Corporate Strategy

Joe Mahoney and Deepak Somaya

Contents
Module 1: Corporate Scope ...................................................................................................................... 2
Lesson 1 ...................................................................................................................................................... 2
Lesson 1-1: Introduction: Corporate Scope ....................................................................................... 2
Lesson 1-2: Vertical Scope ................................................................................................................... 7
Lesson 1-3: Vertical Scope Part 2 ..................................................................................................... 13
Lesson 1-4: Horizontal Scope Part 1 ................................................................................................ 19
Lesson 1-5 Horizontal Scope Part 2.................................................................................................. 24
Lesson 1-6 Horizontal Scope Part 3.................................................................................................. 29
Lesson 1-7 Managing Integrated Firms ............................................................................................ 38
 Corporate Strategy
Joe Mahoney and Deepak Somaya

Module 1: Corporate Scope

Lesson 1
Lesson 1-1: Introduction: Corporate Scope

Hello. Let's start up by understanding what we mean by corporate scope. To do this, we first
need to revisit our definition of corporate strategy. What we mean by corporate strategy of
course, is the pursuit of competitive advantage through the configuration and coordination of a
company's multi-business activities. So when we think about multiple businesses or multiple
activities, it is only natural to ask, what businesses or activities the company is actually
operating in? and that is exactly what we mean by corporate scope. Corporate scope is one of
the central topics, and it's usually the first topic in any serious discussion of corporate strategy.
 Corporate Strategy
Joe Mahoney and Deepak Somaya

So then, what exactly is corporate scope? What we're talking about here is quite simply the
overall footprint of the company. What activities in businesses is the company engaged in? and
how should they be managed? Typically, when thinking about corporate scope, there are three
key dimensions along which corporate scope may vary. Here, let's have Professor Mahoney
explained it.
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Joe Mahoney and Deepak Somaya

The corporate strategy then, to use our textbook definition, is the idea of scope of the firm, and
what does that mean? Well, there's three different areas for scope of the firm, there's the
industry value chain, and another term for that would be vertical integration, which is part of the
title of this module. The second is, what are your products and services you're going to be in?
That would also be in terms of diversification. Then third, the geography, or sometimes called
the global strategy.

So here we see those three dimensions on the screen of the Y axis of the vertical integration or
the stages of the value chain. The geographic scope in the middle of the regional national and
global markets. If it was a cube, it would be the three-dimensional space. Then finally on the x-
axis, is the horizontal integration of what products and services you're in or often referred to as
diversification. So those are the three dimensions that a corporate management team would
need to think about.
 Corporate Strategy
Joe Mahoney and Deepak Somaya

So the three dimensions of corporate scope are vertical, horizontal, and geography. What
stages of the value chain or network is the firm in? What range of products or services, and
where in the world does it compete? The geographic dimension is one that requires a somewhat
different approach that you will see in our international strategy module. So I will focus here
primarily on vertical and horizontal scope, and I want to highlight for you that these are real
choices that companies make all the time.
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Take the case of vertical scope. For example, PepsiCo acquired most of its bottlers in 2009, and
that's a very clear example of a company changing its vertical scope. It added another stage of
activity to its business from within its value chain. By the way, Coca-Cola also did something
very similar soon after in 2010. We call this type of change in vertical scope, forward integration,
as I will explain shortly.

Here's an example of changes in a company's horizontal scope, GE or General Electric, the

company that is Thomas Edison's legacy, has for a very long time operated in many different
industries. But that configuration of industries or businesses has also changed a lot over time.
Take GE in 2001 under CEO Jack Welch. GE was at that time very active in its financial
services business, GE Capital. Credit cards, consumer banking, trading financial assets,
investing in real estate, project financing, and leasing, GE Capital did it all. The company was
also in television and media through its NPC subsidiary and in the plastics and appliances
business.
By 2019, under CEO Larry Culp, even though the overall company is roughly the same size in
revenues, GE had become a very different company. Capital had shrunk to a every tiny sliver of
the overall company, focused only on a few core activities. Instead, other businesses like power
systems and aviation have grown a lot. GE is no longer in the media business for example nor
is it in plastics or in appliances. Instead, it has a new renewable energy business. Its healthcare
business also become a lot bigger. All of this as a result of strategic actions that the company
has taken. These are very deliberate strategic actions. The 2008 financial crisis pulled a lot of
stress and GE Capital. The company got rid of many parts of that business. It also sold many of
its other businesses to raise cash, and began to focus on a core set of businesses that it really
cared about. Some businesses like renewable and power were added to through acquisitions
and invested in quite heavily.
 Corporate Strategy
Joe Mahoney and Deepak Somaya

Lesson 1-2: Vertical Scope

So now that you have some idea what we mean by vertical and horizontal scope, let's begin by
digging in a little deeper into vertical scope. In corporate strategy, we often talk of vertical scope
and vertical integration together, as if they're the same thing. Why? Because when we think
about vertical scope, there are really two related questions. The first question is which parts of
the value chain or the value network a company should operate in? Keep in mind that this can
change over time. A company can choose to jump into a new stage of the value chain, and the
same time get out of another. There are lots of examples of companies that started in retailing
or distribution, and then decided to go into manufacturing a product, and stop being a retailer or
a distributor. Now, why would a company do that? Quite simply because another part of the
value chain might be more profitable than the one they're in.
Now, this is essentially a business strategy question. Notice what I'm describing is a case of a
company stopping its operations in one part of the value chain or value network, and then
refocusing on a different part of the value chain or value network. So in fact, this is a
fundamental business strategy question about which business or businesses you want to be in.
You can address this question with the tools of business strategy, such as whether the business
is attractive based on a Porter's Five Forces Analysis, or if the company has a significant
sustainable competitive advantage in this particular business, or this particular stage of the
value chain.
By the way, this is also true when thinking about horizontal scope as well. There is similar
business strategy analysis that can be applied to the choice of which businesses to operate in.
So this first question, whether you apply it to the vertical or the horizontal case, it's not really a
corporate strategy question. But instead, it's a set of business strategy questions. Generally,
you want companies to try and be in more profitable businesses, or more profitable value stages
if they can. Then the important question for corporate strategy is whether the same company
should be integrated across specific value stages? This is the classic vertical integration
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Joe Mahoney and Deepak Somaya

question. Does managing these different parts of the value chain within the same company
create more value, which exceeds the sum of the parts, if these different stages were managed
across separate companies? But first, I want you to get familiar with a little terminology.

