Growth Strategy \b Growth strategy of a firm is concerned with answering two questions: (a) what businesses should a firm participate in so as to maximize its long-run profitability? and (b) what strategies should the firm use to enter or exit those businesses? By following these strategies, the firm seeks to add shareholder value. In order to ad d valu e, a corporate strategy should enable a company, or o ne or more of its business units, to establish and/or sustain its competitive advantag e. Firms enter businesses either related or unrelated to their core or flag\ ship business, leading to related or unrelated diversification. Related diversification can als\ o take the shape of vertical integration, where the firm enters the businesses of its suppliers or it\ s customers, as it seeks to gain control over the supply and delivery systems. On the other hand, fi\ rms can enter businesses that are complementary to their businesses, but are not necessarily form\ s of vertical integration.
Take the case of ICICI Bank entering the life insurance business through\ its subsidiary, ICICI Prudential Life Insurance. Here, the banking and financial services comp\ any (ICICI Bank) enters the life insurance business with an intention of leveraging its e\ xisting assets (including customer base) and competencies to its advantage in the life insurance \ business.* Growth Strategy \b \f \b \f \b \f \b \b \b \f \b \f\b \f \b \b \b \b \b \f \b \b \b \b \f \f *http://www.iciciprulife.com/ipru/about.jsp (accessed on July 11, 2004). Business Policy and Strategic Management: Concepts and Applications It is not uncommon to see firms entering businesses that are not related\ to their core business. For instance, the Ramco group in India with its dominance in c\ ement, fiber, cement- products, cotton yarn, software systems, and surgical systems, entered t\ he wind power business.* As firms continue their unrelated diversification, they may build a port\ folio of businesses and eventually evolve into a conglomerate, where the distinction between cor\ e business and allied businesses ceases to exist.
For instance, the Tata Group ( www.tata.com) has interests in a variety of businesses, ranging from software, steel, automobiles, and tea to consulting services. It is\ hazardous to guess what the core business of the Tata group is!
Having decided to enter a new business, firms also take multiple ways of\ developing their businesses—internal development, acquisitions, mergers, joint venture\ s, or strategic alliances.
There are both advantages and disadvantages of these methods, and the ch\ oice of the method is dependent on a variety of firm and industry-level factors. In th is chap ter, we exp lore the differen ces b etween sing le-busin ess and multiple-business firms; p urposes, advantages, and disadvantages of vertical integration; why an d how do firms d iversify; and elucidate the valu e added through diversification. TYPOLOGY OF GROWTH STRATEGY A common typology of g rowth strategy is based on “specialization ratio” (th e firm’s sales within its major activity as a proportion o f its total sales) and “relatedness ratio” (the proportion of the firm’s total sales that are related to each other). This is s\ hown in Table 8.1. TABLE 8.1 Classification of Growth Strategy Type of company Specialisation Ratio Relatedness and Sub-Types (Share of major business in total revenue) Low 1. Single Business SR > 95% Companies 2. Vertically Integrated Vertically-related Companies sales > 70% 3. Dominant Business 95% < SR < 70% (3.1) “Dominant-constrained” Companies Majority of other businesses share linkages (3.2) “Dominant-linked” Majority of other businesses related to at least one other business (3.3) “Dominant-unrelated” Majority of other businesses unrelated 4. Related-Business SR < 70% (4.1) “Related-constrained Companies Majority of businesses share linkages (4.1) “Related-linked” Majority businesses linked to at least one other business 5. Unrelated-Business SR < 70% High Companies Source: Adapted from Rumelt (1974).
Level of Diversification * http://www.blonnet.com/2003/11/28/stories/2003112802380200.htm (accessed on July 11, 2004). Chapter 8 Corporate Strategy Formulation Firm infrastructure Human Resource Management Technology Development Procurement Inbound Logistics Coerations Outbound Logistics Marketing and Sales Service Shared Logistics Shared Technology Development Shared Procurement Shared Marketing Functions Inbound Logistics Coerations Outbound Logistics Marketing and Sales Service Margin Margin Firm infrastructure Procurement Technology Development Human Resource Management Several studies show that during 1950s–1970s, the number of single bu\ siness companies fell, as diversification became the preferred form of growth, while the number of\ diversified firms increased.
