Horizontal growth can be achieved through horizontal integration which is the development into activities which are competitive with, or complimentary to, a company’s present activities. Many companies have realised that there are opportunities in other markets for the exploitation of its own competencies e.g. maybe to displace the current provider as a new entrant. Horizontal integration can occur at any stage within the value chain.
Advantages and Disadvantages of Horizontal Integration
Advantages – Increases market power over the next or the previous link in the process
- Enables greater economies of scale to occur
Disadvantages – May restrict customer choice
- Unequal market influence may increase costs overall by the exercise of monopoly power and this may attract the attention of
the Monopolies/Competition Commission
Vertical growth can be achieved through vertical integration which is the extension of a firm’s competitive ability within the same industry. It involves expanding the company’s range of activities backwards into sources of supply and / or forwards towards end users of the final product. A company can achieve vertical integration through two methods;
- it can start its operations in the other stages in the industry’s activity
- it can acquire a company already performing these activities
This process generates cost savings only when the volume needed is big enough to maximise a specific supplier’s economies of scale without any negative impact on the existing quality standard. Backward integration can also benefit the company by diminishing the uncertainty of depending on suppliers of crucial components or support services. It can also lessen a company’s vulnerable position when dealing with powerful suppliers that raise prices at every opportunity. If the firm concerned is low on a key supplier’s priority list it can find itself waiting on shipments every time supplies get tight. If this occurs, the firm’s reputation will suffer through poor production and customer relations activities (where applicable) and backward integration may be a suitable strategic solution
The requirement for forward integration follows much the same concept as above. In many industries, sales agents, wholesalers etc. have no affiliation to any one company’s brand and tend to push what earns them the biggest profits. Poor sales and distribution channels can give rise to high inventory costs and underutilisation of capacity. A company that encounters the above may find it beneficial to integrate forward into wholesaling / retailing in order to have outlets fully committed to representing its products. This can lead into the activity of selling directly to end users which produces important cost savings which has an impact on permitting lower selling prices.
Strategic disadvantages of Vertical Integration
There are serious considerations that need to be evaluated before pursuing a strategy of vertical integration. Issues that need to be considered include some of the following;
- Capital investment in the industry is increased but this increases business risk especially where this investment could have been used for more worthwhile projects
- Integrating forward or backward locks a firm into relying on sources of supply / channels of distribution which can have a negative impact on supplier / end user flexibility
- Balancing capacity, especially at each stage of the value chain, is a very vexing issue
- Forward or backward integration requires very different skills and business capabilities. Companies have to be aware that what they thought would add value to their core businesses may not necessarily work out that way
Advantages and Disadvantages of Vertical Growth
A strategy of vertical growth depends on;
- Whether it can improve the performance of critical activities that reduce costs
- Its impact on investment costs, flexibility and response times
- Its ability to create competitive advantage
A diversification strategy depends upon a company’s growth opportunities in its present industry and it also depends on the available opportunities to utilise its resources and capabilities in other market areas.
Diversified growth can de done through one of two ways;
- Related markets – through vertical integration strategies
- Unrelated markets – this is where the relevant company acts as a ‘holding company’ by operating in areas where its detailed knowledge of the key factors for success is limited. This type of diversification can be operated successfully where the use of tight but clear financial controls is suitably managed.
Three Tests required for justification of a diversification strategy
Strategists, in order to ensure an increase in shareholder value, must use the following three tests;
- The attractiveness test – the industry chosen must be attractive enough to have consistent good returns on investment. This largely depends upon the presence of favourable competitive and market conditions
- The cost-of-entry test – the cost to enter the specific industry must not be so high as to erode the potential for good profitability. The more attractive it is the more expensive it can be to get into
- The better–off test – the diversifying company must bring some potential for competitive advantage to the new business it enters. If this is achieved there is also opportunity for added profitability and share holder value
Once the decision is made to diversify, a choice must be made whether to diversify into a related or unrelated business / businesses. The following are six diversification related strategies;
- Strategies for entering new industries – acquisition, start-up and joint venture
- Related diversification strategies
- Unrelated diversification strategies
- Divestiture and liquidation strategies – if a company is considered for divestiture, it would suggest that it no longer fits or is an attractive investment
- Corporate turnaround, retrenchment and restructuring strategies
- Multinational diversification strategies – an example of this is where a multinational company can benefit from its competitive advantage by transferring its expertise in a core technology to other lines of business able to benefit from its capabilities e.g. Honda – from piston rings to motorcycles to cars, hedge trimmers etc.
The first three are ways to diversify and the last three are strategies that strengthen the positions and performances of companies that have already diversified.
GROWTH BY MERGERS
Mergers are similar to acquisitions in the sense of two companies combining. However, mergers usually arise because neither company has the ability to acquire the other on its own. This has the potential benefit of being more friendly but requires special handling if the benefits are to be realised.
Motives for mergers
These include some of the following;
- It allows the company to enter new product or / and market areas especially where the process of internal development is slow. This is especially true in many ecommerce businesses
- The competitive situation may influence a company to adopt a merger strategy compared to being a new company entering the market. Competitive reaction is reduced if the former strategy is adopted
- De-regulation is a driving force for many mergers which reduces the fragmentation of the market
- Financial motives that enhance opportunities are also a factor
- A lack of resources or competencies to compete successfully may be acquired that will offer better economies of scale or economies of scope
Problems with Mergers
It is important to note that approx. 70% of mergers end up with lower returns to shareholders of both organisations. One of the main reasons for this is due to issues associated with cultural fit. This is where a ‘clash of cultures’ may arise because the organisational routines are so different in each organisation. Cultural fit can be even more problematic with crossborder mergers due to the complication and combination of different national cultures.