What do we mean by vertical integration, or vertical scope, as opposed to horizontal integration,

and how to keep this idea clear in your mind? Similarly, we often hear the term forward
integration, or backward integration. What does that mean? If you have done a course on
business strategy, certainly with my course on business strategy, you're familiar with the idea of
a value chain.
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Joe Mahoney and Deepak Somaya

So if you start with a value chain and turn this on its side, you get a value chain that's oriented
from the bottom to the top. That's this vertical idea. If you think of many such vertical
businesses, possibly in different industries side-by-side, integrating across those businesses,
that's horizontal integration. So if you look at this value chain, at the very front end is the
customer, and the closer you get to the customer, that's what we think of as forward integration.
At the backend, where the raw materials come in, the closer we get to that end, that's what we
think of as backward integration. So for example, if your business is currently in final production,
and it decides to get into distribution and logistics, or even further down into marketing and
sales itself, then that would be an example of forward integration. On the other hand, if the
same company decides to integrate into intermediate stages like making components, or get
into supplier logistics, or even get into raw material production, that would be an example of
backward integration. Now, all activities don't naturally fall within this vertical forward backward
way of looking at things. For example, there are all the support activities. In non-manufacturing
businesses, the value chain itself may make little sense and you may want to use a value
network instead. But even in these cases, there is such a thing as vertical integration. You just
need to break free of the origins of the vertical metaphor, and simply think about whether an
activity is part of the value creation process for the business. Another trigger is anytime you
think of outsourcing. So if you're thinking about outsourcing, and the choice around outsourcing
a particular activity, that's an example of vertical integration. A classic example would be
information technology. Should you build an information technology system yourself, that
supports your business internally, or should you outsource this to someone else? That's a
vertical integration choice. Even though IT is not a primary activity that lies along the value
chain.
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Joe Mahoney and Deepak Somaya

So how can we think about this decision to outsource or vertically integrate? Often, companies
outsource when they don't have the quality of the needed resources or capabilities to handle an
activity. So for example, it may just be difficult for the University of Illinois to reproduce the
software and technology skills that Coursera has built, and is able to add to in it's Silicon Valley
location. I will note here, and this is something I've done some research on, that this kind of
reliance on another firm due to a lack of capabilities can be self-reinforcing. What I mean is that
Coursera, in our example, is constantly able to keep learning and improving its capabilities, as
long as we and others keep outsourcing to them. It becomes harder and harder to catch up
once we start that outsourcing.
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Now, some companies may be strategic about this and actively try to learn from their
outsourcing partners to develop their own capabilities in the long run, so that they can stop
eventually outsourcing a critical or profitable activity. Another reason to outsource maybe that
the partner firm may be better able to aggregate demand and build scale. We can see many
examples of this both on the upstream and downstream end of vertical integration. For example,
companies often outsource primary materials supplies like steel, aluminum or petrochemicals,
and downstream activities like distribution and retail. Quite simply, it's hard for say an appliance
company, or a plastics press company to develop scale in making the needed input materials,
or for companies to aggregate downstream consumer demand in the way that, say, Walmart
can. Similarly, by serving many different universities and learners from all over the world,
Coursera can aggregate demand and build scale in a way that the University of Illinois might not
be able to. Also, it's likely that a standalone organization like Coursera is likely to be much more
responsive to market and technology trends in online education. Because it is focused on a
narrow specific activity, Coursera is likely to stay at the cutting edge of that activity. If it doesn't,
then we can simply switch to another supplier that does
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Joe Mahoney and Deepak Somaya

So on the other hand, why might it makes sense for companies to integrate? One argument
may be market power, such as the possibility of creating entry barriers by controlling a key
resource. For example, perhaps the University of Illinois might reduce the extent of competition
in the online educational space, by owning a popular online platform. Or such ownership may
allow the university to have better control over the prices it wants to charge on such a platform.
Now, keep in mind that both these hypothetical reasons are limited by the presence of
competition, and by antitrust or anti-competition laws. In my judgment, market power arguments
often have serious flaws when they are applied to corporate scope decisions. Another more
valid argument might be that integration can help the university improve quality or cost by giving
it more control over the operations of the platform. Similarly, there may be advantages in
planning, coordinating, or controlling operations on the online platform, and you own it, rather
than working with a supplier. Finally, there is another important argument often made in favor of
vertical integration, which is investments in specialized assets. As we will see shortly, if we need
investments from the supplier that are specific to the buyer, then this creates what we might call
a hold-up problem, that it may not be possible to resolve without vertical integration.
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Joe Mahoney and Deepak Somaya

