B AD 4013: Corporate Strategy MIDTERM EXAM Review Sheet

Exam Format: 30 Multiple choice questions (2 points each – total 60 points), 4 Essay questions (40 points) TOTAL 100 points -questions related to frameworks- REMEMBER, need to know all components, otherwise know concepts Exam Topics: Introduction to Corporate Strategy Define the concept of strategy

● —A firm’s theory about how to gain competitive advantage ● —The mechanism by which firms aim to exploit core competencies and gain a competitive advantage ● —Decisions made in order to obtain outcomes consistent with mission/goals ● Management’s “game plan” to:

○ —Achieve organizational objectives ○ —Conduct operations ○ —Compete successfully

● Strategy is the art of creating value. It provides the intellectual frameworks, conceptual models, and governing ideas that allow a company’s managers to identify opportunities for bringing value to customers and for delivering that value at a profit. In this respect, strategy is the way a company defines its business and links together the only resources that really matter in today’s economy: knowledge and relationships or an organization’s competencies and customers.

What are the key objectives of the firm?

● —Sustainable competitive advantage - occurs when a firm implements a value-creating strategy and other companies are unable to duplicate it or find it too costly to imitate (i.e., the ability to create more economic value than competitors)

● —Your most dangerous competitors are those that are most like you. The differences b/t you and your competitors are the basis of your advantages.

● Unless a business has a unique advantage over its rivals, it has no reason to exist ● —Above-average returns - are returns in excess of what an investor expects to earn from another investment with a similar

amount of risk. Define and give examples of sustainable competitive advantage, above average returns; understand the idea of competitive disadvantage. · Sustainable competitive advantage:

● Provides superior value to customers ● Is hard to imitate ● Enhances one’s ability to respond to changes in the environment

Competitive disadvantage - the firm is generating less value than its competitors ○ Many firms continue to operate even though they do so at a competitive disadvantage in some areas because they usually

have some advantage in another area. If you’re good at something, something else is going to suffer somewhere else ○ Wal-Mart for example: low wages, bad public image, etc. BUT their logistics are good ○ Ex: a business loses it’s liquor license, it is at a competitive disadvantage to the neighboring restaurants that do have one

Define and describe (understand the difference between) economic and accounting performance.

● Measuring Competitive Advantage ○ —Accounting Measures

■ ROA, ROS, ROE, EPS, etc. that exceed industry averages ○ —Economic Measures

■ earning a return in excess of the cost of capital (WACC: weighted average cost of capital) BCG matrix - Analysis of industry and competition; resource allocation

IO Model - Industry in which firm chooses to compete has a stronger influence on the firm’s performance than do choices made by managers inside the organization; 4 assumptions:

● —The external environment is assumed to impose pressure/constraints ● —Most firms competing in an industry are assumed to control similar resources ● —Resources are highly mobile across firms ● —Decision makers are assumed to be rational and acting in the firm’s best interest

External environment + attractive industry + strategy formulation + assets and skills + strategy implementation = superior returns (earning above-average returns: industry)

VRIO Model

● Resource based view- assumes that each organization is a collection of unique resources and capabilities that provide the basis for its strategy and that is the primary source for its returns

● Not all firms have the potential to be the basis for competitive advantage

If a firm has resources that are: ¨Valuable (Does the resource result in an increase in revenues, a decrease in costs, or some combination of the two?) ¨Rare (There may be other firms that possess the resource, but still few enough that there is scarcity) ¨Inimitable (i.e., costly to imitate) (The temporary competitive advantage of valuable and rare resources can be sustained only if competitors find it costly to imitate the resource) ¨Organization (A firm’s structure and control mechanisms must be aligned so as to give people ability and incentive to exploit the firm’s resources) [This component of the RBV theory used to be called “Nonsubstitutable resources”] then the firm can expect to enjoy a sustained competitive advantage

● Ex of valuable and rare resources: ○ Information technology

○ Strategic planning ○ HR management ○ Trust ○ Organizational culture ○ Administrative skills ○ Expertise of top management ○ Guanxi complex networks

● Resource based model- resources + capability + competitive advantage + attractive industry + strategy formulation/ implementation = superior returns

The distinction between corporate and business strategy ● Business level strategy:

○ How to compete in one industry; how are you making profits? ● Corporate level strategy:

○ How to compete in different markets; should we buy another company? Should we form an alliance? What market should we enter? What market should we phase out?

Which industry should we be in? Corporate How should we compete in the market/industry? Business

What is the difference between strategic vision and mission?

● A mission statement focuses on current business activities -- “who we are and what we do” ○ Current product and service offerings ○ Customer needs being served

● A strategic vision concerns a firm’s future business path -- where we are going” ○ Markets to be pursued ○ Kind of company that management is trying to create

Examples of financial and strategic objectives

● —Financial Objectives: ○ —Increase earnings per share 15% annually ○ —Increase annual return on investment from 15% to 20% within 3y ○ —Increase annual dividends per share to stockholders by 5% each year ○ —Maintain a positive cash flow every year

● Strategic Objectives: ○ —Overtake key rivals on quality or customer service or product performance ○ —Boost firm’s reputation with customers ○ —Expand to international markets ○ —Achieve technological superiority ○ —Become leader in new product introductions

How to measure these objectives:

Customer reviews; How many repeat customers; Look at financial statements; Media – any mention on media

What is the difference between planned strategy, reactive strategy, and realized strategy?

● Planned strategy: is deliberate, new initiatives plus ongoing strategy features continued from prior periods ● Reactive strategy: is emergent, adaptive reactions to changing circumstances ● Actual company strategy: is realized, is a combination (I think)

You do not have to study Andrews’ Strategy Framework The External Environment Analysis Describe the general environment (PESTL; know and understand all factors)

● The general environment - elements in the broader society that affect industries and their firms (macro layer, first layer of analysis)

○ Understand broad factors likely to impact your industry now and in the future. ○ Realize that the individual firm has little if any control over these broad trends ○ Thus, firms must ADAPT to important general environment trends. ○ Consider resulting opportunities and threats. ○ Look for intersecting/parallel trends that can be subtle yet ultimately profound. ○ Anticipate! Place your bets for the future!

