the aging population, rising or declining affluence, changes in ethnic composition, geographic distribution of the population, and disparities in income level.
The sociocultural segment includes a higher percentage of women in the workforce, dual-income families, increases in the number of temporary workers, greater concern for healthy diets and physical fitness, greater interest in the environment, and postponement of having kids.
Important areas of the political/legal segment include tort reform, the 1990 Americans with Disabilities Act (ADA), banks being allowed to offer brokerage services, deregulation of utilities and other industries, and increases in the federally mandated minimum wage.
Examples of trends and developments in the technological segment genetic engineering, Internet technology, computer-aided design and computer-aided manufacturing (CAD/CAM), research in artificial and exotic materials, and, on the downside, pollution and global warming.
The economic segment impacts all industries. Key economic indicators include interest rates, unemployment rates, the Consumer Price Index (CPI), the gross domestic product (GDP), and net disposable income.
Firms increasingly operate abroad. Key elements of the global segment include currency exchange rates, increasing global trade, the economic emergence of China, trade agreements amongst national blocs (NAFTA, EU) and the General Agreement on Tariffs and Trade.
In addition to the general environment, managers must consider the competitive environment. This environment consists of many factors that pertain to an industry and affect a firm’s strategies. One of the most commonly used analytical tools for examining the competitive environment is Michael E. Porter’s Five-Forces Model, which the environment in terms of five basic forces:
1. The threat of new entrants;
2. The bargaining power of suppliers;
3. The bargaining power of buyers;
4. The threat of substitutes;
5. The intensity of competitive rivalry.
The threat of new entrants refers to the possibility that the profits of established firms in the industry may be eroded by new competitors. There are six major sources of entry barriers:
(a) economies of scale;
(b) product differentiation;
(c) capital requirements;
(d) switching costs;
(e) access to distribution channels; and
(f) cost disadvantages independent of scale.
If few of these barriers are present, the threat of new entry is high, and vice versa,
The bargaining power of suppliers can drive down industry profitability. Suppliers’ bargaining power will be high in the following instances:
(a) the supplier group is dominated by only a few companies and is more concentrated than the industry it sells to;
(b) the supplier group is not obliged to contend with substitute products for sale to the industry; (c) the industry is not an important customer of the supplier group;
(d) the supplier’s product is an important input to the buyer’s business;
(e) the supplier group’s products are differentiated or it has built up switching costs for the buyer; and
(f) the supplier group poses a credible threat of forward integration.
Like that of suppliers, the bargaining power of customers can also drive down the profits of firms in an industry, especially if a buyer group satisfies the following conditions:
(a) it is concentrated or purchases large volumes relative to seller sales;
(b) the products it purchases from the industry are standard or undifferentiated;
(c) it faces few switching costs;
(d) it earns low profits;
(e) it poses a credible threat of backward integration; and
(f) the industry’s product is unimportant to the quality of its products or services.
All firms in an industry compete with other industries producing substitute products and services. The threat of substitutes limits the potential returns of an industry by placing a ceiling on the prices those firms in an industry can profitably charge. The more attractive the price/performance ratio of substitute products, the tighter the lid on an industry’s profitability is.
The final element of the Five-Forces Model is the intensity of competitive rivalry. Intense rivalry is the result of several interacting factors, including:
(a) numerous or equally balanced competitors;
(b) slow industry growth;
(c) high fixed or storage costs;
(d) lack of differentiation or switching costs;
(e) capacity augmented in large increments; and
(f) high exit barriers.
There are, however, caveats to industry analysis. First, managers should not always avoid low-profit industries, as these can still yield high returns for some players who pursue sound strategies. Second, Porter’s five-force analysis implicitly assumes a zero-sum game, determining how a firm can enhance its position relative to the forces. But this approach can overlook the many potential benefits of developing win-win relationships with buyers and suppliers. Third, the five-force model has been criticized for being essentially a static analysis: external forces and firms’ strategies are continually changing the structure of all industries.
