While all strategy
is aimed at creating competitive advantage
(superior long run return on invested capital
), in practice companies have three connected layers of strategy, each intended to fulfill a specific mission
in support of the aforementioned objective:
- Corporate strategy – what industries will a firm compete in, and how will its holdings in different industries create surplus value?
- Business strategy – within each industry, how does the firm achieve competitive advantage over its rivals?
- Functional strategy – how does each of the main functional parts of a company deploy its resources (essentially these are money, people, and time) in support of the corporate and business strategies? Functional strategies often lend themselves to implementation through tactics, and the difference between strategy and tactics at this level is often indistinct.
Business strategy has been defined as, essentially, the set of choices a firm selects that enable it to compete and win within a particular industry. It is what most people think of when they consider the strategies of businesses. The three best-known business strategies emphasize concentrating efforts and aligning operations to provide one of different desirable benefits for customers:
- The low cost competitor gives its customers the benefit of low price. Wal-Mart is the quintessential example of a low cost competitor in the retail industry.
- The differentiated competitor creates differences that its customers value, and for which they will pay a premium. Sony and BMW are good examples of differentiators. Neither company offers the lowest cost or price in their respective industries; customers are willing to pay extra for the distinctive and valued differences these companies embed in their products.
- The focused competitor concentrates on serving either a segment of a particular market, or may restrict its activities to a defined geographic region. IKEA is a good example of a company that has targeted young, white collar workers as its prime customer segment. Neighbourhood corner stores compete based on choosing a particular geography in which to concentrate their resources. (Note that the focused competitor can also be a low cost or differentiated competitor.)
Corporate strategy is a different concept. Here the aim is to assemble a collection of individually-competitive companies in different industries, while at the same time securing a higher level of performance overall due to a coincident presence in those industries. Performance, as used here, refers only to the price of a company’s stock. This is not necessarily an ideal measure (thought that is a subject for a different node).
Companies with active corporate strategies have been called "conglomerates", in that they lump together very different things as part of a unified whole. Take General Electric as an example. That company researches, designs and manufacturers jet aircraft engines, plastics, light bulbs and medical equipment, among other things. As such, GE is considered to be highly diversified. Internally, it is organized into strategic business units, or SBUs. GE Healthcare would be such an SBU. A full list of GE’s business units can be found at http://www.ge.com/en/company/businesses/index.htm
A measure of diversity is the source of a company’s revenues. One typology, based on the work of Prof. Richard Rumelt, classifies firms based on the activity-specific concentration of revenue as follows:
- Single business – greater than 95% of revenues earned from a single activity
- Dominant business – 70-95% from a single activity
- Related-diversified – less than 70% of revenues from a single activity, but resource sharing between activities
- Unrelated – a portfolio of distinct and possibly unconnected businesses
What possible advantage accrues to shareholders of a diversified firm from the company’s decision to compete in so many industries? Research suggests corporate strategy can work in five ways to generate benefits above and beyond those accruing from the success of each sub-unit’s business strategy:
- Scope economies: Possessing competencies obtained from competitive engagement in multiple arenas enables a company to create advanced products that blend skills held by different SBUs.
- Market power: This means that diversified companies can pool purchasing power across multiple business units to obtain volume discounts from suppliers. Imagine how a 1-2 cent/litre advantage in the cost of gasoline translates into a lower cost for a variety of products.
- Internal capital market: The corporate head office can deploy capital to projects that are of an experimental and hence risky nature. Venture and conventional sources of capital would shun such investments due to their high chance of failure.
- Deployment of culturally-bound advantages: Corporations such as GE can create and nurture management talent, each member steeped in the GE culture, and deploy them over multiple businesses as new opportunities arise.
Despite these advantages, corporate strategy has its critics. Prof. Michael Porter of Harvard Business School has argued that as diversification entails costs, a corporate office must be able to do something remarkable to give shareholders a return superior to that which they would be able to earn on their own by investing in businesses of their choice (i.e., not the bundled collection of businesses assembled by a diversified or conglomerate firm). Porter proposed three tests to determine whether diversification makes sense:
- Attractiveness: Since the amount of profit accessible to a SBU is determined by the structural characteristics of its industry, one must first ask whether that industry is attractive. Porter's Five Forces model is a good way to perform this analysis.
- Cost of entry: As companies in attractive industries usually cost more to acquire, a corporate head office must resist overpayment, as this foregoes the benefits that ostensibly should come from inclusion in a diversified firm.
- Better off: Does the acquisition bring a skill or resource that can transferred to or used by other SBUs in the corporation? What does the parent (head office) capable of doing for the newly acquired SBU?
The logic of these claims notwithstanding, many companies seek to diversity through merger or acquisition for the wrong reasons:
- CEO hubris – despite the evidence that diversification can be a value-destroyer, due to an inflated sense of their own abilities, some CEOs pursue it because they believe they are able to create synergies where other mere mortals might not.
- CEO compensation – As CEO and senior management compensation is tied loosely to the level of a firm’s revenues, from a CEO’s perspective it makes sense to purchase other companies. This increases overall corporate revenues, and hence makes a strong claim for expanded compensation for the company’s leadership. The fact that additional revenues are obtained by degrading a company's balance sheet is conveniently ignored by many feckless boards of directors.
- Shareholder preference – Due to double taxation on dividends in many jurisdictions, many shareholders prefer not to receive them. Instead, they encourage their company’s management to use excess retained earnings for acquisitions, believing that this will generate capital gains that can be realized at an advantageous time.
- Belief that growth is inherently good – Many managers believe that revenue growth is a strong indicator of a company's health, and even purchased growth (through diversification) is preferable to none at all. (The shortcomings of growth as a measure of anything will also be the subject of a future node.)
- Belief that there no new opportunities left in existing businesses – This is an argument premised on novelty. Managers may simply have exhausted ideas about how to expand existing businesses. In fact, there are very few businesses that could not benefit from either incremental innovation or geographic expansion. Usually, there is always at least one good thing that could be done with an existing business before diversifying.
If you wish to learning more about this topic, these books will be of interest:
- Competitive Strategy, by Michael Porter (1980)
- Corporate-Level Strategy: Creating Value in the Multi-Business Corporation, by Michael Goold, Alexander Campbell, and Marcus Alexander (1994)
- The Synergy Trap, by Mark Sirower (1997)
Disclaimer: I have no professional or personal connection with any author, scholar or company mentioned in this node.