The question is, should the company expand horizontally or should the company diversify or expand vertically? There is no clear cut answer to this question. There are advantages and pitfalls to each of these methods and there are many examples of organisation where a certain choice has proven extremely profitable and vice versa. This essay will provide advantages and disadvantages of horizontal expansion by comparing it with vertical and diversified growth. The reader will be presented with the facts and at the end will be allowed to make his own decision.
One major deciding factor on growth strategy will be the organisations long term strategy and the behaviour of the Markets, and its competitors. Horizontal expansion as well as other forms, can occur in a number of methods, this includes firm spending its own profits to expand its business or by acquisitions and mergers with companies operating in the same stage of the vertical production chain. This can be in the same market or in markets in other countries for example the takeover of O2 by a Spanish company called Telephonica.
This strategy of expansion is useful when the firms’ main objective is to increase sales by producing and distributing more of the firms existing products, the advantage is that the company can exploit economies of scale, reducing overheads and expenses. But each company will have a limit to its economies of scale before it starts to experience diseconomies of scale. The company will become too large and this will make it ridged and inflexible to changes in customer demands and market conditions.
If the company expands through merger and acquisitions, the competitive pressure will be reduced as their will be one less rival in the market. This will increase the firms control over the market and could provide a competitive edge. However the disadvantage of this option is that the firm has “all its eggs in one basket” and if the market declines or demand falls the company will suffer and will be unable to offset its losses, this is why most companies in today’s UK market are diversifying; an example is Tesco, it does not just provide groceries it also provides finance related products.
Expanding in other countries can be seen as a method of offsetting your losses in one country. If one country takes a dip in a certain market the other countries market may remain stable. There is an advantage in globalization and internationalising their operation and reducing cost but this is also an advantage of vertical and diversification on an international scale. Since mergers and acquisitions lead to the reduction in the number of substitutes, it may be likely that the elasticity of demand is reduced.
When competition is reduced, price wars are less likely and firms are likely to increase prices, rather then decrease prices, trying to move from a perfect competition scenario to a more profitable monopoly. The fewer the number of players in the market the easier it becomes to form cartels control supply and bully new entrants to the market. The airline industry tried to do this for a number of years to prevent low cost airlines from entering the market. The mergers and acquisitions are closely monitored by the competition commission to prevent large firms from exploiting consumers.
Apart from favourable price elasticity of demand horizontal growth is effective in exploiting revenue growth. Growing demand could stimulate organic growth as more consumers move into the market, a firm can invest in more productive assets to produce supply and satisfy demand. Retail outlets of mobile phones suddenly appeared on the high street to exploit rapid increase in customers. However sooner or later the market will become saturated and profit will become more difficult to obtain.
The advantage of diversification in other fields is that the company can invest to pursue growth opportunities and increase shareholders wealth, these companies will also have an exit strategy and leave the market will it becomes saturated and less profitable. Fiat started to provide financial services to become less dependant on the automotive market and is currently one of the biggest insurers in Italy. BMW have also started to offer financial services in the UK. Horizontally expanded companies are extremely vulnerable to fall in sales and cyclical downturns.
Advantage of diversification is that the firm can provide a stable profit stream by offsetting losses in one area to increasing profits in another area. The obvious reason for horizontal expansion is the benefit of cost reduction. As the firm increases its scale of operation it generally experiences a reduction in long-run average costs. After the merger the company can rationalise its operation which leads to instant reduction in overheads. But it’s important not to become to big that leads to diseconomies of scale.
Another reason for the reduction in costs is due to the benefit attributed to the learning curve. The learning curve was responsible for the reason why European plan manufacturers could not compete with Boeings’ production efficiency in the 1950s. A firm producing 100 units a day learn faster then a firm producing 10 units a day. A company can also improve its efficiency by merging with a company that already has benefited from the learning curve. The question is how easy the knowledge can be transferred?
One major disadvantage of firm that has only expanded horizontally is that it becomes reliant on it suppliers and distributor. If these suppliers have a monopoly structure it has a limitation on cost reduction capability. The firm can vertically expand to resolve this situation if financially viable. If a company is producing large products such as planes and automobiles, will have to have good communication with its suppliers, and to provide good quality products and to maintain control over efficiency and time management it may need to vertically expand due to the fact that delays in delivery can be costly.
When designing a new product it is helpful to know if the supplier can provide the new component. Many car manufacturers and other big product companies have vertically integrated to provide a higher quality product and a more easily manufactured product by removing transaction cost and utilising concurrent engineering, just in time, and other material resource planning techniques. All this reduced cost, increases control and provides a competitive advantage. Horizontal expansion forces the organisation to focus on its core competence, and hopefully making it a master in its field.
Diversification and vertical expansion may confuse the company and make it a jack of all trades and a master of none. Its important for a company specializing in its field to stay ahead and continuously research and develop new products to meet the changing consumer needs and expectations, and always be the first company to bring new technology to the market, other wise the company will suffer and will have change its strategy. Kodak took on great losses when Sony and Cannon launched the patented digital camera in to the market.
Kodak lost its competitive edge and to re-organise its’ business to compete in other market segments. If Kodak was a diversified company it could of switched its core competence from one market to another to stay profitable and offset its losses in the photography sector. Many manufacturers also suffered when good quality product from Japan were imported to the western world this point emphasis the point that the advancement does not necessarily have to be in technology it can also in management and operations.
This is also the reason why Japanese cars have a reputation for reliability and quality. Horizontal expansion is also attributed to the firms’ motivation to add to their key resources and core competencies, an example of this is the acquisition of Pixar by Disney to augment its skills base in the ability to produce animated movies. Another reason for horizontal expansion is that the firm can acquire companies that specialise in a certain area of the whole product allowing the company to provide differentiated products and tap in to consumer surplus.
The main goal of horizontal expansion is to become a monopoly but this will be very difficult as the competition commission is in place in the UK to prevent a company from reaching such position and such a position can only be achieved through intense competition and forcing the other players to leave the market. In order to achieve such a position the company will have to consider other forms of expansion and switch between them according to the changing market environment. In today’s business world the company will have to expand and contract its operations in all three ways. There is no magic solution and no “get rich quick” recipe. The business need to keep a sharp eye on its own and its competitors performances and strategies, as well as be aware or how other industry sectors are performing. But the trend seems to hint diversification is the way ahead.
Bibliography
Lowes, Bryan (Ed/s Pass, C. L. , Sanderson, Stuart). 1994. Companies and markets : understanding business strategy and the market environment. .Blackwell Besanko, David. 2004. Economics of strategy. .3rd edition. John Wiley. Lipczynski, John (Ed/s Wilson, John O. S. , Goddard, John). 2005. Industrial organization: competition, strategy, policy. .2nd edition. Pearson Education.
