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Lecture5
To effectively make strategic decisions it is important to examine the external and the
internal environment
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However, organisations also make strategic decisions about the scope of their
activities
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Vertical integration
Vertical integration is the merging together of two businesses that are at different
stages of production
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Vertical integration can be contrasted to horizontal integration, the merging together
of businesses that are at the same stage of production, such as two supermarkets, or
two food manufacturers
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While merging with something
further back in the process (if a food manufacturer merges with a farm) is known as
backward integration
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In the 1970s and 1980s, many companies that were primarily engaged in exploration
and the extraction of crude petroleum decided to acquire downstream refineries and
distribution networks
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Benefits of vertical integration
Higher entry barriers: The more vertically integrated a business, the greater the
financial and managerial resources required to enter and compete in it
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Of course, this is only effective if
vertical integration becomes necessary for competing
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Technological capabilities: Some claim that, in general, businesses and companies that
are vertically integrated are best equipped to innovate because they participate in
many of the production and distribution activities in which change can occur
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Improved coordination: Vertical integration may permit cost reductions through
improved coordination of production and inventory between stages
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Costs of vertical integration
Reduced flexibility: Because vertical integration implies commitment to a particular
technology or way of operating, it can be an extremely risky strategy
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Vertical integration may also be disadvantageous in responding quickly to new product
development opportunities that require new combinations of technical capabilities
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Compounding risks: Vertical integration represents a compounding of risks because
problems at any one stage of production threaten production and profitability at all
other stages
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Developing distinctive capabilities: even large, technology-based companies such as
Rolls-Royce or Philips cannot maintain IT capabilities that match those of IT services
specialists such as IBM
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For example, if General Motors IT department
only serves the in-house needs of GM, this limits the development of its IT capabilities
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Incentive Problems: with vertical integration, internal supplier-customer relationships
are subject to low incentives
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The incentives for the in-house
technicians to respond promptly to the emails are weak
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Corporate diversification
The object is to have securities that counterbalance one another
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Thus, the
overall portfolio value stays as even as possible
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When one line does poorly, the other line does well, and
overall revenues stays the same or grows
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• Very high levels of diversification: less than 70% of revenue comes from the
dominant business and there are no common links between businesses
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For
firms in declining industries this is a discouraging prospect (perspectiva), especially for
top management
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Companies in lowgrowth, cash-rich industries such as tobacco and oil have been specially tempted to
diversify
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Value creation: Michael Porter defines three essential tests which determine whether
diversification will truly create shareholder value
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For example,
pharmaceuticals offer above average profitability precisely because they are
protected by barriers to entry
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In other words, combining different
businesses must enhance the competitive advantage of the original business
and the competitive advantage of the acquired business
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Economies of scope
exist when using a resource across multiple activities uses less of that resource than
when the activities are carried out independently
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In Virgin´s case they
include the brand, Richard Branson`s skills at attracting media coverage and Virgin`s
business partnering capabilities
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The Relationship between Diversification and Performance

Among British companies, diversification was associated with increased profitability up
to a point, after which further diversification was accompanied by declined
profitability
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McKinsey and Company points to the
benefits of moderate diversification
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McKinsey argues that diversification makes most sense when a company has
exhausted growth opportunities in its existing markets and can match its existing
capabilities to emerging external opportunities
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Mergers and Acquisitions involving companies
in different industries appear to perform especially poorly
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The growing turbulence of the business environment may have increased the costs of
managing widely diversified corporations
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Companies that diversify into businesses
closely related to their core activities were significantly more profitable than those
that pursued unrelated diversification

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