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Chapter 8
Corporate Strategy: Vertical
Integration and
Diversification

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No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Learning Objectives 1-9
1. Define corporate strategy and describe the three dimensions along which it is
assessed.
2. Explain why firms need to grow, and evaluate different growth motives.
3. Describe and evaluate firms’ options to organize economic activity.
4. Describe the two types of vertical integration along the industry value chain:
backward and forward vertical integration.
5. Identify and evaluate benefits and risks of vertical integration.
6. Describe and examine alternatives to vertical integration.
7. Describe and evaluate different types of corporate diversification.
8. Apply core competence-market matrix to derive different diversification
strategies.
9. Explain when a diversification strategy creates a competitive advantage and
when it does not.

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 Corporate Strategy

The decisions that leaders make.

Goal-directed actions that they take in the quest for

competitive advantage.

Boundaries of the firm:

• Vertical integration.
• Diversification.
• Geographic scope.

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 Why Firms Need to Grow

To increase profits and shareholder returns.

To lower costs and achieve economies of scale.

To increase market power.

To reduce risk through diversification.

To motivate management.

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 Three Dimensions of Corporate Strategy

1. Vertical integration.

2. Diversification.

3. Geographic scope.

Underlying concepts that guide these:

• Core Competencies (Chapter 4).
• Economies of Scale (Chapter 6).
• Economies of Scope (Chapter 6).
• Transaction Costs: cost effectiveness of vertical integration
vs. diversification.

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 Transaction Costs

Associated with an economic exchange.

External transaction costs:

• Searching for contractors.
• Negotiating, monitoring, and enforcing contracts.

Internal transaction costs:

• Recruiting and retaining employees.
• Setting up a shop floor.

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 Internal and External Transaction Costs
Exhibit 8.2

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 Make or Buy?

If Costsin-house < Costsmarket,

• Vertically integrate.
• Own production of the inputs.
• Or own output distribution channels.

If Costsmarket < Costsin-house,

• The firm should consider purchasing instead.

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 Organizing Economic Activity: Firms vs. Markets

Exhibit 8.3

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 The Principal-Agent Problem
A major disadvantage of organizing economic activity
within firms.
Principal – the owner of the firm.
• Goal: create shareholder value.

Agent – manager or employee.

• Should act on behalf of the principal.

Problem:
• Agents pursue their own interests (corporate jets, golf outings).
One Solution:
• Stock options to make agents owners.

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 Information Asymmetry

A situation in which:
• One party is more informed than another,
• Due to the possession of private information.
Can result in the crowding out of desirable goods
and services by inferior ones.

Examples: used cars, e-commerce, mortgage

backed securities, R&D projects.

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 Alternatives on the Make-or-Buy Continuum

Exhibit 8.4

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 Vertical Integration

The ownership of inputs or distribution channels.

• “What percentage of a firm’s sales is generated within the
firm’s boundaries?”

Backward Vertical Integration:

• Owning inputs of the value chain.

Forward Vertical Integration:

• Owning activities closer to the customer.

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 Backward and Forward Vertical Integration along an Industry
Value Chain

Exhibit 8.5

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 Vertical Value Chain of Your Cell Phone

Raw materials:
• Chemicals, ceramics, metals, oil for plastic.

Intermediate goods and components:

• Integrated circuits, displays, touchscreens, cameras, and
batteries.

Final Assembly and manufacturing

Marketing, sales, after-sales service and support:

• Pick a service provider.
• Get wireless data and voice service.

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 HTC’s Backward and Forward Integration along the Industry
Value Chain in the Smartphone Industry

Exhibit 8.6

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 Benefits of Vertical Integration

Lowering costs.

Improving quality.

Facilitating scheduling and planning.

Facilitating investments in specialized assets:

• Co-located assets, unique equipment, human capital.

Securing critical supplies and distribution channels.

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 Risks of Vertical Integration

Increasing costs.

Reducing quality.

Reducing flexibility.

Increasing the potential for legal repercussions.

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 When Does Vertical Integration Make
Sense?
When there are issues with raw materials.
• Example: Henry Ford ran mining operations.
To enhance the customer experience.
• Eliminate annoyances and poor interfaces.
Vertical market failure: when transactions are too
risky or costly.

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 Alternatives to Vertical Integration

Taper Integration: Strategic Outsourcing:

• Backward or forward • Moving internal value
integrated. chain activities.
• Plus reliance on outside • To other firms.
firms such as suppliers or • Example: HR
distributors. management system.

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 Taper Integration along the Industry Value Chain

Exhibit 8.7

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 Types of Diversification

Product Diversification:
• Increase in variety of products / services.
• Active in several product markets.

Geographic Diversification:
• Increase in variety of markets / geographic regions.
• Regional, national, or international markets.

Product-Market Diversification:
• Product and geographic diversification.

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 Types of Corporate Diversification

1. Single business: low level of diversification.

2. Dominant business: additional business activity

pursued.

3. Related diversification:
• Constrained: all businesses share competencies.

• Linked: some businesses share competencies.

4. Unrelated diversification (conglomerate): no

businesses share competencies.
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 The Core Competence–Market Matrix
Exhibit 8.9
Source:. Adapted
from G. Hamel and
C.K. Prahalad
(1994), Competing
for the Future
(Boston: Harvard
Business School
Press).

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 The Diversification-Performance Relationship

Exhibit 8.11
Source:. Adapted from L.E. Palich, L.B. Cardinal, and C.C. Miller (2001), “Curvilinearity in the diversification-performance linkage: An examination of
over three decades of research,” Strategic Management Journal 21: 155–174..
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 How Diversification Can Enhance Firm
Performance

Provides economies of scale (reduces costs).

Exploits economies of scope (increases value).

Reduces costs and increase value.

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 Restructuring

Reorganizing and divesting business units and

activities.

Helps refocus a company.

Helps leverage core competencies more fully.

Helpful restructuring tool: BCG growth-share matrix.

• Guides portfolio planning.
• Each category warrants a different strategy.

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 Restructuring the Corporate Portfolio: The Boston Consulting
Group Growth–Share Matrix

Exhibit 8.13

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 Internal Capital Markets

Can be a source of value creation in diversification

strategy.
• A way to allocate capital at a lower cost, if more efficient
than external markets.
A related-diversification strategy can enhance
corporate performance.
• Consider coordination and influence costs.

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© 2019 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.