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Lecture overview
This lecture will cover the following points: The rationale for diversification" Economics based reasons" Economies of scale/ scope" Transaction costs" Incentives and agency costs" Efficiency arguments" Evidence on diversification" Summarise key points
Lecture overview
This lecture will cover the following points: The rationale for diversification Economics based reasons
Economies of scale/ scope Transaction costs Incentives and agency costs
Krugman s New Trade Theory - Why does Toyota sell cars in Germany and Mercedes sell cars in Japan?
International Trade and Economic Geography What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanisation? many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another. Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. - Royal Swedish Academy of Sciences
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diversify?
Most well known firms serve multiple product markets
Apple: Music/ computers/ software/ operating systems Virgin: Transport/ communications/ media
ITC
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ITC
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Nestle
Wants to operate only those businesses about which it has some special knowledge and expertise Instant coffee, infant foods, milk products UHT Milk, butter and curd and noodles, chocolates, confectioneries and other semi processed food products, mineral water Leading brands Cerelac, Nestum, Nescafe, Maggie, Kitkat, Munch, Pure Life
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Classification by relatedness
Proportion of Example revenue from primary activity Single > 95% Daimler Benz, DeBeers, KLM-airlines, Wrigleychewing gum Dominant 70 to 95% Nestle Abbott Labs, Daewoo, Related <70% Phillip Morris Conglomerate <70% 3M, General Electric, Tata Type
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Examples
Most well known firms serve multiple product markets Apple: Music/ computers/ software/ operating systems Virgin: Transport/ communications/ media Diversification across products and across markets can be due to economies of scale and scope Diversification that occur for other reasons tend to be less successful Nokia - wood pulp and paper/ footwear/ televisions/ capacitors
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Diversity An Example
If we take a beaker of water (H2O) and a very concentrated solution of red food coloring and we then add a drop of the coloring to the water we will see the red color diffusing throughout the water and thus, we go from concentration to diversification Economists, as well as chemists and physicists, want to define concentration vs. diversification Concentration and diversification are two ends of the spectrum
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Ways to diversify
Firms can diversify in different ways They can develop new lines of business internally. They can form joint ventures in new areas of business. They can acquire firms in unrelated lines of business.(M&A)
Reasons for diversification a) -Scope Economies outside technology and markets : Unrelated activities
Several firms produce unrelated products and serve unrelated consumer groups (scope). Firms that produce unrelated products and serve unrelated markets could be pursuing scope economies in other dimensions. Two explanations that take this approach are Resource based view of the firm (Edith Penrose). Dominant general management logic (C K Prahlad).
Reasons for diversification a) Scope Economies outside technology and markets Unrelated activities
Resource based view of the firm (Edith Penrose) utilize managerial and organizational underutilzed resources in new areas when growth in existing market is constrained Dominant general management logic (Prahalad and Bettis): Managers of diversified firms may spread their own managerial talent across nominally unrelated business areas. Management has specific skills that can be applied in different areas of activity e.g. information systems, finance, advertising etc.
Evidence: Summary
Diversification can create value, although its benefits relative to non-diversification are unclear Diversifications in related activities outperform those in unrelated activities
Indian Business
Building on Core Competencies Outsourcing Secondary Activities: The contender is most comfortable in building on its core abilities and competes in proven grounds. Hence many emerging Indian companies have decided to refocus on core competencies, while outsourcing or shedding off secondary operations.
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Lecture summary
We have considered the rationale for diversification. We have assessed some examples and some trends related to diversification. We have employed ideas such as: Economies of scale and scope Transaction costs. Efficiency factors.
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70 60 50 40 30 20 10 0 1950 1960 1970 1983 1993 Single business Dominant business Related business Unrelated business
MANAGEMENT GOALS
COMPANY DEVELOPMENTS
Rise of conglomerates Emphasis onrelated Refocusing on Related diversification core businesses & concentric by industrial firms Divestment diversification
Value based Transaction management cost analysis Core competences Dominant logic Dynamic capability
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RISK SPREADING
--Diversification reduces variance of profit flows --But, doesnt create value for shareholdersthey can hold diversified portfolios of securities. --Capital Asset Pricing Model shows that diversification lowers unsystematic risk not systematic risk.
PROFIT
--For diversification to create shareholder value, then bringing together of different businesses under common ownership & must somehow increase their profitability.
ECONOMIES OF SCOPE
Sharing tangible resources (research labs, distribution systems) across multiple businesses Sharing intangible resources (brands, technology) across multiple businesses Transferring functional capabilities (marketing, product development) across businesses Applying general management capabilities to multiple businesses
Economies of scope not a sufficient basis for ECONOMIES diversification ----must be supported by transaction costs FROM Diversification firm can avoid transaction costs by INTERNALIZING operating internal capital and labor markets TRANSACTION Key advantage of diversified firm over external markets--S superior access to information
Relatedness in Diversification
Economies of scope in diversification derive from two types of relatedness: Operational Relatedness-- synergies from sharing resources across businesses (common distribution facilities, brands, joint R&D) Strategic Relatedness-- synergies at the corporate level deriving from the ability to apply common management capabilities to different businesses. Problem of operational relatedness:- the benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.