● PEST / PESTLE analysis ○ political/legal

■ antitrust laws, taxation, labor laws, regulatory issues, impending legislation ○ economic

■ inflation rates, interest rates, unemployment rates, budget or trade deficits or surpluses, exchange rates, savings rate, GNP; GDP

○ sociocultural ■ women in workforce, workforce diversity, habits, values, attitudes, beliefs, life goals/motives, hobbies,

activities, lifestyle trends, consumer behavior ○ technological

■ product innovation, communication advances, process innovation, cost and speed, diffusion, focus of public and private expenditures

○ demographic ■ population size, age structure, geographic distribution, ethnic mix, income distribution, household

composition ○ global

■ key political events, critical global markets, newly industrialized countries, political instability, trade barriers

What are the industry’s dominant economic traits? (provide some examples)

● Market size and growth rate

● Number of competitors and their relative sizes ● Prevalence of backward/forward integration ● Entry/exit barriers ● Nature and pace of technological change ● Product and customer characteristics ● Scale economies and experience curve effects ● Capacity utilization and resource requirements ● Industry profitability

Porter’s Five-Forces model of competition

● Assess strength of each of the five competitive forces ○ Strong? Moderate? Weak?

● The five forces reveal WHY industry profitability is what it is

○ Position company to better cope with current competitive forces ■ Building defenses against the forces or finding position in industry where forces are weakest

○ Anticipate and exploit shifts in the forces ○ Shape the balance of forces to create a new industry structure

● Explain how each force acts to create competitive pressure

○ What are the factors that cause each force to be strong or weak? ■ Rivalry = strong force if:

● Active fight for position among rivals and new offensives to gain sales and market share ● Lots of firms that are relatively equal in size and capability ● Slow market growth (e.g. cell phone) ● Industry conditions tempt some firms to go on the offensive to boost volume and market share

(e.g., price cuts) ● Highly committed to the business and have aspirations for leadership ● High exit barriers ● Customers have low costs in switching to rival brands ● A successful strategic move carries a big payoff ● Costs more to get out of business than to stay in (high exit barriers)

■ Threat of new entrants = strong force if: ● Firms can easily enter the industry, any above normal profits will be bid away quickly ● Barriers to entry (tariffs, quotas, and non-tariff barriers)

○ Customer switching costs ○ Demand side benefits of scale - limits willingness of customers to buy from a newcomer

by reducing price newcomer can command until it builds up a large customer base ○ Capital requirements ○ Incumbent advantages ○ Restrictive gov policy

● Expected reaction of incumbents: retaliation ○ puts cap on profit potential of industry - when threat is high, incumbents must hold down

their prices or boost investment ○ bring new desire to gain share that puts pressure on prices, costs and rate of investment

■ Threat of substitutes = strong force if substitute products are: ● Readily available ● Attractively priced - place ceiling on prices ● Believed to have comparable or better features ● Customer switching costs are low ● Examples: GM, Honda, and Toyota are rivals in that they all produce a small fuel-efficient car.

Public transportation systems are substitutes for these small cars. ● Can be overlooked but are always present

■ Bargaining power of suppliers = strong force if: ● Item makes up large portion of product costs, is crucial to production process, and/or significantly

affects product quality ● Small number of firms in supplier’s industry ● It is costly for buyers to switch suppliers ● They have good reputations and growing demand ● The supplier could vertically integrate forward ● They can supply a component cheaper than industry

members can make it themselves ● Lack of close substitutes for suppliers’ products ● Buying firms are not important customers

■ Bargaining power of buyers = strong force if:

● The product sold is a commodity ● There is a small number of buyers of the focal firm’s output ● They buy in volume quantities ● They can vertically integrate backward ● Their costs in switching to substitutes or other brands are low ● They can purchase from several sellers - buyer believes can always find equivalent product

elsewhere - can play vendors against each other ● Product purchased does not save buyer money ● Many small buyers can be united to act as a block ● Buyers are operating in a competitive industry ● Could decide to package materials themselves for example

● Decide whether overall competition (the combined effect of all five competitive forces) is:

○ brutal (cutthroat), fierce/strong, normal/moderate, or weak What are complementors?

● Complementors are those firms whose products make the focal firm’s products more valuable (Adam Brandenburger and Barry Nalebuff) - Customer benefit of two products combined is greater than sum of each product’s value by itself

○ Complementors are typically found in closely related industries ○ A single firm could be both rival and complementor ○ Not 6th factor when determining profitability since the presence isn’t good or bad

■ Affect profitability through the way they influence the 5 forces ○ Examples:

■ Hardware and software are worthless when separated ■ Value of car is higher when driver has access to gas stations

Strategic group maps (how do we create one, understand how SGM contribute to the competitive analysis, what are some limitations)

● Strategic group consists of those rivals with similar competitive approaches in an industry ● Constructing a Strategic Group Map

○ Identify competitive characteristics that differentiate firms in an industry from one another ○ Plot firms on a two variable map using pairs of these differentiating characteristics ○ Assign firms that fall in about the same strategy space to same strategic group ○ Draw circles around each group, making circles proportional to the size of the groups respective share of total

industry sales ● Variables should NOT be highly correlated, expose BIG differences in how rivals compete, and do NOT have to be either

quantitative or continuous ● Limitations: Only shows 2 dimensions - can vary on competitive variables on the axes

How can businesses respond to the changing environment? Essay question?

● Can leave industry, can try to adapt, can try to change the industry ● Look at Game Theory article*

○ Changing the game (PARTS): Changing the players, Changing the added values, Changing the rules, changing the tactics, changing the scope

The Internal Environment Understand what is a SWOT analysis?

● SWOT is a planning exercise to identify strengths and weaknesses inside an organization and opportunities and threats in the environment

● 1. define organizational objectives ● 2. factors can be strength or weakness or both ● 3. opportunities often confused with strengths.

Define, describe, analyze, and explain the performance implications of the resource based view theory of the firm. This framework was introduced in Chapter 1; however, it is described in detail in this chapter.

