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Course Pack/From Competitive Advantage to Corporate Strategy.pdf
From Competitive
Advantage to
Corporate Strategy
by Michael E. Porter
Reprint 87307
Harvard Business Review
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
HBR
M AY– J U N E 1 9 8 7
From Competitive Advantage to
Corporate Strategy
Michael E. Porter
Corporate strategy, the overall plan for a diver-sified company, is both the darling and thestepchild of contemporary management
practice—the darling because CEOs have been ob-
sessed with diversification since the early 1960s, the
stepchild because almost no consensus exists about
what corporate strategy is, much less about how a
company should formulate it.
A diversified company has two levels of strategy:
business unit (or competitive) strategy and corporate
(or companywide) strategy. Competitive strategy con-
cerns how to create competitive advantage in each of
the businesses in which a company competes. Cor-
porate strategy concerns two different questions: what
businesses the corporation should be in and how the
corporate office should manage the array of business
units.
Corporate strategy is what makes the corporate
whole add up to more than the sum of its business
unit parts. The track record of corporate strategies has
been dismal. I studied the diversification records of
33 large, prestigious U.S. companies over the 1950-
1986 period and found that most of them had divested
many more acquisitions than they had kept. The
corporate strategies of most companies have dissi-
pated instead of created shareholder value.
The need to rethink corporate strategy could hardly
be more urgent. By taking over companies and break-
ing them up, corporate raiders thrive on failed corpo-
rate strategy. Fueled by junk bond financing and
growing acceptability, raiders can expose any com-
pany to takeover, no matter how large or blue chip.
Recognizing past diversification mistakes, some
companies have initiated large-scale restructuring
programs. Others have done nothing at all. Whatever
the response, the strategic questions persist. Those
who have restructured must decide what to do next
to avoid repeating the past; those who have done
nothing must awake to their vulnerability. To sur-
vive, companies must understand what good corpo-
rate strategy is.
A SOBER PICTURE
While there is disquiet about the success of corporate
strategies, none of the available evidence satisfacto-
rily indicates the success or failure of corporate strat-
egy. Most studies have approached the question by
measuring the stock market valuation of mergers,
captured in the movement of the stock prices of
acquiring companies immediately before and after
mergers are announced.
Michael E. Porter is professor of business administration
at the Harvard Business School and author of Competitive
Advantage (Free Press, 1985) and Competitive Strategy
(Free Press, 1980).
Copyright © 1987 by the President and Fellows of Harvard College. All rights reserved.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
These studies show that the market values mergers
as neutral or slightly negative, hardly cause for seri-
ous concern.1 Yet the short-term market reaction is a
highly imperfect measure of the long-term success of
diversification, and no self-respecting executive
would judge a corporate strategy this way.
Studying the diversification programs of a com-
pany over a long period of time is a much more telling
way to determine whether a corporate strategy has
succeeded or failed. My study of 33 companies, many
of which have reputations for good management, is a
unique look at the track record of major corporations.
(For an explanation of the research, see the insert
“Where the Data Come From.”) Each company en-
tered an average of 80 new industries and 27 new
fields. Just over 70% of the new entries were acquisi-
tions, 22% were start-ups, and 8% were joint ven-
tures. IBM, Exxon, Du Pont, and 3M, for example,
focused on start-ups, while ALCO Standard, Beatrice,
and Sara Lee diversified almost solely through acquisi-
tions (Exhibit 1 has a complete rundown).
My data paint a sobering picture of the success ratio
of these moves (see Exhibit 2). I found that on average
corporations divested more than half their acquisi-
tions in new industries and more than 60% of their
acquisitions in entirely new fields. Fourteen compa-
nies left more than 70% of all the acquisitions they
had made in new fields. The track record in unrelated
acquisitions is even worse—the average divestment
rate is a startling 74% (see Exhibit 3). Even a highly
respected company like General Electric divested a
very high percentage of its acquisitions, particularly
those in new fields. Companies near the top of the
list in Exhibit 2 achieved a remarkably low rate of
divestment.Some bear witnessto the successof
well-thought-out corporate strategies. Others, how-
ever, enjoy a lower rate simply because they have not
faced up to their problem units and divested them.
I calculated total shareholder returns (stock price
appreciation plus dividends) over the period of the
study for each company so that I could compare them
with its divestment rate. While companies near the
top of the list have above-average shareholder re-
turns, returns are not a reliable measure of diversifi-
cation success. Shareholder return often depends
heavily on the inherent attractiveness of companies’
base industries. Companies like CBS and General
Mills had extremely profitable base businesses that
subsidized poor diversification track records.
I would like to make one comment on the use of
shareholder value to judge performance. Linking
shareholder value quantitatively to diversification
performance only works if you compare the share-
holder value that is with the shareholder value that
might havebeen without diversification.Because
such a comparison is virtually impossible to make,
measuring diversificationsuccess—thenumberof
units retained by the company—seems to be as good
an indicator as any of the contribution of diversifica-
tion to corporate performance.
My data give a stark indication of the failure of
corporate strategies.2 Of the 33 companies, 6 had been
taken over as my study was being completed (see the
note on Exhibit 2). Only the lawyers, investment
bankers, and original sellers have prospered in most
of these acquisitions, not the shareholders.
PREMISES OF CORPORATE STRATEGY
Any successful corporate strategy builds on a number
of premises. These are facts of life about diversifica-
tion. They cannot be altered, and when ignored, they
explain in part why so many corporate strategies fail.
Competition Occurs at the Business Unit Level. Di-
versified companies do not compete; only their busi-
ness units do.Unless acorporate strategy places
primary attention on nurturing the success of each
unit, the strategy will fail, no matter how elegantly
constructed. Successful corporate strategy must grow
out of and reinforce competitive strategy.
Diversification Inevitably Adds Costs and Con-
straints to Business Units. Obvious costs such as the
corporate overhead allocated to a unit may not be as
important or subtle as the hidden costs and con-
straints. A business unit must explain its decisions
to top management, spend time complying with plan-
ning and other corporate systems, live with parent
company guidelines and personnel policies, and forgo
the opportunity to motivate employees with direct
equity ownership. These costs and constraints can be
reduced but not entirely eliminated.
Shareholders Can Readily Diversify Themselves.
Shareholders can diversify their own portfolios of
stocks by selecting those that best match their pref-
erences andrisk profiles.3 Shareholderscanoften
diversify more cheaply than a corporation because
they can buy shares at the market price and avoid
hefty acquisition premiums.
These premises mean that corporate strategy can-
not succeed unless it truly adds value—to business
units by providing tangible benefits that offset the
inherent costs of lost independence and to sharehold-
ers by diversifying in a way they could not replicate.
PASSING THE ESSENTIAL TESTS
To understand how to formulate corporate strategy,
it is necessary to specify the conditions under which
HARVARD BUSINESS REVIEW May–June 1987 3
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
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4 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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HARVARD BUSINESS REVIEW May–June 1987 5
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
diversification will truly create shareholder value.
These conditions can be summarized in three essen-
tial tests:
1. The attractiveness test. The industries chosen
for diversification must be structurally attrac-
tive or capable of being made attractive.
2. The cost-of-entry test. The cost of entry must
not capitalize all the future profits.
3. The better-off test. Either the new unit must
gain competitive advantage from its link with
the corporation or vice versa.
Of course, most companies will make certain that
their proposed strategies pass some of these tests. But
my study clearly shows that when companies ignored
one or two of them, the strategic results were disas-
trous.
How Attractive Is the Industry?
In the long run, the rate of return available from
competing in an industry is a function of its underly-
ing structure, which I have described in another HBR
article.4 An attractive industry with a high average
return on investment will be difficult to enter be-
cause entry barriers are high, suppliers and buyers
have only modest bargaining power, substitute prod-
ucts or services are few, and the rivalry among com-
petitors is stable. An unattractive industry like steel
will have structural flaws, including a plethora of
substitute materials, powerful and price-sensitive
buyers, and excessive rivalry caused by high fixed
costs and a large group of competitors, many of whom
are state supported.
Diversification cannot create shareholder value
Where the data come from
We studied the 1950–1986 diversification histories of
33 large diversified U.S. companies. They were cho-
sen at random from many broad sectors of the econ-
omy.
To eliminate distortions caused by World War II, we
chose 1950 as the base year and then identified each
business the company was in. We tracked every acqui-
sition, joint venture, and start-up made over this pe-
riod—3,788 in all. We classified each as an entry into
an entirely new sector or field (financial services, for
example), a new industry within a field the company
was already in (insurance, for example), or a geo-
graphic extension of an existing product or service.
We also classified each new field as related or unre-
lated to existing units. Then we tracked whether and
when each entry was divested or shut down and the
number of years each remained part of the corpora-
tion.
Our sources included annual reports, 10K forms, the
F&S Index, and Moody’s, supplemented by our judg-
ment and general knowledge of the industries in-
volved. In a few cases, we asked the companies spe-
cific questions.
It is difficult to determine the success of an entry with-
out knowing the full purchase or start-up price, the
profit history, the amount and timing of ongoing invest-
ments made in the unit, whether any write-offs or write-
downs were taken, and the selling price and terms of
sale. Instead, we employed a relatively simple way to
gauge success: whether the entry was divested or shut
down. The underlying assumption is that a company
will generally not divest or close down a successful
business except in a comparatively few special cases.
Companies divested many of the entries in our sample
within five years, a reflection of disappointment with
performance. Of the comparatively few divestments
where the company disclosed a loss or gain, the divest-
ment resulted in a reported loss in more than half the
cases.
The data in Exhibit 1 cover the entire 1950–1986
period. However, the divestment ratios in Exhibit 2
and Exhibit 3 do not compare entries and divestments
over the entire period because doing so would over-
state the success of diversification. Companies usually
do not shut down or divest new entries immediately
but hold them for some time to give them an opportu-
nity to succeed. Our data show that the average hold-
ing period is five to slightly more than ten years,
though many divestments occur within five years. To ac-
curately gauge the success of diversification, we calcu-
lated the percentage of entries made by 1975 and by
1980 that were divested or closed down as of January
1987. If we had included more recent entries, we
would have biased upward our assessment of how suc-
cessful these entries had been.
As compiled, these data probably understate the
rate of failure. Companies tend to announce acquisi-
tions and other forms of new entry with a flourish but
divestments and shutdowns with a whimper, if at all.
We have done our best to root out every such transac-
tion, but we have undoubtedly missed some. There
may also be new entries that we did not uncover, but
our best impression is that the number is not large.
6 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
unless new industries have favorable structures that
support returns exceeding the cost of capital. If the
industrydoesn’t havesuch returns, the company
must be able to restructure the industry or gain a
sustainable competitive advantage that leads to re-
turns well above the industry average. An industry
need not be attractive before diversification. In fact,
a company might benefit from entering before the
industry shows its full potential. The diversification
can then transform the industry’s structure.
In my research, I often found companies had sus-
pended the attractiveness test because they had a
vague belief that the industry “fit” very closely with
their own businesses. In the hope that the corporate
“comfort” they felt would lead to a happy outcome,
the companies ignored fundamentally poor industry
structures. Unless the close fit allows substantial
competitive advantage, however, such comfort will
turn into pain when diversification results in poor
returns. Royal Dutch Shell and other leading oil com-
panies have had this unhappy experience in a number
of chemicals businesses, where poor industry struc-
tures overcame the benefits of vertical integration
and skills in process technology.
Another common reason for ignoring the attrac-
tiveness test is a low entry cost. Sometimes the buyer
has an inside track or the owner is anxious to sell.
Even if the price is actually low, however, a one-shot
gain will not offset a perpetually poor business. Al-
most always, the company finds it must reinvest in
the newly acquired unit, if only to replace fixed assets
and fund working capital.
Diversifying companies are also prone to use rapid
growth or other simple indicators as a proxy for a
target industry’s attractiveness. Many that rushed
into fast-growing industries (personal computers,
video games, and robotics, for example) were burned
becausethey mistook early growthfor long-term
profit potential. Industries are profitable not because
they are sexy or high tech; they are profitable only if
their structures are attractive.
What Is the Cost of Entry?
Diversification cannot build shareholder value if the
cost of entry into a new business eats up its expected
returns. Strong market forces, however, are working
to do just that. A company can enter new industries
by acquisition or start-up. Acquisitions expose it to
an increasingly efficient merger market. An acquirer
beats the market if it pays a price not fully reflecting
the prospects of the new unit. Yet multiple bidders
are commonplace, information flows rapidly, and
investment bankers and other intermediaries work
aggressively to make the market as efficient as possi-
ble. In recent years, new financial instruments such
as junk bonds have brought new buyers into the
market and made even large companies vulnerable to
takeover. Acquisition premiums are high and reflect
the acquired company’s future prospects—sometimes
too well. Philip Morris paid more than four times book
value for Seven-Up Company, for example. Simple
arithmetic meant that profits had to more than qua-
druple to sustain the preacquisition ROI. Since there
proved to be little Philip Morris could add in market-
ing prowess to the sophisticated marketing wars in
the soft-drink industry, the result was the unsatisfac-
tory financial performance of Seven-Up and ulti-
mately the decision to divest.
In a start-up, the company must overcome entry
barriers. It’s a real catch-22 situation, however, since
attractive industries are attractive because their en-
try barriers are high. Bearing the full cost of the entry
barriers might well dissipate any potential profits.
Otherwise, other entrants to the industry would have
already eroded its profitability.
Inthe excitementoffinding anappealing new
business, companies sometimes forget to apply the
cost-of-entry test. The more attractive a new indus-
try, the more expensive it is to get into.
Will the Business Be Better Off?
A corporation must bring some significant competi-
tive advantage to the new unit, or the new unit must
offer potential for significant advantage to the corpo-
ration. Sometimes, the benefits to the new unit ac-
crue only once, near the time of entry, when the
parent instigates a major overhaul of its strategy or
installs a first-rate management team. Other diversi-
fication yields ongoing competitive advantage if the
new unit can market its product through the well-de-
veloped distribution system of its sister units, for
instance. This is one of the important underpinnings
of the merger of Baxter Travenol and American Hos-
pital Supply.
When the benefit to the new unit comes only once,
the parent company has no rationale for holding the
new unit in its portfolio over the long term. Once the
results of the one-time improvement are clear, the
diversified company no longer adds value to offset the
inevitable costs imposed on the unit. It is best to sell
the unit and free up corporate resources.
The better-off test does not imply that diversifying
corporate risk creates shareholder value in and of
itself. Doing something for shareholders that they
can do themselves is not a basis for corporate strategy.
(Only in the case of a privately held company, in
which the company’s and the shareholder’s risk are
the same, is diversification to reduce risk valuable for
its own sake.) Diversification of risk should only be
a by-product of corporate strategy, not a prime moti-
vator.
Executives ignore the better-off test most of all or
HARVARD BUSINESS REVIEW May–June 1987 7
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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8 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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.
HARVARD BUSINESS REVIEW May–June 1987 9
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
deal with it through arm waving or trumped-up logic
rather than hard strategic analysis. One reason is that
they confuse company size with shareholder value.
In the drive to run a bigger company, they lose sight
of their real job. They may justify the suspension of
the better-off test by pointing to the way they manage
diversity. By cutting corporate staff to the bone and
giving business units nearly complete autonomy,
they believe they avoid the pitfalls. Such thinking
misses the whole point of diversification, which is to
create shareholder value rather than to avoid destroy-
ing it.
CONCEPTS OF CORPORATE STRATEGY
The three tests for successful diversification set the
standards that any corporate strategy must meet;
meeting them is so difficult that most diversification
fails. Many companies lack a clear concept of corpo-
rate strategy to guide their diversification or pursue a
concept that does not address the tests. Others fail
because they implement a strategy poorly.
My study has helped me identify four concepts of
corporate strategy that have been put into prac-
tice—portfolio management, restructuring, transfer-
ring skills, and sharing activities. While the concepts
are not always mutually exclusive, each rests on a
different mechanism by which the corporation cre-
ates shareholder value and each requires the diversi-
fied company to manageand organize itself in a
different way. The first two require no connections
among business units; the second two depend on
them. (See Exhibit 4.) While all four concepts of
strategy have succeeded under the right circum-
stances, today some make more sense than others.
Ignoring any of the concepts is perhaps the quickest
road to failure.
Portfolio Management
The concept of corporate strategy most in use is
portfolio management, which is based primarily on
diversification through acquisition. The corporation
acquires sound, attractive companies with compe-
tent managers who agree to stay on. While acquired
units do not have to be in the same industries as
existing units, the best portfolio managers generally
limit their range of businesses in some way, in part
to limit the specific expertise needed by top manage-
ment.
The acquired units are autonomous, and the teams
that run them are compensated according to the unit
results. The corporation supplies capital and works
with each to infuse it with professional management
techniques. At the same time, top management pro-
vides objective and dispassionate review of business
unit results. Portfolio managers categorize units by
potential and regularly transfer resources from units
that generate cash to those with high potential and
cash needs.
In a portfolio strategy, the corporation seeks to
create shareholder value in a number of ways. It uses
its expertise and analytical resources to spot attrac-
tive acquisition candidates that the individual share-
holder could not. The company provides capital on
favorable terms that reflect corporatewide fundrais-
ing ability. It introduces professional management
skills and discipline. Finally, it provides high-quality
review and coaching, unencumbered by conventional
wisdom or emotional attachments to the business.
The logic of the portfolio management concept
rests on a number of vital assumptions. If a company’s
diversification plan is to meet the attractiveness and
cost-of-entry test, it must find good but undervalued
companies. Acquired companies must be truly under-
valued because the parent does little for the new unit
once it is acquired. To meet the better-off test, the
benefits the corporation provides must yield a signifi-
cant competitive advantage to acquired units. The
style of operating through highly autonomous busi-
ness units must both develop sound business strate-
gies and motivate managers.
In most countries, the days when portfolio manage-
ment was a valid concept of corporate strategy are
past. In the face of increasingly well-developed capi-
tal markets, attractive companies with good manage-
ments show up on everyone’s computer screen and
attract top dollar in terms of acquisition premium.
Simply contributing capital isn’t contributing much.
A sound strategy can easily be funded; small to me-
dium-size companies don’t need a munificent parent.
Other benefits have also eroded. Large companies
no longer corner the market for professional manage-
ment skills; in fact, more and more observers believe
managers cannotnecessarilyrun anything inthe
absence of industry-specific knowledge and experi-
ence. Another supposed advantage of the portfolio
managementconcept—dispassionate review—rests
on similarly shaky ground since the added value of
review alone is questionable in a portfolio of sound
companies.
The benefit of giving business units complete
autonomy is also questionable. Increasingly, a com-
pany’s business units are interrelated, drawn together
by new technology, broadening distribution chan-
nels, and changing regulations. Setting strategies of
units independently may well undermine unit per-
formance. The companies in my sample that have
succeeded in diversification have recognized the
value ofinterrelationships and understood thata
strong sense of corporate identity is as important as
10 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
slavish adherence to parochial business unit financial
results.
But it is the sheer complexity of the management
task that has ultimately defeated even the best port-
folio managers. As the size of the company grows,
portfolio managers need to find more and more deals
just to maintain growth. Supervising dozens or even
hundreds of disparate units and under chain-letter
pressures to add more, management begins to make
mistakes. At the same time, the inevitable costs of
being part of a diversified company take their toll and
unit performance slides while the whole company’s
ROI turns downward. Eventually, a new management
team is installed that initiates wholesale divestments
and pares down the company to its core businesses.
The experiences of Gulf & Western, Consolidated
Foods (now Sara Lee), and ITT are just a few compara-
tively recent examples. Reflecting these realities, the
U.S. capital markets today reward companies that
follow the portfolio management model with a “con-
glomerate discount”; they value the whole less than
the sum of the parts.
In developing countries, where large companies are
few, capital markets are undeveloped, and profes-
sional management is scarce, portfolio management
still works. But it is no longer a valid model for
corporate strategy in advanced economies. Neverthe-
less, the technique is in the limelight today in the
United Kingdom, where it is supported so far by a
newly energized stock market eager for excitement.
But this enthusiasm will wane—as well it should.
Portfolio management is no way to conduct corporate
strategy.
Restructuring
Unlike its passive role as a portfolio manager, when
it serves as banker and reviewer, a company that
bases its strategy on restructuring becomes an active
restructurer of business units. The new businesses
are not necessarily related to existing units. All that
is necessary is unrealized potential.
The restructuring strategy seeks out undeveloped,
sick, or threatened organizations or industries on the
threshold of significant change. The parent inter-
venes, frequently changing the unit management
team, shifting strategy, or infusing the company with
new technology. Then it may make follow-up acqui-
sitions to build a critical mass and sell off unneeded
or unconnected parts and thereby reduce the effective
acquisition cost. The result is a strengthened com-
pany or a transformed industry. As a coda, the parent
sells off the stronger unit once results are clear be-
cause the parent is no longer adding value and top
managementdecidesthat its attention should be
directed elsewhere. (See the insert “An Uncanny Brit-
ish Restructurer” for an example of restructuring.)
When well implemented, the restructuring con-
cept is sound, for it passes the three tests of successful
diversification. The restructurer meets the cost-of-
entry test through the types of company it acquires.
It limits acquisition premiums by buying companies
with problems and lackluster images or by buying
into industries with as yet unforeseen potential. In-
An uncanny British restructurer
Hanson Trust, on its way to becoming Britain’s largest
company, is one of several skillful followers of the re-
structuring concept. A conglomerate with units in many
industries, Hanson might seem on the surface a portfo-
lio manager. In fact, Hanson and one or two other con-
glomerates have a much more effective corporate strat-
egy. Hanson has acquired companies such as London
Brick, Ever Ready Batteries, and SCM, which the city
of London rather disdainfully calls “low tech.’’
Although a mature company suffering from low
growth, the typical Hanson target is not just in any in-
dustry; it has an attractive structure. Its customer and
supplier power is low and rivalry with competitors mod-
erate. The target is a market leader, rich in assets but
formerly poor in management. Hanson pays little of
the present value of future cash flow out in an acquisi-
tion premium and reduces purchase price even further
by aggressively selling off businesses that it cannot im-
prove. In this way, it recoups just over a third of the
cost of a typical acquisition during the first six months
of ownership. Imperial Group’s plush properties in Lon-
don lasted barely two months under Hanson owner-
ship, while Hanson’s recent sale of Courage Breweries
to Elders recouped £1.4 billion of the original £2.1 bil-
lion acquisition price of Imperial Group.
Like the best restructurers, Hanson approaches each
unit with a modus operandi that it has perfected
through repetition.
Hanson emphasizes low costs and tight financial
controls. It has cut an average of 25% of labor costs
out of acquired companies, slashed fixed overheads,
and tightened capital expenditures. To reinforce its
strategy of keeping costs low, Hanson carves out de-
tailed one-year financial budgets with divisional man-
agers and (through generous use of performance-
related bonuses and share option schemes) gives them
incentive to deliver the goods.
It’s too early to tell whether Hanson will adhere to
the last tenet of restructuring-selling turned-around units
once the results are clear. If it succumbs to the allure of
bigness, Hanson may take the course of the failed U.S.
conglomerates.
HARVARD BUSINESS REVIEW May–June 1987 11
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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12 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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.
HARVARD BUSINESS REVIEW May–June 1987 13
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
tervention by the corporation clearly meets the bet-
ter-off test. Provided that the target industries are
structurally attractive, the restructuring model can
create enormous shareholder value. Some restructur-
ing companies are Loew’s, BTR, and General Cinema.
Ironically, many of today’s restructurers are profiting
from yesterday’s portfolio management strategies.
To work, the restructuring strategy requires a cor-
porate management team with the insight to spot
undervalued companies or positionsinindustries
ripe for transformation. The same insight is neces-
sary to actually turn the units around even though
they are in new and unfamiliar businesses.
These requirements expose the restructurer to con-
siderable risk and usually limit the time in which the
company can succeed at the strategy. The most skill-
ful proponents understand this problem, recognize
their mistakes, and move decisively to dispose of
them. The best companies realize they are not just
acquiring companies but restructuring an industry.
Unless they can integrate the acquisitions to create a
whole new strategic position, they are just portfolio
managers in disguise. Another important difficulty
surfaces if so many other companies join the action
that they deplete the pool of suitable candidates and
bid their prices up.
Perhaps the greatest pitfall, however, is that com-
panies find it very hard to dispose of business units
once they are restructured and performing well. Hu-
man nature fights economic rationale. Size supplants
shareholder value as the corporate goal. The company
does not sell a unit even though the company no
longer adds value to the unit. While the transformed
units would be better off in another company that had
related businesses, the restructuringcompany in-
stead retains them. Gradually, it becomes a portfolio
manager. The parent company’s ROI declines as the
need for reinvestment in the units and normal busi-
ness risks eventually offset restructuring’s one-shot
gain. The perceived need to keep growing intensifies
the pace of acquisition; errors result and standards
fall. The restructuring company turns into a con-
glomerate with returns that only equal the average of
all industries at best.
Transferring Skills
The purpose of the first two concepts of corporate
strategy is to create value through a company’s rela-
tionship with each autonomous unit. The corpora-
tion’s role is to be a selector, a banker, and an inter-
venor.
The last two concepts exploit the interrelation-
ships between businesses. In articulating them, how-
ever, one comes face-to-face with the often ill-defined
concept of synergy. If you believe the text of the
countless corporate annual reports, just about any-
thing is related to just about anything else! But imag-
ined synergy is much more common than real synergy.
GM’s purchase of Hughes Aircraft simply because
cars were going electronic and Hughes was an elec-
tronics concern demonstrates the folly of paper syn-
ergy. Such corporate relatedness is an ex post facto
rationalizationof a diversificationundertaken for
other reasons.
Even synergy that is clearly defined often fails to
materialize. Instead of cooperating, business units
often compete. A company that can define the syner-
gies it is pursuing still faces significant organizational
impediments in achieving them.
But the need to capture the benefits of relationships
between businesses has never been more important.
Technological and competitive developments al-
ready link many businesses and are creating new
possibilities for competitive advantage. In such sec-
tors as financial services, computing, office equip-
ment, entertainment, and health care, interrelation-
ships among previously distinct businesses are
perhaps the central concern of strategy.
To understand the role of relatedness in corporate
strategy, we must give new meaning to this ill-de-
fined idea. I have identified a good way to start—the
value chain.5 Every business unit is a collection of
discrete activities ranging from sales to accounting
that allow it to compete. I call them value activities.
It is at this level, not in the company as a whole, that
the unit achieves competitive advantage. I group
these activities in nine categories. Primary activities
create the product or service, deliver and market it,
and provide after-sale support. The categories of pri-
mary activities include inbound logistics, operations,
outbound logistics, marketing and sales, and service.
Support activities provide the inputs and infrastruc-
ture that allow the primary activities to take place.
The categories are company infrastructure, human
resource management, technology development, and
procurement.
The value chain defines the two types of interrela-
tionships thatmay createsynergy. The first is a
company’s ability to transfer skills or expertise
among similar value chains. The second is the ability
to share activities. Two business units, for example,
can share the same sales force or logistics network.
The value chain helps expose the last two (and
most important) concepts of corporate strategy. The
transfer of skills among business units in the diversi-
fied company is the basis for one concept. While each
business unit has a separate value chain, knowledge
about how to perform activities is transferred among
the units. For example, a toiletries business unit,
expert in the marketing of convenience products,
transmits ideas on new positioning concepts, promo-
tional techniques, and packaging possibilities to a
14 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
newly acquired unit that sells cough syrup. Newly
entered industries can benefit from the expertise of
existing units and vice versa.
These opportunities arise when business units
have similar buyers or channels, similar value activi-
ties like government relations or procurement, simi-
larities in the broad configuration of the value chain
(for example, managing a multisite service organiza-
tion), or the same strategic concept (for example, low
cost). Even though the units operate separately, such
similarities allow the sharing of knowledge.
Of course, some similarities are common; one can
imagine them at some level between almost any pair
of businesses. Countless companies have fallen into
the trap of diversifying too readily because of simi-
larities; mere similarity is not enough.
Transferring skills leads to competitive advantage
only if the similarities among businesses meet three
conditions:
1. The activities involved in the businesses are
similar enough that sharing expertise is mean-
ingful. Broad similarities (marketing intensive-
ness, for example, or a common core process
technology such as bending metal) are not a
sufficient basis for diversification. The result-
ing ability to transfer skills is likely to have
little impact on competitive advantage.
2. The transfer of skills involves activities impor-
tant to competitive advantage. Transferring
skills in peripheral activities such as govern-
ment relations or real estate in consumer goods
units may be beneficial but is not a basis for
diversification.
3. Theskillstransferred represent a significant
source of competitive advantage for the receiv-
ing unit. The expertise or skills to be transferred
are both advanced and proprietary enough to be
beyond the capabilities of competitors.
The transferofskills is anactive processthat
significantly changes the strategy or operations of the
receiving unit. The prospect for change must be spe-
cific and identifiable. Almost guaranteeing that no
shareholder value will be created, too many compa-
nies are satisfied with vague prospects or faint hopes
that skills will transfer. The transfer of skills does not
happen by accident or by osmosis. The company will
have to reassign critical personnel, even on a perma-
nent basis, and the participation and support of high-
level management in skills transfer is essential.
Many companies have been defeated at skills transfer
because they have not provided their business units
with any incentives to participate.
Transferring skills meets the tests of diversifica-
tion if the company truly mobilizes proprietary ex-
pertise across units. This makes certain the company
can offset the acquisition premium or lower the cost
of overcoming entry barriers.
The industries the company chooses for diversifi-
cation must pass the attractiveness test. Even a close
fit that reflects opportunities to transfer skills may
not overcome poor industry structure. Opportunities
to transfer skills, however, may help the company
transform the structures of newly entered industries
and send them in favorable directions.
The transfer of skills can be one-time or ongoing.
If the company exhausts opportunities to infuse new
expertise into a unit after the initial postacquisition
period, the unit should ultimately be sold. The cor-
poration is no longer creating shareholder value. Few
companieshave grasped this point, however, and
many gradually suffer mediocre returns. Yet a com-
pany diversified into well-chosen businesses can
transfer skills eventually in many directions. If cor-
porate management conceives of its role in this way
and creates appropriate organizational mechanisms
to facilitate cross-unit interchange, the opportunities
to share expertise will be meaningful.
By using both acquisitions and internal develop-
ment, companies can build a transfer-of-skills strat-
egy. The presence of a strong base of skills sometimes
creates the possibility for internal entry instead of the
acquisition of a going concern. Successful diversifiers
that employ the concept of skills transfer may, how-
ever, often acquire a company in the target industry
as a beachhead and then build on it with their internal
expertise. By doing so, they can reduce some of the
risks of internal entry and speed up the process. Two
companies that have diversified using the transfer-of-
skills concept are 3M and Pepsico.
Sharing Activities
The fourth concept of corporate strategy is based on
sharing activities in the value chains among business
units. Procter & Gamble, for example, employs a
common physical distribution system and sales force
in both paper towels and disposable diapers. McKes-
son, a leading distribution company, will handle such
diverse lines as pharmaceuticals and liquor through
superwarehouses.
The ability to share activities is a potent basis
for corporate strategy because sharing often en-
hances competitive advantage by lowering cost or
raising differentiation. But not all sharing leads to
competitive advantage, and companies can encoun-
ter deep organizational resistance to even beneficial
sharing possibilities. These hard truths have led
many companies to reject synergy prematurely and
retreat to the false simplicity of portfolio manage-
ment.
A cost-benefit analysis of prospective sharing op-
portunities can determine whether synergy is possi-
HARVARD BUSINESS REVIEW May–June 1987 15
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
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io
.
W
ill
in
gn
es
s
to
cu
t
lo
ss
es
b
y
se
lli
ng
o
ff
un
its
w
he
re
re
st
ru
ct
ur
in
g
pr
ov
es
u
nf
ea
si
bl
e
W
ill
in
gn
es
s
to
s
el
l u
ni
ts
w
he
n
re
st
ru
ct
ur
in
g
is
c
om
pl
et
e,
th
e
re
su
lts
ar
e
cl
ea
r,
an
d
m
ar
ke
t
co
nd
iti
on
s
ar
e
fa
vo
ra
bl
e
Pr
op
rie
ta
ry
s
ki
lls
in
a
ct
iv
iti
es
im
po
rta
nt
to
co
m
pe
tit
iv
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ad
va
nt
ag
e
in
ta
rg
et
in
du
st
rie
s
A
bi
lit
y
to
a
cc
om
pl
is
h
th
e
tra
ns
fe
r
of
sk
ill
s
am
on
g
un
its
on
an
on
go
in
g
ba
si
s
A
cq
ui
si
tio
ns
o
f b
ea
ch
he
ad
po
si
tio
ns
in
ne
w
in
du
st
rie
s
as
a
ba
se
A
ct
iv
iti
es
in
e
xi
st
in
g
un
its
th
at
c
an
be
sh
ar
ed
w
ith
n
ew
bu
si
ne
ss
un
its
to
g
ai
n
co
m
pe
tit
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ad
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nt
ag
e
Be
ne
fit
s
of
s
ha
rin
g
th
at
ou
t w
ei
gh
th
e
co
st
s
Bo
th
st
ar
t-u
ps
an
d
ac
qu
is
iti
on
s
as
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nt
ry
ve
hi
cl
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bi
lit
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to
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ve
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or
ga
ni
za
tio
na
l
re
si
st
an
ce
to
bu
si
ne
ss
un
it
co
lla
bo
ra
tio
n
16 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
EX
H
IB
IT
4
C
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pt
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-c
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-b
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ca
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g
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rr
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ag
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at
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cl
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s
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r
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ce
nt
iv
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b
as
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p
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gr
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p,
se
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rp
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ls
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h-
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af
f
m
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be
rs
w
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se
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pr
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or
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ce
nt
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es
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as
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vi
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p
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rp
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lts
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m
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tfa
lls
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p
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tfo
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ag
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tri
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w
ith
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ci
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t c
ap
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Ig
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fa
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in
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st
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st
ru
ct
ur
e
is
n
ot
at
tra
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e
M
is
ta
ki
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ra
pi
d
gr
ow
th
or
a
“h
ot

in
du
st
ry
a
s
su
ffi
ci
en
t
ev
id
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ce
of
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re
st
ru
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ty
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so
lv
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es
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te
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Ig
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ot
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st
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lly
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rit
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om
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rt
w
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w
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ci
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t b
as
is
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r
di
ve
rs
ifi
ca
tio
n
Pr
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id
in
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no
pr
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w
ay
fo
r
sk
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tra
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to
o
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ur
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no
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e
fa
ct
th
at
in
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st
ry
st
ru
ct
ur
e
is
n
ot
at
tra
ct
iv
e
Sh
ar
in
g
fo
r
its
o
w
n
sa
ke
ra
th
er
th
an
b
ec
au
se
it
le
ad
s
to
co
m
pe
tit
iv
e
ad
va
nt
ag
e
A
ss
um
in
g
sh
ar
in
g
w
ill
oc
cu
r
na
tu
ra
lly
w
ith
ou
ts
en
io
r
m
an
ag
em
en
t p
la
yi
ng
an
ac
tiv
e
ro
le
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no
rin
g
th
e
fa
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at
in
du
st
ry
s
tru
ct
ur
e
is
no
t
at
tra
ct
iv
e
HARVARD BUSINESS REVIEW May–June 1987 17
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
ble. Sharing can lower costs if it achieves economies
of scale, boosts the efficiency of utilization, or helps
a company move more rapidly down the learning
curve. The costs of General Electric’s advertising,
sales, and after-sales service activities in major appli-
ances are low because they are spread over a wide
range of appliance products. Sharing can also enhance
the potential for differentiation. A shared order-pro-
cessing system, for instance, may allow new features
and services that a buyer will value. Sharing can also
reduce the cost of differentiation. A shared service
network, for example, may make more advanced,
remote servicing technology economically feasible.
Often, sharing will allow an activity to be wholly
reconfigured in ways that can dramatically raise com-
petitive advantage.
Sharing must involve activities that are significant
to competitive advantage, not just any activity.
P&G’s distribution system is such an instance in the
diaper and paper towel business, where products are
bulky and costly to ship. Conversely, diversification
based on the opportunities to share only corporate
overhead is rarely, if ever, appropriate.
Sharing activities inevitably involves costs that the
benefits must outweigh. One cost is the greater coor-
dination required to manage a shared activity. More
important is the need to compromise the design or
performance of an activity so that it can be shared. A
salesperson handling the products of two business
units, for example, must operate in a way that is
usually not what either unit would choose were it
independent. And if compromise greatly erodes the
unit’s effectiveness, then sharing may reduce rather
than enhance competitive advantage.
Many companies have only superficially identified
their potential for sharing. Companies also merge
activities without consideration of whether they are
sensitive to economies of scale. When they are not,
the coordination costs kill the benefits. Companies
compound such errors by not identifying costs of
sharing in advance, when steps can be taken to mini-
mize them. Costs of compromise can frequently be
mitigated by redesigning the activity for sharing. The
shared salesperson, for example, can be provided with
a remote computer terminal to boost productivity
and provide more customer information. Jamming
Adding value with hospitality
Marriott began in the restaurant business in Washing-
ton, D.C. Because its customers often ordered takeouts
on the way to the national airport, Marriott eventually
entered airline catering. From there, it jumped into
food service management for institutions. Marriott then
began broadening its base of family restaurants and
entered the hotel industry. More recently, it has moved
into restaurants, snack bars, and merchandise shops in
airport terminals and into gourmet restaurants. In addi-
tion, Marriott has branched out from its hotel business
into cruise ships, theme parks, wholesale travel agen-
cies, budget motels, and retirement centers.
Marriott’s diversification has exploited well-devel-
oped skills in food service and hospitality. Marriott’s
kitchens prepare food according to more than 6,000
standardized recipe cards; hotel procedures are also
standardized and painstakingly documented in elabo-
rate manuals. Marriott shares a number of important
activities across units. A shared procurement and distri-
bution system for food serves all Marriott units through
nine regional procurement centers. As a result, Marri-
ott earns 50% higher margins on food service than
any other hotel company. Marriott also has a fully inte-
grated real estate unit that brings corporatewide
power to bear on site acquisitions as well as on the de-
signing and building of all Marriott locations.
Marriott’s diversification strategy balances acquisi-
tions and start-ups. Start-ups or small acquisitions are
used for initial entry, depending on how close the op-
portunities for sharing are. To expand its geographic
base, Marriott acquires companies and then disposes
of the parts that do not fit.
Apart from this success, it is important to note that
Marriott has divested 36% of both its acquisitions and
its start-ups. While this is an above-average record,
Marriott’s mistakes are quite illuminating. Marriott has
largely failed in diversifying into gourmet restaurants,
theme parks, cruise ships, and wholesale travel agen-
cies. In the first three businesses, Marriott discovered it
could not transfer skills despite apparent similarities.
Standardized menus did not work well in gourmet res-
taurants. Running cruise ships and theme parks was
based more on entertainment and pizzazz than the
carefully disciplined management of hotels and mid-
price restaurants. The wholesale travel agencies were
ill fated from the start because Marriott had to com-
pete with an important customer for its hotels and had
no proprietary skills or opportunities to share with
which to add value.
18 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
business units together without such thinking exac-
erbates the costs of sharing.
Despite such pitfalls, opportunities to gain advan-
tage from sharing activities have proliferated because
of momentous developments in technology, deregu-
lation, and competition. The infusion of electronics
and information systems into many industries cre-
ates new opportunities to link businesses. The corpo-
rate strategy of sharing can involve both acquisition
and internal development. Internal development is
often possible because the corporation can bring to
bear clear resources in launching a new unit. Start-ups
are less difficult to integrate than acquisitions. Com-
panies using the shared-activities concept can also
make acquisitions as beachhead landings into a new
industry and then integrate the units through sharing
with other units. Prime examples of companies that
have diversified via using shared activities include
P&G, Du Pont, and IBM. The fields into which each
has diversified are a cluster of tightly related units.
Marriott illustrates both successes and failures in
sharing activities over time. (See the insert “Adding
Value with Hospitality.”)
Following the shared-activities model requires an
organizational context in which business unit collabo-
ration is encouraged and reinforced. Highly autono-
mous business units are inimical to such collabora-
tion. The company must put into place a variety of
what I call horizontal mechanisms—a strong sense of
corporate identity, a clear corporate mission state-
ment that emphasizes the importance of integrating
business unit strategies, an incentive system that re-
wards more than just business unit results, cross-busi-
ness-unit task forces, and other methods of integrating.
A corporate strategy based on shared activities
clearly meets the better-off test because business units
gain ongoing tangible advantages from others within
the corporation. It also meets the cost-of-entry test by
reducing the expense of surmounting the barriers to
internal entry. Other bids for acquisitions that do not
share opportunities will have lower reservation prices.
Even widespread opportunities for sharing activities
do not allow a company to suspend the attractiveness
test, however. Many diversifiers have made the criti-
cal mistake of equating the close fit of a target industry
with attractive diversification. Target industries must
pass the strict requirement test of having an attractive
structure as well as a close fit in opportunities if diver-
sification is to ultimately succeed.
CHOOSING A CORPORATE STRATEGY
Each concept of corporate strategy allows the diver-
sified company to create shareholder value in a dif-
ferent way. Companies can succeed with any of the
concepts if they clearly define the corporation’s role
and objectives, have the skills necessary for meeting
the concept’s prerequisites, organize themselves to
manage diversity in a way that fits the strategy, and
find themselves in an appropriate capital market en-
vironment. The caveat is that portfolio management
is only sensible in limited circumstances.
A company’s choice of corporate strategy is partly
a legacy of its past. If its business units are in unat-
tractiveindustries, the company must start from
scratch. If the company has few truly proprietary
skills or activities it can share in related diversifica-
tion, then its initial diversification must rely on other
concepts. Yet corporate strategy should not be a once-
and-for-all choice but a vision that can evolve. A
company should choose its long-term preferred con-
cept and then proceed pragmatically toward it from
its initial starting point.
Both the strategic logic and the experience of the
companies studied over the last decade suggest that
acompany will create shareholder value through
diversification to a greater and greater extent as its
strategy moves from portfolio management toward
sharing activities. Because they do not rely on supe-
rior insight or other questionable assumptions about
the company’s capabilities, sharing activities and
transferring skills offer the best avenues for value
creation.
Each concept of corporate strategy is not mutually
exclusive of those that come before, a potent advan-
tage of the third and fourth concepts. A company can
employ a restructuring strategy at the same time it
transfers skills or shares activities. A strategy based
on shared activities becomes more powerful if busi-
ness units can also exchange skills. As the Marriott
case illustrates, a company can often pursue the two
strategies together and even incorporate some of the
principles of restructuring with them. When it
chooses industries in which to transfer skills or share
activities, the company can also investigate the pos-
sibility of transforming the industry structure. When
a company bases its strategy on interrelationships, it
has a broader basis on which to create shareholder
value than if it rests its entire strategy on transform-
ing companies in unfamiliar industries.
My study supports the soundness of basing a
corporate strategy on the transfer of skills or shared
activities. The data on the sample companies’ diver-
sification programs illustrate some important char-
acteristics of successful diversifiers. They have made
a disproportionately low percentage of unrelated acqui-
sitions, unrelated being defined as having no clear
opportunity to transfer skills or share important ac-
tivities (see Exhibit 3). Even successful diversifiers
such as 3M, IBM, and TRW have terrible records
when they have strayed into unrelated acquisitions.
HARVARD BUSINESS REVIEW May–June 1987 19
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Successful acquirers diversify into fields, each of
which is related to many others. Procter & Gamble
and IBM, for example, operate in 18 and 19 interre-
lated fields respectively and so enjoy numerous op-
portunities to transfer skills and share activities.
Companies with the best acquisition records tend
to make heavier-than-average use of start-ups and
joint ventures. Most companies shy away from
modes of entry besides acquisition. My results cast
dount on the conventional wisdom regarding start-
ups. Exhibit 3 demonstrates that while joint ventures
are about as risky as acquisitions, start-ups are not.
Moreover, successful companies often have very good
records with start-up units, as 3M, P&G, Johnson &
Johnson, IBM, and United Technologies illustrate.
When a company has the internal strength to start up
a unit, it can be safer and less costly to launch a
company than to rely solely on an acquisition and
then have to deal with the problem of integration.
Japanese diversification histories support the sound-
ness of start-up as an entry alternative.
My data also illustrate that none of the concepts of
corporate strategy works when industry structure is
poor or implementation is bad, no matter how related
the industries are. Xerox acquired companies in re-
lated industries, but the businesses had poor struc-
tures and its skills were insufficient to provide
enough competitive advantage to offset implementa-
tion problems.
An Action Program
To translate the principles of corporate strategy into
successful diversification, a company must first take
an objective look at its existing businesses and the
value added by the corporation. Only through such
an assessment can an understanding of good corpo-
rate strategy grow. That understanding should guide
future diversification as well as the development of
skills and activities with which to select further new
businesses. The following action program provides a
concrete approach to conducting such a review. A
company can choose a corporate strategy by:
1. Identifying the interrelationships among al-
ready existing business units. A company
should begin to develop a corporate strategy by
identifying all the opportunities it has to share
activities or transfer skills in its existing port-
folio of business units. The company will not
only find ways to enhance the competitive ad-
vantage of existing units but also come upon
several possiblediversificationavenues.The
lack of meaningful interrelationships in the
portfolio is an equally important finding, sug-
gesting the need to justify the value added by
the corporation or, alternately, a fundamental
restructuring.
2. Selecting the core businesses that will be the
foundation of the corporate strategy. Success-
ful diversification starts with an understanding
of the core businesses that will serve as the basis
for corporate strategy. Core businesses are those
that are in an attractive industry, have the po-
tential to achieve sustainable competitive ad-
vantage, have important interrelationships
with other business units, and provide skills or
activities that represent a base from which to
diversify.
The company must first make certain its core
businesses are on sound footing by upgrading
management, internationalizing strategy, or
improving technology. The study shows that
geographic extensions of existing units,
whether by acquisition, joint venture, or start-
up, had a substantially lower divestment rate
than diversification.
The company must then patiently dispose of
the units that are not core businesses. Selling
them will free resources that could be better
deployed elsewhere. In some cases disposal im-
plies immediate liquidation, while in others the
company should dress up the units and wait for
a propitious market or a particularly eager
buyer.
3. Creating horizontal organizational mecha-
nismsto facilitate interrelationships among
the core businesses and lay the groundwork for
future related diversification. Top manage-
ment can facilitate interrelationships by em-
phasizing cross-unit collaboration, grouping
units organizationally and modifying incen-
tives, and taking steps to build a strong sense of
corporate identity.
4. Pursuing diversification opportunities that al-
low shared activities. This concept of corporate
strategy is the most compelling, provided a
company’s strategy passes all three tests. A
company should inventory activities in existing
business units that represent the strongest
foundation for sharing, such as strong distribu-
tion channels or world-class technical facilities.
These will in turn lead to potential new busi-
ness areas. A company can use acquisitions as
a beachhead or employ start-ups to exploit in-
ternal capabilities and minimize integrating
problems.
5. Pursuing diversification through the transfer
of skills if opportunities for sharing activities
are limited or exhausted. Companies can pur-
sue this strategy through acquisition, although
they may be able to use start-ups if their existing
20 HARVARD BUSINESS REVIEW May–June 1987
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
units have important skills they can readily
transfer.
Such diversification is often riskier because
of the tough conditions necessary for it to work.
Given the uncertainties, a company should
avoid diversifying on the basis of skills transfer
alone. Rather it should also be viewed as a
stepping-stone to subsequent diversification us-
ing shared activities. New industries should be
chosen that will lead naturally to other busi-
nesses. The goal is to build a cluster of related
and mutually reinforcing business units. The
strategy’s logic implies that the company
should not set the rate of return standards for
the initial foray into a new sector too high.
6. Pursuing a strategy of restructuring if this fits
the skills of management or no good opportu-
nities exist for forging corporate interrelation-
ships. When a company uncovers underman-
aged companies and can deploy adequate
management talent and resources to the ac-
quired units, then it can use a restructuring
strategy. The more developed the capital mar-
kets and the more active the market for compa-
nies, the more restructuring will require a pa-
tient search for that special opportunity rather
than a headlong race to acquire as many bad
apples as possible. Restructuring can be a per-
manent strategy, as it is with Loew’s, or a way
to build a group of businesses that supports a
shift to another corporate strategy.
7. Paying dividends so that the shareholders can
be the portfolio managers. Paying dividends is
better than destroying shareholder value
through diversification based on shaky under-
pinnings. Tax considerations, which some com-
panies cite to avoid dividends, are hardly legiti-
mate reasons to diversify if a company cannot
demonstrate the capacity to do it profitably.
CREATING A CORPORATE THEME
Defining a corporate theme is a good way to ensure
that the corporation will create shareholder value.
Having the right theme helps unite the efforts of
business units and reinforces the ways they interre-
late as well as guides the choice of new businesses to
enter. NEC Corporation, with its “C&C” theme,
provides a good example. NEC integrates its com-
puter, semiconductor, telecommunications, and con-
sumer electronics businesses by merging computers
and communication.
It is all too easy to create a shallow corporate
theme. CBS wanted to be an “entertainment com-
pany,” for example, and built a group of businesses
related to leisure time. It entered such industries as
toys, crafts, musical instruments, sports teams, and
hi-fi retailing. While this corporate theme sounded
good, close listening revealed its hollow ring. None
of these businesses had any significant opportunity
to share activities or transfer skills among them-
selves or with CBS’s traditional broadcastingand
record businesses. They were all sold, often at signifi-
cant losses, except for a few of CBS’s publishing-
related units. Saddled withthe worst acquisition
record in my study, CBS has eroded the shareholder
value created through its strong performance in
broadcasting and records.
Moving from competitive strategy to corporate
strategy is the business equivalent of passing through
the Bermuda Triangle. The failure of corporate strat-
egy reflects the fact that most diversified companies
have failed to think in terms of how they really add
value. A corporate strategy that truly enhances the
competitive advantage of each business unit is the
best defense against the corporate raider. With a
sharper focus on the tests of diversification and the
explicit choice of a clear concept of corporate strat-
egy, companies’ diversification track records from
now on can look a lot different.
1. The studies also show that sellers of companies capture a large
fraction of the gains from merger. See Michael C. Jensen and
Richard S. Ruback, “The Market for Corporate Control: The Sci-
entific Evidence,” Journal of Financial Economics (April 1983): 5,
and Michael C. Jensen, “Takeovers: Folklore and Science,” Har-
vard Business Review (November–December 1984): 109.
2. Some recent evidence also supports the conclusion that
acquired companies often suffer eroding performance after acqui-
sition. See Frederick M. Scherer, “Mergers, Sell-Offs and Manage-
rial Behavior,” in The Economics of Strategic Planning, ed. Lacy
Glenn Thomas (Lexington, Mass.: Lexington Books, 1986), p. 143,
and David A. Ravenscraft and Frederick M. Scherer, “Mergers and
Managerial Performance,” paper presented at the Conference on
Takeovers and Contests for Corporate Control, Columbia Law
School, 1985.
3. This observation has been made by a number of authors. See,
for example, Malcolm S. Salter and Wolf A. Weinhold, Diversifi-
cation Through Acquisition (New York: Free Press, 1979).
4. See MichaelE. Porter, “HowCompetitive Forces Shape
Strategy,” Harvard Business Review (March–April 1979): 86.
5. See Michael E. Porter, Competitive Advantage (New York:
Free Press, 1985).
HARVARD BUSINESS REVIEW May–June 1987 21
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__MACOSX/Course Pack/._From Competitive Advantage to Corporate Strategy.pdf
Course Pack/Olam International.pdf
9 – 5 0 9 – 0 0 2
R E V :F E B R U A R Y3 ,2 0 1 7

________________________________________________________________________________________________________________

Professor David E. Bell and Agribusiness Program Director Mary Shelman, Global Research Group, prepared this case. HBS cases are developed
solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or
ineffective management.

Copyright © 2008, 2009, 2017 President and Fellows of Harvard College.To order copies or request permission to reproduce materials, call 1-
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D A V I DE .B E L L
M A R YS H E L M A N
Olam International

On October 17, 2008, Olam International (Olam) CEO Sunny Verghese watched with concern as
the company’s stock price closed at S$1.001 a share, a three-year low and less than a third of the May
7, 2007, high of S$3.80 (see Exhibit 1). In 20 years, Verghese had built the Singapore-headquartered
firm from a small Nigerian export operation into a global supply chain leader with operations in 60
countries. Olam purchased agricultural commodities such as cashews, sesame, cocoa, and coffee from
200,000 suppliers, combined and processed small lots according to customer needs, and sold them to
major, branded food companies including Nestlé, Kraft, Mars, and Cadbury’s. In addition, Olam
used its supply chains in reverse to sell sugar, wheat flour, rice, and dairy products into markets
where it had local buying operations. Fiscal year2 2008 revenues were S$8.1 billion, up almost 50%
from 2007, while profit after tax increased 54% to S$167.7 million (see Exhibit 2).
While Olam’s early growth had come through organic expansion into adjacent products and
geographies, in 2005 the company completed an initial public offering (IPO) and adopted a targeted
mergers and acquisitions (M&A) strategy. In 2007 and 2008, Olam acquired several companies that fit
the company’s strategic and financial criteria and was evaluating a number of other opportunities.
However, by late 2008, it was clear that the global financial crisis would affect everything from
national growth rates to Olam’s access to capital and debt. Verghese was confident in the strength of
Olam’s business model and was particularly excited about future opportunities in Asia and Africa,
where the firm had a strong presence, but he needed to be sure his strategy was still the correct one in
the face of the new economic environment.
Company History
Olam’s origins traced back to the 140-year-old nonresident Indian conglomerate, Kewalram
Chanrai (KC) Group, and spanned the 7,500 kilometers that separated India and Africa. Facing a
foreign exchange crisis in the late 1980s that limited the import of raw materials necessary to keep
their Nigerian cloth factory running, KC’s owners hired 26-year-old Verghese in 1986 to vertically
integrate into cotton production. Verghese, an Indian with a degree in agricultural management, had
spent five years with Hindustan Lever before joining KC. Verghese leased land from the Nigerian

1 All dollars in this case are Singapore dollars unless otherwise noted. On October 17, 2008, S$1.00 = US$0.654.
2 Olam’s fiscal year ended on June 30.
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509-002 Olam International
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government and established the largest cotton plantation in sub-Saharan Africa as a nucleus, then
supplemented company-produced cotton with the continent’s largest outgrower program,
encompassing 10,000 small farmers. “The first year was a nightmare,” recalled Verghese. “Harvest
time came and we had no combines. I had to get 4,000 laborers to a location 1,600 kilometers from the
capital city. They all had to be paid in advance. After this, I began to think about business more
holistically, how all the pieces—strategy, systems, people, communications, government relations—
needed to be put together in order for it to succeed.”
In 1989, KC asked Verghese—who was considering a return to India to study for a PhD—to
develop an export business for its cotton-related products, previously sold only in the domestic
market, in order to generate foreign exchange earnings to support KC’s manufacturing and trading
interests in Nigeria. “At that point in time, the owners were beginning to examine the family’s role in
the business and to make a distinction between ownership and management,” said Verghese. “After
three-and-a-half years working together, they were comfortable with me, so I became an early
experiment. I was able to take an equity position, arrange clear performance parameters, and get the
owners to agree that they would let me run with it—including the ability to hire and fire.” Olam,3
which meant “transcending boundaries” in Hebrew, was established as an independent company
and began selling ginned cotton, cottonseed oil, and fabric to overseas textile mills.
As Olam’s customer base and market expanded, the owners encouraged Verghese to find other
agricultural products that could be exported from Nigeria, which produced cocoa, cotton, coffee, and
cashews in quantities that exceeded domestic demand. Olam began selling whole cashews to
processors in India. After making his initial purchases from the 40 warehouses in Lagos, Verghese
realized that more of the profit pool could be captured if he bypassed the middlemen and bought
directly from the producers. Olam employed village agents, built and/or leased warehouses in local
towns, and organized transportation for the cashews to Lagos where they were sent out of the
country.
Verghese quickly saw opportunities to enlarge Olam’s activity base. Since cashews were available
only four to five months of the year, he searched for other products produced in the region that could
utilize the company’s fixed assets and people. Olam began buying and exporting sheanuts (a wild
fruit collected for use in chocolate and cosmetic products) in 1991, cocoa and rubber in 1992, and
Robusta coffee in 1993. Verghese also turned to Olam’s customer base to better understand the
dynamics of the cashew business. He learned that Indian cashew processors bought raw materials
from 19 countries, which produced different qualities and sold at different price points. Looking
within one to two hours flying time from Nigeria (to make it easier to manage), he expanded Olam’s
procurement operations into the West African cashew-growing countries of Benin, Ivory Coast, and
Ghana using the same “up country” model, working with growers to develop additional production
capacity and to improve quality.
Olam’s cashew volume increased, and the company was able to forward-integrate into processing.
It sold the vast majority of cashews to processors in India, Vietnam, and Brazil, which removed the
edible kernel (24% of the product) from the shell, which was waste. Olam invested in efficient
shelling and blanching facilities in Africa, using and improving on technology learned from Brazilian,
Vietnamese, and Indian processors. Local processing led to a significant cost advantage; in addition,
the firm was now able to sell its processed cashews directly to food companies, leading to a closer
relationship and a better channel to get information on their current and future needs.

