Strategic Management Final Exam

Chapter 1What Is Strategy and the Strategic Management Process?

Defining Strategy
Strategy- theory about how to gain competitive advantage
o A good strategy is one that generates such advantages
Strategies are based on theories that firms have to gain competitive advantages
these theories are based on a set of assumptions and hypotheses about the way
competition in the industry will likely evolve and hoe that evolution can be exploited
to earn a profit
It is usually very difficult to predict precisely how competition will evolve and so it is
rarely possible to know for sure that a firm is choosing the right strategy
o This is why a firms strategy is almost always a theory
The Strategic Management Process
Strategic management process- a sequential set of analyses and choices that
can increase the likelihood that a firm will choose a good strategy
External analysis
Missionobjectives
strategic
choiceimplementationcompetitive advantage
Internal analysis
A Firms Mission
The first step to the strategic management process
Mission- long-term purpose of the firm
o Defines both what a firm aspires to be in the long run and what it wants to
avoid in the meantime
o Broad statement of purpose and values
o Often written in the form of mission statements
Some missions may not affect performance
o Most mission statements incorporate many common elements:
Define the business in which the firm will operate
How the firm will compete in those businesses
The core values that a firm espouses
Some missions can improve performance
o Visionary firms- firms whose mission is central to all they do
These types of firms usually have long-term profitability
Some missions can hurt firm performance
o Sometimes will be focused only on the personal values and priorities of the
founders/top managers

Objectives
Objectives- specific and measurable targets a firm can use to evaluate the extent
to which it is realizing its mission
o high-quality objectives are tightly connected to elements of a firms mission
and are relatively easy to measure and track over time
o low-quality objectives either do not exist or are not connected to elements of
a firms mission, are not quantitative, and are difficult to measure or difficult
to track over time
External and Internal Analysis
occur simultaneously during the strategic management process
external analysis- identifies the critical threats and opportunities in the firms
competitive environment
o examines how competition in the environment is likely to evolve and what
implications that evolution has for the threats and opportunities a firm is
facing
internal analysis- helps a firm indentify its organizational strengths and
weaknesses
o also helps a firm understand which of its resources and capabilities are likely
to be sources of competitive advantage and which are less likely to be
sources of such advantages
o helps to identify areas within the organization that require improvement and
change
Strategic Choice
after a firm has a mission, objectives, and external and internal analysesit is ready
to make its strategic choices
o strategic choice - theory of how to gain competitive advantage
Strategic choice falls into 2 categories:
o Business-level strategies- actions firms take to gain competitive
advantages in a single market or industry
Cost-leadership and product differentiation
o Corporate level strategies- actions firms take to gain competitive
advantages by operating in multiple markets or industries simultaneously
Vertical integration, diversification, strategic alliance, merger &
acquisition
The objective when making a strategic choice is to choose a strategy that:
o Supports the firms mission
o Is consistent with a firms objectives
o Exploits opportunities in a firms environment with a firms strengths
o Neutralizes threats in a firms environment while avoiding a firms
weaknesses
Strategy Implementation
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Strategy implementation- occurs when a firm adopts organizational policies and

practices that are consistent with its strategy
There are 3 specific organizational policies and practices in implementing
strategies:
o A firms formal organizational structure
o Its formal and informal management control systems
o Employee compensation policies

What is Competitive Advantage?

Competitive advantage- when a firm is able to create more economic value than
rival firms
o Temporary competitive advantage- lasts for a very short time
o Sustained competitive advantage- lasts for a much longer time
Competitive parity- companies that create the same economic value as their
rivals
Competitive disadvantage- companies that create less economic value than their
rivals
o Temporary- lasts a short time
o Sustained- lasts a long time
Measuring Competitive Advantage
Not always easy to directly measure
Two approaches for measuring competitive advantage:
o Accounting performance- a measure of a firms competitive advantage
calculated by using information from its published profit and loss and balance
sheet statements
compare with competitors in an industry
this makes it possible to compare one firm to another
o Economic measures of competitive advantage- compare a firms level of
return to its cost of capital instead of to the average level of return in the
industry
Economic value- the difference between the perceived benefits
gained by a customer that purchases a firms products/services and
the full economic cost of these products/services
o Thus, the size of a firms competitive advantage is the difference between the
economic value a firm is able to create and the economic value its rivals are
able to create
above normal economic profita firm that is earning above its cost of
capital
normal economic profita firm that is earning its cost of capital
below economic profita firm that is earning below its cost of capital
Emergent versus Intended Strategies
emergent strategies- theories of how to gain competitive advantage in an
industry that emerge over time or that have been radically reshaped once they are
initially implemented

