J370: Chapter 6 What is corporate strategy?

Business strategy: a firms theory of how to gain competitive advantage in a single business or industry. (cost leadership and product differentiation) Corporate strategy: a firms theory of how to gain competitive advantage by operating in several businesses simultaneously. (vertical integration, strategic alliances, diversification, and mergers and acquisitions) What is vertical integration? Value chain: set of activities that must be accomplished to bring a product or service from raw materials to the point that it can be sold to a final customer. A firms level of vertical integration is simply the number of steps in this value chain that a firm accomplishes within its boundaries. Firms that are more vertically integrated accomplish more stages of the value chain within their boundaries than firms that are less vertically integrated. A firm engages in backward vertical integration when it incorporates more stages of the value chain within its boundaries and those stages bring it closer to the beginning of the value chain; that is, closer to gaining access to raw materials. A firm engages in forward vertical integration when it incorporates more stages of the value chain within its boundaries and those stages bring it closer to the end of the value chain; that is, closer to interacting directly with final customers. The value of vertical integration There are several situations where vertical integration can either increase a firms revenues or decrease its costs compared to not vertically integrating. Three of the most influential of these situations of when vertical integration can create value for a firm: 1) Vertical integration and the threat of opportunism Opportunism exists when a firm is unfairly exploited in an exchange. (when a party to an exchange expects a high level of quality in a product it is purchasing, only to discover it has received a lower level of quality than expected) One way to reduce the threat of opportunism is to bring an exchange within the boundary of a firm, that is, to vertically integrate into this exchange. Firms should only bring market exchanges within their boundaries when the cost of vertical integration is less than the cost of opportunism. Research has shown that the threat of opportunism is greatest when a party to exchange has made transaction-specific investments any investment in an exchange that has significantly more value in the current exchange than it does in alternative exchanges. Transaction-specific investments make parties to an exchange vulnerable to opportunism, and vertical integration solves this vulnerability problem. 2) Vertical integration and firm capabilities 2 broad implications:

o Firms should vertically integrate into those business activities where they possess valuable, rare, and costly-to-imitate resources and capabilities; so they can appropriate at least some of the profits that using these capabilities to exploit environmental opportunities will create. o Firms should not vertically integrate into business activities where they do not possess the resources necessary to gain competitive advantages. In essence of the capabilities approach to vertical integration: if a firm possesses valuable, rare, and costly-to-imitate resources in a business activity, it should vertically integrate into that activity; otherwise, no vertical integration. 3) Vertical integration and flexibility Flexibility refers to how costly it is for a firm to alter its strategic and organizational decisions. (high when cost is low) In general, vertically integrating is less flexible than not vertically integrating once a firm has vertically integrated, it has committed its organizational structure, its management controls, and its compensation policies to a particular vertically integrated way of doing business. o In a vertically integrated firm decides to get out of a business, it will have to: Sell to close its factories Alter its supply relationships Hurt customers that have come to rely on it as a partner Change its internal reporting structure o In contrast, if a non-vertically integrated firm decides to get out of business, it simply stops. Flexibility is only valuable when the decision-making setting a firm is facing is uncertain when the future value of an exchange cannot be known when investments in that exchange are being made. A flexibility-based approach to vertical integration suggests that rather than vertically integrating into a business activity whose value is highly uncertain, firms should not vertically integrate and but should instead form a strategic alliance to manage this exchange. o The downside risks associated with investing in a strategic alliance are known and fixed they equal the cost of creating and maintaining the alliance. ---Opportunism logic suggests starting with a search for transaction-specific investments; capabilities logic suggests starting with a search for valuable, rare, and costly-to-imitate resources and capabilities. Flexibility logic suggests starting by looking for sources of uncertainty in an exchange--Applying the theories to the management of call centers One of the most common business functions to be outsourced, and even offshored, is a firms call center activities. 3 theories about how call centers should be managed: 1) Transaction-specific investments and managing call center When the call center approach to providing customer service was first developed in the 1980s, it required substantial levels of transaction-specific investment.