Lesson 1-3: Vertical Scope Part 2

It turns out that there's a field of research that directly addresses. These questions about when
to vertically integrate, which is called transaction cost economics, or sometimes called the
theory of the firm.
The main propositions of this field have strong statistical validation, although of course there's
always room for new perspectives.
For example, I'm currently working on research that examines how new digital technologies like
AI and Cloud computing. Might affect vertical integration. Transaction cost economics or TCE is
a theory about the scope of the firm which can be applied to vertical integration. And also the
horizontal scope, as we shall see shortly. One of the most prominent names associated with the
theory is that of Oliver Williamson, who won the Nobel prize in economics in 2009 for this work.
TCE deals with both the cost of transactions or economic exchanges. Which can include things
like negotiating, monitoring and enforcing contracts, as well as administrative costs. Which are
associated with organizing activities in a more hierarchical command and control fashion.
Such hierarchies can be costly in terms of bureaucracy, weak incentives and sclerotic response
to changing environments. In general one might describe market exchanges or outsourcing as
involving more transaction costs. And vertical integration as involving more administrative costs,
but there may be some overlaps in these costs. Depending on the exact way in which
outsourcing or vertical integration is done.
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Now Oliver Williamson's key insight about the optimal scope of the firm. Can be summarized in
the idea of comparative organizational analysis. Essentially Williamson asks us to separate out
two questions that are often commingled when people think about vertical integration. First,
what is the objective of integration? What market power or efficiencies or control or coordination
is being sought? You can similarly think about the objective of outsourcing such as access to
specific capabilities, etc. And the key is to separate this question from the optimal organizational
form. For example, outsourcing or vertical integration that best achieves this objective. The main
point here is not to short-circuit the analysis. And jump from the first stage to the conclusion that
a particular organizational form is needed.
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So to reinforce this key idea, I want to be clear that any time a firm has an objective such as
better control or better efficiency, etc. There is a way to potentially achieve it by vertical
integration, making it, or by the market essentially buying it. Now something I didn't tell you
earlier was that Oliver Williamson was a professor of mine in my PhD program. And I even
worked as his research assistant for a while. And here's something that Williamson often said,
which I think goes to the core of his way of thinking. All organizational forms are flawed. What
he means by this is that the two alternatives, make or buy. Are different in terms of the relative
advantages or disadvantages they provide. So our task must be to compare these relative
advantages and disadvantages. And decide which alternative, on balance, is better for us. At
the most basic level, Williamson's core message, his main mantra, is that using markets or
outsourcing provides better adaptation. Whereas hierarchies or doing things inside a firm
provides better coordination.
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Now typically, we find higher transaction costs in markets, and higher administrative costs within
firms. So let's try to understand where these costs come from. There are of course many
mundane transaction costs in markets such as search costs and haggling costs. To find and
reach a deal with the right partner. But there are also some strategic costs that are important to
recognize. One of these is adverse selection which arises due to information asymmetries that
exist. Between a firm and its transaction partner, say a supplier.
This concept was best illustrated by George Akerlof in his famous Market for Lemons paper, for
which he won the Nobel Prize in 2001. Akerlof was also one of my professors at Berkeley. He is
easily the most brilliant and simultaneously humble person I've ever met. Akerlof's paper
explains why transactions in the used-car market are problematic. He notes that the sellers of
used-cars know more about the car than the buyer. So there is asymmetric information, which
makes it more likely that the owners of bad cars, so-called lemons. Are more likely to want to
sell their car. In turn, this should make buyers more suspicious and less willing to pay more for a
used-car. The result is the well-known phenomenon of a new car losing value the moment you
drive it off the lot. And also explains why many car companies have to step in to offer certified
pre-owned cars. To address buyer concerns about used-car quality.
I explain this more general idea here, so that you can think about how it might apply. To
buyer/seller transactions in the vertical integration context. Essentially one party may know
something that the other doesn't, which then affects how it transacts. For example, a supplier
might not put its best people, something that only it knows, on supporting a buyer's outsourcing
needs. Or it may save the latest technological improvements for its own competing product, etc.
Similarly there's another economic principle called moral hazard, which may also make market
transactions costly. Here the transaction partner has private information about its performance.
That is not measurable or contracted for, which leads to abuse. Economists often talk about the
moral hazard arising from governments being willing to bail out banks, for example. Because
this willingness may lead banks to take on too much risk. In the vertical integration context, a
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downstream dealer or service provider. May take risks or reduce service quality with customers
for example. If the only thing that's measured and rewarded in their contract, is total sales.
Finally, there is this important issue that Williamson emphasizes in his discussion of transaction
costs. Which is often called the holdup problem.
The key idea here is that after the parties enter into a transaction, something changes. So that
one party gains an upper hand and can therefore engage in what Williamson calls opportunism.
Williamson defines opportunism as self-interest seeking with guile. Then due to inherent
uncertainty in the environment, that party has to only wait for the next opportunity. To change
the terms of the contract it originally entered into. One common situation that leads to
opportunism is if one of the parties has to invest in assets that are specific to the other. So for
example, if I get my supplier to buy machinery that's customized to my needs. Or to build an IT
system that's tied into my IT system and so on, I essentially have the supplier at a
disadvantage. Because these investments can only now be used to service my needs. Now I
will say that there are good reasons not to abuse such a relationship. Especially because of the
long-run consequences and reputational effects if you do. But if you are that supplier, you might
want to also think about. How you safeguard against the hazards posed by such specific
investments.
Another example of transaction hazards that can result in opportunistic behavior. Is exposing
your company's core knowledge or technology to your supplier or buyer. After some time, they
may no longer need you. Or pass that knowledge to another supplier who can then compete
with you. So with outsourcing there are these three major sources of transaction costs to worry
about.

Adverse selection, moral hazard and the holdup problem. Just as with market transactions,
hierarchical organization within a single company, also has costs which we'll call administrative
costs. One big source of costs is weak incentives, which simply means that an internal unit. May
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be less laser focused on delivering the very best performance as an external supplier may be.
Why? The supplier knows that if it doesn't perform, it will lose your business. But with an internal
unit, there's often an expectation of continuity. And this may occur in part because internal units
are often governed by fiat. That is within a permissible zone, orders can be given and changed
on what is expected from the unit. Which an internal unit will generally have to comply with. Now
this can be an advantage, but in exchange for this fiat. One typically gives the eternal units more
slack on performance, which means that their incentives are less strong. Also, another problem
with internal units, is the so-called principal-agent problem. Which is often applied in the owner-
manager context as you might have seen in a finance course. But it can also be applied in a
manager-subordinate context. Say if a CEO wants one division in a vertically integrated
company to supply to another. And wants that unit's performance to be top-notch, perhaps
some aspects of performance are unobservable. Then it's likely that the unit will underperform
on those dimensions. You may recognize that this is akin to the moral hazard problem, but with
a manager at the other end, rather than another company.
Last but not least, vertically integrated hierarchies may also exhibit a lack of dynamism. And
less responsiveness to market or technology trends. In part you could see this as a result of
firms being unable to selectively intervene. What this means, is that if your organization a large
company, with all its rules and procedures and bureaucracy. It is hard to selectively go into
specific divisions and functions and say, on this thing and this supply arrangement. I'm going to
treat you like an outside supplier, you either deliver the performance we're asking for, or get cut
off. Now some firms are good at this, at bringing marketlike pressure to bear on their internal
divisions and units. But it has limits inside the firm, so when should firms vertically integrate