intended strategy- a strategy a firm though it was going to pursue a rational

strategy

Chapter 2Evaluating a Firms External Environment

The Structure-Conduct-Performance Model of Firm Performance
Structure-conduct-performance (SCP)- theory which suggests that industry
structure determines a firms conduct which in turn determines its performance
Porters 5 Forces Model
Developed from the SCP Model
Entryhigh barriers to entry make the industry more attractive because there is a
potential for greater than normal returns
Rivalryhigh rivalry leads to lower profits
Buyersfew buyers (buyer power) lead to lower profits
Suppliersfew suppliers (supplier power) lead to lower profits
Substitutescan meet the customers same needs in different ways
Industry Structure and Environmental Opportunities
Fragmented- industries in which a large number of small or medium-sized firms
operate and no small set of firms has dominant market share or creates dominant
technologies
o Many small competitors, no one dominant firm
o Opportunity: consolidation strategy that reduces the number of firms in an
industry by exploiting economies of scale
Emerging- newly created or newly re-created industries formed by technological
innovations, change in demand, of the emergence of new customer needs
o No standard put in place, just breaking out
o Opportunity: first-mover advantages- advantages that come to firms that
make important strategic and technological decisions early in the
development of an industry
Mature- an industry in which, over time, ways of doing business have become
widely understood, technologies have diffused through competitors, and the rate of
innovation in new products and technologies drops
o Profits are no longer really growing
o Opportunity:
product refinement
emphasis on service
process innovation- a firms effort to refine and improve its
current processes
Declining- an industry that has experiences an absolute decline in unit sales over a
sustained period of time
o Declining industry leaders are bailing out (exiting)
o Opportunity: leadership- the firm with the largest market share in an
industry
Niche- when a firm reduced its scope of operations and focuses
on narrow segments of a declining industry

Harvest- when firms engage in a long, systematic, phased

withdrawal from a declining industry, extracting as much value
as possible
Divestment- selling a business with which a firm had been
operating

Chapter 3Evaluating a Firms Internal Capabilities

The Resources-Based View of the Firm
Resource-Based View (RBV)- a model of firm performance that focuses on the
resources and capabilities controlled by a firm as sources of competitive advantage
answers the questions: why do some firms achieve better economic performance
than others?
o Resources- the tangible and intangible assets that a firm controls, which it
can use to conceive of and implement its strategies
o Capabilities- a subset of a firms resources and are defined as tangible and
intangible assets that enable a firm to take full advantage of other resources
it controls (firm as a whole, not of an individualat the collective firm level)
Ex: marketing skills, teamwork, cooperation

Critical Assumptions of the Resource-Based View

Two critical assumptions:
o Resource heterogeneity- different firms may possess different bundles of
resources and capabilities, even if they are competing in the same industry
implies that for a given business activity, some firms may be more
skilled in accomplishing this activity than others
not all resources/capabilities are alike
o resource immobility- some resource and capability differences among firms
may be long lasting because it may be very costly for firms without certain
resources and capabilities to develop or acquire them
o taken together these two assumptions make it possible to explain why some
firms can outperform other firms, even if these firms are all competing in the
same industry

The Question of Organization

a firms potential for competitive advantage depends on the value, rarity, and
imitability of its resources and capabilitiesto fully realize its potential, a firm must
be organized to exploit its resources and capabilities
whether you are aligning your firms structure (formal and informal) with resources
this is important for sustained competitive advantage
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formal reporting structure- a description of who in the organization reports to

whom
management control systems- include a range of formal and informal
mechanisms to ensure that managers are behaving in ways consistent with a firms
strategies
o formal management controls- include a firms budgeting and reporting
activities that keep people higher up in a firms organizational chart informed
about the actions taken by people lower down in a firms organizational chart
o informal management controls- include a firms culture and the
willingness of employees to monitor each others behavior
compensation policies- the ways that firms pay employeescreate incentives for
employees to behave in certain ways

Chapter 4Cost Leadership

What is Cost Leadership?
Cost leadership- focuses on gaining competitive advantages by reducing its costs
to below those of all its competitors

Six Important sources of cost advantages for firms:

Size differences and economies of scale- said to exist when the increase in firm
size (measures in terms of volume of production) is associated with lower cost
(measured in terms of average cost per unit of production)
Size difference and diseconomies of scale- if the volume size of production rises
beyond some optimal point, this can actually lead to an increase in per-unit costs
o If other firms in an industry have grown beyond the optimal firm size, a
smaller firm (with a level of production closer to the optimal) may obtain a
cost advantage even when all firms in the industry are producing very similar
products
o The advantage is for those who do not have diseconomies of scale
Experience differences and learning-curve economies- firms with the greatest
experience in manufacturing a product/service will have the lowest cost in an
industry and thus will have a cost-based advantagelink between cumulative
volumes of production and cost
o Doing something longer than otherslearn how to do it better
Differential low-cost access to productive inputs
o Productive inputs- any supplies used by a firm in conducting its business
activities
o A firm that has a differential low cost access to these factors is likely to have
a lower economic cost compared to rivals
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Technological advantages independent of scale

Policy choices- choices that have an impact on the relative cost position of the
firm

Chapter 5Product Differentiation

What is Product Differentiation?
Product differentiation- a business strategy whereby firms attempt to gain
competitive advantage by increasing the perceived value of their products or
services relative to the perceived value of other firms products or services
Ways Firms can Differentiate their Products:
Directly related to the attributes of the product or service:
o Features
o Complexity
o Timing of product introduction
o Location
On relationships between itself and its customers:
o Customization
o Marketing
o Reputation
Linkages within or between firms:
o Linkages among functions within a firm
o Linkages with other firms
o Product mix
o Distribution channels
o Service and support

Chapter 6Vertical Integration

What is Corporate Level Strategy?
Corporate strategy is a firms theory of how to gain competitive advantage by
operating in several businesses simultaneously
Logic of Corporate Level Strategy
Corporate level strategy should create value:
o such that the value of the corporate whole increases
o such that businesses forming the corporate whole are worth more than they
would be under independent ownership
o that equity holders cannot create through portfolio investing
a corporate level strategy should create synergies that are not available in equity
markets
vertical integration = value chain economies
What is Vertical Integration?