3 Between 1990 and 1995, Olam was a wholly owned subsidiary of the KC Group and operated under the name of Chanrai
International Limited. The business was headquartered in London.
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Olam International 509-002
3
More Products and Countries
While Olam’s cashew business grew, the firm expanded its cotton-sourcing operations to more
countries, always with the mandate to buy as close to the farm gate as possible. (In countries where
government restrictions or mandatory markets precluded buying directly from farmers, Olam
purchased products at the closest point possible.) In 1994, the firm began buying teak from timber
producers in Ghana and selling it to buyers in India. The next year Olam began to use its established
supply chain in reverse: it imported sugar purchased from millers and refiners in Asia into Nigeria
and Ghana, where the company distributed the sugar through its transportation and warehouse
infrastructure to locations as close as possible to the point of consumption. Olam used the same
strategy for rice, another essential food imported into Africa.
Sensing the elements of a successful business model, in 1995, Verghese developed a strategic plan
based on the expansion and replication of the company’s African sourcing operations into Asia,
including Indonesia, Vietnam, Thailand, China, and Papua New Guinea. To support a more
international operation, Olam moved its headquarters to Singapore, encouraged by a concessionary
tax rate of 10% (subsequently reduced to 5% in 2004) from the Singapore government. The overseas
business was reorganized to be wholly owned by Olam International.
Verghese and his top managers continued to refine and apply Olam’s “farm-gate to factory-gate”
supply chain (see Figure A) to new products and geographies, often identifying the next steps based
on customer needs. “We were constantly asking ourselves, ‘What else can we sell them?’” he
explained. For example, much of Olam’s cashew sales were to confectionary companies that used the
nuts in candy. “We knew that they needed cocoa, which was also grown in Africa,” he noted. “We
thought, ‘Why can’t we sell them that, too?’”
Figure A Olam’s Participation in the Agribusiness Supply Chain

Source: Company documents.
Verghese continued:
We developed a repeatable growth formula that was anchored on: (i) sourcing as many
products from our existing origins (cost sharing), (ii) trying to identify new but related
products—agri ‘softs’—to sell to our existing customers, and (iii) focusing differentially on
emerging markets where our operational and risk management capabilities gave us a distinct
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509-002 Olam International
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advantage. This really provided strategic clarity to employees and all other stakeholders and
was a major accelerator of Olam’s growth. (See Exhibit 3 for the Olam model.)
Olam added new products and new origins, including sesame from Africa and coffee, cocoa, and
cotton from Asia and South America. The firm’s sugar business expanded with the addition of direct
sourcing operations in Thailand, Brazil, and India. In 2003, Olam shipped its first consignment of
milk powder into Algeria and then added coffee mixes in Russia in 2004 and the following year in
South Africa, where they were distributed in 80% of the organized retail outlets in the country. “One
thing just led to another,” commented Verghese. At the same time, the firm developed the back-office
services—shipping, insurance, information technology, and risk management—to support the
movement of products around the world.
Verghese explained how the firm’s global sourcing capabilities, expanding supply chain, and
diverse product catalog created value for Olam’s customers:
As we developed the capability to source globally, we could provide customers with
consistent year-round supply, at the exact quality level they needed. With an assured source,
some food manufacturers realized they no longer needed to have their own procurement
operations, such as a cocoa buying group that went out to individual farms in producing
countries, or their own processing plants. This freed up capital, which they used to expand
geographically or invested in margin-enhancing activities such as brand building. This helped
our business with them grow even more. In addition, for a large customer like Nestlé we can
provide numerous ingredients—cocoa, coffee, nuts, sugar, dairy, spices. Dealing with fewer
suppliers makes their purchasing, logistics, and accounting functions more efficient. We are
the brand behind the brands.
Supporting a Growing Business
By the middle of 2004, Olam’s business activities had expanded to include 14 products sourced
from 35 origin countries and sold to 3,000 customers in over 50 destination markets. The firm had a
more than 25% share of the global export market for raw cashew nuts, and was one of the world’s
largest shippers of Robusta coffee and one of the three largest dealers of cocoa worldwide. For the
fiscal year ended June 30, 2004, Olam achieved revenues and profit after tax of S$2.6 billion and
S$48.1 million, respectively. Growth had come without acquisitions and without substantial
investments in fixed capital (tangible fixed assets were S$21.2 million on June 30, 2004). The company
was able to self-fund expansion, although between 2002 and 2004, three outside investors of high
global standing including IFC, Temasek Holdings, and AIF Capital—attracted by the firm’s track
record and future prospects—invested a total of S$42 million.
Human Capital
According to Verghese, Olam’s success was a direct result of the company’s distinctive culture
that had been carefully fostered since its early days in Africa. Most managers shared a common
background that included formal business training, up-country experience, and an entrepreneurial
mind-set. He explained:
Our business model is asset light. Instead of equipment, we depend on thousands of
employees spread across remote locations in multiple countries. It is the local manager’s
performance, supported by our central systems and on-going training, that allows us to be
responsive to local conditions, run a lean and efficient operation, and—by working together
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Olam International 509-002
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with one mind-set—to achieve economies of scale and scope across our businesses. In addition,
we challenge all of our managers to be entrepreneurs and find new business opportunities.
They are our growth engine.
“We have a more systematic approach to human capital development than many of our
competitors,” noted Joydeep Bose, president and global head of human resources. “We shepherd
employees through three levels: first as individual contributors, then as profit center heads, and
ultimately as strategic leaders within the organization. We promote from within whenever possible.
Our growth trajectory means there are lots of possibilities. Employees have the opportunity to start
and build a business, which allows them to mature as professionals.” (See Exhibit 4 for Olam’s
human resource development process.)
Olam hired a significant number of entry-level managers every year. The firm recruited at top
business schools in Asia, including several in India. “We look for individuals that are bright, hungry,
entrepreneurial, and able to work independently,” explained Bose. “We try to sort out early who will
be able to handle the challenges of living up-country. We tell all potential candidates that their first
assignment will be in Africa.” Management graduates underwent a six-month training program that
included classroom sessions, project work, and on-the-job training. (Newly hired, experienced field
managers went through a one-month program.) Verghese himself ran Olam’s Core Process
Programme, a four-day session that introduced new employees to Olam’s governing purpose, vision,
business model, and core values.
After the initial training, new managers were assigned to an up-country location where they
quickly learned the intricacies of buying and selling agricultural commodities. They were given a
Field Operations Manual, which contained detailed policies covering almost every aspect of their
business, and were supported with good IT systems, risk management controls, and further training.
First assignments tended to be short, with frequent moves to gain experience with more products.
Since most of Olam’s products were seasonal, a new manager might spend four months up-country
in Nigeria sourcing cocoa, then be transferred to Tanzania to work as a process manager in a cashew
plant. Given the tough field conditions, early attrition was high, with two-thirds of new hires leaving
in first two years. “But if they survive, they stay a long time,” remarked Bose. Overall attrition was
around 10%, which was low for the industry.
Olam invited seasoned managers who had proven themselves in the field and were recommended
by their colleagues to become part of Olam’s Global Assignee Talent Pool (GATP). GATP members
had a deep familiarity with Olam’s business model, operating systems, risks systems, key business
processes, and culture; in addition, they were ready to move on short notice. “This group is our
foundational growth enablers,” explained Verghese. “They carry our DNA. When we enter a new
country, we send one of them and a CFO and they recruit a senior leadership team.” Bose added, “It
is a ‘plug and play’ system. When they go to a new country, they transfer their competencies and
learning to the local recruits.”
Management
Olam used a matrix management structure, with business (product), geographic, and functional
heads. It organized operations into numerous (130 to 140) profit centers, putting most employees
only two to three spots away from a profit center and allowing managers to have profit-and-loss
responsibility early in their careers. “We believe this is the most effective way of measuring
performance,” commented Bose. “Individual bonuses are generated at the profit center level, not
aggregated at the company level. This is appropriate since metrics and targets are different for a
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509-002 Olam International
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trader compared to a plantation manager.” In addition, top-level employees participated in the
company’s success through share ownership. (In 2008, employees owned about 16% of the company.)
Olam’s corporate center consisted of the executive committee (the top 12 managers, most of whom
had been with the firm since its early years), which functioned like an international board of
directors, and the management committee (a 59-member team of regional heads, product heads, and
function heads). (See Exhibit 5 for Olam’s cross-functional structure.) “We have not lost a single
person from amongst our top 20 managers in the last 10 years,” noted Verghese. “That type of
leadership continuity is unique and worth a lot.” The company used a well-defined strategic
planning and capital allocation process, looking ahead over two three-year cycles. Managers were
encouraged to think broadly during the planning process. “I push managers to submit stretch plans,”
said Verghese. “I expect them to be 75% confident that they can achieve the plan they submit. If they
are more certain than that, then they should do more.”
Supplementing Organic Growth
At the end of 2004, Verghese and his team set an ambitious goal to double shareholder value over
the next three-year cycles. This translated into the need to secure an after-tax earnings CAGR of 26%
over the next six years (see Exhibit 6 for Olam’s plan to build intrinsic, long-term shareholder value).
Looking into the future, the CEO realized that the firm’s intrinsic, organic growth rate was likely to
slow when current businesses “ran out of headroom” as they gained number one or two positions in
their respective markets. New opportunities would be farther from the firm’s roots, as Olam
prepared to migrate down the value chain to become a full-service ingredients supplier. The
transition would require new capabilities in manufacturing and food safety, as well as a shift in
company culture.
Olam decided to make selective M&As to help it evolve as a company. In addition to augmenting
current products and geographies, it would use acquisitions to overcome bottlenecks and quickly
gain scale, obtain desired skills, and/or as an educational tool to get an initial understanding of a
new industry. (See Exhibit 7 for Olam’s “launching point” in 2005.) Verghese expected that inorganic
growth would account for 25% to 30% of Olam earnings by FY2011.
M&A Activities
Olam created a small M&A team, and identified and screened potential targets for conflicts of
interest with current suppliers or customers, high-level financials, initial strategic fit, and M&A
interest by target owners. It evaluated deals that passed the initial screen on parameters relating to
attractiveness (e.g., operational synergy, industry attractiveness, financial attractiveness) and
“winability” (e.g., ability to close the deal and ability of management to execute successfully and
create value). Each deal received a final score that was a combination of attractiveness, winability,
and the expected steady-state earnings (a multiplier ranging from one to three).
Between March 2007 and September 2008, Olam announced eight transactions for a total
investment of S$680.9 million. Most of the acquisitions complemented the firm’s existing product
portfolio. In cotton, Olam won a four-month take-over battle for Queensland Cotton, Australia’s
largest cotton company; in addition, the firm announced a 50:50 joint venture (JV) with Chinatex, the
largest player in the Chinese cotton industry. Together, these transactions made Olam the third
largest and most diversified cotton company in the world. In nuts, the firm purchased U.S.-based
Universal Blanchers (UB), the world’s largest independent peanut processor. The UB acquisition
provided Olam with an entry point into the peanut segment as well as an increased presence in the
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Olam International 509-002
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U.S., one of the largest markets. Olam boosted its dairy business by acquiring Naarden Agro
Products, a casein4 manufacturer with operations in the Netherlands and Poland, and the purchase of
a 25% stake in Dairy Trust Limited (DTL), a New Zealand dairy processor. The DTL investment gave
Olam access to supply from the world’s low-cost milk producer. The spice business gained Key
Foods, owner of one of China’s largest dehydrated garlic facilities, as part of a comprehensive
strategy to move more broadly into food ingredients. Olam also acquired a sugar refinery in
Indonesia and a sugar mill in India to add to its existing processing capabilities.
In addition, Olam made M&As to gain a foothold in four new products: palm, rubber, soybean,
and wheat. In March 2007, Olam announced the purchase of a 35% stake in Chinatex Grains and Oils
Import and Export Corp. (CTGO), which held a leading position in the Chinese soybean industry
with an estimated 11% market share. Olam would source soybeans from Brazil and Argentina for
CTGO. And in September 2008, Olam announced it had been granted an option to purchase 49%
interest in a Nigerian port-based wheat-flour mill. (See Exhibit 8 for more information on Olam’s
acquisitions.)
Partnering with Wilmar
At the same time as it was developing its M&A capabilities, Olam embarked on a different type of
M&A relationship with Wilmar International (Wilmar), Asia’s leading agribusiness group and the
world’s largest integrated palm oil company. With 2007 revenues of US$16.7 billion and net profits of
US$580.4 million, Wilmar operated 160 processing plants, employed over 70,000 people, and was one
of the largest plantation companies in Indonesia and Malaysia. Verghese explained how the two
Singapore-based agribusiness companies came together:
Wilmar’s palm oil business was growing rapidly due to demand for biofuels. But they were
very focused on Asia, where there is limited land for new plantations as well as significant
environmental issues. Wilmar determined that Africa was the best place for them to expand,
but during exploratory studies and visits they realized that it would be difficult for them to
execute there due to the challenging environment. They came to us because of our deep
experience on the ground in Africa, and because they respected our ability to build a global
talent pool.
In 2008, the two firms formed a 50:50 JV, named Nauvu5 Investments, to invest in palm and
rubber assets in Africa. Nauvu’s first three investments (approximately US$244 million) were in
SIFCA, West Africa’s largest, fully integrated palm player (palm oil producer) with 36,000 hectares of
plantations, palm oil refining facilities, and distribution of retail brands. In addition, SIFCA was West
Africa’s largest rubber plantation owner and producer with 50,000 hectares in Côte d’Ivoire, Nigeria,
and Ghana, as well as the second largest producer of sugar in Côte d’Ivoire, with 10,000 hectares of
sugar plantations, milling, and distribution assets. “Financially, Wilmar could have invested in
SIFCA itself,” noted Verghese. “They are comfortable with owning land and managing agricultural
production. But they knew that operating in Africa would be more complicated, so they wanted help.
Now our goal is to expand the scope of this venture to other products, such as sugar.”
In July 2008, Olam and Wilmar expanded their cooperation, together buying a 20% stake in
PureCircle Ltd., a leading producer of natural, zero-calorie, high-intensity sweeteners (HIS) based on
the stevia plant. Olam’s investment was US$53.1 million. The global HIS market, estimated at US$1.3

4 Casein, a protein found in milk, was used as an emulsifying and binding agent in many processed foods.
5 Nauvu meant “beautiful plantation” in Hebrew.
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509-002 Olam International
8
billion, was growing at an average rate of 4% per year. Olam and Wilmar considered stevia a
promising alternative to artificial sweeteners, and viewed the partnership as a strategic step toward
the development and commercialization of a fully integrated, stevia supply chain from upstream
plantations in existing and new locations; midstream extraction at the origins; to downstream
refining of crude extracts into high-intensity natural sweeteners; and the marketing and distribution
of those sweeteners to beverage and food ingredients manufacturers worldwide.
Financing
To fund its long-term plans, Olam launched an IPO of 375 million shares at S$0.62 per share in
January 2005; Olam International was listed on the Main Board of the Singapore Exchange the next
month. The oversubscribed IPO raised a total of S$228.4 million of new capital from 191 institutional
investors in over 20 countries and more than 5,800 retail investors from Singapore. In 2008, Olam
raised additional permanent capital: it announced a preferred offering of 155.6 million new shares at
S$1.97 per share on March 28, just three days after Merrill Lynch downgraded the firm, citing its high
460% net gearing as unsustainable.6 The fully subscribed offer raised S$307 million. And in June 2008,
the company raised $425 million through an oversubscribed placement of convertible bonds.
Board
From its public listing in 2005, Olam sought to build on its existing high standards of corporate
governance and create a world-class governance model to help it achieve its overarching philosophy
of delivering consistent financial performance with integrity. The firm supported the principles of
openness, integrity, and accountability. In 2008, Olam’s 11-member board included 3 executive, 3
nonexecutive, and 5 independent directors who had no economic interest in the company (see
Exhibit 9 for Olam’s board).
Three Pillars
With organic growth and M&A levels increasing, in early 2008 Verghese initiated a portfolio
review to make sure that the company was on the right course to deliver the doubling of shareholder
value every three years that he had committed to. Three “growth pillars” were confirmed during the
exercise.
The first pillar related to Olam’s current product portfolio. “We want to pick a few products and
do whatever it takes to establish broad leadership across the value chain,” explained Verghese. “Our
goal is to drive these businesses to their full potential. We will appoint our best talent as product
heads, and challenge them to build a global leadership position in that commodity. We will devote
the financial resources necessary for selective supply chain integration that will improve our margins.
If we can’t get there in six years, we should get out.”
Second, Olam should look at Africa “through a new lens” and determine how best to monetize the
company’s established competency. “More and more we are hearing about a possible food shortage
and about the need to double food production by 2050,” Verghese said. “If that is so, then the world
will have to look to Africa to become a major producer.” He continued:

6 “Singapore’s Olam aims for $222mln from share offer,” Reuters, March 28, 2008, http://uk.reuters.com/article/
rbssConsumerGoodsAndRetailNews/idUKSIN21620420080328, accessed December 2008.
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Olam International 509-002
9
But given the political and economic complexities, you must have a high tolerance for risk,
which most of our peers don’t have. Olam started in Africa, and we will continue to build in
Africa. There are many other opportunities like our venture with Wilmar. Today, land-
acquisition costs in Africa are a steal compared to Asia, and labor costs are also favorable, even
after adjusting for differences in productivity. However, we must look carefully at the human
capital requirements of any venture and favor those that have existing management systems in
place.
Verghese noted three capabilities necessary to be successful in the region: high execution skills,
including people, systems, and processes to minimize leakages and pilferage; market dominance; and
pricing power, which came from being present in multiple markets and multiple products so to
achieve a low cost position. “It would be very difficult—if not impossible—for someone to replicate
our extensive country-based operations and up-country network,” he said. “For example, we have
5,500 people—mostly women—working at our cashew plant in Tanzania. This type of labor-intensive
operation is critical for the country’s economic development. But it takes a special type of firm to be
willing to invest.” (See Exhibit 10 for pictures of Olam’s Tanzania cashew facility.)
The third pillar, Verghese believed, was that Olam should consider innovative ways to monetize
the firm’s “hidden assets,” such as its up-country networks and risk management capabilities. For
example, Olam could add ancillary services, for instance, providing seasonal micro-credit to farmers
or building a logistics network in Africa to get produce to markets. “But we don’t want to get too
heterogeneous,” commented Verghese. “One possibility would be to start with an idea, incubate it,
and then spin it off once it is established and no longer essential to our local business.” Other novel
offerings might include creation of a pastoral fund (to own agricultural land in Argentina, Brazil,
Ukraine, Russia, and Africa), an agricultural infrastructure assets fund, an agribusiness private equity
fund, or a commodity hedge fund.
Olam in 2008
In mid-October 2008, Verghese had many reasons to be proud. In just under 20 years, he had built
Olam from a single product in a single country to 20 products in 60 origin markets (see Table A for
Olam product list and Exhibit 11 for information on Olam product segments). Sales revenues and net
profit after tax had grown at a CAGR of 53% and 48%, respectively, since 1989. Olam traded 17% of
the world’s cocoa, 16% of the world’s cashew nuts, and 8% of the world’s peanuts. The company had
begun to provide more value-added services to customers, such as traceability (unlike traditional
traders, Olam could guarantee traceability because it controlled the chain all the way back to the farm
gate), organic certification, and fair trade sourcing.
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509-002 Olam International
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Table A Agri-Commodities in Which Olam Participated in 2008 and for Future Participation
Softs Industrial
Edible
Nuts Spices
Pulses
and
Beans
Dairy
and
Livestock Grains Oilseeds Biofuels

Coffee Cotton Cashews Pepper Lentils Dairy Rice Sesame Biodiesel
Cocoa Timber Peanuts Nutmeg Beans Eggs Wheat Palm Ethanol
Sugar Rubber Almonds Cassela Peas Pork Barley Canola
Shea Wool Pecans CuminBeef Corn Soybean
Citrus Fertilizer Macadamia GarlicChicken Oats Cottonseed
Hazel nuts GingerFish Sorghum Linseed
Walnuts Onion Millet Rapeseed
Pinenuts
Pistachios
Desiccated
Coconut
Sunflower

Source: Company documents.
Note: Commodities in bold type are those in which Olam currently participates.

Since its IPO, the market had valued Olam higher than its peers (see Exhibit 12 for Olam’s stock
price compared to other listed agribusiness firms and Exhibit 13 for Olam’s top shareholders).
“People believe that Olam is the premier growth company in this sector,” explained Verghese. “Our
business model has running room for the next six years. We have attractive capital spreads, which are
more important than profit margins. And we have been asset light, although that is changing. Our
goal is to put more capital to work and then generate our current spreads on that new capital and
thereby create fundamental intrinsic shareholder value.”
Size and Scope
Olam’s success also brought challenges. Some managers were concerned that Olam, as it got
larger, would attract more attention from competitors, governments, activists, and even customers.
“When we began to build our businesses in cashew, sesame, spices, we were small,” remarked
Verghese. He continued:
For years, we operated under the radar of the large, integrated supply chain companies like
Cargill and ADM. Then we moved into cocoa, cotton, rice, coffee, and sugar, where they are
our competitors. Before, when they heard the name Olam, they asked ‘Who?’ Now, they know
us. In addition, now that we are larger, we are squarely in the sights of NGOs. We work in
many high-profile countries. For example, last year Greenpeace targeted our timber operations
in the Congo, and as a result, IFC dropped their investment in the company.
As Olam migrated up the value chain, it faced a larger risk of competing with its own customer
base. “We spend a lot of time discussing possible channel conflicts,” noted John Gibbons, president of
Olam Americas. For example, the firm was considering manufacturing for private-label customers
that were in competition with the national brands that Olam already supplied. “We get better
information on demand as we get closer to the shelf,” noted Verghese. And in several emerging
markets, Olam had launched its own food and beverage brands that were sold in retail stores.
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Management Challenges
Other challenges were related to the firm’s M&A efforts. Although deliberately strategic in its
acquisitions, Olam had learned through experience that integration of acquired companies was
complicated and sometimes meant an initial clash of cultures. Acquired employees brought
important new skills and perspectives, but they did not have the field experience, relationships with
the Olam’s global team, or an understanding of how they fit into the company’s distinctive operating
model. Gibbons noted that the goal in some transactions was to learn from the acquisition, not to
change them. “When we bought Universal Blanchers, they were worried that we would try to ‘Olam-
ize’ them,” he recalled. “I told them it was our hope that they would ‘Universal-ize’ us. We need to
understand how they operate and transfer that learning into other Olam businesses. But we are still
working on the best way to do that.”
Other issues were related to Olam’s expansion into different parts of the value chain. For example,
Olam now owned food ingredients businesses and was a partner in plantations. One manager
observed:
Olam’s culture is that of a hard-nosed trading company that operates on volume and very
thin margins. We are always trying to save a penny here, a penny there. At budget review
meetings, Sunny will ask, ‘Why did overhead go up by $20,000?’ Can this coexist with a more
traditional food company, whose objective is to invest in R&D, new product development, and
marketing to push up margins? And can the head of our cashew business appreciate what it
takes to build a plantation?
Verghese questioned whether the firm’s management structure and decision-making process
would need to change as the company got larger and more diverse in its activities. In addition, he
wondered how Olam could maintain the financial discipline necessary to protect supply chain
margins:
Before the IPO, we could barely finance our inventories. We were asset light and ran on a
shoestring. We had less than 1% fixed assets on our balance sheet. But once the IPO occurred,
all of these [internal] projects came out of the closet. Having access to capital has been good,
but perhaps it has also caused us to be less rigorous in what we invest in. The recent economic
conditions have actually been good for us in that respect, because it has reminded us once
again to focus on performance while scrutinizing costs.
Human Resource Challenges
As Olam grew larger, Bose was concerned that human capital would become the limiting factor to
organic growth. He noted that the company’s traditional recruiting model was yielding lower results:
Before, India had a talent surplus, and now there is a talent deficit. There are more domestic
opportunities for top MBAs. Graduates are no longer willing to leave their families and go off
to some rural location where they have no peers, no nightlife, and often live in very basic
conditions. They want to stay in India where they will have a better quality of life. And this is
true not just in India. In Brazil, we can find good candidates, but the business school graduates
don’t want to move to Mato Grosso; they want to move to the cities.
The firm had also run into difficulties when it tried to hire locally in the countries where Olam
had operations. The issue was particularly challenging in Africa. “Our businesses there now depend
on ex-pats, and it’s a hard life for them,” said Verghese. “We are trying to develop local talent, but it
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509-002 Olam International
12
is tough because they don’t have basic skills. The quality of education is low, and there are not
enough training facilities. If they leave their country to get an education, most of them don’t go back.
We have to find a way to invest in the development of local talent, like Unilever did in India in the
1940s.” In 2007, Olam initiated a Latin American Management Trainee Scheme by recruiting
graduates from top schools in Brazil, Peru, and Colombia.
Yet another challenge was a negative perception of agribusiness as a career. Bose explained:
When we do find a good candidate, often they don’t view agriculture as an attractive career
choice. They don’t see it as an exciting or high-growth industry. Sometimes they will even say,
“Instead of working for you, I’m going to work for this well-known bank. My mother
recognizes the name [of the bank], and she can brag about it to her friends.” This problem can’t
be fixed solely with compensation. We have been offering very attractive packages, to attract
talent.
Decisions
Verghese considered his biggest challenge was to maintain Olam’s historic top-line growth of 16%
to 20% CAGR and bottom-line growth of 25% to 30% CAGR, all while earning a 10% equity spread.
• What other products should Olam consider to drive growth? Was entry into mainstream agri-
commodities like soybeans and wheat advisable, given the presence of larger competitors like
Bunge, ADM, and Cargill? Should Olam consider entry into other commodity classes, such as
fertilizer or metals?
• Into which parts of the value chain should Olam consider expanding in order to tap into
incremental growth and profitability, while minimizing conflict with its customers and
suppliers?
• How could Olam exploit its “hidden assets” (e.g., risk management in emerging markets, end-
to-end visibility across the supply chain) to create incremental value for its shareholders
beyond its core business?
Verghese said:
The current downturn will not reduce the operational intensity of our food businesses since
volumes traded will not be significantly affected, but there is increased pressure on margins
and hence the need to reduce overhead. We will continue to invest in our current projects and
will need staff to do that, but the drop in our stock price has meant a fall in the total value of
managerial shareholdings.
Looking ahead, this industry will continue to grow and change due to higher demand and
rising concerns about food security. In Asia, nearly 85% of potentially arable land is already
under cultivation, and in the Middle East, only 1% to 3% of the total land available is arable.
These are areas where consumption is increasing. And the recent run-up in commodity prices
has caused governments large and small to rethink their position on self-sufficiency and free
trade. I am confident that Olam is well positioned to take advantage of the structural change in
our industry.
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Olam International 509-002
13
Exhibit 1 Olam Stock Price (S$)

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509-002 Olam International
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Exhibit 2 Olam Group Financial Information, FY2004–FY2008
Financial Highlights (S$ millions, unless otherwise noted)
FY2004 FY2005 FY2006 FY2007 FY2008
Consolidated Results
Sales volume (‘000 metric tons) 2,052 2,553 3,172 3,773 4,926
Sales revenue 2,610.3 3,369.2 4,361.1 5,455.5 8,111.9
Gross contribution 178.8 228.9 343.1 486.6 681.9
Gross contribution/Ton (S$) 87 90 108 129 138
Net contribution 142.1 179.6 259.4 351.4 504.0
Net contribution/Ton (S$) 69 70 82 93 102
Earnings before interest, tax,
depreciation, and amortization
(EBITDA) 102.0 133.9 203.4 290.9 377.5
Earnings before interest and tax (EBIT) 97.2 126.4 191.2 273.6 366.4
Profit before tax 53.7 74.9 96.7 126.2 165.0
Net profit after tax attributable to
shareholders48.1 67.0 87.2 109.1 167.7
Earnings per share basic (cents) 4.52 5.19 5.61 7.01 10.28
Net dividend per share (cents) 3.80 2.16 3.00 3.50 2.50
Other Financial Information
Total debt 849.7 1,450.7 1,476.8 1,919.9 2,984.6
Shareholders’ equity 189.9 496.7 488.0 432.7 638.4
Net debt to equity (times) 3.95 2.59 2.23 3.45 3.17
Return on Equity (%) 40.7 34.7 17.5 20.6 28.7
Return on invested capital 8.77 10.05 13.21
Interest coverage (times) 2.02 1.86 1.82
Cash to sales (%) 6.79 4.36 4.18
Number of employees 3,003 5,090 6,300 7,678 8,000
Global Assignee Talent Pool168 250 340 400
Note: Fiscal Year ends on June 30.
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Exhibit 2 (continued)
Profit and Loss Accounts (S$ millions)
FY2004 FY2005 FY2006 FY2007 FY2008
Revenue
Sales of goods 2,610.3 3,369.2 4,361.1 5,455.5 8,111.9
Other revenue 12.1 13.1 16.7 22.1 40.5
2,622.4 3,382.4 4,377.8 5,477.6 8,152.4
Costs and Expenses
Cost of goods sold 2,059.8 2,642.9 3,372.2 4,275.9 6,519.2
Shipping and logistics 328.5 463.1 573.5 661.9 879.5
Commission and claims 26.4 27.8 53.1 68.2 61.0
Employee benefits expense 39.2 50.4 66.5 95.5 163.6
Depreciation 4.7 7.6 12.1 17.2 33.8
Net measurement of derivative
instruments 0 0 (0.5) 0.2 (11.0)
Loss/(gain) on foreign exchange 1.5 (13.4) 9.7 (43.7) (21.5)
Other operating expenses 65.0 77.6 100.0 128.7 155.7
Finance costs 43.6 51.5 94.7 147.1 201.4
Share of loss of jointly
controlled entity 0 0 (0.2) 0.4 163
Profit before taxation 53.7 74.9 96.7 126.2 165.0
Taxation (5.6) (7.9) (9.5) (17.2) 2.7
Profit for the financial year 48.1 67.0 87.2 109.0 167.7
Note: Fiscal Year ends on June 30.

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509-002 Olam International
16
Exhibit 2 (continued)
Balance Sheets as of June 30 (S$ millions)
2004 2005 2006 2007 2008
Non-Current Assets
Property, plant, and equipment 21.2 39.2 72.5 129.3 403.4
Intangible assets — — — 96.2 130.3
Deferred tax assets 0.8 0.9 4.6 7.8 36.7
Interests in jointly controlled entities — — 1.6 1.9 0.3
Long-term investments 0.1 1.5 — 81.1 26.8
Other receivables — — 0.5 9.5 25.5
Current Assets

Trade receivables 465.0 649.2 426.8 508.2 724.4
Margin accounts with brokers 5.3 57.3 43.1 86.2 264.0
Inventories 478.1 1,019.0 1,013.9 1,163.2 1,790.2
Advance payments to suppliers 90.1 90.9 160.7 255.7 380.0
Other receivables 77.8 117.6 138.6 199.4 264.0
Short-term investment — — — 13.5 —
Fixed deposits 11.9 61.7 133.9 43.4 163.6
Cash and bank balances 88.5 103.7 162.4 194.2 175.5
Fair value of derivative financial instruments — — 199.6 388.0 1,832.3
1,017.4 1,644.2 2,279.0 2,851,8 5,594.5
Current Liabilities

Trade payables and accruals 155.0 175.0 134.9 255.5 519.9
Other payables 5.4 57.3 31.7 55.9 34.9
Amounts due to bankers 672.7 1,188.0 783.3 545.6 1,790.0
Medium-term notes 177.0 262.8 352.5 450.0 70.0
Provision for taxation 5.9 8.6 13.3 24.9 24.6
Fair value of derivative financial instruments — — 213.5 488.6 2,011.0
1,017.4 1,644.2 1,529.1 1,820.5 4,449.9
Net Current Assets
202.2 455.2 749.9 1,031.3 1,144.6
Non-Current Liabilities

Deferred tax liabilities — — — (3.3) (4.2)
Term loans from banks (0.3) — (213.3) (703.7) (935.1)
Medium-term notes (127.7) (220.7) (189.9)
Convertible redeemable shares (25.6) — — — —
Long-term loan from a corporate shareholder (8.6) — — — —
Net Assets
189.9 496.7 488.0 432.7 638.4
Equity Attributable to Equity
Holders of the Company

Share capital 100.8 155.5 397.0 397.7 704.9
Reserves 89.1 341.3 91.0 35.0 (66.5)
Minority interest — — 0.1 0 (0)
Total Equity
189.9 496.7 488.0 432.7 638.4
Source: Company documents.
Note: Fiscal Year ends on June 30.
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Olam International 509-002
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Exhibit 2 (continued)
Consolidated Cash Flow Statement for the Year Ended June 30 (S$ millions)
2004 2005 2006 2007 2008
Cash flow from operating activities
Profit before taxation 53.7 74.9 96.7 126.2 165.0
Adjustments for:
Share of results from jointly controlled entities 0 0 (0.2) 0.4 0.2
Depreciation of property, plant, and equipment 4.7 7.6 12.1 17.2 33.8
(Gain)/loss on disposal of property, plant, and
equipment 0.1 (0.1) (0.1) 0 (0.6)
Net measurement of derivative instruments — — (0.5) 0.2 (11.0)
Negative goodwill arising from acquisitions — — — (0.2) (5.3)
Cost of share-based payment — — 1.7 5.6 5.6
Interest income (6.8) (2.1) (11.1) (11.9) (19.6)
Interest expense 43.6 51.5 94.7 147.1 201.4
Amortization of intangible assets — — — 0 2.2
Operating cash flows before reinvestment
in working capital 95.3 131.7 193.4 284.6 371.5
Decrease in amount due from a related party 2.4 3.0 — — —
Increase in inventories (167.1) (541.0) 193.4 (143.5) (456.1)
Increase in receivables (114.2) (276.0) 197.7 (192.8) (428.3)
Interest in advance payments to suppliers (33.9) (0.8) (69.8) (95.0) (117.1)
Increase in payables 69.7 20.0 (16.9) 121.1 124.6
Cash used in operations (147.8) (663.1) 291.6 (25.5) (505.4)
Interest income received 6.8 2.1 11.1 11.9 19.6
Interest expense paid (42.7) (47.0) (83.5) (138.7) (218.8)
Tax paid (4.7) (5.3) (5.7) (8.3) (7.0)
Net cash flows used in operating activities (188.3) (713.3) 213.4 (160.6) (711.5)
Cash flows from investing activities
Proceeds from disposal of property, plant, and
equipment 1.2 0.7 0.7 2.5 7.1
Purchase of property, plant, and equipment (9.9) (25.9) (48.4) (45.8) (74.2)
Investment in government security bills — — — (13.5) 13.5
Acquisition of subsidiaries, net of cash acquired — — — (113.7) (162.0)
Purchases of financial assets, available-for-sale — — — (81.1) 0
Investment in a jointly controlled entity — (1.4) — (0.8) (0.1)
Repayment from/(loan) to jointly controlled
entities — — (0.6) (9.0) (0.3)
Net cash flows used in investing activities (8.7) (26.6) (48.3) (261.4) (215.5)
Cash flows from financing activities
Proceeds from loans from banks 40.3 505.4 (142.6) 218.2 1,110.4
Repayment of term loan from a bank (0.1) (0.3)
(Decrease)/increase in amount due to a
corporate shareholder 1.5 (1.4) — — —
Repayment of long-term loan from a corporate (0.2) (8.6) — — —
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509-002 Olam International
18
2004 2005 2006 2007 2008
shareholder
Proceeds from issuance of ordinary shares at
premium 43.8 245.4 — — —
Expenses on issuance of ordinary shares — (10.1) — — —
Proceeds from issue of convertible redeemable
shares at premium 25.6 — — — —
Proceeds from issuance of shares on
exercise of share options — — — 0.8 3.8
Proceeds from issuance of shares on
preferential share offer — — — 0 303.3
Dividends paid on ordinary shares by the
Company (22.7) (24.3) (33.6) (46.6) (54.5)
(Repayment of)/proceeds from issue of
medium-term notes 177.0 85.8 217.4 190.5 (410.8)
Net cash flows provided by
financing activities 265.2 791.2 41.2 362.8 952.2
Net effect of exchange rate changes on
cash and cash equivalents (2.0) 3.9 (26.8) (20.6) (48.6)
Net (decrease)/increase in cash and cash
equivalents 55.2 66.2 179.6 (79.8) (23.4)
Cash and cash equivalents at beginning
of year (33.5) 32.7 87.8 267.4 187.6
Cash and cash equivalents at end of year 32.7 87.8 267.4 187.6 164.3
Source: Company documents.
Note: Fiscal Year ends on June 30.

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Olam International 509-002
19
Exhibit 3 Olam’s Business Model

Source: Company documents.

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So
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ce
:
C
om
pa
ny
d
oc
u
m
en
ts
.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
50
9-
00
2

-2
1-
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xh
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So
ur
ce
:
C
om
pa
ny
d
oc
u
m
en
ts
.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
50
9-
00
2

-2
2-
E
xh
ib
it
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So
ur
ce
:
C
om
pa
ny
d
oc
u
m
en
ts
.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
50
9-
00
2

-2
3-
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So
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:
C
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d
oc
u
m
en
ts
.

For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
509-002 Olam International
24
Exhibit 8 Olam M&A Activities, March 2007–September 2008

ChinatexOlam’s first inorganic initiative, announced in March 2007, was a two-part strategic
partnership with Chinatex Corporation, one of China’s largest state-owned enterprises. An oilseeds
joint venture combined the processing and marketing capability of Chinatex’s subsidiary, Chinatex
Grains and Oils (CTGO), with Olam’s supply chain management capability in Brazil and Argentina.
CTGO had a leading position in the soybean industry in China with a market share of close to 11%.
Olam had strong origination capabilities in Brazil and wanted to add soybeans to its product list.
Olam invested in a 35% stake in CTGO, with an option to increase it to 45% within a period of two
years of setting up a sourcing subsidiary in Brazil.
Olam and Chinatex also announced a 50:50 JV company in China to be involved in sourcing,
ginning, inland logistics, distribution, and risk management for the local cotton market. Chinatex was
the largest player in the Chinese cotton industry. The combination brought together Chinatex’s local
knowledge with Olam’s position as the leading supplier of imported cotton to the Chinese market.
The JV included a preferential purchase agreement whereby at least 30% of Chinatex’s annual cotton
imports would be sourced by Olam. The Chinatex JV venture positioned Olam to play a larger role in
China’s deregulating cotton market.
Universal Blanchers In May 2007, Olam acquired Universal Blanchers (UB), a U.S.-based food
manufacturer that was the world’s largest, independent peanut blancher, ingredient processor, and a
market leader in outsourced peanut products for the snack and confectionary space. The purchase
price was S$112 million. The UB acquisition complemented Olam’s position in other edible nuts and
was a strategic entry point into the peanuts ingredient space. Many food manufacturers still
processed peanuts internally, but Verghese believed that companies would increasingly outsource
operations to independent peanut processors.
Queensland Cotton In July 2007, Olam won a four-month take-over battle against Louis
Dreyfus Commodities to acquire Queensland Cotton Holdings, Australia’s largest cotton company.
The total cash purchase price was S$195.4 million, with Olam paying 24% more than its initial bid.
The combination made Olam the world’s third largest and most diversified global cotton company,
with substantial sourcing operations in Africa, Australia, Brazil, Commonwealth of Independent
States (CIS), India, China, and the U.S., and a strong presence in the major world markets.
Key Foods Olam acquired Key Foods Ingredients (KFI), owner of one of China’s largest
dehydrated garlic facilities, for S$24.5 million in August 2007. The KFI acquisition complemented
Olam’s spice business and provided an entry into the dehydrated garlic business from China to the
U.S., as well as an accelerated entry into the large, dehydrated ingredients market, which was
estimated to be growing at 7%–8% each year.
Naarden Agro Products In September 2007, Olam acquired Naarden Agro Products, an
international supply chain manager of industrial caseins, for S$6.8 million. The deal was a one-step
product adjacency for Olam’s dairy business, as the firms shared the same sourcing channels in
countries such as Ukraine, Poland, Russia, and Belarus. It also provided Olam with a platform to
diversify into the next-step adjacency, edible caseins, which could be supplied to existing Olam food
ingredients customers.
PT Dharmapala Usaha Sukses In October 2007, Olam purchased PT Dharmapala Usaha
Sukses, a sugar refinery based in Indonesia, for approximately S$19.3 million.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Olam International 509-002
25
Dairy Trust Olam acquired a minority stake (24.99%) in Dairy Trust Limited (DTL), a New
Zealand dairy processor, in August 2008 for NZD101.05 million (S$108.1 million). Olam became the
second largest shareholder in DTL, with two seats on the board. New Zealand was the world’s
lowest-cost dairy producer and had the highest medium-term growth in raw milk supply. The
investment supported Olam’s long-term strategy to expand its procurement reach into the key dairy
origins of Oceania and the U.S.
Standard Flour Mills In September 2008, Olam was granted an option to acquire a 49% stake
in Standard Flour Mills Ltd., a Lagos, Nigeria-based producer and wholesaler of wheat flour. Olam
paid S$32.5 million for the share and agreed to invest another S$4.9 million to raise Standard Flour’s
operating capacity. This was part of Olam’s strategy to get into wheat production and wholesaling.
Source: Compiled from company documents.

Exhibit 9 Olam Board of Directors, 2008
1
1
Delivering the Olam Model
Governance & Transparency
6 Board Committees
73% of the Board is Non-Executive 45% is Independent & additional 9% of the Board
would represent minority interest
1
2
3
4
5
6
7
8
10
11
CHAIRMAN
R. Jayachandran
(Non-Executive)
DIRECTOR
N. G. Chanrai
(Non-Executive)
DIRECTOR
Sunny Verghese
Group MD & CEO
(Executive)
DIRECTOR
Sridhar Krishnan
Snr Managing Director
(Executive)
DIRECTOR
A. Shekhar
Snr Managing Director
(Executive)
DIRECTOR
Andy Tse
AIF Capital
(Non-Executive)
DIRECTOR
Wong HengTew
(Independent)
DIRECTOR
Michael Lim
(Independent)
DIRECTOR
Robert Tomlin
(Independent)
DIRECTOR
Jean-Paul Pinard
(Independent)
9 DIRECTORMark Daniell
(Independent)

Source: Company documents.

For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
509-002 Olam International
26
Exhibit 10Olam’s Cashew Plant in Tanzania
Outside Olam’s Cashew Plant

Olam Employee Holding Raw Cashew Nuts

For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Olam International 509-002
27
Exhibit 10 (continued) Olam’s Cashew Plant in Tanzania
Olam Workers Hulling Cashews

Source: Photos provided by Olam.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
509-002 Olam International
28
Exhibit 11 Background on Olam’s Products and Markets
Origins and Products
Olam organized its products into four main segments: Edible Nuts, Spices & Beans (14% of
revenues and 25% of contribution in FY2008); Confectionary and Beverage Ingredients (39% revenues
and 28% contribution); Food Staples and Packaged Foods (25% revenues and 20% contribution); and
Fiber and Wood Products (21% revenues and 27% contribution). See Table B for segment information
and Table C for market share information.
Edible Nuts, Spices, and Beans This segment included cashews (sourcing raw nuts at the
farm gate in 15 producing countries, processing at blanching and packaging facilities in seven origins,
and delivering to the customer’s factory gate in all major markets); peanuts; spices such as black and
white pepper, nutmeg, cassia, dehydrated garlic, etc.; beans and pulses; and sesame; where the global
share reached 13.7% in FY2008.
Confectionary and Beverage Ingredients The segment included coffee and cocoa.
Food Staples and Packaged Foods This segment included rice (Olam consumer brands such
as Mama Gold and Mama Royale in Africa), sugar, and dairy products (Olam brand Pearl, instant
full-cream milk powder, and condensed milk in tins). Olam was the largest rice trader in the world.
In addition, Olam had launched branded packaged foods, such as Tasty Tom tomato paste, across
several West African markets, Enrista indulgence beverages (coffee) in South Africa and Russia, and
Ponchos nut snacks in Russia. The main plank of packaged foods was to build and retain distribution
depth across all markets, as well as to offer exclusive distribution services to major principals,
including Olam’s supply chain customers, that wished to expand the distribution of their brands in
these markets.
Fiber and Wood Products With the 2007 acquisition of Queensland Cotton Holdings and
joint venture with Chinatex (the largest cotton company in China), Olam had become the third largest
and most diversified cotton company in the world. In wood, Olam sourced from around the world to
supply customers in key markets like China and Vietnam. Consumer interest in traceable and
certified wood products was on the rise. Olam had established sourcing relationships with suppliers
of certified teak.
Source: Company documents.
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Olam International 509-002
29
Table B Sales Revenue and Net Contribution by Segment, FY2004–FY2008 (S$ Millions)
2004 2005 2006 2007 2008
Sales revenues by segment
Edible Nuts, Spices, and Beans 391.8 566.8 588.2 783.2 1,168.9
Confectionary and Beverage Ingredients 1,031.2 1,345.9 1,711.3 2,177.8 3,188.9
Food Staples and Packaged Foods 552.9 782.7 1,058.4 1,432.3 2,027.5
Fiber and Wood Products 634.4 673.8 1,003.2 1,432.3 1,726.6
TOTAL 2,610.3 3,369.2 4,361.1 5,455.5 8,111.9
Net contribution by segment
Edible Nuts, Spices, and Beans 29.0 45.3 52.9 68.8 125.0
Confectionary and Beverage Ingredients 58.5 72.9 95.7 126.0 141.0
Food Staples and Packaged Foods 21.3 28.8 42.1 60.1 103.1
Fiber and Wood Products 33.3 46.0 68.7 96.5 134.7
TOTAL 142.1 193.0 259.4 351.4 504.0
Source: Olam.

Table C Market Share Growth by Segment, FY2005–FY2008
2005 2006 2007 2008
Edible Nuts, Spices, and Beans
Cashew11.7% 13.5% 14.4% 16.6%
Peanuts1.8% 2.5% 3.0% 7.8%
Sesame7.7% 9.4% 13.4% 13.7%
Confectionary and Beverage Ingredients
Cocoa11.2% 13.8% 15.5% 17.1%
Coffee3.0% 3.8% 4.5% 7.1%
Food Staples and Packaged Foods
Rice2.9% 2.6% 3.0% 4.0%
Sugar0.8% 1.0% 1.3% 1.5%
Dairy Products0.6% 1.2% 1.8% 2.8%
Fiber and Wood Products
Cotton2.7% 4.2% 4.4% 7.3%
Timber1.1% 1.2% 1.6% 2.1%
Source: Compiled from company documents.

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509-002 Olam International
30

Destination Markets and Customers
Olam sold products to customers in over 80 countries through a network of global sales offices.
Olam customers included food service operators, ingredient companies, and branded food
companies, along with those in the snack, bakery, and confectionary sectors. During the period 2003
to 2007, Olam had diversified its customer base by growing the number of customers 10% each year
(see Table D for geographic breakdown and Table E for customer information).
Table D Sales Revenue by Continent, FY2003–FY2008 (S$ Millions)
2003 2004 2005 2006 2007 2008

Asia and Middle East 627.9 1,053.9 1,205.1 1,649.1 2,074.4 3,171.8
Africa 628.3 778.1 900.3 1,162.9 1,409.1 1,784.6
Europe 791.7 612.2 868.6 969.7 1,271.1 2,068.5
Americas 226.4 166.1 395.2 579.4 700.9 1,084.0

Source: Compiled from company documents.

Table E Customer Information, FY2003–FY2008
2003 2004 2005 2006 2007 2008

Number of Customers 2,668 3,000 3,346 3,828 4,030 6,500

Top 25 Customers’ Share of
Total Sales Revenues (%) 45 29 29 27 24 18

Source: Compiled from company documents.

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Olam International 509-002
31
Exhibit 12 Olam Stock Price Compared to Other Agribusiness Firms, 2005–2008

Exhibit 13 Olam Top 20 Public Institutional Shareholders, October 2008
Name

1. KC Group
2. JP Morgan Asset Management
3. Sunny Verghese
4. UBS Global Asset Management
5. Capital Group
6. AIF Capital
7. William Blair & Co.
8. BNY Mellon (Newton)
9. Columbia Management
10. Deutsche Asset Management
11. T. Rowe Price
12. Fidelity
13. Barclays Group
14. Blackrock Advisors
15. NTUC Income Insurance
16. Prudential
17. State Street Global Advisors
18. Harding Loevner
19. Van Eck Associates
20. Waddell & Read

