Scale and Scope in Industry PDF

Session 3: Scale and Scope within an Industry Prof. Dr. Artur Baldauf © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 1 Discussion Disney Case © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 2 Discussion Disney Case Question 1: Ma...

Session 3: Scale and Scope within an Industry Prof. Dr. Artur Baldauf © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 1 Discussion Disney Case © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 2 Discussion Disney Case Question 1: Make an example for each dimension of scope (vertical integration, geographical direction and product/market) based on Disney. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 3 Discussion Disney Case Question 2: How or where do you think Disney has applied economies of scale? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 4 Paper Scape © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 5 Chapter 3: Scale and Scope Within an Industry Learning Goals: Examine the dimensions of scope. Understand the meaning of economies of scale and scope. Recognize problem areas that arise from the use of scale and scope economies. VISION GOALS STRUCTURE SYSTEM PROCESS Corporate Advantage Identify scale and scope effects. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 6 Chapter 3: Contents Introduction Dimensions of Corporate Scope Economies of Scale (Size/Market Share), Efficiency) EoS vs. Learning Effects Limits to Scale and Experience Economies of Scope (Synergy/Multiproduct, Complementarity) Obstacles to Exploiting Scale and Scope Effects PRACTICE © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 7 Introduction Integration vs. Diversification (1) Integration (Concentration) Diversification Single Business Multi Business (Expansion within the industry) (Expansion across industries) Integration Vertical Horizontal Diversification Related (concentric) Unrelated (conglomerate) B Other Businesses Backward Forward Chapter 3 © Artur Baldauf l Department of Management l University of Bern Current Businesses No Unrelated Links Other Businesses Many Related Links Chapter 4 Corporate Strategy 8 Introduction Integration vs. Diversification (2) Vertical Integration … is an activity for coordinating different areas of the value chain (Stuckey and White, 1993, Sloan Management Review, Spring: 71-82) … is a possible growth alternative Diversification (Chapter 4) “Related” Diversification: How many businesses is it sensible to be engaged in? “Unrelated” Diversification: Does it make sense to expand into an area that is not directly related to the business core? An essential decision of the management is the degree of vertical integration; which part of the value chain should be „controlled“ (stay in the possession of the firm)? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 9 Introduction Expansion within the Industry vs. Diversification: Expansion Alternatives (3) Vertical Integration Diversification in related businesses PostDiversification Strategic Alternatives New Acquisitions Single Business Concentration Diversification in unrelated businesses Terminate Unprofitable Units Restructure the Portfolio Expansion within the industry: Increase of output Vertical integration Geographical expansion © Artur Baldauf l Department of Management l University of Bern Diversification in related & unrelated businesses Set Economic Measures Closure Corporate Strategy 10 Dimensions of „Corporate Scope” Corporate Expansion Alternatives Vertical Integration (Value Chain) Examples: Geographical Direction Microsoft: Supplier of DOS – Applications software (Word, Excel) – upgrading activities (Windows) – backward integration (multimedia) – overseas – new products (Xbox Series X) P&G: candle and soap (1837) – Quelle: Collis and Montgomery, Corporate Strategy, 2005, p. 66 Product/Market (Diversification, Ansoff) © Artur Baldauf l Department of Management l University of Bern vegetable shortening (1911) – laundry detergent (1933) – hair care (1934) – toothpaste (1955) – toilet paper and paper towels (1957) – diapers (1961) – coffee (1963) – pharmaceuticals (1978) – cosmetics (1989) … Corporate Strategy 11 Dimensions of Scope Expansion within the Industry: Vertical Integration Advantage ?? Demand ?? Vertical Integration forwards backwards Is size crucial? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 12 Dimensions of Scope Expansion within the Industry: Vertical Integration Practical Questions: Ikea: Why does Ikea own its stores? Competitive Principle: competitive position (ex. [transaction] costs/sizes) can Intel: Should Intel enter the PCbusiness? Body Shop: Why does Body Shop produce most of its own products? Nike: Why does Nike mainly outsource the production of its products? Vertical integration will only be an alternative, if the be improved. Questions: Does size exist – such as cost advantages? Is market power beneficial? Are there limits to size? Is variety demanded?