What resources make us unique? What gives us an edge? ● Resources:

○ 4 Tangible Resources ■ Financial ■ Physical ■ Technological ■ Organizational

○ 3 Intangible Resources: ■ Human ■ Innovation ■ Reputation

● Critical assumptions of RBV, 1. resource heterogeneity (different firms have different resources) 2. Resource immobility (Resources don’t spread firm-to-firm easily)

● VRIO Framework for RBV (Valuable, rare, inimitable (costly to imitate), organization) ○ Results in sustained competitive advantage.

Value-chain analysis (understand each component: e.g., primary/support activities, inbound/outbound logistics, etc.)

● Helps to identify which resources and capabilities can add value ● Primary activities:

○ Inbound logistics ○ Operations ○ Outbound logistics ○ Marketing & Sales ○ Service

● Support activities: ○ Firm infrastructure ○ Human resource management ○ Technological development ○ Procurement

Define and explain the concepts of benchmarking and outsourcing

● Benchmarking: identify the best practices of competitors and compare them to the organization’s best practices ● Outsourcing: a firm may specialize on some value chain activities and outsource the rest - rather than hiring employees to do

the work Describe the criteria used to determine whether resources and capabilities are distinctive competencies.

● Capabilities are what a firm does, and represent the firm’s capacity or ability to integrate individual firm resources to achieve a desired objective.

● Core competence is something that a company does well relative to other internal activities and it is central to the company’s profitability.

● A distinctive competence is something a company does well relative to competitors. ● A distinctive competence is a source of competitive advantage.

You do not have to study the section on competitive strength assessment Business-Level Strategy (cost leadership and differentiation) Define, describe (positives, risks, when does the strategy work best), and give examples for each one of Porter’s generic competitive strategies (i.e., cost leadership, differentiation, focused cost leadership, focused differentiation, and best cost provider). Need examples for each Ex: Gap puts itself in every square:

● Old Navy - Cost Leadership

● Banana Republic - Differentiation ● Outlet malls - Focused Cost Leadership

Ex: Wal-Mart - Cost Leadership - meticulously looks at methods on how to reduce costs, hard to copy ● Business Level Strategy refers to the strategic choices managers make about how to position a specific business and/or

product line to gain competitive advantage in a single market and industry ● Porter’s Generic Competitive Strategies:

○ Cost Leadership ■ Set of actions designed to produce or deliver goods or service at the lowest cost relative to competitors with

features that are acceptable to customers ■ Cost leadership does not mean low price (but you have an advantage at a low cost) ■ Firms in a market have a strong incentive not to compete on price with the low cost leader ■ Determine and control cost drivers and reconfigure the value chain if needed ■ How to obtain cost advantage?

● Learning and experience ○ The more complicated/technical the process, the greater the experience advantage

● Avoiding diseconomies of scale (price to produce increase as volume increases) (occurs when business has become too large)

● Technological advantages independent of scale ● Strategic choices

○ Vertical integration ○ Firms can make policy choices that give people incentives to reduce cost at every

opportunity ● Key inputs

○ Being in the right place at right time ○ Being first into market - esp. foreign market ○ Locking up a source - buying all of its output

■ Risks of Cost Leadership ● —Getting carried away with aggressive price cutting and ending up with lower, rather than higher,

profitability - can’t sustain business ● —The value of cost advantage depends on its sustainability ● Dramatic technological change could take away your cost advantage ● Competitors may learn how to imitate value chain ● —Focus on efficiency could cause cost leader to overlook changes in customer preferences ● Product or service may be of less quality b/c can’t operate at the higher cost

■ When does it work best? ● —Price competition is vigorous ● —Product is standardized or readily available from many sellers ● —There are few ways to achieve differentiation that have value to buyers ● —Buyers incur low switching costs ● —Buyers are large and have significant bargaining power ● —Industry newcomers use introductory low prices to attract buyers and build customer base

○ Differentiation ■ Set of actions designed by a firm to produce or deliver goods or services (at an acceptable cost) that

customers perceive as being different in ways that are important to them. Find ways to differentiate that create value for buyers and that are not easily matched or cheaply copied by rivals.

■ Value provided by unique features and value characteristics: ● High customer service, superior quality, prestige or exclusivity (non-standardized products) ● Almost anything can be a base of differentiation

■ Bases of differentiation ● —Product Attributes

○ Product Features ○ Product Complexity ○ Location

● —Firm-Customer Relationships ○ Customization – creating a unique product for a customer ○ Marketing – creating brand loyalty through image advertising ○ Reputation

● —Firm Linkages ○ Product mix ○ Distribution channels ○ Service

■ How to obtain advantage? ● —Incorporate features that raise product performance

○ Reliability, durability, ease of use. ● —Incorporate features that increase buyer satisfaction in intangible ways.

○ Buyer desire for status, image, prestige, upscale fashion ● —Deliver value through competitive capabilities that rivals do not have. ● —Incorporate product attributes that lower the buyer’s overall cost of using the product

○ Using an online system to reduce a buyer’s order processing costs ■ Risks of Differentiation

● —Customers may decide that the price differential between the differentiated product and the cost leader’s product is too large

● —Experience may narrow customer’s perceptions of the value of differentiated features of the firm’s products

● —Makers of counterfeit goods may attempt to replicate differentiated features of the firm’s products

● —Over-differentiating such that product features exceed buyers’ needs ● —Not understanding what buyers want or prefer and differentiating on the “wrong” things ● Not as sustainable as cost leadership b/c you always have to keep on top of explaining, adding

features, keeping a brand relevant, have to find way to maximize value ■ When does it work best?

● —Many buyers perceive the differences as having value ● —Buyer needs are diverse ● —Few rival firms are following a similar differentiation approach ● —Competition revolves around rapidly evolving product features.