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__MACOSX/Course Pack/._Olam International.pdf
Course Pack/Getting the Scope of the Business Right.pdf
Getting the Scope of the
Business Right
E x c e r p t e df r o m
The Innovator’s Solution:
Creating and Sustaining Successful Growth
B y
Clayton M. Christensen and Michael E. Raynor
Harvard Business School Press
Boston, Massachusetts
ISBN-13: 978-1-4221-1540-4
1540BC
H A R V A R D
B U S I N E S S
S C H O O L
P R E S S
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Copyright 2006 Harvard Business School Publishing Corporation
All rights reserved
Printed in the United States of America
This chapter was originally published as chapter 5 of The Innovator’s Solution: Creating and Sustain-
ing Successful Growth, copyright 2003 Harvard Business School Publishing Corporation.
No part of this publication may be reproduced, stored in or introduced into a retrieval system,
or transmitted, in any form, or by any means (electronic, mechanical, photocopying,
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Which activities should a new-growth venture do internally in
order to be as successful as possible as fast as possible, and which
should it outsource to a supplier or a partner? Will success be best
built around a proprietary product architecture, or should the
venture embrace modular, open industry standards? What causes
the evolution from closed and proprietary product architectures
to open ones? Might companies need to adopt proprietary solu-
tions again, once open standards have emerged?
Decisions about what to in-source and what to procure from suppli-
ers and partners have a powerful impact on a new-growth venture’s
chances for success. A widely used theory to guide this decision is built
on categories of core and competence. If something fits your core
competence, you should do it inside. If it’s not your core competence
and another firm can do it better, the theory goes, you should rely on
them to provide it.1
Right? Well, sometimes. The problem with the core-competence/
not-your-core-competence categorization is that what might seem to
be a noncore activity today might become an absolutely critical com-
petence to have mastered in a proprietary way in the future, and vice
versa.
chapter five
GETTING THE SCOPE OF
THE BUSINESS RIGHT
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Consider, for example, IBM’s decision to outsource the micro-
processor for its PC business to Intel, and its operating system to Mi-
crosoft. IBM made these decisions in the early 1980s in order to focus
on what it did best—designing, assembling, and marketing computer
systems. Given its history, these choices made perfect sense. Compo-
nent suppliers to IBM historically had lived a miserable, profit-free
existence, and the business press widely praised IBM’s decision to out-
source these components of its PC. It dramatically reduced the cost
and time required for development and launch. And yet in the process
of outsourcing what it did not perceive to be core to the new business,
IBM put into business the two companies that subsequently captured
most of the profit in the industry.
How could IBM have known in advance that such a sensible deci-
sion would prove so costly? More broadly, how can any executive who
is launching a new-growth business, as IBM was doing with its PC di-
vision in the early 1980s, know which value-added activities are those
in which future competence needs to be mastered and kept inside?2
Because evidence from the past can be such a misleading guide to
the future, the only way to see accurately what the future will bring is
to use theory. In this case, we need a circumstance-based theory to de-
scribe the mechanism by which activities become core or peripheral.
Describing this mechanism and showing how managers can use the
theory is the purpose of chapters 5 and 6.
Integrate or Outsource?
IBM and others have demonstrated—inadvertently, of course—that
the core/noncore categorization can lead to serious and even fatal
mistakes. Instead of asking what their company does best today, man-
agers should ask, “What do we need to master today, and what will
we need to master in the future, in order to excel on the trajectory of
improvement that customers will define as important?”
The answer begins with the job-to-be-done approach: Customers
will not buy your product unless it solves an important problem for
them. But what constitutes a “solution” differs across the two cir-
cumstances in figure 5-1: whether products are not good enough or
are more than good enough. The advantage, we have found, goes to
T H EI N N O V A T O R ’ SS O L U T I O N2
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integration when products are not good enough, and to outsourcing
—or specialization and dis-integration—when products are more than
good enough.
To explain, we need to explore the engineering concepts of inter-
dependence and modularity and their importance in shaping a prod-
uct’s design. We will then return to figure 5-1 to see these concepts at
work in the disruption diagram.
Product Architecture and Interfaces
A product’s architecture determines its constituent components and
subsystems and defines how they must interact—fit and work together—
in order to achieve the targeted functionality. The place where any
two components fit together is called an interface. Interfaces exist
within a product, as well as between stages in the value-added chain.
G e t t i n gt h eS c o p eo ft h eB u s i n e s sR i g h t
F I G U R E5 – 1
Product Architectures and Integration
Int
erd
ep
en
de
nt
Ar
ch
ite
ctu
res
, In
teg
rat
ed
C
om
pa
nie
s
P
e
rf
o
rm
a
n
c
e
Time
P
e
rf
o
rm
a
n
c
e
G
a
p
Beat competitors with
functionality and reliability
Performance
Surplus
Beat competitors with
speed, responsiveness,
and convenience
Difference in functionality that can be achieved
with an optimized, interdependent architecture
versus modular architecture
Mo
du
lar
A
rch
ite
ctu
res
, N
on
int
eg
rat
ed
C
om
pa
nie
s
3
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For example, there is an interface between design and manufacturing,
and another between manufacturing and distribution.
An architecture is interdependent at an interface if one part cannot
be created independently of the other part—if the way one is designed
and made depends on the way the other is being designed and made.
When there is an interface across which there are unpredictable inter-
dependencies, then the same organization must simultaneously de-
velop both of the components if it hopes to develop either component.
Interdependent architectures optimize performance, in terms of
functionality and reliability. By definition, these architectures are pro-
prietary because each company will develop its own interdependent
design to optimize performance in a different way. When we use the
term interdependent architecture in this chapter, readers can substi-
tute as synonyms optimized and proprietary architecture.
In contrast, a modular interface is a clean one, in which there are
no unpredictable interdependencies across components or stages of
the value chain. Modular components fit and work together in well-
understood and highly defined ways. A modular architecture specifies
the fit and function of all elements so completely that it doesn’t mat-
ter who makes the components or subsystems, as long as they meet
the specifications. Modular components can be developed in indepen-
dent work groups or by different companies working at arm’s length.
Modular architectures optimize flexibility, but because they re-
quire tight specification, they give engineers fewer degrees of free-
dom in design. As a result, modular flexibility comes at the sacrifice
of performance.3
Pure modularity and interdependence are the ends of a spectrum:
Most products fall somewhere between these extremes. As we shall
see, companies are more likely to succeed when they match product
architecture to their competitive circumstances.
Competing with Interdependent Architecture
in a Not-Good-Enough World
The left side of figure 5-1 indicates that when there is a performance
gap—when product functionality and reliability are not yet good
enough to address the needs of customers in a given tier of the
T H EI N N O V A T O R ’ SS O L U T I O N4
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market—companies must compete by making the best possible prod-
ucts. In the race to do this, firms that build their products around pro-
prietary, interdependent architectures enjoy an important competitive
advantage against competitors whose product architectures are mod-
ular, because the standardization inherent in modularity takes too
many degrees of design freedom away from engineers, and they can-
not optimize performance.
To close the performance gap with each new product generation,
competitive forces compel engineers to fit the pieces of their systems
together in ever-more-efficient ways in order to wring the most
performance possible out of the technology that is available. When
firms must compete by making the best possible products, they can-
not simply assemble standardized components, because from an en-
gineering point of view, standardization of interfaces (meaning fewer
degrees of design freedom) would force them to back away from the
frontier of what is technologically possible. When the product is not
good enough, backing off from the best that can be done means that
you’ll fall behind.
Companies that compete with proprietary, interdependent archi-
tectures must be integrated: They must control the design and manu-
facture of every critical component of the system in order to make
any piece of the system. As an illustration, during the early days of
the mainframe computer industry, when functionality and reliability
were not yet good enough to satisfy the needs of mainstream cus-
tomers, you could not have existed as an independent contract man-
ufacturer of mainframe computers because the way the machines
were designed depended on the art that would be used in manufac-
turing, and vice versa. There was no clean interface between design
and manufacturing. Similarly, you could not have existed as an inde-
pendent supplier of operating systems, core memory, or logic circuitry
to the mainframe industry because these key subsystems had to be
interdependently and iteratively designed, too.4
New, immature technologies are often drafted into use as sustain-
ing improvements when functionality is not good enough. One reason
why entrant companies rarely succeed in commercializing a radically
new technology is that breakthrough sustaining technologies are
rarely plug-compatible with existing systems of use.5 There are almost
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always many unforseen interdependencies that mandate change in
other elements of the system before a viable product that incorporates
a radically new technology can be sold. This makes the new product
development cycle tortuously long when breakthrough technology is
expected to be the foundation for improved performance. The use of
advanced ceramics materials in engines, the deployment of high-
bandwidth DSL lines at the “last mile” of the telecommunications in-
frastructure, the building of superconducting electric motors for ship
propulsion, and the transition from analog to digital to all-optical
telecommunications networks could all only be accomplished by ex-
tensively integrated companies whose scope could encompass all of
the interdependencies that needed to be managed. This is treacherous
terrain for entrants.
For these reasons it wasn’t just IBM that dominated the early com-
puter industry by virtue of its integration. Ford and General Motors,
as the most integrated companies, were the dominant competitors
during the not-good-enough era of the automobile industry’s history.
For the same reasons, RCA, Xerox, AT&T, Standard Oil, and US Steel
dominated their industries at similar stages. These firms enjoyed near-
monopoly power. Their market dominance was the result of the not-
good-enough circumstance, which mandated interdependent product
or value chain architectures and vertical integration.6 But their hege-
mony proved only temporary, because ultimately, companies that have
excelled in the race to make the best possible products find themselves
making products that are too good. When that happens, the intricate
fabric of success of integrated companies like these begins to unravel.
Overshooting and Modularization
One symptom that these changes are afoot—that the functionality
and reliability of a product have become too good—is that salespeo-
ple will return to the office cursing a customer: “Why can’t they see
that our product is better than the competition? They’re treating it
like a commodity!” This is evidence of overshooting. Such companies
find themselves on the right side of figure 5-1, where there is a perfor-
mance surplus. Customers are happy to accept improved products,
but they’re unwilling to pay a premium price to get them.7
T H EI N N O V A T O R ’ SS O L U T I O N6
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Overshooting does not mean that customers will no longer pay for
improvements. It just means that the type of improvement for which
they will pay a premium price will change. Once their requirements
for functionality and reliability have been met, customers begin to re-
define what is not good enough. What becomes not good enough is
that customers can’t get exactly what they want exactly when they
need it, as conveniently as possible. Customers become willing to pay
premium prices for improved performance along this new trajectory
of innovation in speed, convenience, and customization. When this
happens, we say that the basis of competition in a tier of the market
has changed.
The pressure of competing along this new trajectory of improve-
ment forces a gradual evolution in product architecture, as depicted in
figure 5-1—away from the interdependent, proprietary architectures
that had the advantage in the not-good-enough era toward modular
designs in the era of performance surplus. Modular architectures help
companies to compete on the dimensions that matter in the lower-
right portions of the disruption diagram. Companies can introduce
new products faster because they can upgrade individual subsystems
without having to redesign everything. Although standard interfaces
invariably force compromise in system performance, firms have the
slack to trade away some performance with these customers because
functionality is more than good enough.
Modularity has a profound impact on industry structure because
it enables independent, nonintegrated organizations to sell, buy, and
assemble components and subsystems.8 Whereas in the interdepen-
dent world you had to make all of the key elements of the system in
order to make any of them, in a modular world you can prosper by
outsourcing or by supplying just one element. Ultimately, the specifi-
cations for modular interfaces will coalesce as industry standards.
When that happens, companies can mix and match components from
best-of-breed suppliers in order to respond conveniently to the spe-
cific needs of individual customers.
As depicted in figure 5-1, these nonintegrated competitors disrupt
the integrated leader. Although we have drawn this diagram in two di-
mensions for simplicity, technically speaking they are hybrid disrup-
tors because they compete with a modified metric of performance on
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the vertical axis of the disruption diagram, in that they strive to de-
liver rapidly exactly what each customer needs. Yet, because their
nonintegrated structure gives them lower overhead costs, they can
profitably pick off low-end customers with discount prices.
From Interdependent to Modular Design—and Back
The progression from integration to modularization plays itself out
over and over as products improve enough to overshoot customers’
requirements.9 When wave after wave of sequential disruptions sweep
through an industry, this progression repeats itself within each wave.
In the original mainframe value network of the computer industry, for
example, IBM enjoyed unquestioned dominance in the first decade
with its interdependent architectures and vertical integration. In
1964, however, it responded to cost, complexity, and time-to-market
pressure by creating a more modular design starting with its System
360. Modularization forced IBM to back away from the frontier of
functionality, shifting from the left to the right trajectory of perfor-
mance improvement in figure 5-1. This created space at the high end
for competitors such as Control Data and Cray Research, whose in-
terdependent architectures continued to push the bleeding edge of
what was possible.
Opening its architecture was not a mistake for IBM: The eco-
nomics of competition forced it to take these steps. Indeed, modular-
ity reduced development and production costs and enabled IBM to
custom-configure systems for each customer. This created a major
new wave of growth in the industry. Another effect of modulariza-
tion, however, was that nonintegrated companies could begin to
compete effectively. A population of nonintegrated suppliers of plug-
compatible components and subsystems such as disk drives, printers,
and data input devices enjoyed lower overhead costs and began dis-
rupting IBM en masse.10
This cycle repeated itself when minicomputers began their new-
market disruption of mainframes. Digital Equipment Corporation
initially dominated that industry with its proprietary architecture
when minicomputers really weren’t very good, because its hardware
and operating system software were interdependently designed to
T H EI N N O V A T O R ’ SS O L U T I O N8
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maximize performance. As functionality subsequently approached ad-
equacy, however, other competitors such as Data General, Wang Lab-
oratories, and Prime Computer that were far less integrated but much
faster to market began taking significant share.11 As happened in main-
frames, the minicomputer market boomed because of the better and
less-expensive products that this intensified competition created.
The same sequence occurred in the personal computer wave of dis-
ruption. During the early years, Apple Computer—the most inte-
grated company with a proprietary architecture—made by far the best
desktop computers. They were easier to use and crashed much less
often than computers of modular construction. Ultimately, when the
functionality of desktop machines became good enough, IBM’s mod-
ular, open-standard architecture became dominant. Apple’s propri-
etary architecture, which in the not-good-enough circumstance was a
competitive strength, became a competitive liability in the more-than-
good-enough circumstance. Apple as a consequence was relegated to
niche-player status as the growth explosion in personal computers
was captured by the nonintegrated providers of modular machines.
The same transition will have occurred before long in the next two
waves of disruptive computer products—notebook computers and
hand-held wireless devices. The companies that are most successful in
the beginning are those with optimized, interdependent architectures.
Companies whose strategy is prematurely modular will struggle to be
performance-competitive during the early years when performance is
the basis of competition. Later, architectures and industry structures
will evolve toward openness and disintegration.
Figure 5-2 summarizes these transitions in the personal computer
industry in a simplified way, showing how the proprietary systems
and vertically integrated company that was strongest during the in-
dustry’s initial not-good-enough years gave way to a nonintegrated,
horizontally stratified population of companies in its later years. It
almost looks like the industry got pushed through a bologna slicer.
The chart would look similar for each of the value networks in the
industry. In each instance, the driver of modularization and disinte-
gration was not the passage of time or the “maturation” of the in-
dustry per se.12 What drives this process is this predictable causal
sequence:
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1. The pace of technological improvement outstrips the ability of
customers to utilize it, so that a product’s functionality and reli-
ability that were not good enough at one point overshoot what
customers can utilize at a later point.
2. This forces companies to compete differently: The basis of com-
petition changes. As customers become less and less willing to re-
ward further improvements in functionality and reliability with
premium prices, those suppliers that get better and better at con-
veniently giving customers exactly what they want when they
need it are able to earn attractive margins.
3. As competitive pressures force companies to be as fast and
responsive as possible, they solve this problem by evolving the
architecture of their products from being proprietary and inter-
dependent toward being modular.
4. Modularity enables the dis-integration of the industry. A popula-
tion of nonintegrated firms can now outcompete the integrated
firms that had dominated the industry. Whereas integration at
one point was a competitive necessity, it later becomes a compet-
itive disadvantage.13
T H EI N N O V A T O R ’ SS O L U T I O N
F I G U R E5 – 2
The Transition from Vertical Integration to Horizontal Stratification in
the Microprocessor-Based Computer Industry
1978 1990
Independent Contractors
Components
Product Design
Assembly
Operating System
Applications Software
Sales and Distribution
Field Service
A
p
p
le
S
ili
c
o
n
G
ra
p
h
ic
s
H
P
W
o
rk
st
a
ti
o
n
s
a
n
d
S
e
rv
e
rs
Intel, Motorola, Micron, MIPS, Samsung, etc.
Compaq
Dell, Gateway, etc.
Contract Assemblers
Microsoft
Word Perfect, Lotus, Borland, etc.
Businessland,
MicroAge, etc.
Dell, CompUSA
10
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Figure 5-2 is simplified, in that the integrated business model did
not disappear overnight—rather, it became less dominant as the tra-
jectory of performance improvement passed through each tier of each
market and the modular model gradually became more dominant.
We emphasize that the circumstances of performance gaps and
performance surpluses drive the viability of these strategies of archi-
tecture and integration. This means, of course, that if the circumstances
change again, the strategic approach must also change. Indeed, after
1990 there has been some reintegration in the computer industry. We
describe one factor that drives reintegration in the next section, and
return to it in chapter 6.
The Drivers of Reintegration
Because the trajectory of technological improvement typically out-
strips the ability of customers in any given tier of the market to utilize
it, the general current flows from interdependent architectures and in-
tegrated companies toward modular architectures and nonintegrated
companies. But remember, customers’ needs change too. Usually this
happens at a relatively slower pace, as suggested by the dotted lines
on the disruption diagram. On occasion there can be a discontinuous
shift in the functionality that customers demand, essentially shifting
the dotted line in figure 5-1 upward. This flips the industry back to-
ward the left side of the diagram and resets the clock into an era in
which integration once again is the source of competitive advantage.
For example, in the early 1980s Apple Computer’s products em-
ployed a proprietary architecture involving extensive interdependence
within the software and across the hardware–software interface. By
the mid-1980s, however, a population of specialized firms such as
WordPerfect and Lotus, whose products plugged into Microsoft’s
DOS operating system through a well-defined interface, had arisen to
dethrone Apple’s dominance in software. Then in the early 1990s,
the dotted lines of functionality that customers needed in PC soft-
ware seemed to shift up as customers began demanding to transfer
graphics and spreadsheet files into word processing documents, and
so on. This created a performance gap, flipping the industry to the
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not-good-enough side of the world where fitting interdependent
pieces of the system together became competitively critical again.
In response, Microsoft interdependently knitted its Office suite of
products (and later its Web browser) into its Windows operating sys-
tem. This helped it stretch so much closer to what customers needed
than could the population of focused firms that the nonintegrated
software companies, including WordPerfect and Lotus’s 123 spread-
sheet, vaporized very quickly. Microsoft’s dominance did not arise
from monopolistic malfeasance. Rather, its integrated value chain
under not-good-enough conditions enabled it to make products
whose performance came closer to what customers needed than could
nonintegrated competitors under those conditions.14
Today, however, things may be poised to flip again. As computing
becomes more Internet-centric, operating systems with modular ar-
chitectures (such as Linux), and modular programming languages
(such as Java) constitute hybrid disruptions relative to Microsoft.
This modularity is enabling a population of specialized firms to
begin making incursions into this industry.
In a similar way, fifteen years ago in optical telecommunications
the bandwidth available over a fiber was more than good enough for
voice communication; as a consequence, the industry structure was
horizontally stratified, not vertically integrated. Corning made the
optical fiber, Siemens cabled it, and other companies made the multi-
plexers, the amplifiers, and so on. As the screams for more bandwidth
intensified in the late 1990s, the dotted line in figure 5-1 shifted up,
and the industry flipped into a not-good-enough situation. Corning
found that it could not even design its next generation of fiber if it did
not interdependently design the amplifier, for example. It had to inte-
grate across this interface in order to compete, and it did so. Within a
few years, there was more than enough bandwidth over a fiber, and
the rationale for being vertically integrated disappeared again.
The general rule is that companies will prosper when they are inte-
grated across interfaces in the value chain where performance, how-
ever it is defined at that point, is not good enough relative to what
customers require at the next stage of value addition. There are often sev-
eral of these points in the complete value-added chain of an industry.
This means that an industry will rarely be completely nonintegrated or
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integrated. Rather, the points at which integration and nonintegration
are competitively important will predictably shift over time.15 We re-
turn to this notion in greater detail in chapter 6.
Aligning Your Architecture Strategy to Your Circumstances
In a modular world, supplying a component or assembling out-
sourced components are both appropriate “solutions.” In the interde-
pendent world of inadequate functionality, attempting to provide one
piece of the system doesn’t solve anybody’s problem. Knowing this,
we can predict the failure or success of a growth business based on
managers’ choices to compete with modular architectures when the
circumstances mandate interdependence, and vice versa.
Attempting to Grow a Nonintegrated Business
When Functionality Isn’t Good Enough
It’s tempting to think you can launch a new-growth business by pro-
viding one piece of a modular product’s value. Managers often see
specialization as a less daunting path to entry than providing an entire
system solution. It costs less and allows the entrant to focus on what
it does best, leaving the rest of the solution to other partners in the
ecosystem. This works in the circumstances in the lower-right por-
tions of the disruption diagram. But when functionality and reliabil-
ity are inadequate, the seemingly lower hurdle that partnering or
outsourcing seems to present usually proves illusory, and causes many
growth ventures to fail. Modularity often is not technologically or
competitively possible during the early stages of many disruptions.
To succeed with a nonintegrated, specialist strategy, you need to be
certain you’re competing in a modular world. Three conditions must
be met in order for a firm to procure something from a supplier or
partner, or to sell it to a customer. First, both suppliers and customers
need to know what to specify—which attributes of the component are
crucial to the operation of the product system, and which are not. Sec-
ond, they must be able to measure those attributes so that they can
verify that the specifications have been met. Third, there cannot be
any poorly understood or unpredictable interdependencies across the
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customer–supplier interface. The customer needs to understand how
the subsystem will interact with the performance of other pieces of the
system so that it can be used with predictable effect. These three con-
ditions—specifiability, verifiability, and predictability—constitute an
effective modular interface.
When product performance is not good enough—when competi-
tion forces companies to use new technologies in nonstandard prod-
uct architectures to stretch performance as far as possible—these
three conditions often are not met. When there are complex, recipro-
cal, unpredictable interdependencies in the system, a single organiza-
tion’s boundaries must span those interfaces. People cannot efficiently
resolve interdependent problems while working at arm’s length across
an organizational boundary.16
Modular Failures in Interdependent Circumstances
In 1996 the United States government passed legislation to stimulate
competition in local telecommunication services. The law mandated
that independent companies be allowed to sell services to residential
and business customers and then to plug into the switching infra-
structure of the incumbent telephone companies. In response, many
nonintegrated competitive local exchange carriers (CLECs) such as
Northpoint Communications attempted to offer high-speed DSL ac-
cess to the Internet. Corporations and venture capitalists funneled bil-
lions of dollars into these companies.
The vast majority of CLECs failed. This is because DSL service
was in the interdependent realm of figure 5-1. There were too many
subtle and unpredictable interdependencies between what the CLECs
did when they installed service on a customer’s premises and what
the telephone company had to do in response. It wasn’t necessarily
the technical interface that was the problem. The architecture of the
telephone companies’ billing system software, for example, was
interdependent—making it very difficult to account and bill for the
cost of a “plugged-in” CLEC customer. The fact that the telephone
companies were integrated across these interdependent interfaces gave
them a powerful advantage. They understood their own network
and IT system architectures and could consequently deploy their
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offerings more quickly with fewer concerns about the unintended
consequences of reconfiguring their own central office facilities.17
Similarly, in the eagerly anticipated wireless-access-to-data-over-
the-Internet industry, most European and North American competi-
tors tried to enter as nonintegrated specialists, providing one element
of the system. They relied prematurely on industry standards such as
Wireless Applications Protocol (WAP) to define the interfaces be-
tween the handset device, the network, and the new content being de-
veloped. Companies within each link in the value chain were left to
their own devices to determine how best to exploit the wireless Inter-
net. Almost no revenues and billions in losses have resulted. The
“partnering” theology that had become de rigueur among telecom-
munications investors and entrepreneurs who had watched Cisco
succeed by partnering turned out to be misapplied in a different cir-
cumstance in which it couldn’t work—with tragic consequences.
Appropriate Integration
In contrast, Japan’s NTT DoCoMo and J-Phone have approached the
new-market disruptive opportunity of the wireless Internet with far
greater integration across stages of the value chain. These growth ven-
tures already claim tens of millions of customers and billions in rev-
enue.18 Although they do not own every upstream or downstream
connection in the value chain, DoCoMo and J-Phone carefully man-
age the interfaces with their content providers and handset manufac-
turers. Their interdependent approach allows them to surmount the
technological limitations of wireless data and to create user inter-
faces, a revenue model, and a billing infrastructure that make the cus-
tomer experience as seamless as possible.19
The DoCoMo and J-Phone networks comprise competing, propri-
etary systems. Isn’t this inefficient? Executives and investors indeed
are often eager to hammer out the standards before they invest their
money, to preempt wasteful duplication of competing standards and
the possibility that a competitor’s approach might emerge as the in-
dustry’s standard. This works when functionality and reliability and
the consequent competitive conditions permit it. But when they do
not, then having competing proprietary systems is not wasteful.20 Far
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more is wasted when huge sums are spent on an architectural ap-
proach that does not fit the basis of competition. True, one system ul-
timately may define the standard, and those whose standards do not
prevail may fall by the wayside after their initial success, or they may
become niche players. Competition of this sort inspired Adam Smith
and Charles Darwin to write their books.
Parenthetically, we note that in some of its ventures abroad, such
as in its partnership with AT&T Wireless in the United States, Do-
CoMo has followed its partners’ strategy of adopting industry stan-
dards with less vertical integration and has stumbled badly, just like
its American and European counterparts. It’s not DoCoMo that
makes the difference. It’s employing the right strategy in the right cir-
cumstances that makes the difference.
Being in the Right Place at the Right Time
We noted earlier that the pure forms of interdependence and modu-
larity are the extremes on a continuum, and companies may choose
strategies anywhere along the spectrum at any point in time. A com-
pany may not necessarily fail if it starts with a prematurely modular
architecture when the basis of competition is functionality and relia-
bility. It will simply suffer from an important competitive disadvan-
tage until the basis of competition shifts and modularity becomes the
predominant architectural form. This was the experience of IBM and
its clones in the personal computer industry. The superior perfor-
mance of Apple’s computers did not preclude IBM from succeeding.
IBM just had to fight its performance disadvantage because it opted
prematurely for a modular architecture.
What happens to the initial leaders when they overshoot, after
having jumped ahead of the pack with performance and reliability ad-
vantages that were grounded in proprietary architecture? The answer
is that they need to modularize and open up their architectures and
begin aggressively to sell their subsystems as modules to other com-
panies whose low-cost assembly capability can help grow the market.
Had good theory been available to provide guidance, for example,
there is no reason why the executives of Apple Computer could not
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have modularized their design and have begun selling their operating
system with its interdependent applications to other computer assem-
blers, preempting Microsoft’s development of Windows. Nokia ap-
pears today to be facing the same decision. We sense that adding even
more features and functions to standard wireless handsets is over-
shooting what its less-demanding customers can utilize; and a dis-
integrated handset industry that utilizes Symbian’s operating system
is rapidly gaining traction. The next chapter will show that a com-
pany can begin with a proprietary architecture when disruptive cir-
cumstances mandate it, and then, when the basis of competition
changes, open its architecture to become a supplier of key subsystems
to low-cost assemblers. If it does this, it can avoid the traps of be-
coming a niche player on the one hand and the supplier of an undif-
ferentiated commodity on the other. The company can become
capitalism’s equivalent of Wayne Gretzky, the hockey great. Gretzky
had an instinct not to skate to where the puck presently was on the
ice, but instead to skate to where the puck was going to be. Chapter 6
can help managers steer their companies not to the profitable busi-
nesses of the past, but to where the money will be.
There are few decisions in building and sustaining a new-growth
business that scream more loudly for sound, circumstance-based the-
ory than those addressed in this chapter. When the functionality and
reliability of a product are not good enough to meet customers’
needs, then the companies that will enjoy significant competitive
advantage are those whose product architectures are proprietary
and that are integrated across the performance-limiting interfaces
in the value chain. When functionality and reliability become more
than adequate, so that speed and responsiveness are the dimensions
of competition that are not now good enough, then the opposite is
true. A population of nonintegrated, specialized companies whose
rules of interaction are defined by modular architectures and in-
dustry standards holds the upper hand.
At the beginning of a wave of new-market disruption, the com-
panies that initially will be the most successful will be integrated
firms whose architectures are proprietary because the product
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isn’t yet good enough. After a few years of success in performance
improvement, those disruptive pioneers themselves become sus-
ceptible to hybrid disruption by a faster and more flexible popula-
tion of nonintegrated companies whose focus gives them lower
overhead costs.
For a company that serves customers in multiple tiers of the
market, managing the transition is tricky, because the strategy and
business model that are required to successfully reach unsatisfied
customers in higher tiers are very different from those that are nec-
essary to compete with speed, flexibility, and low cost in lower
tiers of the market. Pursuing both ends at once and in the right
way often requires multiple business units—a topic that we ad-
dress in the next two chapters.
Notes
1. We are indebted to a host of thoughtful researchers who have framed the ex-
istence and the role of core and competence in making these decisions. These
include C. K. Prahalad and Gary Hamel, “The Core Competence of the Cor-
poration,” Harvard Business Review, May–June 1990, 79–91; and Geoffrey
Moore, Living on the Fault Line (New York: HarperBusiness, 2002). It is
worth noting that “core competence,” as the term was originally coined by
C. K. Prahalad and Gary Hamel in their seminal article, was actually an
apology for the diversified firm. They were developing a view of diversifica-
tion based on the exploitation of established capabilities, broadly defined.
We interpret their work as consistent with a well-respected stream of re-
search and theoretical development that goes all the way back to Edith Pen-
rose’s 1959 book The Theory of the Growth of the Firm (New York: Wiley).
This line of thinking is very powerful and useful. As it is used now, however,
the term “core competence” has become synonymous with “focus”; that is,
firms that seek to exploit their core competence do not diversify—if any-
thing, they focus their business on those activities that they do particularly
well. It is this “meaning in use” that we feel is misguided.
2. IBM arguably had much deeper technological capability in integrated circuit
and operating system design and manufacturing than did Intel or Microsoft
at the time IBM put these companies into business. It probably is more cor-
rect, therefore, to say that this decision was based more on what was core
than what was competence. The sense that IBM needed to outsource was
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based on the correct perception of the new venture’s managers that they
needed a far lower overhead cost structure to become acceptably profitable
to the corporation and needed to be much faster in new-product develop-
ment than the company’s established internal development processes, which
had been honed in a world of complicated interdependent products with
longer development cycles, could handle.
3. In the past decade there has been a flowering of important studies on these
concepts. We have found the following ones to be particularly helpful: Re-
becca Henderson and Kim B. Clark, “Architectural Innovation: The Recon-
figuration of Existing Product Technologies and the Failure of Established
Firms,” Administrative Science Quarterly 35 (1990): 9–30; K. Monteverde,
“Technical Dialog as an Incentive for Vertical Integration in the Semicon-
ductor Industry,” Management Science 41 (1995): 1624–1638; Karl Ulrich,
“The Role of Product Architecture in the Manufacturing Firm,” Research
Policy 24 (1995): 419–440; Ron Sanchez and J. T. Mahoney, “Modularity,
Flexibility and Knowledge Management in Product and Organization De-
sign,” Strategic Management Journal 17 (1996): 63–76; and Carliss Baldwin
and Kim B. Clark, Design Rules: The Power of Modularity (Cambridge,
MA: MIT Press, 2000).
4. The language we have used here characterizes the extremes of interdepen-
dence, and we have chosen the extreme end of the spectrum simply to make
the concept as clear as possible. In complex product systems, there are vary-
ing degrees of interdependence, which differ over time, component by com-
ponent. The challenges of interdependence can also be dealt with to some
degree through the nature of supplier relationships. See, for example, Jeffrey
Dyer, Collaborative Advantage: Winning Through Extended Enterprise Sup-
plier Networks (New York: Oxford University Press, 2000).
5. Many readers have equated in their minds the terms disruptive and break-
through. It is extremely important, for purposes of prediction and under-
standing, not to confuse the terms. Almost invariably, what prior writers
have termed “breakthrough” technologies have, in our parlance, a sustain-
ing impact on the trajectory of technological progress. Some sustaining
innovations are simple, incremental year-to-year improvements. Other sus-
taining innovations are dramatic, breakthrough leapfrogs ahead of the com-
petition, up the sustaining trajectory. For predictive purposes, however, the
distinction between incremental and breakthrough technologies rarely mat-
ters. Because both types have a sustaining impact, the established firms typ-
ically triumph. Disruptive innovations usually do not entail technological
breakthroughs. Rather, they package available technologies in a disruptive
business model. New breakthrough technologies that emerge from research
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labs are almost always sustaining in character, and almost always entail un-
predictable interdependencies with other subsystems in the product. Hence,
there are two powerful reasons why the established firms have a strong ad-
vantage in commercializing these technologies.
6. Professor Alfred Chandler’s The Visible Hand (Cambridge, MA: Belknap
Press, 1977) is a classic study of how and why vertical integration is critical
to the growth of many industries during their early period.
7. Economists’ concept of utility, or the satisfaction that customers receive
when they buy and use a product, is a good way to describe how competi-
tion in an industry changes when this happens. The marginal utility that cus-
tomers receive is the incremental addition to satisfaction that they get from
buying a better-performing product. The increased price that they are will-
ing to pay for a better product will be proportional to the increased utility
they receive from using it—in other words, the marginal price improvement
will equal the improvement in marginal utility. When customers can no longer
utilize further improvements in a product, marginal utility falls toward zero,
and as a result customers become unwilling to pay higher prices for better-
performing products.
8. Sanchez and Mahoney, in “Modularity, Flexibility and Knowledge Manage-
ment in Product and Organization Design,” were among the first to describe
this phenomenon.
9. The landmark work of Professors Carliss Baldwin and Kim B. Clark, cited
in note 3, describes the process of modularization in a cogent, useful way.
We recommend it to those who are interested in studying the process in
greater detail.
10. Many students of IBM’s history will disagree with our statement that com-
petition forced the opening of IBM’s architecture, contending instead that
the U.S. government’s antitrust litigation forced IBM open. The antitrust ac-
tion clearly influenced IBM, but we would argue that government action or
not, competitive and disruptive forces would have brought an end to IBM’s
position of near-monopoly power.
11. Tracy Kidder’s Pulitzer Prize–winning account of product development at
Data General, The Soul of a New Machine (New York: Avon Books, 1981),
describes what life was like as the basis of competition began to change in
the minicomputer industry.
12. MIT Professor Charles Fine has written an important book on this topic as
well: Clockspeed (Reading, MA: Perseus Books, 1998). Fine observed that
industries go through cycles of integration and nonintegration in a sort of
“double helix” cycle. We hope that the model outlined here and in chapter 6
both confirms and adds causal richness to Fine’s findings.
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13. The evolving structure of the lending industry offers a clear example of these
forces at work. Integrated banks such as J.P. Morgan Chase have powerful
competitive advantages in the most complex tiers of the lending market.
Integration is key to their ability to knit together huge, complex financing
packages for sophisticated and demanding global customers. Decisions
about whether and how much to lend cannot be made according to fixed for-
mulas and measures; they can only be made through the intuition of experi-
enced lending officers.
Credit scoring technology and asset securitization, however, are disrupting
and dis-integrating the simpler tiers of the lending market. In these tiers,
lenders know and can measure precisely those attributes that determine
whether borrowers will repay a loan. Verifiable information about borrow-
ers—such as how long they have lived where they live, how long they have
worked where they work, what their income is, and whether they’ve paid other
bills on time—is combined to make algorithm-based lending decisions. Credit
scoring took root in the 1960s in the simplest tier of the lending market, in de-
partment stores’ decisions to issue their own credit cards. Then, unfortunately
for the big banks, the disruptive horde moved inexorably up-market in pursuit
of profit—first to general consumer credit card loans, then to automobile loans
and mortgage loans, and now to small business loans. The lending industry in
these simpler tiers of the market has largely dis-integrated. Specialist nonbank
companies have emerged to provide each slice of added value in these tiers of
the lending industry. Whereas integration is a big advantage in the most com-
plex tiers of the market, in overserved tiers it is a disadvantage.
14. Our conclusions support those of Stan J. Liebowitz and Stephen E. Margo-
lis in Winners, Losers & Microsoft: Competition and Antitrust in High Tech-
nology (Oakland, CA: Independent Institute, 1999).
15. Another good illustration of this is the push being made by Apple Computer,
at the time of this writing, to be the gateway to the consumer for multimedia
entertainment. Apple’s interdependent integration of the operating system
and applications creates convenience, which customers value at this point
because convenience is not yet good enough.
16. Specifiability, measurability, and predictability constitute what an economist
would term “sufficient information” for an efficient market to emerge at an
interface, allowing organizations to deal with each other at arm’s length. A
fundamental tenet of capitalism is that the invisible hand of market compe-
tition is superior to that of managerial oversight as a coordinating mecha-
nism between actors in a market. This is why, when a modular interface
becomes defined, an industry will dis-integrate at that interface. However,
when specifiability, measurability, and predictability do not exist, efficient
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markets cannot function. It is under these circumstances that managerial
oversight and coordination perform better than market competition as a co-
ordinating mechanism.
This is an important underpinning of the award-winning findings of Pro-
fessor Tarun Khanna and his colleagues, which show that in developing
economies, diversified business conglomerates outperform focused, indepen-
dent companies, whereas the reverse is true in developed economies. See, for
example, Tarun Khanna and Krishna G. Palepu, “Why Focused Strategies
May Be Wrong for Emerging Markets,” Harvard Business Review, July–Au-
gust 1997, 41–51; and Tarun Khanna and Jan Rivkin, “Estimating the
Performance Effects of Business Groups in Emerging Markets,” Strategic
Management Journal 22 (2001): 45–74.
A bedrock set of concepts in understanding why organizational integra-
tion is critical when the conditions of modularity are not met is developed in
the transaction cost economics (TCE) school of thought, which traces its ori-
gins to the work of Ronald Coase (R. H. Coase, “The Nature of the Firm,”
Econometrica 4 [1937]: 386–405). Coase argued that firms were created
when it got “too expensive” to negotiate and enforce contracts between oth-
erwise “independent” parties. More recently, the work of Oliver Williamson
has proven seminal in the exploration of transaction costs as a determinant
of firm boundaries. See, for example, O. E. Williamson, Markets and Hier-
archies (New York: Free Press, 1975); “Transaction Cost Economics,” in
The Economic Institutions of Capitalism, ed., O. E. Williamson (New York:
Free Press, 1985), 15– 42; and “Transaction-Cost Economics: The Gover-
nance of Contractual Relations,” in Organiational Economics, ed., J. B. Bar-
ney and W. G. Ouichi (San Francisco: Jossey-Bass, 1986). In particular, TCE
has been used to explain the various ways in which firms might expand their
operating scope: either through unrelated diversification (C. W. L. Hill, et
al., “Cooperative Versus Competitive Structures in Related and Unrelated
Diversified Firms,” Organization Science 3, no. 4 [1992]: 501–521); related
diversification (D. J. Teece, “Economics of Scope and the Scope of the En-
terprise,” Journal of Economic Behavior and Organization 1 [1980]:
223–247); and D. J. Teece, “Toward an Economic Theory of the Multiprod-
uct Firm,” Journal of Economic Behavior and Organization 3 [1982],
39–63); or vertical integration (K. Arrow, The Limits of Organization [New
York: W. W. Norton, 1974]; B. R. G. Klein, et al., “Vertical Integration, Ap-
propriable Rents and Competitive Contracting Process,” Journal of Law
and Economics 21 [1978] 297–326; and K. R. Harrigan, “Vertical Integra-
tion and Corporate Strategy,” Academy of Management Journal 28, no. 2
[1985]: 397–425). More generally, this line of research is known as the
“market failures” paradigm for explaining changes in firm scope (K. N. M.
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Dundas, and P. R. Richardson, “Corporate Strategy and the Concept of
Market Failure,” Strategic Management Journal 1, no. 2 [1980]: 177–188).
Our hope is that we have advanced this line of thinking by elaborating more
precisely the considerations that give rise to the contracting difficulties that
lie at the heart of the TCE school.
17. Even if the incumbent local exchange carriers (ILECs) didn’t understand all
the complexities and unintended consequences better than CLEC engineers,
organizationally they were much better positioned to resolve any difficulties,
since they could appeal to organizational mechanisms rather than have to
rely on cumbersome and likely incomplete ex ante contracts.
18. See Jeffrey Lee Funk, The Mobile Internet: How Japan Dialed Up and the
West Disconnected (Hong Kong: ISI Publications, 2001). This really is an
extraordinarily insightful study from which a host of insights can be
gleaned. In his own language, Funk shows that another important reason
why DoCoMo and J-Phone were so successful in Japan is that they followed
the pattern that we describe in chapters 3 and 4 of this book. They initially
targeted customers who were largely non-Internet users (teenaged girls) and
helped them get done better a job that they had already been trying to do:
have fun with their friends. Western entrants into this market, in contrast,
envisioned sophisticated offerings to be sold to current customers of mobile
phones (who primarily used them for business) and current users of the wire-
line Internet. An internal perspective on this development can be found in
Mari Matsunaga, The Birth of I-Mode: An Analogue Account of the Mobile
Internet (Singapore: Chuang Yi Publishing, 2001). Matsunaga was one of
the key players in the development of i-mode at DoCoMo.
19. See “Integrate to Innovate,” a Deloitte Research study by Michael E. Raynor
and Clayton M. Christensen. Available at , or upon
request from delresearch@dc.com.
20. Some readers who are familiar with the different experiences of the Euro-
pean and American mobile telephony industries may take issue with this
paragraph. Very early on, the Europeans coalesced around a prenegotiated
standard called GSM, which enabled mobile phone users to use their phones
in any country. Mobile phone usage took off more rapidly and achieved
higher penetration rates than in America, where several competing stan-
dards were battling it out. Many analysts have drawn the general conclusion
from the Europeans’ strategy of quickly coalescing around a standard that it
is always advisable to avoid the wasteful duplication of competing mutually
incompatible architectures. We believe that the benefits of a single standard
have been largely exaggerated, and that other important differences between
the United States and Europe which contributed significantly to the differen-
tial adoption rates have not been given their due.
G e t t i n gt h eS c o p eo ft h eB u s i n e s sR i g h t 23
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First, the benefits of a single standard appear to have manifested them-
selves largely in terms of supply-side rather than demand-side benefits. That
is, by stipulating a single standard, European manufacturers of network equip-
ment and handsets were able to achieve greater scale economies than compa-
nies manufacturing for the North American markets. This might well have
manifested itself in the form of lower prices to consumers; however, the rele-
vant comparison is not the cost of mobile telephony in Europe versus North
America—these services were not competing with each other. The relevant
comparison is with wireline telephony in each respsective market. And here
it is worth noting that wireline local and long distance telephony services are
much more expensive in Europe than in North America, and as a result, wire-
less telephony was a much more attractive substitute for wireline in Europe
than in North America. The putative demand-side benefit of transnational
usage has not, to our knowledge, been demonstrated in the usage patterns of
European consumers. Consequently, we would be willing to suggest that a
far more powerful cause of the relative success of mobile telephony in Europe
was not that schoolgirls from Sweden could use their handset when on holi-
day in Spain, but rather the relative improvement in ease of use and cost pro-
vided by mobile telephony versus the wireline alternative.
Second, and perhaps even more important, European regulation man-
dated that “calling party pays” with respect to mobile phone usage, whereas
North American regulators mandated that “mobile party pays.” In other
words, in Europe, if you call someone’s mobile phone number, you pay the
cost of the call; to the recipient, it’s free. In North America, if someone calls
you on your mobile phone, it’s on your dime. As a result, Europeans were far
freer in giving out their mobile phone numbers, hence increasing the likeli-
hood of usage. For more on this topic, see Strategis Group, “Calling Party
Pays Case Study Analysis; ITU-BDT Telecommunication Regulatory Data-
base”; and ITU Web site: .
Teasing out the effects of each of these contributors (the GSM standard,
lower relative price versus wireline, and calling party pays regulation), as
well as others that might be adduced is not a trivial task. But we would sug-
gest that the impact of the single standard is far less than typically implied,
and certainly is not the principal factor in explaining higher mobile phone
penetration rates in Europe versus North America.
T H EI N N O V A T O R ’ SS O L U T I O N24
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chpt05_8520.pdf
__MACOSX/Course Pack/._Getting the Scope of the Business Right.pdf
Course Pack/Global Value Chain Management.pdf

908M14

ECCO A/S — GLOBAL VALUE CHAIN MANAGEMENT

Professor Bo Bernhard Nielsen, Professor Torben Pedersen and Management Consultant Jacob Pyndt wrote this case solely to
provide material for class discussion.The authors do not intend to illustrate either effective or ineffective handling of a managerial
situation.The authors may have disguised certain names and other identifying information to protect confidentiality.

This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the
permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights
organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western
University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com.

Copyright©2008, Richard Ivey School of Business Foundation Version:2017-05-10

Despite the summer, the weather was hazy on that day in May 2004 as the airplane took off from Hongqiao
International Airport, Shanghai. The plane was likely to encounter some turbulence on its way to
Copenhagen Airport in Denmark. The chief operations officer (COO) of the Danish shoe manufacturer
ECCO A/S (ECCO), Mikael Thinghuus, did not particularly enjoy bumpy flights, but the rough flight
could not overshadow the confidence and optimism he felt after his visit to Xiamen in southeast China.
This was his third visit in three months.

During 2003/2004, ECCO spent substantial resources on analyzing where to establish production facilities
in China. On this trip, together with Flemming Brønd, the production director in China, Thinghuus had
finalized negotiations with Novo Nordisk Engineering (NNE). NNE possessed valuable experience in
building factories in China, experience gained through their work for Novozymes and Novo Nordisk. Now
everything seemed to be in place. Construction was to begin in August, machines would be installed in
January 2005, and the first pair of shoes would be leaving the factory by the end of March 2005 if all went
well. The plan was to build five closely connected factories over the next four years with a total capacity of
five million pairs of shoes per year, serving both export needs and the Chinese market, which was expected
to grow in the future.

Thinghuus felt relieved. He was confident that the massive investments in China would serve as a solid
footstep on a fast growing market and provide a unique export platform to the global shoe market.
However, he could not rest on his laurels. The massive investment in China was an integrated part of
ECCO’s continuous attempt to optimize various activities in the value chain. Operating five distinct
factories in Portugal, Slovakia, Indonesia, Thailand and shortly in China combined with a declared vision
of integrating the global value chain, the task at hand was certainly complicated. Moreover, ECCO had one
tannery located in the Netherlands and two located adjacent to shoe production facilities in Indonesia and
Thailand. These tanneries enabled ECCO to maintain control of leather processing and ensure the quality
of the leather utilized in ECCO’s shoe manufacturing.

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INTRODUCING ECCO

It has always been our philosophy that quality is the only thing that endures. That is why
we constantly work to create the perfect shoe — so good that you forget you are wearing
it. It has to be light and solid, designed on the basis of the newest technology and
knowledge about comfort and materials. ECCO have to be the world’s best shoes — shoes
with internal values.

Karl Toosbuy, founder

With the simple slogan “A perfect fit — a simple idea,” Karl Toosbuy founded ECCO in Bredebro,
Denmark in 1963. Inspired by the open and harsh landscape of southern Jutland, Toosbuy presented ECCO
as a company with a passion for pleasant walking. Today, after more than 40 years of craftsmanship and
dedication to uncompromised quality, ECCO remains extremely committed to comfort, design and a
perfectly fitting shoe with the goal of constantly developing shoes that are pleasant to walk in, regardless of
the weather conditions. The company’s vision is to be the “most wanted brand within innovation and
comfort footwear — a position that only can be attained by constantly and courageously researching new
paths, investing in employees, in our core competencies of product development and production
technology.”1

ECCO aimed at producing the world’s most comfortable and modern footwear for work and leisure.
Footwear for work, leisure and festive occasions had to be designed and constructed with uncompromising
attention to customer comfort. Evidently, trends in the market in terms of fashion and elegance were
important, but usability was ECCO’s highest design priority. As Søren Steffensen, executive vice-
president, stated: “ECCO is not a fashion brand and it never will be. We do not sell shoes where the brand
name is the most important and quality is a secondary consideration. Primarily, we sell high-quality shoes
and that is where we seek recognition.”2

Products and Markets

The ECCO group produces various types of shoes, including casual and outdoor shoes for men, ladies, and
children, as well as semi-sport shoes, for two different seasons — spring/summer and autumn/winter. In
2004, the sales split between the different categories was children 11 per cent, ladies 47 per cent, men 30
per cent, and sport 12 per cent. The sport division produced outdoor, walking, running and golf shoes.
ECCO’s golf shoes category had experienced particularly significant growth. ECCO’s development of golf
shoes had started as a joke between Toosbuy and Dieter Kasprzak, chief executive officer (CEO), on the
golf course 10 years ago. In 2004, the joke turned into 300,000 pairs sold, sponsorships of international
golfers like Thomas Bjørn and Colin Montgomerie, and numerous endorsements in independent tests of
golf equipment in the United States. Having tested ECCO’s golf shoes, Rankmark, an American company
conducting objective tests and analyses of golf products, stated that “ECCO Golf Footwear was preferred
by more than 90 per cent of golfers over their current brands.”

In 2004, ECCO exported more than 90 per cent of its production, with the United States, Germany and
Japan being the main markets. ECCO’s international profile was reflected in the workforce composition. In
the same year, ECCO employed 9,657 employees, of which 553 were located in Denmark. The company
worked constantly on creating new markets, particularly in Asia and Central and Eastern Europe. The

1 http://www.ecco.com/int/en/aboutus/index.jsp, accessed April 2005.
2 Berlingske News Magazine, March 7, 2004.
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North American market — the United States and Canada — was of great importance to ECCO. In 2004,
the company’s American operations attained 17 per cent growth in sales when compared to 2003. That
year, the American operations accounted for DKK 875 million in revenue, roughly 26 per cent of ECCO’s
total sales.3 The American subsidiary had streamlined its vendorship, cutting the number from 1,200 in
2002 to 1,000 in 2004, yet the remaining dealers had purchased a higher volume. In addition, ECCO
increased its number of partnerships by 18 to 34 in 2004. The American market was lucrative as shoes
were selling at high prices. Men’s shoes typically cost between US$150 and US$450 and the highly
successful golf shoes were sold for between US$200 and US$400. The majority of ECCO’s sales in North
America went through exclusive department stores, such as Nordstrom’s and Dillard’s.

FINANCE AND OWNERSHIP STRUCTURE

During the period from 1999 to 2003, ECCO experienced stagnating productivity and declining operating
margins (see Exhibit 1).For instance, the operating margin fell from 15 per cent in 2000 to five per cent in
2002. Moreover, company debts increased from DKK 1 billion to DKK 2 billion following investments in
expansion and inventories. In response to these negative trends, ECCO launched strategic initiatives to
streamline logistics, focus on more modern shoes and facilitate monitoring of the market. 2004 brought
signs of improvement as the company achieved earnings of DKK 150 million and lifted its operating
margin to eight per cent. The reduction of stock had a particularly notable effect on the 2004 result, further
freeing up capital to finance ECCO’s ambitious growth plan. The company’s goal was to increase revenue
to approximately DKK 8 billion to DKK 9 billion by 2013, selling 24 million pairs of shoes per year.

Despite financial constraints in the beginning of the 21st century, which could have triggered an Initial
public offering (IPO) to raise capital, ownership of the company was kept within the family. Prior to his
death, Toosbuy passed on his shares to his daughter, Hanni Toosbuy, who was chairman of the supervisory
board (see Exhibit 2). Commenting on the ownership structure of ECCO, Karl Toosbuy stated:

I do not believe that an IPO is in the best interest of the company. ECCO is stronger given
the family ownership. The family can take higher risks. We are able to allocate. In many
cases, we do not have the time to investigate things as profoundly as a listed company
ought to do. Yet, we are sure that what we want is the right thing. Then we act instead of
waiting.4

Organizational Developments

Operating on a global scale required employees with international mindsets and good adaptability skills.
Since its inception, ECCO had given high priority to the continuous education and training of its
employees. The company invested aggressively in vocational training, career development, developmental
conversations and expatriation. ECCO’s establishment of the Education and Conference Centre in 1994,
the research centre Futura in 1996, and the ECCO Business Academy in 2001 served as signs of
commitment to these issues. According to Karl Toosbuy, these investments were vital to allowing ECCO
to recruit internally for management positions and, thereby, accomplish his strategy announced in 1991.
This strategy stated that 80 per cent of the company’s leaders should come from inside ECCO. Twice
during the 1990s, Toosbuy had stepped down as CEO only to reinstall himself some years later,
underpinning the importance of knowing the company inside-out and adapting to ECCO’s culture.

3 Børsen, December 22, 2004.
4 Børsen, February 20, 1998.
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Despite the founder’s intention of internal recruitment for management positions, on two recent occasions
this ambition could not be met. In 2001, ECCO hired Søren Steffensen in the position of sales and
marketing director. Coming from a position of retail director in the Danish fashion clothing company, Carli
Gry, had a reputation of knowing every shopping corner in Europe and was an efficient negotiator. In
addition, Mikael Thinghuus took over the position of chief operating officer (COO) in 2003, having held
positions at IBM and the East Asiatic Company. The third member of the executive committee was Jens
Christian Meier, executive vice-president, who had spent most of his career within shoe manufacturing. He
actually initiated his career at ECCO, continued at Clarks, and then moved on to Elefanten Shoes as
managing director before returning to ECCO. His main responsibilities lay within the fields of logistics,
sourcing and handling ECCO’s production facilities. When Karl Toosbuy died in June 2004, his son-in-
law, Dieter Kasprzak, became CEO. Kasprzak had spent 23 years with ECCO, primarily as the director of
design and product development. Whereas Toosbuy was known for his abilities to develop unique
production techniques, Kasprzak was a designer by trade and was much more involved in product
development and branding. The death of Toosbuy triggered considerations about future development
becoming more market-oriented. Thinghuus commented: “Evidently, we may learn something from the
marketing oriented firms [Nike, Reebok and Adidas]. We should aim at becoming better at telling what we
stand for. We cannot expect that our unique production technology will last an eternity.”5

ECCO’S GLOBAL VALUE CHAIN

ECCO maintained focus on the entire value chain, or from “cow to shoe” as the company liked to put it.
ECCO bought raw hides and transformed them, into various kinds of leather usable in shoe manufacturing.
Leather constituted the main material in shoe uppers, which were produced at ECCO’s production sites
(see Exhibits 3 and 4). The company owned several tanneries in the Netherlands, Thailand (opened in
1999) and Indonesia, which supplied leather to ECCO’s factories all over the world. ECCO’s 2001
acquisition of the largest tannery in the Netherlands, followed by a tannery and leather research centre in
2002, made it possible to access leading expert knowledge about tanning. ECCO’s Dutch tannery
manufactured around 3,500 rawhides a day, corresponding to approximately one million cows per year.
Apart from providing ECCO’s factories with “wetblue” (see Exhibit 3), the development and research
centre’s main task was to explore less polluting tanning methods and experiment with various kinds of
leather for the coming generation of ECCO shoes. The centre employed 15 specialists who were also
responsible for training employees from Thailand and Indonesia, allowing new technology and improved
tannery methods to be disseminated. ECCO was among the five largest producers of leather worldwide.
The majority of the rawhides originated from Germany, France, Denmark and Finland. Apart from
supplying leather to its shoe factories around the world, it also sold leather to the auto and furniture
industries. Explaining ECCO’s tanning activities, Toosbuy commented: “To us, it is a matter of the level of
ambition. We make high demands on quality and lead times — higher than any of our suppliers have been
able to accommodate. In essence, we really do not have an alternative to being self-sufficient.”6

In addition, the plan was to set up a tannery in conjunction with the factories in China. ECCO’s strategy
was quite unique, as most of its competitors had phased out in-house production. Companies like Clarks
and Timberland had followed Nike’s marketing-oriented business model by outsourcing the production to
a large extent. These companies were described as branded marketers, i.e., manufacturers without factories,
who only design and market their goods. While Timberland produced approximately 10 per cent of its
shoes in-house, Clarks had completely outsourced its production. ECCO, by contrast, produced 80 per cent
of its shoes in-house. The remaining 20 per cent were outsourced as these shoes (for instance, ladies’ shoes

5 Berlingske News Magazine, March 7, 2004.
6 Jyllands-Posten, May 22, 2002.
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with thin soles and certain types of sport shoes) contained specific features that would not benefit from
ECCO’s “direct injected” technology.

ECCO’s production process could be divided into five strategic roles or phases: full-scale, benchmarking,
ramp-up, prototype and laboratory production. The objectives of full-scale production were to uphold
demand, quality and operational reliability, and still produce high volumes. Benchmarking production, on
the other hand, strove to retain knowledge and competencies in terms of opportunities for improvements
and production cost structure. ECCO had full-scale production units in Portugal, Indonesia, Thailand,
Slovakia and China (in operation from March 2005). A logical consequence of ECCO’s control of their
value chain was that benchmarking served more to evaluate such aspects as the production unit in Portugal,
vis-à-vis the plant in Slovakia, than to establish parameters upon which to evaluate external partners. The
ramp-up process encompassed the set-up for the production system at large, such as running an assembly
system based on new technology. While the newest technology came from Bredebro, Denmark, the actual
establishment of the production system, including the streamlining of processes and the specific volumes
of various kinds of materials, took place in ECCO’s foreign production units. The development of new
products, prototypes and laboratory production technologies, was carried out at ECCO’s production site in
Denmark. In particular, ECCO’s research centre, Futura in Tønder, Denmark, experimented with new
materials, processes and technologies. Over the years, ECCO had seen a sharp division of tasks between
Denmark and various foreign production sites. Earlier operations in Denmark had encompassed all design,
prototype, ramp-up, quality control, branding, marketing and most research and development (R&D)
aspects, while ECCO foreign plants performed volume production. For instance, ECCO had split up R&D
activities, relocating many activities to the production sites, which evidently were more in touch with
ECCO’s R&D efforts from a practical perspective. The R&D activities conducted at the production sites
revolved around support for the production process and optimization of materials.

ECCO’s full-scale production process involved both manual labor and capital-intensive machinery.
Normally, the uppers were cut by hydraulic presses called clicking machines, although at times hand
cutting was used in the manufacture of shoes made of fine leather (see Exhibit 5). The upper was then
attached to the insole with adhesives, tacks, and staples. Applying advanced machinery, the uppers were
then placed in an injection-molding machine where the shoe bottom, including the outsole and heel, was
attached to the uppers under very high pressure. Lastly, each pair of shoes went through the finishing
process using various operations, such as bottom securing and edge trimming, which improved the
durability and appearance of the shoe. According to ECCO’s estimates, each pair of shoes comprised
approximately 30 minutes of manual labor.

ECCO’s tannery operations revolved around similar phases, including prototype, laboratory and ramp-up
production of leather, which took place in the Netherlands. The full-scale processing of leather took place
in tanneries in Indonesia and Thailand. ECCO’s maintaining ownership of the tannery operations not only
reflected the company’s commitment to quality but also illustrated a high level of ambition and confidence.
ECCO’s profound belief that “we cannot get the best quality if we do not do it ourselves,” as often stated
by Toosbuy, still permeated the company’s business philosophy in 2005.

Although design and product development processes were generally conducted by the head office in
Bredebro, Denmark, at times the division between the different phases was not clear-cut. For instance, the
design and development of shoe uppers happened with the strong involvement of the subsidiary in
Indonesia in order to transform the design into high-quality, comfortable shoe uppers. Prior to beginning
actual production for the next season, the subsidiary in Indonesia was required to make production
samples. ECCO’s marketing team would screen the samples to forecast volumes and style of production.
Based on the sales forecast, headquarters would allocate production orders among its network of
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subsidiaries and licensees. The production of shoe uppers itself generally involved significant manual
work. When the shoe uppers were completed they were shipped by sea to another group’s facilities for
subsequent processing according to the allocation set by headquarters. Finished shoes were distributed via
the group’s distribution centre and sales agents.

ECCO’s distribution system was also vital to its business. ECCO had two main distribution centres; one in
the United States and one in Tønder, Denmark. The latter was expanded in 2001 with four additional
warehouses totaling 9,000 square meters, doubling the capacity from one million to two million pairs of
shoes. The majority of ECCO’s shoe production went through Tønder, however, over the last years only
between six and nine per cent of total production was actually sold on the Danish market. The
consolidation of distribution in Tønder also involved the closure of ECCO’s distribution centre in Brøndby,
Denmark and the warehouse in Bredebro, Denmark. The majority of shoe shipments arrived through the
harbor of Aarhus, Denmark, but ECCO also utilized vans for transportation and freight planes in urgent
cases. Through the use of a bar code system, the distribution centre was able to ship 60,000 pairs of shoes
per day by lorry to 25 countries. Shoes for markets outside Europe were shipped by sea.

Recent developments within the shoe business had resulted in retailers ordering a larger proportion of
shoes in advance. Retailers typically ordered 75 to 80 per cent of ECCO’s production in advance of the
season, while 20 to 25 per cent of orders aimed to fill up a retailer’s stock. These replenishment orders had
to be delivered with only a few days notice.

PRODUCTION TECHNOLOGY

Since its foundation, ECCO emphasized production technology as a key asset to the company. The founder
was, above all, known and recognized for his profound knowledge of inventing and fine-tuning cutting-
edge production techniques. The core of ECCO’s product strategy was shoes based on “direct injection”
technology. In simple terms, the shoe uppers were attached to the sole under very high pressure, utilizing
very capital-intensive machinery. In contrast, both the sewing of uppers and the final finish before shoes
left the factory were performed manually. Competitors had tried for a long time to apply the same
techniques or to license ECCO’s production techniques, however, ECCO performed many small tasks
differently throughout the process, which improved quality and made it hard to imitate. Of a total
production of 12 million pairs of shoes in 2004, 80 per cent were based on the direct injection technology.
The remaining pairs, mostly shoes with very thin soles, were outsourced as they would not benefit from
ECCO’s core technology. Kasprzak’s vision was to make individually based shoes fine-tuned to each
customer. As he stated: “Our strength is our technology and our ability to produce high-tech products. I
believe that we can be the first in the world to produce individual shoes in terms of design and instant fit by
applying the newest technology.”7

As a result of the importance of ECCO’s production methods and the fact that production was kept in-
house, in 1980 ECCO began cooperating closely with Main Group, an Italian company specialized in
injection machine molds and services for footwear. In 2002, Main Group started operations in China and
ECCO expected to benefit from cheaper Main Group machines when initiating its production in China in
spring 2005.

7 Berlingske Tidende, September 5, 2004.
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INTERNATIONALIZATION OF PRODUCTION

Following a decade of tremendous growth, ECCO’s first steps towards globalization occurred through
exports and the establishment of upper production in Brazil in 1974. Since then, the main forces driving
ECCO’s internationalization have been i) establishment of a market presence, and ii) reduction of labor
costs and increasing flexibility. ECCO was one of the offshoring pioneers in Danish manufacturing. Over a
period of 25 years, ECCO established 26 sales subsidiaries covering the entire world and four international
production units. The objective of these establishments, apart from achieving labor cost savings, was to
spread risk. Initially, the various production sites were capable of producing the same types of shoes,
indicating an insignificant degree of specialization in the production units. However, in recent years,
ECCO had strived to narrow each unit and capitalize on its core competencies (see Exhibits 6 and 7). The
early internationalization process affected the composition of employees — by 2004 only 553 worked in
Denmark while 9,104 worked outside of Denmark (see Exhibit 8). Of these, 8,094 worked in production,
while 1,010 worked in sales.

Portugal

ECCO’s first relocation of production occurred in 1984 with part of production being moved to Portugal.
Although Portugal traditionally held a leading position in both the production of uppers and shoe assembly,
ECCO then relocated some of these processes to production sites in Thailand and Indonesia in 1993 and
1991, respectively. Few uppers were produced in Portugal and the number of shoes leaving the factory
decreased substantially from 2000 to 2004 (see Exhibit 7). In addition, in response to increasing labor
costs, ECCO strove to make the Portuguese unit more high-tech, thereby decreasing the number of
employees. While the Portuguese unit was more capital intensive, the focus on technology had transformed
the plant into ECCO’s leading developer within laser-technology.

Indonesia

The Indonesian production unit, opened in 1991, specialized in producing shoe uppers for the ECCO
group, while the finishing processes, such as attaching shoe uppers to soles, were undertaken in other
facilities of the group. The production unit in Indonesia satisfied approximately 40 to 50 per cent of the
group’s shoe upper demand. In shoe production, the main materials required were rawhides (procured
locally as well as imported) that were processed into semi-finished and finished leather. Other materials
required for production included reinforcement, yarn and accessories. Apart from the leather, the majority
of the materials (70 to 80 per cent) were obtained from European suppliers, in particular granulate and
Gore-Tex. Procurement of raw material took eight weeks from the placement of the order until materials
were ready to be shipped, and another five weeks for sea shipment.

Thailand

ECCO’s production facility in Thailand, opened in 1993, encompassed both tannery and assembling
facilities. In 2004, the site produced roughly 37 per cent of the uppers, primarily for shoe assembly in
Thailand where 40 per cent of total unit volume was produced. ECCO’s production site in Thailand was
rather successful in terms of output, employee satisfaction and size. Over the years, the number of
employees increased substantially and annual employee turnover was less than seven per cent. Moreover,
the Thais had a good eye for small details and were able to deliver first class workmanship. These
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characteristics led ECCO to concentrate the production of its most complicated shoes in Thailand,
including golf shoes and its advanced trekking boots.

Slovakia

Opened in 1998, ECCO’s production unit in Slovakia primarily assembled shoes and, to a lesser extent,
uppers. The plant employed 824 people in 2004 and produced shoes primarily within the men’s segment.
The underlying rationale for setting up production in Slovakia, apart from lower labor costs, was the
country’s proximity to promising markets like Russia and Poland. Prior to entering Slovakia, Toosbuy
stated: “We need bigger production capacity and quicker deliveries. Our goal is to increase production
capacity by 15 per cent per year. One of our challenges associated with production in Asia is the three to
four week transportation time.”8 Years later, ECCO’s executive production director, Flemming Brønd,
added:

Shoe manufacturing is labor intensive, thus the wage level is of paramount importance.
We already had a factory in Portugal, yet we were searching for an optimal location for a
new plant in Europe as labor costs were raising in Portugal. We have the majority of our
uppers flown in from Indonesia and India after which the shoes are assembled. Although
we automated the assembly process by using robots, we still needed skilled labor to handle
the machines.9

Having established production facilities in Slovakia, ECCO set up a production network in close proximity
to the company’s major markets. This facility also provided some leeway in terms of driving up volume
between plants, thereby alleviating the risks of an interruption in production due, for instance, to political
unrest in Thailand. Despite ECCO’s global production facilities, the plant in Bredebro, Denmark still
constituted ECCO’s primary model in terms of the development of cutting-edge production technology.