A value chain is a set of activities that must be accomplished to being a product of

service from raw materials to the point that it can be sold to the final consumer
Vertical integration the number of steps in the value chain that a firm
accomplishes within its boundaries
o Backward vertical integration- firm incorporates more stages of the value
chain within its boundaries and those stages bring it closer to the beginning
of the value chain, that it, closer to gaining access to raw materials
Ex: when computer companies develop their own software they are
engaging in vertical integration because these actions are close to the
beginning of the value chain
o Forward vertical integration- when a firm 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
Ex: when companies staff and operate their own call centers in the US
because these activities bring them closer to the ultimate customer

Value Chain Economies

The Logic of Value Chain Economies
o the focal firm is able to create synergy with the other firm(s)
cost reduction
revenue enhancement
the focal firm is able to capture above normal economic returns (avoid perfect
competition)
Value of Vertical Integration
Market vs. Integrated Economic Exchange markets and integrated hierarchies are
forms in which:
o economic exchange can take place
o economic exchange should be conducted in the form that maximizes value
for the focal firm
o thus, firms assess which form is likely to generate more value
Integration makes sense when the focal firm can capture more value than a market
exchange provides

Value of Vertical Integration

Three value considerations:
o Leverage capabilities- enabling the firm to exploit the VRIO resources and
capabilities
This approach has 2 broad implications:
Suggests that firms should vertically integrate into those
business activities where they possess valuable, rare, and
costly-to-imitate resources and capabilitiesthis way, the firm
can appropriate at least some of the profits that using these
capabilities to exploit environmental opportunities will create

Suggests that firms should not vertically integrate into business

activities where they do not possess the resources necessary to
gain competitive advantages
o Thus, if a firm possesses valuable, rare, and costly-toimitate resources in a business activity, it should vertically
integrate into that activity
firm capabilities may be sources of competitive advantage in other
businesses
if not, then dont integrate exchange
manage opportunism- reducing the threat of opportunism
vertical integration can reduce the threat of opportunism- exists
when a firm is unfairly exploited in an exchange
ex: when a party to an exchange expects high level of quality in
a product it is purchasing, only to discover it has received a
lower level of quality than it expected
opportunism may be checked by internalizing (TSI)bring the
exchange within the boundary of the firm
managers can directly monitor and control this exchange that is
brought within the boundary of a firm brings a firm closer to its
ultimate suppliers (backward), if the exchange that is brought
within the boundary of a firm brings a firm closer to its ultimate
customer (forward)
internalizing must be less costly than opportunism
transaction-specific investment- any investment in an exchange
that has significantly more value in the current exchange than it does
in alternative exchanges
ex: the oil and the pipeline companythe pipeline company has
more to lose
exploit flexibility- enabling the firm to retain flexibility
flexibility- refers to how costly it is for a firm to alter its strategic and
organizational decisions
flexibility is high when the cost of changing strategic choices is
low
flexibility is low when the cost of changing strategic choices is
high
vertically integrating is less flexible than not vertically
integrating because once a firm has integrated it has
committed its organizational structure, management controls,
and its compensation policies to a particular vertically integrated
way of doing business
internalizing is usually less flexible
flexibility is prized when uncertainty is high
flexibility is not always valuable
it is only valuable when the decision-making setting a firm is
facing is uncertain
a decision making setting is uncertain when the future value of
an exchange cannot be known when investments in that
exchange are being made
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in these situationsless vertical integration is better than

more vertical integration

Rarity of Vertical Integration

Integration vs. Non-Integration
o a firms integration strategy may be rare because the firm integrates or
because the firm does not integrate
o thus, the question of rareness does not depend on the number of forms
observed
o a firms integration strategy is rare or common with respect to the value
created by the strategy
Example: Toyotas Choice Not to Integrate Suppliers
Imitability of Vertical Integration
Form vs. Function
o the form, per se, is usually not costly to imitate
o the value-producing function of integration may be costly to imitate, if:
the integrated firm possesses resource combinations that are the result
of:
historical uniqueness
causal ambiguity
social complexity
o small numbers prevent further integration
o capital requirements are prohibitive
Imitability of Vertical Integration
Modes of Entry
o acquisition and internal development are alternative modes of entry into
vertical integration
thus, one firm may acquire a supplier while a competitor could imitate
that strategy through internal development
in both cases, the boundaries of the firm would encompass the new
business
o strategic alliances can be viewed as a substitute for vertical integration
without the costs of ownership
Organizing Vertical Integrations
the organizational structure that is used to implement cost leadership and product
differentiation (the functional or U-form structure) is also used to implement a
vertical integration strategy
o decisions about which activities to vertically integrate into determine the
range and responsibilities of the marketing function within a functionally
organized firm
o vertical integration decisions made by the firm determine the structure of a
functionally organized firm
Management Controls
What needs to be controlled in a vertically integrated firm?
managers efforts to achieve the desired value chain economies
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o
o
o

cooperation and competition among and between functions

the integration of new businesses into the existing business
time horizon of managers

Organizing Vertical Integrations

Management Controls
o Budgets
separating strategic and operational budgets
strategic: inputs and outputs
operational: outputs
o Board Committees
provide oversight and direction to managers
operations committees- typically meets monthly and usually
consists of the CEO and each of the heads of the functional
areas included in the firm
executive committees- typically consists of a CEO and 2 or 3
functional senior managers
help ensure that strategic direction is maintained
These mechanisms focus management attention on achieving value chain
economies
Organizing Vertical Integrations
Compensation challenges:
o Opportunism bases vertical integration and compensation policy:
This suggests that employees who make firm-specific investments in
their jobs will often be able to create more value for a firm than
employees who do not make firm-specific investments
These are a type of transaction specific investment
Firm specific investments- investments made by employees
that have more value in a particular firm than in alternative
firms
Needs to create incentives for employees whose firm-specific
investments could create great value to actually make those
investments
Opportunism:
Salary
Cash bonus: Individual
Stock grants: Individual
o Capabilities and Compensation
Also acknowledge the importance of firm-specific investments in
creating value for a firm
Capabilities explanations tend to focus on firm-specific investments
made by groups of employees