Here's the overall takeaway. There is no general prescription that outsourcing or vertical
integration is always better. Rather, the important thing is to align the attributes of the
transaction. With the governance mode, vertical integration or outsourcing, that is appropriate
for these attributes. So for example, if one needs investment in specific assets, or there are
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technology leakage hazards. Or it's difficult to measure the performance of the partner, it might
be better to vertically integrate. On the other hand, if you really need strong incentives for
performance. Or more adaptation over time to market or technology trends, then outsourcing
may be better.

Lesson 1-4: Horizontal Scope Part 1

So let's turn now to the question of horizontal scope or diversification. As with vertical scope,
there are two questions here. Which businesses a company should operate in, and whether the
same company should be integrated across a set of businesses. Now, the first question again is
primarily a business strategy question. It is possible to exit current businesses and enter into
other more profitable ones, or to start new businesses and diverse them if it doesn't make sense
to own all the businesses together. So the second question here, which is a question about
whether a firm should be horizontally diversified, is really the key one.
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To get you thinking about this question, let me highlight that an example of diversification is the
modern and multi-specialty university such as the University of Illinois Urbana-Champaign. As
you probably know, there are some business schools that are independent stand-alone entities,
not closely connected or located with the larger university. What do you think are some
advantages of having a business school as part of a larger diversified university such as the
University of Illinois? What are some disadvantages? Please reflect and write down your
answers.
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One morning, I walked into the wonderful atrium of our business school and asked the same
question to some of our students, faculty, and even one former associate dean. What are the
advantages of having the Gies College of Business be part of a larger university, be part of the
University of Illinois Urbana-Champaign, and what are the disadvantages? Here's what they had
to say.
So I'm here with Jim Dong who was formerly the dean of our undergraduate program and is
also a very valued colleague of mine in business administration.
One of my colleagues, Alma Quan and a friend of his from another department and I thought I
pose this question to both of them.
So I'm here with Arjun, one of our undergraduate students. I have with me two of our
undergraduate students, Caleb and Rang. So I'm here with Eli and Monica. I'm going to pose a
question to him. What is the value of having the business school be part of the larger university?
Couldn't we perhaps do better on our own, for example, and there are several business schools
that are stand-alone business schools? If you could just list one pro and one con being part of
this larger university, I'd be interested to hear. I think the stand-alone model is a clarity of focus.
It's really easy to get everyone working in the same direction, and I think that's really important
for any organization or any unit of an organization. That becomes the downside, that becomes
more challenging when you're part of a larger enterprise like a university. As you know well,
faculty will often be asked to engage in other activities for the good of the campus.
Yeah, one of the great synergies you find in the university is definitely the opportunity to connect
with faculty and colleagues across the campus and actually learn from them, and then take
those ideas and bring them into your teaching or your research. It's interdisciplinary learning
and diverse perspectives that come with all the classes and projects. I really sought to improve
my business acumen, because that's something the engineering curriculum just doesn't provide
me and by having the Gies College of Business at the University of Illinois, I'm able to minor in
business, which is something I'm going to pursue in the following years.
I think that I benefit a lot from having other departments within the University under the same
roof as the business school. For instance, our friend, Ron Huan , he's from the math
department, not from business school. But I invited him over because I wanted to talk about
possible research and I wanted to ask him a bunch of math questions that I would need in my
research. The comprehensive university is a very natural ground for interdisciplinary research.
So you can talk to people in other fields with different expertise, you can generate new ideas.
It's having the resources of the other universities such as the College of Engineering being able
to help you with technology, coding problems now, just with how do engineering and business
are coming together with the worlds, I think that's one of the biggest pros.
Also is obviously that we have a bigger population, then we have friends and students from
different backgrounds, different cultures, and also different majors. So when we make friends
and we have conversation with other people, we get more exposed to other fields and and
grounds.
Yeah, definitely one of the advantages would be, we have such strong programs outside of the
College of Business. So if people want to double major in something outside of business, you
have that possibility and they're all very strong programs with great research opportunities.
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The resources that we have need to be diverted to various other activities to meet the
university's needs, such as service courses is one thing.
One of the downsides is sometimes you can get lost in a large pool of students. University of
Illinois is very big and if a College of Business is also affiliated with such a large university,
sometimes the students can feel as though they maybe they're not as special as other people or
they get lost in the large pool. If we were by ourselves, then we wouldn't have the resources be
more specific for only the business students. But because we're in a larger university, we share
our resources with engineering students, science, music, and all the above, yes.

