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Chapter 8
Corporate Strategy: Vertical
Integration and
Diversification

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 LEARNING OBJECTIVES
1. Define corporate strategy and describe the three dimensions along which it is
assessed.
2. Explain why firms need to grow, and evaluate different growth motives.
3. Describe and evaluate different options that firms have to organize economic
activity.
4. Describe the two types of vertical integration along the industry value chain:
backward and forward vertical integration.
5. Identify and evaluate benefits and risks of vertical integration.
6. Describe and examine alternatives to vertical integration.
7. Describe and evaluate different types of corporate diversification.
8. Apply core competence–market matrix to derive different diversification
strategies.
9. Explain when a diversification strategy creates a competitive advantage and
when it does not.

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 Corporate Strategy
The decisions that leaders make.
Goal-directed actions that they take in the quest
for competitive advantage.
Where to compete?
Boundaries of the firm:
• Vertical integration.
• Horizontal diversification.
• Geographic scope.

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 Why Firms Need to Grow
• To increase profitability and shareholder returns.
• To lower costs and achieve economies of scale.
• To increase market power.
• To reduce risk through diversification.
• To motivate management and employees.

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 Three Dimensions of Corporate Strategy
1. Vertical integration.
2. Diversification.
3. Geographic scope.

Underlying strategic management concepts that guide these are:

• Core Competencies
• Economies of Scale
• Economies of Scope
• Transaction Costs: cost effectiveness of vertical integration vs.
diversification.

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 Transaction Costs
Associated with an economic exchange.
Understanding transaction costs enables strategic
leaders to answer the question of whether it is cost-
effective for their firm to expand through vertical
integration or horizontal diversification.

External transaction costs: Internal transaction costs:

• Searching for contractors. • Recruiting and retaining
• Negotiating, monitoring, employees.
and enforcing contracts. • Setting up a shop floor.

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 Internal and External Transaction Costs
Exhibit 8.3

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 Make or Buy?
Predictions derived from transaction cost economics guide
strategic leaders in deciding which activities a firm should
pursue in-house ("make") versus which goods and services
to obtain externally ("buy"). These decisions help determine
the boundaries of the firm.
If Costsin-house < Costsmarket:
• Vertically integrate.
• Own production of the inputs.
• Or own output distribution channels.

If Costsmarket < Costsin-house:

• The firm should consider purchasing instead.

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 Organizing Economic Activity: Firms vs.
Markets
Exhibit 8.4

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 The Principal-Agent Problem
A major disadvantage of organizing economic
activity within firms as opposed to within markets.
Principal: the owner of the firm.
• Goal: create shareholder value.
Agent: manager or employee.
• Should act on behalf of the principal.
Problem:
• Agents pursue their own interests (job security and
managerial perks) that conflict with the principal's goals.
One Solution:
• Stock options to make agents owners.
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 Information Asymmetry
A situation in which:
• One party is more informed than another due to the
possession of private information.

Can result in the crowding out of desirable goods

and services by inferior ones.

Examples: used cars, e-commerce, mortgage-

backed securities, R&D projects.

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 Alternatives on the Make-or-Buy Continuum
Exhibit 8.5

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 Vertical Integration
The ownership of inputs or distribution channels.
• “What percentage of a firm’s sales is generated within the
firm’s boundaries?”

Backward Vertical Integration: Forward Vertical Integration:

• Owning inputs of the value chain. • Owning activities closer to the
customer.

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 Backward and Forward Vertical Integration
along an Industry Value Chain
Exhibit 8.6

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 Vertical Value Chain of Your Cell Phone
Raw materials:
• Chemicals, ceramics, metals, oil for plastic.
Intermediate goods and components:
• Integrated circuits, displays, touchscreens, cameras,
and batteries.
Final Assembly and manufacturing
Marketing, sales, after-sales service and support:
• Pick a service provider.
• Get wireless data and voice service.
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 HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry

Exhibit 8.7

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Not All Industry Value Chains Stages Are Regularly
Profitable

There are large differences in profit potential in

different stages of the value chain.

Different stages of the vertical value chain

correspond to different profit potentials.
• Apple positioned itself along the value chain in areas of
the highest profit potential, upstream in R&D and product
design and downstream in marketing and sales.
• Foxconn, in contrast, has a low-profit potential because it
focuses on manufacturing

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 Benefits of Vertical Integration

Lowering costs.
Improving quality.
Facilitating scheduling and planning.
Facilitating investments in specialized assets:
• Co-located assets, unique equipment, human capital.
Securing critical supplies and distribution channels.

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 Risks of Vertical Integration

• Increasing costs.
• Reducing quality.
• Reducing flexibility.
• Increasing the potential for legal repercussions.

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 When Does Vertical Integration Make Sense?

When there are issues with raw materials.

• Example: Henry Ford ran mining operations.
To enhance the customer experience.
• Eliminate annoyances and poor interfaces.
Vertical market failure: when transactions are too
risky or costly.

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 Alternatives to Vertical Integration
Taper Integration: Strategic Outsourcing:
• Backward or forward • Moving one or more
integrated. internal value chain
• Plus reliance on outside activities to other firms.
firms such as suppliers or • Example: HR
distributors. management system.

Using taper integration,

firms can combine internal
and external knowledge,
possibly paving the path for
innovation.

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 Taper Integration along the Industry Value
Chain
Exhibit 8.9

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 Types of Diversification

Product Diversification:
• Increase in variety of products / services.
• Active in several product markets.
Geographic Diversification:
• Increase in variety of markets / geographic regions.
• Regional, national, or international markets.
Product-Market Diversification:
• Product and geographic diversification.

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 Types of Corporate Diversification

1. Single business: low level of diversification.

2. Dominant business: additional business activity
pursued.
3. Related diversification:
• Constrained: all businesses share competencies.
• Linked: some businesses share competencies.
4. Unrelated diversification (conglomerate): no
businesses share competencies.

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 The Core Competence–Market Matrix
Exhibit 8.11

© McGraw Hill LLC Source: Author’s adaptation from G. Hamel and C.K. Prahalad (1994), Competing for the Future (Boston: Harvard Business School Press). 25
 The Diversification-Performance Relationship
Exhibit 8.13

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 How Diversification Can Enhance Firm
Performance
• Provides economies of scale (reduces costs).
• Exploits economies of scope (increases value).
• Reduces costs and increase value.

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 Restructuring

Reorganizing and divesting business units and

activities.
Helps refocus a company.

Helps leverage core competencies more fully.

Helpful restructuring tool: BCG growth-share matrix.

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

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 Restructuring the Corporate Portfolio: The Boston
Consulting Group Growth–Share Matrix
Exhibit 8.15

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 Internal Capital Markets
Can be a source of value creation in diversification
strategy.
• A way to allocate capital at a lower cost, if more efficient
than external markets.

A related-diversification strategy can enhance

corporate performance.
• Consider coordination and influence costs.
• Coordination costs are a function of the number, size, and
types of businesses that are linked.
• Influence costs occur due to political manipulation by
managers to influence capital and resource allocation
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