In an industry analysis, two assumptions cannot be assailed: (1) no two firms are totally different, and (2) no two firms are exactly the same. Clusters of firms that share similar strategies are known as strategic groups. The value of strategic grouping is fourfold. First, it helps a firm to identify barriers to mobility that protect a group from attacks by other groups; second, it helps a firm identify groups whose competitive position may be marginal or tenuous; third, it helps chart the future directions of firms’ strategies; and fourth, it is helpful in thinking through the implications of each industry trend for the strategic group as a whole.
Assessing the Internal Environment of the Firm
Value-chain analysis sees the organization as a sequential process of value-creating activities. Activities can be classified in two categories: primary activities and support activities. Primary activities are sequential activities of the value chain that refer to the physical creation of the product or service. There are five primary activities, explained below:
Inbound Logistics: location of distribution facilities to minimize shipping times, excellent material and inventory control systems, systems to reduce time to send “returns” to suppliers, warehouse layout and designs to increase efficiency of operations for incoming materials.
Operations: efficient plant operations to minimize costs, appropriate level of automation in manufacturing, quality production control systems to reduce costs and enhance quality, efficient plant layout and workflow design.
Outbound Logistics: effective shipping processes to provide quick delivery and minimize damages, efficient finished goods warehousing processes, shipping of goods in large lot sizes to minimize transportation costs, quality material handling equipment to increase order picking.
Marketing and Sales: highly motivated and competent sales force, innovative approaches to promotion and advertising, selection of most appropriate distribution channels, proper identification of customer segments and needs, effective pricing strategies.
Service: effective use of procedures to solicit customer feedback and to act on information, quick response to customer needs and emergencies, ability to furnish replacement parts as required, effective management of parts and equipment inventory, quality of service personnel and ongoing training, appropriate warranty and guarantee policies.
Next to primary activities, there are support activities, i.e. activities of the value chain that either add value by themselves or add value through important relationships with primary and other support activities. There are four support activities, listed and explained below:
General Administration: effective planning systems to attain overall goals and objectives, ability of top management to anticipate and act on key environmental trends and events, ability to obtain low-cost funds for capital expenditures and working capital, excellent relationships with diverse stakeholder groups, ability to coordinate and integrate activities across the “value system”, high visibility to inculcate organizational culture and values, effective IT to integrate value-creating activities.
Human Resource Management: effective recruiting and development and retention mechanisms for employees, quality relations with trade unions, quality work environment to maximize overall employee performance and minimize absentee-ism, reward and incentive programs to motivate.
Technology Development: effective R&D activities for process and product initiatives, positive collaborative relationships between R&D and other departments, state-of-the-art facilities and equipment, culture that enhances creativity and innovation, excellent qualifications of personnel.
Procurement: procurement of raw material inputs to optimize quality and speed and to minimize the associated costs, development of “win-win” relationships with suppliers, effective procedures to purchase advertising and media services, analysis and selection of alternate sources of inputs to minimize dependence on one supplier, ability to make proper lease-vs.-buy decisions.
Managers should not ignore the importance of relationships among value-chain activities. There are two levels: (1) interrelationships between activities within the firm, and (2) relationships among activities within the firm and with other organizations that are part of the firm’s expanded value chain, e.g. buyers and suppliers.
The resource-based view of the firm is the perspective that firms’ competitive advantages are due to their endowment of strategic resources that are valuable, rare, costly to imitate, and costly to substitute. It combines two perspectives: (1) the internal analysis of phenomena within a company, and (2) an external analysis of the industry and its competitive environment. A firm possesses three key types of resources, explained below.
Tangible resources are organizational assets that are relatively easy to identify, including financial resources, physical assets, organizational resources, and technological resources. Intangible resources are organizational assets that are difficult to identify and account for and are typically embedded in unique routines and practices, including human resources, reputation resources, and innovation resources. Organizational capabilities are the competencies and skills that a firm employs to transform inputs into outputs.
For a resource to provide a firm with the potential for a sustainable competitive advantage it must have four attributes. It must be valuable (neutralize threats and exploit opportunities), rare (not many firms possess), difficult to imitate (physically unique, path dependency, causal ambiguity, social complexity), and difficult to substitute (no equivalent strategic resources or capabilities). Only if a resource satisfies all four of these conditions, it creates sustainable competitive advantages. If a resource is valuable and rare, it creates a temporary competitive advantage; if it is only valuable, it creates competitive parity. If it satisfies none of the conditions, there is a competitive disadvantage.
The resource-based view, however, is not suited for addressing how a firm’s profits will be distributed to a firm’s management and workers. There are four factors that help explain the extent to which employees and managers will be able to obtain a proportionally high level of the profits that they generate:
• Employee bargaining power;
• Employee replacement cost;
• Employee exit cost;
• Manager bargaining power.
Two approaches can be used when evaluating a firm’s performance. The first is financial ratio analysis, which, generally speaking, identifies how a firm performs according to its balance sheet, income statement, and market valuation. The starting point in analyzing the financial position of a firm is to compute and analyze five different types of financial ratios: • Short-term solvency or liquidity;
• Long-term solvency measures;
• Asset management (turnover);
• Market value;
• Profitability.
A meaningful ratio analysis should not only calculate and interpret financial ratios, but also how they change over time and are interrelated.
Path dependency means a resource is developed and/or accumulated through a unique series of events.
Causal ambiguity means a resource is costly to imitate because a competitor cannot determine what it is and/or how it can be recreated.
Social complexity means a resource is costly to imitate because the social engineering required is beyond the capability of competitors, including interpersonal relations among managers, organizational culture, and reputation with buyers and suppliers.
When analyzing firms’ financial performance, important reference points are needed. Issues that must be taken into account to make financial analysis more meaningful are: (a) historical comparisons; (b) comparison with industry norms; and (c) comparison with key competitors. The second approach takes a broader stake-holder view: firms must satisfy a broad range of stakeholders to ensure long-term viability. A method that combines both the second and the first approach is the balanced scorecard, which is a method to evaluate a firm’s performance using the following four questions:
• How do customers see us? (i.e. the customer perspective);
• What must we excel at? (i.e. the internal business perspective);
• Can we keep improving/creating value? (i.e. the innovation and learning perspective);
• How do we look to shareholders? (i.e. the financial perspective).
While most agree that the balanced scorecard concept is an appropriate and useful tool, there are design and implementation issues that may decrease its value, including: (a) lack of clear strategy; (b) limited or ineffective executive sponsorship; (c) too much emphasis on financial measures rather than nonfinancial measures; (d) poor data on actual performance; (e) in-appropriate links of scorecard measures to compensation; and (f) inconsistent or inappro-priate terminology.
Recognizing a Firm’s Intellectual Assets
In the knowledge economy, wealth is created through the effective management of workers instead of by the efficient control of physical and financial assets. Many have defined intellectual capital as the difference between the market value and the book value of the firm, including assets such as reputation, employee loyalty and commitment, customer relationships, company values, brand names, and the experience and skills of employees. Intellectual capital can be divided into four types of knowledge.
Explicit knowledge is knowledge that is codified, documented, easily reproduced, and widely distributed. Tacit knowledge is knowledge that is in the minds of employees and is based on their experiences and backgrounds.
Human capital is the individual capabilities, skills, knowledge, and experience of the firm’s employees and managers. Human capital consists of three interdependent activities: (1) attracting human capital; (2) retaining human capital; and (3) developing human capital. For developing human capital, it is especially impor-tant to: (3.a) encourage widespread development; (3.b) transfer knowledge; (3.c) monitor progress and track development; and (3.d) evaluate human capital. For retaining human capital, firms need: (2.a) their people to identify with the organization’s mission and values; (2.b) create challenging work and a stimulating environment; and (2.c) provide (non-)financial rewards and incentives.
Finally, social capital is the network of relation-ships that individuals have both outside and inside the organization. Developing social capital helps tie knowledge workers to a given firm. The Pied Piper Effect refers to groups of professionals, not individuals, who en-masse leave (or join) an organization. Social relation-ships thus provide an important mechanism for obtaining both resources and information from individuals and organizations outside the firm.