I'd like to begin by clarifying some terms in anticipation of potential confusion. I'd like to alert you
that in mergers, particularly in public policy discussions, the term horizontal mergers is
sometimes used. It refers to merging with another company in the exact same industry. So it's
really about increasing the size of the company in the same business. So one automobile
insurance company merging with another automobile insurance company would be a horizontal
merger. But more generally, when we think of horizontal scope, we're thinking of the firm's
footprint across a set of different, not the same business. That is, the firm's diversification.
Within diversification, a common terminology that's often used is that of related and unrelated
diversification, which we will also come to in just a little bit.
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I think one nice way to understand diversification is to view it through historical lens. In
particular, there was a period in the 1960s and 1970s when conglomerates were quite common
in the United States. They are still quite popular in many other parts of the world. The heyday of
conglomerates came to an end in the 1980s, which is illustrated in the movie, Wall Street
starring Michael Douglas has a hard charging corporate raider called Gordon Gekko who buys
up conglomerate and bakes them up. I might add that he does this in the movie with little regard
for the social harm he's causing. But Gekko also makes the case that the companies are being
mismanaged and destroying value, so that he needs to come in and fix them. In one famous
scene, Gekko comes in to this meeting of shareholders and boast how much value is created by
breaking up other companies. He then goes on to complain about how the company that he's
particularly focused on has so many vice presidents that do nothing in the corporate office and
seem to simply push paper between each other. He talks about how the company has lost a lot
of value and has made losses for many years. He then goes on to propose a solution where he
buys up the company and breaks it up. What follows is perhaps the most famous line in the
movie about greed being good. So how exactly does Gekko propose to create value from this
company? Indeed, from any conglomerate. Let's try to understand this a little bit more deeply.
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Lesson 1-5 Horizontal Scope Part 2

To understand the conglomerates that grew up in post-war America. It would be useful to visit
the corporate strategy framework called the BCG Matrix, or sometimes the BCG GE Matrix.
Because it was developed by the Boston Consulting Group for its client GE, General Electric.
Perhaps the most well-known conglomerate of this era. The central idea in the BCG matrix is
that a corporation needs to be active in different businesses. That are at various stages of their
industry life cycle. Some late in the life cycle, where the industry is mature and the market is
growing very slowly. And others early where the industry is young and the markets growing very
fast. This market growth is graphed along the vertical axis. Graphed on the horizontal axis is
market share, sometimes graphed as relative market share. That is the market share of the
focal company, relative to its largest competitor. More generally, the two axes can be interpreted
as market or industry attractiveness on the vertical axis. And company strength on the
horizontal axis. Mapped on the BCG matrix are the company's businesses, also called strategic
business units or SBUs. Whose needs and performance will evolve over time. The strategic
goal of using this tool, is to create a portfolio of SBUs that is well balanced between current and
future success. And between resource availability and resource needs. So conglomerates
manage portfolios of businesses in this way, and the question is how it all made sense. How did
conglomerates create value from this assortment of businesses?
One key source of value was a set of management tools, based primarily in accounting and
financial analysis. And even some frameworks from strategy like the BCG matrix. These tools
allowed conglomerates to manage businesses professionally. At a time when there was less
management knowledge available to other companies. So despite some bureaucracy and
inefficiency, conglomerates were able to extract more value from the businesses they managed.
By applying these management tools.
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And the other source of value, which is what we will focus on now. Is the redeployment or
transfer of resources between a company's businesses. In particular the BCG Matrix
emphasized the redeployment of cash from businesses that had too much of it, to others that
needed it. The bubbles in this BCG matrix illustrate the business units or SBUs of a company.
With the larger bubbles representing larger businesses by revenue. These SBUs are then
categorized into four types, dogs, questions marks, stars, and cash cows, based on where they
are in the matrix. Dogs are business that are neither in growing industries, nor an area of
strength for the company. Generally the expectation was that these businesses would be
divested to raise cash. At the opposite end, stars are SBUs with fast growing markets and
strong market share. These businesses are the future of the company, which it should be
investing in, so cash is put into these SBUs. Cash cows are typically yesterday's stores,
businesses in which the company has a strong presence. But in markets that aren't growing as
quickly, so there's less need to invest in these businesses. And they will likely be yielding
excess cash due to the company strong position. And that cash can be redeployed elsewhere.
Finally, there are the question marks, which are in fast growing markets. But where the
company is yet to establish a strong presence. Here the company has to make a choice. Should
it invest and strengthen its position by investing more cash, or give up and divest the business?
Thus, the name question marks. All in all the idea with the BCG matrix is to either divest
businesses. Or invest in fast growing ones in order to build strong positions in them. Eventually,
these star businesses would mature and become cash cows. And throw off cash for the
company to invest in the next generation of stores.
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Joe Mahoney and Deepak Somaya

So effectively, conglomerates acted as their own bankers. Which was quite effective in an era
when US financial markets were much less developed. Which is something you still see today in
other countries. So what happened to these conglomerates? Let's answer that question by
looking at a specific conglomerate of this era, ITT. ITT started out as International Telephone
and Telegraph. And as the name suggests, the company was in the telecom business in many
countries. Selling both telecom equipment and telecom services. Starting in the 1950s, and
particularly under CEO Harold Geneen. ITT undertook an aggressive strategy of diversification
into many unrelated businesses. In other words, it became a conglomerate. ITT entered into
insurance, Hartford was a major ITT insurance company. Into hotels, with the Sheraton Group
which eventually became Starwood. And even in training services and car rentals, for a time ITT
owned Avis Rent a Car. Geneen's model was simple, that all these businesses were the same,
that it was all about managing by the numbers. In other words, by analyzing the financials, you
could manage any business. This goes back to the idea of professional management being a
key capability. That these conglomerates brought to their portfolio of companies. The other idea
of course, was that companies like ITT were able to transfer resources between their many
businesses. Which was not available to specialized non-conglomerate companies. However,
over time, conglomerates like ITT began to find that general management knowledge. Was not
enough to manage businesses well, they needed more specialized knowledge. They found that
hotels was actually a much different business than insurance, or telecom, or engineered
products.
Also, management capabilities were becoming more common in business. And conglomerates
were not effective in creating value from unrelated businesses. The corporate headquarters staff
was getting too bloated, and not really adding much value to manage these businesses. Which
is also what Gordon Gekko railed about in the movie Wall Street. And then by having so many
businesses under one umbrella. The focused incentive to maximize performance in each
business, was also getting muted over time. All in all, the conglomerate model began to lose its
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shine. So ITT began to sell off businesses starting in the early 1980s, after Geneen stepped
down as CEO and chairman. By the late 1990s, the company had even sold off its insurance
and hotel businesses.

