Vertical Integration and Outsourcing

Vertical integration allows you to perform additional functions in the chain of production. This eliminates
middle men in your supply chain by expanding your activities in the supply chain. Backward vertical
integration prevails when you extend the scope of your production activities toward the sources of your raw
materials.
For example, you may opt to process dog food for your dog breeding business instead of buying processed
foods from veterinary suppliers. Forward integration occurs when you take up roles that are closer to the final
consumers in the supply chain. For instance, you may choose to incorporate dog training in your dog breeding
business. This way, you get to supply your dogs directly to customers seeking trained dogs, rather than
supplying the dogs to dog trainers.
The viability of vertical integration is not limited to any specific industry. You can apply it in any industry
depending on the goals you want to achieve. However, logistics and supply chain management stands out as one
industry where you can effectively adopt vertical integration, because vertical integration elevates your
operation to different levels of your supply chain. For instance, backward vertical integration makes you a
supplier of your raw materials, while forward integration grants you greater roles in the production and
distribution activities of your industrys supply chain. Nonetheless, the strategy is viable across many other
industries for as long as it fits with your overall business strategy.
Outsourcing entails giving out noncore, process-intensive or capital-demanding operations to companies that
specialize in providing these services. You can outsource functions such as payroll, information technology,
research and development and customer care services. Outsourcing spares you the burden of acquiring costly
equipment, machinery or license rights to expensive software products. This allows you to concentrate on the
core aspects of your business, enhance efficiency and cut operational costs.
You cannot tie down outsourcing to any particular industry because it is applicable across different sectors.
However, it mostly applied in industries that incur huge costs of labor and capital resources. For example, it
may be more appropriate to outsource the storage and warehousing functions of your cargo haulage business
than to maintain a network of your own stores and warehouses. When it comes to labor costs, outsourcing helps
you streamline your work force, as contracting firms remain responsible for the welfare of their own employees.
Outsourcing is ideal for industries, such as manufacturing, that require huge work force and capital resources.
ENTERING NEW INDUSTRIES THROUGH DIVERSIFICATION
Diversification is a corporate strategy to enter into a new market or industry which the business is not currently
in, whilst also creating a new product for that new market. This is most risky section of the Ansoff Matrix, as
the business has no experience in the new market and does not know if the product is going to be successful.
Diversification strategies are used to expand firms' operations by adding markets, products, services, or stages
of production to the existing business. The purpose of diversification is to allow the company to enter lines of
business that are different from current operations. When the new venture is strategically related to the existing
lines of business, it is called concentric diversification. Conglomerate diversification occurs when there is no
common thread of strategic fit or relationship between the new and old lines of business; the new and old
businesses are unrelated.
A diversified company is one that operates in two or more different or distinct industries (industries not in

adjacent stages of an industry value chain as in vertical integration) to find ways to increase its long- run
profitability.
Creating Value through Diversification
Most companies first consider diversification when they are generating financial resources in excess of
those necessary to maintain a competitive advantage in their original business or industry.
The question strategic managers must tackle is how to invest a companys excess resources in such a
way that they will create the most value and profitability in the long run.
Diversification can help a company create greater value in three main ways:
by permitting superior internal governance
by transferring competencies among businesses
And, by realizing economies of scope.
Superior Internal Governance
The term internal governance refers to the manner in which the top executives of a company manage
(or govern) its business units, divisions, and functions.
In a diversified company, effective or superior governance revolves around how well top managers can
develop strategies that improve the competitive positioning of its business units in the industries where they
compete. Diversification creates value when top managers operate the companys different business units so
effectively that they perform better than they would if they were separate and independent companies.
It is important to recognize that this is not an easy thing to do. In fact, it is one of the most difficult tasks
facing top managers and the reason why some CEOs and other top executives are paid tens of millions of
dollars a year.
Research suggests that the top, or corporate, managers who are successful at creating value through
superior internal governance seem to make a number of similar kinds of strategic decisions. First, they organize
the different business units of the company into self- contained divisions each of which operates separately.
Second, these divisions tend to be managed by corporate executives in a highly decentralized fashion.
Corporate executives do not get involved in the day- to- day operations of each division. Instead, they set
challenging financial goals for each division, probe the general managers of each division about their strategy
for attaining these goals, monitor divisional performance, and hold divisional managers accountable for that
performance. Third, corporate managers are careful to link their internal monitoring and control mechanisms to
incentive pay systems that reward divisional personnel for attaining, and especially for surpassing, performance
goals. Although this may sound easy to do, in practice it requires highly skilled corporate executives to pull it
off.
An extension of this approach is an acquisition and restructuring strategy, which involves corporate
managers acquiring inefficient and poorly managed enterprises and then creating value by installing their
superior internal governance in these acquired companies and restructuring their operations systems to improve
their performance.
This strategy can be considered as diversification because the acquired company does not have to be in the same
industry as the acquiring company.
The performance of an acquired company can be improved in various ways. First, the acquiring
company usually replaces the top management team of the acquired company with a more aggressive top
management team one often drawn from its own ranks of executives who understand the ways to achieve