… Types: Forward, Backward, Taper, Full © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 13 Economies of Scale (EoS) and Economies of Scale exist, when average costs are falling over the relevant range of output (at capacity) Single-site: related to the size of the manufacturing unit (physical) Multiple-site: related to more plants (more nonphysical i.e. marketing) Minimum Efficient Scale is the smallest scale at which economies of scale are exhausted (determined by the amount of competitors in an industry) © Artur Baldauf l Department of Management l University of Bern Average Cost (AC) Minimum Efficient Scale (MES) MES AC Quantity Corporate Strategy 14 Economies of Scale (EoS) Numerical Example Plant A Plant B Capacity 100 100 200 Fixed Costs 1000 1000 1600 10/Unit 10/Unit 10/Unit Capacity Utilization Level 50 100 200 Average Cost per Unit 30 20 18 Variable Costs Operating Leverage EoS ➔ Scale effects make up 10 % (2 units; compare the full capacity utilization level from Plant A and B). ➔ Note: “optimally used is important”: if just based on number of units --operating leverage © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 15 Economies of Scale (EoS) 0.15 0.10 SF Dr. Pepper Diet Pepsi Diet 7-Up Diet Rite 0.05 Fresca Seven-Up Dr. Pepper Sprite Pepsi 0.02 Advertising Spending ($ per Unit) 0.20 Empirical Evidence: Soft Drink Industry 10 20 50 100 200 500 Coke 1,000 Yearly Sales Volume (in Millions of Units) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 16 Economies of Scale (EoS) Sources and Benefits Non-dividable fixed costs (an input cannot be scaled down below a certain minimum) Special machines Some costs are fixed (R&D; marketing; advanced training; set-up costs) Certain transportation routes Specialization and increasing productivity of variable inputs (division of labor) Savings of Stocks (to run out of stock – however, stocking has a cost) Cube-square rule: © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 17 Minimum Efficient Scale (MES) Attention: High Volume ≠ Cost Advantage © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 18 Minimum Efficient Scale (MES) Examples Industry Sector MES as percent of the US consumption Refrigerators 14.1 % Cigarettes 6.6 % Beer Brewing 3.4 % Oil Refineries 1.9 % Painting 1.4 % Shoes 0.2 % Scale effects determine the competitor intensity (3-4 competitors/industry; Henderson) Source: F.M. Scherer, A. Bechenstein, E. Kaufer, R.D. Murphy, The Economics of Multiplant Operation (Campridge, Mass. Harvard University Press, 1975, p. 80 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 19 EoS and “Learning” Central Terminology Economies of Scale Lower cost per unit is based on larger current/actual production volumes. Learning Effects Cost reductions based on “learning by doing”. Experience Curve Systematic cost per unit reduction based on increasing, cumulative (ex. observe more times per period) output. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 20 The learning curve describes how experience or learning generates cost advantages (with every doubling the …) Firms “learn by doing” Experience shifts the average cost curve Average Cost (AC) Experience/Learning Curve AC1 AC2 Quantity © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 21 Comparing EoS und Learning Effects © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 22 Experience/Learning Curve A cost advantage can be generated through a high level of (cumulative) output Advantage is measured by the progress ratio: Progress ratio = AC(2Qx) AC(Qx) Range generally from 0.7 and 0.9 But not in every industry! © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 23 Experience/Learning Curve Strategic Implications It is implicit that a firm may wish to charge a low price initially to secure market penetration penetration pricing versus “cream-skimming” Japanese electronic corporations Firms should take a strategic view of their product lines : BCG matrix and product life cycle Firms can organize to enhance learning Share information Reduce fluctuation/turnover Learning Economies ≠ Economies of Scale Capital intensive industries with few learning effects may not be concerned with labor turnover EoS = short run; Experience = long run (path dependency = resource) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 24 Do costs decline indefinitely as scale and experience continue to rise? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 25 Limits to Scale and Experience: Average Costs (SFr. per Unit) Diseconomies of Scale 250‘ Asset 500‘ Asset Economies of Scale 750‘ Asset Diseconomies of Scale Output Quantity (Units per Week) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 26 Limits to Scale and Experience: Diseconomies of Scale Size of demand (at a certain level costs increase) Size approaches increasing personal costs Incentive and bureaucracy effects (coordination) “Conflicting out” Professional services firms, for example, may find it difficult to sign up a client if a competitor is already client of the firm. Necessary resources are not available (ex. top chefs) Strategic risks (ex. Ford vs. GM) The volume of the scale effects changes itself over time (ex. new technology) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 27 Economies of Scope “when it is less costly to combine two or more product lines in one firm than to produce them separately“ (C/M 2006, p. 72) Economies of Scope exist when savings can be achieved through the production and sale of many products (across functions or units) (so called SYNERGY – „joint production economies“) Formal: C(x+y) < C(x) + C(y) If economies of scope exist, corporations attempt to increase their variety of products Economies of scope are not only related to the physical production process Observable intangible resources (image) To exploit economies of scope, a firm must “leverage competencies” or “compete on capabilities”. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 28 Economies of Scope Examples McDonald’s © Artur Baldauf l Department of Management l University of Bern Heinz Nestle Corporate Strategy 29 Economies of Scope Horizontal Integration Advantage Demand Horizontal Integration ✓Products ✓Geographical © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 30 Obstacles to Exploiting „Scale“ and „Scope“ Poor analysis/cost planning Implementation difficulties (bureaucratic obstacles) Core Rigidities: too long reliance on (existing) advantages. Changes are difficult: Conflicts with signals that advise of necessary changes (ex. obsolete assets) New processes can not be introduced Institutionalized capabilities appear as Inertia Problems concerning the definition of „RELATEDNESS“ (product- vs. resourceoriented) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 31 PRACTICE Identification of Scale and Scope Economies: Value-Chain Analysis Value Chain: divides a firm’s activities into discrete processes (through the procurement of production factor (raw materials) to the delivery to customers); allows costs and differentiation to be simultaneously examined (Customer Value: Cost-to-serve/acquire, segmentation) Observation Units: Industry Value Chain Analysis: an industry or an industry sector is conceived as a value chain in reference to upstream and downstream activities Added value = more total value created by an industry (including the relevant business) – created industry value without the business or That value which would be lost in the industry if the corporation were to vanish from the market Corporate Value Chain Analysis: an organization/ corporation is seen as an internal value chain from (discrete) activities © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 32 PRACTICE System of the Value Chain Upstream Value Chain Activities, costs and gains of the suppliers Downstream Value Chain Corporationspecific Value Chain Internal Activities, costs and gains Costs, quality etc. of inputs influence the costs and quality of the produced products © Artur Baldauf l Department of Management l University of Bern Activities, costs and margins of forward supported strategic partners Buyer/seller Value Chain Costs and gains of upstream levels influence not only the price for the (end) buyer, but also their satisfaction … Corporate Strategy 33 PRACTICE Value Creation Customer Willingness to Pay Value is generated in a corporation through exchange activities with the customers and suppliers – An isolated corporation cannot create value Willingness to Pay = the highest price that a customer is willing to pay for a product of the corporation Corporation Supplier Total Value Created Supplier Opportunity Cost © Artur Baldauf l Department of Management l University of Bern Supplier Opportunity Cost = willingness to receive = the lowest price that a supplier in reference to the production of a product with specific resources is willing to accept Value Created: the difference between the customer‘s willingness to pay and the opportunity cost of the resources Corporate Strategy 34 PRACTICE Allocation of “Value” Customer Willingness to Pay Value captured by customer Price Corporation Value captured by firm Cost Supplier Value captured by supplier Supplier Opportunity Cost © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 35 Example of an Industry Value Chain Production by farmers Cocoa plant growing Cocoa pod harvesting Sourcing and marketing (trading) Cocoa bean sourcing, cleaning and trading Cocoa bean fermentig and drying Processing Manufacturing and distribution Cocoa bean roasting and grinding Industrial chocolate (coverture) Production of semi-finished cocoa products (powder, butter and liquor) Dairy, confectionary and bakery products Retailing to final consumers Packaging, commercial marketing and retailing of chocolate products Source: Agricultural commodity value chains: The effects of market concentration on farmers and producing countries – the case of cocoa. United Nations Conference on Trade and Development, 2016, https://unctad.org/system/files/official-document/tdb63d2_en.pdf © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 36 Example of vertical integration: Apple aims to produce its own chips