The rump ITT that remained didn't stop there, in 2011, the company was again split into three
parts. A water business called Xylem, a defense business called Exelis. And the remaining ITT
business that was mainly in Engineered Parts. Xylem and Exelis were spun out into separate
companies. Interestingly, Engineered Parts had been the star SBU within ITT, and the other two
businesses were cash cows. So what was ITT doing here? Giving up its cash cow businesses
and staying with a business that required cash to grow? In fact, ITT's former CEO, Geneen, had
a real aversion to losing sources of cash. He's noted as saying the only unforgivable sin in
business is to run out of cash
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Also interesting is the stock market reaction to the news that ITT was splitting up in 2011. ITT
stock zoomed up almost 20%. This is real money we're talking about, it created a few billion
dollars of wealth here. So what's going on, why is the stock market so happy about this news?
And if we put on our BCG matrix hat, how will ITT now meet the cash it needs to grow, after its
cash cow businesses have been divested? Think about this and write down your answers.
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To understand what went on with ITT 's breakup, we need to bring back our familiar toolkit of
comparative organization. Generally, we can think of two modes for ITT's businesses or
strategic business units to operate. In the first mode, they operate as one company, with internal
cash transfers from cash cows to stars to fund their growth. In the other mode, ITT's businesses
operate as separate companies, like they did after the breakup. Using financial markets for
investing surplus cash, or raising cash as needed. So the question is which one is more
efficient, and why? From the reaction of the stock market, it seems like the internal transfers of
cash using the BCG matrix approach is less efficient. Instead, modern financial markets may be
quite efficient at allocating cash. If ITT star business needs money, it can simply go to the equity
markets, the bond markets, or to a bank. Keep in mind that we're talking about the situation in
the United States in 2011. Which may be different than the 1960s or in other countries. And of
course, general management principles were widely used in business by 2011. So they would
not add any significant value to managing these three unrelated businesses in a single
company. On the flip side, by combining these businesses under a single, possibly more
bureaucratic entity. Pre-2011 ITT may have been adding inefficiencies and suppressing the
value they could potentially create. So when the company announced the split, investors felt
that the separate companies would be able to do much better. By focusing on the respective
businesses And therefore bid up the company's stock price.

Lesson 1-6 Horizontal Scope Part 3

What we saw with ITT has been confirmed to be the more general pattern observed in research
when looking at the relationship between diversification and firm performance. Unrelated
diversification is generally associated with lower performance, which indicates a diversification
discount, at least in the United States. A diversification discount implies that the value of the
combined business is lower than the sum of its parts. By the way, the so-called dominant
business firms in this graph are diversified firms that still have most of their revenues coming
from a single dominant business. Now interestingly, the graph also indicates that the best
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performance is associated with firms that undertake related diversification, and we will come
back to this very shortly.

But first, we need to go back to our story about Conglomerates and what happened to them in
the 1980s. In other words, what was Gordon Gekko doing in Wall Street that was making him all
this money, and by the way, also making a lot of money for other shareholders. Well, if you
understood that many Conglomerates were experiencing a diversification discount, you already
know the answer. A diversification discount means that the value of the diversified firm is less
than the sum of its SBU's, the sum of its separate businesses if they operated independently.
So Gordon Gekko's strategy was quite simply to forcibly take over these Conglomerates and
then create value by breaking them up into their component parts, and also by getting rid of a lot
of their headquarters staff who are not adding much value. During this period, many takeovers
will also structured a so-called leveraged buyouts, which meant that they were financed with a
lot of debt at very high interest rates, and this debt was simply added to the company's balance
sheet. Private equity firms use a version of this approach even today, although they're usually
not working with Conglomerate targets.
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One big Conglomerates still left in the United States is GE, which has been going through its
own slow and painful process of unwinding. A stock market darling in the 1980s and 1990s, GE
managed to survive as a Conglomerate because it was much more aggressive in shedding
many of the excesses of the Conglomerate model. GE CEO, Jack Welch, got rid of most staff
and corporate headquarters for example. Neutron Jack, they called him because it was like a
neutron bomb had gone off that got rid of all the people and only left the empty buildings
standing. Welch also brought very strong focus and incentives to each SPU in GE's portfolio
through his number one, number two mantra. All businesses were required to become number
one or number two in their industry or they would be divested. This is also a way to ensure that
GE had a lot of good star and cash cow businesses for the future. You may know that GE has
been struggling after the 2008 recession exposed the risks that it had been taking in its capital
business. After narrowing its focus considerably, GE is today figuring out how to create value
from a set of fewer and more related businesses. In other words, GE is trying to figure out how it
can create a diversification premium.
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So let us now turn our attention to this question. How can companies create value through
diversification? As we've seen with vertical integration, it might be useful here as well to
consider the different motivations why companies may enter into diversification. So for example,
companies may enter related businesses to increase their market power by reducing
competition from related products. For example, a chain of pizza restaurants may also operate a
Mexican fast-food chain as Yum! Brands does with Pizza Hut and Taco Bell. But I will caution
again that overt attempts at reducing competition are likely to run afoul of anti-trust laws, and
often these attempts don't actually work in a free and dynamic economy. The second and
possibly more important motivation for diversification is what people often call synergies.
Essentially, synergies are complementarities between businesses or so-called economies of
scope from operating more than one business at the same time. To take the Yum! Brands
example again, Pizza Hut, Taco Bell, and KFC, all part of Yum! Brands, can lower costs by
buying supplies in bulk or developing restaurants sites together.
Two types of synergies are often highlighted in the literature; one, firms can scale common
resources that can be used in multiple businesses. For example, Nike and Under Armour can
use their brands to sell both clothes and shoes at the same time. Amazon can use its
technology platform, originally created to sell books, to sell a wide range of different products.
Incidentally, the types of general management skills that Conglomerates used across multiple
industries in the early years can be seen as an example of scaling. But these days, scalable
resources are typically much more specialized so that they only apply to a limited set of
businesses. Now second, firms can develop slack resources in one business and redeploy
these resources to other businesses. In fact, the allocation of cash between SBUs and a
Conglomerate is an example of such redeployment.
But again, today's businesses can easily obtain a very general resource like cash from the
financial markets. So resource allocation needs to be about much more specialized resources
that are unique to the firm. So for example, Uber can redeploy some of its fleet of cars and
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drivers to its food delivery business and possibly even some it's technology development and
managerial talent to this business. Managers may also sometimes diversify to reduce risk or
grow the size of the firm. These motives are a bit problematic because shareholders are
generally able to reduce risk by diversifying their asset portfolios. So diversification at the firm
level may serve mainly to reduce managers risks rather than those of shareholders. Similarly, it
is often argued that diversification driven by empire building, may be the result of managerial
hubris or even misaligned incentives. Because top managers are often compensated in
proportion to the size of the company they manage. So they have incentives to simply diversify
in order to grow the size of the company.
Finally, diversification may also be undertaken to pursue profitable opportunities. However, if
these opportunities have no relation with the firm's other businesses, it may be optimal to spin
out these new businesses at the earliest chance. All in all, the core motivations for
diversification that are generally accepted to create value for the company, are the ones related
to resource and capability-based synergies between businesses