China

ECCO’s establishment of production facilities in China was by no means a spontaneous act. Toosbuy had,
on various occasions, visited China to assess locations and the timing of entry. China’s recent membership
of the World Trade Organization (WTO) allowed for 100 per cent foreign ownership of production sites.
This, combined with the fact that approximately 50 per cent of the world’s shoe production took place in
China, made the country too important to ignore. ECCO chose a site in Xiamen just north of the province
of Guangdong, which Kasprzak described as “a smaller yet dynamic community where we have been very
well received and provided good and competent service from the local authorities.”The plan was to build
five factories over the next five years, as well as a very advanced tannery, including a beam house to
convert rawhides. Total investment including tanneries would amount to approximately DKK 500 million.
When realized, the Chinese production site would become ECCO’s largest worldwide, delivering some
five million pairs of shoes annually. Although mostly targeted for export, one of the factories would serve
the Chinese market exclusively. ECCO expected to employ around 3,000 people in China.

Although low labor costs and taxes were considered, access to local manpower was the decisive factor
when establishing operations in China. “Taxes are more or less the same in different zones, so it did not
influence our location decision as such. On the other hand, it was important to us that Xiamen could

8 Berlingske Tidende, February 2, 1998.
9 Jyllands-Posten, December 12, 2003.
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Page 9 9B08M014

provide local employees who we can train and keep for a longer period of time, which is definitely not the
case in other places in China.”10

ECCO had high hopes for sales to the Chinese consumers as well. Over the next three years, the company
hoped to double sales to 500,000 pairs. To realize this ambition, a formal sales subsidiary had been formed
together with Aibu, ECCO’s long-standing partner in China. Over the last eight years, their partnership had
evolved from one shop to selling approximately 250,000 pairs of shoes targeted at the segment for
exclusive shoes. The plan was to strengthen collaborative ties even further through a combination of
Aibu’s unique market knowledge and position in the Chinese market, together with ECCO’s strong brand
and accumulated experiences with positioning shoes on a global scale. In fact, the experience from other
Danish design icons operating in China suggested a network approach to gain the loyalty of the Chinese
consumers. However, the approach was not without risks, as it involved being complaisant while at the
same time keeping critical knowledge close to the chest until formal contracts had been signed. During
2003/2004, ECCO had been plagued by Chinese manufacturers copying the ECCO design. According to
Søren Steffensen, executive vice-president of sales, every single case was pursued and handled by a special
unit of attorneys at ECCO whose primary task was to protect the company’s brand and design.

THE COMPETITIVE LANDSCAPE

Generally, the market for lifestyle casual footwear was highly competitive and subject to changes in
consumer preferences. Fierce competition had sparked investments in both cost optimization and new
technologies. First, the quest for competitive pricing had driven the search for new ways of producing and
assembling in order to lower costs and reduce time to market. Operations were streamlined and formerly
manual processes were automated. Second, incumbents invested in new technology, improved customer
service, and market knowledge.

Traditionally, the footwear industry had been fragmented, yet in recent years, the distinction between
athletic and lifestyle casual footwear blurred. Financially strong athletic shoe companies, like Nike and
Reebok, competed directly with some of ECCO’s products. On the other hand, ECCO’s expansion into
such new segments as golf shoes gave rise to new competitors. In addition, the industry felt increasing
pressure from retailers that had established products under private labels. As a consequence of the fuzzy
boundaries between different footwear product categories and geographical regions, pinpointing ECCO’s
competitors was a challenge. However, ECCO itself regarded Geox, Clarks and Timberland as its main
competitive threats worldwide (see Exhibit 9).

Geox

By all measures, the Italian shoemaker Geox constituted a competitive threat to ECCO’s operations in the
casual lifestyle footwear segment. Founded in 1994 by the Italian entrepreneur Mario Moretti Polegato,
Geox achieved impressive growth rates, increasing sales from €147.6 million in 2001 to €340.1 million in
2004, corresponding to a compound annual growth rate (CAGR) of 32 per cent. The success of Geox was
based on perforated rubber soles in which a special waterproof and breathable membrane was inserted,
allowing the vapor from perspiration to leave but still preventing water from entering the shoe — a
technology protected by over 30 patents. Geox’s headquarters and R&D facilities were located in the
centre of a large shoe-making area northwest of Venice — Montebelluna. Geox had its own production

10 Assistant General Manager, Morten Bay Jensen.
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facilities in Slovakia and Romania and outsourced to manufacturers in China, Vietnam and Indonesia. The
entire production process and logistics were closely monitored in-house from headquarters in Italy.

In terms of distribution, Geox operated with a business model similar to ECCO’s. The company’s shoes
were sold in more than 60 countries through a worldwide distribution network of more than 230 single-
brand Geox Shop stores and about 8,000 multibrand points of sale.

Geox had global ambitions. The company still had a strong penetration in the Italian market, which
generated approximately 55 per cent of sales. International sales were gaining momentum, however,
comprising 45 per cent in 2004, with Germany, France, Iberia (Spain and Portugal) and the United States
being the largest markets. Geox increased sales by 250 per cent from 2002 (US$4 million) to 2003 (US$14
million) in the very competitive American market. As a comparison, ECCO grew only 4.5 per cent in this
market with sales of US$115 million in 2003 (see Exhibit 10). Although extremely successful, Geox
planned to enter clothing in order to circumvent sudden shifts in consumer tastes.

Clarks

Clarks, the English shoemaker, was the biggest player within the casual lifestyle footwear segment,
achieving global sales of US$1,534 million in 2003 (see Exhibit 9). Since its humble beginnings in 1825,
Clarks had grown into a global shoemaker producing 35 million pairs and offering a wide product portfolio
under the slogan “from career wear to weekend wear.” Clarks’ product portfolio included casual, dress
casual, boots and sandals. Central to various categories were Clarks’ widely used technical features like
“active air” (an air-cushioning technology) and “waterproof” (impermeable membrane sewn inside the
boot), which sought to improve comfort, performance and versatility.

Clarks, like other shoe manufacturers, had vigorously sought lower labor costs in response to fierce
competition. The company once had 15 plants across the United Kingdom, but by 2005, only one small
factory with 37 employees remained in Millom, Cumbria. The most recent closure occurred in early 2005
when the company shifted production to independent factories in Vietnam, Romania and China. According
to company spokesman John Keery, this move was vital to ensuring that the business remained financially
viable. As he stated: “The cost of manufacturing in the UK has increased over the last 20 years and we
have been able to source our shoes cheaper in the Far East.”11Based on cost considerations, availability of
materials and capacity issues within individual countries, Clarks sourced shoes from 12 different
manufacturers located primarily in Asia. Clarks kept less than one per cent of its production in-house. By
using many independent manufacturers, Clarks was exposed to a variety of technologies, materials and
shoemaking techniques and thus could access various types of expertise. However, monitoring material
standard and product quality was an enormous task.

Timberland

Founded in Boston in 1918 by Nathan Swartz, Timberland designed, marketed and distributed under the
Timberland® and Timberland PRO® brands. Their products included footwear and apparel and accessories
products for men, women and children. Having introduced the waterproof boot based on injection-molding
technology in 1973, Timberland’s primary strength resided within the outdoor boot category, which
competed with ECCO’s outdoor and sport product categories. In 1978 and 1979, Timberland added casual
and boat shoes to its line to become more than just a boot company. In the eighties, the company strived to
be recognized as a lifestyle brand and entered Italy as the first international market. During the 1990s,

11 www.bbc.co.uk/somerset/content/articles/2005/01/10/clarks_feature.shtml, accessed March 2005.
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Timberland introduced kids’ footwear and launched the Timberland PRO® series designed for maximum
surface contact and targeted at skilled tradesmen and working professionals.

Timberland’s 2003 total revenue of US$1,328 million was comprised of footwear (76.7 per cent) and
apparel and accessories (23.3 per cent), making Timberland twice the size of ECCO in terms of product
sales. Despite the company’s late appearance in international markets, international sales comprised 38.5
per cent of total generated revenue — up from 29.5 per cent in 2001. Timberland’s products in the United
States and internationally were sold through independent retailers, department stores, athletic stores,
Timberland specialty stores and factory outlets dedicated exclusively to Timberland products. In Europe,
products were sold mostly through franchised retail stores.

In terms of manufacturing, Timberland operated production facilities in Puerto Rico and the Dominican
Republic. Contrary to ECCO, which on average produced 80 per cent of its shoes in-house, Timberland
manufactured only 10 per cent of total unit volume, with the remainder of the footwear production being
performed by independent manufactures in China, Vietnam and Thailand. Timberland believed that
attaining some internal manufacturing capabilities, such as refined production techniques, planning
efficiencies and lead time reduction, might prove beneficial when collaborating with manufactures in Asia.
To facilitate this collaboration, Timberland set up a quality management group to develop, review and
update the company’s quality and production standards in Bangkok, Zhu Hai, Hong Kong and Ho Chi
Minh City (Saigon).

In terms of leather supplies, Timberland purchased from an independent web of 60 suppliers who were
subject to rigid quality controls. This required substantial resources in order to scrutinize and monitor the
supplier network. Analysts argued that Timberland was vulnerable to price increases on raw materials.
Gross margins were negatively affected by increases in the cost of leather as selling prices did not increase
proportionally. Shoe manufacturers like Timberland found it difficult to pass on the extra cost to the
consumer. In order to diminish the effect of increasing prices for leather and other materials, Timberland
was forced to closely monitor the market prices and interact closely with suppliers to achieve maximum
price stability. By 2003, 10 suppliers provided approximately 80 per cent of Timberland’s leather
purchases.

As the plane approached Copenhagen Airport, Mikael Thinghuus recalled a management board meeting
prior to his visit to China. Several viewpoints concerning ECCO’s future strategy had been presented and,
while no one discredited ECCO’s unique production assets, there was a sentiment that advantages accruing
from world-class production technologies could not be sustained forever. “We are not going to exist in 20
years time if we cannot excite and cast a spell over our customers,” one member of the committee
commented. Another added: “We do not operate marketing budgets of the same magnitude as the big
fashion brands. But our shoes are produced with an unconditional commitment to quality and our history is
truly unique. We need to be better at telling that story.” Thinghuus was pondering:

“We need to be more concrete about the process towards market orientation. How can we
relate better to our customers while at the same time being able to exploit efficiencies from
a global value chain? Integrated or not. And what about entering new markets? The recent
market expansion in China was just the beginning. Long-term outlook seemed favorable.
Yet, was it feasible to invest in new markets, increase marketing efforts, and optimize a
global value chain — all at the same time?”

Irrespective of the outcome of these thoughts, it was pivotal to consider how strategic initiatives would go
hand in hand with ECCO’s philosophy of integrating the value chain from cow to shoe.
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ECCO’s operating margin and productivity 1999-2004
400
600
800
1000
1200
1400
1999 2000 2001 2002 2003 2004
Year
S
o
ld
s
h
o
e
s
p
e
r
e
m
p
lo
y
e
e
0
2
4
6
8
10
12
14
16
O
p
e
ra
ti
n
g
m
a
rg
in
Exhibit 1

ECCO’S FINANCIAL HIGHLIGHTS 1999 TO 2004

Source: ECCO annual reports 1999-2004
ECCO’s consolidated financial highlights and key ratios 1999-2004
(DKK million) 1999 2000 2001 2002 2003 2004
Net revenue 2,552 2,836 3,216 3,360 3,169 3,394
Profit before amortization and
depreciation
409 560 416 343 370 448
Amortization and -106 -143 -167 -187 -189 -181
Profit before financials 302 416 249 156 182 267
Net financials -25 -112 -93 -73 -61 -61
Profit before tax 277 305 156 82 120 206
Group profit 195 216 123 60 71 164
Profit for the year 185 208 115 51 62 151

Key ratios (%)
Operating margin 11.9 14.7 7.8 4.6 5.7 7.9
Return on assets 11.7 10.6 5 2.8 4.3 7
ROIC 12.7 14.5 8.1 5.3 6.5 9.1
Investment ratio 3.3 2.2 1.5 1.2 1.2 1.2
Return on equity 28.9 25.7 12.4 5.3 6.5 15.2
Solvency ratio 30.9 31.1 31.4 33 34.1 35.1
Liquidity ratio 1.8 1.9 2.1 2 1.9 2

Pairs of shoes sold (millions) 9.160 9.603 10.14 10.65 11.22 12.04
Number of employees (2004) 8,290 8,853 9,087 8,839 9,388 9,657
Sold shoes per employee 1,104 1,084 1,116 1,205 1,195 1,247
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Exhibit 2

COMPOSITION OF MANAGEMENT BOARD AS OF 2004

Source: ECCO’s annual report 2004

Supervisory Board
Hanni Toosbuy Kasprzak,
Chairman

Jens Christian
Meier
Executive Vice-president,
Production

Dieter Kasprzak
Chief Executive Officer

Mikael Thinghuus
Chief Operating Officer

Søren Steffensen
Executive Vice-president,
Sales & Retail

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DistributionManufacturingTanningRaw Materials
Cattle Hides
Goat
Skins
Goats
Sheeps
Sheep
Skins
Heavy leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Sheep and goats).
Pickle, wet blue
and crust
Lining for
shoes,
Shoe uppers
&
Shoe
assembling
Distribution
Centre in the
US
Distribution
Centre in
Tønder
Operations performed in-house by ECCO
V
a
ri
o
u
s
E
C
C
O
s
p
e
c
ia
lt
y
o
u
tle
ts
a
n
d

m
u
lti
b
ra
n
d
s
to
re
s
DistributionManufacturingTanningRaw Materials
Cattle Hides
Goat
Skins
Goats
Sheeps
Sheep
Skins
Heavy leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Sheep and goats).
Pickle, wet blue
and crust
Lining for
shoes,
Shoe uppers
&
Shoe
assembling
Distribution
Centre in the
US
Distribution
Centre in
Tønder
Operations performed in-house by ECCO
V
a
ri
o
u
s
E
C
C
O
s
p
e
c
ia
lt
y
o
u
tle
ts
a
n
d

m
u
lti
b
ra
n
d
s
to
re
s
DistributionManufacturingTanningRaw Materials DistributionManufacturingTanningRaw Materials
Cattle Hides
Goat
Skins
Goats
Sheeps
Sheep
Skins
Heavy leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Bovine)
Pickle, wet blue
and crust
Light leather
(Sheep and goats).
Pickle, wet blue
and crust
Lining for
shoes,
Shoe uppers
&
Shoe
assembling
Distribution
Centre in the
US
Distribution
Centre in
Tønder
Operations performed in-house by ECCO
V
a
ri
o
u
s
E
C
C
O
s
p
e
c
ia
lt
y
o
u
tle
ts
a
n
d

m
u
lti
b
ra
n
d
s
to
re
s
Exhibit 3

ECCO’S VALUE CHAIN AND EXPLANATION OF TANNERY OPERATION

Explanations:
Pickled: the stage of tanning where the hair is removed usually for sheepskins
Wetblue: the next stage when lime is added to preserve skin
Crust: the third stage when the remaining flesh and fat proteins are removed
Finished: the final stage when the skin is dyed and finished using chrome sulphate and is converted to processed leather
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Exhibit 4

CONVERTING SKIN AND HIDES INTO LEATHER

Source: A Blueprint for the African Leather Industry — a development, investment and trade guide for the leather industry in
Africa, UNIDO 2004, p. 17.
Steps in leather production

The production of leather from hides and skins involves the treatment of raw materials, i.e., the conversion
of the raw hide or skin, a putrecible material, into leather, a stable material. This material is obtained after
passing through the different treatment and processing steps described in points 1 to 4. The production
processes in a tannery can be divided into four main categories, though the processes employed in each
of these categories may change, depending on the raw material used and the final goods that are to be
produced.

1. Hides and Skins Storage and Beam-house Operations
Upon delivery, hides and skins can be sorted, trimmed, cured (when the raw material cannot be
processed immediately) and stored pending operations in the beam house. The following processes are
typically carried out in the beam house of a tannery: soaking, de-haring, liming, fleshing (mechanical
scraping off of the excessive organic material) and splitting (mechanically splitting regulates the thickness
of hides and skins, splitting them horizontally into a grain layer, and, if the hide is thick enough, a flesh
layer).

2. Tannery Operations
Typically the following processes are carried out in the tannery: de-liming, bating, pickling and tanning.
Once pickling has been carried out to reduce the pH of the pelt prior to tanning, pickled pelts, i.e.,
sheepskins can be traded. In the tanning process the collagen fibre is stabilized by the tanning agents so
that the hide (the raw material) is no longer susceptible to putrefaction. The two main categories of
tanning agents are minerals (trivalent chromium salts) and vegetable (quebracho and mimosa). The
tanned hides and skins, once they have been converted to a non-putrescible material called leather, are
tradable as intermediate products (wetblue). However, if leather is to be used to manufacture consumer
products, it needs further processing and finishing.

3. Post-Tanning Operations
Post-tanning operations generally involve washing out the acids that are still present in the leather
following the tanning process. According to the desired leather type to be produced the leather is retanned
(to improve the feel and handle of leathers), dyed with water-soluble dyestuffs (to produce even colours
over the whole surface of each hide and skin), fat liquored (leathers must be lubricated to achieve
product-specific characteristics and to re-establish the fat content lost in the previous procedures) and
finally dried. After drying, the leather may be referred to as crust, which is a tradable intermediate product.
Operations carried out in the beam house, the tannery, and the post-tanning areas are often referred to as
wet processing, as they are performed in processing vessels filled with water to which the necessary
chemicals are added to produce the desired reaction. After post-tanning the leather is dried and
subsequent operations are referred to as dry processing. Typically, hides and skins are traded in the
salted state, or, increasingly, as intermediate products, particularly in the wetblue condition for bovine
hides and the pickled condition for ovine skins.

4. Finishing Operations
The art of finishing is to give the leather as thin a finish as possible without harming the known
characteristics of leather, such as its look and its ability to breathe. The aim of this process is to treat the
upper (grain) surface to give it the desired final look. By grounding (applying a base coat to leather to
block pores before applying the true finish coats), coating, seasoning, embossing (to create a raised
design upon a leather surface by pressure from a heated engraved plate or roller) and ironing (to pass a
heated iron over the grain surface of the leather to smooth it and/or to give it a glossy appearance) the
leather will have, as desired by fashion, a shiny or matt, single or multi-coloured, smooth or clearly
grained surface. The overall objective of finishing is to enhance the appearance of the leather and to
provide the appropriate performance characteristics in terms of colour, gloss, and handling, among others.
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Exhibit 5

ILLUSTRATION OF DIFFERENT COMPONENTS IN THE CONSTRUCTION
OF ECCO’S WALKATHON SHOE

Source: ECCO internal illustration
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Exhibit 6

ECCO’S PRODUCTION OUTPUT WORLDWIDE 2000-2004

Source: ECCO’s environmental report 2004

2004 2003 2002 2001 2000
Bredebro, Denmark (1963)
Activity: Shoe factory. Development and preparation of new articles and prototype testing. No.
of employees: 124
– Uppers produced (pairs) 3,805 3,720 4,482 5,281 –
– Shoes produced (pairs) 20,577 38,000 211,413 478,674 800,605
Santa Maria da Feria, Portugal (1984)
Activity: Shoe factory. Production of uppers and shoes. No. of employees: 720
– Uppers produced (pairs) 20,737 79,690 241,961 438,299 535,200
– Shoes produced (pairs) 2,649,178 2,442,395 2,590,327 3,769,754 4,150,000
Surabaya, Indonesia (1991)
Activity: Tannery and shoe factory. Production of wetblue, crust, leather, uppers and shoes.
No. of employees: 3554
– Wetblue produced (ft2) 18,249,560 15,970,001 15,338,582 8,432,162 11,134,743
– Leather produced (ft2) 15,098,971 14,062,152 12,048,197 15,566,070 15,104,307
– Uppers produced (pairs) 5,326,300 4,664,023 4,063,840 3,968,559 3,750,000
– Shoes produced (pairs) 246,018 29,119 – – 220,000
Ayudhthaya, Thailand (1993)
Activity: Tannery and shoe factory. Production of crust, leather, uppers and shoes. No. of
employees: 2775
– Leather produced (ft2) 10,095,425 9,138,590 8,046,037 8,291,589 5,800,000
– Uppers produced (pairs) 3,237,054 2,868,227 2,708,639 2,891,591 3,150,000
– Shoes produced (pairs) 3,910,382 3,319,623 3,264,747 3,102,710 3,200,000
Martin, Slovakia (1998)
Activity: Shoe factory. Production of uppers and shoes. No. of employees: 824
– Uppers produced (pairs) 163,297 259,136 792,473 287,694 130,000
– Shoes produced (pairs) 2,771,025 2,265,312 1,974,408 1,657,498 1,500,000
Dongen, The Netherlands (2001)
Activity: Tannery. Production of wetblue. Leather and development centre. Acquired by ECCO
in 2001. No. of employees: 79
– Wetblue produced (ft2) 19,931,818 26,704,106 30,886,062 23,686,640
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Exhibit 7

ECCO’S PRODUCTION OUTPUT WORLDWIDE 2000-2004

Production of shoes (in pairs) 2000-2004
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
4,500,000
2000 2001 2002 2003 2004
Denmark Portugal Indonesia Thailand Slovakia

Production of leather and wetblue 2000-2004
0
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
35,000,000
2000 2001 2002 2003 2004
ft
2
Wetblue (Indonesia) Leather (Indonesia)
Leather (Thailand) Wetblue (the Netherlands)

Production of uppers 2000-2004 (in pairs)
0
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
2000 2001 2002 2003 2004
Denmark Portugal Indonesia Thailand Slovakia

Source: ECCO annual report, various issues
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Exhibit 8

EMPLOYEE STATISTICS — GEOGRAPHICAL COMPOSITION 1980-2004

Composition of employees in ECCO by geography
0
2,000
4,000
6,000
8,000
10,000
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Employees in Denmark Employees outside Denmark

Source: various annual reports and internal documents

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Exhibit 9

GLOBAL SALES OF LIFESTYLE CASUAL FOOTWEAR BRAND SALES
(IN US$ MILLION) 2002-2003

Rank Company 2002 2003 % change
1 Clarks 1,399 1,534 9.6%
29.2% 29.6%
2 ECCO 502 590 17.5%
10.5% 11.4%
3 Rockport 385 361 6.2%
8.0% 7.0%
4 Geox 208 329 58.2%
4.3% 6.3%
5 Birkenstock 270 300 11.1%
5.6% 5.8%
6 Bass 275 285 3.6%
5.7% 5.5%
7 Caterpillar 209 210 0.5%
4.4% 4.0%
8 Doc Martens 295 195 -34.0%
6.2% 3.8%
Others 1,252 1,383
26.1% 26.7%
Total $4,795 $5,187 8.2%

Note: Timberland is not included in the table. The company offers footwear across different categories including rugged
footwear and athletic footwear as well as casual lifestyle footwear.
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Page 21 9B08M014

Exhibit 10

U.S. SALES OF LIFESTYLE CASUAL FOOTWEAR BRAND SALES
(IN US$ MILLION) 2002-2003

Source: JP Morgan — Apparel and Footwear Yearbook 2003
Rank Company 2002 2003 % change
1 Clarks 339 375 10.6%
18.8% 21.5%
2 Rockport 291 266 -8.6%
16.2% 15.2%
3 Bass 258 265 2.7%
14.3% 15.2%
4 Doc Martens 195 127 -34.9%
10.8% 7.3%
5 ECCO 110 115 4.5%
6.1% 6.6%
6 Birkenstock 110 80 -27.3%
6.1% 4.6%
7 Dansko 62 71 14.5%
3.4% 4.1%
8 Mephisto 55 55 0.0%
3.1% 3.1%
9 Sperry 49 53 8.2%
2.7% 3.0%
10 Josef Seibel 33 35 6.1%
1.8% 2.0%
11 Catterpillar 33 30 -9.1%
1.8% 1.7%
12 Sebago 20 16 -20.0%
1.1% 0.9%
13 Geox 4 14 250.0%
0.2% 0.8%
14 Stonefly 10 11 10.0%
0.6% 0.6%
14 FinnComfort 10 11 10.0%
0.6% 0.6%
Others 220 224
12.2% 12.8%
Total $1,799 $1,748 -2.8%
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__MACOSX/Course Pack/._Global Value Chain Management.pdf
Course Pack/Boeing 787 Manufacturing a Dream.pdf

9 – 6 1 5 – 0 4 8
R E V :M A Y2 9 ,2 0 1 5

HBS Professor Rory McDonald and Professor Suresh Kotha (University of Washington) prepared this case. This case was developed from
published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. H BS cases are
developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of
effective or ineffective management.

Copyright © 2015 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
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R O R YM C D O N A L D
S U R E S HK O T H A
Boeing 787: Manufacturing a Dream
On April 19, 2013, the U.S. Federal Aviation Authority (FAA) permitted the new Boeing 787
airplanes that it had summarily grounded several months earlier to return to service. The agency had
grounded the airplane because of problems associated with its lithium-ion battery. Ray Conner, CEO
of Boeing Commercial, was relieved. The Dreamliner was a technical marvel, and a great deal was
riding on its success. Boeing had delivered the first Boeing 787-8 only 18 months earlier. On that
occasion, presenting the ceremonial key to the CEO of All Nippon Airways (ANA), Conner’s
predecessor Jim Albaugh had made some expansive assertions:
It is not often that we have the chance to make history, do something big and bold
that will change the world in untold ways and endure long after we are gone. That’s
what the 787 Dreamliner is and what ANA and Boeing have done together—build what
truly is the first new airplane of the twenty-first century.1
The 787 represented a radical departure from Boeing’s previous approach to designing and
building commercial airplanes. The majority of the wings and fuselage were constructed of advanced
composites, making possible a super-efficient plane that could fly as fast as the fastest commercial
airplanes while using 20 percent less fuel than comparably sized planes. The business model too
represented a radical departure from past programs:Boeing and a group of risk-sharing partners
around the globe were jointly responsible for the 787’s design and manufacture. These risk-sharing
partners funded their own research and development, and built sections of the airplane at
manufacturing plants scattered around the world; Boeing transported the completed sections to final-
assembly plants in the United States.
But the 787 program had not unfolded as Boeing’s top management had envisioned. (See the
Appendix for a chronology of events.) The program was plagued with delays, large cost overruns,
and contentious management/labor squabbles. The first airplane was ultimately delivered 40 months
behind schedule, after several billion dollars in cost overruns.2 Boeing then had to produce some 800
airplanes for close to 60 airline customers (as of April 2013). In 2013 the company was intent on
increasing the production rate at its two final-assembly facilities.3
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615-048 Boeing 787: Manufacturing a Dream
2
The Road to Launch of the 787 (1996–2002)
Founded in 1916 near Seattle, Washington, the Boeing Company is a leading producer of military
and commercial aircraft. The company consists of two main businesses—Commercial Airplanes and
Defense, Space, & Security—supported by nine corporate functions. Boeing has dominated the
commercial airline industry since the 1950s, and posted over $86 billion in revenues in 2013. (See
Exhibit 1 for recent financial highlights.) The company has 168,400 employees, in all 50 states and 70
countries, and contracts with 26,500 suppliers and partners worldwide.
Six months after Phil Condit succeeded Frank Schrontz as CEO of Boeing in 1996, Condit merged
Boeing with Rockwell Aerospace and Rockwell’s defense units. The Rockwell units, renamed Boeing
North America, subsequently operated as a Boeing subsidiary. In 1997 Boeing merged with
McDonnell Douglas, its main rival for defense aircraft and space contracts. Condit retained the titles
of CEO and chairman; Harry Stonecipher, CEO of McDonnell Douglas at the time of the merger,
became president and COO.
Working with Stonecipher, Condit promptly unveiled a vision for the merged company (see
Exhibit 2). Under the rubric, “People working together as one global company for aerospace
leadership,” the Boeing 2016 Vision specified Boeing’s three core competencies, including large-scale
systems integration. Boeing would seek leadership in aerospace by undertaking programs that would
leverage its expertise at large-scale systems integration. “We will continuously develop, advance and
protect the technical excellence that allows us to integrate effectively the systems we design and
produce,” the document declared. The intent was for Boeing to move beyond just manufacturing
commercial airplanes.
The vision statement asserted that Boeing’s two other core competencies—”detailed customer
knowledge and focus” and “lean, efficient design and production systems”— would enable the
company to understand, anticipate, and respond to its customers’ needs and to design production
systems that would be among the best in the world.
Top management would also seek to enhance shareholder value. In the words of the Vision 2016
document, “We must generate superior returns on the assets entrusted to us by our shareholders.”
Condit specified that Boeing would use RONA (return on net assets) to assess all investment
decisions. Some industry observers interpreted this assertion as evidence that Boeing management
wanted to change the company’s identity from that of a wrench-turning manufacturer to that of a
master planner, marketer, and snap-together assembler.4
Boeing’s Strategy in Commercial Aviation
In 2000, three years after announcing Vision 2016, Boeing entered the space and communications
sector by acquiring Hughes Electronic Corporation’s space and communications business. As Boeing
was focused on the merger and acquisition, Boeing’s main rival in the commercial sector, announced
the launch of the A380, a super-jumbo jet designed to carry 555 passengers on two full-length decks,
about 35 percent more capacity than the 747.Several years earlier both companies had explored the
prospects of a super-jumbo airplane, but Boeing had concluded that demand for such a large aircraft
failed to make a “business case” for building one (that is, it would not generate sufficient RONA).5
Instead Boeing reasoned that its existing family of planes—the 777, 767, and 747—would satisfy
increased global demand. Citing in-house research, Boeing’s senior marketing executives often
publicly asserted in various forums that passengers preferred the “point-to-point” (city-to-city)
approach to travel to the “hub-spoke-network” approach then in effect; the point-to-point approach
would require smaller planes with greater range, not larger ones.6
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Boeing 787: Manufacturing a Dream 615-048
3
For its part, Airbus reasoned that the existing hub-and-spoke network was here to stay, given that
much of the world lacked the kind of airports that the point-to-point approach called for. Airbus
research suggested that super-jumbos were necessary to alleviate congestion at global hubs. When
Boeing chose not to collaborate, Airbus charged ahead with the goal of delivering a super-jumbo by
2004.
The year 2003 was pivotal in the commercial aviation industry. Airbus, founded in 1970 as an
unwieldy confederation of four European aerospace firms, overtook the 89-year-old Boeing as the
world’s largest builder of commercial airplanes. The same year Airbus delivered 305 new jets, Boeing
only 281. Analysts quickly crowned Airbus the new leader in commercial aircraft.7 As NBC later
reported:
It was 2003, and Boeing—the company that defined modern air travel—had just lost
its title as the world’s largest plane manufacturer to European rival Airbus. . . . [I]ts stock
had plunged to the lowest price in decades. . . . Two years after the 9/11 terrorist attacks,
financially troubled airlines were reluctant to buy new planes. Boeing needed something
revolutionary to win back customers.8
Given Boeing’s vision of moving beyond commercial airplanes and its reluctance to invest in a
new airplane program, longtime industry observers questioned Boeing’s commitment and ability to
compete effectively against Airbus. As some keen industry followers observed:
With no new aircraft programs in place to compete with the emerging Airbus line of
products (including the A380), the technology gulf between Boeing and Airbus is
expected to widen. . . . At present [2003], Boeing does not have any commercial aircraft
that operate with fly-by-wire navigational systems, nor does Boeing have a replacement
for the aging 747 (which is nearing the end of its life cycle).9
Many in the industry speculated that Boeing would soon exit the market for commercial jets and
focus on defense contracts, commercial aviation services, and other businesses. Analyst Richard
Aboulafia observed that after launching the 777 in 1995 Boeing had “spent eight years shortchanging
its product line but returning billions to its shareholders.”10 Airbus’s A380 launch intensified
questions about Boeing’s intentions for its commercial division. Boeing’s stock price, which had
reached a high of almost $70 in December 2000, closed at $29 on October 14, 2002—a drop of 68
percent in shareholder value in two years (partly accounted for by an airline-industry slump
following the terrorist attack of September 11, 2001).
A Blueprint for a New Airplane (2003-2007)
To blunt Airbus’s momentum and maintain legitimacy with key stakeholders, Boeing announced
the launch of a modified 747. But the announcement failed to excite customers; the airplane, first
introduced in 1969, was considered obsolete. Boeing then announced the introduction of a fast
subsonic airplane, the Sonic Cruiser, which excited industry observers but not potential airline
customers. In the face of tepid customer enthusiasm, Boeing turned to a radical new airplane: the
787.11
The business case for the Dreamliner was simple: to design and deliver a super-efficient plane as
fast as the fastest existing commercial airplanes, and to encourage airlines to retire their legacy
airplanes and replace them with 787s. Boeing claimed that the proposed airplane would use 20
percent less fuel than comparable-size airplanes, a potential breakthrough for the industry that would
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615-048 Boeing 787: Manufacturing a Dream
4
lend long-range capabilities to a midsize aircraft (200–300 seats). A 787 would be able to fly as far as
the Airbus A380, about 8,500 nautical miles.12
For the traveling public, the 787 airplane would offer several improvements: wider seats and
aisles, larger lavatories, spacious luggage bins, and 19 x 11-inch windows that would provide all
passengers a view of the horizon. The airplane’s ceiling would feature a calming simulated sky to
enhance the perception of spaciousness. To reduce travel fatigue during long flights, Boeing would
increase cabin humidity and pressure to a 6,000-foot altitude rather than the traditional 8,000 feet.
Beginning in April 2004, customers flooded Boeing with orders.
Product architecture More than a dozen aerospace companies helped Boeing select advanced
composites and aluminum alloys for the plane’s structure. Much of the primary structure, including
the wings and fuselage were built from a titanium and graphite, making the 787 the first commercial
all-composite airplane. This decision would enable Boeing to build large integrated assemblies or
“work packages” in different parts of the world (e.g., Australia, Korea, Japan, Italy), for final
assembly at Boeing’s manufacturing plants in Everett, Washington. As The Seattle Times reported:
Boeing has long acknowledged that every plane it builds contains thousands of parts
built by domestic and foreign suppliers. The “build vs. buy” ratio is normally 30 percent
of parts built by Boeing and 70 percent built by suppliers. The [787 program] would take
Boeing’s reliance on outside suppliers to a new level as it embodies high-level
engineering and “systems integration.”That means its suppliers would assemble parts
into major sections of the plane. . . . [S]uppliers could even do more work that up to now
has been closely guarded by Boeing, such as construction of the wings and assembly of
large fuselage sections.13
To manage the integration, Boeing initiated a mega-contract with IBM and French software maker
Dassault Systemes, which helped implement one of the largest Project Life-Cycle Management (PLM)
systems ever undertaken. To ensure the program remained on time and on budget, Boeing’s partners
had to use the same PLM database and tools.
The 787 standard engine interface would accommodate two types of engine—the GE Next
Generation or the Rolls-Royce Trent 1000. While the interface was a first in aviation history, the team
surmised that financiers and leasing companies would find the interchangeability among engines
attractive, and would value the increased flexibility of the 787 asset. New engine designs were
expected to contribute as much as 8 percent of the increased efficiency envisioned for the airplane.14
A global-partnership model A global team of risk-sharing partners would take equity
stakes; each investor would have a financial incentive to minimize cost and help market the plane in
its home country.15Media reports noted that Boeing was imposing a limit on the financial
investment required for participation in the program, an approach in line with its stated corporate
objective of improving RONA. A retrospective NBS account later explained:
[The company] was no longer the trailblazing, risk-taking Boeing of a generation
earlier. The company had acquired rival McDonnell Douglas in 1997. Many McDonnell
Douglas executives held leadership positions in the new company. The joke was that
McDonnell Douglas used Boeing’s money to buy Boeing. The 707 and 747 were
blockbuster bets that nearly ruined the company before paying off. McDonnell Douglas
executives didn’t have the same appetite for gambling.16
A Wall Street Journal account elaborated:
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Boeing 787: Manufacturing a Dream 615-048
5
At the time [2003], Boeing had focused on building derivatives rather than new
products. Mr. [Alan] Mulally, then head of Boeing’s commercial airplane operations,
had to persuade CEO Harry Stonecipher [the company’s largest shareholder and former
CEO of McDonnell Douglas] and others to pursue a costly all new aircraft. Mr.
Stonecipher and his allies were reluctant to commit to a new jetliner unless the cost fell
sharply.17
In late 2003, Condit resigned as CEO and was replaced by Stonecipher. To persuade the board of
directors to sign off on the 787 program, Mulally and the 787 team had to convince important
partners to take on half of the program’s estimated $10 billion development costs. After approval by
the board, Mike Bair, a 24-year veteran, was appointed VP and general manager of the program. The
group of engineers assembled to help Bair collectively had over 100 years of experience building
airplanes.
Exhibit 3 shows the team initially assembled to manage the 787 program. Exhibit 4 is Boeing’s
blueprint for its new global-partnership strategy product architecture. The global-partnership model
entailed distributed manufacturing, distributed engineering, air transportation of large airplane
sections, and final assembly.
Distributed engineering In the past Boeing had worked with partners in a mode called
“build to print”: engineers developed a design and detailed drawings (often hundreds of pages) for
every part of the plane, and then contracted to build the parts to exact specifications. The 787
program was different. Boeing wanted its 787 partners to “build to performance,”: that is, the
detailed drawings and tooling would be the direct responsibility of Boeing’s partners—along with
the financial risk of participating in the project.
Boeing would focus on the airplane’s architectural definition, and the fundamental analyses that
were required to get it certified, higher-level capabilities that their risk-sharing partners lacked. The
premise behind letting partners do much of the design, was that they could them optimize their
factories for efficient production.
Distributed manufacturing Boeing’s approach to manufacturing the 787 also differed
significantly from past programs. Its partner teams would be responsible for large structural sections,
including the wings.
Japan’s leading aircraft manufacturers—Kawasaki, Fuji, and Mitsubishi Heavy Industries—would
take on much of the airplane’s structural work and the wings. These risk-sharing partners joined
Boeing’s new global engineering and production network in keeping with the network architecture
laid out in Vision 2016. Boeing had a 30-year relationship with the Japanese partners and liked the
disciplined approach they brought to the table. The Italian partners provided some unique
intellectual property that Boeing did not have access to.
As Phil Condit explained in 2008, a few years after leaving the company:
As driven by our 2016 strategy, Boeing has been building a unique capability to
effectively work with global partners in collaborating on major components of an
airplane, and integrating them into a highly reliable completed commercial airplane
system. The 787 is the latest manifestation of this capability, with Tier 1 “stuffed” major
components such as the wings, tails, fuselage, and engines. . . . There is a lot of concern
[in the media] about us having a global partner build the wing of the airplane. The
arguments went along the lines that the wing design and manufacture is Boeing’s
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615-048 Boeing 787: Manufacturing a Dream
6
DNA—we can’t allow an outsider to build the wing. The 2016 strategy indicates
otherwise. In fact, the reason we originally built the wings ourselves is that it was so big
and difficult to transport, the costs were too high to ship from someplace else. Other
than that consideration, there was no secret event compelling us to build the wing in-
house.18
Exhibit 5 is a simplified illustration of the production network for the 787, and of the approach
that Boeing employed to build the airplane as of 2004. The lower-case e connotes the relatively
diminished role of Boeing engineering personnel relative to past programs. This configuration
reduced Boeing’s financial risk because its partners bore the significant R&D costs.
Boeing intended to certify and deliver the airplane by 2008. The plane’s configuration was
scheduled to be finalized by the end of 2005; the first flight test was scheduled for 2007.
The wings were made at Mitsubishi Heavy Industry and Fuji Heavy Industry’s new facilities at
Nagoya, Japan, and air-transported to Boeing in Everett. The main landing-gear wheel well, the
forward fuselage, and the center-wing box were built and air-transported from Kawasaki’ Heavy
Industry’s Nagoya factory to the Global Aeronautica [GA] factory in Charleston, South Carolina.
Alenia, the Italian partner, made the center fuselage and transported it to the GA factory in
Charleston (GA was a joint venture between Vought and Alenia). The horizontal stabilizers would be
delivered to Vought’s Charleston factory, which also made the aft-fuselage sections. Spirit, a Boeing
spinoff in Wichita, Kansas, made the forward fuselage. The rightmost rectangle in Exhibit 5
demarcates Boeing’s boundaries, showing the company as a separate entity central to the modular
product strategy.
Air transportation and final assembly To speed up transport of aircraft sections to the final
assembly site, Boeing employed air transportation for parts delivery, a first for the company.This
approach also embodied the lean-management principles espoused by the Vision 2016 document.
The expected delivery time was one day; other programs’ delivery times had been as long as 30 days.
Air transport was expected to result in a savings of 20–40 percent over traditional shipping
approaches. Boeing estimated that the savings would allow its initial investment in air-transport
assets to be recouped during the first few years of production. The company relied on four modified
747-400s, aptly named “Dreamlifters,” to move the 787 components.
Boeing estimated that final assembly of a plane could be accomplished in three days, saving
valuable assembly time. This was possible because unlike metals, composites contract or expand with
changing temperatures. Also, the plane’s body “barrel” sections could be built in one piece, using
robots.19
Bair and his team had spent three years developing the blueprint for the 787 and setting up the
manufacturing network. On July 8, 2007, a date chosen for its symbolic value (7/8/07), Boeing rolled
out the first airplane, an event that officially marked the end of the design phase. By then customers
had ordered hundreds of airplanes (see Exhibit 6). It was now up to Boeing to deliver the product to
its waiting customers.
Delays and Boeing’s Response
But beginning in September 2007, the 787 program ran into embarrassing delays—delays that
represented a serious setback to Boeing’s intention to become a large-scale systems integrator.
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Boeing 787: Manufacturing a Dream 615-048
7
Reasons for Delay
Many industry observers blamed Boeing’s global-partnership model for the delays. The model
outsourced an unprecedented share of manufacturing to partners in the United States, Italy, and
Japan. According to the Wall Street Journal:
Boeing extolled the business virtues of having suppliers from as far away as Japan
and Italy build much of the fuel-efficient new jetliner, with Boeing performing final
assembly. . . . But the plan backfired when suppliers fell behind in getting their jobs
done [and] Boeing was forced to turn to its own union workforce to piece together the
first few airplanes after they arrived at the company’s factory in Everett, Wash., with
thousands of missing parts.20
Exhibit 7 provides a summary and reasons for the delivery delays as they pertain to the
production network that Bair and his team had developed.
“Many of these [first-tier supplier] partner companies have struggled either in building the
components themselves or getting the parts they need from [second-tier suppliers] in time to meet
Boeing’s rigorous construction schedule,”21 Business Week reported in early 2008. Published reports
pinpointed one particular reason for the delay: botched assembly of the first 787 fuselages at two
factories in Charleston, South Carolina (see Exhibit 7, delays 4 and 5). Vought Aircraft Industries
managed one factory; Global Aeronautical (GA), an alliance between Vought and Italy’s Alenia,
managed the other. GA was responsible for integrating the large fuselage sections from Italy and
Japan with Boeing-furnished parts.
According to a blunt account in the Seattle Times: “The two factories planted here to build big
Boeing 787 Dreamliner fuselage sections began as a disastrous experience in outsourcing. Their
incomplete work played a large part in the snafus that snarled the final assembly line in Everett that
has delayed the 787’s first flight by 14 months.”22 Elmer Doty, CEO of Vought, responded sharply:
Vought’s role in the venture became problematic when the supply chain broke down
and work that was to be completed by other major suppliers arrived in Charleston
unfinished. . . . The problem was Vought had no control over the procurement of those
large pieces [from Kawasaki, the Japanese partner]. Boeing as the prime contractor was
responsible for managing those major partners. . . . To manage the traveled work
efficiently, you need that responsibility. . . . That is best done by the prime [contractor,
Boeing].23
Doty blamed Boeing’s network design and reporting relationships for the delays.
Media accounts also blamed problems at the Spirit Aerosystems plant, formerly Boeing Wichita,
for early delays (see Exhibit 7, delay 1). Spirit was responsible for the forward fuselage, including the
cockpit installation; Honeywell was responsible for computer code that ran the airplane’s flight
control.24
Alongside these supply-chain and partner-capability issues, Boeing machinists objected to
Boeing’s global-partnership model and the outsourcing it entailed. In 2008 the machinists decided to
strike. The eight-week work stoppage resulted in further delay (see Exhibit 7, delay 5).
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615-048 Boeing 787: Manufacturing a Dream
8
Management’s Response
Top management defended its approach. Jim McNerney, who had succeeded Harry Stonecipher
as CEO in 2005 when Stonecipher violated the company’s code of conduct, readily admitted Boeing’s
execution problems, but saw no reason to change the overall approach. In McNerney’s words:
The global partnership model of the 787 remains a fundamentally sound strategy. It
makes sense to utilize technology and technical talent from around the world. It makes
sense to be involved with the industrial bases of countries that also support big
customers of ours. But we may have gone a little too far, too fast in a couple of areas. I
expect we’ll modify our approach somewhat on future programs—possibly drawing the
lines differently in places with regard to what we ask our partners to do, but also
sharpening our tools for overseeing overall supply chain activities.25
In an open letter to Boeing employees, McNerney described some of the delays (specifically Delay
4 in Exhibit 7):
Two themes have emerged from the 787 at this early stage in its life. One centers on
innovation, the other on execution. . . . Fundamental game-changing innovation like
what we’re pursuing on the 787 usually has a “bleeding-edge” quality; it goes beyond
“leading edge” into a realm where both the risks and the potential returns are high.
As example of bleeding-edge innovation, published reports pointed to problems with composites,
specifically with the carbon-fiber technology used for structural sections of the airplane, including the
wing box designed by Kawasaki Heavy Industries. Redesigning the wing box—which according to
the 787 blueprint was the responsibility of Boeing’s partner [Kawasaki]—now became Boeing’s
problem.
Responding to Delays
Within days of announcing the first delay in September 2007, Mike Bair was reassigned and
replaced by Pat Shanahan as vice president and general manager of the 787 program. Shanahan, who
had joined Boeing in 1986, had recently been credited with turning around the Chinook helicopter,
the V-22 Osprey tilt-rotor airplane, and ground-based missile-defense programs at Boeing’s Defense
division. By this time, too, Alan Mulally had left Boeing to head Ford Motor Company.
Changes under Pat Shanahan (October 2007–December 2008)
Shanahan quickly made changes in the lineup of the 787 executive team and reassigned
responsibilities for airplane development, the global-supply chain, and final assembly and delivery.
Under Shanahan’s leadership, program managers took steps to address the delay and get the 787
back on schedule.
Promoting collaboration Shanahan reassigned engineers to the 787 program from other
divisions, and assigned them responsibility for specific parts, such as electrical systems, structures,
and computers.26 Importantly, the engineers’ role thus shifted from passive observer to active
participant. This approach resulted in part from McNerney’s directive that Boeing managers “take a
more aggressive role in sticking their noses into suppliers’ operations, including stationing Boeing
employees in every major supplier’s factory.”27
Boeing engineers began to collaborate intensely with partner firms to resolve immediate issues
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Boeing 787: Manufacturing a Dream 615-048
9
and avoid future delays. Boeing threw money at the delays (about $2 billion in additional R&D
expenses) and, according to The Wall Street Journal, dispatched “hundreds of its own employees to
attack problems at plants in Italy, Japan and South Carolina.”28Boeing engineers and production
workers were co-located at the factories of Tier 1 suppliers to share their expertise and facilitate
integration.
Bottlenecks at the GA and Vought factories in Charleston absorbed much of Shanahan’s attention.
These facilities were staging sites for preassembling fuselage sections from the Japanese and Italian
partners. As Shanahan pointedly noted, only some of Boeing’s partners were having difficulty
executing the agreed-on plan:
We’ve had people, whether it’s supervision helping them incorporating [design]
changes back in Charleston or folks helping them with their supply chain, that’s been
ongoing for a better part of the startup of the program [since 2006]. More recently we
had a higher influx of people into Charleston, because when you compare the capability
and capacity, the limitation is there, it’s not at Spirit, it’s not at MHI [Mitsubishi Heavy
Industries] or KHI [Kawasaki Heavy Industries] or FHI [Fuji Heavy Industries]. That
seems to have the biggest payoff.29
The Wall Street Journal, surveying Boeing’s interventions, reported that “Boeing helped eliminate
four days from the time it takes to drill holes in various fuselage sections when they arrived at
Global, as well as identifying modifications to equipment that will allow the factory to reach full
potential rates more swiftly.”30 Still unsatisfied with the speed of progress, Boeing bought Vought
Aircraft Industries’ 50 percent stake in GA, resulting in a Boeing and Alenia joint venture, in March
2008.
Developing tools and routines for integration The new strategy dictated that, instead of
individual parts, stuffed modules or “work packages” would be assembled at Everett. Managers tried
to optimize the Everett factory for “snap-fitting” preassembled fuselage sections. But when
incomplete work packages began to arrive (see Exhibit 7, delay 3), the Everett factory was unable to
assemble the subsections.
Scott Carson, then-CEO of Boeing Commercial, responded by pointing out that Boeing lacked
oversight of the work being done by its Tier 1 partners. “In addition to oversight [of the program],
you need insight into what’s actually going on in those [partner] factories. . . . Had we had adequate
insight, we could have helped our suppliers understand the challenges.”31In other words, Boeing
managers recognized that greater visibility on the part of its partner facilities would enable Boeing to
predict, not just react to, supply-chain contingencies (e.g., delays 3, 4, 5, and 6). Ben Funston, a Boeing
supply-management executive, put it this way:
On a legacy program you can pretty much walk out into the Everett factory and kind
of get a feel for how production’s going. . . . The reason isn’t because that’s an all inside
make, but basically because we ship in a bunch of small sub-assemblies and we integrate
it all here. . . . The 787 program is totally different—a different business model. We still
have a global footprint, but those partners are doing all the design and integration and
build so that by the time you get here to Everett, you’re receiving a few sections of
fuselage and wings and we integrate it here. . . . We needed a tool to give us situational
awareness into the production system, the ability to have early issue detection and real-
time problem resolution. If you find it here or even at the partner before he’s getting
ready to ship, it’s too late.32
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615-048 Boeing 787: Manufacturing a Dream
10
The Production Integration Center To gain a better understanding of the supply chain, the
787 team created the Production Integration Center (PIC) in December 2008. According to Bob Noble,
VP for 787’s supply chain, the center’s purpose was “to provide situational awareness, early issue
detection and real-time problem resolution for the 787 Dreamliner production system.”33 PIC also
continuously monitored conditions around the world, ranging from natural disasters like tornados
and earthquakes to riots and epidemics, which could all potentially affect production.34
The PIC is a 5,100-square-foot high-tech operations center that operates around the clock. Its 27
workstations each have three screens; at the front of the room a 40’x10’ video screen’s 24 displays
monitor world news and global weather patterns, provide real-time information on production issues
at each supplier, track the functioning of computer servers, and display shipping schedules for the
four giant Dreamlifters (converted 747s) that transport parts to the Everett plant.35 The center is
manned by multifunctional teams of specialists in aircraft design, avionics, structures, technology,
assembly, and logistics, as well as translators of 28 languages.
The aim of the PIC is to promote supply-chain integration and resolve problems as they arise. If
an engineer at a partner site has an issue, he or she can contact appropriate Boeing personnel via the
PIC to help resolve it. An industry observer explained:
Suppliers as far afield as Australia, Italy, Japan and Russia could call in through
translators and show Boeing engineers in the center close-up images of their
components using high-definition handheld video cameras. … Immediate multimedia
communications have eliminated the problem of unclear email exchanges between
distant engineers who work on opposite ends of the clock.36
In conjunction with construction of the PIC, Boeing developed a set of proprietary routines to
monitor production status throughout the 787 global network.a Managers electronically recorded and
monitored transactions to ensure that problems were addressed and resolved. Using information
generated by partners, the PIC team developed routines and graphic-display techniques to monitor
the manufacturing process using cameras installed at a partner’s site.
As call volumes increased, PIC managers adopted a priority system.37 Ben Funston, a senior
executive, explained, “If we came in and said this is an absolute line-stopper for the program, then
everyone stops what they are doing at that site and realigns to that priority.”38
PIC bore responsibility for transporting subassemblies from Europe and Asia, and for ensuring
that they arrived at the U.S. assembly sites. It also scheduled transportation of preassembled sections
from South Carolina and Washington.
Evolution of the PIC Over time, as the nature and volume of calls to the PIC changed, the
center evolved. Initially, incoming calls focused on design issues. To address later calls about
production-related issues at partner factories, the center used multidisciplinary teams of engineers
representing the main components of the aircraft. PIC was organized to support each Tier 1 supplier
(that is, groups within PIC were assigned to handle integration problems at a specific supplier). As

a These routines range from recording and monitoring phone calls from partner engineers to sophisticated simulations of how
the production system might react if faced with large-scale disruptions due to natural disasters.
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Boeing 787: Manufacturing a Dream 615-048
11
the supply chain stabilized, the focus shifted to the rapid delivery of critical parts needed at final-
assembly sites.b
Industry experts agree that the PIC was pivotal in stabilizing the 787’s supply chain, as measured
by fewer delays stemming from design changes due to flight tests and less traveled work.39 (Traveled
work is work assigned to a supplier but later sent to Everett, for scheduling reasons, for Boeing
workers to complete.) Thanks to improved communication and collaboration, the time devoted to
problem resolution between partner engineers and Boeing was significantly shortened.
Changes under Scott Fancher (December 2008–February 2012)
As supply-chain issues were addressed and progress was made, Scott Fancher succeeded
Shanahan as VP and general manager of the 787 program.Fancher was responsible for day-to-day
operations. He had previously headed Boeing’s missile-defense systems, a U.S. defense-related
program. Fancher would report to Shanahan, now in charge of all Boeing commercial aircraft
programs.
Asked about delays, Fancher responded:
You know, you get into a situation where either some of the first tiers or their sub-
tiers simply aren’t able to perform.There could be a lot of reasons for that; it could be
they are in financial stress, it could be that technically they’ve run into a situation they
can’t handle, or it could be the complexity of the production of the product they’ve
designed is beyond their capability, so we tend to look at the root cause of the non-
performance and how we can help them succeed. . . . As we go forward, we’ll look at
rebalancing the work scope, as we sort through where work is most efficiently and cost-
effectively done, but by and large the focus is on helping our supply chain succeed, not
moving the work in a rapid fashion [without completing it].40
Redrawing Boeing’s boundaries In a significant if unsurprising move, Boeing bought
Vought’s Charleston factory in August 2009.The plant would assemble a major section of the 787’s
fuselage, relegating Vought to the role of a supplier of components and subsystems. It was no longer
a risk-sharing partner responsible for pre-assemble of fuselage sections. In December, Boeing
dissolved its joint venture with Alenia and took over Alenia’s Charleston factory. In doing so, Boeing
assumed all pre-assembly of the major fuselage components at the Charleston location.
Boeing reorganized Vought’s factory and took responsibility for assembling the airplane’s floor
grid, previously outsourced to Israel Aircraft Industries; that supplier’s role would be limited to
delivering components to be assembled into full sections by Boeing employees and installed into the
fuselage at the Charleston plant. These changes in organizational boundaries—internalizing
previously outsourced work, reorganizing the roles of second-tier suppliers—were covered
extensively in the media. Areas of responsibility were redefined throughout the global supply
network to match Boeing’s and suppliers’ capabilities.
Building a new plant in South Carolina In October 2009, Boeing announced its intention to
build a second final-assembly plant in South Carolina, adjacent to the factories acquired from Vought

b In 2013, the center was redesigned to mirror the final factory assembly layout at Everett. PIC had developed routines—
protocols for meetings, ad-hoc requests to move large cargo, disruption reports to senior management and partners—to
manage supply-chain integration. Currently Boeing supply-chain managers are replicating PIC-like capabilities on a smaller
scale to increase the visibility of Tier 2 suppliers at other facilities.
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615-048 Boeing 787: Manufacturing a Dream
12
and GA. Boeing hoped this billion-dollar investment would double its production capacity on the
787. According to one press report:
The news [about construction of a factory] came shortly after South Carolina
legislators approved an economic incentive package . . . tailored to lure the Boeing
assembly plant to the state. The incentive package would allow lawmakers to guarantee
tax breaks and low-interest loans for an unidentified economic development prospect.41
Jim Albaugh, who succeeded Scott Carson as CEO Commercial in September 2009, gave an eye-
opening explanation for the move:
The overriding factor was not the business climate [in Everett]. And it was not the
wages we are paying today. . . . It was that we can’t afford to have a work stoppage [due
to strikes] every three years. And we can’t afford to continue the rate of escalation of
wages.42
Albaugh was referring to a series of strikes at its Everett plants that had plagued Boeing since the
1990s.The most recent, an eight-week work stoppage in 2008, had cost Boeing nearly $2 billion in
lost revenues and delayed the 787 schedule. Following publication of Albaugh’s comment, the
company’s official position was that he had been misquoted and that the location of the second final-
assembly plant was based on multiple criteria. (South Carolina is a “right-to-work” state where
compelling workers to join a union or pay union dues is not permitted.) According to the Wall Street
Journal:
Boeing’s main union initially fought plans for the North Charleston plant. The
machinists persuaded the National Labor Relations Board to file a complaint last spring,
two months before the production was to start, alleging that Boeing had selected the
plant as illegal retaliation for the 2008 strike. The NLRB dropped the complaint
following an agreement between Boeing and the union to build the next version of its
single-aisle 737 Max at its unionized Renton, Wash., factory.43
Analysts speculated that Boeing’s new facility in South Carolina could change the character of the
U.S. airframe industry, as had happened decades earlier when car manufacturers moved production
from Detroit to factories in the South.
Under Fancher’s leadership, the South Carolina plant became fully operational relatively quickly,
and delivered its first 787 Dreamliner to Air India on October 12, 2012. The plant employed over 6,000
non-union workers, with a goal of increasing production to three airplanes a month by late 2013.
Enter Larry Loftis
In February 2012 Boeing made its fourth leadership change, announcing that Larry Loftis was to
succeed Fancher as VP and general manager of the 787 program. Announcing the change, Albaugh
said, “As this program transitions into production, this appointment will take advantage of Larry’s
more than 32 years of commercial production experience and knowledge of Boeing’s production
system.” The previous year Loftis had led the 777 to a record year of 200 orders and was credited
with transitioning the 777 program to a lean manufacturing system. The increasing popularity of the
777 was a major reason that Airbus cancelled production of its A340 model in 2011.44
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Boeing 787: Manufacturing a Dream 615-048
13
Decisions Going Forward
After nearly three-and-a-half years of delay, Boeing delivered the first 787 airplane to All Nippon
Airways on September 26, 2011. Even as they announced production of the 787-9, a second-
generation version that would carry 40 more passengers and fly greater distances than the original
model, top management was anxious to apply the lessons learned from the 787 program. One worry
was that a longer version of the airplane could cause disruptions in the supply chain as suppliers
adapted to a different design.
In June 2012, Ray Conner succeeded Jim Albaugh as CEO of Boeing Commercial. Conner
promptly assembled a team to look at the lessons Boeing could take away from the 787 experience.
He was particularly eager to examine strategic issues:
 Was Boeing’s global-partnership model inherently flawed, as many of its critics and the
media argued? Or was the global partnership model a fundamentally sound strategy
whose implementation had been mishandled?
 What went wrong and why?
 How had different program leaders responded to the program delays? Were more
changes called for as production shifted to manufacturing the new 787-9?
 Should Boeing continue to pursue a global partnership model for future airplane
programs? And, in light of the history of the 787 program, should the company reconsider
Vision 2016?
Meanwhile, the Dreamliner program was under pressure to speed up deliveries of the 787 to
reduce the backlog of over 800 orders. The 787 program’s production rate was being increased to ten
airplanes per month, seven in Everett and three in South Carolina, by late 2013. Pressure to deliver
more airplanes intensified in the wake of incidents that raised questions about the lithium-ion
batteries in airplanes already in service.
On January 7, 2013, a fire broke out aboard an empty Japan Airlines 787, when the plane landed in
Boston. Two days later United Airlines reported problems with wiring in the same area as the battery
fire on the JAL plane. A week later an ANA 787 had to make an emergency landing when pilots
received a computer warning of smoke inside the electrical compartments. The FAA, which had
already opened a safety investigation, immediately grounded all 787 airplanes pending further
review. After extensive investigation and further flight testing, Boeing made changes to the airplane’s
battery system; it never definitively determined the root cause of the failure. Satisfied with Boeing’s
changes, the FAA permitted the Dreamliner to resume service on April 19, 2013. The first 50 airplanes
already delivered to customers would be retrofitted with Boeing’s safety solution.

