Why Do Firms Diversify? • 83
raising its unit costs (depending on the rate of forgetting.) To take another example, if a firm enjoys a cost advantage due to a capital-intensive production process and resultant scale economies, then it may be less concerned about labor turnover than a competitor that enjoys low costs due to learning a complex labor-intensive production process.
DIVERSIFICATION
We have thus far considered the importance of size in firms that remain focused on a single activity (economies of scale) or related activities (economies of scope). Many well-known firms operate in seemingly far-flung industries. Sometimes the industries are connected by subtle but important scope economies, such as the product design skills that allow Apple to prosper in computers and cell phones. But in many cases the potential for scope economies is limited, such as when England’s EMI diversified in medical-imaging equipment and popular music. These firms are often described as conglomerates involved in unrelated diversification. Many of the world’s largest firms follow this strategy. India’s Tata Group operates in a wide range of businesses including information technology, energy, pharmaceuticals, Italian handcrafted furniture, and automobiles (including the Tata, Jaguar, and Land Rover nameplates). South Korea’s Hyundai Group is in steel production, elevators, ocean shipping, and, of course, automobiles.
In the remainder of this chapter, we explore a variety of rationales for business conglomerates, as well as examine empirical evidence that casts some doubt on the wisdom of unrelated diversification.
WHY DO FIRMS DIVERSIFY?
Diversification is costly, especially when one firm acquires another. In addition to the costs of financing the deal, the resulting conglomerate may suffer from a variety of costs loosely associated with bureaucracy. We take up these bureaucracy costs in Chapter 3.
If diversification has its costs, there must be some equal or greater benefits. Firms may choose to diversify for either of two reasons. First, diversification may benefit the firm’s owners by increasing the efficiency of the firm. Second, if the firm’s owners are not directly involved in deciding whether to diversify, diversification decisions may reflect the preferences of the firm’s managers.
In this section we explore both possibilities. First we discuss how diversification may affect corporate efficiency and thereby affect the value accruing to the firm’s owners. We discuss ways in which diversification can both enhance and reduce efficiency. We then discuss how a firm’s manager may benefit from diversifying the firm, why shareholders may be unable to prevent diversification that does not create value, and what forces constrain management’s ability to diversify firms.
Efficiency-based Reasons for Diversification
We begin by discussing both the benefits and the costs of corporate diversification to a firm’s shareholders.
84 • Chapter 2 • The Horizontal Boundaries of the Firm
Scope Economies
One motive for diversification may be to achieve economies of scope. Although there may be little opportunity to spread fixed production costs across businesses like automobiles and pharmaceuticals, scope economies can come from spreading a firm’s underutilized organizational resources to new areas.14 In particular, C. K. Prahalad and Richard Bettis suggest that managers of diversified firms may spread their own managerial talent across business areas that do not seem to enjoy economies of scope. They call this a “dominant general management logic,” which comprises “the way in which managers conceptualize the business and make critical resource allocations— be it in technologies, product development, distribution, advertising, or in human resource management.”15 The dominant general management logic may seem at odds with the notion of diseconomies of scale, discussed earlier, that result when talent is spread too thin, which is why we emphasize the gains from spreading underutilized resources.
EXAMPLE 2.5 APPLE: DIVERSIFYING OUTSIDE OF THE BOX
Over the past decade, Apple has gone from being a focused computer maker given up for dead to the world’s most valuable technology company. From the Mac to the iPod, iPhone and iPad, Apple has thrived by leveraging economies of scope to suit changing trends and times. Constant innovation and efficient diversification have helped Apple excite its customers and build remarkable brand loyalty. As a result, Apple dominates its markets and commands a price premium.
Steve Jobs, Steve Wozniak, and Ronald Wayne founded Apple in the 1970s. With Jobs at the helm, the company quickly became known for its personal computers with a userfriendly operating system. Apple garnered rave reviews from loyal users, but most consumers purchased Microsoft-based personal computers because of Microsoft’s lower price and greater availability. Apple made a big splash in 1984 when it ran a famous commercial for its McIntosh computer during the Super Bowl. But an industrywide sales slump led to Jobs’s dismissal later that same year. Despite constant design innovations and ongoing problems with Microsoft Windows operating systems, Apple could not build its market share of the PC business much above its loyal 10 percent.
In an effort to reverse its fortunes, Apple brought Jobs back in 1996. He immediately terminated several ongoing projects and focused
on a question that must have seemed anything but innovative at the time: “What can we do to make more people buy the Mac?” Apple introduced the iMac, with its revolutionary design that integrated the computer into the monitor, doing away with the traditional big black box. With sales of the Mac on the rise, Apple began looking outside of the box for further growth.
Apple saw great opportunities in personal digital devices. Digital cameras and camcorders already had well-established markets, but existing digital music players were either big and clunky or small and useless, with unfriendly user interfaces. Jobs asked veteran engineer Jon Rubinstein to build a better product, one that used the iMac as a programming engine. Robinson had been responsible for many of the company’s hardware innovations and saw the potential of a miniature hard drive newly developed by Apple’s supplier Toshiba. This little disk became one of the core technologies of the iPod. Apple licensed the SoundJam MP music player from a small company and retooled it into its own media player, iTunes. Apple also relied heavily on its own capabilities. Apple’s prestigious design group made prototype after prototype to ensure that iPod would fit Apple’s “user friendly” brand image. The design group worked with Apple’s hardware engineers, power group, and programmers, leveraging technologies and skills used on the iMac.