Part of social capital is the social network. Social network analysis depicts the pattern of inter-actions between individuals and aids to diagnose effective and ineffective patterns. In a social relationship, there are closure (the degree to which members of a social network have ties with other group members) and bridging (stress the importance of ties connecting otherwise disconnected people) relationships. Structural holes are social gaps between groups in a social network where there are few relationships that bridge the groups. A potential downside of social capital is called groupthink, which is a tendency for individuals in an organization not to question shared beliefs.
Nowadays, technology plays an important role in leveraging knowledge and human capital. The use of technology has also allowed professionals to work as part of electronic teams to enhance the speed and effectiveness with which products are developed. Advantages of e-teams are that they not restricted by geographic constraints, and they can be very effective in generating social capital. However, challenges include a lack of what is called “identification and combi-nation”. These two processes are central to the effective functioning of face-to-face groups.
Intellectual property rights are more difficult to determine and protect than property rights for physical assets. But if intellectual property is not reliably protected by the state, no individuals will have the incentive to develop new products and services. Dynamic capabilities entail the capacity to build and protect a competitive advantage. They are about the ability of an organization to challenge the conventional wisdom within its industry and market, learn and innovate, adapt to the changing world, and continuously adopt new ways to serve the evolving needs of the market.
Business-Level Strategy
Michael E. Porter described three generic strategies that a firm can use to achieve a compe-titive advantage. The first of these strategies is overall cost leadership, which is based on appeal to the industry-wide market using a competitive advantage based on low cost. To generate above-average performance, a firm that uses this strategy must attain competitive parity on the basis of differentiation relative to its competitors. There are a number of potential pitfalls that a cost leadership strategy encounters: (a) too much focus on one or a few value-chain activities; (b) all rivals share a common input or raw material; (c) the strategy is imitated too easily; (d) a lack of parity on differentiation; and (e) erosion of cost advantages when the pricing information available to customers increases.
The second generic strategy is a differentiation strategy. As the name implies, this strategy consists of creating differences in the firm’s product or service offering by creating some-thing that is perceived industry-wide as unique and valued by customers. Firms create sustain-able differentiation advantages and attain above average performance when their price premiums exceed the extra costs incurred in being unique. Pitfalls of the differentiation strategy include: (a) uniqueness that is not valuable; (b) too much differentiation; (c) the price premium is too high; (d) differentiation that is too easily imitated; (e) dilution of brand identification through product-line extensions; and (f) perceptions of differen-tiation may vary between buyers and sellers.
The third and final generic strategy, the focus strategy, is based on a narrow competitive scope within an industry. Essentially this strategy is about the exploitation of a particular market niche. Focus strategy has two variants: cost focus (creating a cost advantage in the target segment) and differentiation focus (differentiate in the target market). Potential pitfalls of focus strategies are: (a) erosion of cost advantages within the narrow segment; (b) even product and service offerings that are highly focused are subject to competition from new entrants and from imitation; and (c) focusers can become too focused to satisfy buyer needs.
High performers are firms that attain both cost and differentiation advantages. This strategy allows a firm to provide two types of value to customers: differentiated attributes and lower prices. There are three approaches to combining overall low-cost and differentiation: (1) auto-mated and flexible manufacturing systems; (2) exploiting the profit pool concept for sustain-able competitive advantage; and (3) coordinating the “extended” value chain by way of infor-mation technology. Pitfalls of this integrated approach are: (a) failing to attain both strategies may result in ending up with neither one – i.e. being stuck in the middle; (b) underestimating the challenges and expenses associated with coordinating value-creating activities in the extended value chain; and (c) miscalculating sources of revenue and profit pools in the firm’s industry.
The industry life cycle refers to the stages of introduction, growth, maturity, and decline that occur over the life of an industry. Below, each stage of the industry life cycle will be discussed.
The first stage of the industry life cycle is the introduction stage. It is characterized by new products that are not yet known to customers, poorly defined market segments, unspecified product features, low sales growth, rapid techno-logical change, operating losses, and a need for financial support. The challenge that firms face in the introduction stage becomes one of: (a) developing the product and finding ways to get users to try it; and (b) generating enough exposure so the product emerges as the standard by which all other rivals’ products are evaluated.