The percentage of both related and unrelated diversified firms increased\ dramatically over this period, as can be seen from the Table 8.2, which shows the largest companies in the US and the UK. TABLE 8.2 Ch anges in the Growth Strategy of the largest US an d UK firms durin g 1950s–1970s UK–largest 305 US–Fortune 500 firms manufacturing firms 1949 1974 1960 1975 Single business firm 42.0% 14.4%34.2% 12.5% Vertically integrated companies 12.8% 12.4% 2% 3.4% Dominant business companies 15.4% 10.2% 23.5% 21.6% Related business companies 25.7% 42.3% 32.0% 49.0% Unrelated business companies 4.1% 20.7% 7.4% 13.5% Total100% 100%100% 100% Source: Rumelt, R. (1982), Diversification strategy and profitability, Strategic Management Journal, 3: 359–370 and Jammine, A.P. (1984), Product diversification, inter\ national expansion and performance:
a study of strategic risk management in U.K. Manufacturing, Ph.D. disser\ tation, London Business School.
Research also shows that while the related diversified firms improved th\ eir performance, the unrelated diversified firms were unprofitable. During the 1980s, unrelat\ ed diversified firms in the US came under attack from leveraged buyouts, and were restructured a\ nd focused around fewer, related set of businesses, through sale of unrelated businesses.
Proctor and Gamble (P&G) restructured during the 1980s to focus on bus\ inesses that had a high degree of relatedness ratio, i.e., sharing of physical resources an\ d market power, and Business Policy and Strategic Management: Concepts and Applications transfer and exchange of knowledge and learning. An example was the pape\ r towels business and the baby diapers business. Value chain analysis as shown above indic\ ated the extent of relatedness. Both these businesses shared procurement, in-bound logistic\ s, and technology development (both used paper, sourced from common vendors), as well as\ marketing functions (both were consumer products, marketed through common channels).
Source: Porter, M.E. (1985), Competitive Advantage: Creating and sustaining superior performance , New York: Free Press.
The restructuring trend diffused to the European companies in the 1990s,\ as the companies sought to refocus and mobilize resources from sale of unrelated businesses for \ a pan-European or internationalization strategy. After the East Asian crisis of 1997, many\ Asian companies have also become more conscious of the need for restructuring and achieving relate\ dness to be able to compete on a global scale. Consequently, a variety of corporate strategy\ patterns are becoming evident within each industry. Different companies within an industry may\ pursue different paths of corporate growth through diversification, based on diverse bases of r\ elatedness in their businesses. Thus, hospitals have gone into hotels, oil companies into fo\ od retailing, car companies into finance, and electric suppliers into telecom and other utilities (\ see Exhibit). Hotels Catering Hospitals Managed Care Pharma industry Biotech Agro industry Nutraceuticals Consumer goods Supermarkets Car industry Car Fleet Management Transport services “Car bank” Bank All-finance Insurances Gas station shops Gasolin Food retailing Oil industry WaterMulti utility Electricity Telekom TV, Hifi Multimedia Software Computer Outsourcing IT-consulting \b \f The primary concern o f growth strategy in a sin gle business firm lies in answering a basic q uestion—is there value added? Most firms begin their operations as a single busin ess, usually fo r wan t of resources (financial, operating, or managerial) or capabilities. \ As firms grow, they seek to Source: Bruche, G. (2000), Corporate Strategy, Relatedness and Diversificatio\ n, Working Paper #13 of the Business Institute, Berlin. Chapter 8 Corporate Strategy Formulation expand their businesses. As a firm invests in building industry-specific capabilities, it seeks to secure its competitive advantage in that business. With its current resources and capabilities, the firm grows with the market, and adds significant value to its shareholders, customers, and employees.
On the other hand, a significant market risk is associated with the focus on a single business.
As the market grows and the firm continues to secure and sustain its competitive advantage, it continues to add value. But if either the market begins to shrink or the company begins to lose its competitive advantage (either due to changes in technology, customer preferences, new or improved product/service offers from competitors, or regulatory changes that disfavor the firm and its strategies), the firm ceases to add value. This market risk could have been hedged by investing in other businesses that would not be affected together with this particular business.
Another disadvantage of a single-business is the extent and depth of relationships that the firm needs to maintain with its raw material suppliers, technology vendors, business partners, marketing channel partners (wholesalers, distributors, and retailers), and other such firms and agencies.
What Single Business is Not!
A large number of manufacturers in India operate in one dominant business related to some agriculture product. For instance, many companies are engaged in the primary processing of castor seed and oil. A growing number of firms have over the years sought to diversify, seeking opportunities for value addition. While the law makes it mandatory to provide segment results, most of these companies claim that they operate in a single business. For instance, Tata Motors, which operates in Heavy and Light Commercial Vehicles and passenger cars, claims that it operates in a single business segment. However, it discusses the environments of these markets separately in management discussion and analysis part of the annual report, suggesting that the market for these products is independent. A major reason is that the firms do not wish their competitors to find out about the performance of their individual businesses.
Source: Narasimhan, M.S. and S. Vijayalakshmi (2004), The baggage of opaqueness, February 5, Business Line.
When a corporation performs activities in multiple lines of business spanning more than one block of the industry value chain, it is considered vertically integrated. In an industry value chain, different firms could perform the various activities that add value to the consumer. This industry structure gives rise to various forms of transaction costs as each firm makes its profits, and builds in inefficiencies in the transfer of goods and services from one firm to another. Vertical integration is an attempt at reducing these transaction costs in delivering the final value to the end-consumers. Vertical integration helps an organization integrate its businesses efficiently so that output of one business feeds into the other. Vertical integration could be either backward integration—through coordinating upstream operations (operations closer to the sources of raw materials), or forward integration—through coordinating downstream operations (operations closer to the end-customers). Business Policy and Strategic Management: Concepts and Applications Before an organization decides to vertically integrate, it needs to answer the following questions.
(a) Are our existing suppliers (or customers) meeting the needs of the end-customers?
When specific skills and competencies are required to perform certain activities in the industry value chain that are not easy to learn/imitate/replicate, it would be better to have those set of activities performed by specialists.
For instance, the shoe maker Nike has effectively used this strategy of outsourcing its production to units in South East Asia, and its logistics to Federal Express, while focusing on brand building and marketing.
On the other hand, if ensuring the right quality of raw materials or providing the right products/service to one’s customers through a tight control of activities is important, integrating vertically might be necessary. Vertical integration into performing such critical activities of the businesses ensures that the firm is able to provide the requisite quality of products/services at appropriate prices.
Sometimes, vertical integration may also significantly help in entering into that set of activities that provide high volumes or high margins in that business.
For instance, in the Indian dairy business, the Gujarat Cooperative Milk Marketing Federation (GCMMF) is vertically integrated through promotion of cattle health, cattle feed, collection of milk from farmers, pasteurization, processing into milk powders, producing value added products including butter, cheese and ice cream, their distribution, and their marketing under the brand name ‘Amul’. In this industry, vertical integration helps GCMMF, a traditionally milk collection and processing firm, to enter into activities with significant value addition—manufacturing and marketing of milk products.
(b) How volatile is the competitive situation?
When the competitive environment is volatile, i.e., when competitors’ actions and counter- actions are not easily predictable, or when the technology in the industry is changing fast, or when the basis of competition in the industry is changing frequently, it is best to keep to one’s specialization, rather than commit one’s resources into activities that span the industry value chain. In such cases of volatile environments, flexibility is maintained by outsourcing, and consolidation, so that as things change, the firm could easily adapt to the new bases of competition and/or even exit the business easily if required.
(c) Is it possible to influence the behavior of our upstream/downstream businesses?
Many times a firm could significantly influence the activities of its suppliers and customers.
For instance, a firm could enter into long-term relationships with its suppliers whereby their businesses become mutually interdependent. This mutual interdependence paves the way for a cooperative relationship where both the firms learn from each other, while maintaining market relationships using periodic renegotiation of the contracts. Control over supply and quality of critical inputs could be maintained through establishing such relationships with at least two significant suppliers, and similarly assurance of a minimum level of business could be built in the contract. In such conditions, it would be mutually beneficial for firms to invest in vendor Chapter 8 Corporate Strategy Formulation development and assuring the quality of the inputs/services, rather than getting into those activities themselves.
(d) Will vertical integration enhance the structural position of the business?
Vertical integration has the potential to take firms into such businesses that could have been traditionally wielding significant market power or the potential for high volumes or high margins.
For example, the erstwhile Gramophone Company of India (GCI) integrated forward to distribution of music through the internet through their e-commerce website www.saregama.com in order to reap the high margins available in the distribution business, as well as capitalize on their large library of copyrighted music.
Effective vertical integration may offer several benefits to a firm:
(a)Build entry barriers:Verticalintegration could create entry barriers for new entrants (or existing competitors) by denying them either sources of supply of critical inputs, or access to significant customers.
(b)Reduce transaction costs:Vertical integration could reduce transaction costs, such as buying and selling costs, inventory holding costs, and ordering costs.
(c)Better control and coordination of operations:With vertical integration of critical activities either upstream or downstream, firms can have tighter control over the supply of critical inpurts, or the quality of products/services delivered.
(d)Spread fixed and/or overhead costs over a large number of products/services:Vertical integration can help in apportioning fixed and/or overhead costs (like distribution costs, or branding and marketing expenses) over a large number of products and services.
Vertical integration is not free of limitations. Many firms are forced to disintegrate vertically because they underestimated these limitations. The major limitations are as follows:
(a) When the different lines of businesses operate with different minimum efficient scales, ‘balancing the line’ across the various businesses is difficult, and therefore ineffi- ciencies might creep in. When plants of minimum efficient scales create a situation where one of the lines in the business has a larger capacity than those of its customers, the excess production has to be sold in the market to its competitors, resulting in transaction costs that vertical integration was originally designed to avoid.
(b) Vertical integration can force organizations to commit to particular technologies/ products, and risk losing their flexibility in times of technological obsolescence or changes in customers’ tastes and preferences. In order to remain competitive and up-to- date with the market, the vertically integrated corporation has a responsibility to be innovative and efficient at all the lines of businesses it operates in, in comparison to its tightly focused competitors in each of the lines of businesses.
(c) Vertically integrated firms have to deal with the problem of integrating significantly Business Policy and Strategic Management: Concepts and Applications different lines of business into a coherent whole. Each of these lines of business could be faced with different critical success factors, and the internal organizing, structure, and cultures could be different across different business lines. For a vertically integrated firm to become truly integrated, it must manage these differences through a robust system of organizing, culture building, and performance management across all its business lines. The challenge can be daunting, as in the following case:
Take, for example, the pharmaceutical industry, where conducting basic research involves managing scientists working in a collegiate culture; doing product development involves managing pharmacists and chemists working in an informal culture; manufacturing the drugs involves managing engineers and workers in a formal hierarchy; and marketing and distribution of the drugs involves managing logistics partners, and a field force of medical representatives selling the products to the physicians and retailers. Many firms, in order to balance the advantages and limitations of vertical integration follow a strategy of tapered or hybrid form of vertical integration (see Figure 8.1). As opposed to full vertical integration, a hybrid strategy allows the firm to integrate some elements fully, while depending on suppliers or customers for others. While helping the firm reap some of the benefits of vertical integration, this strategy also brings in the benefits of outsourcing to the firm— controlling some of the bureaucratic costs of running an organization. Bureaucratic costs that outsourcing controls include the lack of insiders’ incentive to learn and reduce their operating costs, and the lack of strategic flexibility for the firm in times of changing technology or uncertain market demand.
Hybrid or tapered vertical integration helps balance the reduction in transaction costs and bureaucratic costs through keeping the internal suppliers ‘on their toes’, as they are constantly benchmarked against their more focused external counterparts. A similar pressure is exerted on the suppliers, as they are also aware that the firm has a potential to fully integrate, and they could Chapter 8 Corporate Strategy Formulation \b lose their business if they are not competitive. This constant pressure \ on both sides to remain competitive could significantly accentuate the significant benefits of v\ ertical integration, viz., elimination of transaction costs, and ensuring control over critical sup\ pliers and customers.
The public transportation and electricity distribution services in Mumba\ i are carried out by BEST Undertaking— the Brihanmumbai Electric Supply and Transport Undertaking.* The operation wing of the transportation engineering department of BEST consists of 25\ bus depots spread over the areas of greater Mumbai. All the depots carry out various maintenanc\ e functions, including preventive maintenance, unit replacement, and body damage repairs of bus\ es. They also stock various units, important chassis/bus components. BEST faces higher in-ho\ use labor cost; therefore it gives many jobs, such as body building, body repairs, tyre \ re-treading, tyre cut repairs and reclaimation of spares, to outside contractors. This allows \ it to have benchmarks to control internal costs, and to gain learning about the alternative appro\ aches and best practices. \b \f The corporate diversification is driven by an assumption that good managers would be able to manage any business irrespective of the product/service, and that multip\ le businesses would balance cash flows of the corporate. In the case of related diversificat\ ions, where the output or processes of one business would feed into one or more businesses, the di\ versified corporation would look for synergies across different businesses. ‘A fundamental \ role of diversification is for corporate managers to create value for shareholders in ways sharehol\ ders cannot do better for themselves.’ (Lubatkin, 1998). It could be argued that sharehol\ ders do not need corporate managers to create value through diversification; instead, they could cr\ eate a portfolio of stocks to ensure balanced cash flows. Therefore, a diversification that does not c\ reate a value greater than a shareholder’s portfolio would ideally not be justified. This value ad\ dition would be possible only when diversification results in either the improvement in the core proce\ sses, or in enhancing the structural position of the business leading to significant competitive a\ dvantage. For instance, with their highly qualified pool of managers (like the Tata Administrative S\ ervices) and state-of-the-art business practices (the Tata Excellence Business Model), business hous\ es like the Tatas are able to add significant value to the variety of businesses they are in. A significant feature of competition is as follows—‘competition occurs at the business unit level, and not at the corporate level.’ A successful g rowth strategy should appreciate th is fact, and facilitate and reinforce the comp etitive strategies of individ ual business units. The nature o f competitive strategies for each of the business units co uld vary depending on the specific indu stry context of th ose businesses, and th e corporate strategy sho uld be able to provide adequate emphasis on the comp etitive success o f each of th e business units. Diversification results in the increase in costs of coordination, planni\ ng, of building the corporate brand/image along with the product/business unit image, and of\ alignment of financial reporting and personnel policies with the existing corporate systems of \ the firm. Therefore, diversification cannot succeed unless it provides for significant value \ addition: (a) to business units by reinforcing and complementing their competitive strategies, and\ providing for tangible benefits to the business units in return to their loss of independence; \ and (b) to shareholders by providing them the portfolio of business that they could not replicate i\ n the capital market. *http://www.bestundertaking.com/trans_engg.asp#OrganisationalSetup , (Accessed June 20, 2005). Business Policy and Strategic Management: Concepts and Applications As an organization decides to diversify, there are three means available to them—mergers/ acquisitions, strategic alliances/joint ventures, and internal development.
Mergers and Acquisitions Merger and acquisition refer to the outright purchase of a company already in operation by another company, where there is only one company existing after the transaction. Acquisitions are the quickest way to diversify into a new business, as managers get to buy established brands, production facilities, trained and experienced employees, and distribution channels in one deal.
Take for example the acquisition of Qutub Hotel (earlier an ITDC property) by the Indian writing instruments market leader, Luxor Writing Instruments Private Limited. With this acquisition and more to follow, Luxor intends to diversify into hotels and other related businesses.* Such acquisitions of existing firms help acquiring companies readily gain access to cash flows immediately, as compensation to the cost paid for the acquisition.
Strategic Alliances and Joint Ventures Strategic alliances refer to agreements between companies to form collaborative arrangements and partnerships. When a new legal entity is created in a strategic alliance, the partnership is called a joint venture. Strategic alliances/joint ventures are entered into when firms see complementarities amongst their competences. Collaborative synergies are the dominant basis for firms entering into strategic alliances or joint ventures.
For example, Indian diversified business group TATA has entered into a joint venture with American International Group Inc. (AIG), the leading US based international insurance and financial services organization and largest underwriter of commercial and industrial insurance in America, to form a new entity called TATA-AIG Life Insurance Company. † It represents the trust and integrity of TATA Group combined with the international expertise and financial strength of AIG Inc. ‡ Internal Development Internal development occurs when firms diversify into other businesses through a process of developing their own skills and resources, and making fresh investments into creating the appropriate manufacturing and/or marketing infrastructure. Companies like Reliance Industries Limited (www.ril.com) have grown into a variety of businesses through internal development of greenfield ventures, and internally building the requisite skills and competencies for managing those businesses.
*http://www.blonnet.com/catalyst/2002/12/19/stories/2002121900140300.htm (accessed on July 11, 2004).
†http://www.tata.com/tata_aig_life/ (accessed on July 11, 2004).
‡http://www.tata-aig.com (accessed on July 11, 2004). Chapter 8 Corporate Strategy Formulation \b \b \f There are three forms of diversification—vertical, horizontal, and ge\ ographic. When firms diversify across the value chain, either forward or backward, it is know\ n as vertical diversifi- cation. When firms diversify into business that complement their existin\ g business(es), it is known as horizontal diversification. When firms expand their existing products\ /services to other geographic areas, it is referred to as geographic diversification.
Take for instance, the diversification of NTPC in areas related to their\ core business of power generation, including hydro power, power distribution, trading, coal min\ ing, LNG etc. Through a series of acquisitions and joint ventures, NTPC has forayed into busin\ esses both backward and forward of power generation, as well as horizontal into hydro power \ (from their core business of thermal power), as well as its international operations in \ countries including Bangladesh and Oman.* Table 8.3 describes, with examples, the three means and modes of diversi\ fication. Firms can either diversify vertically, horizontally, or geographically (into new \ markets). The means of diversification could be either through acquisitions and mergers, strate\ gic alliances and joint ventures, or through internal development. Vertical HorizontalGeographic Acquisitions Strategic alliances Internal development Dr. Reddy’s Laboratories has grown through acquiring their raw material suppliers.
State Bank of India entered credit card business, through a JV with GE Capital. 2 Reliance Industries has significantly backward integrated through greenfield ventures. Sterlite group has grown over different businesses through acquisitions like BALCO, and HZL. 1 Tata group’s alliance with AIG for Tata-AIG insurance. 3 GAIL India Limited’s diversification into petrochemicals and telecommunication businesses. Ranbaxy is expanding into the US market through a series of acquisitions.
Maruti Suzuki as a route for Suzuki to enter the Indian automobile market.
Auto majors like Ford and Hyundai invested in India through their own manufacturing facilities.
TABLE 8.3 Means and modes of diversification \f When a firm decides to diversify, it could decide to diversify either in\ business related to its existing lines of businesses, or in businesses that are unrelated to its\ existing businesses.
Related diversification presents opportunities for a firm to levarage th\ e assets, capabilities, and strengths in another business, in a manner such that more value woul\ d be generated with both 1. http://www.frontlineonnet.com/fl1806/18060320.htm (accessed on July 11, 2004).
2. http://careers.gecapitalindia.com/careers/businesses/sbi.htm (accessed on July 11, 2004).
3. http://www.tata-aig.com (accessed on July 11, 2004).
*http://www.ntpc.co.in/aboutus/jointventures.shtml (accessed on July 11, 2004). Business Policy and Strategic Management: Concepts and Applications businesses being part of the same firm, rather than as different firms. For example, it would add significant value to a steel company to enter into iron ore mining, as long as the critical capabilities required in steel manufacturing (such as scheduling and logistics) could be leveraged in their iron ore mining business as well. It is also possible for related diversification to add value through leveraging complementary capabilities across the businesses. For example, airline firms would largely benefit from diversification into resorts and hotels in tourist destinations, as both the businesses would share similar customers, and they could leverage each others’ specialized capabilities.
Related diversification adds value through:
1. Transferring skills, expertise, and capabilities from one business to another: Firms can leverage their capabilities across different businesses to reduce costs, enhance value-added, enlarge the market, or enhance customer satisfaction.
2. Combining the value chains:Firms can significantly lower costs and increase efficiencies by combining the value chains of multiple businesses (such as manufactur- ing multiple products in the same manufacturing plant; using the same logistics — warehousing and transportation, across multiple products; and marketing and selling multiple products and services through the same sales force and channels.) 3. Leveraging strong brand names:Firms could leverage their existing strong brand names across multiple businesses to help achieve significant market share and customer loyalty. For instance, the Indian telecom major Bharti Televentures Ltd.
(www.bharti.com), now leverages their leading brand name “AirTel” (that was originally their brand name for mobile services) across all its other telecom businesses, that include fixed-line services, broadband and internet services, and enterprise voice and data solutions.
4. Creating stronger capabilities:Firms can create stronger competitive capabilities by combining the relative strengths of multiple businesses. For instance, Hindustan Lever Limited (www.hll.com) leverages its strong distribution network that was built for FMCG products to distribute their ice-cream brand “Kwality Wall’s”. This combines the brand strength of Kwality Wall’s with the distribution muscle of Hindustan Lever Limited (HLL) to create a competitive capability difficult for competitors to imitate.
For related diversification to add value, firms need to exploit economies of scope across businesses. Economies of scope are costs savings or efficiency improvements that are attributed to transferring the capabilities from one or more businesses to another. Such economies of scope can exist at the operational level through sharing of activities (in research and development, manufacturing, and distribution and logistics); or at the corporate level through transfer of core capabilities (such as know-how, market power, financial resources, and project management capabilities); or both. For instance, firms like HLL might share packaging and distribution facilities for all its food products, as well as leverage their corporate brand management skills and marketing resources across multiple brands.
Unrelated diversification adds value to firms through ensuring consistently good financial returns, with little or no opportunity to integrate and synergize across businesses. Unrelated diversification is adopted when the senior management of the firm believes in their managerial capability to seek and exploit a growth and earnings opportunity in any industry. For example, firms like the Tata Sons in India (www.tata.com) have diversified into a variety of industries, under a common corporate umbrella. Chapter 8 Corporate Strategy Formulation The criteria for choosing unrelated industries to diversify typically include: (a) growth and earnings potential; (b) contribution to the corporate’s top-line and bottom-line growth; (c) attractiveness of the industry in terms of sustainable growth and earnings, competitive pressures, regulatory changes, and capital requirement; and (d) the cost of entering the business (either the cost of setting up a new business, or the cost of acquisition of an existing firm). Quite often, unrelated diversification is pursued through acquisition of existing firms, rather than setting up new firms in unrelated business. Typically, soft acquisition targets are those firms (a) with investment constraints (including cash-shortages) in a high growth industry, (b) that are significantly undervalued and could be acquired at low acquisition premiums, and (c) that are sick/struggling and could be turned around by the acquiring firms with their managerial capabilities and financial resources.