ECONOMIES OF SCOPE
Economies of scope exist whenever it is less costly for two or more companies to be operated under centralised management than to function as separate independent companies. Most economies of scope fall into one of four categories;
- Technology Fits – when there is potential for sharing common technology. This allows for more effective performance of technology-related activities
- Operating Fits – opportunities exist on this category due to the combination of activities or transfer skills / capabilities in procurement, conducting R & D, improving production processes etc.
- Distribution and Customer-Related Fits – when the value chains of different businesses overlap to such an extent that the products are used by the same customers, opportunities exist for cost savings in such areas as using a single sales force for all products instead of separate sales forces for each product line etc.
- Managerial Fits – benefits in this category can be obtained when managerial knowledge in one line of business can be transferred to another line
Sources of Inter-firm Economies of Scope that can motivate strategic alliances
- Exploiting economies of scale
- Learning from competitors
- Managing risk and sharing costs
- Low-cost entry into new markets
- Managing uncertainty
PROFIT MAXIMISATION OBJECTIVE WHEN MANAGEMENT IS SEPARATE FROM OWNERSHIP
The traditional theory of the firm assumes that its sole objective is to maximise profit. The managerial theories make the assumption that where ownership (shareholders / stockholders) and control (management) of the company are separated, the objective that guides the firm will be the one that management sets. This is generally done through the process of maximising sales revenue or growth. Some commentators, like Marris, argue that growth is a separate objective from profit. Growth may also be a means of securing greater stability for the firm.
Profit Maximisation vs. Wealth Maximisation
Maximisation of profits is generally regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximising shareholder wealth. For example, total profits are not as important as earnings per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills / Bonds. Even maximisation of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment project that will produce RWF60,000,000 return 3 years from now more valuable than the project that will produce annual returns of RWF20,000,000 in each of the next 3 years? An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few existing stockholders would think favourably of a project that promised its first return in 50 years. We must take into account the time pattern of returns in our analysis.
ALTERNATIVE THEORIES OF THE FIRM
Firms are in business for a simple reason – to make money. Traditional economic theory suggests that firms make their decisions on supply and output on the basis of profit maximisation. However, many economists and managerial scientists question that the sole aim of a firm is the maximisation of profits.
The most serious examination on the theory of the firm comes from those who question whether firms even make an effort to maximise their profits. A firm (especially a large conglomerate) is not a single decision-maker but a collection of people within it. This implies that in order to understand the decision-making process within firms, we have to analyse who controls the firm and what their interests and motivations are.
The fact that most large companies are not run by their owners is often brought forward to support this claim. A large corporation typically is owned by thousands of shareholders / stockholders, most of whom have nothing to do with the business decisions. Those decisions are made by a professional management team, appointed by a salaried board of directors.
In most cases these managers will not own stock in the company which may lead to strongly differing goals of owners and managers. When managers’ salaries stay unaffected by higher profits they may pursue other goals to raise their personal profile.
This behaviour strikes the astute observer regularly when, for example, reading or watching the financial media. Managers often mention the rises in sales or the growth of their company rather then the profits. Some economists like Begg (1996) argued that managers have an incentive to promote growth as usually these same managers of larger companies generally obtain higher salaries.
PRINCIPAL – AGENT THEORY
The principal – agent theory is the theory of devising compensation rules that induce an agent to act in the best interests of a principal. Agents, whether they are managers or workers, pursue their own goals and often impose costs on a principal.
Principal-agent problem – the central dilemma investigated by principal agent theorists is how to get the agent to act in the best interests of the principal when the agent has an informational advantage over the principal and has different interests from the principal. Sappington (1991) provides a discussion of principal-agent incentive problems;
(A) Privatisation as a solution to the principal-agent problem.
Principals must balance agency costs against costs of debt financing and other costs associated with not separating ownership from control. The issue of privatisation of government services hinges not only on the relative production costs in the public vs. private sector, but also on agency / transaction costs. This is made more complicated by the fact that there are many forms of separation of ownership / sovereignty from control, including many forms of contracting out, which can carry high agency costs. Indeed, contractors may be in-house governmental agents, not representing privatization at all.
Agency costs are a type of transaction cost, reflecting the fact that without incurring costs, it is impossible for principals to ensure agents will act in the principals’ interest. Agency costs include the costs of investigating and selecting appropriate agents, gaining information to set performance standards, monitoring agents and residual losses. Agency costs have policy implications.
- Information costs in contract management – in addition to recognising that contract management involves agency costs, one may also observe that the informational advantage of the contractor regarding performance means that the contractor may be able to impose high agency costs by resisting the principal’s effort to gain information. The more difficult for the principal to gain information on performance outcomes, the more likely that contracts will be framed instead in terms of contractor behaviour
- Goal incongruity – between principal and agent increases the incentive of the agent to withhold information from the principal (Simonsen and Hill, 1998).
- Agent risk aversion – some agents are more risk-averse than others, perhaps due to organisational culture issues. Risk-averse agents are more prone to withhold information from principals, increasing agency costs.
- Interdependence can also make processes and procedures more complex and uncertain, in turn increasing agency costs of obtaining performance information.
- Communication costs. The agent may not follow the intent of the principal when there has been insufficient investment of time and personnel, and investment in communications channels, by the principal, resulting in lack of clarity and / or consistency of messages from the principal (Goggin et al, 1990).