Branson & the Virgin Companies: Making strategic sense of apparent entrepreneurial chaos
KEY RESOURCES
Virgin brand Branson -charisma/image --PR skills -networking skills -entrepreneurial flair
DOMINANT LOGIC
Seek competitive advantage by start-up cos. pursuing innovative differentiation in underserved market with sleepy incumbents
CHARACTERISTICS OF MARKETS THAT CONFORM TO THIS LOGIC
Whats the business model? (Does Virgin create value by being an entrepreneurial incubator, a venture capital fund, a diversified corporation, or what?) Which businesses to divest? Criteria for future diversification What type of structure?Is there a need for greater formalization?
consumer dominant incumbent scope for new approaches to customer service high entry barriers to other start-ups Branson/Virgin image appeals to customers
Virgin Conglomorate
Business opportunities are like buses, there s always another one coming Richard Branson Virgin Group is a diversified group of more than 200 privately held companies. The largest of these are Virgin Atlantic Airways, the number two airline in the United Kingdom; Virgin Holidays, a vacation tour operator; the Virgin Retail Group, which operates numerous Virgin Megastores, a retail concept featuring videos, music CDs, and computer games; and Virgin Direct, which offers financial services. Other Virgin businesses include beverage maker Virgin Cola, a record label, book and music publishing operations, hotels, an Internet service provider, movie theaters, a radio station, cosmetics and bridal retailing concepts, and a line of clothing. Holding this disparate group of companies together is the combination of Richard Branson and the Virgin brand name. British entrepreneur Branson dropped out of boarding school at the age of 17, in 1967, to start his own magazine. That venture called Student was an immediate success, establishing the foundation for what would become a multibillion-dollar conglomerate.
Diversification
STRATEGY AND COMPETITIVE ADVANTAGE IN DIVERSIFIED COMPANIES
A company is diversified when it is in two or more lines of business Strategy-making in a diversified company is a bigger picture exercise than crafting a strategy for a single line-of-business A diversified company needs a multi-industry, multi-business strategy A strategic action plan must be developed for several different businesses competing in diverse industry environments
Uneconomical or risky to go it alone Pooling competencies of two partners provides more competitive strength Foreign partners are needed to surmount Import quotas Tariffs Nationalistic political interests Cultural roadblocks
Involves diversifying into businesses whose value chains possess competitively valuable strategic fits with the value chain(s) of the present business(es) Capturing the strategic fits makes related diversification a 2 + 2 = 5 phenomenon
Arise from ability to eliminate costs by operating two or more businesses under same corporate umbrella Exist when it is less costly for two or more businesses to operate under centralized management than to function independently Cost saving opportunities can stem from interrelationships anywhere along businesses value chains
Benefits don t occur by themselves ! Businesses with sharing potential must be reorganized to coordinate activities Means must be found to make skills transfer effective Benefits of some strategic coordination must exist to justify sacrificing business-unit autonomy Competitive advantage potential exists To expand resources and strategic assets and To create new ones faster and cheaper than rivals
Approach is to venture into any business in which we think we can make a profit Firms pursuing unrelated diversification are often referred to as conglomerates
Post-Diversification Strategies
Divestiture and liquidation Corporate turnaround Corporate retrenchment Portfolio restructuring Multinational diversification
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Levels of Diversification
1. Low Levels
Single Business Strategy
Corporate-level strategy in which the firm generates 95% or more of its sales revenue from its core business area E.g. Daimler Benz, DeBeers
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Levels of Diversification
2. Moderate to High Levels
Related Constrained Diversification Strategy
Less than 70% of revenue comes from the dominant business(from primary activity) Direct links (I.e., share products, technology and distribution linkages) between the firm's businesses E.gn Abott Labs
Levels of Diversification
3. Very High Levels: Unrelated (Conglomerate)
Less than 70% of revenue comes from (primary activity)dominant business No relationships between businesses E.g. 3M, General Motors
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Transaction costs
Coordination among independent firms may involve higher transaction costs.
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Cons
Combining two businesses in a single firm is likely to result in substantial influence costs. Resource allocation can be influenced by lobbying. Costly control systems may be needed that reward managers based on division profits and discipline managers by tying their careers to business unit objectives. Internal capital markets may not work well in practice. Shareholders can diversify their own personal portfolios. Corporate managers are not really needed to do this. Identifying undervalued firms may not be as easy as it sounds.
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