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Socially complex in natureteamwork, cooperation, culture

have evolved within a firmcan all increase the value of a firm
significantly and are all costly-to imitate
Leveraging Capabilities:
Cash bonus: Group
Stock Grants: Group
Flexibility and Compensation
Compensation must have known downside risks and significant upside
potential
Exploiting Flexibility:
Stock options: individual
Stock options: group

Vertical Integration Options When Perusing International Market Opportunities

Not vertically integrated- importing/exporting
Somewhat vertically integrated- licensing, strategic alliances, joint ventures
Vertically integrated- foreign direct investment

Chapter 7Corporate Diversification

What is Corporate Diversification?
Corporate diversification- a firm implements this strategy when it operates in
multiple industries or markets simultaneously
o Product diversification strategy- when a firm operates in multiple industries
simultaneously
o Geographic market diversification- when a firm operates in multiple
geographic markets simultaneously
Product-market diversification- when a firm implements both of these types of
diversification simultaneously
Logic of Corporate Level Strategy
Corporate level strategy should create value:
o such that businesses forming the corporate whole are worth more than they
would be under independent ownership
o that equity holders cannot create through portfolio investing
Therefore:
o a corporate level strategy must create synergies
o economies of scope diversification
Integration and Diversification
Integration
Raw materialsSupplierfocal firmdistributioncustomer
Backward
Forward

Diversification
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Other businessescurrent businessesother businesses

No links
unrelated
related
many links
Types of Corporate Diversification
At a general level:
o Product diversificationoperating in multiple industries
o Geographic market diversificationoperating in multiple geographic markets
o Product-market diversificationoperating in multiple industries in multiple
geographic markets
Types of Corporate Diversification
At a more specific level:
o Limited diversificationwhen all or most of its business activities fall within a
single industry and geographic market
single business: > 95% of sales in single business
dominant business: 70% to 95% in single business
o related diversificationwhen less than 70% of a firms revenue comes from a
single product market and its multiple lines of business are linked
related-constrained: all businesses related on most dimensions
70% of firm revenues comes from a single business, and different
businesses share numerous links and common attributes
related-linked: some businesses related on some dimensionsless
than 70% of a firms revenues comes from a single business, and
different businesses share only a few links and common attributes or
different links and common attributes
o unrelated diversification
businesses are not related: less than 70% of firm revenue comes
from a single business, and there are few, if any, links or common
attributes among business
Product and Geographic Diversification
Possibilities:
o single-business in one geographic area
o single-business in multiple geographic areas
o related-constrained in one or multiple geographic areas related-linked in one
or multiple geographic areas
o unrelated in one or multiple geographic areas
Note:
o relatedness usually refers to products
o seemingly unrelated products may be related on other dimensions
Competitive Advantage
If a diversification strategy meets the VRIO criteria it may create competitive
advantage
Value of Diversification
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 that firm operates in
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o
o
o

the term scope refers to the range of businesses in which diversified firms
operate in
for this reason, only diversified firms can exploit economies of scope
economies of scope create value to the extent that they increase a firms
revenues or decrease its costs compared to what would be the case if these
economies were not exploited

Two criteria for Value of Diversification:

There must be some economy of scope
The focal firm must have a cost advantage over outside equity holders in exploiting
any economies of scope
Economies of Scope
Operational
o Sharing activitiesexploiting efficiencies of sharing business activities
Ex: Frito-Lays Tucking
o Spreading Core Competenciesexploiting competencies in other
businesses
Competency must be strategically relevant
Ex: orbits
Financial
o Internal capital market
premise: insiders can allocate capital across divisions more efficiently
than the external capital market
works only if managers have better information
may protect proprietary information
may suffer from escalating commitment
Ex: Hanson Trust, PLC
o Risk Reduction
counter cyclical businesses may provide decreased overall risk
However individual investors can usually do this more efficiently than a
firm
Ex: snow skis and water skis
o Tax advantages
transfer pricing policy allows profits in one division to be offset by
losses in another division
this is especially true internationally
can be used to smooth income
Ex: Ireland
Anticompetitive
o Multipoint competition
Mutual forbearance
a firm chooses not to compete aggressively in one market to avoid
competition in another market
ex: American airlines and delta: Dallas and Atlanta
o Market Power
Using profits from one business to compete in another business
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Using buying power in one business to obtain advantage in another

business
Managerialism
o Maximizing management compensation
an economy of scope that accrues to managers at the expense of
equity holders
managers of larger firms receive more compensation (larger scope =
more compensation)
therefore, managers have an incentive to acquire other firms and
become ever larger
even though the incentive is there, it is difficult to know if
managerialism is the reason for an acquisition
Equity Holders and Economies of Scope
Most economies of scope cannot be captured by equity holders
o risk reduction can be captured by equity holders
Managers should consider whether corporate diversification will generate
economies of scope that equity holders can capture
o if a corporate diversification move is unlikely to generate valuable economies
of scope, managers should avoid it

Rareness of Diversification
Diversification per se is not rare
Underlying economies of scope may be rare
o relationships that allow an economy of scope to be exploited may be rare
o an economy of scope may be rare because it is naturally or economically
limited
a soft drink bottler buys the only source of spring water available
a hotel in a resort town creates a large water park, there are only
enough customers to support one park
Limitability of Diversification
Duplication of economies of scope
o Less costly-to-duplicate
Employee compensation
Tax advantages
Risk reduction
Shared activities may be costly depending on relationships
o Costly-to-duplicate
Core competencies
Internal capital allocation
Multipoint competition
Exploiting market power