Having listed some motivations to diversify, it is important to return again to the Williamsonian
approach of comparative organizational analysis. Now this may be a little less obvious for
diversification than it is in the case of vertical integration. But with diversification as well, there's
typically some market type arrangement; an alliance, long-term contract, licensing, etc, that
might be a plausible alternative to diversification. For example, if Pizza Hut, Taco Bell, and KFC
were separate companies, couldn't they still cooperate to an alliance to develop real estate
locations for their restaurants? and it is important to consider the relative pros and cons of such
alternatives.
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To underscore this point, let me take you to my interview with Mark Moran, a senior executive at
John Deere and Company, who you might know as the largest manufacturer of electrical
equipment in the world. Mark is the head of John Deere's very successful Corporate Innovation
Center located in the University of Illinois Research Park. Home to many other prominent
companies working with our university to advance their innovation and product development. I
ask Mark why Deere was diversified into some product categories but not others, even though
there may be some synergies with those products.
If I think about Deere, There are a number of areas having to do with agriculture and so on
where Deere is very prominent in, but there's some areas that we've chosen not to be in. So
mining is one that I think about and especially think about some of your competitors. They seem
to be in many of the same areas as you, but also in mining. But there might be other examples
of this I'm wondering what some of the logic is in how you diversify and where you're not
diversifying to. Sure. I think if you go back over our history, go back to the early '80s, the farm
crisis in the US, we weren't terribly diversified at that point. We were an Ag equipment company
and there were 16 US based Ag companies going into the '80s. I think I have this right. There
was one that had not either ceased to be or been renamed or acquired over the course of that
decade we're the only ones that made it. So that was the aha moment for us that we need to
diversify and get out of our very cyclical market. Diversification comes in a couple of ways. In
one level, globalization is a form of diversification. Especially for cyclical markets that have
some tie to weather patterns. So that helped. But at the same time we knew we needed to get
into things that weren't on that same cadence. I don't know that we would articulate it this way,
but if you look back at it, I think it's fair to say we just looked at what other things look like a
tractor and have a lot of common components? So how do we bring some scale to our channel,
into our engineering, and what are businesses that are big enough to get into? Mining is really
big, really demanding. So our equipment gets bigger and bigger organically where we need to
be in that space, we have tended to lean on Hitachi as a partner. They make equipment like
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that, we have a great relationship with them for excavators. So we've just said let's use our
channel for Hitachi equipment. It's pretty specialized and not as much in common with normal
construction equipment as you'd think because the duty cycle.
That's wonderful. Actually, it's a very nice example of highlighting that acquiring or diversifying
yourself is not necessarily the only solution to achieve the same goal. The goal here might be to
have a full fleet of vehicles of different kinds, and you could achieve the same goal through
alliance partnerships with somebody else.
Yeah, that's exactly right. So in mining where they're probably going to want construction
equipment as well, Hitachi is a good partner. For more of a yard landscape, we have
partnerships where some steel products and some Honda products will appear at our
dealerships because those are things just they don't make sense for us to make, but we know
the customers are going to want them. So how do we get them into the dealership? While
they're there will assume they'll buy some green stuff out of the deal.
I want to recommend to you the mode of thinking that Mark highlights that actual diversification
can be viewed as an alternative to and be compared with other organizational alternatives such
as an alliance to achieve the same ends.

Such a comparative organizational analysis would again return us to analyzing the relative
advantages and disadvantages of organizing within a firm, as is the case with diversification
versus organizing through the market, as is the case with any alternative diversification such as
an alliance. I will not belabor the points made on this chart about these relative advantages and
disadvantages, which we have already discussed in the context of vertical integration
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Joe Mahoney and Deepak Somaya

The implications for diversification therefore can be summarized in the form of two key tests for
the diversification to be considered value creating. The first test is what one often calls the
better-off test, does the combination of businesses create value? Or in other words, two
synergies exist. The second test is the ownership test, which is the outcome of your
comparative organizational analysis. To access the value from the presume synergies, does the
same company need to own the businesses? Or in other words, do we need a hierarchy
organized within a single company to achieve the synergies or can we do it better with a market
like arrangement?
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The importance of resource-based synergies in our analysis of diversification also suggests a

link between resources and the idea of relatedness in diversification. Quite simply, relatedness
in diversification implies relatedness in the underlying firm-specific resources. The logic here is
straightforward. The reason that diversification may be better than market alternatives is that the
synergies arise out of resources that are highly firm-specific and not available in the market.
Does relatedness emerges because these firm-specific resources are either scaled or
redeployed across businesses in order to generate synergies, and this can only be done inside
a company.
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Joe Mahoney and Deepak Somaya