○ Focused Business level strategies (Cost Leadership & Differentiation) ■ Set of actions concentrated on a narrow piece of the total market (also called market niche strategies)

● isolating a particular buyer group ● isolating a unique segment of a product line ● concentrating on a particular geographic market ● finding their “niche”

■ Factors that may drive focused strategies ● —Large firms may overlook small niches ● —Firm may lack resources to compete in the broader market ● —Industry has many different niches and segments ● —Focus may allow the firm to direct resources to certain value chain activities to build

competitive advantage ● —Costly or difficult for multi-segment competitors to meet specialized needs of niche members

■ Risks of focused strategies ● —Firm may be “outfocused” by competitors ● —Large competitor may set its sights on your niche market ● —Segment becomes so attractive it becomes crowded with rivals, causing profits to decline ● —Preferences of niche market may change to match those of broad market

○ Integrated Cost Leadership / Differentiation ■ Advantages

● —Combine a strategic emphasis on low-cost with a strategic emphasis on differentiation (also called best-cost provider strategies)

● —A firm that successfully uses an integrated cost leadership/differentiation strategy should be in a better position to:

○ adapt quickly to environmental changes ○ learn new skills and technologies more quickly ○ effectively leverage its core competencies while competing against its rivals

■ Benefits ● Successful firms using this strategy have above-average returns ● Firm offers two types of values to customers

○ –Some differentiated features (but less than a true differentiated firm) ○ Relatively low cost (but not as low as the cost leader’s price)

■ Risks ● An integrated cost/differentiation business level strategy often involves compromises (neither the

lowest cost nor the most differentiated firm)

● The firm may become “stuck in the middle” Corporate-level Strategy – diversification What is diversification? (related/unrelated) When and why should a company diversify?

● Related diversification- expand business into something related. All businesses share products, technological and distribution linkages.

● Unrelated diversification- expand business in a direction the business doesn’t already pursue. Businesses have no linkages.

● Diversification is… broadening business ● When?

○ Diminishing growth prospects in present business ○ Opportunities to gain competitive advantage by broadening present business ○ Opportunities to transfer existing competencies to new businesses ○ Potential cost-saving opportunities to be realized by entering related businesses ○ Availability of adequate financial and organizational resources

■ When the company is in a strong competitive position and there is a slow market growth -- Diversification is a top priority.

■ When the company is in a weak competitive position and there is a slow market growth -- Diversification merits consideration.

● Why? ○ Diversifying to enhance strategic competitiveness

Related diversification ■ Economies of scope represent cost savings attributed to entering an additional business and sharing

activities or using capabilities and core competencies developed in another business that can be transferred to a new business without significant additional costs. ● Operational relatedness in sharing activities; in transferring skills or corporate core competencies

among units (eliminates duplication and provides intangible resources) Synergies: diversifying into businesses whose value chains possess competitively valuable “strategic fits” with the value chain(s) of the present business(es).

■ Market power motives: Blocking competitors through multipoint competition (mutual forbearance)

Unrelated diversification ■ Financial economies of scope:

○ Improve efficiency of capital allocation (internal capital markets) ○ Restructuring of acquired assets (Firm A buys firm B and restructures assets so it can operate

more profitably, then A sells B for a profit in the external market) ■ Best targets for unrelated diversification:

○ Companies with undervalued assets (Capital gains may be realized) ○ Companies in financial distress

n Reasons for diversification that are value-neutral with respect to strategic competitiveness: ¨ to avoid violations of antitrust regulations ¨ to take advantage of tax incentives ¨ to overcome low performance ¨ to reduce the uncertain of future cash flows ¨ to reduce the overall firm risk

n Managerial motives for diversification (value reducing): ¨ to diversify managerial employment risk ¨ to increase managerial compensation (an economy of scope that accrues to managers at the expense of equity

holders) Diversification adds benefits to top-level managers but not shareholders

n Benefits don’t occur just because a company has diversified into related businesses! Diversification is capable of increasing shareholder value if it passes these tests:

¨ Industry attractiveness test n Produces good ROE n Favorable competitive positions n Will be profitable over long term

¨ Evaluating business-unit competitive strength n How much will it cost to enter the market?

n Will good profits be realized, after considering the entry or acquisition costs? ¨ Determining the competitive value of strategic fit in 1 ¨ Better-off test

n Is there an opportunity to create sustainable competitive advantage by this move? Strategy alternatives for a company looking to diversify (advantages, disadvantages)

● Merger and Acquisition of an Existing Company ○ Advantages

■ Quicker entry into target market ■ Easier to overcome certain entry barriers

● Technological inexperience ● Gaining access to reliable suppliers ● Being of a size to match rivals in terms of efficiency and costs ● Getting adequate distribution access

Acquisitions – Advantages n An acquisition can:

¨ Reduce the negative effect of rivalry on a firm’s financial performance ¨ Reduce a firm’s dependence on one or more products or markets

n Reducing a company’s dependence on specific markets alters the firm’s competitive scope n An acquiring firm can gain capabilities that the firm does not currently possess n Synergy is greatest when firms acquire other firms with different but related and complementary capabilities in order to build

their own knowledge based Acquisitions – Disadvantages High Costs

¨ High premiums typically paid by acquiring firms ¨ Increased interest costs from higher leverage ¨ High advisory fees and other transaction costs ¨ Poison Pills—things target companies do so they are less attractive to takeover

Strategic Problems ¨ High turnover among the managers of the acquired firm ¨ Short-Term Managerial Distraction—takes managers away from the critical tasks of the core businesses ¨ Long-Term Managerial Distraction—lose sight of the factors that lead to success in their core businesses ¨ Less Innovation ¨ No organizational fit—cultures or systems don’t combine well ¨ Increased risk—increased leverage. ¨ Company becomes too large

Integration challenges include: ¨ Combining two disparate corporate cultures ¨ Linking different financial and control systems ¨ Building effective working relationships (particularly when management styles differ) ¨ Resolving problems regarding the status of the newly acquired firm’s executives ¨ Loss of key personnel weakens the acquired firm’s capabilities and reduces its value

Joint Ventures & Strategic Partnerships ○ Good way to diversify when:

■ Uneconomical or risky to go it alone ■ Pooling competencies of two partners provides more competitive strength ■ Foreign partners are needed to overcome cultural roadblocks or the lack of knowledge about markets of

particular countries ○ Raises questions

■ Which partner will do what

■ Who has effective control ○ Potential conflicts

■ Control over strategy and long-term direction ■ How operations will be conducted ■ Control over cash flows and profits ■ Personalities and cultures of partners

The relationship between diversification and performance

-Dominant Business -Related Constrained -Unrelated Business

Level of Diversification The relationship between diversification and risk

Single Business -Dominant Bus. -Related Constrained -Related Linked -Unrelated Bus Level of Diversification Corporate-level Strategy – vertical integration Define forward and backward vertical integration.