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Substitution for Diversification

Internal development
o Start a new business under the corporate whole
o A firm may grow and develop each of its businesses separately
o Avoids potential cross-firm integration issues
Strategic alliances
o Find a partner with the desired complementary assets
o Less costly than acquiring a firm

International Diversification
Three types of international risk:
o Cultural/popular
product may not be accepted simply because of your country or origin
Ex: resistance to McDonalds by Frances older generation
o Financial
Currency exchange
General economic conditions
Ex: Asian economic crisis of the 1990s
o Political
Nationalization
Quotas
Tariffs
Regulations
Ex: Bolivia nationalized its petroleum industry in the 70s
International Diversification
Managing international risks
o Cultural/popular
Avoidance
Neutral branding (disguising country of origin)
Ex: Haagen-Dazs
o Financial
Currency hedging
Geographic diversification
Spreading risk across several countries
o Political
Find a local partner
Political neutrality
Negotiation with governments
Foreign governments often have an interest in direct investment
Ex: case international in brazil

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Quantifying Political Risks

Country attributes summarize most of the important determinants of political irk for
firms pursuing international strategies
Firms can apply the criteria by evaluating the political and economic conditions in a
country and by adding up the scores associated with the conditions
Countries in western Europe and North America are least risky
o The least risky country in the entire world to do business with is
Luxembourgfollowed by Switzerland, Norway, Denmark, US, and Sweden
Countries currently experiencing civil unrest and revolution are among the most
risky
o The most risk country in the entire world to do business with is North Korea
followed by Afghanistan, Iraq, Cuba, Marshall Islands, and Zaire
Countries in Asia range from very low risk to very high risk
Countries in Africa tend to be relatively risky

Chapter 8Organizing to Implement Corporate Diversification

Implementation Issues
How information flows
Where and by whom are decision made
How to influence the behavior of people
How can the interests of employees be aligned with the interests of the firm?
Organizational Structure and Implementing Corporate Diversification
Multidivisional (M-Form)- the most common organizational structure for
implementing a corporate diversification strategy
o Each business that the firm engages in is managed through a division
o Divisions- strategic business units (SBU)
o The M-form is designed to create checks and balances for managers that
increase the probability that a diversified firm will be managed in ways
consistent with the interests of the equity holders
board of directors
Senior executive
Financelegalaccounting|R &Dsaleshuman resources
Division general manager ADivision general manager BDivision general manager C
Division A
Division B
Division C
Roles and Responsibilities of Major Components of the M-Form Structure
Board of directors- monitor decision making in a firm to ensure that it is
consistent with the interests of outside equity holders
Institutional investors- monitor decision-making to ensure that it is consistent
with the interests of major institutional equity investors
Senior executives- formulate corporate strategies consistent with equity holders
interests to assure strategy implementation
o Decide the businesses in which the firm will operate
o Decide how the firm should compete in those businesses
o Specify the economies of scope around which the diversified firm will operate
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o Encourage cooperation across divisions to exploit economies of scope

o Evaluate performance of divisions
o Allocate capital across divisions
Corporate staff- provides information to the senior executive about internal and
external environments for strategy formulation and implementation
Division general managers- formulate divisional strategies consistent with
corporate strategies and assure strategy implementation
o Decide how the division will compete in its business
o Coordinate the decision and actions of functional managers reporting to the
division general manager to implement divisional strategy
o Compete for corporate capital allocations
o Cooperate with other divisions to exploit corporate economies of scope
Shared activity managers- support the operations of multiple divisions

The Need for Organizational Structure

Information processing requirements
o as organizations become larger and more complex, information processing
requirements exceed individual capacity
bounded rationality
satisficinginstead of choosing the actual best mathematical outcome,
chose what is good enoughthis occurs because if information
overload
o organizational structure divides information processing into manageable
blocks (span of control)
The Agency Relationship
A trade off
o M-Form Structure
o Divides information processing requirements into manageable
blocksdivides owners from managers
o Interests of owners and manages may diverge
The Agency Relationship
Managing agency
o Principals:
Individual shareholders
Institutional shareholders
Can have a dual role
o Monitors:
Board of directors
o Agents:
Senior executive
Corporate staff
Division general managers
Shared activity managers
The Office of the President
o Chairman of the board (monitoring)
o Chief Executive Office (strategy formulation)
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o Chief Operating Officer (strategy implementation)

One person:
o ChairmanCEOCOO
Two people:
o Chairman
o CEOCOO
Or
o ChairmanCEO
o COO
Three people:
o Chairman
o CEO
o COO