o Great deal of special-purpose equipment had to be purchased. o Employees would have to be fully aware of all problems likely to emerge with the use of a firms products very complex training. Thus, vertical integration into call center management made a great deal of sense. However, as technology improved, training was much faster follow scripts that were prewritten and preloaded onto their computers. Now, not vertically integrating into call center management made a great deal of sense. 2) Capabilities and managing call centers In the early days, how well a firm operated its call centers could actually be a source of competitive advantage. Over time, as more and more call center management suppliers were created, and as the technology and training required to staff a call center became more widely available, the ability of a cost center to be a source of competitive advantage for a firm dropped still valuable, but it was no longer rare or costly to imitate. It is not surprising to see call center management businesses outsourced and the firm focusing on those business functions where they might be able to gain a sustained competitive advantage. 3) Flexibility and managing call center One of the biggest uncertainties is the question of whether the people staffing the phones actually help a firms customers. In the face of this uncertainty, maintaining relationships with several different call center management companies each of who adopted different technological solutions to the problem of how to use call center employees to assist customers who are using very complex products gives a firm technological flexibility that it would not otherwise have, -These three explanations sometimes will contradict each other (opportunism and capabilities explanations of whether Wal-Mart suppliers should forward vertically integrate into the discount retail industry. -However, each approach generally leads to the same conclusion about how a firm should vertically integrate. Vertical integration and sustained competitive advantage In order for vertical integration to be a source of sustained competitive advantage, not only must it be valuable, it must also be rare and costly to imitate, and a firm must be organized to implement it correctly. The rarity of vertical integration Can be rare because it is one of a small number of firms that is able to vertically integrate efficiently or because it is one of a small number of firms that is able to adopt a nonvertically integrated approach to managing an exchange. A firm may be able to create value through vertical integration, when most of its competitors are not able to, for at least 3 reasons: o Rare transaction-specific investment and vertical integration firms that engage in developing new technologies or new business approaches that require its

business partners to make substantial transaction-specific investments, will find it is in their self-interest to vertically integrate. o Rare capabilities and vertical integration if a firm has capabilities that are valuable and rare, then vertically integrating into businesses that exploit these capabilities can enable a firm to gain at least a temporary competitive advantage; the belief that a firm possesses valuable and rare capabilities is often a justification for rare vertical integration decisions in an industry. o Rare uncertainty and vertical integration if a firm is able to resolve uncertainty (ex. new uncertain technology) faster than its competitors, it is able to gain some of the advantages of vertical integration sooner than its competitors. Rare vertical dis-integration Whenever a firm is among the first in its industry to conclude that the level of specific investment required to manage an economic exchange is no longer high, or that a particular exchange is no longer rare or costly to imitate, or that the level of uncertainty about the value of an exchange has increased, it may be among the first in its industry to vertically dis-integrate this exchange. The imitability of vertical integration Both direct duplication and substitution can be used to imitate another firms valuable and rare vertical integration choices. o Direct duplication occurs when competitors develop or obtain the resources and capabilities that enable another firm to implement a valuable and rare vertical integration strategy o Substitutes major substitute for vertical integration is strategic alliances. Organizing to implement vertical integration Involves corporate strategy, organizational structure, management controls, and compensation policies: o Organizational structure and implementing vertical integration U-form structure: same that is used to implement a cost leadership and product differentiation strategy; CEO: strategy formulation and strategy implementation. o Resolving functional conflicts in a vertically integrated firm both expected and normal; CEO: help resolve conflicts in ways that facilitate the implementation of the firms strategy. o Management controls and implementing vertical integration budgeting and management committee oversight processes. Budgeting process developed for costs, revenues, and a variety of other activities performed by a firms functional managers; can have unintended negative consequences (overemphasize short-term behavior that is easy to measure and underemphasize longer-term behavior that is more difficult to measure). To counter the short-termism effects: o The process used in developing budgets is open and participative

o The process reflects the economic reality facing functional managers and the firm o Quantitative evaluations of a functional managers performance are augmented by qualitative evaluations of that performance. Management committee oversight process 2 common are executive committee and operations committee: Executive committee typically consists of CEO and 2 or 3 key functional senior managers; meets weekly to review the performance of the firm on a short-term basis (accounting, legal, and other central functions). Operations committee typically consists of the CEO and each of the heads of the functional areas; tracks performance over time intervals slightly longer than the weekly interval.

Compensation in implementing vertical integration strategies Opportunism-based vertical integration and compensation policy suggests that employees who make firm-specific investments, investments made by employees that have more value in a particular firm than in an alternative firm, (type of transactionspecific investment) in their jobs will often be able to create more value for a firm than employees who do not. Capabilities and compensation focuses on firm-specific investments made by groups of employees; suggests that not only should a firms compensation policy encourage employees whose firm-specific investments could create value to actually make those investments, it also recognizes that these investments will often be collective in nature. Flexibility and compensation follows that compensation that has fixed and known downside risks and significant upside potential would encourage employees to choose and implement flexible vertical integration strategies. Compensation alternatives - Types of compensation and approaches to making vertical integration decisions: Opportunism explanation Salary Cash bonuses - ind. performance Stock grants - ind. performance Capabilities explanations Cash bonuses - group performance Stock grants group performance Flexibility explanations Stock options - ind., corporate, or group performance o Stock grants: payments to employees in a firms stock based on individual performance. o Stock option: employees are given the right, but not the obligation, to purchase stock at a predetermined price. Vertical integration in an international context

In some setting, firms exploit international market opportunities not by outsourcing to independent foreign firms, but by entering those international markets in a vertically integrated way. o Vertical integration options when pursuing international market opportunities: o Not vertically o Somewhat o Vertically integrated vertically integrated integrated o Importing/exporting o licensing o foreign direct investment o Strategic alliances o Joint ventures