● Forward integration- dispose of own outputs ● Backward integration- produce own inputs

● Forward vertical integration - disposing of own inputs; when a manufacturer decides to perform distribution and/or retail

functions within the distribution channel. This is commonly referred to as "eliminating the middle man," as manufacturers may cut out the wholesaler to sell directly to retailers or the retailer to sell directly to customers.

○ Advantageous for a firm to establish its own distribution network if ■ Undependable distribution channels undermine steady production operations

○ Integrating forward into distribution and retailing ■ May be cheaper than going through independent distributors ■ May help achieve stronger product differentiation, allowing escape from price competition ■ May provide better access to users

Backward vertical integration - producing own inputs ○ Generates cost savings only if volume needed is big enough to capture efficiencies of suppliers ○ Potential to reduce costs exists when

■ Suppliers have sizable profit margins ■ Item supplied is a major cost component ■ Resource requirements are easily met

○ Can produce a differentiation-based competitive advantage when it results in a better quality part ○ Reduces risk of depending on suppliers of crucial raw materials / parts / components

Describe how vertical integration creates value by reducing the threat of opportunism (remember the example we discussed in class involving the refinery and the pipeline company).

n Vertical integration is a firm’s ownership of vertically related activities (the assets that were previously held by two firms are combined into a single firm.)

n Vertical integration can occur in 2 directions: ¨ Backward Integration (producing own inputs) ¨ Forward Integration (disposing of own outputs)

See notes from class Discuss the benefits and costs of vertical integration. Describe alternatives to vertical integration. (don’t need to memorize all benefits, know 2 or 3 & be able to talk about)

● Benefits of vertical integration ○ The focal firm is able to create synergy with the other firm(s) ○ Economies of combined operations ○ Economies of internal control and coordination ○ Assure supply or demand ○ Better quality control and coordination ○ Protect proprietary technology ○ Gain access to information ○ Avoid costs of dealing with the market ○ Gain (or offset) market power

● Costs of vertical integration ○ Differences between stages in optimal scale of operation ○ Managing strategically different businesses ○ Locks firm deeper into same industry ○ Higher capital investment ○ Reduced flexibility in responding to demand uncertainty, changes in technology, customer preferences, etc. ○ Sometimes limits the access to outside information/ technology ○ Reduced incentives ○ Costs of bureaucratic hierarchy

● Alternatives to vertical integration ○ Cooperative relationships

■ Long term contracts / strategic alliances and joint ventures (strategic alliances can be viewed as a substitute for vertical integration—without the costs of ownership)

○ Strategic outsourcing/ may be detrimental when: ■ Holdup – company becomes too dependent on specialist provider ■ Loss of information – company loses important customer contact or competitive information

Corporate-level Strategy - mergers and acquisitions Discuss reasons firms use an acquisition strategy to achieve strategic competitiveness (define and describe the construct of “market power”)

● Reasons for Acquisition ○ Increased market power (horizontal and vertical acquisition) ○ Overcoming entry barriers ○ Getting access to proprietary products or services ○ Access to an established brand name ○ Lower risk compared to developing new products ○ Learning and developing new capabilities ○ Avoiding excessive competition ○ Increased diversification ○ Cost new product development/increased speed to market

Describe problems that work against developing a competitive advantage using an acquisition strategy. Due diligence

● Problems: Company becomes too large:

○ Additional costs of controls may exceed the benefits of the economies of scale and additional market power ○ Larger size may lead to more bureaucratic controls ○ Formalized controls often lead to relatively rigid and standardized managerial behavior ○ Firm may produce less innovation ○ Due Diligence - the process of evaluating a target firm for acquisition

■ Ineffective due diligence may result in paying an excessive premium for the target company ○ Evaluation requires examining:

■ Financing of the intended transaction ■ Differences in culture between the firms ■ Tax consequences of the transaction ■ Actions necessary to meld the two workforces

Define the restructuring strategy (understand the difference between downsizing, down scoping, and LBO)

● Restructuring strategy - A strategy through which a firm changes its set of businesses or financial structure ○ Failure of an acquisition strategy often precedes restructuring strategy ○ Types

■ Downsizing - A reduction in the number of a firm’s employees and sometimes in the number of its operating units. 89% cite expense reduction (46% succeeded) 67% for competitive advantage (19% succeeded)

■ Retrenchment /Downscoping - A divestiture, spin-off or other means of eliminating businesses unrelated to a firm’s core businesses (plant closing, liquidation) (could be combined with downsizing)

● Sell-offs: assets are sold to another company; value is usually determined by market forces. ● Spin-off: Spin-off represents a pro-rata distribution of shares of a subsidiary to shareholders;

parent can maintain ties with the spun-off unit ■ Leveraged buyouts LBO - A restructuring strategy whereby a party buys all of a firm’s assets using debt.

● LBOs involve a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. (Usually, under a LBO, the entire public stock of a company is purchased with debt)

Understand the risks of strategic alliances (you should learn the terms: holdup, adverse selection, moral hazard)

● Risks of SA ? ○ Partners may:

■ act opportunistically - Holdup ■ misrepresent competencies brought to the partnership – Adverse Selection ■ fail to make committed resources and capabilities available to other partners, providing inputs of

lesser value than promised – Moral Hazard ■ Risk of being too transparent - exposing too much info about yourself - What if they learn it and apply it

and put you out of business? ■ Good way to avoid risk of owning company ■ Don’t have has much control

Understand some of the actions companies might use to prevent a takeover (e.g., financial, assets or third party defense)

● Involuntary restructuring - actions designed to thwart the takeover: ○ Financial

■ Shark repellents ■ Poison pills ■ Leveraged recapitalizations ■ Greenmail ■ Litigation

○ Assets ■ Scorched earth defense - defensive asset restructuring ■ Crown jewel sales - sell sought after unit ■ Pac-man defense - target launches attempt to acquire bidder

○ Third party ■ White knight defense ■ Other bidder (competitive bid situation)

You do not have to study the methods of corporate valuation.

