What is the Classic Framework?
- Attractive Industry Structure (Where to compete? External to your organization but impacts your performance)
& - Sustainable Competitive Advantage (How to compete? The result of choices your organization makes internally)
→ leads to the central goal:
Superior Long-Run Return on Investment (Good firm strategy leads to sustained higher profits than competitors and thus better return on investment.)
Define Horizontal Boundaries
Managerial Decisions:
What products should the firm sell? What is the right quantity of each product to sell?
- Horizontal Boundaries identify the varieties (scope) and quantity (scale) of products and services that a firm produces.
Define Vertical Boundaries
What should the firm buy from other firms? What should the firm make itself?
Define Scope
- Specialized (one industry): Coca cola (soft drinks), SAB-Miller (beer), GAP (fashion retailing).
v.s. - Diversified (multiple industries): General Electric (e.g. GE healthcare, GE Capital), Samsung, and Virgin.
Define Economies of Scale
- Declining average cost with volume
- The higher the quantity of products you produce, the lower your marginal average cost (i.e. cost of production decreases).
- However, after you reach a certain quantity of production, your cost of production starts increasing again.
- The minimum efficient scale (MES) is the lowest level of output at which costs are minimized.
i.e. after you reach MES and you continue to produce, after a while, your costs start to increase again. the sweet spot is to maintain your MES and don’t produce further than that.
E.g., Large firms with low unit cost: Due to economies of scale, if the firm cuts back on production, costs increases.
Define Economies of Scope
- Cost savings when different goods/services are produced “under one roof”
- Key: It is cheaper for a single firm to produce both good A and good B than for one firm to produce A and another to produce B. *although product A and B should be related so you can share some of those costs.
e.g., It makes sense for Netflix to offer both movies and TV shows, it does not make sense for Spotify to sell clothing. - Case: If you have one manufacturing plant and you only make one product inside that plant. All the fixed costs associated with the manufacturing plant is on one product. However, if you produce 2-3 other products under the same roof (i.e. using the same manufacturing plant), you are splitting the fixed costs of your plant over 3 different products.
→ Helps you save costs in the long run, as you split the fixed costs into different cost centres based on what you are producing.
Reminder on Cost functions
Total Costs TC(Q): total costs of producing Q units of output (including labor costs, capital costs etc.)
TC(Q) = Fixed Costs + Variable Costs
*Fixed costs are independent of Q
*Variable costs are dependent on Q
Average Cost AC(Q): cost per unit of output
AC(Q) = TC(Q) / Q
Define Learning Curve
- Cost advantage from accumulated expertise. i.e. average (or unit) cost declines with cumulated output (across time).
- The more experience you have producing, the lower your unit cost.
- Difference with economies of scale is that with learning curve, you are learning as you are doing.
- Regardless of the quantity of production, you have the advantage of producing at the lowest cost b/c you are continuously improving and learning as you are producing.
- Occurs both at the individual level through improvements in dexterity (skill in performing tasks) and problem solving and at the group level through the development and refinement of organization routines.
E.g.1., Target opened 133 stores in Canada all at once. This aggressive expansion did not allow time for learning and was a failure. Target abandoned its Canadian stores after only 2 years.
E.g.2., A large firm with low unit cost: Due to learning economies, if the firm cuts back production, cost remains the same. This is b/c you have continuously learned to improve your processes to the point that when you reduce production your costs will remain the same.
Define Diseconomies of Scale
The sources of such diseconomies are:
1. Increasing labour costs
2. Bureaucracy effects - monitoring/influencing costs
3. Scarcity of specialized resources
4. “Conflicting out” (i.e. Conflict of Interest between companies)
*Monitoring/Influencing costs: you will need to monitor before you get the project. you also need to influence that you’re able to get the funding for that project.
→ The more you produce, the higher the monitoring/influencing cost.
Define Vertical Boundaries
- Vertical Boundaries identify the production activities that a firm performs.
- Key Managerial Decision: Should the firm make or buy its inputs?
a) Vertically Integrated (make): Scott Paper (cuts its own timber, mills it, makes paper products and distributes them)
b) Disintegrated (buy): Nike, Benetton
E.g., Netflix has moved from a model of buying movies and series to producing its own. Same with Amazon.
*Companies that are able to produce its own inputs, we call them fully, vertically integrated firms.
Make or Buy Continuum
- Make: the firm performs the activity itself.
- Buy: the firm is relying on an independent firm to perform the activity.
Two extremes along the continuum:
1. Arm’s length market transaction (Buying the inputs from suppliers at market rate, have no form of relationship with them).
2. Long Term Contracts
3. Strategic Alliances
(With both, you can reduce the power of suppliers to easily hijack your prices).
4. Parent Subsidiary Relationship (Where you have another subsidiary of the company doing the activity for you).
5. Perform Activity Internally (You perform all your activities internally).
Define Vertical Boundaries
Five Reasons to Buy:
Tangible Benefits:
1. Proprietary Information: Meaning you don’t have the proprietary rights/patent over that product. You can only keep buying that input from the patent owner.
2. Economies of Scale: An outsourced company may be able to produce the input at a much lower cost, which means they’re likely able to achieve a lower cost than you if you were to internalize that activity.
3. Learning Curves
Intangible Benefits:
4. Agency Costs (a.k.a. Agency Theory): By deciding to do an activity internally, it may lead to higher costs of influencing the activity, or managing the people.
E.g., As the owner of your company, you might encounter a situation where the manager you’ve hired prioritizes their own interests over yours. In such cases, you incur agency costs by needing to closely monitor your agents to ensure their actions align with the best interests of the firm.
5. Influence Costs: Negotiating for financing lead to higher costs of influencing the activity, to get new projects internally.
Three reasons to Make:
1. Coordination: You want to internalize those activities and coordinate them by yourself to avoid uncertainties from suppliers (e.g. Gain more control over pricing and mitigate the risk of suppliers denying further supply.)
2. Private Information: You want to protect your private information. (E.g. Inc. proprietary information about how you produce your products, or a particular patent that you do not wish to share.)
3. Opportunistic Behaviour and Transaction Costs: From the supplier’s perspective, opportunistic behaviour implies the possibility of the supplier hijacking the prices of the inputs they provide. (Part of Porters Five forces (Power of Supplier) Transaction costs include the expenses associated with organizing and coordinating exchanges between the two market partners.
*Important elements of transaction costs include the cost of negotiating, writing, and enforcing contracts.
* Solution to prevent opportunistic behaviour and lower transaction costs is to sign a long term contract with your parters. However, there is no complete contract.
Takeaway
- The firm can be bounded horizontally (by: Economies of Scale, Economies of scope and Learning curve) and vertically (make or buy decisions).