The second stage is the growth stage. This stage is characterized by strong increases in sales, growing competition, developing brand recog-nition, and a need for financing complementary value-chain activities such as marketing, sales, customer service, and research and development. The primary key to success in this stage is to build consumer preferences for specific brands. In this stage, revenues increase at an accelerating pace because: (a) new consumers are trying the product; and (b) a growing proportion of satis-fied customers are making repeat purchases.
The third stage, the maturity stage, is character-ized by slowing demand growth, saturated markets, direct competition, price competition, and strategic emphasis on efficient operations. By (re)positioning their products in unexpected ways, firms can change how customers mentally categorize them. This can be done using one of two strategies: reverse positioning, which strips away product attributes while adding new ones, resulting in a lower prices, and breakaway positioning, which associates the product with a radically different category. Similar to reverse positioning, this strategy permits the product to shift backward on the life-cycle curve, moving from the dismal maturity phase to a growth opportunity.
The final stage of the industry life cycle is the decline stage. This stage is characterized by falling sales and profits, increasing price compe-tition, and industry consolidation. Firms must face up to the strategic choices of either exiting or staying and attempting to consolidate their position in the industry. Four basic strategies are available in the decline phase: (1) maintaining; (2) harvesting; (3) exiting the market; and (4) consolidation.
A turnaround strategy is a strategy that reverses a firm’s decline in performance and returns it to growth and profitability. A need for turnaround may occur in any stage of the life cycle, but is most prevalent in the maturity and decline stage. There are three basic turnaround strategies: (1) asset and cost surgery; (2) selective product and market pruning; and (3) piecemeal productivity improvements.
Corporate-Level Strategy
Firms diversify to achieve synergy. There are two meanings to this term: related diversification enables a firm to benefit from horizontal relationships across different businesses in the diversified corporation by leveraging core competencies and sharing activities. This allows a firm to benefit from economies of scope, i.e. cost savings that arise because of this leveraging.
Firms generate value by leveraging their core competencies. Core competencies are a firm’s strategic resources that reflect the collective learning in the organization. Core competencies must meet three criteria to generate value: (1) they must enhance competitive advantage by creating superior customer value; (2) different businesses in the corporation must be similar in at least one important way related to them; and (3) they must be difficult to imitate or substitute.
Organizations can also achieve synergy by sharing activities, i.e. having activities of two or more businesses’ value chains done by one of the businesses. The most common types of synergy that result from sharing activities are cost reductions. Furthermore, sharing activities can also lead to enhanced revenues.
Firms can also achieve related diversification through market power, which entails the firm’s ability to profit through restricting or controlling supply to a market (vertical integration, i.e. an extension of the firm by integrating preceding or successive production processes) or coordinating with other firms to reduce investments (pooled negotiation power).
Benefits of vertical integration include: (a) a secure source of raw materials or distribution channels; (b) protection of and control over valuable asses; (c) access to new business opportunities; and (d) simplified procurement and administrative procedures. However, there are also risks that need to be considered: (a) costs and expenses associated with increased overhead and capital expenditures; (b) loss of flexibility resulting from large investments; (c) problems associated with unbalanced capacities along the value chain; and (d) additional administrative costs associated with managing a more complex set of activities.
In making vertical integration decisions, the following six issues should be considered: (1) is the company satisfied with the quality of the value that its present suppliers and distributors are providing? (2) Are there activities in the industry value chain presently being outsourced or performed independently by others that are a viable source of future profits? (3) Is there a high level of stability in the demand for the products of the organization? (4) How high is the pro-portion of additional production capacity that is actually absorbed by existing products or by the prospects of new and similar products? (5) Does the company have the required competencies to execute the vertical integration strategies? And (6) will the vertical integration initiative have potential negative impacts on the firm’s stake-holders?
Another approach that prove to be very useful in understanding vertical integration is the transaction cost perspective, which is a perspective that the choice of a transaction’s governance structure (such as vertical integration or market transaction) is influenced by transaction costs, including search, negotiation, contracting, monitoring, and enforcement costs, associated with each choice. Vertical integration, however, gives rise to a different set of costs referred to as administrative costs.