Lesson 1-7 Managing Integrated Firms

Last but not least, it's worthwhile noting a few things about managing integrated firms, whether
they're vertically integrated or horizontally diversified. In both cases, we have adopted a similar
broad playbook. First, dealing the benefits sought through integration from the governance
mode used to achieve those benefits. Then conduct a dispassionate comparative organizational
analysis to identify whether integration or diversification makes sense relative to market-based
alternatives.
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But I want to emphasize that the concepts and theories we've looked at have implications that
extend beyond the simple question of say, whether or not to vertically integrate. What do I
mean? Let's think about this a slightly different way. Ask yourself, why haven't PepsiCo and
Coca-Cola always owned their bottlers? If it makes so much sense to be vertically integrated,
wouldn't there have always been so? If you take this a step further, you might realize that there
are some features of the bottling operation that can benefit from a market type arrangement
working with independent bottlers. But there are also some features that apparently can benefit
from being more vertically integrated. What are these features? For example, it may be valuable
to have independent bottlers who are incentivized to and also inherently do understand their
local markets and business conditions well. Independent bottlers may hustle more and
penetrate the market better and lower routine operating costs more effectively than a vertically
integrated bottling operation. But recognizing these challenges, if you were Coca-Cola, you
might think creatively about how to maintain at least some of these market-like features even in
a vertically integrated bottling operation. Perhaps managers in the bottling operation need to get
commissions based on the profits from the region they're responsible for.
Similarly, a reason to vertically integrate maybe to ensure that PepsiCo has more control over
the overall quality of service that retailers and consumers receive from bottlers. Or to ensure
that new technology or marketing investments are made. Which bottlers may be hesitant to do
because the investments are in assets that are specific to PepsiCo. So even if the company
chooses to outsource bottling, it might think of ways in the bottling contract to ensure that these
goals are met. For example, it might require that all customer-facing personnel off the bottler go
through mandatory training programs, or require some level of annual marketing investment by
the bottler as directed by PepsiCo. The general point here is that recognizing the issues that
affect the vertical integration decision also has implications for how companies manage their
outsourced operations or they're vertically integrated business, whichever they choose.
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There are similar implications for how companies manage related units when they diversify or
not. For example, companies such as Google and Amazon often have units that could easily be
independent companies. So how should these units be managed? I would think that these units
would be managed with some degree of autonomy for the unit. In fact, the creation of alphabet
as a parent company with units like Waymo as independent subsidiaries under that umbrella
can be seen as an effort in that direction from Google. At the same time, you might think of
specific types of coordination that may be needed to ensure that the quasi-independent unit
realize the synergies with the parent company. For Amazon, the entire reason to diversify into
groceries by acquiring Whole Foods Market is to develop an online grocery business. So for
example, the integration of Amazon's IT systems with that of Whole Foods is a major priority.
But at the same time, Amazon may also want to allow Whole Foods to operate quasi-
independently in other areas and ensure that its managers have the right incentives to make it a
great organic grocery store.

It is important therefore, to underscore that the approach companies take to diversification can
vary; from more autonomous to more coordinated approaches. More autonomous approaches
seek to replicate market like incentives, whereas coordinated approaches seek to reduce
transaction costs through more hierarchical organization. The best approach depends largely on
the nature of synergies that one is trying to create through diversification. If the synergies are
from resource scaling or sharing, this is likely to need more active ongoing coordination to
manage the sharing of that resource. Consider, for example, the sharing of a brand across
multiple units. In this case, any changes to the brand or changes to how it is used in one
particular unit will need to be coordinated with all the other units to ensure that their interests are
not undermined by the change. Similarly, think about sharing a technology platform like
Amazons and how much coordination may be needed across Amazon's different business lines
if the platform needs to be upgraded at any given point.
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Collision Montgomery have noted in their writing that such coordination of shared resources
requires more obtrusive operational control of the units in order to realize the associated
synergies in diversified firms. On the other hand, if the synergies are from resource deployment
or transferring resources, it may allow for more autonomy of units and only financial controls
being used to manage them. In fact, this is exactly the approach suggested by the BCG matrix
where the resource being transferred was cash and each business will be managed quasi-
independently by focusing mainly on its financial performance. The manager of the unit would
propose plans and targets, but have significant autonomy beyond that to achieve the
performance that she or he is pursuing. All of this is made possible because the synergies
generated by resource transfers don't require active real-time management to realize the
synergies. Instead, simply paying attention to the resources and treating them as a corporate
pool that can be redeployed is mainly what is needed. In fact, with GE, one resource that the
company continues to develop and redeploy from one unit to another is managerial talent. This
talent is considered a corporate resource within GE and not under the control of individual units.
This is one way that GE has continued to be successful as a diversified company

In this module, we have tended to focus on vertical integration and diversification as being about
stark distinct choices and to a degree, there is a sharp boundary between activities that are
inside the company and those that are outside. But it is also important to recognize that in
practice there exists a range of possibilities from full integration one end, to pure market modes
on the other. Many of these modes in the middle of the spectrum fall under the broad label of
strategic alliances, which are often viable alternatives to within firm integration or diversification.
We will revisit strategic alliances in a different lecture. But even when thinking about integration
within the firm, we have seen that there is a choice between more autonomous and more
coordinated alternatives. Indeed, this is the theme in this map of organizational alternatives
more generally. To use Williamson's description, as we go more towards the left of the
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spectrum, we get more autonomy and adaptation and as we go more towards the right, we get
more coordination and control.

So in conclusion, this module on corporate scope has focused primarily on the vertical and
horizontal scope of companies. That isn't the choices of vertical integration and diversification. A
central idea and theme throughout has been the Williamson E. concept of comparative
organizational analysis. We look at plausible, market-like alternatives to integration and
compare the advantages and disadvantages of these alternatives. In general, market-like
organization provides better adaptation and more autonomy, whereas within hierarchies we get
more coordination and better control. We also looked at the concepts of diversification discount
and diversification premium, unrelated diversification, which we concluded really meant
diversification into businesses that are related in their resources. Finally, we also learned a little
bit about the history of conglomerates and the BCG matrix