to increase hard/software integration Sources: Apple unveils new iMac and iPad with in-house M1 chippublished, published 21.04.2021 Apple is breaking a 15-year partnership with Intel on its Macs — here's why , published 10.11.2020 © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 37 PRACTICE Value Chain Analysis for a Corporation Explore the value chain for every product in reference to the activities. (that means, identify the value-generating resources and activities) Strengths and weaknesses? Inspection of resources and not only the products!! Explore every product that exists within the value chain for connections: Can one activity be substituted for another? Search for potential synergies between different product lines and businesses: Are there Economies of Scope? © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 38 PRACTICE Value Chain Firm Infrastructure (general management, accounting, finance, strategic planning) Human Resource Management (recruiting, training, development) Support Activities Technology Development (R&D, product and process improvement) Procurement (purchasing of raw materials, machines, supplies) Inbound Logistics Operations (machining, (raw materials, assembling handling and testing) warehousing) Outbound Logistics Marketing & Sales (advertising, (warehousing and distribution promotion, pricing, of finished channel product) management) Primary Activities © Artur Baldauf l Department of Management l University of Bern Service (installation, Repair, parts) Source: Adapted from Michael E. Porter, 1985, p. 37 Corporate Strategy 39 PRACTICE Value Chain: Extended Model Firm Infrastructure Human Resource Management Technology Development Procurement Inbound Logistics Marketing Management Operations Advertising Outbound Logistics Sales Force Admin. © Artur Baldauf l Department of Management l University of Bern Marketing & Sales Sales Force Oper. Service Technical Literature Promotion Corporate Strategy 40 Scale and Scope: Takeaways Size and Scope are relevant to assess „expansion within an industry) Size (Scale) matters – however, not always (MES) and also “learnings” have to be considered Scope (Synergies) Systematic analysis of „Size“ and „Scope“ effects are essential (otherwise: value for the firm is not always achievable) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 41 Appendices © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 42 Economies of Scale (EoS) Analytical Issues c = aS b Costs (C) b c2  S 2  =   c1  S1  log c = log a + b log S c... Costs S... (Production) Capacity b... Scale Parameters a... Constant c = aS b Capacity (S) Interpretation of b: % change of the costs with (1%) capacity change b0 … Diseconomies of Scale In practice it relates to „doubling“ Slope of the line (if on log-log) © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 43 Experience/Learning Curve f ( x) = ax Based on the observation of costs in the airplane production Observe: „the real unit costs decrease with every doubling of the accumulated production quantity by a constant amount“ That is a clear correlation (one-to-one function, every y is correlated and inverse to x); the function has an inverse. Inverse is a logarithmic function. c = aPb ct = c0 P b b ct  Pt  c =   , bzw. t = 2b c0  Po  c0 log c = log a + b log P Cost (C) c = aP − b c... Costs P... cumulative production b... Scale parameter, learning rate a... Constant © Artur Baldauf l Department of Management l University of Bern Accumulated Volume (P) Corporate Strategy 44 Experience/Learning Curve Effects Numerical Example Example Year 2015 2016 2017 2018 2019 2020 Corporation A Accumulated Production (real) Cost quantity per Unit (Unit) sfr (Euro) 1000 10000 20000 40000 70000 100000 100.00 Corporation B Accumulated (real) Cost Production per Unit quantity (Unit) sfr (Euro) 1000 6000 10000 18000 25000 35000 Corporation C Accumulated Production (real) Cost quantity per Unit (Unit) sfr (Euro) 90.00 1000 8000 10000 12000 80.00 Corporations A, B, and C are active in a market that has developed dynamically since 2015. A progress ratio of 20% is determined to be empirical. Task: Calculate the development of the costs per unit in the years 2015 to 2020. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 45 Experience/Learning Curve Effects Numerical Example Example Year 2015 2016 2017 2018 2019 2020 Corporation A Accumulated (real) Cost Production per Unit quantity sfr (Euro) (Unit) 1000 10000 20000 40000 70000 100000 100.00 47.65 38.12 Corporation B Accumulated (real) Cost Production per Unit quantity sfr (Euro) (Unit) 1000 6000 10000 18000 25000 35000 90.00 50.55 42.89 Corporation C Accumulated (real) Cost Production per Unit quantity (Unit) sfr (Euro) 1000 8000 10000 12000 80.00 Corporations A, B und C are active in a market that has developed dynamically since 2015. Tasks: Determine the learning rate of the market. Calculate the costs per unit of the corporation for the years 2015 to 2020. © Artur Baldauf l Department of Management l University of Bern Corporate Strategy 46