Contrary to in related diversification, potential benefits in unrelated diversification can be gained from vertical relationships, i.e. creation of synergies from the interaction of the corporate office with the individual business units. There are two main sources of such synergies: parenting and restructuring, and portfolio management. Both perspectives will be discussed in the following paragraphs.
The positive contributions of the corporate office to a new business as a result of expertise and support provided and not as a result of substantial changes in assets, capital structure, or management is referred to as the parenting advantage. Another means by which the corporate office can add substantial value to a business is by restructuring, which is defined as the intervention of the corporate office in a new business that substantially changes the assets, capital structure (capital restructuring), and/or management, including selling off parts of the business (asset restructuring) changing management (management restructuring), reducing payroll and unnecessary sources of expenses, changing strategies, and infusing the new business with new technology, processes, and reward systems.
Portfolio management is a method of (a) assessing the competitive position of a business within a corporation, (b) suggesting strategic alternatives for each business, and (c) to identify priorities for the allocation of resources between the businesses. The key purpose of portfolio management is to assist a firm in achieving a balanced portfolio of businesses.
The Boston Consultancy Group has identified four types of strategic business units:
• Stars are competing in high-growth industries; relatively high market shares; long-term growth potential; should continue to receive substantial funding.
• Question marks are competing in high growth industries; relatively low market shares; invest resources to enhance their competitive positions;
• Cash cows have high market shares; low-growth industry; limited long-run potential; present source of current cash flows to support stars/question marks;
• Dogs have weak market share; low-growth industries; limited potential; recommend divesting.
In using portfolio management, a firm tries to create synergies and value in a number of ways. First, portfolio analysis gives a snapshot of the businesses in a corporation’s portfolio, enabling more effective resource allocation. Second, the expertise and analytical resources in the corporate office provide guidance in determining what firms may be (un)attractive acquisitions. Third, the corporate office is able to provide financial resources to the business units on favorable terms that reflect the corporation’s overall ability to raise funds.
There are, however, a number of limitations to portfolio analysis: (1) they are overly simplistic, because they consists only of the dimensions of growth and market share; (2) they view each business as separate, ignoring potential synergies; (3) the process may become overly mechanical, ignoring judgment and expertise; (4) the reliance on strict rules for resource distribution across strategic business units can be detrimental to a firm’s long-term viability; and (5) the imagery (cash cows, question marks, stars and dogs) may lead to overly simplistic prescriptions. The previous part of this chapter has dealt with the types of diversification. The remainder will deal with how diversification can be achieved.
There are three basic means of diversification. Through mergers (the combining of two or more firms into one new legal entity) and acquisitions (the incorporation of one firm into another through purchase), corporations can directly acquire a firm’s assets and competencies.
Motives and benefits of mergers and acquisitions include: (a) obtaining valuable resources that can help an organization expand its product offerings and services; (b) provide firms with the opportunity to attain the three bases of synergy, i.e. leveraging core competencies, sharing activities, and building market power; (c) consolidation within an industry and forcing other players to merge.
However, there are also limitations to mergers and acquisitions: (a) the takeover premium that is paid for an acquisition is very high; (b) competing firms can often imitate any advantages realized or copy synergies that result from the merger and/or acquisition; (c) managers’ credibility and ego might get in the way of sound business decisions; and (d) there can be many cultural issues that may doom the intended benefits from M&A endeavors.
The other side of the “M&A coin” are divestments, which entails the exit of a business from the firm’s portfolio. Divesting a business can accomplish many objectives, including: (1) enabling managers to focus more directly on the firm’s core businesses; (2) providing the firm with more resources to spend on attractive alternatives; and (3) raising cash to fund existing businesses.
A strategic alliance is a cooperative relation-ship between two or more firms. Joint ventures represent a special case of alliances, where two or more firms contribute equity to establish a new legal entity. Both play a prominent role in leading firms’ strategies, because they have many potential advantages, including entering new markets, reducing manufacturing (or other) costs in the value chain, and developing and diffusing new technologies.
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