Strategy Implementation: Corporate Governance What is corporate governance?

● —Mechanisms that determine allocation of decision making authority

● —A relationship among stakeholders used to control the strategic direction and performance of organizations

● —Concerned with making strategic decisions more effectively

● —Used to establish order between a firm’s owners and its top-level managers whose interests may be in conflict

Define and explain the “agency problem”? (agency theory) ● —Principal and agent have divergent interests and goals ● —Shareholders lack direct control of large, publicly traded corporations ● —Agent makes decisions that result in the pursuit of goals that could be in conflict with those of the principal ● —Agent could become victim to managerial opportunism - managerial opportunism is the seeking of self-interest goals; ● —Managerial opportunism prevents the maximization of shareholder wealth (the primary goal of owner/principals) ● —It is difficult or expensive for the principal to verify that the agent has behaved appropriately

What are the mechanisms that are used to find a solution to the agency problem? (i.e., describe the internal and external governance mechanisms)

● Internal Governance ○ Ownership Concentration - relative amounts of stock owned by individual shareholders and institutional

investors ■ —Large block shareholders have a strong incentive to monitor management closely.

They may also obtain Board seats (Financial institutions are legally forbidden from directly holding board seats)

■ —The increasing influence of institutional owners (stock mutual funds and pension funds) Have the size (proxy voting power) and incentive (demand for returns to funds) to discipline ineffective top-level managers

■ —Shareholder activism: If a consensus exists, shareholders can vote as a block to elect their candidates to the board Managerial share ownership may align their interest with shareholders, but it also increases manager's power.

○ Board of Directors - —Individuals responsible for representing the firm’s owners by monitoring top-level managers’ strategic decisions

■ —Group of elected individuals that acts in the owners’ interests to formally monitor and control the firm’s top-level executives. Board has the power to:

● —Direct the affairs of the organization ● —Punish and reward managers ● —Protect owners from managerial opportunism ● —Enhancing the effectiveness of boards and directors: ● More diversity in the backgrounds of board members ● More formal processes to evaluate the board’s performance ● Changes in compensation of directors

○ Executive Compensation - —Use of salary, bonuses, and long-term incentives to align managers’ interests with shareholders’ interests

■ —Forms of compensation (Salary, bonuses, long-term performance incentives, stock awards, stock options)

■ —Factors complicating executive compensation: ● —Strategic decisions by top-level managers are complex, non-routine and affect the firm

over an extended period ● —Unintended consequences of stock options ● —Firm performance not as important than firm size

External Governance ○ Market for Corporate Control

■ —Purchase of a firm that is underperforming relative to industry rivals in order to improve its strategic competitiveness

■ external auditors ■ government regulations

What is the role of CEO? What is CEO duality? Role of CEO: 1. Provide executive leadership

● Articulate a strategic vision for the firm ● Present roles for others to identify with and follow ● Communicate high performance standards and show confidence in followers’ ability to achieve those standards

2. Manage the strategic planning process. ● Evaluate divisions/units to make sure they fit in the overall corporate plan

CEO duality: when an individual is both the chief executive officer and the chairman of the board of directors. What is the relationship between CEO pay and performance? What is the relationship between CEO pay and firm size?

● Relationship b/t CEO pay and performance ○ Linear - The better the performance of the firm, the higher the CEO pay

● Relationship b/t CEO pay and firm size ○ Curvilinear - CEO pay increases at a decreasing rate ○

CEO Pay and Performance, CEO pay and firm size, and performance and size graphs on slides 27-29, Corporate Governance and Culture Observations of Compensation Levels

● —Compensation reflects expected value awarded during the year. It does not reflect value of compensation realized. (The press often cites realized pay; this can be misleading, in that it reflects pay granted over multiple years but realized in one.)

● —Company size is a major determinant of compensation levels (not performance). ● —There is a large pay differential between the pay granted to the CEO and the pay granted to other senior

executives. (On average, the CEO earns 1.8 times the pay of the 2nd highest officer. The 2nd highest earns 1.2 times the 3rd) ● —The press often cites the ratio of CEO pay to that of the average employee as a sign of excessive compensation. (This

figure varies greatly with methodology. It has been calculated as either 180, 300, 400, or 500 in recent years. It also varies with industry, size, location, and measurement period.)

● —Compensation is best evaluated in terms of suitability for the job. Still, boards should be mindful of public perception. What is the relationship between firm performance and firm size? Other research findings about boards of directors

● Relationship b/t firm performance and firm size ○ Curvilinear - Beyond some point, as size increases, firm performance declines

Sarbanes-Oxley Act

● —This act represents a shift toward government regulation of corporate standards relating to auditing, accounting, quality control, ethics, and independence, through the Public Company Accounting Oversight Board (PCAOB).

● —Section 404 requires the Company’s CEO and CFO to annually assess internal controls, and sign written statements, acknowledging responsibility in maintaining controls over financial reporting.

Corporate Culture

● —Corporate culture refers to a specific collection of values and norms shared by organizational members - Employees selected based on how well their personalities “fit” in

○ Symbols and Artifacts ○ —Beliefs about how business ought to be conducted ○ —Values and principles of management ○ Work climate and atmosphere ○ Stories illustrating company’s values

○ —Taboos and political don’ts ○ —Traditions ○ Assumptions

● —“A system of shared meaning held by members that distinguish the organization from other organizations” (Robbins). ● —“The way we do things around here” (Deal & Kennedy). ● Can make or break an organization ● —Helps organizations solve two basic problems

○ —Internal integration ○ —External adaptation

● Functions of Corporate culture ○ —Defines the boundaries between organizations ○ —Identifies members of the organization ○ —Generates commitment to the organization ○ —Stabilizes the social system of the organization ○ —Increases behavioral consistency

You should also be familiar with the main issues confronting the companies discussed during each case analysis (Coke, Dell, Aldi, Zara). In addition, you should know how to define (explain, describe) the concepts introduced during the semester such as: economy of scale, economies of scope, benchmarking, managerial hubris, etc. (no multiple choice questions about cases) Economies of scope = factors that make it cheaper to produce a range of products together than to produce each one of them on its own; allows for ability to diversify in related markets

Ex: McDonalds can produce both hamburgers and French fries at a lower average cost than what it would cost two separate

firms to produce the same goods. This is because McDonalds hamburgers and French fries share the use of food storage, preparation

facilities, and so forth during production.