The Office of the President

Information Filtering
o information about the divisions businesses is filtered as it rises to the senior
executive
the senior executive can manage the information flow
o information flow should not exceed the bounded rationality of managers at
any level in the organization
o information should flow should be matched with decision-making authority
Management Controls
Evaluating divisional performance- because divisions are profit-and-loss
centers, evaluating divisional performance should be straightforwarddivisions that
are very profitable should be evaluated more positively than divisions that are less
profitable
o Measurement
Accounting :
Diversified firms use three standards of comparison when
evaluating the performance of a division:
A hurdle rate that is common across all the different business
units in a firm
A divisions budgeted level of performance
The average level of profitability of firms in a divisions industry
Economic:
Economic value added (EVA)calculated by subtracting the cost
of capital employed in a division from that divisions earnings
EVA = adjusted acct earnings (WACC X total capital employed
by a division)
o Economies of Scope and the Ambiguity of Divisional Performance
It is not possible to unambiguously evaluate the performance of
individual divisions in a firm
The fact that there are economies of scope in a diversified firm means
that all of the businesses in a firm operates in are more valuable
bundled together than they would be if kept separate from one another
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Solutions:
o Force businesses in a diversified firm to operate
independently of each otherunable to recognize the
economies of scope that were the justification of
diversification in the first place
o The quantitative evaluation of divisional performance
(accounting or economic) must be supplemented by the
experience and judgment of senior executives in a
diversified firm
o Allocating costs and revenues
Allocating capitala potentially valuable economy of scope, for internal capital
allocation to be a justification for diversification, the information made available to
senior executives allocating capital must be superior in amount and quality to the
information available to external sources of capital in the external capital market
o Both the quality and the quantity for the information available in an internal
capital market depend on the organization of the diversified firm
o Managers want to look goodgeneral managers have a strong incentive to
overstate their divisions prospects and understate its problems
o Zero-based budgeting- corporate execs create a list of all capital allocation
requests from divisions in a firm and rank them in order of importance and
fund all the projects a firm can afford

Transferring intermediate products

o The existence of economies of scope across multiple divisions in a diversified
firm often means that products or services produced in one division are used
as inputs as products/services in a second division
Intermediate products/services- can be transferred between and of
the units in an M-form organization
This transfer is most important and problematic when it occurs
between profit center divisions
o The transfer of intermediate products/services is managed through a transferpricing systemone division sells its product/service to a second division for
a transfer pricethis price is set by the firms corporate management to
accomplish corporate objectives
o Setting prices
Exchange autonomy
o buying and selling division general managers are free to
negotiate transfer price without corporate involvement
o transfer price is set equal to the selling divisions price to
external customers
Mandated Full Cost
o Transfer price is set equal to the selling divisions actual
cost of production
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Transfer price is set equal to the selling divisions

standard cost (the cost of production if the selling division
were operating at max efficiency)
Mandated Market-based
o Transfer price is set equal to the market price in the
selling divisions market
Dual pricing
o Transfer price for the buying division is set equal to the
selling divisions actual or standard costs
o Transfer price for the selling division is set equal to the
price to external customers or to the market price in the
selling divisions market
o

Compensation Policies
Compensation committee
o In theory:
represents interests of owners in setting compensation of top
executive team
sets compensation based on performance or market
o in practice:
sometimes appear to be beholden to executives
compensation decisions often bear little relationship to performance
Aligning incentives
o Research shows:
For the CEO and senior managersstock options and stock grants are
tied to performance
Cash bonus and salary are not tied to performance
o Theory predicts:
stock options and stock grants have a long time horizon
cash bonus and salary have a short time horizon
Refocusing
Corporate level strategy may call for exiting a business
o a conglomeration discount may exist
the corporation may lack necessary skills
expected economies of scope may not exist
o the corporation may need funds for core activities
International Implementation
Global strategy
o Centralized hubstrategic and operational decisions are retained at
corporate headquarters
Facilitates global integrationsame product everywhere you go
Exploits a global product
Exploits scale economies
Multi-domestic strategy
o Decentralized federation- strategic and operational decisions are
delegated to divisions or country companies
Highly autonomous units
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 Very responsive locally

Coordination federation- operational decisions are delegated to divisions
or country companies; strategic decisions are retained at corporate
headquarters
Less autonomous
Some shared activities between divisions
Transnational structure- strategic and operational decisions are delegated to
those operational entities that maximize responsiveness to local conditions and
international integration
o Facilitates both local responsiveness and global integration
o Country managers are responsible for exploiting economies of scope
o Corporate HQ constantly scans the globe looking for best practices
o

Chapter 9Strategic Alliances

What is a Strategic Alliance?
Strategic Alliance- Any cooperative effort between two or more independent
organizations to develop, manufacture, or sell products or services
o Three types of Alliances
Non-equity alliance- cooperation between firms is managed directly
through contracts, without cross-equity holdings or an independent
firm being created
Contracts
o Licensing- one firm allows others to use its brand name to
sell products
o Supply- one firm agrees to supply to others
o distribution agreements- one firm agrees to distribute the
products of others
Equity alliance- cooperative contracts are supplemented by equity
investments by one partner in the other partnersometimes these
investments are reciprocated
Cross equity holdings
Partners own stakes in each other
Joint venture- cooperating firms form an independent firm in which
they invest. Profits from this independent firm compensate partners for
this investment
Joint equity holdings
Independent firm is created and owned by the partners

Motivation for Alliances

Create economic value by:
o accessing complementary resources and capabilities
o leveraging existing resources and capabilities
An alliance is an organizational form of exchange that:
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should produce a gain from trade due to some comparative or absolute

advantage
Implication: Choose partners that are better at something than you are
(complementary resources)
o