Unrelated diversification adds value through:
1. Spreading business risk across multiple businesses:The financial and business risk of the corporate is spread across industries, markets, and consumers who are relatively distinct from each other. This largely helps when the firms is active in industries that are volatile and fast-changing.
2. Optimization of financial investments:The corporates can prioritize and optimize their financial investments across multiple businesses, including diverting cash flows from cash-rich businesses to investment-hungry businesses (see the next section on portfolio techniques for more details).
3. Exploiting corporate resources and management capabilities:The financial resources and managerial capabilities of the corporate top management can be effectively leveraged across multiple businesses, to enhance shareholder wealth.
Unrelated diversification adds value only when at least one of the above three conditions are fulfilled. Unrelated diversification works under the assumption that the senior managers in the firm possess the capabilities to manage a diverse set of businesses. Quite often, there is a need for specialized managerial skills for specific industries (especially those in high-growth or volatile businesses such as chemicals, pharmaceuticals, high technology, or knowledge-based industries).
In such cases, the corporate office (senior mangager) might not be quite capable of evaluating the growth opportunities, investment requirements, or earnings potentials in specialized industries, and their decisions might be counter-productive. Portfolio techniques refer to the set of tools used by a multi-business firm to assess, monitor, and evaluate the performance and contribution of its various businesses to its corporate goals and objectives. Bourgeois III, L.J. (1988) summarized the methodology of portfolio planning as follows: Identify separate business units [(divisions, departments, or strategic business units (SBUs)] that correspond to markets or industries that the company serves. Classify the various SBUs on a two-dimensional grid based on competitive position and market potential. Assign to each SBU a strategic mission—growth, maintain the position, harvest the market, or divest, depending on their position on the grid. Based on these strategic missions, allocate resources to each of the SBUs. \b Business Policy and Strategic Management: Concepts and Applications called stars. They operate in high profitability, with high potential fo\ r cash generation. These businesses need a lot of cash to be put back into the business to mainta\ in their dominant position in the market.
Businesses with high market shares in low growth markets are called cash\ cows. They have a high potential for generating cash with very little new investment in \ assets; or in other words, they require much lesser cash to be invested back into their businesses.\ The proper strategy is to generate cash out of the cash cows for investing in other businesses. Businesses with low market shares in low growth businesses are called do\ gs. Their low market shares indicate that they do not have a high potential to generat\ e cash, although they do not need any cash to be invested to stay in the business. But, there is \ also very little opportunity to alter the market share relationships, even if large amount of cash is\ invested in the business. Businesses with low market shares in high growth businesses are known as\ question marks.
The business has low potential to generate cash, whereas the cash demand\ s to stay in the business are very high. The company should either invest heavily in this business\ to ensure that a dominant market position is achieved (become stars), or get out to avo\ id becoming dogs as the market matures and the market growth rate slows down. The major shortcoming in the BCG approach is that it forces managers to \ treat each of the businesses as independent businesses with no relationship at all amongst\ them, which is rarely so. Multiple businesses might share a manufacturing facility, distributi\ on system, or even brand names, so such a segmented approach would not work. The second shortcomi\ ng is that the BCG approach depends on just two factors—market shares, and market growth\ potential. There is a danger of managers taking huge financial decisions based on just two fac\ tors.
\b The BCG approach is based on the experience curve effect. The experience\ curve effect holds that a firm should seek a dominant market position in a business. If the\ firm does not have a dominant market position, it should either seek a dominant position or e\ xit that business. Having attained a dominant position, the emphasis should be on retaining that p\ osition. As shown in Figure 8.2, businesses with high market shares in high growt\ h markets are \b \f \b \f \f !\f " # \f\b " # $ % \b \b &'\f \b \b ( \b \f \f\b) \b * + , ,\b\f - \b \b . $ \b \b\f \b