superior governance. Then the new top management team in charge looks for ways to reduce operating costs by,
for example, selling off unproductive assets such as executive jets and very expensive corporate headquarters
buildings, and by finding ways to reduce the number of managers and employees (badly managed companies
frequently let their labor forces grow out of control).
The top management team put in place by the acquiring company then focuses on how the acquired
businesses were managed previously and seeks out ways to improve the business units efficiency, quality,
innovativeness, and responsiveness to customers. In addition, the acquiring company often establishes, for the
acquired company, performance goals that cannot be met without significant improvements in operating
efficiency. It also makes the new top management aware that failure to achieve performance improvements
consistent with these goals within a given amount of time will probably result in losing their jobs. Finally, to
motivate the new top management team and the other managers of the acquired unit to undertake such
demanding and stressful activities, the acquiring company directly links performance improvements in the
acquired unit to pay incentives.
This system of rewards and punishments established by the corporate executives of the acquiring
company gives the new managers of the acquired business unit every incentive to look for ways of improving
the efficiency of the unit under their charge. GE, Textron, United Technologies, and IBM are good examples of
companies that operate in this way.
Transferring Competencies
A second way for a company to create value from diversification is to transfer its existing distinctive
competencies in one or more value creation functions (for example, manufacturing, marketing, materials
management, and R&D) to other industries. Top managers seek out companies in new industries where they
believe they can apply these competencies to create value and increase profitability. For example, they may use
the superior skills in one or more of their companys value creation functions to improve the competitive
position of the new business unit. Alternatively, corporate managers may decide to acquire a company in a
different industry because they believe the acquired company possesses superior skills that can improve the
efficiency of their existing value creation activities.
If successful, such competency transfers can lower the costs of value creation in one or more of a
companys diversified businesses or enable one or more of these businesses to perform their value creation
functions in a way that leads to differentiation and a premium price. The transfer of Philip Morriss existing
marketing skills to Miller Brewing is one of the classic examples of how value can be created by competency
transfers. Drawing on its marketing and competitive positioning skills, Philip Morris pioneered the introduction
of Miller Lite, a product that redefined the brewing industry and moved Miller from Number six to Number two
in the market.
Economies of Scope
The phrase two can live cheaper than one expresses the idea behind economies of scope. When two or
more business units can share resources or capabilities such as manufacturing facilities, distribution channels,
advertising campaigns, and R&D costs, total operating costs fall because of economies of scope. Each business
unit that shares a common resource has to pay less to operate a particular functional activity.
Procter & Gambles disposable diaper and paper towel businesses offer one of the best examples of the
successful realization of economies of scope. These businesses share the costs of procuring certain raw
materials (such as paper) and of developing the technology for new products and processes. In addition, a joint
sales force sells both products to supermarkets, and both products are shipped via the same distribution system.
This resource sharing has given both business units a cost advantage that has enabled them to undercut the
prices of their less diversified competitors.