Ex: is a company such as Proctor & Gamble, which produces hundreds of products from razors to toothpaste. They can

afford to hire expensive graphic designers and marketing experts who will use their skills across the product lines. Because the costs

are spread out, this lowers the average total cost of production for each product.

Economies of scale = factors that cause the average cost of producing something to fall as the volume of its output increase; maximizing the output of your assets

Ex: own a fleet of trucks and use them to deliver – come back empty = only using 50%

Ex: have a plane and have the seats of empty – not using it to its full capacity

Ex: Supermarket - If you had a delivery of just 100 cartons of milk the average cost is quite high. The marginal cost of delivering

10,000 cartons is quite low. You still need to pay only one driver, the fuel costs will be similar = Buy food in bulk - the average cost

of transporting 10,000 products to store is going to be a lot less than transporting 100.

Diseconomies of scale. The larger an organization becomes in order to reap economies of scale, the more complex it has to

be to manage and run such scale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained

from greater scale. In other words, economies of scale cannot be gleaned forever.

Managerial hubris is the unrealistic belief held by managers in bidding firms that they can manage the assets of a target firm more efficiently than the target firm's current management. Managerial hubris is one reason why a manager may choose to invest in a merger that on average generates no profits Benchmarking - is used to identify what other businesses do to increase profit and productivity, and then adapting those methods to make your business become more competitive. Imagine if you had a car lot that sells 50 cars per month and down the street a competitor sells 300 cars per month. By studying and identifying what your competitor is doing, you could increase sales.

● Coke- ○ complex industry, can’t do simple porter’s model ○ Ended up competing against the bottlers since consumers could choose between bottle, can or fountain ○ Coke created single internal org called BIG that consolidated Coke’s own bottling ops and investments under one

roof ○ Coke could sell its concentrate at flat rate regardless of how packaged = tied profits to volume growth

■ Bottlers’ profits depended on which package types they sold in which channels ○ Pepsi - expanded through franchise bottling network w/greater focus on retail sales over fountain

■ Also had control over gatorade & quaker oats ● Dell

○ You observe an advantage if you address a segment of the market - You can preserve an advantage if you pick a specific market segment - Focus Differentiation, niche market - targeted people who only wanted customizable computers (educated buyer)

○ “Direct model” - dealt directly with end customers - shipments straight to customers, short inventory time compared to competitors = saving $$ because no retail buybacks or anything that had to do with retail, computer components get cheaper by the day

■ Transaction buyers: small-medium businesses & home computer users ■ Relationship buyers: large orgs that placed repeat orders for multiple PCs

○ Poor customer service ○ Why couldn’t other companies copy strategy?

■ System already in place - high costs to switch, train employees ■ Was addressing niche market which makes it hard for competitors to get in same niche

● Aldi ○ low cost, low differentiation, different than walmart ○ maintain as few unnecessary costs as possible - simplicity, focus

■ fewer employees - customers got products out of boxes themselves ● pay employees well - few of them

■ limited advertising ■ want customer to know they’re only paying for the product and not overhead costs ■ limited product selection - inventory turned over quickly

● quick check out ■ low prices - frugality ■ efficient operations ■ private labels - value proposition - wanted private label to exceed leading national brands in taste,

performance, etc ■ not about shopping experience

○ Can control and preserve things in niche market but must stay within that - can’t do “middle of the road” strategy ● Zara

○ vertical integration, value chain, made sense for them, illuminates a lot of ways in industry Articles: Porter, M. (1996) “What is Strategy” HBR • Why does Porter argue in this article that operational effectiveness is necessary but not sufficient for increased corporate performance?

● Operational effectiveness (OE) means performing similar activities better than rivals perform them. ○ Refers to anything that allows a company to better utilize its inputs ○ A company can outperform rivals only if it can establish a difference that it can preserve. ○ Constant improvement in operational effectiveness is necessary to achieve superior profitability.

However, it is not usually sufficient. - staying ahead of rivals gets harder everyday - competitors can imitate - raising the bar for everyone

● Strategic positioning means performing different activities from rivals’ or performing similar activities in different ways.

• Why does Porter suggest that a company’s strategic plan depends on its capability to create a unique position, make clear trade-offs, and tighten fit?

● Fit is important because discrete activities affect one another ○ Reinforcing, consistency ○ Fit reduces costs or increases differentiation ○ Interlocked activities make it harder to imitate

Porter, M. (2008) “The five competitive forces that shape strategy” (HBR)

• This is a key article … please read it carefully. It describes in detail Porter’s five forces model which you should know well. You could have a question on the exam asking you to explain how the government policy might impact the likelihood of a new entry in an industry or to briefly mention what might be the required elements of a good industry analysis.

INFO ABOVE UNDER 5 FORCES Henderson, B. (1989) “The origin of strategy” HBR

• What does Henderson say about natural competition and strategy? ● When two things try to coexist, eventually one will displace the other

○ Have to have unique advantage - variety - rich environment ○ Those that adapt the best displace the rest ○ What differentiates competitors varies ○ Your most dangerous competition are the ones most like you

Strategy is the management of natural competition; that is how it compresses time. Natural competition does not have any of these 5 characteristics, but strategic competition does which is why strategic competition compresses time [what would take years to accomplish goes way faster because of strategic competition] 5 elements of Strategic competition:

1. Ability to understand competitive behavior as a system of interactions 2. Ability to use this understanding to predict how a given strategic move will rebalance competitive equilibrium 3. Resources that can be permanently committed to new uses even though the benefits will be deferred 4. Ability to predict risk and return 5. Willingness to act.