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615-048 Boeing 787: Manufacturing a Dream
14
Exhibit 1 Boeing’s Financial Highlights, 2006-2013 (in $M except earnings per share and operating
margins)

Source: Boeing Annual Reports.

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Boeing 787: Manufacturing a Dream 615-048
15
Exhibit 2 Boeing 2016 Vision Document, 1997

Source: Internet Archive, “WayBack Machine Boeing,”
https://web.archive.org/web/20130702000047/http://www.boeing.com/assets/pdf/companyoffices/aboutus/co
mmunity/Vision_2016_chart.pdf, accessed February 2015.
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https://web.archive.org/web/20130702000047/http:/www.boeing.com/assets/pdf/companyoffices/aboutus/community/Vision_2016_chart.pdf
https://web.archive.org/web/20130702000047/http:/www.boeing.com/assets/pdf/companyoffices/aboutus/community/Vision_2016_chart.pdf
615-048 Boeing 787: Manufacturing a Dream
16
Exhibit 3 787 Executive Team, 2003

Michael B. Bair, 46, is a 24-year Boeing veteran who most recently led the company’s Commercial
Aviation Services business. He also played a key role in development of the Boeing 777 and has served in a
variety of senior marketing and sales positions.
Walter B. Gillette, 61, will be responsible for full development of the airplane, including engineering,
manufacturing and partner alignment. Gillette led the company’s development work on the Sonic
Cruiser’s enabling technologies, which form the foundation of the new super-efficient airplane. In his 37
years with the company, Gillette has worked on every new Boeing commercial jet.
John N. Feren, 47, will lead sales, marketing, and in-service support. Feren brings 25 years of
commercial airplane sales, marketing and program management experience to his new position. He most
recently served as vice president of sales for airlines in Americas leasing companies worldwide.
Craig A. Saddler, 43, will lead finance and business operations. A 22-year company veteran, Saddler
has an extensive background in financial operations, most recently serving as chief financial officer of the
company’s Shared Services Group, president of Boeing Travel Management Co., and interim president of
Boeing Realty Corp.
Source: Boeing Press Releases, January 29 2003. http://boeing.mediaroom.com/2003-01-29-Boeing-Selects-Leaders-for-New-
Commercial-Airplane-Development-Programaccessed February 2015.
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http://www.boeing.com/news/releases/2003/q1/saddler.pdf
http://boeing.mediaroom.com/2003-01-29-Boeing-Selects-Leaders-for-New-Commercial-Airplane-Development-Program
http://boeing.mediaroom.com/2003-01-29-Boeing-Selects-Leaders-for-New-Commercial-Airplane-Development-Program
Boeing 787: Manufacturing a Dream 615-048
17
Exhibit 4 787 Dreamliner—Major Partners and Proposed Product Architecture

Source: Molly Parker, “Boeing Co. bringing 787 plant to North Charleston,” Charleston Business Journal, October 28 2009.
http://www.charlestonbusiness.com/news/31440-boeing-co-bringing-787-plant-to-north-charleston/,accessed
February 2015.
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http://www.charlestonbusiness.com/news/31440-boeing-co-bringing-787-plant-to-north-charleston/
615-048 Boeing 787: Manufacturing a Dream
18
Exhibit 5 Production Network for the Boeing 787 Dreamliner, 2004

Source: Casewriter analysis and interpretation.
Note: The circled upper-case E in the various supplier boxes denotes engineering work passed on to risk-sharing partners.
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Boeing 787: Manufacturing a Dream 615-048
19
Exhibit 6 Cumulative Net Orders of the 787 Dreamliner, (2004–2013)

Source: Boeing Corporation Data. http://active.boeing.com/commercial/orders/index.cfm , accessed February 2015.
55
290
447
816
909
850 846 859 847
889
0
100
200
300
400
500
600
700
800
900
1000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
N
u
m
b
e
r
o
f
7
8
7
a
ir
p
la
n
e
s
o
rd
e
re
d
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http://active.boeing.com/commercial/orders/index.cfm
615-048 Boeing 787: Manufacturing a Dream
20
Exhibit 7 Delays in the 787 Program and Boeing’s Explanations, 2007-2009
Delay # Announcement Date
Cumulative
Duration
Explanation (as reported by Boeing and discussed
in the media)

1 September 2007 3 months Problems result from unexpected shortages of fasteners
and the inability of Spirit—a Boeing spinoff—to deliver the
forward fuselage module (see Exhibit 5). Spirit blames
incomplete software code for flight-control systems
manufactured by Honeywell, a Tier 2 supplier to Spirit.

2 October 20076 months Media reports and Boeing blame Boeing’s supply-chain
network. No details are specified.

3 January 20089 months Boeing blames startup challenges at its own factory and at
factories in the extended global supply chain, specifically the
supply chains and capabilities of Boeing’s subsidiaries and
Tier 1 partners.

4 April 20081 year Boeing blames problems with carbon-fiber technology in the
center wing box made by a Japanese partner. The wing box
was too light and needed strengthening. The media identify
this partner as Kawasaki Heavy Industries (KHI). Though
the problem is the primary responsibility of KHI, Boeing
engineers work on a patch.
Boeing blames botched assembly of fuselages at the
Charleston, Vought, and GA factories. Incomplete work
transported from these factories creates issues on the final
assembly line at Boeing’s Everett plant. Vought blames
Kawasaki Heavy Industries for sending incomplete work and
notes its own lack of authority to discipline supplier.

5 December 2008 2 years Delays are due to improper work by partners. Boeing must
replace improperly installed fasteners in the early production
airplanes. The media attribute the faulty installation to
Boeing’s poorly written technical specifications and
suppliers’ lack of experience with such work. (The suppliers
are GA and Vought.)
Boeing faces a 58-day strike by the machinists’ union at its
Everett plant. The machinists reject wage increases offered
by Boeing and object to Boeing’s global partnership model,
which outsources 787 jobs.

6 June 23, 2009 2+ yearsDelays are blamed on structural flaws resulting from mating
the wings to the fuselage. The flaws are blamed on
engineering issues without specifying responsibility.
Mitsubishi Heavy Industries, a Japanese partner, is
responsible for the wings.

Source: Casewriter. Boeing Press Releases and Public Reports, http://boeing.mediaroom.com, accessed February 2015.
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http://boeing.mediaroom.com/
Boeing 787: Manufacturing a Dream 615-048
21
Appendix A: Boeing 787 Dreamliner: Chronology of Events

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615-048 Boeing 787: Manufacturing a Dream
22
Endnotes

1 “Boeing, ANA Celebrate First 787 Dreamliner Delivery,” Boeing Press Release, September 26, 2011, on Boeing website,
http://boeing.mediaroom.com/2011-09-26-Boeing-ANA-Celebrate-First-787-Dreamliner-Delivery, accessed September 2014.
2 Dominic Gates and Melissa Allison, “Boeing, ANA celebrate first 787 delivery,” The Seattle Times, September, 26, 2011,
http://www.seattletimes.com/business/boeing-ana-celebrate-first-787-delivery/, accessed May 2015.
3 Jon Ostrower, “Boeing aims at smooth ramp-up,” Flight Global, June, 14, 2011,
http://www.flightglobal.com/news/articles/boeing-aims-at-smooth-ramp-up-357533/, accessed May 2015.
4 John Newhouse, Boeing versus Airbus: The Inside Story of the Greatest International Competition in Business (New York:
Knopf, 2007).
5 “Delivery Begins of The World’s Largest Civil Aircraft with Wings,”Airbus Press Release, April 5, 2004, on Airbus website,
http://www.airbus.com/presscentre/pressreleases/press-release-detail/detail/airbus-press-centre-press-release-10/,
accessed September 2014.
6 Rick Roff, “A Smart Bet,” Frontiers, June 2003, http://www.boeing.com/news/frontiers/archive/2003/june/cover1.html
7 Alex Taylor III, “Lord Of The Air: What’s left for Airbus after overtaking Boeing in the commercial aircraft market? Building a
really big plane,” Fortune, November 10, 2003,
http://archive.fortune.com/magazines/fortune/fortune_archive/2003/11/10/352824/index.htm, accessed September 2014.
8 Scott Mayerowitz, “What went wrong with Boeing’s 787 Dreamliner,” NBC Bay Area, January 25, 2013,
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–
188336221.html, accessed September 2014.
9 Alan MacPherson and David Pritchard, “The International decentralization of US commercial aircraft production:
implications for the US employment and trade.” Futures, 25 (2003): 221, p. 229.
10 Richard Aboulafia, “The Airbus Debacle,” The Wall Street Journal, June 20, 2006,
http://online.wsj.com/articles/SB115076743837384778, accessed September 2014.
11 “Boeing Celebrates the Premiere of the 787 Dreamliner,” Boeing Press Release, July 8, 2007, on Boeing website,
http://boeing.mediaroom.com/2007-07-08-Boeing-Celebrates-the-Premiere-of-the-787-Dreamliner, accessed September 2014.
12 “Boeing 787 Dreamliner Provides New Solutions for Airlines, Passengers,” Boeing Press Release
http://www.boeing.com/singapore2014/pdf/BCA/bkg-787.pdf , accessed May 2015.
13 ”Who will supply all the parts?” The Seattle Times, June 15, 2003,
http://community.seattletimes.nwsource.com/archive/?date=20030615&slug=7e73question15, accessed September 2014.
14 Stephen Clark, “787 Propulsion System” Aeromagazine, 2012,
http://www.boeing.com/commercial/aeromagazine/articles/2012_q3/pdfs/AERO_2012q3_article2.pdf , accessed May 2015.
15 Ibid.
16 Scott Mayerowitz, “What went wrong with Boeing’s 787 Dreamliner,” NBC Bay Area, January 25, 2013,
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–
188336221.html, accessed September 2014.
17 Jon Ostrower and Joann Lublin, “The Two Men Behind the 787,” The Wall Street Journal, January 24, 2013,
http://online.wsj.com/news/articles/SB10001424127887324039504578260164279497602, accessed September 2014.
18 Suresh Kotha and Kannan Srikanth, “Managing a Global Partnership Model: Lessons from the Boeing 787 ‘Dreamliner’
Program,” Global Strategy Journal, February 2013, http://onlinelibrary.wiley.com/doi/10.1111/j.2042-
5805.2012.01050.x/abstract, accessed September 2014.
19 Bill Sweetman, “Boeing, Boeing, Gone?” Popular Science, June 2004, http://www.popsci.com/military-aviation-
space/article/2004-05/boeing-boeing-gone, accessed September 2014.
20 J. Lynn Lunsford, “Outsourcing at Crux of Boeing Strike,” The Wall Street Journal, September 8, 2008,
http://online.wsj.com/articles/SB122083149762108451, accessed September 2014.
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http://boeing.mediaroom.com/2011-09-26-Boeing-ANA-Celebrate-First-787-Dreamliner-Delivery
http://www.seattletimes.com/business/boeing-ana-celebrate-first-787-delivery/
http://www.flightglobal.com/news/articles/boeing-aims-at-smooth-ramp-up-357533/
http://www.airbus.com/presscentre/pressreleases/press-release-detail/detail/airbus-press-centre-press-release-10/
http://www.boeing.com/news/frontiers/archive/2003/june/cover1.html
http://archive.fortune.com/magazines/fortune/fortune_archive/2003/11/10/352824/index.htm
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–188336221.html
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–188336221.html
http://online.wsj.com/articles/SB115076743837384778
http://boeing.mediaroom.com/2007-07-08-Boeing-Celebrates-the-Premiere-of-the-787-Dreamliner
http://www.boeing.com/singapore2014/pdf/BCA/bkg-787.pdf
http://community.seattletimes.nwsource.com/archive/?date=20030615&slug=7e73question15
http://www.boeing.com/commercial/aeromagazine/articles/2012_q3/pdfs/AERO_2012q3_article2.pdf
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–188336221.html
http://www.nbcbayarea.com/news/national-international/NATL-From-the-Start-Dreamliner-Jet-Program-Was-Rushed–188336221.html
http://online.wsj.com/news/articles/SB10001424127887324039504578260164279497602
http://onlinelibrary.wiley.com/doi/10.1111/j.2042-5805.2012.01050.x/abstract
http://onlinelibrary.wiley.com/doi/10.1111/j.2042-5805.2012.01050.x/abstract
http://www.popsci.com/military-aviation-space/article/2004-05/boeing-boeing-gone
http://www.popsci.com/military-aviation-space/article/2004-05/boeing-boeing-gone
http://online.wsj.com/articles/SB122083149762108451
Boeing 787: Manufacturing a Dream 615-048
23

21 Judith Crown & Carol Matlack, “Boeing Delays Dreamliner Again,” Business Week, April 9, 2008,
http://www.businessweek.com/stories/2008-04-09/boeing-delays-dreamliner-againbusinessweek-business-news-stock-
market-and-financial-advice, accessed September 2014.
22 Dominic Gates, “Boeing Expertise Speeding Up 787 partners,” The Seattle Times, June 11, 2008,
http://seattletimes.com/html/boeingaerospace/2004470059_charleston11.html, accessed September 2014.
23 Dominic Gates, “Boeing partner Vought gives sides of 787’s missteps,” The Seattle Times, June 11, 2008,
http://www.seattletimes.com/business/boeing-aerospace/boeing-partner-vought-gives-side-of-787s-missteps/, accessed
May 2015.
24 J. Lynn Lunsford, “Boeing scrambles to repair problems with new plane,” The Wall Street Journal, December 7, 2007,
http://online.wsj.com/articles/SB119698754167616531, accessed September 2014.
25 James McNerney to Boeing staff, memorandum regarding “Time to deliver on the 787”, April 21, 2008, Boeing, from The
Wall Street Journal, http://online.wsj.com/public/resources/documents/boeingmemo-04242008.pdf, accessed September
2014.
26 Daniel Michaels & Peter Sanders, “Dreamliner Production Gets Closer Monitoring,” The Wall Street Journal, October 8, 2009,
http://online.wsj.com/articles/SB125486824367569007, accessed September 2014.
27 J. Lynn Lunsford, “Boeing CEO Fights Headwind,” The Wall Street Journal, April 25, 2008,
http://online.wsj.com/articles/SB120906014850342063, accessed September 2014.
28 J. Lynn Lunsford, “Boeing Scrambles to Repair Problems With New Plane,” The Wall Street Journal, December 7, 2007,
http://online.wsj.com/articles/SB119698754167616531, accessed September 2014.
29 Jon Ostrower, “Source: Boeing to buy Vought’s 787 operations,” Flightglobal, July 1, 2009,
http://www.flightglobal.com/blogs/flightblogger/2009/07/sources_boeing_to_buy_voughts/, accessed September 2014.
30 J. Lynn Lunsford, “Boeing Moves to Solve 787 Delays,” The Wall Street Journal, March 29, 2008,
http://online.wsj.com/news/articles/SB120671274797471773, accessed September 2014.
31 J. Lynn Lunsford, “Boeing Scrambles to Repair Problems With New Plane,” The Wall Street Journal, December 7, 2007,
http://online.wsj.com/articles/SB119698754167616531, accessed September 2014.
32 Steve Creedy, “The Boeing 787 team that is leaving a dream,” The Australian, April 23, 2010,
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-
1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b, accessed September 2014. Emphasis added.
33 Jon Ostrower, “Source: Boeing to buy Vought’s 787 operations,” Flightglobal, July 1, 2009,
http://www.flightglobal.com/blogs/flightblogger/2009/07/sources_boeing_to_buy_voughts/, accessed September 2014.
34 Ibid.
35 Andrea James, “Boeing’s 787 production is mission-controlled,” Seattle Post Intelligencer, April 30, 2009,
http://www.seattlepi.com/business/article/Boeing-s-787-production-is-mission-controlled-1303651.php, accessed September
2014.
36 Daniel Michaels & Peter Sanders, “Dreamliner Production Gets Closer Monitoring,” The Wall Street Journal, October 8, 2009,
http://online.wsj.com/articles/SB125486824367569007, accessed September 2014.
37 Steve Creedy, “The Boeing 787 team that is leaving a dream,” The Australian, April 23, 2010,
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-
1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b, accessed September 2014.
38 Ibid.
39 Jon Ostrower, “PARIS AIR SHOW: Realising the 787 dream,” Flightglobal, June 5, 2009,
http://www.flightglobal.com/news/articles/paris-air-show-realising-the-787-dream-327485/, accessed September 2014.
40 Jon Ostrower, “Speculative musings: What does the future hold for Vought?” Flightglobal, June 1, 2009,
http://www.flightglobal.com/blogs/flightblogger/2009/06/speculative_musings_what_does/, accessed September 2014.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
http://www.businessweek.com/stories/2008-04-09/boeing-delays-dreamliner-againbusinessweek-business-news-stock-market-and-financial-advice
http://www.businessweek.com/stories/2008-04-09/boeing-delays-dreamliner-againbusinessweek-business-news-stock-market-and-financial-advice
http://seattletimes.com/html/boeingaerospace/2004470059_charleston11.html
http://www.seattletimes.com/business/boeing-aerospace/boeing-partner-vought-gives-side-of-787s-missteps/
http://online.wsj.com/articles/SB119698754167616531
http://online.wsj.com/public/resources/documents/boeingmemo-04242008.pdf
http://online.wsj.com/articles/SB125486824367569007
http://online.wsj.com/articles/SB120906014850342063
http://online.wsj.com/articles/SB119698754167616531
http://www.flightglobal.com/blogs/flightblogger/2009/07/sources_boeing_to_buy_voughts/
http://online.wsj.com/news/articles/SB120671274797471773
http://online.wsj.com/articles/SB119698754167616531
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b
http://www.flightglobal.com/blogs/flightblogger/2009/07/sources_boeing_to_buy_voughts/
http://www.seattlepi.com/business/article/Boeing-s-787-production-is-mission-controlled-1303651.php
http://online.wsj.com/articles/SB125486824367569007
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b
http://www.theaustralian.com.au/business/aviation/the-boeing-787-team-that-is-living-a-dream/story-e6frg95x-1225857133866?nk=64b17a69d9fe26c9054e74bf8696555b
http://www.flightglobal.com/news/articles/paris-air-show-realising-the-787-dream-327485/
http://www.flightglobal.com/blogs/flightblogger/2009/06/speculative_musings_what_does/
615-048 Boeing 787: Manufacturing a Dream
24

41 Daniel Lovering, “Boeing picks South Carolina for the 2nd 787 line,” The Seattle Times, October 28, 2009,
http://seattletimes.com/html/localnews/2010155279_apusboeing787plant3rdldwritethru.html, accessed September 2014.
42 Dominic Gates, “Albaugh: Boeing’s ‘first preference’ is to build planes in Puget Sound Region,” The Seattle Times, March 1,
2010, http://seattletimes.com/html/businesstechnology/2011228282_albaugh02.html, accessed September 2014.
43 Ibid.
44 David Kesmodel & Susan Carey, “Boeing Replaces 787 Chief,” The Wall Street Journal, February 25, 2012,
http://online.wsj.com/news/articles/SB10001424052970203960804577243250629556334, accessed September 2014.
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
http://seattletimes.com/html/localnews/2010155279_apusboeing787plant3rdldwritethru.html
http://seattletimes.com/html/businesstechnology/2011228282_albaugh02.html
http://online.wsj.com/news/articles/SB10001424052970203960804577243250629556334
__MACOSX/Course Pack/._Boeing 787 Manufacturing a Dream.pdf
Course Pack/Managing the Multibusiness Corporation.pdf
Harvard Business School 9-391-286
Rev. April 24, 1997
Professor David Collis prepared this case as the basis for class discussion.
Copyright © 1991 by the President and Fellows of Harvard College.To order copies or request permission to
reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to
http://www.hbsp.harvard.edu.No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permi ssion of Harvard Business School.
1
Managing the Multibusiness Corporation
Much of the detail regarding how particular corporations are organized to realize the value
inherent in their corporate strategies is described in the individual cases taught in the course. Rather
than repeat that detail, or the ways in which the elements of organizational design can be mutually
reinforcing, this note outlines a more theoretical approach to managing the multibusiness
corporation.By exposing some of the fundamentals of organizational economics and introducing
some of the newer notions developed by academics working in that area,1 it is intended to inform the
pragmatic choices that corporations must make concerning the many elements of organizational
design.It should, however, be recognized that this note is not intended to be a complete statement of
how to organize the corporation.
Traditionally, the issue of how to manage the multibusiness corporation has been discussed
under the rubric of centralization versus decentralization.Should corporations closely control their
business units, or should they be left to run autonomously?Centralization theoretically facilitates
efficiency and improves coordination, but to the detriment of incentives and entrepreneurial behavior
in business units.Decentralization, in contrast, allows divisional management to respond to the
demands of their own businesses, but sacrifices opportunities to exploit scope economies and address
issues and markets that are not entirely within the domain of one division.The history of General
Electric under successive chairmen up to Jack Welch, for example, can be interpreted as alternating
between these two extremes.
However, this unidimensional treatment of corporate control has come to be recognized as
too limited.There is more variance in the level of autonomy than is implied by the simple
centralized/decentralized dichotomy because there are many elements of organization design that
affect decision making inside the corporation.In the literature on managing multinational
corporations, for example, the current perspective is that the “transnational” corporation can
effectively manage the competing demands for global integration (centralization) with local
responsiveness (decentralization) by, among other things, choosing a different emphasis for each
functional activity, allocating multiple roles to each country organization, and superimposing a
collective rather than a self-interested culture on the company.2This note, therefore, addresses the
issue of managing the multibusiness corporation by, first, recognizing the multiplicity of structures,
systems, and processes that the corporation has available to control and coordinate its businesses,
and second, by arguing that the choice among the alternatives for each of these elements of
organization design must be contingent on the corporate strategy.
1Organizational economics is a broad term that covers a number of approaches, some of which even disagree.
Specific approaches include transactions cost, agency, team, incomplete contracts, and imperfect decision-
making theory.The syllabus provides reference to these different theories.
2C.B. Bartlett and S. Ghoshal, Managing Across Borders:The Transnational Solution (New York: Free Press, 1988).
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391-286 Managing the Multibusiness Corporation
2
Organizational Design Variables
Among earlier classifications of organizational design variables, one of the best known is the
McKinsey “Seven S’s”—strategy, structure, systems, style, superordinate goals, staff, and skills.3 The
importance of this list was that it illustrated that such variables were not limited to the hard elements
of organization structure, but also included the soft elements of culture and people. Alternative
groupings for the various ways in which corporations could affect divisional behavior have also been
advanced.Professor Vancil, for example, described organization structure, management style, and
reward, communication, resource allocation, and reporting systems.4This note suggests another set
of groupings, for which the details are less important than the recognition that the list of
organizational levers is long (and can be further extended by subdividing each item), and also
suggests that there is a basic distinction between the formal structures and systems, and the informal
procedural and cultural elements of organizational design.
• Organization Structure
– organization chart
– corporate functions
– ad hoc teams
– conflict resolution mechanisms
• Planning and Control Systems
– strategic planning
– budgeting
– MIS
– resource allocation
– transfer prices
• HRM
– personnel
– reward/incentive schemes
measurement variables
• Culture and Style
– top management role
– culture
– symbolic actions
– management style
This is, however, merely a pragmatic list of levers.Clearly, we want to understand how to
choose among the myriad possible configurations of each of these variables for each particular
corporate strategy.Should the formal organizational structure be arranged by function, product
division, or as a matrix?Should incentive schemes reward business or corporate performance? Long
or short term results?Qualitative or quantitative variables? etc.
The Contingency Theory of Corporate Structure
How can we be more practical and specific in our recommendations?The first way is to
recognize the need for the internal consistency of the sixteen organizational design variables (or
however many we wish to include on the list).It would, for example, be contradictory for Kraft
General Foods to initiate personnel transfers between the two companies in order to influence the
culture at General Foods, without standardizing compensation and incentive schemes in the two
companies.In particular, both formal and informal elements of organization design need to be
congruent, a result which Saatchi & Saatchi was unable to achieve when it restructured its advertising
agencies in the late 1980s.
However, just as important as keeping the various organizational variables internally
consistent is aligning their arrangement with the other elements of corporate strategy. In other words,
3Reported in R.T. Pascale and A.G. Athos, The Art of Japanese Management(New York: Warner Books, 1981).
4R.F. Vancil, “Texas Instruments,” Harvard Business School Teaching Note No. 182-054.See also R.F. Vancil,
Decentralization:Managerial Ambiguity by Design (Homewood, IL:Dow Jones Irwin, 1978).
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Managing the Multibusiness Corporation 391-286
3
the corporate structure should be contingent on the corporate strategy, 5most particularly on the
resources that are the source of corporate advantage.The argument for this is derived from
contingency theory, which predicts that “the internal characteristics of an effective organization are
contingent upon the work it must perform in dealing with its environment”6 (such as coping with
environmental uncertainty, or integrating interdependent divisions).7
It is this contingency requirement which almost certainly makes corporate strategies
mutually exclusive.A corporation will, for example, have enormous difficulty operating some
divisions as a conglomerate, others as new ventures, and yet others as operating divisions.Either the
requisite difference in organizational design for each type of strategy will create cognitive dissonance
at the corporate level, and a sense of inequity and envy at the division level (when, for example,
managers in a successful but small start up unit receive several-million dollar salaries in lieu of an
equity share in their unit), or else it will cause the corporation to become merely a combination of two
separate units.This is the case at Warner-Lambert, which successfully runs its pharmaceutical
business differently from its consumer products business, but which thereby creates no value by
having the two businesses united in a single corporation.Even the corporate level staff, for example,
is essentially divided between the two halves of the company.
To further understand the contingency requirements for each corporate strategy it is perhaps
most revealing to explain how the tasks and roles for the corporate office influence the arrangement
of the organizational design variables.
Corporate Tasks
Any corporation has to perform three tasks if it is to justify its existence as a multibusiness
entity.The first is simply the performance of the “public company” functions,such as financial and
taxation reporting, which are required of any legally constituted parent organization.The second is
the establishment of the administrative context for the control of decentralized decision making .
This recognizes that in any modern corporate entity most decisions are efficiently made by those
individuals who possess the appropriate local information (what Jensen calls specific information8).
The third task for the corporate office is to deploy the corporate resourcesin each of the business
units in order to create value from its ownership of those businesses.
These tasks refer to the specific roles that the corporate office, or the center more broadly
defined, performs, which are over and above those which the single business unit (SBU) performs by
itself. This does not imply that all resources reside directly at the corporate level.Many resources,
such as a company’s tacit collective knowledge of a technology, are embedded in the business units.
Nevertheless, the corporate center must control their usage and in some way act to mobilize those
resources and effect their transfer or coordination between divisions.Otherwise, there is no
justification for corporate ownership.
Public company functionsThe “public company” functions of the corporation, such as public and
investor relations, legal, financial, and tax reporting, etc., are legally required of any corporate entity.
5For an example see J.R. Galbraith and R.K. Kazanjian, Strategy Implementation:Systems and Process(St. Paul,
MN: West Publishing Company, 1985), p. 116.The thesis that “structure follows strategy” was originally
developed by Alfred Chandler in his seminal work, Strategy and Structure (Cambridge, MA:MIT Press, 1962).
6J.W. Lorsch and S.A. Allen, Managing Diversity and Interdependence (Boston, MA:Harvard Business School
Press, 1973), p. 71.
7Contingency theory has a long tradition in organizational theory, and is supported by empirical research, much
of which was conducted at Harvard Business School.See, for example, the summary in Galbraith and Kazanjian,
op. cit.
8See Jensen’s distinction, drawn from Hayek, between general knowledge that can practically and economically
be transferred among individuals, and specific knowledge that is hard to exchange (Jensen M.E. “Organizations
Theory and Methodology,” The Accounting Review, Vol. 58, April 1983, 319-339).
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391-286 Managing the Multibusiness Corporation
4
The same is true of the routine oversight of business unit behavior to prevent fraud, ensure
consistency with FASB accounting standards, etc.The division would have to perform those
regulatory tasks regardless of ownership, and performing them at the corporate level does not
contribute to corporate advantage.These functions are an expense of doing business as a legal entity
and should be performed as efficiently as possible by independently structured corporate units.
Related to these functions in many corporations are the performance of certain scaleable
overhead activities for the divisions.Many corporations, for example, centralize pension
administration in a corporate unit because it is cheaper than having each division do its own
administration.Unlike the true public company functions, however, these activities should only be
performed at the corporate level if it is the cost effective solution.To ensure that this is the case, these
functions should be structured as corporate service units that are made available to the divisions to
use if they so choose.Structuring such activities as “internal markets”9 places pressure on the
corporate unit to be competitive with outside suppliers in cost and service provision, and,
appropriately, gives divisions control over the decision as to whether the corporate units are indeed
the efficient provider of those services.To the extent that there are any economies of scale in the
performance of these activities, they are optimally centralized at the head office and made available
to the divisions on request.However, the potential value created in the performance of this corporate
task is extremely limited and does not by itself normally justify the existence of a multibusiness
corporation.
Control of decentralized decision making The second task the corporate office must perform is to
set the administrative context for the control of decentralized decision making.In many ways, the
traditional centralization/decentralization argument applied most directly to the task of the
corporate office.Should business units be free to make decisions autonomously, or should the
corporate office determine their choice of strategic direction and functional policies?All corporations
intervene to some extent to change decisions made in their business units because of the need to
overcome the agency problem of business units pursuing behavior in their own self-interest.The
capital budgeting process, for example, is employed by every corporation to oversee business unit
behavior.Corporate involvement in strategic planning and annual budgeting are other methods
employed by nearly all corporations to influence business decisions.Thus, because many of the
methods that corporations use are similar, the centralization/decentralization debate has become one
of nuance—”exactly how centralized is the strategic planning process in this corporation compared to
the executive promotion process?”Instead of continuing that debate, this note expands on the more
fundamental distinction between outcome control and behavior control.
This distinction is rooted in theory.10Corporate management has two choices when faced
with agency problems because it cannot directly evaluate the effort and ability of business unit
executives, and cannot be fully aware of the effect of the environment on business unit
performance. 11Either corporate executives can monitor outcomes and presume that they correlate
with effort, or they can monitor behavior and so directly try to influence effort.The former is
preferable (because it minimizes the corporate control cost) when output and effort correlate closely
without being distorted by exogenous factors.The latter is preferable either when there is much
uncertainty or many uncontrollable events so that output and effort are poorly correlated, or when
senior management understands which behavioral items most affect outcomes and so can program
management tasks.As a consequence, behavior control requires an operating expertise that is found
9See, for example, the arguments in Halal, W.E., A Geranmayeh, and J. Pourdehnad, “Internal Markets” (New
York, Wiley, 1993).
10See K.M. Eisenhardt, “Agency Theory:An Assessment and Review,” Academy of Management Review, Vol. 14
(1989): 57-74.
11A third choice is “clan” control, whereby a culture of “the corporate good” is established, so that the agency
problem simply disappears as business unit managers interpret acting for the corporate good as being in their
own self interest. See, for example, W.G. Ouchi, “A Conceptual Framework for the Design of Organization
Control Mechanisms,” Management Science, vol. 25 (1979):833-848.
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Managing the Multibusiness Corporation 391-286
5
when the resource is fairly specific, like Cooper Industries’ cellular manufacturing process know-
how.Outcome control is more appropriate when the resource is more generic, such as is the case
with GE’s general management skills.
Outcome controlis achieved by altering the incentive structure for business unit managers. In
this case, corporate management need not directly monitor decision making; rather the incentive
structure induces managers to behave appropriately.This is the approach of financially controlled
firms such as Hanson Trust.By putting a particular set of incentive and measurement schemes in
place, Hanson is able to focus business managers’ attention on return on investment and cash flow in
a way that it was not before the acquisition.While this may improve the performance of the acquired
firm, installing only an incentive scheme is unlikely to yield a corporate advantage.Anyone,
including existing large corporations, can in principle change their own incentive systems (giving
divisional managers a share of profits, for example), if it will induce behavior modification.This role
must also, therefore, leverage a resource which is more than just a unique incentive and measurement
system, if it is to create a corporate advantage. 12
The other way the corporation can control decentralized decision making is through behavior
control .Under behavior control, the corporation directly monitors business unit behavior, such as
capital requests, reduction in inventories, or new strategic moves.Operating companies, like Cooper
Industries, make suggestions and offer advice when requested, and evaluate division managers on
the specific decisions they made, rather than on the financial outcome of those decisions.Merely
second-guessing divisional executives will not, however, add value.13Therefore, this role must also
leverage a unique resource.The corporation must possess some unique skills, or its corporate
executives must be expert managers in the particular industry in which they are intervening, if it is to
truly possess a “corporate advantage.”
Behavior control, then, directly influences the behavior or decisions of business-unit
managers because it evaluates those decisions.Outcome control, in contrast, does not concern itself
with particular actions.Rather, it influences business unit behavior by incenting managers to make
decisions whose outcomes will be rewarded.Further clarification of the distinction is evident when
an unforeseen and uncontrollable exogenous event threatens to disrupt a business unit’s plans.The
distinction is then between outcome control, which would say, “do whatever is necessary to reach the
profit target we set,” and behavior control, which would say, “what decisions are you going to make
that will capitalize on this opportunity to improve our strategic position?” Ex post, a corporation
implementing outcome control will punish the division for failing to reach its profit target.At most it
may recognize that profit was down for uncontrollable reasons and correct for that by comparing the
business unit’s profit performance to competitors.A corporation practicing behavior control will
ignore the profit outcome and instead evaluate performance by asking, “What did you do to cope
with this unforeseen event?Did you cut inventories?Did you cut them 10 percent across the board,
or selectively according to the asset turn of each product line?”It may, as a result, reward the
division even though profit was below target.
Deployment of corporate resourcesThe third task of the corporation is to deploy its resources in
the business to create value.The corporation has two choices for how to perform this task.
The first way the corporation can fulfill this task is to coordinate activitiesamong business
units.This is the traditional case of exploiting synergy between business units, when the
corporation’s performance moves from being the sum of local (separate business) optima, to the
12Indeed, the unique resource that many financially controlled firms like Hanson possess if often not the
incentive scheme; it is either a reputation which gets them access to capital and private information on potential
acquirees, or an individual’s skill at stock picking (the Tisches at Loews).
13Imperfect decision-making theory does suggest instances when adding an extra layer of decisionmakers
reduces error. See R.K. Sah and J.E. Stiglitz, “Committees, Hierarchies and Polyarchies,” Economic Journal , vol. 98,
no. 391 (June 1988):451-470.
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391-286 Managing the Multibusiness Corporation
6
global (corporate) optimum.If there are no scope economies between business units, the corporation
can allow every SBU to maximize its own profits in order to optimize corporate performance.If,
however, there are any shared resources (and hence scope economies) between business units,
allowing each to maximize its own performance will lead to a suboptimal corporate outcome.If
Johnson and Johnson (J&J) allowed every one of its business units to build a hospital salesforce
because each felt it received the best attention from its own salespeople, hospitals would react by
shutting the door on the tenth J&J salesman to call that day.While J&J as a whole is better off with
fewer salesforces, no one business unit is willing to give up its own salesforce.Thus, the corporate
office can create value by coordinating the decision of business units to provide the optimum number
of hospital salesforces for the corporation.In this case, the unique resource is created and exploited
by the linkage of separate businesses within the corporation and the coordination of their activities.
If the corporation did not own these businesses, the resource would not exist.
The second way for the corporate office to create value is through the central provision of a
resource ..In this role the corporation makes available a resource it possesses to business units to use
as they choose.Some corporations, such as Cooper Industries, have a central manufacturing services
function available to implement “best demonstrated practice” across divisions.Other companies,
such as Disney, can be thought of as providing a corporate brand name as a central service.Still
others effectively treat executives as a centralized resource, moving managers between divisions in
order to transfer the tacit knowledge and skills of individuals among divisions.To the extent that
each of these services can become one of the critical resources of the corporation, providing access to
them allows divisions to leverage those resources and generates value.In contrast to coordinating
activities, this mode of deploying corporate resources allows each division to act independently with
the resources they have been provided.Executives at PepsiCo, for example, run the soft drink, snack
food, and restaurant businesses almost completely autonomously, even if they themselves move
frequently among the businesses.
One particularly important central resource that the corporation can provide is access to
capital.While an efficient capital market would make this service merely a public company function,
if the capital market is irrational this task can be a real source of value.The PE chain letter game
played by conglomerates in the 1960s14 and the use of junk bonds in the 1980s were essentially ways
for firms to exploit irrationality in the capital market.By using their financial reputation (the critical
corporate resource in this instance) some corporations could create value by providing cheap capital
to divisions which otherwise could not have accessed the capital market on such favorable terms.
Furthermore, because the corporation is the owner of the businesses it manages, it has access to
information which the capital market does not.15The multibusiness corporation can then potentially
arbitrage this superior inside information to create value by allocating capital between divisions.
This categorization of corporate tasks is exhaustive, but it is not mutually exclusive.A
central manufacturing services unit, for example, can both directly provide a resource (assistance
with shop floor layout) and facilitate cross business unit coordination (deciding in which division to
locate a new machine shop).Leveraging a core competence in optoelectronics, as Sharp does, might
require both coordinating decisions across business units and the centralized provision of personnel
in whom the tacit technical knowledge resides.The intent of the categorization is really to identify
the broad ways in which a corporation can fulfill its tasks and so create “corporate advantage.”
14In the 1960s, the stock market focused on EPS growth as a measure of value.Unfortunately, EPS growth can
be achieved simply by issuing stock to acquire a company with a lower PE ratio.Many firms, notably
conglomerates, used this device to raise cheap capital.They acquired a company at a lower PE than their own,
automatically showed a rise in EPS, and were then rewarded by a rise in their PE.This allowed them to acquire
another company at a lower PE than their own, and so on.
15This is a reasonable assumption since most firms do not want to disclose proprietary or confidential material to
the public and so to competitors.
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Organizational Design, Choices
Corporations must choose either outcome or behavior control, and employ one or the other
of the roles to realize the value inherent in their resources if they are to be successful. They should,
therefore, according to contingency theory, align their structure, systems, and procedures according
to those choices.Thus corporations merely providing a central resource to business units should not
have expansive corporate functional staffs to set policies for or intervene in business unit operations.
The implications of each of the corporate roles for corporate structure, systems, and processes are laid
out below:
Outcome and behavior controlIt should be recognized that the distinction between behavior and
outcome control is exaggerated—corporations practicing outcome control will also ask the behavioral
control type of question, but the distinction is real and affects how each of the corporate systems are
used.Cooper Industries, for example, evaluates 800 corporate executives according to multiple
qualitative and quantitative performance measures.Berkshire Partners evaluates 50 executives
according to profit performance.Review of strategic plans and budgets, and monthly performance at
Cooper Industries are “interactive” between corporate and divisional executives,16 while at Textron,
divisional management is not even present at the monthly review of performance.
Differences between these two approaches to the control of decentralized decision making
are, therefore, systematic, and can be summarized on certain key dimensions in the archetypes
described below:
Outcome Control
Organization Structure:
– independent self-contained business units, so that executives are given authority
over all the activities for which they are held responsible.
Reward and Incentive:
– incentives that are a substantial share of total compensation in order to motivate
managers, and that are paid out according to a single quantitative objective
financial measure which is adhered to for a number of years in order to reduce
gaming over the target.
Resource allocation
– tight capital expenditure controls to prevent the dissipation of free cash flows in
value destroying investments.
Personnel:
– no personnel transfers between divisions so that executive incentives are aligned
with the long term performance of their own division.
– replacement of poorly performing divisional executives by others from within
the industry in order to provide the requisite industry expertise.
16“Interactive” is Prof. Simons’s term for when top managers “personally and regularly involve themselves in
the decisions of subordinates.”See R. Simons, “Strategic Orientation and Top Management Attention to Control
Systems,” Strategic Management Journal, vol. 12, no. 1 (1991): 49-62.
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Corporate Office:
– a tiny corporate office whose function is the objective analysis of financial results.
– one level of independent review, typically an executive vice president role, that
focuses on performance relative to the annual budget.
MIS:
– aggregate financial reporting as the only standardized corporate system.
Behavior Control
Reward and Incentive:
– short-term financial rewards less important than long-term career progression.
Performance measurement includes multiple qualitative as well as quantitative
goals, and operating as well financial data.
Personnel:
– internal career paths and active career development in order to retain industry
and company specific expertise in-house.
Culture:
– a common corporate culture so that managers can move freely and easily among
divisions.
MIS:
– many common systems and specified procedures to standardize behavior
Corporate Office:
– experienced corporate management that acts as a valued advisor to, as well as an
independent monitor of divisional management.
At the extreme, this distinction is illustrated by the contrast between highly diversified
conglomerates or LBO firms, which run their business units by the numbers because corporate
management understands little about the businesses they control, and true operating companies,
where corporate management understands the businesses, often more thoroughly than the divisional
executives.The distinction also throws light on the kinds of business that each type of control is
particularly appropriate for.17For outcome control to be successful, there must be a close correlation
between effort and performance with few exogenous shocks.If these conditions are not met, agency
costs become unacceptable.The uncertainties involved in high-technology businesses and new
ventures explain why few conglomerates or LBOs are successful in the computer or biotechnology
industries. 18As a consequence, conglomerates and LBOs are likely to be successful in mature
17This argument was originally suggested by Professor George Baker.
18These are instead the domain of venture capitalists who practice control at the project level—releasing funds
incrementally as each project is completed and plans for the next project presented.
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technology businesses with no technical surprises, and with the market leader strategy, which
produces few competitive surprises.These types of businesses also have the useful characteristic that
single financial measures (such as cash flow) are effective indicators of strategic position.Similarly,
the requirements for successful behavior control—knowledge of the industry, types of problems
typically faced, etc.—should make it clear why the scope of operating companies employing such
methods of control must be carefully constrained to those industry settings (not necessarily product
related) with which corporate management is familiar.
In fact, these two examples are illustrations of the “dominant logic”19 mentioned in the
earlier conceptual note “Corporate Strategy:A Conceptual Framework,” and evidence in support of
contingency theory.There need be no product similarities between businesses for them to be
successfully included in a single corporation.Instead, the underlying relationship can be that they
are susceptible to the particular choice of outcome (or behavior) control employed by the corporation
and the particular resource being exploited as the source of value.Saatchi & Saatchi’s failure to
recognize the different nature of the planning systems needed in consulting and advertising is an
example of a violation of this principle.
Central provision of a resource The first role the corporate office can perform that leverages a
corporation’s resources across multiple markets is the central provision of a resource, such as a brand
name or a manufacturing services unit. 20This can be thought of as transferring skills among the
divisions. 21Generally speaking, since the central resource is merely being made available for use
within business units, those units are best left to operate autonomously. Incentive schemes that
reward business unit profit maximization will maximize these profits, and profit maximization by
each unit will optimize corporate performance.
The two important decisions when implementing the central provision of a resource are who
is responsible for developing the resource, and who is responsible for transferring it to the divisions.
The choice in each case is between the corporate office itself, and the divisions. 22
When the corporate office develops the resource, there is a staff function at the corporate
level responsible for building the capability or setting a policy.When the divisions develop the
resource, each division experiments for itself.If the corporation is responsible for transferring the
resource among divisions, a corporate unit will either mandate a policy or the division whose best
practice will be copied.If the divisions are responsible for the transfer of best practices, they will be
free to ask the corporate center or other divisions for advice, but they will not be required to use the
practices developed there.
19See C.K. Prahalad and R.A. Bettis, “The Dominant Logic:A New Linkage Between Diversity and
Performance,” Strategic Management Journal, Vol. 7 (1986):485-501.
20This refers to the provision of services that are used entirely within the business unit and do not involve any
coordination across business units beyond choosing the overall level of the central service available.
21See M.E. Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review , Vol. 64 (1987):
43-59.
22This matrix is derived from Bartlett and Ghosal “Managing Across Borders,” and Campbell, A., “Building
Core Skills,” in Campbell, A. and Luchs, K.S. “Strategic Synergy,” Oxford: Butterworth Heinemann (1992.
173-197.
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Corporate
Corporate Center of
Competence
(including personnel)
Manual of
Procedures
ROLE IN DEVELOPMENT PROCESS
Division Individual
Network
Best Demonstrated
Practice Transfer
Division Corporation
ROLE IN TRANSFER PROCESS DIVISION
This matrix gives rise to the most common forms of the central provision of a resource,
including the transfer of skills among businesses by the movement of experienced personnel; the
replication of best demonstrated practices developed by one of the divisions; and a corporate unit
that acts as a center of competence that is made available to the divisions.
These choices are most clearly exemplified in a franchise organization, which in many ways
is the archetype of this form of corporate structure.McDonald’s, for example, determines its
marketing mix, advertising campaigns, etc., which it provides to franchises in order to retain control
of the brand name.Through the franchise agreement it also specifies operating systems and controls
that franchises must implement and constrains what products they can sell.These organizational
arrangements ensure that autonomous franchisees do not degrade the central resource which
McDonald’s possesses, while leaving them free to operate within those constraints.
With the central provision of a resource, its use by one division often does not affect its use
by another, so that the divisions can continue to operate independently.Disney provides Mickey
Mouse to its divisions, which operate more or less autonomously.The only areas in which Disney
does not let its divisions operate freely is in the exercise of quality control, and in those limited
activities, notably marketing, where they do overlap.These are the areas where some central
coordination is required to prevent free riding on the valuable corporate resources.
Coordination across business unitsThe fundamental problem faced by a corporation which is
attempting to share activities across business units is that the sum of business unit optima is
not necessarily equal to the corporate optimum.At Kraft General Foods, if the various product
groups retained their own sales forces and distribution networks to optimize their performance, the
sales and distribution functions would be inefficiently configured.At GM, if the ACG was given a
mandate to reduce component proliferation, the car platforms would lose some freedom in designing
cars for their target customers.In all these cases, leaving business unit managers to maximize their
own performance could not be relied upon to achieve the corporate optimum.
In the picture below, the production frontier refers to the maximum output that unit A and B
can obtain from using the shared resource.Where the frontier crosses the two axes is when either
unit A or B gets all the resource.Between those two points, the production frontier represents the
tradeoff between A’s and B’s output as the allocation of the resource is shifted between the two
business units.If the corporation is currently producing at point 1, self-interested cooperation alone
will lead A and B to move along some path to reach a point like 2.However, self-interested
cooperation will constrain that path to points in the quadrant northeast of point 1.A will not agree to
a solution that goes to the left of point 1, nor will B agree to one that goes below point 1.Thus, if the
corporate optimum is actually at point 3, it will never be reached without formal coordination.23
23Unless one allows for side payments between the two parties.
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Production frontier
Output of Unit A
Increasing profit
Output of Unit B
3
1
2

However, coordination is not uniformly good because it involves costs.These include the
costs of coordination, inflexibility, and compromise, 24 but most particularly, the loss of incentives.By
definition, if a business unit has complete authority and responsibility for an activity, then incenting
the business unit to maximize its own performance will achieve the optimum.This becomes
impossible when the business does not have control of all its activities. The potential for loss of
incentives, for conflict between business units, and for individual business-unit optimization to lead
to less than the corporate optimum, arises over resources whose use or provision is divided between
business units.25Thus, corporate coordination need only be concerned with shared resources; other
resources can safely be allocated to, and controlled by the relevant business units.This reveals a vital
principle of selective coordination —only coordinate those resources or activities that are shared.
To resolve the dilemma of how to manage these shared resources, corporations can adopt a
variety of devices, such as altering incentive structures to reward cooperative behavior (possibly by
including corporate stock options in divisional compensation), or introducing a matrix structure that
depends on lower level managers to resolve the tradeoffs themselves.None of these are complete
solutions because they each involve their own particular tradeoffs.However, we can help decide
among these devices by recognizing that there is a hierarchy of increasingly centralized intervention
along which they can be arrayed.
This hierarchy describes the ways to achieve the desired coordination over shared resources
(see below).26The five levels identified below are not meant to be definitive, although additional
modes and systems of coordination should be able to be positioned in the hierarchy according to the
degree of central intervention involved.
24See M.E. Porter, “Competitive Advantage,” chapter 9, New York: Free Press (1986).
25In principle, therefore, the problem can be resolved by combining the business units which share the resource.This only
pushes the coordination problem one level down in the corporation.
26This hierarchy follows A. Campbell, “Synergy and Decentralization,” Ashridge Management Center (February 1991). For
a similar version see Galbraith and Kazanjian, op. cit., p. 72.
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•Mode System
• Bilateral Negotiation, Act in Self Interest Personal Relationships, Networks
• Coordination of Information Flows Council
• Recommendation Matrix Organization, Facilitator
—responsibility without authority
• Prescribed Behavior Manual/System
• Formal Centralized Decision Organization Structure
At the top of the hierarchy are those modes of coordination which involve the least
centralized intervention.Allowing business units to independently seek out those cooperative
activities that are in their own self-interest to implement are included here.Kraft executives, for
example, themselves chose to switch their media purchasing to General Foods after the merger
because they were simply able to buy at lower prices.The next level involves some formalized
system for the coordination of information flows, but again with no obligation on the part of
divisions to act unless they desire to do so themselves.Kraft General Foods’ purchasing councils are
an example of formalized exchange of information combined with decentralized decision making.
Establishing lead business units to develop a particular product, which other units can then decide
whether to adopt, is another example.The next level of intervention is to establish a position with
responsibility to coordinate activity, but with no authority to order business units to adopt any
recommendations made.This was the role expected of the executive vice president of Marketing at
Kraft General Foods.It is similar to the role played by a project or team head in a matrix organization
with a primarily functional structure.The role becomes one of persuasion rather than the formal
exercise of power.The fourth level is to have a procedure specified in a manual or a system which
removes business unit discretion, such as Cooper Industries’ two volumes of procedures governing
items including purchases from sister divisions. The final step in the hierarchy is the establishment of
a central function with authority to control the shared resource.Allowing a corporate manufacturing
department to operate facilities for all divisions would be an example of this last level in the
hierarchy.
The importance of this hierarchy is threefold.First, the other elements of organizational
design, such as incentives, should be aligned with the primary mode of coordination.Second, the
choice of mode of intervention can be made according to the level of suboptimization that will result
from inferior coordination because there is a tradeoff along the hierarchy between the incentive
benefits of business unit autonomy, and inefficient decisions.
In principle, if we can identify how far 3 is outside the NE quadrant (in the earlier picture) we
can then determine the extent to which the corporation needs to impose more interventionist modes
of coordination.In practice, the rule of thumb is that the bigger the gain from coordination, the more
interventionist should be the mode of control.The importance of exploiting the resource
interdependencies between business units in related product corporations, such as Kraft General
Foods, explains, for example, why companies like these need more centralized coordination than
conglomerates. 27
The third observation about the hierarchy is that it is often best to introduce coordination by
gradually moving down the hierarchy.Part of the initial success of the Kraft General Foods merger
was that management “picked off the easy fruit first,” i.e., initially exploited the synergies that were
in the divisions own self-interest to adopt.This built credibility in the value of synergy and led
businesses themselves to recognize that additional synergy could only be realized by imposing more
centralized forms of coordination.Rather than leaping to the extreme of the hierarchy, a gradual
progression to the extreme appears to be the best way to introduce coordination to a corporation.

27See, for example, the findings of Lorsch and Allen, op. cit.
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Since the coordination of activities between business units is often necessary for only a subset
of a corporation’s units, one effective organizational device is to introduce the group or sector level.
All related business units are placed within the group and a pseudo-corporate office is installed at the
group headquarters specifically to manage linkages among the business units. In this way,
coordination at the corporate office is replaced by the group level.Kraft General Foods, for example,
represents this organizing structure within Philip Morris.There is, however, another justification for
the group structure:the limitation on spans of control.If a CEO cannot supervise more than ten
divisions, an intermediate layer of corporate management is added.The important distinction
between the two rationales is that in the latter case there will be no group functional staffs, because
the only role of the group is an information buffer and condenser. In the former case, such staffs may
well exist to coordinate activities.
Multiple Roles
To the extent to which corporations are leveraging more than one resource to create value
across their businesses (e.g. Cooper Industries), the structure/systems/procedures adopted will not
be uniformly determined.Rather, particular organizational elements will be amended to ensure that
each and every resource is effectively mobilized.Cooper Industries, for example, was basically
organized to manage behavior control. It also provided some central resources to business units,
notably the manufacturing services group.By having this group set policies itself and making it
available free of charge, control was kept at the corporate level.However, it was also structured to
coordinate activities across business units.This was achieved by placing related businesses, such as
the “tool basket,” in a sector under one group vice president.Thus, while the main resource
determined the basic organizational form of “semi-autonomy,” other organizational mechanisms
were used to ensure that the value of other resources was also realized.Similarly, many corporations
have corporatewide purchasing units or councils to exploit procurement scale economies.There is
nothing wrong with adding this to other corporate structures, provided its intent is clearly
recognized and it does not spill over to other activities.
Organizational Economics Postscript
To analyze organizational choices theoretically, we can use organizational economics to
define the organization of the corporation as a set of three fundamental elements: 28
– information structure
– allocation of decision rights
– incentive and measurement schemes
The information structure of the corporation describes who knows what about the current
state of the corporation (from whether machine #624 is currently down, to whether the profit on
product x last month was $.2m).The allocation of decision rights refers to who is involved, and in
what ways, in the making of every decision inside the corporation.It effectively summarizes both the
formal allocation of authority, and the influence of informal processes on the distribution of power
inside the corporation.The incentive schemes involve all the reward and punishment mechanisms
that are in place to motivate behavior in the corporation.They include not only financial
compensation (of all forms) but also nonfinancial factors, such as peer group respect, self-esteem,
promotion, worker development, and loyalty.

28This definition is derived from M.E. Jensen, “Organization Theory and Methodology,” The Accounting Review,
vol. 58 (April 1983): 319-339, and S. Baiman, “Agency Research in Managerial Accounting:A Second Look,”
Accounting Organizations and Society , vol. 15, no. 4 (1990):341-371.
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In principle, if we could fully define these three elements and combine them with data on
individual endowments and preferences, we could predict firm behavior.We would know who was
involved in making a particular decision, what information they had when they made that decision,29
and what their interest was in the outcome of that decision.In practice, of course, it is impossible to
condense the complexity of organizational variables down to this level of discreteness.Nevertheless,
it is important to recognize that the organizational variables described earlier work through their
effect on these three elements.30Thus, a change in organization structure can be analyzed according
to its effect on who is responsible for particular decisions, the information they will have, and what
their incentives will be.It also illustrates why changes in organization structure create ambiguity
until the new distribution of these three parameters has been clarified, for example, as at Kraft
General Foods, by employing a decision grid.

29Including the information that was in the interest of non-decisionmakers to transfer to the decision maker.
30In economic terms, the goal of aligning structure with corporate strategy can be expressed as choosing an
arrangement of these three elements that minimizes the governance costs of the corporation.These costs are the
sum of the management time spent searching for the optimal decision and the penalty for making suboptimum
decisions. The latter results from:(a) information transfer losses (including the degradation in the content of
information as it is transferred, and the decay in value as it becomes less timely); (b) inferior incentives (agency
costs); (c) cooperative decision making among discrete units that can only reach a Pareto optimal solution; and
(d) imperfect decision making. Although the net result of this is best expressed as a broad tradeoff between
centralization and decentralization, progress being made by organizational economics on all these costs is likely
to enlighten this tradeoff.
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__MACOSX/Course Pack/._Managing the Multibusiness Corporation.pdf
Course Pack/Note on Diversification as a Strategy.pdf
Harvard Business School 9-382-129
Rev. June 12, 1986
This note was prepared by Professors Malcolm S. Salter and Michael E. Porter as a basis for class discussion.
Copyright © 1982 by the President and Fellows of Harvard College.To order copies or request permission to
reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to
http://www.hbsp.harvard.edu.No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of Harvard Business School.
1
Note on Diversification as a Strategy
Definitions
The terms “diversified” and “diversification” can suggest innumerable meanings. Ralph
Cordiner, a former chief executive at the General Electric Company, used the terms in at least six
different senses during his tenure as CEO: “developmental (R&D) diversification,” “functional
diversification,” “product diversification,” “customer diversification,” “geographic (international)
diversification,” and “diversification of the means of financing.” Thus, diversification, according to
Cordiner, was a change in any of the above-mentioned elements of General Electric’s corporate
strategy.1
A more traditional meaning of diversification is limited to product market diversification.
Much economic research has measured the degree of a company’s product market diversification by
counting the number of businesses falling into different standard industrial classifications (S.I.C.)
codes or determining the percentage of sales accounted for by a company’s principal business.
However, these approaches by themselves fail to reflect the degree of relatedness or unrelatedness
among the various businesses.
A now widely accepted classification scheme for diversified companies combines the extent
of diversification with a measure of the nature of its relatedness.2 Based on observations of how
diversification strategies differ in the strengths, skills or purposes that underlie a firm’s cumulative
diversification moves and the way new activities are related to old ones, Rumelt identified three
major types and nine total types of diversified companies. The key parameter of Rumelt’s
classification is a company’s “specialization ratio,” or the proportion of its revenues derived from the
largest single group of related businesses. Businesses are considered related if they (1) serve similar
markets and use similar distribution systems, (2) employ similar production technologies, or (3)
exploit similar science-based research.
1 James P. Baughman, “Problems and Performance of the Role of the Chief Executive in the General Electric
Company, 1892–1974,” mimeo, July 5, 1974.
2 Richard P. Rumelt, Strategy, Structure and Economic Performance, Division of Research, Harvard Business School,
1974. Rumelt’s classification was an extension of one initially presented in Leonard Wrigley, “Divisional
Autonomy and Diversification,” unpublished DBA dissertation, Harvard Graduate School of Business
Administration, 1970.
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382-129 Note on Diversification as a Strategy
2
For our purposes, Rumelt’s three major categories of diversified companies—Dominant
Business Companies, Related Business Companies, and Unrelated Business Companies provide the
most useful framework for analysis. Dominant Business Companies, according to Rumelt’s definition,
derive 70–95% of sales from a single business or vertically integrated chain of businesses.
Representative companies in this category include General Motors, IBM, Texaco, and Scott Paper.
Related Business Companies have diversified by adding activities that are tangibly related to the
collective skills and strengths possessed by the company. No single business accounts for more than
70% of such a company’s sales. Du Pont, Eastman Kodak, General Electric, and General Foods are
indicative of companies which fall into this category. Unrelated Business Companies, commonly
called conglomerates, have diversified without necessarily relating new businesses to old. In this type
of company no single business accounts for as much as 70% of sales. Such companies as Litton, LTV,
Rockwell International, Olin, and Textron are representative of Unrelated Business Companies.
Performance of Diversified Companies
The performance of diversified companies can be analyzed in many ways.3 Many
contemporary economists have studied the question of whether or not corporate diversification,
particularly unrelated or conglomerate diversification, has led to superior means of reducing
investment risk or improving capital returns. In addition, several business policy researchers have
attempted to analyze the performance of diversified companies relative to that of other classes of
companies. Finally, the business press has tracked the performance of various samples of diversified
companies for years.
Oversimplifying to some degree, the general conclusions of many financial economists is that
strategies of unrelated diversification have not led to increased corporate returns on investment,
although defensive diversification (diversification out of industries with low profitability) has often
enabled firms to increase their profitability from inferior to average levels. In addition, several
empirical studies based on capital market data have found that while conglomerates may have
achieved some risk reduction relative to individual firms, it typically came through reducing
company-specific risk and increasing the more relevant market-related risks of the firm. These studies
concluded that in every comparison they made mutual funds provided more efficient diversification
than unrelated corporate diversifiers, as well as better risk/return trade-offs.
Business policy research provides additional insights into the comparative performance of
different types of diversified companies. Rumelt, for example, concludes that Dominant Business
Companies under-performed, on average, all other classes of diversified companies based on five
accounting-based performance measures from 1950–1970. Unrelated Business Companies, the group
that grew the most during the two decades under study, showed significantly higher corporate
growth rates but also showed the lowest rates of capital productivity. Related Business Companies,
however, outperformed the averages on all five measures. This group had the second highest set of
growth rates while achieving the highest returns on capital. While Rumelt’s findings do not allow for
the differing mixes of businesses (which differ in intrinsic profitability) each firm operated in, they
nevertheless summarize the dilemma many companies face. Sticking close to traditional businesses
can condemn a company to mediocre performance. However, wide-ranging diversification places the
productivity of capital at significant risk. And the chances for successful related diversification will
depend highly upon the characteristics of the base industry a company is in.4
3 For a detailed analysis of the performance of diversified companies, see Malcolm S. Salter and Wolf A.
Weinhold, Diversification Through Acquisition, The Free Press, 1979, Chapters 1 and 5.
4 Richard P. Rumelt, Strategy, Structure and Economic Performance, op. cit., and “Diversity and profitability’’
(UCLA Working Paper, 1977).
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3
More recent business policy studies based upon capital market performance measures
generally confirm Rumelt’s findings. Singh and Montgomery5 and Lubatkin6 have determined that
the combined gains received by target and bidder firms from acquisitions vary by the strategic
characteristics of the merger. Shelton, taking the analysis one step further, shows that for the 1962–
1983 period acquisitions in which a high proportion of target businesses permitted the bidder access
to new but related customers and markets created the most value.7
Surveys run by Forbes and Business Week also contribute relevant performance data. Both
surveys indicate that Unrelated Business Companies (or conglomerates) have generally been poor
performers relative to industry averages. This is particularly the case in their capital productivity,
which was quite volatile partly because of their extensive use of financial leverage. This survey data
also shows that average price/earnings ratios for widely diversified companies (which reflect
investors’ future outlooks for these companies) have until recently been severely discounted from the
average price/earnings ratio for the market as a whole. As widely diversified a company such as Gulf
& Western, has divested operations and reduced their debt, their price/earnings ratios have tended to
increase.
All three sources of evidence suggest that diversification is not a panacea for lagging
corporate performance and that a diversification strategy needs to be planned and executed with
utmost care. The evidence also indicates, however, that both related and unrelated diversification can
be rewarding for both investors and managers alike. This possibility, along with the economic and
political risks facing many industries, will inevitably lead more companies to try their hand at
diversification. The mixed track record of their predecessors should warn these companies that their
task will not be an easy one.
The Concept of Strategy in the Diversified Company
Since business units or divisions competing in individual industries are the building blocks of
diversified companies, strategy formulation in individual industries is equally important for
diversified and undiversified firms alike. However, strategy for the diversified firm is more than a
collection of strategies in individual business units. A company needs a broader conception of
strategy in order to make the diversified whole more than the sum of its individual (business unit)
parts. Furthermore, the concept of strategy and the tests of strategy need to be modified in order to
address the problems of the corporate level in the diversified firm.
5 H. Singh and C. A. Montgomery, “Corporate Acquisitions and Economic Performance” (unpublished
manuscript, 1984).
6 M. Lubatkin, “Merger Strategies and Shareholder Returns: A Test for Merger Synergy” (unpublished
manuscript, 1984).
7 Lois Shelton, “The Role of Strategic Business Fits in Creating Gains to Acquisitions” (unpublished doctoral
dissertation, Harvard University, 1985).
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382-129 Note on Diversification as a Strategy
4
As a working beginning, we can identify five important components of strategy for a
diversified company as shown in Figure 1:8
Figure 1 Components of Strategy for the Diversified Company
Concept of Fit
Among Businesses
Concept of Corporate
Management of Business Units
Corporate Goals
Concept of Assembly
of the Portfolio
Generic Functional
Policies
Components of Strategy for a Diversified Company
Corporate Goals: Corporate goals are the corporate level analog of the goals for the single
business company. Corporate goals typically include a broad statement of purpose and specific
economic and noneconomic objectives in such areas as profitability, growth, financial stability, and
social responsibility. Together, these goals should reflect how top management intends to create
economic value for investors and to serve the interests of other groups affected by the company’s
operations.
Concept of Fit Among Businesses: The concept of fit is the company’s concept of how the
individual business units in the corporate entity relate to one another in a technological, product, or
other sense. There are a wide variety of possible concepts of fit, ranging from unrelated businesses
tied together solely by financial criteria (as in Gulf & Western Industries), to highly related businesses
sharing assets and skills (as in Caterpillar), to concepts of fit deriving from product/market portfolio
models. Alternative concepts of fit will be examined in more detail below.
Concept for Assembly: The concept for assembly is the company’s approach to actually finding
and acquiring (or developing internally) business units to be added to the corporate portfolio. The
concept of assembly necessarily encompasses a variety of levels. At the broadest level, a company
must choose some mix of internal development of new businesses, acquisition, venture capital
subsidiaries, joint ventures and other mechanisms as approaches to assembling businesses new to the
company. At a more operational level, a company must also have some approach to carrying out its
mechanism for assembling new businesses. If assembly is based on diversifying acquisitions, for
example, an acquirer might choose among pursuing such disparate targets as distressed companies,
companies with good management which will stay on, privately held companies where the founders
will sell cheaply to preserve their creations, or divisions of other diversified companies. The acquirer
must also choose among alternatives such as using common stock for payment or seeking to use any
of a number of other specie. Finally, a diversifying company must also have an organizational
mechanism in place to carry out its concept of assembly. In acquisitions, for example, it will need
some organizational unit to uncover acquisition possibilities and analyze them, possibly employing
outside finders or investment bankers. Any concept of assembly chosen will require a source of ideas,
organizational arrangements, and philosophies about how to make it work. A company banking
heavily on internal development for adding new businesses, for example, will need to give clear
8 These aspects of corporate strategy influence and are influenced by strategy formulation at the business unit
level.
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Note on Diversification as a Strategy 382-129
5
signals to its managers to propose new business ideas, and to have a new venture division or other
special organizational arrangements in order to provide the environment for new businesses to grow.
Concept of Corporate Management of Business Units: Every diversified company must have
an explicit or implicit approach to the relationship between corporate management and business
units: organization structure, controls, incentives and resource allocation procedures. Basically, this
relationship defines the respective roles that corporate management and business unit management
will take, and how corporate management will measure and reward business unit managers in
fulfilling their roles. There are a wide variety of concepts of management that may be adopted.
Broadly, they range from giving individual units complete autonomy and measuring and rewarding
division management on financial performance (characteristic of companies like Textron), to more
hands-on involvement by corporate management in division affairs (as in companies like General
Electric). In contrast to unrelated diversifiers, corporate management in related diversifiers typically
play an active role in centralized R&D, divisional strategy formulation, personnel selection, and so
forth. Berg has shown how diversified companies vary greatly in the size and role of their central
staff, reflecting differences in the ways the companies pursued diversification.9
The concept of managing a diversified company also must include a means of identifying
businesses that prove inappropriate to the company and of divesting or closing them. Such a
mechanism might be termed a resource allocation system in reverse, and needs to include a system
for spotting problem businesses, for gathering necessary data for divestment decisions and an
organizational mechanism for actually carrying out divestment.
Generic Functional Policies: Generic functional policies are corporatewide philosophies or
approaches to managing certain functional areas of the business. The most obvious and most common
generic functional policies in diversified companies exist in areas like finance and labor. Nearly all
diversified companies set financial policy centrally (capital structure, cash reserves, etc.) and raise
capital centrally. Companies also sometimes have corporatewide labor policies, such as policies about
desirability of unionization and the level of management at which collective bargaining will occur.
Corporatewide functional policies can go even further. Some diversified companies articulate
corporatewide functional policies such as the following:
We strive for technological leadership in all businesses (as at Gould).
We will contribute X percent of net income of each business unit to the local
community (as at Dayton Hudson).
We seek to be the low-cost producer in all our businesses (as at Emerson
Electric).
We can observe successful diversified companies that employ a wide variety of different
approaches to each of the components of diversified company strategy. Just as there is no one
successful strategy for competing in a particular business, so too there is no one “right” strategy for
the diversified company. However, the five components in the diversified company need to form a
consistent whole.
9 Norman Berg, “Corporate Role in Diversified Firms” (mimeo, Division of Research, Graduate School of
Business Administration, Harvard University, 1971).
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382-129 Note on Diversification as a Strategy
6
Value Creation and Strategic “Fit”
As noted above, one of the important aspects of the strategy of a diversified company is the
“fit” or relationship among distinct businesses in the portfolio. While intuitively clear, making the
notion of fit precise has proven to be elusive. This is because fit among businesses in a portfolio can
take a variety of different forms and lead to a variety of economic benefits.
Strategic fit can be described in terms of financial characteristics of a portfolio, generic
functional skills such as consumer marketing abilities, complementary strategic assets such as
electronics capability in a medical instrumentation business, shared strategic logics, and compatible
management styles. Whatever the basis of fit, it must reflect a concept of how to create real economic
value for shareholders. While satisfying the interests of shareholders may sometimes conflict with the
interests of managers, employees, and the public at large, the relative priority of shareholder interests
must be maintained over the long run. This is not to say that shareholders should have absolute
priority, but merely that when a conflict among various interests develops, the board of directors
must determine how much of the shareholder interest needs to be sacrificed at any point in time. If
shareholder interests in value creation are consistently subordinated to other interests, the company
cannot expect to attract capital and retain investor interest over the long run. Ultimately, the company
and the economic and social values flowing from it will fade.
How, then, can a diversifying company create real economic value for its shareholders? How
does the notion of strategic fit relate to value creation?10 Put most succinctly, a company following a
diversification strategy can create value for its shareholders only when the combination of the skills
and resources of the two businesses satisfies at least one of the following conditions:
1. An income stream greater than what could be realized from a portfolio
investment in the two companies.
2. A reduction in the variability of the income stream greater than that could be
realized from a portfolio investment in the two businesses.
Included in both conditions is explicit comparison of corporate diversification on the
shareholder’s behalf with independent portfolio diversification on the investor’s part. This
comparison deserves comment.
Most benefits derived from reducing company-specific or unsystematic risk through
diversification are, of course, equally available to the individual investor. Diversified companies can
achieve trade-offs between total risk and return that are superior to the trade-offs available to single
business companies.11 But diversified companies cannot create value for their shareholders merely by
diversifying away unsystematic risk.12
Inasmuch as investors can diversify away unsystematic risk themselves, in efficient capital
markets unsystematic risk is irrelevant in the equity valuation process. A diversifying company can
10 The following discussion has been adapted from Salter and Weinhold, Diversification Through Acquisition,
Chapter 2.
11 A superior risk-return trade-off would be achieved by either obtaining a higher return for the same risk or a
lower risk for the same return.
12 According to contemporary financial theory, a-security’s risk and return can be decomposed into two
elements: (1) what is specific to each company and called “unsystematic” because it can be diversified way, and
(2) what is “systematic” because it is common to all securities (the securities market) and hence nondiversifiable.
Since the unsystematic risk of any security can be eliminated through simple portfolio diversification, the
investor does not need widely diversified companies to eliminate the risk for him.
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Note on Diversification as a Strategy 382-129
7
create value for its shareholders only when its risk-return trade-offs include benefits unavailable
through simple portfolio diversification.
There are seven principal ways in which acquisition-minded companies can obtain returns
greater than those obtainable from simple portfolio diversification. The first four are particularly
relevant to related diversification, while the last three are more relevant to unrelated diversification.
Each reflects a slightly different notion of strategic fit.
1. A diversifying acquisition can raise the productivity of capital when the
particular skills and one merger partner’s knowledge of the industry are applied
to the competitive problems and opportunities facing the other partner.
When the reinforcement of skills and resources critical to success of one of the combined
company’s businesses leads to increased profitability, value will be created for the shareholders of an
acquisition-minded company. This transfer of skills and/or resources between businesses has been
characterized by the term “synergy.” The creation of value is the realization of potential synergy.
Generic skills and shared strategic logics are commonly at the base of this value creation process. BIC
Pen, for example, applies a strategy of standardized products, heavy consumer advertising, and
highly integrated low-cost manufacturing to a variety of consumer businesses such as pens,
disposable lighters, pantyhose, and razors.
2. Investments in markets closely related to current fields of operation can reduce
long-run average costs.
A reduction in average costs can accrue from scale effects, rationalization of production and
other managerial efforts, and technological innovation. For example, a marketing department’s
budget as a percent of sales will decline if existing resources can be used to market new or related
products. Similarly, a large company like Procter & Gamble can expect its per-unit distribution costs
to decline when it augments the use of its existing distribution system to move products to the
marketplace. This notion has been the basis of many acquisitions made by consumer products
companies.
3. Business expansion in an area of competence can lead to the generation of a
“critical mass” of resources necessary to outperform the competition.
In many industries, companies have to achieve a certain size, or critical mass, before they can
compete effectively with their competitors.
For example, the principal way many small laboratory instrumentation companies hope to
offer sustained competition against such entrenched companies as Hewlett-Packard, Tektronix,
Beckman Instruments, and Technicon is to attain a size giving them sufficient cash flow to underwrite
competitive research and development programs. One way to reach this size and develop unique
strategic assets is to make closely related diversifying acquisitions.
4. Diversification into related product markets can enable a company to reduce
systematic risks.
Many of the possibilities for reducing risk through diversification are implicit in the previous
three ways to increase returns because risk and return are closely related measurements. However,
diversifying by acquiring a company in a related product market can enable a company to reduce its
technological, production, or marketing risks. If these reduced business risks can be translated into a
less variable income stream for the company, value is created.
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382-129 Note on Diversification as a Strategy
8
5. The diversified company can route cash from units operating with a surplus to
units operating with a deficit and can thereby reduce the need of individual
businesses to purchase working capital funds from outside sources.
Through centralizing cash balances, corporate headquarters can act as the banker for its
operating subsidiaries and can thus balance the cyclical working capital requirements of its divisions
as the economy progresses through a business cycle or as its divisions experience seasonal
fluctuations. This type of working capital management is, of course, an operating benefit completely
separate from the recycling of cash on an investment basis.
6. Managers of a diversified company can direct its currently high net cash flow
businesses to transfer investment funds to the businesses in which net cash flow
is zero or negative but in which management expects positive cash flow to
develop. The aim is to improve the long-run profitability of the corporation.
This potential benefit is a by-product of the U.S. tax code, which imposes double taxation of
dividends once via corporate profits taxes and once via personal income taxes. By reinvesting its
surplus cash flow, the company defers taxes that stockholders otherwise would have to pay on the
company’s dividends.
This point has an important extension. Diversified companies have access to information that
is often unavailable to the investment community. This information is the internally generated market
data about each industry in which it operates, data that include information about the competitive
position and potential of each company in the industry.
With this inside information, diversified enterprises can enjoy a significantly better position
in assessing the investment merits of particular projects and entire industries than individual
investors can. Such access enables the companies to choose the most attractive projects and thereby to
allocate capital among “their” industries more efficiently than the capital markets can.
7. Through risk pooling, the diversified company can lower its cost of debt and
leverage itself more than its nondiversified equivalent. The company’s total cost
of capital thereby goes down and provides stockholders with returns in excess of
those available from a comparable portfolio of securities.
As the number of businesses in the portfolio of an unrelated diversifier grows and the overall
variability of its operating income or cash flow declines, its standing as a credit risk should rise.
Because the company pools its own divisions’ risks and supports any component threatened with
bankruptcy, theoretically (at least) the company should have a somewhat lower cost of debt than that
of companies unable to pool their risks. More important, the reduced variability of the diversified
company’s cash flow improves its ability to borrow.
This superior financial leverage enables the corporation’s shareholders to shift some risk to
government and thereby reduces the company’s total cost of capital. (Since interest, in contrast to
dividends, is tax deductible, the government shoulders part of the cost of debt capitalization in a
business venture.) These benefits become significant, however, only when the enterprise aggressively
manages its financial risks by employing a high debt-equity ratio or by operating several very risky,
unrelated projects in its portfolio of businesses.
While this type of company can enjoy a lower cost of capital than a less diversified company
of comparable size, it can also have a higher cost of equity capital than the other type. This possibility
stems from the fact that part of the financial risk of debt capitalization is borne by the equity owners.
In addition, investors’ perceptions of risk are not solely conditioned by the degree of diversification in
corporate assets. Indeed, the professional investor may be unwilling to lower the rate of return on
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Note on Diversification as a Strategy 382-129
9
equity capital just because a company has acquired a well-balanced or purportedly countercyclical
collection of businesses.
In sum, diversification can offer potentially significant benefits to the firm and its
shareholders. The most significant shareholder benefits from related diversification accrue when the
special skills and industry knowledge of one merger partner can be applied to the competitive
problems and opportunities facing the other. It is worth stressing that not only must these special
skills and resources exist in one of the two partners, but they must also be transferable and usable by
the other. Shareholder benefits from unrelated or conglomerate diversification can occur where more
efficient capital management leads to a larger return for corporate investors than that available from a
diversified portfolio of securities of comparable systematic risk. Additional benefits, not strictly due
to diversification, can be created for a company’s shareholders where an acquiring company can
obtain undervalued assets or can successfully revitalize previously underutilized assets.
In general, the operating benefits of related diversification tend to have the greatest potential
for improving corporate performance. As one moves from related diversification towards unrelated
diversification the nature of the potential benefits changes as will their potential impact. Operating
“synergies” related to integrating functional activities fade into benefits stemming from general
management efficiencies. Eventually, when the totally unrelated diversifying acquisition is made,
only financial benefits can be achieved.
Unfortunately, those benefits of diversification which offer the greatest potential are usually
those least likely to be implemented. Of the synergies usually claimed possible in a diversifying
acquisition, financial synergies are often unnoted while operating synergies are widely trumpeted.
Yet, the overwhelming evidence is that the benefits most commonly achieved have occurred in the
financial area. It is not hard to understand why this is so. All one has to do is to reflect on the nature
of the corporation. Most managers will agree that the greatest impediment to change is the
inflexibility of the organization itself. Ironically enough, the realization of operating benefits
accompanying diversification usually requires significant changes in the company’s organizational
format and administrative behavior. These changes are typically slow to come, but the process can be
facilitated by recognizing the need to relate the key components of a diversification strategy together.
Without doing so, the benefits of both related and unrelated diversification may prove to be elusive.
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Course Pack/The Resource Pathways Framework Solving the Build, Borrow, or Buy Growth Dilemma.pdf

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978-1-4221-9501-7

CHAPTER ONE
The Resource Pathways Framework

Solving the “Build, Borrow, or Buy” Growth Dilemma
From
Build, Borrow, or Buy: Solving the Growth
Dilemma
By Laurence Capron and Will Mitchell

© 2012 by Harvard Business School Publishing Corporation.
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The Resource Pathways
Framework
Business ecosystems change constantly. Opportunities come and go
quickly. The race is won by those most agile and swift. To compete and
grow, companies worldwide must regularly expand or reinvent their
resources. Media businesses need new digital offerings, retail banks
must add Internet banking services, automakers face pressure to offer
green technologies, food companies’ customers demand more-health-
ful products, and pharmaceutical firms need to constantly absorb the
fruits of biomedical research. Indeed, there is hardly a sector in which
change is not a permanent wild card.
The pace of this market-driven, technological, regulatory, and
competitive ferment requires that companies continuously analyze
and address the gaps in their existing knowledge and skills. Inevitably,
these gaps present leaders with important choices.
Closing those gaps is an unending business challenge. Companies
face a dizzying diversity of expert skills and knowledge sources and the
growing global competition to acquire them. This competition spans
both the developed world and the fast-growing emerging markets.
More and more, firms find themselves navigating a global expanse of
evolving geopolitical and institutional boundaries, a reality that affects
new entrepreneurial businesses and deep-pocketed, established com-
panies alike.
C
H
A
P
T
E
R
1
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2 Build, Borrow, or Buy
But no matter their size or pedigree, firms seeking to bridge
resource gaps have a limited number of options: they can innovate
internally (build); enter into contracts or alliances and joint ventures
(borrow); or merge or acquire (buy). This trio of straightforward cate-
gories masks a complex mix of considerations that make selection dif-
ficult and outcomes uncertain. Articles in the business press highlight
businesses’ frequent failure to innovate successfully, to sign contracts
or forge alliances that remain harmonious and productive, or to realize
the predicted synergies of a seemingly potent acquisition.
Our research and experience have found that companies of all
kinds across the globe struggle to find and manage the resources criti-
cal for their future success. Failure to obtain new resources has two
root causes. First, and most visibly, firms often struggle to implement
the paths they have chosen for obtaining resources; second, and less
well understood, the paths chosen are often the wrong ones.
Because each path presents many difficulties, executives must
understand when one path makes more sense than another. Indeed,
choosing a wrong path will, in itself, make implementation more diffi-
cult and can lead to the implementation trap. In this trap, the firm fails
because it tries harder and harder to implement the wrong way of
obtaining key resources.
Our core message throughout this book is simple: firms that learn to
select the right pathways to obtain new resources gain competitive advan-
tages. Conversely, firms that do not carefully weigh competing paths,
but instead dutifully replicate a preferred past method—no matter how
diligently they pursue it—will often stumble and fail. They will lose
ground to firms that pursue more disciplined approaches of reviewing,
selecting, and balancing the different resource-development paths.
(“A Tale of Two Deals” highlights the advantages and disadvantages of
various pathways.)
As noted in the introduction, our step-by-step resource pathways
framework helps you choose the best way of obtaining the resources
you need to exploit strategic opportunities. Part of the framework’s
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The Resource Pathways Framework
A TALE OF TWO DEALS
Selection Mistake Meets Selection Success
The 2002 purchase of the Compaq Computer Corporation by Hewlett-
Packard (HP) embodies a tale of two selection processes—one successful
and the other not.
At the time of the $25 billion deal, HP’s acquisition of Compaq was highly
controversial. Yet, despite many predictions of catastrophe, the deal helped
HP complete its transformation from a scientific instruments company into a
personal-computing leader.
Less successful was an earlier pair of acquisitions by Compaq. From its
founding in 1982 through the 1990s, Compaq grew to become one of the
world’s leading business and retail PC manufacturers. But in the mid-1990s, the
company faced competitive pressure from Dell and other industry rivals. In 1997
and 1998, Compaq purchased Tandem Computers, a producer of high-end
business computers, and Digital Equipment Corporation (DEC), a leading maker
of minicomputers. Compaq believed that these two acquisitions would allow it
to compete with the likes of IBM as a broad-based computer manufacturer.
But Compaq had no blueprint for integrating and exploiting the acquired
properties. Fundamentally, it could not assess the feasibility of postacquisition
integration or identify the right ways to fill complementary resource gaps. Com-
paq struggled to make the pieces fit together. The resulting fragmentation dam-
aged its ability to compete successfully with better-integrated computer makers.
Compaq made two mistakes in its acquisition decision. First, it did not care-
fully assess the difficulties of absorbing two ambitious—and very different—
acquisitions in consecutive years. Second, having failed to weigh integration
issues, it had effectively overlooked potential problems that might have led it to
walk away from the deal. Deals sometimes fall through, often for good reasons.
If you are well informed enough to dodge a bullet, you then have the chance to
shift gears and pursue a more appropriate business-transformation strategy.
But Compaq was unable to recover from the failed acquisitions. It became
available as a target.
Conversely, in the 1990s, HP had grown from its roots as a scientific instru-
ments innovator, becoming a strong player in the minicomputer segment and
3
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4 Build, Borrow, or Buy
an industry leader in PC printers. In the late 1990s, HP decided to focus on the
computer industry. It separated its traditional scientific instruments unit and
several related businesses into a separate company called Agilent. In 2002, HP
saw Compaq as a lever to help expand its computer industry presence.
Unlike Compaq, HP paid considerable attention to how it would select the
necessary resources for this strategy. It looked carefully at the feasibility of
postacquisition integration and at ways of complementing the acquisition with
both internal development and alliance support. Before completing the Com-
paq deal, HP set up a brigade of integration teams to specify activities the
company would need to undertake to integrate Compaq’s resources and to
identify HP resources that would become redundant once the firms com-
bined. The integration was led by a highly respected senior executive who
reported directly to HP’s CEO, Carly Fiorina. Immediately after the deal was
completed, a senior executive from Compaq joined the integration team as
coleader.
In parallel, HP’s senior leadership recognized complementary resource
gaps that the company would need to fill through build and borrow strategies.
HP therefore set up multiple project teams to develop software and hardware
bridges that would interconnect key parts of the newly integrated businesses
(for example, linking Compaq’s computers to HP’s printer product lines). In
addition, HP identified partners to help it expand the integrated business—for
example, working closely with SAP to develop software HP would need for its
expanded business-oriented services.
The combination of build, borrow, and buy strategies following the Com-
paq acquisition led to major changes at HP over the next decade—and ulti-
mately to financial success. The company laid off thousands of people from
the target companies and traditional HP units. At the same time, though, it
added staff to support the change in strategic direction. The company quickly
became the world’s largest PC maker and reinforced its leadership in the
printer business.
Early financial results were mediocre. There were losses in 2002 and low
profitability through 2005. By 2006, however, the transformation had pro-
duced substantial success. The company had returned to strong profitability,
growing sales by 50 percent while increasing staffing by only 10 percent.
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The Resource Pathways Framework
power is its simplicity. Even so, you can expect internal and external
pressures to lead you and other decision makers on bumpy detours.
Why? It is human nature for business leaders to rely repeatedly on
what they know best. Over time, organizations develop a dominant
way of obtaining resources. A strong R&D business may naturally
default to building through internal innovation; a business that has
grown through acquisitions is likely to look at each new gap as an
opportunity to buy again; and a company that values rapid response
and high flexibility in new markets may prefer borrowing through
expedient temporary alliances or well-defined contract purchases.
Each kind of organization has grown into a default approach for get-
ting what it needs. And each default approach has become the hammer
to which every opportunity looks like a nail.
Consequently, most businesses will need to break old habits. And
old habits die hard! You will need great discipline to stay the course.
But if you do, you will respond to each new opportunity appropriately.
Success will depend less on outside forces, such as markets and tech-
nologies, than on the discipline and commitment of key decision mak-
ers within the firm.
Most businesses think far too little about the pathway they select;
instead, they focus on implementation—and end up wondering why all
Over the next five years, HP grew sales by a further 50 percent while the
company maintained profitability—despite having doubled personnel as it
invested in areas of the transformed business to build on its market leadership.
Of course, no single transformation can respond to ongoing competitive
dynamics. In 2012, under new leadership, HP is considering new changes to
the business mix. As part of this shift, the company acquired Autonomy
Corporation for $10 billion in 2011, to provide resources that HP will need for
expanding its enterprise information management business.
5
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6 Build, Borrow, or Buy
their hard work is unavailing. By focusing on the selection challenge,
the resource pathways framework leads to more effective implementa-
tion, because of its emphasis on the right path. Let’s start by comparing
the basic pathway choices.
The Resource Pathways Choices
Building through internal development or innovation can create pow-
erful new value by recombining a firm’s existing resources, but even
the most aggressive R&D firms can’t create all the skills and resources
they need solely through internal development efforts. Companies
must draw on external sources to complement organic growth. Exter-
nal sourcing can take many forms. At the simplest level, a resource-
seeking firm can contract with other organizations that are willing to
sell the needed resources. Alternatively, it may acquire resources by col-
laborating with or purchasing another company.
Acquisition is often touted as the fastest way to obtain a portfolio of
resources—along with supporting teams, processes, and cultures. Yet
purchasing a business requires an arduous M&A transaction and the
postmerger integration of the acquisition into the organization—
a difficult process that often fails.
Although internal development and M&A are dramatically differ-
ent paths, both allow the resource-seeking firm to exercise strong con-
trol over the needed resources and the value the resources ultimately
produce. Since many firms assume that ownership or control of
resources is necessary to achieve competitive advantage, they see
themselves facing a simple choice to either build or buy.
That is a mistake. Borrowing new resources, through contracts or
alliances with partner organizations, is often a valuable path.
Contracts and alliances offer temporary access to targeted resources
under more flexible terms and at lower risks and costs than other
modes. As described below, this was certainly the experience of the
pharmaceutical industry.
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The Resource Pathways Framework
From Fortresses to Networks
Until the 1970s, the multinational companies in the pharmaceutical sec-
tor emphasized in-house R&D, production, and marketing resources.
Companies relied mainly on organic growth, missing out on contribu-
tions from external innovators. During the subsequent decades, devel-
opments in biotechnology and genomics—amplified by the global
spread of innovative resources—prompted many pharmas to open up
their R&D processes to accommodate a mix of contracts, alliances, and
acquisitions. Today, major pharmaceutical firms around the world—
such as Eli Lilly (US), Sanofi-Aventis (France), Teva (Israel), and Astellas
(Japan)—commonly pursue innovation and research as much outside
as inside their own laboratories.
Thus, pharmaceutical firms are transforming themselves from the
old self-contained, fully integrated model into a far more open and
flexible networked model. In response to this new openness, a profu-
sion of resource providers has emerged to serve the pharmaceuticals’
growing appetite for knowledge assets and development tools.
This transformation is not unique to the pharmaceutical sector.
Information technology is fueling a boom in firms specializing in
knowledge development and aggregation and analytics. No matter the
industry, the ability to obtain resources in different ways requires that
you learn and master when to build, buy, or borrow resources.
All three major approaches to growth—build, borrow, and buy—
are vitally important. Internal development projects, contracts,
alliances, and M&A constitute tens of thousands of deals worldwide
each year. Moreover, the growth in each type of activity involves nearly
all industries and countries—with ever-greater volumes of cross-
industry and cross-border investment and deals.
In all this activity, there is no discernible global shift from one
dominant form of obtaining new resources to another. Instead,
businesses increasingly require a sophisticated, enterprise-wide ability
to use multiple modes of obtaining targeted resources as circumstances
warrant.
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8 Build, Borrow, or Buy
Beating Different Paths to the Same Place
The choice of a path is neither obvious nor easy, but is unique to a par-
ticular company. Therefore, two companies from the same industry,
facing similar competitive forces, might select different paths to obtain
new resources. Assuming their choices were made by a careful consid-
eration of multiple options, both paths could be right for those com-
panies. Conversely, if each firm reflexively chose its traditional
preference, the choice would only be the right path by accident!
Companies in the smartphone industry employ a wide variety of
pathways to market these multifeatured devices. While some firms’
selections show signs of careful consideration—including a sophisti-
cated recourse to multiple strategies for different elements of the same
innovation—others seem more a matter of trial and error.
For example, Nokia initially used a borrow strategy, forming an
alliance in 1998 with the UK software firm Psion (in conjunction with
Ericsson and Motorola) to develop the Symbian operating system. To
gain full control of Symbian, Nokia eventually bought the operating
system from Psion in 2004. Research In Motion, meanwhile, has pur-
sued a build strategy to make its successful BlackBerry line more
smartphone-like. But the company has yet to demonstrate that it has
the necessary resources for internal development alone. And HP
resorted to a buy strategy for its ticket into the smartphone market. In
2009, it acquired Palm, maker of the Palm personal digital assistant
(PDA) and developer of the webOS operating system, which HP
planned to use in devices ranging from smartphones to PCs. Apple,
meanwhile, followed a sophisticated build-borrow-buy strategy for its
iPhone, taking the lead in designing the operating system, while pursu-
ing and managing various technology licenses and alliances for other
components and making a few key acquisitions. Google, joining the
smartphone fray from its leading Internet position, has used both buy
and borrow strategies. It acquired the mobile software firm Android in
2005 and then supported the platform through an industry consor-
tium of hardware, software, and telecommunication companies,
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The Resource Pathways Framework
complemented with alliances with smartphone providers such as HTC
and Samsung.
Traditional publishing firms have also followed divergent paths to
fill digital resource gaps. Publishing e-books, online magazines, and
other digital assets calls for skills both highly diverse and distinct from
those of traditional publishing. Among them are the abilities to create
multiplatform content, master data analytics, and interact with online
communities.
To close its digital resource gaps, the Finnish media company
Sanoma Group acquired a Dutch digital publishing company, Ilse
Media, which then drove digital growth across the company. Axel
Springer, the leading German publishing group, made significant
internal investments in building the digital skills of its existing journal-
ists and marketing people while creating integrated newsrooms and a
cross-media advertising sales group.
Springer quickly discovered that it couldn’t generate enough
growth by turning traditional print into digital formats. So it changed
paths and embarked on multiple acquisitions of “native” Internet busi-
nesses (AuFeminin.com and immonet.de) that were only indirectly
related to core print activities. Springer has operated the acquired
businesses on an arm’s-length basis as it decides how best to integrate
them over time. This example—like others whose first path chosen
was eventually abandoned—shows how an ill-considered selection
may produce disappointing results.
The British publisher Pearson Group pursued a mixed buy-build
strategy, acquiring digital companies even as it sought to upgrade the
skills of internal staff and to bridge the cultural divide between digital
and print media. And the Associated Press entered into long-term
partnerships with selected technology providers rather than acquire or
develop internally the technical skills needed to create digital offerings.
In the automobile industry, similarly, manufacturers have adopted
different ways of obtaining premium-market resources. Toyota has
used internal growth to make inroads on the premium market with its
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Build, Borrow, or Buy
Lexus branded cars. Many other firms have used acquisitions to rap-
idly acquire premium technologies and brand names. The Indian con-
glomerate Tata bought Jaguar in 2008 from its US parent, Ford, and
the Chinese car firm Geely acquired Volvo in 2010, also from Ford. Still
other car firms have turned to contractual agreements: the Romanian
automaker Dacia licensed technology from Renault (and later became
part of the French firm). There are also more substantial partnerships,
such as the multiproduct alliances between the French automaker
Peugeot-Citroën and the Japanese automaker Mitsubishi Motors (on
4×4 and electric vehicles in 2005 and 2010, respectively) and the
Franco-German equity joint venture formed in 2011, BMW Peugeot
Citroën Electrification, to develop hybrid systems.
With all that choice, how do companies select the right path to
obtain a specific resource that they need? Do they follow specific guid-
ing principles? Do the principles depend on the nature of the gap,
external pressures, internal skills and personnel, costs, the need to act
quickly, the CEO’s inclinations, or other factors? In reality, all these
conditions are relevant when a company seeks strategic resources.
Given the stakes, you might expect that companies would have
well-developed processes for selecting the best mode for acquiring new
resources. But dysfunction is surprisingly more the norm than the
exception. Our research over the years has shown that executives are
often confused about the best way to obtain resources. They lack access
to tools, guidelines, or even shared company wisdom that would help
them make sound decisions. The following example—from a study we
conducted in the global telecom industry—illustrates the conse-
quences.
The Implementation Trap
In the late 1990s, a leading European supplier of telecom technologies,
with a strong position in voice technology, launched an effort to com-
pete in the fast-developing data environment. The company—well
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The Resource Pathways Framework
known for its superior engineering skills—had long favored internal
R&D, so that was the path it chose. Because most data-networking
innovation was then occurring in Silicon Valley, the company had
difficulty competing for enough new talent to sustain the internal
development effort. Lacking relevant know-how, the company failed
in its internal innovation efforts.
Ultimately, the company’s executives realized that they lacked not
only the necessary technical skills but even the industry contacts and
level of insight needed to identify best-of-breed technologies, consult-
ing partners, and top talent. So they forged an alliance with an up-and-
coming firm in Silicon Valley, hoping that the collaboration would
help them quickly boost their market credibility and data networking
skills. But the alliance lasted only a few months before disagreements
between the partners over market and technology strategy caused a
damaging bottleneck that undermined collaboration.
After these internal development and alliance activities failed, the
company finally decided to acquire three US companies and combine
them into a new US-based firm that would run the data communica-
tion business for the corporate group. The acquisitions finally gave the
company a credible position in data networking.
An executive at this firm described the painful trial-and-error
process, from building to borrowing to buying: “Each failure revealed
more of this pattern: that we needed to reach a certain threshold of
competency before we could run effective internal development or be
an effective partner within an alliance. We had to finally turn to acqui-
sitions in order to accelerate R&D.”
The stories of this company and many others exemplify the
implementation trap: a company works doggedly to perfect the wrong
course of action. It plays out like this: faced with a need for new
resources, a company pursues them in ways it believes worked in the
past. For instance, R&D teams typically prefer to develop future
capabilities through organic innovation. As one telecom executive told
us: “We have superb technical skills on the engineering side. Internal
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Build, Borrow, or Buy
people tend to think they should be given a chance to do it on their
own. We need to break this perception barrier . . . We need to develop a
capability to manage alliances and acquisitions. The issue is how you
bring such process skills into our people’s mind-set.”
Unfortunately, when companies do try to break that barrier by try-
ing something new, they tend not to stick with it long enough. An
executive at a leading US telecom company shared with us his frustra-
tion that his company, instead of exploring the roots of its early fail-
ures with alliances, simply ruled them out of future consideration.
The result is that many firms adopt a small set of methods for man-
aging their corporate development activities. Indeed, when adding to
its strategic arsenal, the typical company relies heavily on just one dom-
inant path—commonly either internal development or acquisitions—
perhaps complemented with a supplemental method.
For instance, our study of the telecommunications industry found
that only one-third of the surveyed firms actively used more than two
methods of obtaining new resources. About 40 percent relied heavily
on one main way of growing. When those companies did add a string
to their bow, it was usually just one additional pathway: for example,
M&A to complement internal development.
Reliance on only one dominant mode leads firms to believe that their
success depends on working hard at implementing that mode. Business
leaders often blame poor implementation when their firms struggle in
the effort to add new resources. More than half of the 162 telecom firms
we surveyed flagged implementation—particularly the lack of person-
nel and skills (67 percent) and an inability to integrate external resources
effectively (50 percent)—as the primary cause of problems.
But the blame is misplaced. The real culprit is an ineffective process
for selecting the right paths for obtaining resources. Sticking to a
familiar or popular path may work in the short term. But in the long
term, the implementation trap becomes a self-reinforcing cycle,
with each new resource an occasion for continuously improving
implementation of the wrong activities. To be sure, firms that fall into
the trap do end up doing the wrong things quite well. They then
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The Resource Pathways Framework
become deeply frustrated when they struggle competitively. Assuming
that the cause is implementation perpetuates the problem.
Instead, executives must think carefully about the important work
that precedes implementation: the disciplined process of selecting the
best way to obtain new resources. Firms that select the best path inte-
grate new resources more quickly, cheaply, and effectively than do
competitors. Our telecom study revealed that firms using multiple
modes to obtain new resources were 46 percent more likely to survive
over a five-year period than those using only alliances, 26 percent
more likely than those using only M&A, and 12 percent more likely
than those using only internal development.
Of course, some companies invest considerable time and effort in
their build-borrow-buy decisions. Throughout the book, we will draw
on many of the firms we have studied, including well-known compa-
nies from around the world. But even leading firms can make mistakes,
sometimes rushing into deals without thoroughly exploring the impli-
cations, or succumbing to internal or external pressures to favor one
pathway over another. The discouraging results of such lapses remind
the firms to reassert the necessary discipline. Let’s look now at what
that discipline involves.
Finding Your Resource Pathways
The resource pathways framework allows you to compare the potential
benefits and risks of all the possible sourcing modes and, ultimately,
select the best option for obtaining needed resources. In devising the
framework, we’ve assumed that your firm has developed its corporate
strategy and identified its resource gaps—whether through structured
planning activities or other more ad hoc processes. Nonetheless, the
sidebar “Recognizing Resource Gaps” highlights problems that can
arise if that work has not been done properly. As a useful preliminary,
you may want to revisit initial strategic planning activities and confirm
that identified resource gaps and targeted resources align well with
your firm’s broader strategy.
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Build, Borrow, or Buy
RECOGNIZING RESOURCE GAPS
The old adage about errant computer data—“garbage in, garbage out”—applies
to the challenge of correctly identifying resource needs. It’s unproductive to follow
the right pathway to the wrong resources. Consequently, you need to make sure
you target the right resources.
Companies sometimes stumble at the initial stage of targeting the right
resources for the strategy they have set, especially when they have enjoyed
great success in a dominant core domain. When it comes time to pursue a
new strategy, with a new product line or in a new market, companies’ past
habits and expectations may lead them to misjudge the needed resources.
Ingrained competencies, entrenched processes, and the power of existing
brands can impede a clear-eyed assessment of resource gaps—particularly
when the gaps result from disruptions in the competitive environment or from
emerging fields or markets.
A prototypical example of this type of failure occurred when successful
producers of steam locomotives responded to new diesel and electric loco-
motives by producing the most advanced, cost-competitive steam locomo-
tives ever seen. Despite their hard work, these once-famous companies
disappeared into the mists of business history, seen only thereafter on the
logos of toy trains.
More recently, both Nokia and Research In Motion have struggled to
respond to advances in consumer smartphones. Both companies overvalued
the relevance of their existing internal resources in responding to advances
from Apple, Google, HTC, and Samsung. Each has lagged badly in the smart-
phone market.
A form of myopia prevents companies from seeing that their existing core
resources are unequal to the competitive demands of the moment—a prob-
lem caused by misaligned resource-management strategies. Consider what
happens when management is properly aligned. In the locomotive example of
the early twentieth century, a few steam locomotive producers—perhaps most
notably Siemens—recognized the opportunity to build on their existing
resource base by allying with firms possessing expertise in diesel and electric
technologies. They became leaders in the new field because they targeted the
right resources—the ones they lacked internally but recognized as core to
their future survival. Likewise, in the smartphone market, Samsung combined
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The Resource Pathways Framework
Assessing the Different Resource Pathways
The framework focuses on resources you deem to be strategically
important—those that, when added, will either reinforce your existing
competitive advantages or lay the groundwork for new ones. We will
continue to stress the question of strategic importance, because it will
help you think about how much to invest in resources that turn out to
have less strategic value than you initially believed.
Four questions frame the selection of the different pathways (inter-
nal development, basic contracts, alliances, and acquisitions). These
questions derived from our field interviews and work with firms across
various industries and countries. We validated the relevance of the
four criteria through a large-scale survey that we administered within
the global telecommunications industry and through subsequent dis-
cussions with executives in many industries and countries and with
our MBA and executive MBA students. Figure 1-1 illustrates the
resource pathways framework as a decision tree addressing the four
key questions.
Although the questions are general enough to address most con-
texts, we offer additional detail throughout the book to help you tailor
your own decisions to your company’s particular circumstances. The
internal development with focused alliances to take a leading position in
Android-based systems.
New competitive realities often call for radically different resources. If your
company fails to understand what resources it needs to compete in the
future, it makes little difference what pathway you take to obtain them. If you
have doubts about which resources your company needs to achieve its goals,
your first step should be to use your company’s strategic planning process to
identify key resource gaps.
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Build, Borrow, or Buy
balance of this chapter summarizes the four key questions that will
guide your path selection.
Question 1. Are Your Internal Resources Relevant?
Can you leverage existing company resources to satisfy new needs?
Developing new resources internally is often faster and more effective
than obtaining them from third parties. But this strategy is viable only
when internal resources (knowledge bases, processes, and incentive
systems) are similar to those you need to develop and superior to those
of competitors in the targeted area. If so, your internal resources are
relevant.
F I G U R E1 – 1
The resource pathways framework as a decision tree
Strategic resource gap
Build?
Internal development
Contract/licensing
Alliance
Acquisition
Low
H
ig
h
Internal resource relevance
Borrow via contract?
Low
H
ig
h
Resource tradability
Borrow via alliance?
High
L
o
wDesired closeness with
resource partner
Buy?
Low
H
ig
hFeasibility of target firm
integration
Revisit build-borrow-buy options,
or redefine strategy
16
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The Resource Pathways Framework
Often, existing resources will not be relevant. For instance, most
traditional publishing firms’ legacy print-media resources were so far
removed from digital media that publishers had to bring in outside
resources through acquisitions and partnerships—often after trying
without success to have inside staff learn the ropes.
Likewise, a global investment bank recently sought to develop a
private-equity business in Eastern Europe. The CEO of the country
unit first assessed whether internal development might be feasible, but
concluded that the local bank lacked sufficient expertise to develop a
private-equity offering internally. Nor did the parent company have
private-equity experience—which requires a deft understanding of
activities ranging from deal origination to exit strategies. The CEO
considered hiring away a competitor’s team to support internal
innovation. However, not only would that be expensive, but the bank
would also risk being unable to retain and leverage the outside team’s
expertise. After concluding that internal resources lacked relevance for
the new business, the CEO began reviewing external options.
You might think answering this first question is easy. Yet companies
often vastly underestimate the actual distance between their existing
resources and the targeted resources. Like many print publishers,
business leaders more easily see the similarities than the profound
differences: “Reporting, writing, and editing are the same for a Web
page as a printed newspaper, right?” Well, yes and no. Traditional pub-
lishers failed to grasp radical shifts in the business model, technology,
customer and revenue strategies, and the implications of community
interaction—all of which continue to evolve. Seeing only what’s simi-
lar, a business can fixate on internal development because it doesn’t
know what it doesn’t know.
Internal development is fraught with obstacles that firms often
overlook—until later. Businesses choose the build path as their first
option and only consider external sources after encountering major
setbacks. Among our sample of telecom firms, 75 percent used internal
development as their preferred means of obtaining new resources. But
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Build, Borrow, or Buy
when asked to evaluate the effectiveness of the internal path, many
executives admitted they were disappointed. Almost half said that they
failed to create the desired new resources because they were unable to
properly manage internal development, and nearly two-thirds
reported friction associated with integrating and diffusing the inter-
nally created resources throughout their organization.
In chapter 2 we will review how to assess the relevance of your
existing resources for internal development and how to recognize—
even at the outset of the selection process—when it is best to go
straight to external sourcing.
Question 2. Are the Targeted Resources Tradable?
Once you’ve determined that you need to look externally for resources,
you must weigh which type of external sourcing mode to use—from
the simplest and most straightforward to those of higher cost,
complexity, and commitment. (By tradable, we mean that you can
negotiate and write a basic contract that will both protect the rights of
the contracting parties and specify how they will exchange resources.)
The first option is obtaining what you need via contract, a basic
form of borrowing resources that another firm has created. Arm’s-
length contracts often help companies identify, evaluate, and obtain
bundles of new resources and absorb them quickly. Pharmaceutical
firms commonly license the rights to register and market other compa-
nies’ drugs in particular geographic markets. Chemical firms have long
used contracts as a way of obtaining new molecular compounds. In
turn, the companies sometimes out-license the rights to compounds
or applications that they do not want to develop themselves. For exam-
ple, W. L. Gore and Associates licenses the rights to use DuPont’s PTFE
polymer for use in medical implants and rain-resistant clothing. The
two companies have always managed these relationships using basic
contracts.
Contracting is often the simplest way of obtaining needed
resources. However, companies often overlook it. Instead, they seek
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The Resource Pathways Framework
first to pursue an alliance or acquisition. We found that many firms
overestimate their need for strategic control while underestimating the
likelihood of achieving adequate control through third-party relation-
ships. Overvaluing your need for control can lead you to paths that
waste resources and, worse, deny you the opportunity to learn from
independent partners. Yes, you need to protect your firm’s core
resources, but selecting the wrong sourcing mode can inhibit your
ability to replenish that core.
Trust plays a role in answering this question. Firms often fear that
an external party may not play fair in the agreements or that they may
have to give up too much revenue to a contractual partner if they do
not control commercialization. Only a third of the telecom firms we
surveyed actively use contracts to obtain new resources. In fact, 70 per-
cent said they would choose an alliance or acquisition over a contract,
especially when the targeted resources affect core parts of their busi-
ness. Only 30 percent of the surveyed firms had made systematic
efforts to assess external resources available from suppliers. Thus, most
firms decide on more complicated external sourcing options without
first considering the simpler expedient of licensing through a basic
contract. Such an oversight is often counterproductive.
It is important to carefully weigh potentially favorable conditions
for a basic contract before turning to alliances and acquisitions—which
require substantially greater management time and attention. Obtain-
ing new resources via contract requires clarity in defining the targeted
resources. Likewise, you must understand how the value of the new
resources will be protected (and have some familiarity with, and confi-
dence in, the relevant legal system).
Of course, sometimes a contract is inappropriate. But a company
can’t make that judgment without first investigating the option. Recall
the global investment bank that wanted to launch a private-equity
service through its Eastern European unit. Its leadership team initially
weighed whether to contract with a local private-equity firm. In such
an arrangement, the global business would provide products, brand
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Build, Borrow, or Buy
equity, and global coordination while the local partner would provide
local investment selection, deal structuring, monitoring, and exit
skills. Such a contract would have required a solid incentive structure
to secure strategic alignment with the partner. Alignment was critically
important because the bank alone would have dealt with clients
regarding investment results, processes, ethics, and partner due dili-
gence. Moreover, the arrangement would require the private-equity
firm to hire new employees to handle tasks that it did not explicitly
contract to perform. After reviewing this option, the team concluded
that the transaction costs between the two parties would be prohibi-
tively high—driven up by the extensive coordination needs and by
concerns that the partners might either take advantage of the relation-
ship or fail to execute their responsibilities fully.
Chapter 3 will review how you can assess the tradability of your
targeted resources. Tradability will help you decide when to obtain tar-
geted resources via basic contracts, such as in-licenses and out-
licenses, and when to consider more complex arrangements, such as
alliances and acquisitions, with other firms.
Question 3. How Close Do You Need to
Be with Your Resource Partner?
If your targeted resources are not easily tradable, you will need to consider
an alliance or acquisition. Given a choice between those options, our mes-
sage is simple: because M&A is the most complex path, reserve it only
when it really pays to have a deep collaboration with the resource provider.
Alliances can take many forms, ranging from R&D and marketing
partnerships to freestanding joint ventures. Thus, alliances might be
relatively simple agreements or complex relationships involving multi-
stage contracts, cross-investments, and complicated rights stipula-
tions. All alliances, however, rely on ongoing interactions in which
independent actors—these may be competitors, complementary
firms, or other organizations (such as universities and public insti-
tutes)—commit resources to a joint activity.
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The Resource Pathways Framework
Pharmaceutical companies commonly use alliances to develop and
market specific drugs. In many cases, simply in-licensing the rights to a
molecule would be risky because of the need to participate actively in
the development process. Falling short of the intense control of an
acquisition, alliances allow partner firms to collaborate on focused
projects with explicit aims.
Of course, some projects are so complicated that the level of part-
ner interaction renders the collaboration unworkable. In the Eastern
European bank unit, for example, the alliance option at first seemed
promising. It combined the strengths of global and local resources and
strong incentives for the local partner to work hard to expand the busi-
ness. The team rejected this option—after much consideration—
because the bank’s dominant motive in undertaking the strategy was
to build a broad set of skills for itself and to keep tight control over the
investment process. The bank concluded that the local private-equity
partner would be loath to help launch a new competitor. Worse, the
partner might use its close alignment to glean competitive insights for
the future. There was also a secondary misgiving: most private-equity
firms are unaccustomed to the stringent requirements of more tradi-
tional banks. The team feared that the structure of the joint venture
would be likely to create ongoing conflicts between the partners about
governance and processes.
Paranoia is a common business condition. Many firms are simply
suspicious of collaboration, often for the wrong reasons. As we noted
above, many executives overvalue control—and believe that collabora-
tion will reduce their control over resources.
In our conversations with executives from telecommunication
incumbents, many viewed alliances “as a route to diminishing our
skills,” as a way “of shopping core competencies rather than sharing
knowledge,” and as eventually transforming partners into competitors.
Fully 80 percent of the surveyed executives shared concerns of exclusiv-
ity, control, and resource protection. Not surprisingly, 80 percent also
reported that they used M&A, rather than alliances, to gain exclusive
21
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Build, Borrow, or Buy
access to the firm controlling the needed resource. More than two-
thirds of the executives also wanted to keep their own assets closely
held, choosing M&A over alliances to protect their differentiation and
unique resources.
As you can see, alliances are often tricky to manage. Some analysts
suggest that no more than 30 percent of alliances succeed in meeting
the partners’ respective goals. Because alliances are almost always tran-
sient relationships, executives naturally fear the negative consequences
of collaborating with a partner that might abuse them before or during
the alliance or after exiting it. Those who can overcome such fears will
have to actively manage alliances throughout their life cycles and easily
foresee milestones and termination. Despite the risks, however, you
should carefully assess the potential of an alliance before jumping
heedlessly onto the acquisition path.
Chapter 4 will help you decide how to choose between alliances
and acquisitions when interfirm collaboration is needed. As we will
demonstrate, alliances are most effective when relatively few people
and organizational units from each party must work together to coor-
dinate the joint activities. A limited cast of characters also makes it eas-
ier to align the partners’ incentives. But if the joint actions to obtain
and develop strategic resources require deep involvement—for coordi-
nating the use of resources or attempting to align goals, or both—you
will usually benefit by considering an acquisition. You will have bought
not only key resources, but also the assurance of retaining the value of
their successful exploitation.
Question 4. Can You Integrate the Target Firm?
Before choosing the M&A path, bear in mind that acquisitions are
almost always more time-consuming and expensive than even the
most pessimistic scenario you could imagine. Acquisition is, for good
reason, the mode of last resort—reserved for cases that don’t suit any
other path. However, that doesn’t mean you must undertake an acqui-
sition simply because you’ve analyzed and rejected the other modes.
22
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The Resource Pathways Framework
If you value strategic control over the targeted resources and have
already concluded that less integrative modes (contracts or alliances)
will not achieve what you seek from the relationship, then you must
assess whether you can effectively integrate the target firm’s resources
without damaging employee motivation at either firm. In our private-
equity example, the team members were ultimately considering
whether a skilled local target existed and was willing to sell at a viable
price. They had concluded that acquisition appeared to be the optimal
path. It offered the fastest way of developing a product. Unlike a team
lift-out, in which a team is hired away from a competitor, an acquisition
would bring the target’s full pool of assets (including reputation) to the
bank. The buy mode also offered greater freedom in restructuring local
operations. Finally, the Eastern Europe unit would benefit from the sup-
port of its global parent, which has strong skills in pre-acquisition due
diligence and postdeal integration of new personnel and assets.
However, the corporate development team was fully aware of the
integration challenges and the importance of retaining the targeted
resources. An acquisition would work only if the acquired resources
could be fully leveraged to generate investment opportunities and
strong investment performance. Moreover, the acquirer would have to
provide value by bringing its expertise in legal, compliance, and risk
management and by securing a solid country distribution base. In
short, the team had to assess whether postdeal integration was feasible
before deciding on acquisition.
It is very hard to make M&A succeed. For every successful story,
there are multiple failures: some studies suggest that—as with
alliances—just 30 percent of M&A achieve their goals. The main rea-
son is that integrating the acquired entity almost always involves
unanticipated obstacles and expenses. Personnel you wish to retain—
because of their strong skills—typically have other opportunities,
which they frequently pursue. The tremendous power and potential of
the buy mode is matched by the severity of its challenges. For this rea-
son, it is important to use acquisitions selectively.
23
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Build, Borrow, or Buy
Chapter 5 will help you decide under what circumstances to com-
mit to an acquisition instead of other options that initially seemed
infeasible. If you most likely cannot integrate the acquired target’s
resources within your organization, then you must reconsider the
alternatives: set up more complex versions of the different sourcing
modes and view them as learning experiments; explore the possibility
of targeting substitute resources; or review your strategic goals and
then revise or abandon the current resource search.
Managing the Portfolio
The framework we describe in this book not only applies to decisions
concerning the acquisition of resources but can also help a firm
dynamically manage how it owns and manages those acquired
resources over time. In chapter 6, therefore, we present a model for
continuously assessing existing resources, resource gaps, and needs for
divestiture of resources that have outlived their usefulness. Finally, in
chapter 7, we help you manage a balanced build-borrow-buy portfolio
and develop a strong selection capability within your organization.
These responsibilities require not only a rigorous approach to each
sourcing decision, but also the ability to balance all such decisions
across your organization, over time. In that way, you can maintain a
viable combination of building on existing skills and exploring new
opportunities. This balance clearly poses significant leadership chal-
lenges that we will highlight in our discussion.
Let’s now look at the first choice that you need to make as you
embark on the acquisition of a new resource.
24
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APPENDIX A
The Resource Pathways
Framework: Full Model
Strategic resource gap
Build?
Low
H
ig
h
Internal resource relevance
Strong
knowledge
fit?
Knowledge
questions
Governance
questions
Strong
organizational
fit?
Internal development
Borrow via contract?
Low
H
ig
h
Resource tradability
High
resource
clarity?
High
resource
protection?
Contract/licensing
Borrow via alliance?
High
L
o
wDesired closeness with
resource partner
Narrow
collaboration
scope?
Compatible
partner
goals?
Alliance
Revisit build-borrow-buy
options, or redefine strategy
Buy?
Low
H
ig
hFeasibility of target firm
integration
Clear
integration
map?
High
employee
motivation?
Acquisition
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References
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(1996): 8–30.
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References 27
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Course Pack/DuPont Corporation Sale of Performance Coatings.pdf
UV6790
Rev. May 11, 2017

This case was prepared by Susan Chaplinsky, Tipton P. Snavely Professor of Business Administration; and Felicia Marston, Professor of Commerce,
McIntire School of Commerce; with the assistance of Brett Merker, Research Assistant. It was written as a basis for class discussion rather than to
illustrate an effective or ineffective handling of an administrative situation. Copyright  2014 by the University of Virginia Darden School Foundation,
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DuPont Corporation: Sale of Performance Coatings

In January 2012, Ellen Kullman, CEO and chairman of DuPont, was reviewing an internal report on the
company’s Performance Coatings division. A month earlier, she had dismissed rumors that the business was
up for sale after reports had surfaced that the company had hired Credit Suisse to seek potential buyers for it.
Kullman stated that the business would be given a “chance” to see if it could meet certain performance
targets, saying: “From a performance standpoint we will give them a chance to see if they can get there. If any
of our businesses can’t obtain their targets, obviously we will look at alternatives.”1 For several years, the
business, which produced paint for the auto and trucking industries, had struggled with low demand and high
raw-material costs that had hurt profits. During her tenure as CEO, Kullman had attempted to move DuPont
away from commodity chemicals to a specialty chemical and science–focused products business. It was no
longer clear whether DuPont Performance Coatings (DPC) fit her strategic vision for the firm. Still, the issue
was what course would produce the greatest value for shareholders. She had called for an internal review of
the business that fall to assess its value to DuPont compared to what outside parties might pay for it. Those
reports were now complete, and she would have to decide whether to retain the business or sell it and, if so,
at what price.
History of DuPont
E. I. du Pont de Nemours and Company was one of the longest continually operating companies in the
United States. It traced its origin to a French émigré, Eleuthère Irénée (E. I.) du Pont, who had studied
chemistry and who, at age 14, had written a paper on gunpowder. In 1799, his family fled revolutionary
France, and in 1802, he founded a company in Delaware, at the urging of Thomas Jefferson, to manufacturer
gunpowder.2 From its origins in gunpowder, in the 1880s, the company pioneered the manufacture of
dynamite. At the turn of the 20th century, the chemistry of nitrocellulose, critical to explosives, began to
spawn early innovations in plastics, lacquers, films, and fibers. In 1911, the U.S. government, citing antitrust
reasons, forced DuPont to break up its monopoly gunpowder business. Notwithstanding this, the company
made enormous profits during World War I, which it used to diversify into other businesses. By 2011,
DuPont was among the world’s largest chemical companies; it had $38 billion in sales and operations in 90
1 Stefan Baumgarten, “DuPont CEO Slams News Media Over Reports of Coatings Business Sale,” ICIS News, December 13, 2011.
2 Du Pont’s gunpowder company was capitalized at $36,000, with 18 shares worth $2,000 each, a portion of which was used to purchase a site on
Brandywine Creek for $6,740. Jefferson advised du Pont of the new nation’s need for gunpowder and gave him his first order, calling the agreement
between the two a “handshake that built a country,” from E. I. du Pont de Nemours and Company, “DuPont—200 Years of Service to the U.S.
Government in Times of Need.”
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countries. Among its most well-known products were nylon (introduced in 1935), Tyvek (used in
construction), Kevlar (a protection product), and Teflon (a protective surface). Exhibit 1 shows the evolving
nature of DuPont’s businesses since its founding.
Kullman’s Watch
Kullman joined DuPont in 1988 as a marketing manager after starting her career at GE. Within DuPont,
she had a reputation for making businesses grow, a legacy she attributed to her father, who was a landscaper.
In 1998, she launched a safety consulting business, which later became the Safety & Protection business,
which boasted sales approaching $4 billion in 2011. She was named DuPont’s CEO in January 2009 and, later
that same year, chairman. That year was a difficult one for the company because its performance was closely
tied to the broader economy, which had fallen into a recession. Shortly after her appointment as CEO, in
February 2009, DuPont’s stock price fell below $19, a multiyear low (Exhibit 2). In response to the
downturn, Kullman cut costs, laid off 4,500 employees, and continued to transition the company from a
commodity chemical business to a specialty chemical and science–driven business. Commodity chemicals
typically were cyclical, and intense priced-based competition kept margins low. By moving toward specialty
chemicals and more customized products based on DuPont’s research and development (R&D), Kullman
hoped to focus the company on higher-growth and -margin businesses.
As part of this plan, the company acquired Danisco, a leading food ingredient and enzyme company, for
$7.1 billion in January 2011. It was the second-largest acquisition in company history, smaller only than the
1999 acquisition of Pioneer Hi-Bred International, a maker of genetically modified seeds. With the shift
taking place away from the “Old DuPont” to a more specialty-focused company, the drivers of growth over
the next few years were likely to be Agriculture, Nutrition & Health, Performance Chemicals, and the nascent
Industrial Biosciences businesses. Kullman saw the firm’s future increasingly at the core of industrial
biotechnology; the company was positioned to compete in agriculture, nutrition, and advanced materials. She
articulated her direction for the firm in the 2010 annual report:
We have attractive growth opportunities supported by market-driven science and fueled by global
megatrends associated with population growth. We are allocating resources to drive the highest
growth opportunities…Global population will pass the 7 billion mark in 2011 and exceed 9 billion
people by 2050—or about 150,000 more people on the planet every day. This will translate into
critical needs in the areas of feeding the world, reducing our dependence on fossil fuels and keeping
people and the environment safe—the megatrends that are driving our science and innovation….3
With her push to match the company’s focus to these megatrends, DuPont’s business units were
evaluated to determine whether they fit this vision and could meet the company’s performance goals. The
company had publicly stated that its longer-term performance goals were to achieve 7% sales growth annually
and 12% earning margins. The firm had eight separate business units: Agriculture (24% of 2011 sales),
Performance Chemicals (21%), Performance Materials (18%), Performance Coatings (11%), Safety &
Protection (10%), Electronics & Communications (8%), Nutrition & Health (6%), and Industrial Biosciences
(2%). Based on 2011 revenue, Agriculture had grown to be DuPont’s largest business (Exhibit 3). Although
there was some unevenness in growth over the past two years, most of DuPont’s divisions had been able to
grow sales in line with the 7% goal. This was also true of DPC, which, in rebounding from the lows of 2009,
had grown sales by 12.5% in 2011, but the growth rate in sales over the next two years was expected to be
3 DuPont, “Letter to Shareholders,” 2010 Annual Review, 2011, 2.
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only 3% to 5% (Exhibit 4). More concerning was that its profit margins were the lowest among the eight
businesses. All of this suggested that DPC would have to significantly improve its growth and profitability to
meet DuPont’s performance goals.
Performance Coatings
DPC was formed in March 1999 when Herberts GmbH and DuPont Automotive Finishes merged.4 Its
products included high-performance liquid and powder coatings for motor vehicle original equipment
manufacturers (OEMs), the motor vehicle aftermarket (refinishing), and general industrial applications, such
as coatings for heavy equipment, pipes and appliances, and electrical insulation.5 DPC employees liked to say
that the products they made didn’t make cars go faster, they just made them look good going faster. From
2007 to 2011, sales had grown at a –0.3% cumulative average growth rate (CAGR) and profits had declined at
a –6.0% CAGR (Exhibit 5). Due to the company’s exposure to the auto sector, sales and earnings had been
adversely affected by the 2008 and 2009 downturn. In 2011, the company posted stronger revenue growth of
12.5%, but most of this was attributed to price increases, which were unlikely to continue. Notwithstanding
the pickup in sales, operating margins remained muted because of rising input costs. Nearly 50% of the key
raw-material inputs (e.g., hydrocarbon solvents and organic pigments) were tied to crude oil prices, which had
risen since the middle of 2010 due to tight supply and improving economic conditions.
Key competitive factors in its business included technology and technical expertise, product innovation
and quality, breadth of product line, service, and price. In most industrial applications, the coating itself was
only a small part of total production costs (e.g., 10% to 15%), and most customers were willing to pay more
for technologically advanced coatings if it reduced application costs (e.g., labor). The industry in general was
also not highly capital-intensive—capital expenditures and R&D were relatively small in comparison to the
variable costs of production.
DPC held the number-four position in the global industrial coatings market, where it faced strong
competition in all the business verticals that made up the industry (Exhibit 6). The market was highly
fragmented: two companies—PPG Industries and Akzo Nobel N.V., each with sales greater than
$10 billion—together accounted for 25% of industry sales. Seventeen firms had sales between $1 billion and
$10 billion, the range of DPC’s sales, which accounted for 45% of sales. The remainder of sales came from
over 60 additional firms. Given the increased pressures for cutting costs and finding higher-growth
opportunities, over the last six years, the industry had been consolidating; the market share of the six top
companies increased from 28% in 2005 to 35% in 2011.6 The top-10 global competitors controlled 60% to
75% of the sales in U.S. and European markets. To varying degrees, all the top competitors saw opportunities
for growth in the less saturated Asia-Pacific and Latin American markets.
Relative to peers, DPC’s strengths were in refinishing and the vehicle OEM market. In 2011, the vehicle
aftermarket accounted for 43% of the division’s sales, down from 53% of sales in 2009. The decline in
refinishing was of concern because its profit margins tended to be higher than those in the vehicle OEM
market. Of the $7 billion global refinishing market, PPG and DuPont were the market leaders—each had
approximately a 28% market share—followed by Akzo Nobel (17% market share). Sales to motor vehicle
4 DuPont had been a supplier of paint to the U.S. auto industry since its infancy, providing paint to General Motors in the 1920s. Herberts, a
subsidiary of Hoechst, was acquired for $1.9 billion, making the combined firms the largest supplier of automotive finishes in the world. At the time,
80% of Herberts’s operations were in Europe, while 75% of DuPont’s business was in North America.
5 Sales to OEMs included all vehicles (e.g., cars, trucks, buses, and motorcycles).
6 Buckingham Research Group, PPG Industries: “Other” Industrial Coatings Review, May 21, 2012.
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OEMs accounted for 37% of DPC’s 2011 sales, and DPC held the number-three market position in the
OEM paint market behind PPG and BASF SE.
The two key drivers of revenue for these businesses were miles driven and vehicle sales. Miles driven was
correlated with the incidence of collisions, which affected the demand for paint from refinishing, and sales of
vehicles generated demand for paint from OEMs (Exhibit 7). Trends in the refinishing market were generally
steady to negative. In the past several years, the number of miles driven in the United States had tapered off,
resulting in fewer collisions. Potentially offsetting this trend was an expected increase in miles driven—and
relatedly, collisions—outside the United States.
Also reducing the demand for paint was a significant dropoff in the number of damaged cars that were
refinished. This was due to more damaged cars being written off (“totaled”) and insurance companies
imposing higher deductibles such that damaged cars more frequently went without repair. In the United
Kingdom, for example, an estimated 7% of damaged cars were written off in 2010 compared to 5% in 2000;
that translated to 80,000 fewer cars requiring repair (and paint) every year.7 Further, advances in the quality of
paint used by OEMs made it more durable and resistant to scratches and weathering.
The OEM market had experienced a sharp decline in global motor vehicle production in 2009 that had
since begun to recover (Exhibit 8). In 2011, North American vehicle production (13.5 million units) still fell
short of its 2007 level (15.5 million units). Over the past decade, most of the growth in vehicle production
had taken place in countries outside the United States, particularly in emerging markets. For example,
between 2000 and 2010, China and India had experienced an astonishing 763% and 344% increase,
respectively, in vehicle manufacturing. DPC’s existing customer base was heavily concentrated in Detroit, but
North America accounted for only 27% of its revenues. As vehicle manufacturing continued to grow outside
North America, DPC’s revenues would likely expand in those markets.
DPC’s overall revenues were closely tied to GDP growth, which was expected to be 1% to 2% in 2012–
13 in the United States, largely flat in Europe, and more positive but erratic in emerging markets. Most
analysts expected that emerging-market growth coupled with unprecedented fleet aging would spur a recovery
in vehicle sales on the order of 3% to 5% per year.8 Increases in sales, however, did not necessarily translate
into higher profits for several reasons. First, the OEM profit margins were set by multiyear contracts with
vehicle manufacturers, which made it difficult for paint suppliers to quickly pass on raw-material price
increases. By comparison, the margins in refinishing were primarily based on claims paid by insurance
companies, which left consumers less price sensitive to repair costs. Second, growing concerns about lead, the
high cost of treating airborne emissions and solid hazardous waste generated by paint operations, and new
regulations covering the global chemical industry in Europe were all expected to increase environmental
compliance costs gradually over time.
Although a bullish scenario could be concocted for DPC, industry trends suggested that stable to modest
improvement was the more likely course for the business over the next several years. As part of the internal
review, DuPont attempted to assess DPC’s value if it remained a division of the company. DuPont’s internal
targets for DPC were annual revenue growth of 3% to 5% and operating margins of 10% to 12%. Given
DPC’s mixed track record of performance, the internal review set targets at 4% for growth and 10% for
margins, the low end of the targeted range. Other assumptions underlying the stand-alone valuation were
7 Morgan Stanley, “E. I. du Pont de Nemours & Co.,” analyst report, February 13, 2012.
8 Morgan Stanley, 5.
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incorporated into the analysis itself (Exhibit 9) and together yielded a value of approximately $4 billion for
the division.
Potential Buyers
When news surfaced in late October 2011 that DuPont was seeking a potential buyer for DPC,
companies including PPG, BASF, Akzo Nobel, and Valspar Corporation were mentioned as prospective
strategic buyers. For all but BASF, a potential purchase price of $4 billion would be a sizable transaction to
complete (Exhibit 10). In response to a question about his company’s potential interest, Valspar CEO Gary
E. Hendrickson said that DPC was “a little too big a bite for us.”9 Although the $4 billion price tag would
also be large in the current environment for private equity (PE) firms, Blackstone, Advent International,
KKR & Co., Onex Corporation, and Clayton, Dubilier & Rice were all reportedly considering bids or had
already made inquiries about the division.10 The interest from PE firms was not surprising, given that buyout
firms were sitting on record levels of “dry powder” cumulatively totaling over $400 billion at the end of 2011.
A large portion of that was concentrated in buyout funds with 2006 and 2007 vintage years. In those years,
buyout funds had raised record amounts of capital but had found it difficult to invest in the ensuing crisis
years. As these funds neared the end of their investment periods, their general partners were under increasing
pressure to find investments.
A leveraged buyout (LBO) was the purchase of a firm facilitated by large amounts of debt financing. In
an LBO, the PE firm or sponsor would arrange debt financing for the deal and contribute the balance of
financing with equity from one or more of its funds. Because of the anticipated higher debt load, PE firms
generally looked for firms that could readily service the debt. Target characteristics might include steady and
predictable cash flows, assets that provided good collateral for debt, or non-core assets that could be sold to
pay down debt. Debt support (and returns) could also be bolstered if the targets had opportunities to grow
EBITDA by increasing sales or cutting costs. For similar reasons, sponsors looked for mature firms that did
not seemingly require large amounts of additional capital expenditures or R&D. Most sponsors also looked
for a strong management team because they typically were not hands-on operators and had to rely on the
target’s management to run day-to-day operations.
Of course, to make a good return, the sponsor had to increase the target’s value above its purchase price
over a typically four- to five-year period, after which it would seek to exit the investment. Sponsors in PE
deals generally looked to three factors to drive returns in their investee companies: benefits from the use of
leverage, growth in EBITDA, and multiple arbitrage (i.e., buy at a low multiple and sell at a high multiple).
Benefits of leverage
One benefit of leverage was that interest on debt was tax deductible and therefore the cost of debt was
lower than the cost of equity. As a result, increasing leverage could produce interest tax shields that enhanced
the company’s value. The use of leverage could also help augment a sponsor’s returns, because for a given
price paid for the business, more debt financing directly translated to a smaller equity contribution. All else
equal, the smaller the equity base, the higher the return. Additionally, as equity holders, the sponsors received
their share of the difference between the selling price (i.e., enterprise value of the firm at exit) and the equity
9 Doug Cameron, “Valspar: DuPont Coatings Business Too Big a Bite for Us to Buy,” Wall Street Journal, May 14, 2012.
10 At the same time, DuPont hired Greenhill & Co. to handle the sale of a smaller part of the business that handled coatings for tractors and
playground equipment. Zachary R. Mider and Jeffrey McCracken, “DuPont Is Said to Weigh $4 Billion Sale of Auto-Paint Unit,” Bloomberg, October
28, 2011.
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Page 6UV6790

value remaining after the debt and other senior claims were paid off. In a highly leveraged company, a
relatively small increase in the firm’s enterprise value could lead to a substantial increase in the sponsor’s
equity value. But high leverage also increased the sponsor’s risk, since, analogously, a relatively small decline
in enterprise value could materially reduce the value of its equity. High leverage could also be instrumental in
driving returns for another reason—high interest and principal payments helped focus management’s
attention on improving performance and operating efficiency to generate cash for debt service.
DPC as a stand-alone company was expected to be all equity financed, and therefore the use of leverage
was a potential source of value for PE sponsors. Sponsors typically spoke to bankers ahead of a deal to gauge
how much debt might be available to finance the transaction. The total financing that would have to be raised
depended on how much the sponsors paid for the target. Given its size, DPC would be considered a large
buyout, which was generally defined as a deal above $1 billion in size. The number of large buyouts had
declined precipitously from 98 deals in 2007 to just 10 in 2009, before clawing back to 36 deals in 2011
(Exhibit 11). The pressure to put money to work and the resulting pickup in number of deals had increased
median purchase price multiples (PPMs) to 9.0× in 2011, almost as high as their peak of 9.5× in 2008. Not
unrelatedly, the increase in PPMs coincided with easing in the credit markets as the markets moved further
away from the financial crisis. Total debt-to-EBITDA multiples contracted sharply, from 7.6× in 2007 to
3.3× in 2009, necessitating a large increase in equity contributions from the sponsors. Thereafter, there had
been a significant increase in debt availability: the median debt multiple expanded to 6.2× in 2011. Over
2010–11, large buyouts had been approximately 60% debt financed on average. If current trends held, it
appeared that PE firms would have generous amounts of debt financing available, on the order of 5.5× to
6.0× EBITDA for a potential purchase of DPC.
Growth in EBITDA
Growth in EBITDA created value by improving the target’s operations by undertaking measures such as
product expansions, cost reductions, and add-on acquisitions. In assessing the opportunity for growth in
EBITDA, PE firms routinely conducted extensive due diligence to develop improvement plans after they
gained control of a company. A first step in this process was often to compare the target’s performance to
that of close competitors. Because PPG’s industrial and performance coatings business segments directly
competed with DPC, it was DPC’s closest peer. Compared with DPC, PPG had projected slightly stronger
sales growth and had achieved higher margins. PPG’s mix of products accounted for some of the difference,
but DPC’s lower margins were mostly the result of higher costs and overhead. Based on this assessment and
other due diligence, sponsors might reasonably expect to increase DPC’s sales growth by 1% to 2% and
improve its operating margins by 200 to 250 basis points.
DPC was led by DuPont veteran John McCool, 58, who was well regarded in the industry. McCool had
held a variety of leadership positions since joining DuPont’s Textile Fibers department in 1976. Kullman
named McCool president in 2010 after he had served as vice president for DPC’s Europe, Middle East, and
Africa (EMEA) operations. She had given him the specific charge to turn the division’s performance around.
All the PE firms that were contemplating a bid for DPC would have to evaluate McCool and his team to see
if they had the requisite skills to head the new company. If the current team was found wanting, the sponsors
would have to be prepared to replace management as part of their plans.
Multiple arbitrage
Multiple arbitrage arose when a sponsor received a higher PPM at exit for a target than it paid for it. All
else equal, the higher the entry PPM, the lower the chances of a sponsor achieving multiple arbitrage. At a
stand-alone value of approximately $4 billion, it looked as if DPC’s potential buyers would have to pay on the
order of 7× projected EBITDA for the company. Exit opportunities could arise from an IPO, sale to a
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Page 7UV6790

strategic buyer, or sale to another PE fund (secondary buyout). Over the period 2006 to 2011, sales to
strategic buyers had been the most frequent mode of exit by PE firms (Exhibit 12). Due to the growth in the
size of the PE sector, however, secondary buyouts were a strong second to them. IPOs had fallen off as exit
vehicles, in part due to uncertain market conditions accompanying the financial crisis and its aftermath.
Because strategic buyers likely had greater opportunity for operating synergies with a target company, they
were commonly thought to pay more for a target than financial buyers. Based on the PPMs of recent exits,
however, the average PPM for exits to secondary buyouts was somewhat higher than the average PPM of
exits to strategic buyers (Exhibit 12). Based on the current valuation of PPG and potential market expansion,
sponsors might look to achieve 7.5× to 8.0× EBITDA at exit for DPC, given improvements in margins and
growth as a private firm.
Decision
If Ellen Kullman decided to divest DPC, she would put in motion an auction for the division. At that
point, DuPont would provide detailed information about the target and invite interested parties to bid. As
part of that process, she would likely set a minimum price for bidders. Her stand-alone valuation suggested
that the division was worth nearly $4 billion to DuPont. She would then need to assess how much potential
additional value could be obtained, both separately and jointly, from EBITDA growth, multiple arbitrage, and
the use of leverage to give her some idea of the potential range of values that bidders might offer. Relative to
that, she knew that sponsors would likely seek higher returns to justify the greater financial risk from the use
of leverage. Although financial buyers naturally sought the highest possible internal rate of return (IRR), in
the current environment of tough competition, they often had to settle for IRRs of 20%. With that in mind,
she would formulate her minimum required bid to ensure that shareholders’ interests were served no matter
what decision she reached about DPC.

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Page 9UV6790

Exhibit 2
DuPont Corporation: Sale of Performance Coatings
Stock Price Performance

Performance Relative to S&P 500

Data source: Yahoo! Finance.
$0
$10
$20
$30
$40
$50
$60
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
S
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Page 10UV6790

Exhibit 3
DuPont Corporation: Sale of Performance Coatings
Business Segment Performance
(dollars in millions)

* After significant items.

Data source: Company reports.

Segment Sales
2009 2010 2011 2009 2010 2011
Agriculture $7,069 $7,845 $9,166 7.9% 11.0% 16.8%
Electronics & Communications 1,918 2,764 3,173 -10.7% 44.1% 14.8%
Nutrition & Health 1,218 1,240 2,460 -13.2% 1.8% 98.4%
Performance Chemicals 4,964 6,322 7,794 -14.5% 27.4% 23.3%
Performance Coatings 3,429 3,806 4,281 -21.4% 11.0% 12.5%
Performance Materials 4,768 6,287 6,815 -25.3% 31.9% 8.4%
Safety & Protection 2,811 3,364 3,934 -24.4% 19.7% 16.9%
Industrial Biosciences 705
Other 15819440
Total segment sales 26,33531,82238,368
Elimination of transfers (226) (317) (407)
Net sales $26,109 $31,505 $37,961 -14.5% 20.7% 20.5%
2009 2010 2011 2009 2010 2011
Agriculture $1,160 $1,293 $1,527 16.4% 16.5% 16.7%
Electronics & Communications 874453554.5% 16.1% 11.2%
Nutrition & Health 6462445.3% 5.0% 1.8%
Performance Chemicals 5471,081 1,923 11.0% 17.1% 24.7%
Performance Coatings 692492712.0% 6.5% 6.3%
Performance Materials 2879949736.0% 15.8% 14.3%
Safety & Protection 2604545009.2% 13.5% 12.7%
Industrial Biosciences (1)-0.1%
Pharmaceuticals (discontinued) 1,037 489289
Other (169) (206) (235)
Total pretax operating income $3,342 $4,861 $5,646 12.8% 15.4% 14.9%
Pretax Operating Income*
Year-over-Year Growth
Segment Margins
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For the exclusive use of l. zhou, 2022.
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For the exclusive use of l. zhou, 2022.
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For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Page 14UV6790

Exhibit 7
DuPont Corporation: Sale of Performance Coatings
Trends Affecting Paint Demand in Vehicle Aftermarket
U.S. Vehicle Miles Traveled (billions)

Data source: U.S. Federal Highway Administration, Highway Statistics.

U.S. Motor Vehicle Accidents per Million

Data source: National Safety Council.
2,300
2,400
2,500
2,600
2,700
2,800
2,900
3,000
3,100
1997 1999 2001 2003 2005 2007 2009 2011
M
il
es
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el
(
b
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li
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s)
0
2
4
6
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10
12
14
16
18
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M
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A
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ts
(
p
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m
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)
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Page 15UV6790

Exhibit 8
DuPont Corporation: Sale of Performance Coatings
Trends Affecting Paint Demand from Vehicle Manufacturers
World Motor Vehicle Production

Notes: NA = North America (United States, Canada, and Mexico); ROW = Rest of World.

World Production of Vehicles, 2000 and 2010.
2000 2010 % Change
North America 17,699 12,177 –31%
United States 12,800 7,761 –39%
Canada 2,964 2,071 –30%
Mexico 1,935 2,345 21%
Asia-Oceania 17,928 40,900 128%
Japan 10,144 9,625 –5%
China 2,069 18,263 783%
India 796 3,537 344%
South Korea 3,115 4,272 37%
Europe 20,275 19,822 –2%
France 3,348 2,229 –33%
Germany 5,527 5,906 7%
Italy 1,738 838 –52%
Spain 3,032 2,388 –21%
United Kingdom 1,814 1,393 –23%
South America 2,076 4,464 115%
Data source: Organisation Internationale des Constructeurs d’Automobiles (OICA) production statistics.
0
10
20
30
40
50
60
70
80
90
1997 1999 2001 2003 2005 2007 2009 2011
W
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(u
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it
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NA ROW
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
P
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16

U
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For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
P
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For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
P
ag
e
18

U
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For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Page 19UV6790

Exhibit 11
DuPont Corporation: Sale of Performance Coatings
Buyout Deals
Volume and Number of Buyout Deals above $1 Billion

Debt, Equity, and Purchase Price Multiples for Buyout Deals
Medians 2004 2005 2006 2007 2008 2009 2010 2011
Total Debt/EBITDA 5.3 5.0 5.9 7.6 4.4 3.3 4.6 6.2
Equity/EBITDA 2.3 3.2 3.1 1.2 5.0 3.2 2.7 2.8
Purchase Price/EBITDA 7.6 8.2 9.0 8.8 9.4 6.5 7.3 9.0
Data source: PitchBook, Annual Private Equity Breakdown 2012.
28
33
61
98
41
10
31
36
0
20
40
60
80
100
120
$0
$100
$200
$300
$400
$500
$600
2004 2005 2006 2007 2008 2009 2010 2011
N
o
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B

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m
e
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b
il
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s)
Above $1B Under $1B No. Deals > $1B
For the exclusive use of l. zhou, 2022.
This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California – Riverside from Mar 2022 to Jun 2022.
Page 20UV6790

Exhibit 12
DuPont Corporation: Sale of Performance Coatings
Private Equity Exits
Number of Exits by Exit Type

Exit Multiple by Exit Type

Data source: PitchBook and Grant Thornton, Private Equity Exits Report, 2012 Annual Edition.
219
266
229
150
252
240
66
51
14
24
40
30
164
193
107
33
142 150
0
50
100
150
200
250
300
2006 2007 2008 2009 2010 2011
N
u
m
b
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o
f
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x
it
s
Strategic buyer PE-backed IPO Secondary buyouts
Medians 2006 2007 2008 2009 2010 2011 Average
Strategic buyer 9.5 10.9 9.5 8.0 8.5 8.7 9.2
PE-backed IPOs 5.8 11.7 10.8 7.4 7.2 5.1 8.0
Secondary buyouts 11.0 6.9 9.8 12.4 9.4 9.6 9.9
p y yp
For the exclusive use of l. zhou, 2022.
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__MACOSX/Course Pack/._DuPont Corporation Sale of Performance Coatings.pdf
Course Pack/Microsoft’s Diversification Strategy.pdf

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This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. __MACOSX/Course Pack/._Microsoft's Diversification Strategy.pdf Course Pack/Divestiture Strategy's Missing Link.pdf Divestiture: Strategy’s Missing Link by Lee Dranikoff, Tim Koller, and Antoon Schneider Reprint r0205e For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. HBR Case Study r0205a A Pain in the (Supply) Chain John Butman HBR at Large r0205b How Resilience Works Diane L. Coutu Different Voice r0205c Turning an Industry Inside Out: A Conversation with Robert Redford Change the Way You Persuade r0205d Gary A. Williams and Robert B. Miller HBR Spotlight: Practical Strategy Divestiture: Strategy’s Missing Link r0205e Lee Dranikoff, Tim Koller, and Antoon Schneider Why Business Models Matter r0205f Joan Magretta Disruptive Change: When Trying Harder r0205g Is Part of the Problem Clark Gilbert and Joseph L. Bower Tool Kit r0205h Read a Plant – Fast R. Eugene Goodson The Entrepreneur r0205j A Test for the Fainthearted Walter Kuemmerle May 2002 For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. Executives spend a lot of time creating and acquiring businesses but rarely devote attention to divesting them. As a result, they often end up selling businesses too late and at too low a price, sacrificing shareholder value. Divestiture: Strategy’s Missing Link by Lee Dranikoff, Tim Koller, and Antoon Schneider mart apple farmers routinely saw off dead and weakened branches to keep their trees healthy. Every year, they also cut back a number of vigorous limbs – those that are blocking light from the rest of the tree or otherwise hampering its growth. And, as the grow- ing season progresses, they pick and discard some per- fectly good apples, ensuring that the remaining fruit gets the energy needed to reach its full size and ripeness. Only through such careful, systematic pruning does an orchard produce its highest possible yield. There’s an important lesson here for managers. Al- though most companies dedicate considerable time and attention to acquiring and creating new businesses, not to mention refining their existing operations, few devote much effort to divestitures. But like the annual pruning of apple trees, regularly divesting businesses – even some good, healthy ones – ensures that remaining units reach their full potential and that the overall company grows stronger. Some executives do understand the value of a well- planned divestiture program. Divestiture was, for in- stance, a cornerstone of General Electric’s strategy under Jack Welch – every bit as important as mergers and ac- quisitions. During the first four years of his tenure as CEO, Welch divested 117 business units, accounting for 20% of GE’s assets. Sandy Weill, now chief executive of Citigroup, made 11 significant divestitures while leading the Travelers Group through the 1990s, and he recently announced plans to spin off the Travelers Property Casu- alty business from Citigroup. Richard Wambold, CEO of Pactiv, a specialty-packaging company, has sold six busi- nesses since 1999, using the proceeds to strengthen the company’s balance sheet and invest in high-growth op- portunities. Greg Summe, CEO of PerkinElmer, has used a combination of divestitures and acquisitions to com- pletely reshape his enterprise, transforming it from a sup- plier of low-margin services to the government into an innovative high-tech company. Copyright © 2002 by Harvard Business School Publishing Corporation. All rights reserved. 3 S For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. Other managers can also use divestiture to strengthen and rejuvenate their companies, but only if they look be- yond the stigma currently associated with selling off busi- nesses and embrace divestiture as vital to their strategies. Too Little, Too Late In a study of the performance of the 200 largest U.S. corporations from 1990 to 2000, McKinsey & Company found that those companies that actively manage their business portfolios through acquisitions and divestitures create substantially more shareholder value than those that passively hold their businesses. One hundred dollars invested in the average active manager in January 1990 would have been worth $459 by the end of the decade; that same $100 would have grown to only $353 if invested in the average passive manager. We also found significant differences in performance among the active managers. Those that balanced their acquisitions and divestitures performed better than those that focused more narrowly on either acquiring or divesting. (See the exhibit “Active Portfolio Management Pays.”) We also discovered, however, a strong bias against di- vestiture. Of the 200 companies we studied, fewer than half divested three or more substantial businesses – those with a disclosed worth of at least $100 million – during all of the 1990s. And only 20% divested more than a half dozen substantial businesses. Acquisitions were much more common than divestitures. Altogether, the 200 com- panies bought 40% more businesses than they sold – a finding that’s consistent with an earlier study, conducted by Constantinos Markides of the London Business School, which found that large companies completed 34% more acquisitions than divestitures during the 1980s. When companies do divest, they almost always do so reactively, in response to some kind of pressure. If you doubt that, try this experiment: Pick a week at random, and tally all the divestitures that are noteworthy enough to be reported in your favorite business newspaper. For each one, check to see how analysts and journalists ex- plain its rationale. Invariably, you’ll find that the over- whelming majority of divestitures are done under some sort of pressure – perhaps the divested business is suffer- ing heavy losses, the parent has a suffocating debt burden, or Wall Street analysts have turned negative. In studying nearly 50 of the largest divestitures com- pleted over the past four years, we found that more than three-quarters of them fit this reactive model. And most of these were not just done under strained circumstances; they happened only after long delays, when problems became so obvious that action became unavoidable. An earlier study by David Ravenscraft and F.M. Schrerer backs up this point. They found that divested businesses had below-average operating profits for seven years prior to being sold. (See the exhibit “Most Divestitures Are Reactive.”) Clearly, corporations divest too little, too late. Why? The reluctance to divest, we’ve found, is rarely purposeful. It’s not part of a well-planned strategy. Rather, it reflects a pervasive belief in business that, while acquisitions are H B RS p o t l i g h t 😛 r a c t i ca lS t r a t e g y Active Portfolio Management Pays Companies that actively manage their portfolios of businesses deliver higher shareholder returns than companies that passively hold their portfolios. Among active managers, those that balance acquisitions and divestitures outperform those that focus solely on either acquisitions or divestitures. Lee Dranikoff is an associate principal with McKinsey & Company, where he is a leader of the high-tech practice. Tim Koller is a McKinsey principal and a coauthor of Valuation: Measuring and Managing the Value of Com- panies (Wiley, 2000). Antoon Schneider is an engagement manager in McKinsey’s private-equity practice. They are based in New York. 4 harvard business review $353 passive $459 active $392 divestor $442 acquirer $519 balanced active versus passive approaches average number of transactions: 2 15 breakdown of active approaches Value of $100 invested from January 1990 to December 1999* *Risk- adjusted for beta For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. marks of strong, growth-focused executives, divesti- tures signal weakness and even failure. This stigma is prevalent in the top management ranks of many compa- nies but is felt most strongly within divested businesses themselves. As Pactiv’s Wambold explains, “Managers of divested businesses can think that they have failed or con- sider themselves second-class citizens.” This attitude feeds on itself. When managers postpone a divestiture until a unit is obviously failing, they guarantee that the move will be seen as an act of des- peration, further reinforcing the negative connotations of divestitures and making exec- utives even more reluctant to pursue them. But executives shouldn’t feel ashamed to get rid of busi- nesses. The marketplace shows, in no uncertain terms, that ac- tive divestiture is central to value creation. In their recent book, Creative Destruction, Richard Foster and Sarah Kaplan point out that while senior managers spend most of their time improving operations, capital markets are actively creating and removing businesses. Over the last five years, the annual turnover rate among companies in the S&P 500 was nearly 7%. That means that about 30 to 50 companies drop out of the S&P every year. The mar- ketplace, in other words, is far more efficient than the typical company in disposing of businesses – and, not sur- prisingly, the returns generated by the market over the long haul far outstrip those of the average publicly held company. Divestiture is not a symbol of failure; it’s a badge of smart, market-oriented management. The High Costs of Holding Moving from reactive to proactive divestiture is not easy, of course. The desire to hold on to businesses, particularly successful ones, is strong. A business may generate sub- stantial cash flows. It may deliver marketplace advantages through its relationships with key customer groups. Or it may have strong sentimental attachments for employees or other stakeholders, representing an important com- ponent of a company’s iden- tity. For executives, selling a business can sometimes seem like treason. When Welch sold off GE’s housewares unit, for instance, he got angry letters from employees accusing him of destroying the company’s heritage. But whatever the costs of divesting a business, holding on to a unit too long also imposes costs – both on the entire corporation and on the unit it- self. Though these costs are often hidden, and accumulate slowly, they can be onerous, far outweighing the benefits of keeping the business. Let’s look at the three forms these costs take. Costs to the Corporation. The stability provided by well-established, profitable businesses is a mixed blessing. On the one hand, such businesses can produce cash and help keep earnings smooth and predictable. On the other hand, they can cripple a company, dulling its desire to create new, high-growth businesses. Determined busi- ness building often requires a sense of crisis – a clear and pressing need for growth. But stability breeds comfort, may 2002 5 D i v e s t i t u r e :S t r a t e g y ’sM i s s i n gL i n k Most Divestitures Are Reactive More than three-quarters of divestitures are reactive, done in response to pres- sure on the parent or the unit. And nearly two-thirds of the reactive divestitures are delayed, taking place only after the parent or unit has suffered from weak performance for a number of years. Sources: Wall Street Journal, September of 1998, 1999, and 2000 and August of 2001; literature search; analyst reports; financial statements. 24% 35% 65% 100% = 50 divestitures 76% Proactive Reactive Rapid Response • Quick exit as soon as underperformance becomes clear • Timely response to market pressure Delayed Response • Persistent, long-term underperformance • Ongoing investor pressure • Fire sale or shutdown Managers can use divestiture to strengthen and rejuvenate their companies, but only if they look beyond the stigma currently associated with selling off businesses. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. tempering any feeling of urgency and causing a company to stagnate. Long-held, low-growth businesses may pro- vide the cash that allows a corporation to thrive today, but they can hinder it from preparing for a prosperous tomorrow. Some companies understand this fact. The defense giant General Dynamics, for example, divested several substantial businesses during the early 1990s to set the stage for an aggressive acquisition program – and a sharp increase in shareholder returns – later in the de- cade. (See the exhibit “How General Dynamics Shrank in Order to Grow.”) Stability can also hamper growth in other ways. Com- panies dominated by mature, low-growth businesses often develop inflexible, risk-averse cultures–cultures that stifle innovation and free thinking, that make it difficult to attract energetic and entrepreneurial talent, and that confuse or even repel investors. PerkinElmer’s Summe confronted that exact situation when he took over as CEO early in 1998. He quickly launched a series of divestitures not just to reposition the company but also to attract a new team of executives. In a recent HBR interview, he recalled, “We knew recruiting talent for the senior ranks would be a challenge given PerkinElmer’s steady-as- she-goes reputation.” (It’s important to note that cultural conflicts can work the other way as well: Large, high- growth businesses can impose cultural costs on their slower-growing sister units – lenient attitudes about cost control, for example.) Long-held businesses can also usurp more corporate resources than they merit. They can, for example, take up investment funds that might have gone to creating new businesses with stronger growth prospects. Or, more subtly, they can drain precious management time. In the absence of radical decentralization (which some compa- nies have adopted but which can pose its own challenges), a senior executive team can only manage a limited num- ber of businesses. A stagnant portfolio can thus leave a company’s management paralyzed, unable to focus on new opportunities. Pactiv, which every year reviews the role of each business unit as part of the overall company’s strategic-planning process, sees divestiture as a powerful way to free up resources. When explaining why the com- pany sold its aluminum business despite its strong cash flow, CEO Wambold says,“It was using resources and man- agement time we could use better elsewhere, and its cyclical nature [made Pactiv] more difficult for investors to understand. It didn’t offer the same potential as the other businesses.” Finally, the wrong mix of businesses can confuse cus- tomers. That was one of the reasons AT&T decided, per- haps belatedly, to break itself up in 1996. The company was providing telephone services to the public but was also selling equipment to competitors. As the telecom- munications markets became more competitive, cus- tomers of the manufacturing operation (now Lucent) grew concerned about conflicts of interest with AT&T’s telephone services business. In a 1996 speech, AT&T’s CEO Robert Allen explained, “If our network equipment busi- ness made the best products on the market, we wanted the Bell companies or British Telecom to buy from us without concerns that AT&T’s services business was also competing with them. Conversely, we wanted our services business to pursue its opportunities aggressively, uncon- strained by fears that they might bother a competitor who was a potential customer for AT&T equipment.” Costs to the Unit. The company as a whole is not the only one damaged when a business unit is held too long. The unit also suffers. A corporate parent is not a mere 6 harvard business review H B RS p o t l i g h t 😛 r a c t i ca lS t r a t e g y How General Dynamics Shrank in Order to Grow Aggressive divestitures by General Dynamics in the early 1990s set the stage for a series of acquisitions later in the decade, dramatically improving the company’s returns to shareholders. Sources: Compustat; company reports; Hoovers. 1,800 Divestiture 1,600 1,400 1,200 1,000 800 600 400 200 0 1990 1991 1993 1994 1995 1996 1997 1998 1999 2000 2001 Acquisition General Dynamics’ total returns to shareholders Indexed; January 1990 = 100 1992 Exit defense industry Reenter defense industry For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. caretaker of its businesses; it provides many of the skills and resources the businesses need to fulfill their poten- tial. And different parents have different skills and re- sources. Some, like strong venture capital firms, under- stand how to seed a business, providing important capabilities in such areas as product development, sales and marketing, and alliance creation. Some understand how to grow it, offering expertise in, for example, opera- tional planning and capital management. Others know how to manage mature businesses, providing assistance in operations rationalization, cost management, and the like. It is rare for a parent to have the expertise required to help a business through every stage of its life cycle. (See the exhibit “Matching Business Units and Parents.”) The problem arises when a corporate parent stops adding distinctive value to a unit but refuses to let it go. At that stage – regardless of the unit’s financial contribu- tion–the parent is no longer the natural owner of the unit and should consider selling it or spinning it off. That’s what Wambold did with Pactiv’s polyethylene-packaging business. Although the unit was the largest player in its market, the polyethylene industry remained highly frag- mented, and Wambold saw that Pactiv did not have the resources needed to spearhead a further industry consol- idation. As a result, it was not best positioned to take the unit to the next level of performance. So in January 2001, Pactiv sold the unit to Tyco, whose strategy was to expand its polyethylene business. As Wambold explains, “You have to know what business you are good at and let some- one else manage the rest.” In his autobiography, Jack: Straight from the Gut, Welch tells an illuminating story about how divestiture can lib- erate business units and their employees. He recounts how a general manager of an air-conditioning business that GE had sold told him about the sale’s salutary effects: “Jack, I love it here. When I get up in the morning and come to work, my boss is thinking about air-conditioning all day. He loves air-conditioning. He thinks it’s wonder- ful. Every time I talked to you on the phone, it was about some customer complaint or my margins. You hated air- conditioning. Jack, today we’re all winners and we all feel it. In Louisville, I was the orphan.” Few corporations today actively consider whether they are adding unique value to each of their businesses. As a result, they may be harming the units’ prospects and undermining the morale of their people. Depressed Exit Price. The final cost of postponing divestitures is the direct impact on shareholder returns. Just as with acquisitions, a well-timed divestiture can con- tribute to shareholder value, and a poorly timed one can destroy value. Unfortunately, when it comes to managing business units, most corporations fail to follow the age-old maxim “Buy low, sell high.” Rather, as we’ve seen, they unload a unit only after several years of poor perfor- mance – at fire-sale prices. In some cases, industries are so turbulent that managers simply cannot foresee market peaks and troughs. In other cases, they may be able to identify the peaks but be unable to find a buyer willing to pay the going price. In most cases, however, companies just look the other way until it is too late. Timing the market perfectly is not possible, of course. But a simple rule of thumb can improve a company’s timing considerably: Sell sooner. For the vast majority of divestitures we’ve studied, it’s clear that an earlier sale would have generated much higher returns. There’s a good, if disturbing, reason for this. As Foster and Kap- lan’s research suggests, the longer a business exists, the worse it performs for shareholders. Total returns fall in may 2002 7 D i v e s t i t u r e :S t r a t e g y ’sM i s s i n gL i n k Matching Business Units and Parents As a business proceeds through the three major phases of its industry life cycle, what it needs from its parent company changes substantially. It’s unrealistic to assume that a single parent can provide all the different capabilities needed for a business to thrive over the long term. • new product development • new business building • strategic planning and market insight • marketing and sales innovation • alliance and partnership development • financial management • operational planning and management • capital management • brand management • mergers, acquisitions, and divestitures • consolidation and rationalization • cost management Industry phase Corporate - center capabilities needed Growth Launch Maturity For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. a predictable way throughout its life cycle, as illustrated in the exhibit “Time Is the Enemy of Businesses.” The implication is clear. Managers should expect that, over time, even the best, most operationally sound businesses will cease to perform as well for shareholders as their younger peers. That’s not to say that the businesses will be unprofitable but rather that the capital markets will no longer reward their steady performance with substantial share price increases. There is another, more immediate reward for not de- laying the sale of a business. Several studies have shown that divesting companies outperform the market by be- tween 2% and 5% in the period surrounding the divesti- ture announcement. When it comes to divestiture, there’s no good reason to procrastinate. Making It Happen When a coordinated divestiture program happens today in corporate America, it is more often than not a result of a change in a company’s leadership, as was the case with Welch at GE, Wambold at Pactiv, and Summe at PerkinElmer. Our research found that just over 50% of all significant divestitures take place within two years of the appointment of a new chief executive. Fresh to the role, the incoming CEO can assess the situation without bias, make decisions without fear, and take the hard actions necessary to unload businesses. But there’s no reason that incumbent CEOs can’t do the same. Yes, launching a pro- active divestiture program goes against the grain of cur- rent business practice and against the sensibilities of many managers and employees. But it’s necessary to keep a company profitable and growing over the long term. By following a rigorous, carefully managed five-step pro- cess, companies are more apt to get a proactive divestiture program off the ground, build support for it throughout the ranks, and ultimately make it a core element of their corporate strategies. (For an overview of the process, see the exhibit “A Template for Proactive Divestiture.”) Prepare the organization. “Today is a sad day for our company.” Those are the words that traditionally accom- pany divestiture announcements. And they underscore just how challenging it is to make divestiture a routine part of doing business. Because the stigma surrounding divestiture is so strong, people will naturally resist it, at least initially. It’s critical, therefore, that senior managers spend a lot of time explaining the rationale for divesti- ture and why it’s essential to the corporation’s health. PerkinElmer’s leadership team, for instance, prepared the ground for its divestiture program by talking directly and repeatedly with people throughout the organization. CEO Summe held regular “town hall” meetings with each of his businesses, explaining the company’s strategy and divestiture’s role in it. In time, as a company begins to enjoy the results of proactive divestiture, the stigma should fade, and divestiture should become an expected event in a business unit’s life cycle. Until then, though, management will have to assure employees that divesti- ture is a sign not of failure but of strength. When a company is first building divestiture skills, it can be useful to introduce some formal forcing mecha- nisms to ensure that divestiture is routinely considered. A company might, for instance, “date stamp” all its busi- nesses. The purpose is not to force a divestment by a spe- cific date but rather to ensure that divestiture is seriously considered at regular intervals. Private equity firms have done this for years with strong results, and some public companies are starting to do the same. Pactiv, for in- 8 harvard business review H B RS p o t l i g h t 😛 r a c t i ca lS t r a t e g y Time Is the Enemy of Businesses A business’s shareholder returns decrease as it ages. Source: Richard Foster and Sarah Kaplan, Creative Destruction (Doubleday, 2001). 1 5 10 15 20 25 A business’s average total return to shareholders relative to its industry Business’s age in years -10% -5% 0% 5% 10% 15% median trend line For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. stance, as part of its strategic planning process, reviews each business every year, reevaluating its contribution to the corporation’s overall strategic goals. The process takes several days, and the board of directors is intimately in- volved, providing an outside perspective. CEO Wambold comments, “We measure each of our businesses against strict criteria: Does it meet our growth, margin, and re- turn-on-capital hurdle rates, and does it have the ability to become number one or two in its industry? We are quite pragmatic. If a business does not contribute to our overall vision, it has to go.” There are other ways to force con- sideration of divestiture, including imposing limits on portfolio size, setting fixed ratios of divestitures to acquisitions, or hiring people with trading mind-sets to sit on boards or fill key strategic roles. Identify candidates. When you shift from reactive to proactive divestiture, you suddenly have to think about selling off good, profitable businesses. That can be quite a shock to many people, even in the most senior management ranks. It’s important, therefore, to establish concrete criteria for analysis and apply them objectively to every unit. Four factors, in particular, should be considered: The Business Unit’s Impact on the Rest of the Corpora- tion. What effects, positive and negative, does the busi- ness unit have on other units and on the corporation as a whole? A number of analyses can be used to answer this question. A cultural audit, for example, can help assess whether a unit’s culture clashes with the rest of the cor- poration. An analysis of the CEO’s calendar can identify units that consume a disproportionate share of manage- ment time. Interviews with unit managers and a review of denied capital spending requests can identify opportuni- ties that are not being explored because of competitive conflicts. Talking with recruiters can provide a sense of whether a unit is hindering the rest of the company in attracting talent. On the positive side, a unit should be examined to determine whether it furnishes the rest of the corpora- tion with new growth options or other valuable benefits such as shared R&D resources. The Corporation’s Impact on the Business Unit. What value does the corporation add to the busi- ness unit relative to other poten- tial owners? This analysis has four parts: determining if the parent’s skills are what the unit needs to excel; deciding whether the pre- vailing corporate culture suits the unit; and quantifying the synergies between the busi- ness unit and the rest of the corporation. The matching skills, cultural fit, and synergies then have to be compared with what another owner could offer the unit. The Unit’s Ability to Beat Market Expectations. Does the market currently overvalue or undervalue the business? This analysis can be difficult – management needs to esti- mate the unit’s value based on future expectations for performance and compare that number to the unit’s im- plied market value embedded in the stock price. But as difficult as it is, this analysis is essential because it will show executives whether the unit can realistically create may 2002 9 D i v e s t i t u r e :S t r a t e g y ’sM i s s i n gL i n k A Template for Proactive Divestiture Divestiture is not a one- shot effort. It needs to become a routine part of a company’s strategy. An iterative, five-step approach works best. • Explain to employees the rationale for the divestiture and why it’s essential to the corporation’s health. • Introduce forcing mechanisms to ensure that managers actively consider divestiture. • Establish concrete criteria for determining candidates, including a unit’s impact on the rest of the corporation, the corporation’s impact on the unit, the unit’s ability to meet or surpass market expectations, and the optimal portfolio for the company. • Analyze the practical issues (taxes, availability of buyers, and so forth) to narrow the list of candidates. • Identify buyers and determine how best to structure the sale (for example, a simple sale for cash, a spin-off to shareholders, or complex structures involving two-step transactions and contingent compensation). • Ensure that employees are not distracted during the sale process, perhaps by offering them additional incentives. • Hold off on the sale announcement until the completion of the deal seems likely. • Communicate the reason for the sale concisely and simply. • Reinvest the funds, management time, and support-function capacities in attractive new growth opportunities. Managers should expect that, over time, even the best, most operationally sound businesses will cease to perform as well for shareholders as their younger peers. Prepare the organization Identify candidates Structure the deal Communicate the decision Create new businesses For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. value in the future. Because the analysis will sometimes reveal that existing businesses are overvalued, it will tend to make executives much more aggressive in selling off units and even in changing the overall identity of the cor- poration. The divestiture candidates pinpointed by this analysis may, for instance, include cash cows, which have always been held sacred. Why sell cash cows? Because they are in mature industries and have limited potential for achieving growth beyond the market’s expectations. While a cash cow can deliver benefits to a com- pany, providing protection during downturns, for example, or being a source of funding for new invest- ments, it usually contributes little to shareholder value. Indeed, a cash cow can be very risky to hold be- cause its market value will often decline sharply if it loses any market share – an event that at some point hap- pens to virtually all high-market-share businesses. More- over, cash cows frequently impose some of the highest hidden costs of ownership on both the parent and its other business units. The Corporation’s Overall Portfolio. What is the best combination of businesses for the company to hold? By examining the portfolio that would remain if different sets of divestitures occurred, you can see the impact on the overall company. This analysis can be both quantita- tive (assessing cross-unit synergies, for example) and qual- itative (determining the value the corporate center pro- vides to the business or the business’s role in how Wall Street views the company). It is important to note here that no one type of portfolio is best for every company. The purpose of a divestiture strategy should not be sim- ply to transform a diversified, multibusiness company into a focused, single-business company. In fact, research by McKinsey’s Neil Harper and Patrick Viguerie has shown that the capital markets reward a moderate de- gree of diversification. Between 1980 and 2000, moder- ately diversified companies delivered shareholder returns that were at least as strong as, and in some cases stronger than, those of many focused companies and consistently stronger than those of highly diver- sified companies. These four analyses will high- light attractive candidates for di- vestiture. Not all of the candidates will end up being sold, however. Practical considerations – such as taxes, availability of buyers, market reaction, payment mix, use of di- vestiture proceeds, and dilution of earnings – also need to be taken into account. Such factors can narrow the list of candidates and can place constraints on exit timing. Some readers will argue that the practical issues should be considered first. We disagree. Many corporations over- emphasize the practical issues and thus presume that di- vesting is impossible. By focusing on more strategic con- siderations at the outset, companies will build momentum for divestiture and will look at the practical constraints as problems to be overcome rather than as roadblocks to action. Greg Summe points out that fear of earnings dilu- tion can often stop management from considering di- vestiture. As he notes, though, “Selling a great cash busi- ness will lower your earnings per share. But you can still do well by your shareholders by reinvesting the proceeds in a higher growth business, which should lead to a com- pensating increase in your price/earnings multiple.” 10 harvard business review H B RS p o t l i g h t 😛 r a c t i ca lS t r a t e g y Our Research In developing our perspective on divestitures, we drew on three sources of information and analysis: McKinsey Corporate Performance Study McKinsey tracked the performance of more than 2,000 companies in 27 industries over almost four decades in order to model capital markets in the U.S. economy. The study closely replicates the real economy, except that it does not encompass all industries or companies. Companies were in- cluded in the study when they were big enough to be part of the largest 80% of U.S. companies (regardless of whether they are still in existence today). Companies that were acquired or went bankrupt were deleted from the database. Transaction History of the 200 Largest Companies from 1990 to 2000 Three McKinsey colleagues (Jay Brandimarte, Robert McNish, and William Fallon) identified 200 of the largest companies in 1990 that were still trading independently in 2000 and examined all their acquisitions and divestitures during that period that were worth more than $100 million. We used this database to rank and compare share- holder returns and transaction frequency. Rationale of 50 Important Deals from 1998 to 2001 We identified all the divestitures mentioned on the front page of the Wall Street Journal during September of 1998, 1999, and 2000, and August of 2001. (For 2001, we used the deals mentioned in Wise executives divest businesses so that they can create new ones and expand existing ones. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. Structure the deal. Once you’ve narrowed the list of candidates, you need to think about potential buyers and how best to structure the deal. You will typically have many options, from a simple sale for cash, to a spin-off to shareholders, to more complex structures involving two-step transactions and contingent compensation. Citi- group, for example, appears to be structuring its divesti- ture of Travelers as a two-step spinout, possibly to mini- mize its tax liability. Even with a straightforward sale for cash, you need to decide how to conduct the sale: Do you have an auction with many buyers, an exclusive negoti- ation with the most logical buyer, or something in be- tween? As you consider your options, keep in mind your reasons for divesting. Most frequently, these reasons will lead you to favor simple, quick transactions that mini- mize the costs to the unit being sold and the parent. When considering costs, you’ll need to take into account not only transaction-related expenses but also the costs of time, complexity, and taxes. Because spin-offs can be done tax free, they can be particularly attractive in certain situations. Many of the basic skills required in executing divesti- tures mirror those involved in acquisitions, such as coor- dinating the work of bankers, lawyers, and accountants. But there are unique considerations as well. You need to ensure that the employees of the divested unit are not dis- tracted during the sale process. To keep employees fo- cused on the business, PerkinElmer gives them additional monetary incentives to meet their operational targets. You also need to untangle the unit from the rest of the company. At a minimum, shared services such as human resources and financial management must be scaled back. In many cases, the links go much deeper, with business units sharing facilities, intellectual property, and people. While the challenges of separating businesses can some- times seem overwhelming, it’s important to remember that the process can actually deliver substantial benefits, helping companies uncover ways to achieve greater sim- plicity and transparency in their remaining operations. Communicate the decision. There’s no getting around it: Telling a business unit that it’s going to be sold is tough. In some cases, it will make sense to deliver the message as soon as the unit is selected as a divestiture can- didate. But doing so can backfire if the deal falls through. Therefore, as a general rule, we suggest holding off on the announcement until the sale appears likely. As Pactiv’s Wambold explains,“It is best to reduce uncertainty where possible, so once it becomes clear that a business unit is going to be sold, we are up-front about the decision with our people. However, when it is not yet clear, it can be best to delay communication. Telling someone that the unit might be sold increases uncertainty and can harm the business.” Regardless of the timing of communication, the rea- soning must be stated concisely and simply. GE’s Welch famously told his business units that they had to be num- ber one or number two in an industry that fell into one of three categories: core manufacturing, technology, and services. If they failed that test, they knew precisely why they were being sold. Similarly, PerkinElmer’s Summe uses two simple criteria: If a business cannot attain mar- ket leadership or cannot deliver double-digit revenue growth, it becomes a candidate for divestiture. Create new businesses. The final step in a proactive divestiture program is, ironically, creation. As compa- nies prune businesses, they also need to formulate ex- pansion plans focused on strengthening remaining busi- nesses, starting new ones, or making acquisitions. The goal should be to create a cycle of rejuvenation, through which the corporate portfolio of business is continually refreshed. • • • Divestiture is not an end in itself. Rather, it is a means to a larger end: building a company that can grow and prosper over the long haul. Wise executives divest busi- nesses so that they can create new ones and expand exist- ing ones. All the funds, management time, and support- function capacity that are freed up through a divestiture should therefore be reinvested in creating shareholder value. In some cases, this will mean returning money to shareholders. But more likely than not, it will mean in- vesting in attractive growth opportunities. In companies as in the marketplace, creation and destruction go hand in hand; neither flourishes without the other. Reprint r0205e To place an order, call 1-800-988-0886. may 2002 11 D i v e s t i t u r e :S t r a t e g y ’sM i s s i n gL i n k August, as the World Trade Center attacks made September an abnormal month.) We investigated the circumstances surrounding each of these di- vestitures in detail by looking at press comments and analyst research before and after the deal, as well as by analyzing the financial performance of the parent and the divested business unit in the years preceding the deal. We considered deals to have been done in reaction to pressure only when we found clear supporting evidence – we suspect that a far greater number of deals were actually done under pressure, but companies often prefer to hide that fact from public view. We also consid- ered the timing of those divestitures that were done in reaction to pressure. Furthermore, we re- searched the tenure of the CEOs of the divesting companies. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. __MACOSX/Course Pack/._Divestiture Strategy's Missing Link.pdf Course Pack/The Walt Disney Company and Pixar, Inc To Acquire or Not to Acquire.pdf 9 - 7 0 9 -4 6 2 R E V :N O V E M B E R1 1 ,2 0 2 1 Professors Juan Alcácer and David Collis and Research Associate Mary Furey prepared this case. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2009, 2010, 2021 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800- 545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. J U A NA L C A C E R D A V I DC O L L I S M A R YF U R E Y The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? In November 2005, Robert Iger, the newly appointed CEO of the Walt Disney Company, eagerly awaited the box office results of Chicken Little, the company’s second computer-generated (CG) feature film. He knew that, for Disney as a whole to be successful, he had to get the animation business right, particularly the new CG technology that was rapidly supplanting hand-drawn animation.1Yet the company had been reliant on a contract with animation studio Pixar, which had produced hits such as Toy Story and Finding Nemo, for most of its recent animated film revenue. And the co-production agreement, brokered during the tenure of his predecessor, Michael Eisner, was set to expire in 2006 after the release of Cars, the fifth movie in the five-picture deal. Unfortunately, contract renewal negotiations between Steve Jobs, CEO of Pixar, and Eisner had broken down in 2004 amid reports of personal conflict. When he assumed his new role, Iger reopened the lines of communication between the companies. In fact, he had just struck a deal with Jobs to sell Disney-owned, ABC-produced television shows—such as “Desperate Housewives”—through Apple’s iTunes Music Store.2Iger knew that a deal with Pixar was possible; it was just a question of what that deal would look like.Did it make the most sense for Disney to simply buy Pixar? Walt Disney Feature Animation Walt Disney Feature Animation began with the production of Snow White and the Seven Dwarfs in 1934. Toys and memorabilia based on the movie’s characters were stocked in stores such as Woolworth’s around the film’s release, a move that became a trademark of Disney’s strategy. After many early successes, the animation division struggled for decades after Walt Disney’s death but was rejuvenated with the arrival of Michael Eisner, as well as Jeffrey Katzenberg as chairman of Walt Disney Studios, in 1984. Under them, the studio produced a string of hit films that included The Little Mermaid and Beauty and the Beast, up to the enormous success of 1994’s The Lion King, which alone generated over $1 billion in net income for the company. Disney’s Feature Animation unit was described as an open, collaborative environment. So open, in fact, that leadership relied on all employees to generate story ideas. Three times a year, Michael Eisner, Roy Disney, and two other Disney executives would host a “Gong Show” during which all employees had the opportunity to present their story ideas. The executives would cull the best ones and ultimately For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 2 choose the winner. “It’s a very collective approach to our work. We spend a lot of time in meetings arguing, discussing, and trying to come to a consensus,”3 as one commented.Most of Disney’s animated story lines came out of these meetings. The winner was remunerated for his or her contribution and, while figures were not made publicly available, some said winners earned up to $20,000.4Disney animators were compensated, in part, based on the success of the film, which made it difficult for other studios to lure talent away.5 Eisner believed in making clear who was good at their job, and who was not so good, and wanted to give control to leaders who had a sense of judgment about creativity and business. Seventy-five percent of the time, he was able to find a director who had these skills and wanted to work on a particular movie; the rest of the time directors would be told to “just do it.”6 Katzenberg, who was known for his grueling work ethic and passion for animation, made it his personal mission to bring the studio back to its former glory. He supervised every aspect of the studio’s films. According to one former Disney executive, “Jeffrey is the sheep dog and the wolf. He’s the sheep dog guarding us, and the wolf hunting us.”7 Katzenberg was credited with hammering out the storytelling of each film and ensuring that each film had a moral resonance. He also brought on external talent to each movie, such as Elton John, who contributed songs for The Lion King. Recent Box Office Performance After The Lion King in 1994, every Disney-produced animated film fell below expectations (see Exhibit 1). When asked in 1997 about the division’s disappointing performance, Eisner replied, “I don’t think people quite understand our company. We have many avenues to make money from one of our animated films. The video revenues from one of our films are large, the consumer products huge.”8 Some of the same features that observers credited for Disney Animations’ success—large staff, large budgets, and lots of time—were also blamed for its demise. Disney Animation had just 275 employees in 1988; about 950 in 1994 for the release of The Lion King; and 2,200 at its peak in 1999.9 Competition for animators in the 1990s also caused salaries, which accounted for 80% of each film’s cost, to balloon, with top animators’ pay rising from $125,000 in 1994 to $550,000 in 1999.10 And these pay increases affected employees across the board. In 1994, Eisner refused to promote Katzenberg to president of the company, prompting his swift departure. The absence of Katzenberg, who was generally considered to be the studio’s creative force, struck many as the cause of the decline. As one commentator noted, “the company’s once-invincible animation studio has fallen on hard times since studio chief Jeffrey Katzenberg left.”11 In 1997, Katzenberg, along with Steven Spielberg and David Geffen, started rival animation studio DreamWorks. According to reports, in the years that followed, DreamWorks attempted to lure away some of Disney’s best animators.12 Joe Roth, former chairman of 20th Century Fox, became chairman of Walt Disney Studios after Katzenberg’s departure. In charge for six years, he focused the studio’s energy on live action films.13 Peter Schneider, former head of Disney Animation, took over in 2000 after Roth left. Schneider’s goal was to deliver “emotional, thematic stories.”14 He worked solely with established Disney directors and producers and relied on his younger development staff to broker deals with up-and-coming filmmakers, in contrast to the hands-on deal-making style of his predecessors, Katzenberg and Roth.15 The product development group assigned directors for each animated movie. In the late 1990s, Disney set up a “Secret Lab” in an old Lockheed plant near Burbank Airport as a response to the growing popularity of three-dimensional (3D) CG films. The group’s first CG project For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 709-462 3 was the costly Dinosaur, which was released in 2000 to a strong opening weekend, but which ultimately disappointed at the box office. The Lab was shuttered in 2001 after Roy Disney viewed and rejected the second project underway, Wildlife, which he thought was packed with adult themes and strayed too far from Disney’s family-friendly brand offering. Disney then focused its animation efforts on traditional two-dimensional (2D) projects such as 2001’s Atlantis: The Lost Empire.16 In 2002, under new feature-animation chief Thomas Schumacher, Disney embarked on an aggressive cost-cutting mission. Lilo & Stitch, the first movie made in the new environment, cost about $80 million to make, versus $150 million for the 1999 Tarzan. Instead of 573 animators crafting 170,000 individual drawings, a crew of 208 rendered 130,000 drawings.17 Cost-cutting efforts took Disney’s animation department from its high to around 1,100 in 2003. At that point, as rival studios, such as News Corp.’s 20th Century Fox, exited the market, salaries slid precipitously. The market rate for the animator who brought home $550,000 in 1994 was half as much by the early 2000s.18 Apart from omitting redundancies, Disney Animation kept costs down by cutting corners where it could, in ways that were imperceptible to audiences. For example, the group eliminated things such as the number of characters seen in each frame or the amount of motion in the background.19 The television-animation unit also produced very low-cost films, like The Tigger Movie, which could make money with only $45 million in box office receipts, since the production cost was kept down to $15 million.20 In 2003, Disney Studios finally set up its own CG animation department. However, many staff members needed to be retrained in the new technology, which cost Disney money, heightened tension, and depressed morale within the studio. Disney decided to slow production on its animated films to give the staff more time to work on them and hammer out the story lines. American Dog and Rapunzel Unbraided, the second and third releases after Chicken Little, were both pushed back.21 Throughout this period, Disney came to rely on revenue and characters produced by its partner, Pixar. Between 1998 and 2004, Pixar CG movies contributed a total of more than $3.5 billion to Disney Studio revenues, and more than $1.2 billion to Disney’s operating income (Exhibits 2 and 2a).Pixar’s contribution represented 10% of revenue and over 60% of total operating income for the studios over the period. In 2005, Disney even set up a group known as Circle 7 to produce sequels to Pixar movies.The 40-person staff working on Toy Story 3 in March 2005 grew to 160 people during the following year.22 Movie Economics While box office revenues from the theatrical release were the typical measure of a movie’s success, financial success actually came from other revenue streams generated by the movie. By 2005, such sources included home video sales (originally on cassette tapes, but increasingly on DVD); pay-per- view and video-on-demand on cable channels; television showings, whether on free channels, such as NBC and CBS, or on cable channels; merchandise sales including toys, apparel, books, etc.; and video games and other electronic uses of the characters (see Exhibit 3). By 2005, the largest of these revenue sources was not theatrical box office but home video. Because character-related sales had such a long tail, revenue for a hit animated movie would come in over many years—up to decades for classic movies that were re-released theatrically and in home video form. Given the longevity of a great movie, film libraries were valuable assets. DreamWorks’ film library, for example, was about to be sold to Paramount for $900 million.23 Sequels to successful movies were another important source of revenue. The sequels to Toy Story, Shrek, and Ice Age, for example, generated between 30% and 90% more box office revenue than the originals. Once a character had been established, the existence of a built-in audience for subsequent For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 4 movies reduced marketing costs. Successful sequels would also extend the life of the original movie, particularly for animated features that appealed to successive generations of young children. Pixar Inc. Pixar was unusual among movie studios in generating a succession of box office hits.Its first five full-length films each grossed over $350 million.24Steve Jobs said, “Everybody has tried to break into the animation market since Snow White was released in 1937. So far, only two companies have ever produced a blockbuster production grossing more than $100 million, Disney and Pixar.”25 Pixar’s animation broke from the traditional model because the company did not use hand drawings but rather 3D computer-generated models. In 2D traditional animation, frames comprised hand-drawn cels, which required the skills of hundreds of people working for two to three years. Traditional animation constricted artists’ flexibility, too—if a change needed to be made to a character or scene, all subsequent frames had to be changed. Three-dimensional CG, on the other hand, used mathematical models to redraw each cel and mimic camera angles in ways that traditional animation could not. Pixar used its own proprietary computer animation technology to generate incredibly lifelike 3D images and backgrounds, although CG still could not quite make human characters look perfectly realistic. Said Jobs, “We have 10 years of proprietary software systems that you cannot buy anything close to in the marketplace. You have to build them yourself.”26 Pixar’s technology allowed animators to manipulate hundreds of motion control points within a single character, to reuse animated images, and to edit easily.27 These technologies enabled Pixar to make animated films faster than its competitors and at a fraction of their cost. For example, the company made Toy Story with just 110 staff members, who spent the time saved on animation to focus on story and character development, as well as fine- tuning visual details.28 HistoryPixar traced its origins to the University of Utah in the 1970s, where a young Edwin Catmull studied computer science in a program renowned for creating the new field of computer graphics. Around the same time, Alexander Schure, president of New York Institute of Technology (NYIT), hired a team of animators to make a film version of “Tubby the Tuba,” a children’s record. Frustrated by the limitations of hand-drawn animation, Schure flew to the University of Utah, where he met and recruited Catmull to work at the Institute. Catmull and his hand-picked team spent four years at NYIT, where they made inroads into the field despite never producing the Tubby the Tuba movie.29 In 1979, George Lucas approached Catmull’s team with an offer to work on special effects for Lucasfilm, producer of the wildly successful Star Wars and Indiana Jones franchises. While working there in the early 1980s, Catmull met John Lasseter at a computer graphics conference and the two became friends. Lasseter, a young animator from Disney, had studied at California Institute of the Arts with the likes of Tim Burton. Skilled in art as a young boy, Lasseter read a book on the art of animation and Disney during his freshman year of high school and realized what he wanted to do with his life. After graduation, he joined the ranks at Disney and worked on Mickey’s Christmas Carol. He commented, “I felt that Disney was, at the time, doing the same old thing. They had reached a certain plateau technically and artistically with, I think, 101 Dalmatians, and then everything had been kind of the same ever since then, with a glimmer of characters or sequences that were special.”30 In 1984, Lasseter went to Lucasfilm’s computer division under Catmull. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 709-462 5 In 1986, Steve Jobs—who had left Apple Computer the year before—bought the Lucasfilm computer business, then called Pixar, for $10 million.31 Initially, Jobs intended Pixar to be a computer hardware and software company. He spent the next several years subsidizing the company to the tune of nearly $50 million from his personal funds. When the graphics computers did not sell, Jobs cut a third of Pixar’s staff in 1991 and left only the animation division.32Jobs said, “If I knew in 1986 how much it was going to cost to keep Pixar going, I doubt if I would have bought the company. The problem was, for many years the cost of the computers required to make animation we could sell was tremendously high.Only in the past few years has the price come down to the point that it makes business sense” (see Exhibits 4 and 4a).33 SoftwarePixar initially developed three proprietary technologies:RenderMan, Marionette, and Ringmaster. In 1989, the company released RenderMan, a software system that applied texture and color to 3-D objects and was used for visual effects. Pixar used RenderMan itself and sold it to Disney, Lucasfilm, Sony, and DreamWorks, which used it to create effects like the dinosaurs in Jurassic Park. The program served as Pixar’s main source of revenue during the company’s early years. As of 2005, it had developed special effects for 100 films, and 44 of the last 47 movies that won the Oscar in visual effects had used RenderMan. In 2001, Catmull, along with two other Pixar scientists, won an Oscar for RenderMan and its advancements to the field of motion picture rendering. Marionette, the primary software tool for Pixar animators, was designed specifically for character animation and articulation, compared with other animation software that was designed to address product design and special effects. Ringmaster was a production management system used to track internal projects and served as the overarching system to coordinate and sequence the animation, tracking the vast amount of data employed in a three-dimensional animated film. Short films and commercialsTo develop its computer-generated technology and storytelling creativity, Pixar had incorporated short films into its corporate strategy since its inception. In 1986, Pixar produced Luxo, Jr., the first computer-animated film to be nominated for an Oscar. In 1989, Tin Toy won the Oscar for best short film. In 1997, Geri’s Game not only won Pixar an Oscar, but also enabled the company to advance its technology in skin and cloth, while 2000’s For the Birds advanced the technology in fur and feathers. By 2005, the Pixar team had won 20 Academy Awards.34 Pixar also sought revenue through the production of animated or partially animated television commercials for companies and products such as Coca-Cola, Listerine, and Lifesavers, but gave up this line of revenue in 1996 to pursue movies. Animated feature filmsJobs, Catmull, and Lasseter all had one ambition in common: to make an animated feature film. Said Jobs, “Ed shared with me his dream to make the first computer-animated feature film. And I bought into that dreamboat sort of spiritually and financially. And we bought the computer division from Lucasfilm, we incorporated it as Pixar, an independent company, and we were off to the races.”35 In 1991, Lasseter believed Pixar was finally ready to break into film. He pitched an hour-long made-for-TV movie to Katzenberg, who, impressed by Lasseter, came back with an offer to do a full-length movie backed by Disney. Disney and Pixar’s Relationship CAPSDisney and Pixar’s relationship began in 1986, when the two studios collaborated on the development of Computer Animated Production Systems (CAPS), a production system owned by Disney and used to make some of its two-dimensional cel-based animated movies. Disney’s first use of CAPS was for The Rescuers Down Under, and the company continued to use CAPS for many of its For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 6 animated feature films, including The Lion King. This relationship with Pixar surpassed Disney’s expectations. 36 Feature film agreementFollowing Lasseter’s proposal, Disney and Pixar signed a deal in 1991 to produce the first of three full-length 3D CG animated movies (see Exhibits 5 and 6). Disney agreed to fully fund the production cost of the movie in return for owning the movie rights. While neither company disclosed the movie’s budget, industry experts estimated that it was between $10 and $20 million.37 Pixar was to be paid a participation fee based on total revenue for the movie and would fund the overage if production costs exceeded a certain pre-agreed budget (although Pixar could recover these costs if the film met certain profit targets). Disney retained control over scheduling the film’s release dates. In its 1995 S-1 filing, Pixar stated: “Disney has been by far the most successful producer of animation feature films and other family oriented movies distributed by Disney are likely to be in the market concurrently with and competing with Pixar’s animated feature films.”38 This three-picture deal resulted in the 1995 hit film Toy Story, directed by Lasseter, which garnered more than $350 million in box office and video sales, making it the highest-grossing film released in the United States that year.39 Yet from 1995 to 1998, Pixar earned only $56 million in revenue. When asked if he had regrets about inking the deal, Jobs said, “None, no. We’re working with the best in the business and we’re learning a lot. We call it going to Disney University.”40 Co-production agreementFollowing the success of Toy Story, Disney bought 5% of Pixar in 1997 just after its IPO,41 paying $15 million for 1 million shares with warrants to buy an additional 1.5 million shares of common stock at higher prices.42, 43The purchase was part of a 10-year deal, signed on February 24, 1997, whereby Pixar would exclusively produce for Disney at least five original full- length animated films. Production costs, which averaged $120 million per film, would be shared equally between the two companies (see Exhibit 6 and 7). Disney would fund all of the marketing expenditures, which had to be covered before Pixar would receive half the remaining revenues from the box office and 50% of the other revenue streams after paying Disney’s distribution fee. Pixar would receive no share of any revenues generated in the Disney theme parks, cruise ships, or other location- based entertainment. The net result was that Pixar would earn perhaps up to 40% of the total profits that the movie generated. Disney, in contrast, received a distribution fee of 12.5% of the box office earnings, in addition to its half share of the box office and the remaining revenue share of the other sources of income. In total, the company would receive at least 60% of each movie’s profits (see Exhibit 8).44 Disney retained the exclusive distribution and exploitation rights to all feature films produced under the deal. This included the right to produce sequels, which Pixar could choose not to co- finance.45 In contrast, if Pixar wished to exploit or distribute any of its films or characters, it would have to pay a license fee to Disney. Disney retained final control over all marketing and distribution decisions, although each partner’s input would be considered and everything would be co-branded. One example was the release date of each year’s Pixar movie. In principle, Disney could choose to give preference to one of its own movies for key release dates, like July 4.However, Disney could not release one of its own G-rated movies within a window of a certain number of weeks of the Disney/Pixar movie release. Pixar had final control over the production of each film. The last two pictures under the original 1991 deal would be the first two pictures of this new deal, as would any sequels to Toy Story. The deal would take Disney and Pixar through the release of Cars in the summer of 2006. Citigroup estimated that the five-film deal added over $1.5 billion in operating income and $0.44 in EPS to Disney’s bottom line throughout the decade-long partnership, including non-box office revenue sources.46 For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 709-462 7 The co-production agreement also covered ancillary revenue streams, as follows: • Home video—Home video sales constituted a large portion of the lifetime revenue from Pixar’s films. The company believed that the popularity of the DVD format drove sales. Monsters, Inc., for example, was the best-selling home video in 2002, and Finding Nemo was the highest-selling video of all time in the United States. • Television—ABC Networks showed Pixar movies on its television channel at a fee of between 4% and 7% of the movie’s domestic box office gross, with a cap of about $15 million. This was substantially less than Disney paid for Harry Potter movies and less than Fox paid for Spider-Man. • Licensing agreements—In 2002, Starz licensed the pay-TV rights to Monsters, Inc., Finding Nemo, The Incredibles, and the forthcoming Cars. 47 • Merchandise and games—Pixar and Disney awarded video game publisher THQ Interactive the rights to create games of Finding Nemo, The Incredibles, and Cars.In 2004, Pixar struck an exclusive deal with THQ that gave it the rights to four films beginning with Ratatouille, which came out in 2007. Renegotiation for distribution-only dealSince 2002, Steve Jobs had been trying to broker a deal with Disney whereby Pixar would shoulder all of the films’ production costs in return for 100% ownership of the films, leaving Disney with just a lower, fixed distribution fee.48 Pixar’s 2002 Annual Report stated, “We have produced four tremendously successful films to date, and we believe that this success, combined with the strength of our financial resources, position us to negotiate an arrangement with more favorable economic terms.”49 In September 2003, Pixar lobbied for a stake in the upcoming The Incredibles and Cars. Disney countered by offering a stake in return for a higher distribution fee. Final negotiations in 2004 covered how long Disney would hold the rights to future Pixar movies, whether Pixar would have the rights to any sequels, and who would get television rights.50 Throughout the negotiations, Pixar often called for a deal akin to the one that George Lucas struck with 20th Century Fox for the Star Wars series (see Exhibit 9). Pixar thought that, if it negotiated a new distribution deal with another studio, it would seek complete control in return for funding all costs and paying only an 8% distribution fee. In principle, this would give Pixar access to 90% of a film’s lifetime revenue across all methods of distribution (in return, however, for bearing all of the cost and risk).51 The treatment of sequels was a sticking point in negotiations with Disney. Under the terms of the 1997 agreement, Disney could produce sequels to Pixar movies, without Pixar’s involvement, for theatrical release or as direct-to-video releases. In its 2002 10K filing, Pixar stated, “Disney’s decision governs,”52 regarding disagreements over sequel production. Pixar feared that the cheaper sequels and direct-to-video quickies produced without its involvement, like Cinderella II, could potentially tarnish its brand. Indeed, Disney was intending to make Toy Story 3 by itself, since Pixar had declined to be involved. Another point of contention was whether or not Toy Story 3 would be counted against the five-picture deal; Disney didn’t want it to, but Pixar did.53 Reports surfaced in 2004 that Jobs wanted Disney to return the rights of two yet-to-be-released films, The Incredibles and Cars, thereby blocking Disney’s attempts to produce sequels for the two films. Pixar’s final offer to Disney was that the latter could distribute each of Pixar’s films for five years, after which the rights would be returned to Pixar. Pixar also wanted Disney to give up its co-ownership of past films.54 For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 8 Relations between Jobs and Eisner had been rocky.55 One analyst said “they hate each other” and attributed Pixar’s decision to walk away from negotiations over an earlier deal to personal conflicts between Jobs and Eisner.56 Jobs had previously criticized Eisner publicly, saying that Pixar executives “feel sick” about the prospect of Disney marketing Pixar films.57 Eisner, in turn, predicted that Finding Nemo, the next Pixar release, would be a flop and was infuriated by Apple’s “Rip, Mix, Burn” advertising campaign, which he saw as an incitement to piracy.58 Tom Staggs, Disney CFO, said that Disney could not accept Pixar’s final offer because doing so would have cost Disney “hundreds of millions of dollars it is already entitled to under the existing agreement.”59 Others close to the deal attributed the rocky relations to the length and tone of the negotiations, during which Disney often left Pixar hanging for weeks on end.60 Pixar identified Sony, Warner Brothers, and 20th Century Fox as potential suitors. In 2003, Jobs noted, “We’ve talked to many of these studios, and we know we can get the deal we want.”61 On January 29, 2004, Pixar announced that it was ending its talks with Disney to renew the existing agreement and was looking for another partner.62 The breakdown of the Disney/Pixar partnership lent strength to calls by some Disney board members to remove Eisner and was one of the factors that led to his eventual departure. In response to the news, former board members Roy Disney and Stanley Gold issued a statement: “More than a year ago, we warned the Disney board that we believed Michael Eisner was mismanaging the Pixar partnership and expressed our concern that the relationship was in jeopardy.”63 Warner Brothers immediately announced an interest in negotiating with Pixar.64 Disney studio head Dick Cook responded by saying, “No one has a lock on talent, no one has a lock on creativity or technology or storytelling.”65 Pixar’s Corporate Culture Jobs believed that Pixar’s competition would feel pressure to replicate his company’s style because they lacked the creativity, the technology, and the “blending.” He noted: “We have spent 10 years merging two cultures together. It sounds really easy, like you put a technical person here, and a creative person there, and they go out to lunch, and somehow, it all works.It’s not.It’s really tough. And it took us 10 years to figure out how to do this.”66 At Pixar, the technical computer staff and the creative development group, including the animators, an art department, and a story department, worked together, driven by the mantra that the story came first, and that creativity existed at all levels of the organization. Pixar believed in the primacy of people. Catmull noted, “If you give a good idea to a mediocre team, they will screw it up; if you give a mediocre idea to a great team, they will either fix it or throw it away and come up with something that works.”67 Pixar hired talented people and then created a supportive, trusting working environment in which collaboration could thrive. Employees were picked based not only on creative talent, but on whether they would be a good fit with the organization. According to one employee: “The most important thing I was asked over and over again was, ‘Can I work with you?’ Then it was, ‘Are you qualified for the job?’You can have a lot of creative purity and still be the most dysfunctional group on the planet.”68 Pixar readily accepted prominent outsiders from companies like Industrial Light & Magic (ILM) and Lucasfilm’s special effects division. According to John Lasseter: “At Pixar, an animator is more an actor than an artist. Sure, they can draw, but the real trick is to make these 3-D characters come to life. That requires acting ability more than anything else.”69 The methodical nature with which Lasseter approached his films was well documented. Analyzing a two-second shot, Lasseter directed: “Let’s return Mr. Potato Head’s facial For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 709-462 9 features to the default position, so it’s easier for the baby to bite off his nose,” or “And let’s see if we can make the baby’s slobber more elastic, so it sticks and stretches longer.”70 Pixar operated according to three basic principles. The first was that “everyone must have the freedom to communicate with anyone.”71 Pixar corporate headquarters in Emeryville, California, was designed with exactly that principle in mind. After learning from Disney mentors that the company did its best work when staff members were all housed together in close quarters in the old Hyperion Studio, Jobs and Lasseter realized the importance of creating a single campus-like environment, with an atrium center that maximized chance encounters and employee interaction. Second, “it must be safe for everyone to offer ideas.” Each film was “filmmaker led” by the producer and director who had championed the idea and were committed to its success, and who received little oversight. If a problem arose, the team called on the “creative brain trust”—a group that comprised Lasseter and eight directors—to engage in a back-and-forth on how to make a movie better. It remained the team’s job, however, to decide what to do with the advice.72 According to reports, this group almost entirely reworked two of Pixar’s movies when production team members themselves felt that their projects were not up the company’s highest standards. Lasseter also imported and expanded on a review process—the “dailies”—from Disney and ILM. Rather than including only senior management, Pixar’s daily review audience was the entire animation crew, who were encouraged to provide constructive feedback. The epitome of this approach was a philosophy of “Plussing,” which Lasseter defined as “making something pretty good pretty great, making a fine-tune here and there until an idea sings.”73 The result was a deeply engrained culture that believed that everything Pixar produced had to be done to one excellent quality standard.74 Third, the company vowed to “stay close to innovations happening in the academic community.”75 In fact, most of Pixar’s technical employees held PhDs. Lasseter firmly believed in the interplay between art and technology, and the infusion of better technology at each stage of production—an environment in which, as he said, “art challenged technology, and then technology inspired art.”76 The company also established Pixar University to offer classes in drawing, acting, and motion, as well as to encourage technical directors and artists to study alongside the animators.77 Lasseter signed a 10-year employment contract with Pixar in 2001 as head of the animation studios. He received a signing bonus of $5 million, an annual salary of $2.5 million, and options on 1 million Pixar shares. Eisner had once remarked that Lasseter was the only difference between Disney and Pixar.78 The rest of Pixar’s 750 employees were employed at will. And loyalty was high. Unlike other studios, where animators were hired and fired based on movie demand, Pixar retained its employees throughout the years. The company historically released one movie per year, a pace that kept the directors on staff busy, because each project took at least four years to complete. If there wasn’t work to be done on a film, Pixar assigned employees to projects in research and development. Pixar went public one week after the release of Toy Story in 1995, raising $140 million in the largest IPO of the year (Exhibit 10). Steve Jobs retained about 50% of the ownership of Pixar, and although he was occupied at Apple, he spent half his time at Pixar in the early years. Competition Pixar competed with other major film studios that produced movies targeting the family segment, such as Fox, Sony, Lucasfilm, DreamWorks, MGM, Universal, Paramount, and, to a certain extent, Disney. Because animated films generated the highest returns of all movie genres, and barriers to entry decreased as access to technology grew, competition in the CG space became fierce. Recent animated For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 10 successes included Ice Age and Robots (Fox’s Blue Sky subsidiary) and Polar Express (Warner Brothers). Even Disney, in conjunction with Vanguard, released Valiant and, through its own CG unit, Chicken Little. Also, a handful of fledging animation studios proliferated in California’s Bay Area. Companies such as Orphanage, Wild Brain Inc., and CritterPix Inc. all announced plans to create CG feature films starring lovable, relatable characters. While each studio was at a different stage in its evolution—the Orphanage supplied special effects for movie studios while Wild Brain won an award for best computer-generated short film at the 2001 World Animation Celebration—all had the same ambition: to be the next Pixar.79 Pixar’s most formidable rival was DreamWorks, Katzenberg’s studio and owner of the Shrek franchise. Katzenberg was determined to create a studio that matched Disney’s success in animation. But he invoked the inverse of the Disney formula—rather than making movies for children and the child that exists in everyone, the DreamWorks’ motto was to make movies for adults and the adult in each child.80 The studio’s success did not happen immediately, but rather arose through much trial and error. The success of Shrek came as a bit of a surprise even to Katzenberg, who said: “It was one of the riskiest movies I’d ever done. It defied conventional wisdom in every way, the antithesis of everything an animated movie had been.”81 The failure of DreamWorks’ Spirit: Stallion of the Cimarron in 2002 and Sinbad: Legend of the Seven Seas in 2003 signaled to Katzenberg “the last gasp of old-style animation.”82 Shortly thereafter, Katzenberg replaced 200 graphic artists with 200 computer artists. When efforts to lure Pixar away from Disney failed, DreamWorks executives renewed ties with U.K.-based animation studio Aardman Animations, who had worked with them on Chicken Run, for the upcoming Wallace & Gromit. Between 1998 and 2005, DreamWorks’ successful CG releases included Antz, Shrek, Shark Tale, Shrek 2, and Madagascar. The studio’s average worldwide box office for that period was $317 million, compared with Pixar’s $538 million.83 However, DreamWorks, with its staff of 1,280, produced two CG films a year as opposed to Pixar’s one, leading to $1 billion in revenue in 2004. Production costs were high—DreamWorks’ average movie cost between $100 million and $130 million. Direct-to-video films, which cost roughly $30 million to make, were an integral part of DreamWorks’ yearly release schedule, along with one original and one sequel. The studio boasted 14 directors on long-term contracts and included staff from 38 countries.84 DreamWorks had a distribution deal with Paramount through 2012 by which it paid Paramount an 8% fee, which was lower than the industry average. That 8% fee applied to all revenue streams excluding merchandising, and expenses before revenue recognition.85 In October 2004, the DreamWorks IPO separated DreamWorks Animation from DreamWorks SKG, Inc., a U.S. film studio. As part of the deal, DreamWorks SKG became responsible for the marketing and distribution of the animation studio’s products; it also received an 8% fee. Acquisition? Robert Iger knew that he wanted to maintain his company’s relationship with Pixar. The question was on what terms. Many media analysts argued for an acquisition, reasoning that animation was integral to Disney’s corporate strategy because characters from animated films drove retail in its theme parks and consumer product divisions.86 And Pixar’s track record for producing smash hits was unmatched. “This is the kind of synergy that makes a good deal of sense,” as one commentator wrote.87 Merrill Lynch analyst Jessica Reif Cohen termed it a “near-perfect strategic fit.”88 Some said the move would transform Disney into the studio of the 1930s—a “boutique” that was “unencumbered by a large bureaucratic apparatus.” Bringing Jobs and Lasseter into the fold, they argued, would be like bringing back Walt himself.89 For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 709-462 11 Almost all media commentators recognized the cultural clash that was likely to occur when a small, independent studio was incorporated into a behemoth corporation. Who would end up running animation in the combined entity? Or would Pixar simply be left alone, as had occurred when Disney acquired the independent production company Miramax? Many feared the outcome when Jobs, and his forceful personality, entered the mix in the highly-charged Disney boardroom. “Steve Jobs on the Disney board would probably be good for Disney shareholders—but it could be hell for those who sit around the board table with him.”90 Others wondered what was in it for Apple, and worried that Jobs might be spreading himself too thin.91Jobs was once again at the helm of Apple, a company basking in the success of the iPod and poised for further product launches. Considering Jobs’s point of view, one commentator suggested that brand association would be a positive outcome of the deal. “Having Apple’s top executive and co-founder associated with the world’s premier family-entertainment brand can’t help but give Apple and its products a family-friendly stamp of approval in certain circles.”92 And then there were the financials. Investment bank analysts estimated that if Disney purchased Pixar, it would have to pay an enterprise value fee of between $6.5 billion and $7.4 billion, given Pixar’s $5.9 billion market capitalization. The deal would likely be done as an exchange of stock, which, at a price of $7.5 billion, would take place at a 2.3 : 1 Disney : Pixar share exchange ratio. Credit Suisse valuations of Pixar, which the bank compiled for Pixar’s board using a variety of techniques, ranged from 1.093:1 to 2.365:1, although that price included the cash on Pixar’s balance sheet (see Exhibit 11). Many analysts believed that that the acquisition would be too expensive for Disney. The projected price-to-earnings (P/E) ratio for Pixar was 46. DreamWorks, its closest competitor with a market value of $2.6 billion and revenues of nearly $1 billion, had a P/E multiple of 30.93 Deutsche Bank analysts called the potential deal “nonsensical” because it would be heavily dilutive with Disney trading at a P/E of 17, and because of a potential creative talent exodus.94If Pixar’s creative talent walked out, “Disney just bought the most expensive computers ever sold,” noted Lawrence Haverty, fund manager at Gabelli Asset Management.95 Deutsche Bank analysts rationalized that Disney could make 65 sequels to the Pixar hits for the proposed $6.5 billion purchase price.96 Amid acquisition speculation, reports surfaced that Disney was prepared to renegotiate the terms of the 1997 contract to cover the 2007 release of Ratatouille. Under the terms of the one-film deal, Pixar would fully finance and retain ownership rights for Ratatouille, paying only a straight distribution fee to Disney. Bob Iger reflected on next steps. He believed that, as he said, “the importance of animation to Disney over the years is obvious. Nothing creates more of an impact at this company than a successful animated film. When we go into China, for example, it’s not because we’re called Disney, but because of Snow White and The Lion King and Toy Story.”97 Given this, should he reengineer Disney Animation to better compete with Pixar?Should he strike a distribution deal with another animation studio?If he stuck with Pixar, should he negotiate a new distribution deal and at what terms, or should he instead acquire the entire company? For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 709-462 The Walt Disney Company and Pixar Inc.: To Acquire or Not to Acquire? 12 Exhibit 1 Animated Film Performance by Studio as of November 2005 ($ millions) Studio Film Formata Release Date U.S. Box International Box Total Box Disney Little Mermaid HD Nov-89 $112.0 $111.0 $223.0 Beauty and the Beast HD Nov-91 $145.9 $207.0 $352.9 Aladdin HD Nov-92 $217.4 $285.0 $502.4 Lion King HD Jun-94 $312.9 $459.0 $771.9 Pocahontas HD Jun-95 $141.6 $205.6 $347.2 Hunchback of Notre Dame HD Jun-96 $100.1 $225.2 $325.3 Hercules HD Jun-97 $99.1 $153.6 $252.7 Mulan HD Jun-98 $120.6 $183.0 $303.6 Tarzan HD Jun-99 $171.1 $264.2 $435.3 Dinosaur CG May-00 $137.8 $210.0 $347.8 Emperor’s New Groove HD Dec-00 $89.3 $70.6 $159.9 Atlantis: The Lost Empire HD Jun-01 $84.1 $84.6 $168.7 Lilo & Stitch HD Jun-02 $145.8 $127.4 $273.2 Treasure Planet HD Nov-02 $38.2 $71.4 $109.6 Jungle Book 2 HD Feb-03 $47.9 $87.3 $135.2 Piglet’s Big Movie HD Mar-03 $34.7 $39.8 $74.5 Brother Bear HD Oct-03 $85.3 $164.3 $249.6 Teacher’s Pet HD Jan-04 $6.5 $0.0 $6.5 Home on the Range HD Apr-04 $50.0 $53.9 $103.9 Average $112.6 $158.0 $270.7 Pixar Toy Story CG Nov-95 $191.8 $166.4 $358.2 A Bug’s Life CG Nov-98 $162.8 $195.2 $358.0 Toy Story 2 CG Nov-99 $245.9 $239.9 $485.8 Monsters, Inc. CG Nov-01 $255.9 $273.1 $529.0 Finding Nemo CG May-03 $339.7 $524.9 $864.6 The Incredibles CG Nov-04 $261.4 $370.0 $631.4 Average $242.9 $294.9 $537.8 DWA Antz CG Oct-98 $90.6 $91.0 $181.6 Prince of Egypt HD Dec-98 $101.2 $127.0 $228.2 Road to El Dorado HD Mar-00 $50.8 $27.0 $77.8 Chicken Run SM Jun-00 $106.8 $99.0 $205.8 Shrek CG May-01 $267.7 $238.0 $476.7 Spirit: Stallion of the Cimarron HD May-02 $73.2 $48.0 $121.2 Sinbad: Legend of the Seven Seas HD Jul-03 $26.3 $54.0 $80.3 Shrek 2 CG May-04 $441.2 $477.3 $918.5 Shark Tale CG Oct-04 $160.9 $202.6 $363.5 Madagascar CG May-05 $193.2 $327.2 $520.4 Wallace & GromitbOct-05 $50.0 $67.8 $117.8 Average $151.2 $169.1 $317.4 Warner Bros. Space Jam HD Nov-96 $90.4 $140.0 $230.4 Iron Giant HD Aug-99 $23.2 $6.0 $29.2 Osmosis Jones HD Aug-01 $13.6 $0.4 $14.0 Looney Tunes: Back in Action HD Nov-03 $21.0 $47.5 $68.5 Polar Express CG Nov-04 $162.8 $120.4 $283.1 Average $62.2 $62.9 $125.1 Fox Anastasia HD Nov-97 $58.4 $81.4 $139.8 Titan A.E. HD Jun-00 $22.8 $14.0 $36.8 Ice Age CG Mar-02 $176.4 $206.3 $382.7 Robots CG Mar-05 $128.2 $132.5 $260.7 Average $96.5 $108.5 $205.0 Source: SG Cowen & Co., “Walt Disney Company,” November 3, 2005, via Investext, accessed October 2008. a HD = Hand-drawn, CG = Computer-generated, SM = Stop-motion. b Still in release at time of reporting. For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 70 9- 46 2 -1 3- E xh ib it 2 W al t D is ne y C om pa ny F in an ci al s ($ m ill io ns ) 9/ 30 /1 99 9 9/ 30 /2 00 0 9/ 30 /2 00 1 9/ 30 /2 00 2 9/ 30 /2 00 3 9/ 30 /2 00 4 10 /1 /2 00 5 N et s al es 23 ,4 35 25 ,3 25 25 ,1 72 25 ,3 29 27 ,0 61 30 ,7 52 31 ,9 44 C os t o f g oo ds 19 ,7 15 21 ,5 67 21 ,5 73 22 ,9 24 24 ,3 30 26 ,7 04 27 ,8 37 G ro ss p ro fit 3, 72 0 3, 75 8 3, 59 9 2, 40 5 2, 73 1 4, 04 8 4, 10 7 D ep re ci at io n, d ep le tio n an d am or tiz at io n, w / i m pa irm en t 1, 37 7 2, 28 7 3, 00 1 1, 04 2 1, 09 0 1, 26 2 1, 33 9 N on -o pe ra tin g in co m e -1 09 60 5 -1 ,0 05 52 9 -4 59 32 0 49 1 In te re st e xp en se 61 2 49 7 54 4 72 3 N A 62 9 60 5 In co m e be fo re ta x 2, 40 3 2, 63 3 1, 28 3 2, 19 0 2, 25 4 3, 73 9 3, 98 7 P ro vi si on fo r in co m e ta xe s 1, 01 4 1, 60 6 1, 05 9 85 3 78 9 1, 19 7 1, 24 1 M in or ity in te re st ( in c) 89 10 7 10 4 10 1 12 7 19 7 17 7 N et in co m e 1, 30 0 92 0 -1 58 1, 23 6 1, 26 7 2, 34 5 2, 53 3 A S S E TS T ot al c ur re nt a ss et s 9, 72 7 10 ,0 07 6, 60 5 7, 84 9 8, 31 4 9, 36 9 8, 84 5 N et p ro pe rty a nd e qu ip m en t 11 ,3 46 12 ,3 10 12 ,9 06 12 ,7 80 12 ,6 78 16 ,4 82 16 ,9 68 In ta ng ib le s 15 ,6 95 16 ,1 17 20 ,4 83 25 ,8 18 25 ,9 57 25 ,7 19 25 ,1 32 TO TA L A S S E TS 43 ,6 79 45 ,0 27 43 ,8 10 50 ,0 45 49 ,9 88 53 ,9 02 53 ,1 58 LI A B IL IT IE S Lo ng -t er m d eb t 9, 27 8 6, 95 9 8, 94 0 12 ,4 67 10 ,6 43 8, 07 2 8, 83 4 T ot al li ab ili tie s 22 ,3 56 20 ,5 71 20 ,7 56 26 ,1 66 25 ,7 69 27 ,0 23 25 ,7 00 S ha re ho ld er e qu ity 20 ,9 75 24 ,1 00 22 ,6 72 23 ,4 45 23 ,7 91 26 ,0 81 26 ,2 10 TO TA L LI A B IL IT IE S A N D N E T W O R TH 43 ,6 79 45 ,0 27 43 ,8 10 50 ,0 45 49 ,9 88 53 ,9 02 53 ,1 58 So ur ce : W al t D is ne y C om pa ny S E C fi na nc ia l d at a ex tr ac te d fr om T ho m so n O ne B an ke r, a cc es se d O ct ob er 2 00 8, a nd R ef in it iv , a cc es se d N ov em be r 20 21 . For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 70 9- 46 2 -1 4- E xh ib it 2 a W al t D is ne y C om pa ny B us in es s Se gm en t R es ul ts ($ m ill io ns ) 19 95 19 96 19 97 a 19 98 19 99 b 20 00 20 01 20 02 20 03 20 04 20 05 R ev en ue s C re at iv e C on te nt $7 ,7 36 $1 0, 15 9 M ed ia N et w or ks $6 ,5 22 $7 ,1 42 $7 ,5 12 $9 ,6 15 $9 ,5 69 $9 ,7 33 $1 0, 94 1 $1 1, 77 8 $1 3, 20 7 B ro ad ca st in g 41 4 4, 07 8 P ar ks a nd R es or ts 5, 01 4 5, 53 2 6, 10 6 6, 80 3 7, 00 4 6, 46 5 6, 41 2 7, 75 0 9, 02 3 T he m e P ar ks & R es or ts 4, 00 1 4, 50 2 S tu di o E nt er ta in m en t 6, 98 1 6, 84 9 6, 54 8 5, 99 4 6, 10 6 6, 69 1 7, 36 4 8, 71 3 7, 58 7 C on su m er P ro du ct s 3, 78 2 3, 19 3 3, 03 0 2, 62 2 2, 59 0 2, 44 0 2, 34 4 2, 51 1 2, 12 7 In te rn et 17 4 26 0 20 6 36 8 $1 2, 15 1 $1 8, 73 9 T ot al $2 2, 47 3 $2 2, 97 6 $2 3, 40 2 $2 5, 40 2 $2 5, 26 9 $2 5, 32 9 $2 7, 06 1 $3 0, 75 2 $3 1, 94 4 O pe ra tin g In co m e C re at iv e C on te nt $1 ,5 31 $1 ,5 61 M ed ia N et w or ks 1, 69 9 $1 ,7 46 $1 ,6 11 $2 ,2 98 $1 ,7 58 $9 86 $1 ,2 13 2, 57 4 3, 20 9 B ro ad ca st in g 76 78 2 P ar ks a nd R es or ts 1, 13 6 1, 28 8 1, 44 6 1, 62 0 1, 58 6 1, 16 9 95 7 1, 07 7 1, 17 8 T he m e P ar ks & R es or ts 85 9 99 0 S tu di o E nt er ta in m en t 1, 07 9 76 9 11 6 11 0 26 0 27 3 62 0 66 2 20 7 A cc ou nt in g C ha ng e (3 00 ) C on su m er P ro du ct s 89 3 80 1 60 7 45 5 40 1 39 4 38 4 54 7 54 3 In te rn et (5 6) (9 4) (9 3) (4 02 ) A m or tiz at io n (4 39 ) (4 31 ) (4 56 ) (1 23 3) $2 ,4 66 $3 ,0 33 T ot al $4 ,3 12 $4 ,0 79 $3 ,2 31 $2 ,8 48 $4 ,0 05 $2 ,8 22 $3 ,1 74 $4 ,8 60 $5 ,1 37 So ur ce : C om pa ny 1 0K fi lin gs . a Be fo re 1 99 7, a ni m at io n fe ll un de r cr ea ti ve c on te nt ; a ft er 1 99 7, it fe ll un de r st ud io e nt er ta in m en t. b Be gi nn in g in 1 99 9, th e co m pa ny c ha ng ed h ow o pe ra ti ng s eg m en t i nf or m at io n w as r ep or te d, a nd it r es ta te d re po rt s fr om 1 99 7 to c on fo rm to n ew s ta nd ar ds . In 2 00 1, th e In te rn et w as no lo ng er tr ea te d as a s ep ar at e se gm en t a nd a m or ti za ti on w as n o lo ng er r ep or te d as a s ep ar at e lin e it em . For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 70 9- 46 2 -1 5- E xh ib it 3 A gg re ga te W or ld w id e Pe rf or m an ce o f P ix ar a nd D re am W or ks A ni m at io n M ov ie s P ix ar a D re am W or k s A n im at io nb (F iv e M ov ie s 19 95 –2 00 3) (E ig h t M ov ie s 19 98 –2 00 4) T ot al R ev en u e ($ m il li on ) A ve ra ge p er M ov ie ($ m il li on ) % o f T ot al R ev en ue T ot al R ev en u e ($ m il li on ) A ve ra ge p er M ov ie ($ m il li on ) % o f T ot al R ev en ue B ox O ffi ce 1, 23 6 24 7 23 .7 % 1, 06 9 13 4 26 .9 % H om e V id eo 3, 10 3 60 2 59 .5 % 2, 34 5 29 3 59 .0 % T el ev is io n 38 5 77 7. 4% 33 5 42 8. 4% M er ch an di se 49 5 99 9. 5% 22 4 28 5. 6% So ur ce : A da pt ed fr om R ic ha rd G re en fi el d an d D oc H or n, “ Pi xa r vs . D re am W or ks : E it he r, N ei th er , o r Bo th ?” F ul cr um G lo ba l P ar tn er s L LC r es ea rc h, O ct ob er 2 6, 2 00 4, v ia T ho m so n O ne B an ke r, a cc es se d N ov em be r 20 08 . N ot e: T ot al s di ff er fr om th os e in E xh ib it 1 d ue to ti m in g of r ep or t. a Pi xa r M ov ie s = To y St or y, A B ug ’s L if e, T oy S to ry 2 , M on st er s, In c. , a nd F in di ng N em o. b D re am W or ks m ov ie s = A nt z, P ri ce o f E gy pt , R oa d to E ld or ad o, C hi ck en R un , S hr ek , S pi ri t, Si nb ad , a nd S hr ek 2 . For the exclusive use of l. zhou, 2022. This document is authorized for use only by lele zhou in Management 214 Corporate Strategy taught by Steven Sommer, University of California - Riverside from Mar 2022 to Jun 2022. 70 9- 46 2 -1 6- E xh ib it 4 Pi xa r Fi na nc ia ls ($ m ill io ns ) 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 R ev en ue s S of tw ar e 3. 3 3. 1 3. 3 4. 5 3. 8 5. 7 9. 1 6. 9 8. 1 12 .1 12 .6 A ni m at io n S er vi ce s 2. 3 2. 5 3. 9 1. 6 0. 6 0. 9 0. 8 0. 0 0. 0 0. 0 0. 0 F ilm 0 0 18 .8 26 .9 9. 8 11 4. 4 16 2. 3 63 .4 19 3. 6 25 0. 4 26 0. 8 P at en t L ic en si ng 0 6. 5 9. 1 1. 7 0. 1 0. 0 0. 0 0. 0 0. 0 0. 0 0. 0 T ot al R ev en ue s 5. 6 12 .1 35 .2 34 .7 14 .3 12 1. 0 17 2. 3 70 .2 20 1. 7 26 2. 5 27 3. 5 C os ts S of tw ar e 1. 2 0. 5 0. 1 0. 1 0. 7 0. 7 0. 6 0. 5 0. 5 0. 0 0. 0 A ni m at io n S er vi ce s 2 1. 9 3 1 0. 1 0. 5 0. 4 0. 0 0. 0 0. 0 0. 0 F ilm 0 0 1. 6 1. 5 0. 0 30 .5 36 .0 11 .8 41 .0 38 .0 29 .9 T ot al C os ts 3. 1 2. 4 4. 7 2. 5 0. 9 31 .7 37 .0 12 .3 41 .5 38 .1 29 .9 O pe ra tin g E xp en se s R es ea rc h an d D ev el op m en t 2. 3 4. 1 3. 2 4. 7 3. 9 6. 3 5. 6 6. 3 8. 5 15 .3 17 .4 S al es a nd M ar ke tin g 2. 2 1. 6 1. 5 1. 5 1. 3 1. 5 1. 6 2. 0 1. 3 2. 4 2. 5 G en er al a nd A dm in is tr at iv e 0. 8 3 4. 2 5. 1 7. 0 7. 0 7. 7 8. 1 9. 7 12 .8 15 .0 O pe ra tin g E xp en se R ei m bu rs em en t 0 0 0 -2 .2 0. 0 0. 0 0. 0 0. 0 0. 0 0. 0 0. 0 T ot al O pe ra tin g E xp en se s 5. 3 8. 7 8. 9 9. 1 12 .1 14 .8 14 .9 16 .4 19 .5 30 .5 34 .9 In co m e fr om C on tin ui ng O pe ra tio ns -2 .8 1 20 .3 23 .1 1. 3 74 .5 12 0. 4 41 .5 14 0. 7 19 3. 3 20 8. 7 O th er In co m e, N et 0. 5 0. 7 8 8. 8 8. 8 7. 5 13 .0 14 .4 10 .3 10 .5 12 .4 In co m e T ax es 0 -0 .1 -2 -9 .9 -2 .6 -3 2. 9 -5 5. 4 -1 9. 9 -6 1. 1 -7 9. 7 -7 9. 4 N et In co m e -2 .4 1. 6 25 .3 22 .2 7. 8 49 .2 78 .4 36 .2 89 .9 12 4. 8 14 1. 7 So ur ce : C om pi le d fr om P ru de nt ia l F in an ci al R es ea rc h, “ Pi xa r” C om pa ny R ep or ts , v ia T ho m so n In ve st ex t, ac ce ss ed N ov em be r 20 08 . E xh ib it 4 a Pi xa r B al an ce S he et (i n $ th ou sa nd s) 10 /1 /2 00 5 1/ 1/ 20 05 A ss et s C as h an d In ve st m en ts 1, 04 3, 66 4 85 4, 78 4 T ot al A ss et s 1, 44 3, 46 2 1, 27 5, 03 7 Li ab ili tie s an d S ha re ho ld er s’ E qu ity T ot al L ia bi lit ie s 55 ,9 77 54 ,9 42 T ot al S ha re ho ld er s’ E qu ity 1, 38 7, 48 5 1, 22 0, 09 5 T ot al L ia bi lit ie s an d S ha re ho ld er s' E qu ity 1, 44 3, 46 2 1, 27 5, 03 7 So ur ce : Pi xa r 10 Q F ili ng , O ct ob er 1 , 2 00 5, v ia T ho m so n O