Why Do Firms Diversify? • 85
Apple introduced the iPod in October 2001. Together with iTunes, it not only turned around Apple’s finances, it rewrote the entire digital music landscape. This remarkable success changed the face of Apple overnight from being a rebel computer company to the trendy digital electronics company. And the iPod had a “halo effect” on the iMac; Apple products were trendier than ever.
Apple next turned its attention to cellular phones. Inspired by tablet PCs, Jobs believed that cell phones were going to become important devices for portable information access. Although the headset business was highly competitive, one point of market share was worth $1.4 billion. More importantly, there were no products that integrated all of the functions that one could incorporate into a handheld device. Research in Motion’s Blackberry had taken a big step toward convergence, but Apple planned
to go further, and expected to command a steep price premium if it succeeded. Once again building on existing strengths, Jobs took the video iPod and stuffed it with a version of the OS X operating system, so that the phone could handle web browsers and e-mail clients. GPS and wireless capabilities were added. Independent programmers found the iPhone to be a perfect vehicle for new applications. Today’s iPhones are expensive and highly profitable. By the end of fiscal year 2011, Apple had sold a total of 140 million iPhones, which accounts for a market share of less than 10 percent of all cell phones. More important to Apple, the product generates over half of total industry profits.
With each innovation, from the iPod to the iPhone and the iPad, Apple puts its existing skills in design, engineering, and programming to surprising new uses. Time will tell what new surprises Apple has in store.
The dominant general management logic applies most directly when managers develop specific skills—say, in information systems or finance—that can be applied to seemingly unrelated businesses without stretching management too thin. Managers sometimes mistakenly apply this logic when they develop particular skills but diversify into businesses that do not require them. For example, some observers of the 1995 Disney–ABC merger wondered whether Michael Eisner’s ability to develop marketing plans for Disney’s animated motion pictures would translate into skill at the scheduling of network television programming. The dominant general management logic is more problematic when managers perceive themselves to possess superior general management skills with which they can justify any diversification. Indeed, the dominant general management logic may be used to justify any and all unjustifiable diversifications.
Internal Capital Markets
Combining unrelated businesses may also lead a firm to make use of an internal capital market. The internal capital market, which we describe in more detail in Chapter 3, describes the allocation of available working capital within the firm, as opposed to the capital raised outside the firm via debt and equity markets. To understand the role of internal capital markets in diversification, suppose that a cash-rich business and a cash-constrained business operate under a single corporate umbrella. The central office of the firm can use proceeds from the cash-rich business to fund profitable investment opportunities in the cash-constrained business. Thus, the diversified firm can create value in a way that smaller focused firms cannot, provided that diversification allows the cash-constrained business to make profitable investments that would not otherwise be made, for example, by issuing debt or equity. This idea forms the basis of the important Boston Consulting Group Growth/Share paradigm.
86 • Chapter 2 • The Horizontal Boundaries of the Firm
FIGURE 2.9
The BCG Growth/Share Matrix
The growth/share matrix divides products into four categories according to their potential for growth and relative market share. Some strategists recommended that firms use the profits earned from cash cows to ramp up production of rising stars and problem children. As the latter products move down their learning curves, they become cash cows in the next investment cycle.
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Beginning 30 years ago, the Boston Consulting Group (BCG) has preached aggressive growth strategies as a way of exploiting the learning curve. Figure 2.9 depicts a typical BCG growth/share matrix. The matrix distinguishes a firm’s product lines on two dimensions: growth of the market in which the product is situated, and the product’s market share relative to the share of its next-largest competitors. A product line was classified into one of four categories. A rising star is a product in a growing market with a high relative share. A cash cow is a product in a stable or declining market with a high relative share. A problem child is a product in a growing market with a low relative share. A dog is a product in a stable or declining market with a low relative share.
The BCG strategy for successfully managing a portfolio of products was based on taking advantage of learning curves and the product life cycle.16 According to this product life-cycle model, firms use profits from established cash cow products to fund increased production of early-stage problem child and rising star products. Learning economies cement the advantages of rising stars, which eventually mature into cash cows and help renew the investment cycle.
BCG deserves credit for recognizing the strategic importance of learning curves. However, it would be a mistake to apply the BCG framework without considering its underlying principles. As we have discussed, learning curves are by no means ubiquitous or uniform where they do occur. At the same time, product life cycles are easier to identify after they have been completed than during the planning process. Many products ranging from nylon to the Segway personal transporter that were forecast to have tremendous potential for growth did not meet expectations.
Perhaps the most controversial element of the BCG framework is the role of the firm as “banker.” Recall that diversification allows businesses access to a corporation’s working capital. Thus, the central office of the corporation must act like a banker, deciding which businesses to invest in. Given the sophistication of modern financial markets, one wonders if firms must really rely on “cash cows” to find capital to fund their “rising stars.” Jeremy Stein argues that the answer to this question may well be yes, for several reasons.17 First, a firm may find it difficult to find external providers willing to fund new ventures due to asymmetric information. Firms seeking to expand usually know more about their prospects for success than potential bondand equity holders outside the firm. Outsiders may suspect that firms disproportionately seek outside funding for questionable projects, saving their internal working capital for the most promising projects. When firms seek outside funding for projects that they believe are truly worthwhile, they can be met with skepticism and high interest rates.