How Strategic Alliances Create Value

Improve current operations:
o Exploiting economies of scale
partner brings increased market share and/or manufacturing capacity
o learning from partners
a partner brings technology and/or market knowledge
o risk and cost sharing
a partner bears a portion of the risk and/or cost of the alliance
Shaping the competitive environment
o Facilitating technology standards
partners may agree on a standard and avoid a market battle for the
standard
network industries- industries where single technical standards and
increasing returns to scale tend to dominate, competition in these
industries tends to focus on which of several competing standards will
be chosen
increasing returns to scale- in network industries, the value
of a product/service increases as the number of people using it
increases
o facilitating tacit collusion
partners may communicate within an alliance in subtle, legal ways
whereas the same communication between competitors outside an
alliance would be illegal
Facilitating entry and exit
o Low-cost entry into new industries
a partner provides instant access and legitimacy
o Low-cost exit from industries
a partner is an informed buyer
o Managing uncertainty
alliances may serve as real options- option that a firm buys under
uncertain conditions to retain the ability to move quickly into a market
if valuable opps present themselves
o Low-cost entry into new geographic markets
partners provide local market knowledge, access, and legitimacy with
governments and customers
Challenges to Value Creation and Allocation
Incentives to Misappropriate Value (Cheat)
o An alliance is an exchange context in which:
partner inputs may be difficult to monitor
actual value creation may be difficult to monitor
o value appropriation (allocating the value) may be:
difficult to monitor
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 subject to power dynamics

Three Forms of Misappropriating Value
Holdupexploiting the transaction-specific investment of partners
o When one firm makes more transaction-specific investments in a strategic
alliance than partner firms make
o Transaction specific investmentwhenever an investments value in its firstbest use (within the alliance) is much greater than its value in its second-best
use (outside of the alliance)
Moral hazardproviding inputs of lesser value than promised
o Partners in an alliance may possess high-quality resources and capabilities of
significant value in an alliance, but fail to make those resources and
capabilities available to alliance partners
Adverse selectionmisrepresenting the value of inputs
o advertise something that you do not actually have
o Exists when an alliance partner promises to bring to an alliance certain
resources that it either does not control or cannot acquire
Sustained Competitive Advantage
Are strategic alliances rare?
o As a form of organizing economic exchange, NO!
However, the sources of value creation within alliances may be rare
The strategic alliances arent rare, but the value they create may be considered rare
o firms may form a combination of complementary resources within an alliance
that is rare
o the stock of such complementary resources may be limited so that first
movers have a rare combination
Are strategic alliances costly to imitate?
o As a form of organizing economic exchange, NO!
the organizational form per se is easily duplicated
However, the resource combinations that create value in alliances may be very
costly, if not impossible, to imitate if:
o the value creating combination depends on social complexity (trust), causal
ambiguity, and/or historical uniqueness
Substitutes for Strategic Alliances
Going it alone- when firms attempt to develop all of the resource and capabilities
they need to exploit market opportunities and neutralize market threats by
themselves
o sometimes can create the same, or more, value than using alliances
alliances will be preferred over going it alone when:
o the level of transaction-specific investment required to complete an exchange
is moderate
o an exchange partner possesses valuable, rare, and costly-to-imitate
resources and capabilities
o there Is great uncertainty about the future value of an exchange
alliances will be preferred over acquisitions when:
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o
o
o
o

there are legal constraints on acquisitions

acquisitions limit a firms flexibility under conditions of high uncertainty
there is substantial unwanted organizational baggage in an acquired firm
the value of a firms resources and capabilities depends on its independence

Organizing Strategic Alliances

Governance responses to the challenges of value creation and allocation
Formal/codified
o Explicit Contracts & Legal Sanctions
creates mutual understanding
imposes costs for cheating
conflict resolution
o equity investments
aligns interests of partners through ownership in each other
indirect effect
o joint ventures
aligns interests of partners through ownership of independent firm
direct effect
informal
o firm reputations
the shadow of the future constrains cheating
o trust
may allow partners to exploit opportunities that would be infeasible
with other mechanisms
These responses are not mutually exclusive:
o contracts may be used with equity investments and joint ventures along with
firm
o reputation and trust reputation and trust come into play in every type of
alliance
o Reputation and trust may be sources of competitive advantage because they
are costly to imitate
International Expansion
Alliances may be attractive because:
o Local market knowledge is usually critical
o governments may require a local partner
o international expansion may be:
fraught with uncertainty
high risk
expensive
o alliance investment may be more easily reversed than internal development
or acquisition

Chapter 10Mergers and Acquisitions

Logic of corporate level strategy applies
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Corporate level strategy should create value:

o such that the value of the corporate whole increases
o such that businesses forming the corporate whole are worth more than they
would be under independent ownership
o that equity holders cannot create through portfolio investing

Mergers and Acquisitions Defined

o Mergerstwo firms are combined on a relatively co-equal basis
parent stocks are usually retired and new stock issued
name may be one of the parents or a combination
one of the parents usually emerges as the dominant management
o Acquisitionsone firm buys another firm
can be a controlling share, a majority, or all of the target firms stock
can be friendly or hostile
usually done through a tender offer
the words are often used interchangeably even though they mean something very
different
merger sounds more amicable, less threatening
Do Mergers and Acquisitions Create Value?
The logic:
o Unrelated M&A Activity
there would be no expectation of value creation due to the lack of
synergies between businesses
there might be value creation due to efficiencies from an internal
capital market
there might be value creation due to the exploitation of a
conglomerate discount
o a corporate raider who buys and restructures firms
Types of Mergers and Acquisitions
Federal Trade Commission (FTC )Categories:
o Related:
Vertical- a firm acquires former suppliers or customers
Horizontal- a firm acquires a former competitor
Product extension- a firm gains access to complementary products
through an acquisition
Market extension- a firm gains access to complementary markets
through an acquisition
o Unrelated:
Conglomerate- there is no strategic relatedness between a bidding
and a target firm
Economic Profits in Unrelated Acquisitions
The target firmobject of the acquisition has a current market value of $10,000
The bidding firms have a current market value of $15,000
Because there is no strategic relatedness between the bidding firms and the target
firm, the value of the bidding firms when combined with the target firm equals the
26

