Strategic Management & Competitive

Advantage: Concepts and Cases

Sixth Edition, Global Edition

Chapter 7
Corporate Diversification

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Learning Objectives (1 of 2)

7.1 Define corporate diversification and describe five types

of corporate diversification.
7.2 Specify the two conditions that a corporate
diversification strategy must meet to create economic
value.
a. Define the concept of “economies of scope” and
identify nine potential economies of scope a
diversified firm might try to exploit.
b. Identify which of these economies of scope a firm’s
outside equity investors can realize on their own at
low cost.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Learning Objectives (2 of 2)

7.3 Specify the circumstances under which a firm’s

diversification strategy will be a source of sustained
competitive advantage.
a. Explain which of the economies of scope identified in
this chapter are more likely to be subject to low-cost
imitation and which are less likely to be subject to low-
cost imitation.
b. Identify two potential substitutes for corporate
diversification.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

The Strategic Management Process

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Logic of Corporate Level Strategy

Corporate level strategy should create value:

1. such that businesses forming the corporate whole are
worth more than they would be under independent
ownership
2. that equity holders cannot create through portfolio
investing

• Therefore,
‒ a corporate level strategy must create synergies
▪ economies of scope—diversification

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Integration and Diversification

Integration

Backward Forward

Diversification
Other Current Other
Businesses Businesses Businesses

No Unrelated Related Many

Links Links
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Types of Corporate Diversification (1 of 2)

At a general level…
• Product Diversification:
– operating in multiple industries
• Geographic-Market Diversification:
– operating in multiple geographic markets
• Product-Market Diversification:
– operating in multiple industries in multiple geographic
markets

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Types of Corporate Diversification (2 of 2)
When a firm chooses to diversify, it faces a decision as to how related
the new business(es) is(are) to the existing businesses of the firm
At a more specific level…
• Limited Diversification
– single business: >95% of sales in single business
– dominant business: 70–95% in single business
• Related Diversification
– related constrained: all businesses related on most
dimensions (Pepsico)
– related linked: some businesses related on some
dimensions (Disney)
• Unrelated Diversification
– businesses are not related (General Electric)
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
 Types of Corporate Diversification
Limited Diversification
1. Single business: > 95% of sales in single business:

A single-business firm is technically not diversified because it gets 95

percent or more of its total revenues from one business.

2. Dominant business: 70% to 95% in single business:

A dominant-business firm is different in that it has moved beyond a complete

focus on one business by obtaining revenues from other businesses.
However, it is still largely dependent upon one industry.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Types of Corporate Diversification
Related Diversification
3. Related-constrained: when all the businesses in
which a firm operates share a significant number of
inputs, production technologies, distribution channels,
similar customers, etc. (most dimensions).

Example : Bic, PepsiCo

4. Related-linked: when the different businesses that a

single firm pursues are linked on only a couple of
dimensions, or if different sets of businesses are
linked along very different dimensions.

Example : Disney
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Types of Corporate Diversification
Unrelated Diversification

5. Businesses are not related

An unrelated diversified firm (called a conglomerate) owns

businesses in its portfolio that share few, if any, common
attributes. The management approach in such firms is to regard
each business as a stand-alone entity.

Example: General Electric

Transportation/energy/healthcare/ lighting

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Types of Corporate Diversification

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Product and Geographic Diversification
• Possibilities:
– single business in one geographic area
– single business in multiple geographic areas
– related constrained in one or multiple geographic areas
– related linked in one or multiple geographic areas
– unrelated in one or multiple geographic areas
• Note:
– Relatedness usually refers to products.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Competitive Advantage

If a diversification strategy meets the VRIO criteria…

Is it Valuable?
Is it Rare?
Is it costly to Imitate?
Is the firm Organized to exploit it?
…it may create competitive advantage.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Value of Diversification

Two Criteria: for corporate diversification to be economically

valuable, TWO conditions must hold

1) There must be some economy of scope

(Economies of scope exist in a firm when the value
of the products or services it sells increases as a
function of the number of businesses in which that
firm operates. The term scope refers to the range of
businesses in which a diversified firm operates).
2) The focal firm must have a cost advantage over
outside equity holders in exploiting any economies of
scope
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Value of Diversification (2 of 2)