Natural competition works by a process of low-risk, incremental trial and error, small changes are tried and tested, beneficial ones are adopted and maintained, unmanaged change takes forever to produce results.

Collins, J. and Porras, J. (1996) “Building your Company’s Vision” HBR

• Understand, define, and provide an example for the concepts of core ideology, core values, core purpose, and BHAG. A well conceived vision consists of two major components: core ideology and envisioned future ● Core Ideology: Defines what we stand for and why we exist as a company. It is considered more important to

know who you are then where you are going. No matter the ever changing world around a company with a strong core ideology it is bound to lead to a successful company.

○ Core Values: The essential and enduring tenets of an organization. Timeless guiding principles. We have them because they define for us what we stand for and we would hold them even if they become a competitive disadvantage in certain situations. A company should not change its core values in response to a market change rather it should change markets if necessary to remain true to its core values.

○ Core Purpose: The organization reason for being. Reflects peoples idealistic motivations for doing the company’s work.

■ Example: 3M - to solve unsolved problems ■ Example: Nike - To experience the emotion of competition, winning, and crushing

competitors ■ BHAG - Big, hairy, Audacious, Goals - way to stimulate progress

● Clear and compelling - focal point of effort, energizing, takes little or no explanation

● Vivid description

● Clearly articulated - reachable in 10-30 yrs - envisioned future

● Core ideology- (Made up of core values and core purpose) “a consistent identity that transcends product or market life cycles, technological breakthroughs, management fads, and individual leaders. Ex: The HP way, the declaration of independence

● Core values- These are the essential and enduring tenets of an organization, a small set of guiding principles, they require no external justification, they have intrinsic value and importance inside the organization. Ex: Disney’s core values of imagination and wholesomeness

● Core Purpose- the second part of core ideology, is the organization’s reason for being, it reflects people’s idealistic motivations for doing the company’s work, it captures the soul of the organization. (should last at least 100 years) It can’t be achieved, it is like a rising star on the horizon, forever pursued but never reached Ex: 3M purpose is the perpetual quest to solve unsolved problems innovatively

● BHAG-(Big, Hairy, Audacious Goal) bold missions that help stimulate progress, they are 10 to 30 year goals, clear and compelling, serves as a unifying focal point and effort, may have only a 50% to 70% likelihood of actually succeeding, Ex: Ford to democratize the automobile

● Four broad categories: ○ Target BHAGs ○ Common-enemy BHAG’s ○ Role-model BHAG’s ○ Internal-transformation BHAG’s

Kim, W and Mauborgne, R (2004) “Blue ocean strategy” HBR

• Describe (contrast, compare) the blue ocean and the red ocean strategies. ● Red ocean - all the industries in existence today - competitive rules of the game are understood - rivals try to

grab greater share of existing demand - water turns bloody ● Blue ocean - unknown market space - untainted by competition - demand is created rather than fought over

○ Can be created by giving rise to completely new industry or created from within red ocean ■ Cirque de Soleil created from within - sought out new market segment of people - “reinvented the

circus” ● Create blue oceans of uncontested market space

Red oceans represent all the industries in existence today- the known market space. Industry boundaries are defined and accepted, and the competitive rules of the game are well understood. As the space gets more and more crowded, prospects for profit and growth are reduced [about confronting an opponent and driving him off a battlefield of limited territory] Exploit existing demand, make the value/cost trade off, align system on differentiation OR low cost Blue oceans denote all the industries not in existence today- the unknown market space, untainted by competition, demand is created rather than fought over. There is ample opportunity for growth that is both profitable and rapid. [doing business where there is no competitor] break the value/cost trade off, align whole system in pursuit of differentiation AND low cost In most cases, blue oceans are created from within a red ocean when a company alters the boundaries of an existing industry

Brandenburger & Nalebuff, B. (1995) “The right game: use game theory to shape strategy” How might managers use insights from game theory to benefit the organization? (Understand and briefly explain the ideas of win-win strategy, changing the game of business, changing the players, changing the added values, changing the rules, and changing the scope.)

Win Win- sometimes to the best way to succeed is to let others do well Win - win strategies have several advantages: -more potential for new opportunities -easier to implement (b/c competitors resist less) -more sustainable -imitation is beneficial Changing the game of business: it is all about value, creating and capturing it

● The first step is drawing the Value Net map (shows all the interdependencies in the game) ● Identifying all of the elements in the game (PARTS):

○ Players: Customers, suppliers, substitutors, and complementors. None of these players are fixed ○ Added Values: What each player brings to the table

○ Rules: there is no universal set of rules, they give structure to the game and can be created by laws, customs, practicalities, and contracts

○ Tactics: Used to shape how players perceive the game, and hence how they play it ○ Scope: The boundaries of the game

Markides, C. (1997) “To diversify or not to diversify” HBR

• What are some of the critical questions a company might need to answer prior to diversification? 1. What can our company do better than its competitors in the current market? 2. Can we catch up or leapfrog competitors at their own game? 3. What strategic assets do we need in order to succeed in the new market? 4. Will diversification break up strategic assets that need to be kept together? 5. Will we be simply a player in the new market or will we emerge a winner? 6. What can our company learn by diversifying and are we sufficiently organized to learn it?

Cullinan, G., LeRoux, J., and Weddigen, R.(2004) “When to walk away from a deal?” HBR • The authors introduce in their article a “map of synergies.” Which deals are likely to generate cost- savings synergies and which ones are revenue-generating synergies? Cost savings synergies are closer to the center, can be realized quickly, and are likely to succeed. Those on the outside are revenue generating synergies, which require a lot of time and management and are less likely to succeed. • What are the key elements of due diligence (i.e., the four basic questions)?

1. What are we really buying? 2. What is the target’s stand-alone value? 3. What is our walk-away price? 4. Where are the synergies- and the skeletons?

• What should acquirers do in order to conduct an effective target assessment? ● Get to know the customers ● Check out the competition ● Verify the cost economics ● Take stock of capabilities ● Make an accounting assessment to make sure they aren’t stuffing distribution channels or falsifying numbers ● Make sure to use all of the elements of due diligence (the four questions above)