sum of the value of these firms as separate entitiesthe value of the combined
would be $25,000
o Bidding firms will be willing to pay a price for a target up to the value that the
target firm adds to the bidder once it is acquiredany price less than
$10,000 will be a source of economic profit for the bidding firm
o The bidding will increase until it reaches $10,000thus the bidding firm will
earn a zero economic profit
Different Sources of Relatedness between Bidding and Target Firms
Lubatkins List of Potential Sources of bidder-target relatedness:
o Technological economies
Scale economies that occur when the physical processes inside a firm
are altered so that the same amounts of input produce a higher
quantity of outputs
Sources of technical economies include marketing, production,
experience, scheduling, banking, and compensation
o Pecuniary economies
Economies achieved by the ability of firms to dictate prices by exerting
market power
o Diversification economies
Economies achieved by improving a firms performance relative to its
risk attributes or lowering its risk attributes relative to its performance
Sources of diversification economies include portfolio management and
risk reduction
Economic Profits in Related Acquisitions
If bidding and target firms are strategically related, then the economic value of
these 2 combined firms is greater than their economic value as separate entities
1 target and 10 bidding firms, market value of the target is 10,000 and the bidding
firms is 15,000
o When any of the bidding firms and the target firm are combined the value is
32,000
Bidding firms will be willing to pay a price for a target up to the value that a target
firm adds once its acquiredmax bidding price is 17,000
The successful bidding firm will bid 17,000 and earn zero economic profit
The target firm will earn an economic profit of 7,000
Do Mergers and Acquisitions Create Value?
The logic:
o Related M&A activity
o Value creation would be expected due to synergies between divisions
Economies of scale
Economies of scope
Transferring competencies
Sharing infrastructure
The empirical evidence:
o Research is based on stock market reaction to the announcement of M&A
activity

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this reflects the markets assessment of the expected value of the merger or
acquisition
o these studies look at what happens to the price of both the acquirers stock
and the targets stock
thus, we can see who is capturing any expected value that may be
created
M&A activity creates value, on average, as follows:
o Acquiring firmsno value created
o Target firmsvalue increases by about 25%
o Related M&A activity creates more value than unrelated M&A activity
o M&A activity creates value, but target firms capture it
Expected vs. operational value
o

Possible Motivations to Engage in Acquisitions Even Though they usually dont Generate
Profits for Bidding Firms
Survival:
o Avoid competitive disadvantage
o Avoid sale disadvantages
Free cash flow:
o the amount of cash a firm has to invest after all positive net present value
investments in its ongoing businesses have been funded
o Cash generating, normal return investment
Agency problems
o Managers benefit from increases in size
o Managers benefit from diversification
Managerial hubris:
o Unrealistic belief held by managers in bidding firms that they can manage the
assets of a target firm more efficiently than the target firms current
management
o Managers believe they can beat the odds
Potential for Above normal profits:
some M&A activity does generate above normal profits (expected and
operational over the long run)
proposed M&A activity may satisfy the logic of corporate level strategy
managers may see economies that the market cant see

Jensen and Rubacks List of Reasons Why Bidding Firms Might Want to Engage in
Acquisition Strategies
to reduce production and distribution costs:
o through economies of scale
o through vertical integration
o through the adoption of more efficient production or organizational
technology
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through the increased utilization of the bidders management team

through a reduction of agency costs by bringing organization-specific assets
under common ownership
Financial Motivations:
o To gain access to underutilized tax shields
o To avoid bankruptcy costs
o To increase leverage opportunities
o To gain other tax advantages
o To gain market power in product markets
o To eliminate inefficient target management
o
o

Competitive Advantage
Can an M&A strategy generate sustained competitive advantage?
o Yes, if managers abilities meet VRIO criteria:
Managers may be good at recognizing & exploiting potentially valuecreating economies with other firms
Managers may be good at doing deals
Managers may be good at both
Recognizing and exploiting economies of scope
o Private economies: example
Firm Cs recognized value is $10,000
Firm A sees value of $12,000 in Firm C
Firm A can earn a profit of $2,000 only if the economy remains private
o Costly to imitate economies: example
if the economy between A & C is costly to imitate, it doesnt matter if
other firms know
Firm A can still earn a $2,000 profit
o Unexpected economies: example
Firm C has a market value of $10,000
Firm A buys Firm C for $10,000
Firm C turns out to be worth $12,000
Rules

for Bidding Firm Managers

Search for valuable and rare economies of scope
Limit information to other bidders
Limit information to the target
Avoid winning bidding wars
Close the deal quickly
Operate in thinly traded acquisition markets
o A market where there are only a small number of buyers and sellers, where
information about opportunities in the market is not widely known, and where
interests besides purely maximizing the value of a firm can be important

Rules

for Target Firm Managers

Seek information from bidders
Invite other bidders to join in bidding contest
Delay, but do not stop the acquisition
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Implementation Issues
Structure, control, and compensation
o M&A activity requires responses to these issues:
m-form structure is typically used
management controls & compensation policies are similar to those
used in diversification strategies
o Managers must decide on the level of integration:
target firm may remain somewhat autonomous
target firm may be completely integrated
Cultural differences
o high levels of integration require greater cultural blending
o cultural blending may be a matter of:
combining elements of both cultures
essentially replacing one culture with the other
o integration may be very costly, often unanticipated
o the ability to integrate efficiently may be a source of competitive advantage
Government Policy
o governments may constrain ownership by foreign firms
o governments may restrict repatriation of profits
o government labor policy may limit a firms ability to apply management
practices to target firm

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