Similarly, one of the motives behind the merger of Citicorp and Travelers Insurance to form Citigroup
was that the merger would allow Travelers to sell its insurance products and financial services through
Citicorps retail banking network. To put it differently, the merger was intended to allow the expanded group to
better utilize a major existing common resource its retail banking customer network. This merger was a total
failure; it turned out that Citicorps customers had little interest in buying insurance from a bank. Citigroup sold
Travelers to MetLife because the merger had not created value. The decision to diversify, like all corporate
strategies, is a complex one, and it is hard to make the right decisions all the time.
Like competency transfers, diversification to realize economies of scope is possible only if there is a real
opportunity for sharing the skills and services of one or more of the value creation functions between a
companys existing and new business units. Diversification for this reason should be pursued only when sharing
is likely to generate a significant competitive advantage in one or more of a companys business units.
Moreover, managers need to be aware that the costs of managing and coordinating the activities of the newly
linked business units to achieve economies of scope are substantial and may outweigh the value that can be
created by such a strategy. This is apparently what happened to Citigroup.
Thus, just as in the case of vertical integration, the costs of managing and coordinating the skill and
resource exchanges between business units increase substantially as the number and diversity of its business
units increase. This places a limit on the amount of diversification that can profitably be pursued. It makes
sense for a company to diversify only as long as the extra value created by such a strategy exceeds the increased
costs associated with incorporating additional business units into a company. Many companies diversify past
this point, acquiring too many new companies, and their performance declines.
Related versus Unrelated Diversification
One issue that a diversifying company must resolve is whether to diversify into totally new businesses and
industries or into those that are related to its existing business because their value chains share something in
common. The choices it makes determine whether a company pursues related diversification and/or unrelated
diversification.
Related diversification is the strategy of operating a business unit in a new industry that is related to a
companys existing business units by some form of linkage or connection between one or more components of
each business units value chain. Normally, these linkages are based on manufacturing, marketing, or
technological connections or similarities. The diversification of Philip Morris into the brewing industry with the
acquisition of Miller Brewing is an example of related diversification, because there are marketing similarities
between the brewing and tobacco businesses (both are consumer product businesses in which competitive
success depends on competitive positioning skills).
Unrelated diversification is diversification into a new business or industry that has no obvious value chain
connection with any of the businesses or industries in which a company is currently operating. A company
pursuing unrelated diversification is often called a conglomerate, a term that implies the company is made up of
a number of diverse businesses. By definition, a related company can create value by resource sharing and by
transferring competencies between businesses. It can also carry out some restructuring. In contrast, because
there are no connections or similarities between the value chains of unrelated businesses, an unrelated company
cannot create value by sharing resources or transferring competencies. Unrelated diversifiers can create value
only by pursuing an acquisition and restructuring strategy.
Related diversification can create value in more ways than unrelated diversification, so one might expect related
diversification to be the preferred strategy. In addition, related diversification is normally perceived as involving
fewer risks, because the company is moving into businesses and industries about which top management has
some knowledge. Probably because of those considerations, most diversified companies display a preference for

related diversification.21 Indeed, in the last decade; many companies pursuing unrelated diversification have
decided to split themselves up into totally self- contained companies to increase the value they can create. In
2007, for example, the conglomerate Tyco split into three separate public companies focusing on the
electronics, health care, and security and fire protection businesses for this reason and each separate company
has performed at a higher level since.
What is Related Diversification?
It is when a business adds or expands its existing product lines or markets. For example, a phone company that
adds or expands its wireless products and services by purchasing another wireless company is engaging in
related diversification.
With a related diversification strategy you have the advantage of understanding the business and of knowing
what the industry opportunities and threats are; yet a number of related acquisitions fail to provide the benefits
or returns originally predicted.
Why? It is usually because the diversification analysis under-estimates the cost of some of the softer
issues: change management, integrating two cultures, handling employees, layoffs and terminations,
promotions, and even recruitment. And on the other side, the diversification analysis might over-estimate the
benefits to be gained in synergies.
What is Unrelated Diversification?
It is when a business adds new, or unrelated, product lines or markets. For example, the same phone company
might decide to go into the television business or into the radio business. This is unrelated diversification: there
is no direct fit with the existing business.
Why would a company want to engage in unrelated diversification? Because there may be cost efficiencies. Or
the acquisition might provide an offsetting cash flow during a seasonal lull. The driver for this acquisition
decision is profit; it needs to be a low risk investment, with high potential for return.