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Economies of Scope (1 of 7)

Types

1. Operational Economies of Scope

2. Financial Economies of Scope
3. Anticompetitive Economies of Scope
4. Managerialism (employee & stakeholder
incentive for diversification)

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Economies of Scope (2 of 7)

1. Operational Economies of Scope

1.1 Sharing Activities
– exploiting efficiencies of sharing business activities
- Increase revenue (product bundles and positive
reputations)
Example: IBM, HP, GM
1.2 Spreading Core Competencies
‒ exploiting core competencies in other businesses
‒ competency must be strategically relevant
Example: Orbitz

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

 Economies of Scope
A Hypothetical Firm Sharing Activities Among Three Businesses

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Economies of Scope (3 of 7)

2- Financial Economies of Scope

2.1 Internal Capital Market
– Premise: insiders can allocate capital across divisions
more efficiently than the external capital market.
▪ works only if managers have detailed and accurate
information about the actual performance of the
business.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Economies of Scope (4 of 7)
2.2 Risk Reduction
– counter cyclical businesses may provide decreased
overall risk
However, individual investors can usually do this more
efficiently than a firm
2.3 Tax Advantages
– Diversified firms may also benefit from tax
advantages. Losses in one business can offset
profits in others .
– Tax advantages of diversification can be especially
important in the international context. Because of
differing tax rates across borders.
Example: Ireland
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
 Economies of Scope (6 of 7)

3- Anticompetitive Economies of Scope

• Multipoint Competition
– mutual forbearance
▪ a firm chooses not to compete aggressively in one
market to avoid competition in another market
Example: P&G and Unilever : American Airlines and Delta
• Market Power
‒ using profits from one business to compete in another
business
‒ using buying power in one business to obtain advantage in
another business
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Economies of Scope (7 of 7)

4- Firm Size and Employee Incentives to Diversify

– Managers of larger firms receive more compensation

(larger scope = more compensation).
– Therefore, managers have an incentive to acquire
other firms and become ever larger.
• Recently, the traditional relationship between firm
size and management compensation has begun to
break down. More and more, the compensation of
senior managers is being tied to the firm’s economic
performance.
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Equity Holders and Economies of Scope

• Most economies of scope cannot be captured by equity

holders.
– Risk reduction can be captured by equity holders.
• Managers should consider whether corporate
diversification will generate economies of scope that equity
holders can capture.
– If a corporate diversification move is unlikely to
generate valuable economies of scope, managers
should avoid it.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Rareness of Diversification

Diversification per se is not rare.

• Underlying economies of scope may be rare.
– Relationships that allow an economy of scope to be
exploited may be rare.
– An economy of scope may be rare because it is
naturally or economically limited.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Imitability of Diversification (1 of 2)

Duplication of Economies of Scope

Less Costly-to-Duplicate Costly-to-Duplicate

Shared Activities* Core Competencies
Tax Advantages Internal Capital Allocation
Risk Reduction Multipoint Competition
Employee Compensation Exploiting Market Power

(codified/tangible) (tacit/intangible)

*may be costly depending on relationships

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Imitability of Diversification (2 of 2)

Substitution of Economies of Scope

• Internal Development
• start a new business under the corporate whole
• avoids potential cross-firm integration issues
• Strategic Alliances
• find a partner with the desired complementary assets
• less costly than acquiring a firm
Competitors may use these strategies to arrive at a position
of diversification without buying another firm.
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved
Summary (1 of 2)

• Corporate Strategy: In what businesses should the firm

operate?
– An understanding of diversification helps managers
answer that question.
Two Criteria:
1. economies of scope must exist
2. must create value that outside equity holders cannot
create on their own

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

Summary (2 of 2)

Economies of Scope
– a case of synergy—combined activities generate
greater value than independent activities
– may generate competitive advantage if they meet the
VRIO criteria
Firms should pursue diversification only if careful analysis
shows that competitive advantage is likely!

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved