Journal of Strategy and Management The customer-centric logic of multi-product corporations Lalit Manral
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JSMA 9,1
The customer-centric logic of multi-product corporations Lalit Manral Department of Management, College of Business, University of Central Oklahoma, Edmond, Oklahoma, USA
74 Received 7 May 2015 Accepted 23 July 2015
Abstract
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Purpose – The purpose of this paper is to articulates a customer-centric logic to explain the strategic behavior of multi-product corporations whose portfolio of complementary product offerings belong to diverse industries. Design/methodology/approach – The paper develops a theoretical framework to explain the heterogeneity in multi-product corporations’ motivation and ability to leverage the demand-side strategic assets developed in their home-markets to enter new markets and thereby improve their longrun corporate performance. Practical implications – The paper includes implications for strategic behavior of multi-product corporations in various industrial sectors such as telecommunications, financial services, consumer discretionary and staples, real estate, and so on. Originality/value – The profitable applicability of demand-side strategic assets to new contexts should be explained both by the motivation of multi-product consumers (to purchase a portfolio of complementary products from a diversified seller) as well as the motivation of multi-product corporations (to leverage their demand-side strategic assets to enter new markets). Keywords Customer-centric strategy, Multi-product corporations, Multi-product customers Paper type Conceptual paper
Journal of Strategy and Management Vol. 9 No. 1, 2016 pp. 74-92 © Emerald Group Publishing Limited 1755-425X DOI 10.1108/JSMA-05-2015-0036
Introduction We invoke a theory of demand-side diversification to explain the strategic behavior of multi-product corporations that serve portfolios of complementary products, which may originate in different industries. The alternate customer-centric strategic logic featured in this theory explains why a firm selling product A may offer a complementary product B (from another industry) without actually possessing the supply-side strategic assets that can be shared across the two businesses. Our theory features multi-product consumers whose consumption value increases if they purchase one or more complements to a basic industry product. Our arguments are analogous but not similar to the argument in the marketing literature on multi-product retailers (Rhodes, 2015). Hence, our theory excludes multi-product retailers (e.g. Walmart, etc.) that subsidize a few basic products and charge higher prices for the rest. It remains an empirical fact that strategic behavior of many multi-product corporations do not render themselves explainable in terms of extant productcentric supply-side logic of related diversification (e.g. Ye et al., 2012). The pervasive corporate practice of offering complementary products – observed across such diverse industries as consumer banking, telecommunications services, residential and commercial properties, etc. – is an exemplar of the “unexplained” pattern of diversification behavior. Even though these multi-product corporations satisfy the conceptual definition of diversified firms (Gort, 1962; Teece, 1980; Ramanujam and Varadarajan, 1989), the myriad “supply-side” theoretical rationales – for the corporate advantage – do not really capture the performance benefits that accrues to them.
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A few conceptual papers invoke the value-based business strategy framework (Brandenburger and Stuart, 1996) in conjunction with the “one-stop shop convenience argument in the marketing literature (refer Rhodes, 2015, for the latest review) to develop a demand-side explanation of how firms” consumer-focussed strategies influence value creation and appropriation (Adner and Levinthal, 2001; Adner, 2002; Adner and Zemsky, 2006; Priem, 2007; refer Priem et al., 2012, for a review). In fact, a couple of papers suggest that firms’ horizontal scope decisions may also be motivated by demand-side considerations of exploiting consumer synergies instead of just supply-side synergies featured in the literature (e.g. Chatain and Zemsky, 2007; Ye et al., 2012). On the other hand, Ye et al. (2012) in a conceptual paper posit two performance benefits of demand-side diversification. First, the hypothetical revenue-enhancing effect of demand-side diversification draws on the “one-stop-shop convenience” argument that explains consumers’ willingness to purchase from a diversified seller (e.g. Porter, 1990; Klemperer and Padilla, 1997; Nalebuff and Brandenburger, 1995; Nalebuff, 2003; Cottrell and Nault, 2004). The convenience of one-stop-shop is explained in terms of both economizing effects (e.g. Klemperer and Padilla, 1997; Nalebuff and Brandenburger, 1995; Nalebuff, 2003; Cottrell and Nault, 2004) and value generating effects (e.g. Spiller and Zelner, 1997; Priem, 2007; Chatain and Zemsky, 2007; Chatain, 2011). Second, the explanation of the hypothetical profit-enhancing effect of demand-side diversification draws on the “superior customer-value” argument that explains consumers’ willingness to pay a premium for a portfolio of complementary products sold by a diversified seller. However, these rudimentary efforts at theory building are yet to produce a coherent theoretical narrative capable of explaining any phenomenon of substance (beyond a few simple examples) let alone provide a rigorous framework for empirical validation of complex diversification phenomena. We complement the aforementioned demand-side logic of (sic) “exploiting consumer synergies” (Ye et al., 2012) with a customer-centric logic of strategic behavior of multi-products corporations. Our explanation of demand-side diversification builds on both the first, resource-based view of related diversification (for studies prior to 2000, refer Palich et al., 2000; Miller, 2004, 2006; Levinthal and Wu, 2010; Wan et al., 2011; Wu, 2013) and second, the market power advantage logic of unrelated diversification (e.g. Caves, 1981; Sobel, 1984; Saloner, 1987; Bolton and Scharfstein, 1990). First, our concept of demand-side diversification extends the product-centric logic of “supply-side” relatedness featured in the resource-based view of diversification to also include a customer-centric logic of “demand-side” relatedness in terms of shared demand-side strategic assets (Manral and Harrigan, 2016). Second, our concept of demand-side diversification builds on the market power advantage logic of unrelated diversification to explain how multi-product firms leverage their demand-side strategic assets in home market to possibly gain advantage in the target markets (Manral and Harrigan, 2016). The proposed customer-centric strategic logic of multi-product corporations not only satisfies the primary condition of related diversification – profitable applicability of strategic assets in the target markets – but also serves as the capstone for the logic of demand-side relatedness. We define a firm’s demand-side strategic assets to include those that either support its customers’ value chain activities, or underpin the linkages between the its own value chain activities and its customers’ value chain activities. Hence, the primary distinguishing characteristic of a firm’s demand-side strategic assets are that they are embedded in a relationship with the firm’s current or potential customers (Manral and Harrigan, 2015).
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The rest of the paper is organized as follows. The next section discusses the phenomenon that our theory seeks to explain. The subsequent section briefly reviews two dominant theories in diversification to identify the gaps that preclude their application to explain the strategic behavior of many multi-product corporations. The following section outlines the proposed customer-centric logic and develops a comprehensive theoretical explanation of the strategic behavior of multi-product corporations that offer a portfolio of complementary goods. The final section discusses the implications for theory, empirical research, and diversification practice. Phenomenon: corporate portfolio of complementary products The phenomenological motivation of this paper is provided by the lack of a convincing theoretical rationale for an important product-scope choice wherein firms offer a portfolio of complementary products to provide greater value to their existing or potential customers. Herein, a seller of product A (industry A) also sells a complementary product B (industry B) to its customers for product A. This corporate practice of expanding product scope should not be confused with firms’ efforts to increase product variety (e.g. Cottrell and Nault, 2004), or cross-selling (e.g. Akcura and Srinivasan, 2005; Kamakura, 2007), or bundling and its variants such as mixedbundling, tying, metering, and so on (Nalebuff, 2003, for a detailed review). Firms offering a portfolio of complementary products could be diversified within and/or across industries. We distinguish between a within-industry portfolio and an inter-industry portfolio of complements. If only for expositional clarity, we define entities that offer within-industry portfolio of complementary products as multi-product firms while those who offer complementary products across industries as multi-product corporations. An example of a within-industry portfolio of complements offered by a multiproduct firm would be that of (say) a toothpaste and toothbrush offered by an oral products company (e.g. Erdem, 1998) – whose demands are obviously positively correlated and who share a common customer-base (e.g. Wernerfelt, 1988; Montgomery and Wernerfelt, 1992). Another example would be the individually available elements of Microsoft Office Suite – a word processing software (Word), presentation software (PowerPoint), a spreadsheet (Excel), and database software (Access) – thereby offering consumers a choice to purchase one or more of them. Similarly, many retail banks provide a variety of other services (e.g. credit cards, etc.) to complement the checking account services offered to their customers. This paper focusses on the inter-industry portfolio of complementary products A and B offered by a hypothetical multi-product corporation. On the supply-side, the complementary products A and B are supported by distinct technologies or production functions. On the demand-side, the two industries serve an overlapping customer-base. Typically, consumers purchase both A and B to increase their value. An example of an inter-industry portfolio offered by a multi-product conglomerate is provided by D.R. Horton (www.drhorton.com/corp/), a leading builder and developer of single-family homes, townhomes, and condominiums in the USA. It sells residential homes (product A) and also offers mortgage services (complementary product B) to the home buyers through a subsidiary DHI mortgage (www.dhimortgage.com/). Why would a home builder diversify into mortgage services? However, not all builders own a mortgage company. A few have tie-ups with mortgage companies and a few others do not provide the complementary service. Similarly, why do not all retailers offer credit cards to their customers? Have you purchased a Toyota car that was financed by Toyota financial services?
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The strategic behavior of multi-product corporations that offer an inter-industry portfolio of complementary products gives rise to important questions that are not really answered by the signaling theory of umbrella branding in marketing or the product-centric logic of diversification. What common resources/capabilities explain the logic of demand-side diversification other than the fact that the portfolio businesses serve common customers? What contextual characteristics, if any, influence the firms’ choice to diversify (or not) on the demand-side? If the aforementioned strategic behavior contributes to overall corporate performance then prevents all business firms from exploiting this practice to improve their performance? If not, then why do so many firms choose to engage in this practice? Yet, not all firms who choose to diversify on the demand-side succeed. In 1981, Sears, Roebuck and Company, then the largest US retail store chain, acquired first, Coldwell, Banker & Company, then the largest real estate brokerage in the USA, and second, Dean Witter Reynolds Inc., then the fifth largest brokerage house in the USA (Ghemawat, 1999/2010). The objective of Sears’ demand-side diversification (by way of acquisition) was to become the “largest consumer-oriented financial service entity” in the country (NYT, 1981). The customer-centric logic of the demand-side diversification was that it would allow Sears to “sell a customer a house, get him a mortgage and handle his investments, as well as sell him furniture and apparel, service his car and write his insurance (NYT, 1981).” A few years later Sears divested both subsidiaries. Literature review: profitable applicability of strategic assets Our proposed customer-centric logic of strategic behavior of multi-product corporations – that offer an inter-industry portfolio of complementary products – is underpinned by a theoretical explanation that combines the resource-based view of related diversification (e.g. Chatterjee and Wernerfelt, 1991) with the market power advantage logic of unrelated diversification (e.g. Montgomery, 1985, 1994). We review both streams to address the conceptual gaps that preclude their application (independent of each other or jointly) to explain the customer-centric strategic behavior of multi-product corporations. On the one hand, the resource-based view of diversification provides theoretical wherewithal to explain the economizing effect of shared demand-side strategic assets but remain inadequate to the task of explaining the value generating effect of shared demand-side strategic assets. On the other hand, the “market power advantage” literature has struggled to empirically validate either the actual deployment of the theorized “anti-competitive” mechanisms by unrelated diversifiers in the real world (Palich et al., 2000) or the “market power advantage” logic of unrelated diversification (Montgomery, 1994). Sharing strategic assets across related businesses Firms benefit from diversifying into those related businesses where they foresee efficiency gains due to resource substitutability (e.g. Willig, 1979; Teece, 1980, 1982) and/or potential for value generation due to resource complementarities (e.g. Teece et al., 1994). Economizing effects. Multi-product corporations enjoy demand-side cost advantage vis-à-vis their specialized rivals in the markets for complementary products (e.g. Salinger, 1995; Klemperer and Padilla, 1997; McAfee et al., 1989). A firm incurs demand-side costs to: acquire customers; retain existing customers; and convince existing customers to use more (quantity) of the complementary product/service offered. While the first (i.e. customer acquisition cost) is a one-time investment, the
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other two are recurring investments over the life-cycle of the customer (e.g. Jain and Singh, 2002; Gupta and Lehmann, 2003; Manral, 2010). However, by ignoring how multi-product firms economize on future investments of the second and third type (referred above) the literature ends up providing a static explanation of the economizing effects of shared demand-side strategic assets. Additionally, the literature also does not distinguish between the types of demand-side investments on which a multi-product firm is assumed (by the analyst) to economize. We argue that multi-product corporations enjoy cost advantage over specialized rivals in the target markets due to lower recurring costs of trying to retain their customers and convincing the latter to use more of the complementary product/service offered. A multi-product corporation’s demand-side costs incurred in market for product A not only generate future benefits in that market but also the market for complementary product B. Our argument rests on the explanation of future benefits of advertising and marketing expenses that has been discussed in the accounting literature (e.g. Anderson et al., 2003; Kovacs, 2004). Value generating effects. The literature on the performance benefits of related diversification provides pretty slim pickings when it comes to the empirical validation of the value creating effect of shared supply-side resources and/or capabilities across “related” businesses (e.g. Markides and Williamson, 1996; Tanriverdi and Venkatraman, 2005; Miller, 2006). Does a multi-product corporation’s decision to offer an inter-industry portfolio of product A and a complementary product B positively influence the value of its demand-side strategic assets shared across the two markets for A and B? If so, then how? In another empirical paper we explain how the shared demand-side strategic assets contribute to the diversified firms’ ability to influence the aggregate demand for the products in the home and the target market. However, over time the commoditization of certain complements, erodes the value that customers derive from consuming both products. Consequently, multi-product firms introduce new complements so as to maintain high consumer value through their offerings. Leveraging strategic assets across unrelated businesses Two types of market power advantage are discerned in the literature (e.g. Berry, 1975; Montgomery, 1985, 1994; Palich et al., 2000). First, a diversified entity’s overall corporate power may translate into market power in individual product markets. The superior efficiency of internal factor markets, which explains the aforementioned corporate power, lies in diversified firms’ ability to better evaluate tacit know-how and/ or intangible resources. On the other hand, a dominant firm in a particular market may diversify into new product markets to leverage its market power in its home market to benefit in target markets. The theorized market power advantage of this type of unrelated diversification focusses on various anti-competitive or collusive mechanisms that broadly diversified firms could employ to create or exploit market power (e.g. Caves, 1981; Sobel, 1984; Saloner, 1987; Bolton and Scharfstein, 1990). The management literature on diversification, in its reluctance to dabble with the concept of market power advantage logic of diversification, has ignored an intuitively appealing theoretical insight concerning unrelated diversification (e.g. Montgomery, 1985, 1994). The ignored theoretical insight is that the ex ante logic of unrelated diversification is underpinned by both firm- and market-specific characteristics. The structural characteristics of a firm’s home- and target-industry influence both its choice to diversify and the performance implications of the choice to diversify
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(e.g. Berry, 1975; Miller, 2004, 2006). They do so by influencing the diversifying firms’ assessment of the feasibility of employing a particular anti-competitive mechanism (e.g. multi-market contact) in that context. However, barring a few exceptions (e.g. Miller, 2006) the management literature on diversification typically ignores the effect of contextual factors (e.g. Porter, 1987; Dess et al., 1990) in the diversifying firms’ ability to leverage their market power into other markets. Needless to say the literature on product market diversification in management has ignored the role of demand-side characteristics of the home- and target-industries despite exhortations by leading scholars. Reconciling the logic of related and unrelated diversification Although the market power advantage logic of unrelated diversification does not find much empirical support for its purported explanation of unrelated diversification, it is not really inconsistent with the resource-based view of diversification (Montgomery, 1985, 1994). Montgomery (1985) highlights the missing theoretical rationale in the market power advantage logic and suggests that one should consider the resources and/or capabilities that explain a firm’s market power in the first place in its home industry. She argues that the theorized effectiveness of the collusive mechanisms – employed by the “unrelated” diversifier – actually depends upon the contextual factors, some of which may be missing in the theoretical explanation, thereby resulting in lack of empirical evidence when tested with real world data. She argues that broadly diversified firms may not possess industry-specific or specialized assets required to address the specific critical success factors of particular target industries and hence are at a disadvantage vis-à-vis focussed firms. Theory: a customer-centric strategic logic of multi-product corporations A customer-centric logic explains the strategic behavior of multi-product corporations that diversify away from their home market (for product A) to offer a portfolio of complementary products (say B, C, D, etc.) to their customer-base of product A. By definition of demand-side diversification, a multi-product corporation that serves the two markets necessarily serves an overlapping customer-base for the two products. First, we conceptually distinguish the customer-centric logic from other horizontal scope decisions of multi-product corporations (Table I). The latter include growth strategies that require multi-product firms to: increase product variety in a particular product market according to a narrow-scope differentiation strategy; enter new product market segments in the same industry to increase horizontal scope according to a broad-scope differentiation strategy; or simply cross-sell their products across customer-types. Second, we explore the profitable applicability of demand-side strategic assets in terms of the costs of applying these assets to new contexts: adjustment costs; and opportunity costs. Third, we link the consumer synergies argument (e.g. Ye et al., 2012) with the “anti-competitive” explanation of bundling (Nalebuff, 2003, for a comprehensive review) to explain – how the multi-product consumers’ preferences influence the strategic behavior of multi-product corporations. The strategic behavior of multi-product corporations A distinguishing feature of demand-side diversification is the demand-side outcome of the diversifying firm’s strategic choice. The said outcome includes a possible, but by no means certain, increase in market-size from a pre-diversification SiA to a
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Strategy Multi-variety/ narrow-scope Characteristics differentiation
Distinct/ overlapping customer-base for the portfolio products Demand-side To fill empty implications (adjacent) locations in a hypothetical multi-dimensional product-attribute space Supply-side implications
Typical competitive implication Table I. The strategic logic of (selective) multi-product firms
Cross-selling
Demand-side diversification
Inter-industry Within- or interdiversification to industry expand product diversification to scope expand product scope To offer a portfolio To offer a portfolio To offer a portfolio of complementary of unrelated or of products products that complementary (imperfect belong to distinct products that substitutes) in a industries belong to distinct horizontally product market segmented/ segments of an fragmented industry or even industry distinct industries Products used by different customers Products used by the same customer
Horizontally/ vertically differentiated variants within a product category To offer variety in a Objective of single product firm’s category of a horizontal scope decision horizontally differentiated industry Type of expansion of horizontal scope
Broad-scope differentiation
Increased supplyside cost of offering a wider variety Economies of scale and scope in various value chain activities (sourcing, manufacturing, distribution, selling, etc.) Market preemption to deter entry by rivals
Within-industry diversification to expand product scope
To increase marketsize: Si(H+T) SiH (home product market-segment) +SiT (target product market-segment)
To increase ordersize: Ru(1+2) Ru1 (user’s ordersize for product 1) + Ru2 (user’s ordersize for product 2)
To increase average individual consumption: qu(H+T) qiH (home market product A) + qiT (complementary product B) The increased Increased supplyThe increased side cost of offering supply-side cost of supply-side cost of selling additional a wider portfolio selling Economies of scale products/services to complementary and scope in various its customer-base products/services to across N products its customer-base value chain activities (sourcing, (S1, S2, S3, …, SN) (SH) manufacturing, Economies of scope Economies of scope distribution, selling, in distribution and in selling legacy etc.) selling product A with a complementary product B Leveraging market Mutual forbearance Increasing power in home customer by introducing market to gain knowledge by products across advantage in target developing different product customer intimacy market segments
post-diversification SiA + SiB. (SiA refers to the market-size of firm i in market for product A.) However, by definition the outcome includes an increase in the average individual consumption (e.g. revenue per customer) by the diversifying firm’s customer-base for the legacy product A: from a pre-diversification qiA to a
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post-diversification qiA + qiB. (qiA refers to the average individual consumption of the customer-base of firm i in market for product A.) The strategic logic of multi-product firm behavior We impose a definitional restriction that the products in a multi-product corporation’s portfolio are necessarily complements in the case of demand-side diversification. The concept of cross-selling does not impose any such restrictions. In the case of multi-variety firms the portfolio products range from weak to strong substitutes. In the case of multi-product broad-scope differentiators they are mostly imperfect substitutes that serve distinct product sub-markets. In the case of demand-side diversification a common consumer purchases both products in the portfolio (e.g. computer hardware and computer software), which is similar to the case of cross-selling. However, in the case of product variety and broad-scope differentiation the focal firm does not target the same customer. The customer chooses between the two substitutes in a portfolio (e.g. a Sedan and an SUV). Hence, one should not confuse a diversified firm that sells a portfolio of complements (e.g. a videogames company like Nintendo that sells both console and game titles) with either a multi-variety firm (e.g. a large specialized or single-brand retailer say Gap) or a broad-scope differentiator (e.g. a large automobile manufacturer like GM whose products serve different segments of the automobile industry). Demand-side diversification vs narrow-scope differentiation. The literature on product variety explains two main strategic rationale underlying incumbents’ choice to invest in product variety (Lancaster, 1990; Carlton and Dana, 2008). First, incumbents invest in substitutes to increase their overall performance in terms of total revenue and/ or market share. Second, incumbents invest in substitutes to deter entry. However, incumbents are constrained from offering a large number of variants as doing so may prevent them from realizing economies of scale in production and marketing. This product-centric approach to firm behavior involves increasing product variety to fill up the vacant spots in a hypothetical product attribute space in a product market. However, this stream of literature on product variety often ignores the strategic role of complements in increasing a firm’s product variety due to supply-side constraints and market-size limitations. While the literature assumes that substitutes are based on a common or similar technologies, complements are often based on different technologies. Demand-side diversification vs broad-scope differentiation. The logic of broad-scope differentiation manifests itself as within-industry increase of product scope (e.g. Porter, 1980). This type of firm behavior can be understood in terms of the increase in marketsize (S): from a pre-diversification, SH (home market), to a post-diversification SH + ST, achieved by serving an additional target market (ST). For instance, many consumer appliances companies (e.g. Maytag) that begin by serving one product sub-market seek to increase their product scope over time by entering other product sub-markets (e.g. Collis and Montgomery, 1998/2005). The within-industry diversification behavior of broad-scope differentiators is primarily governed by the supply-side economies of sharing strategic assets across the product sub-markets (or segments or categories). The expanding firm does not seek an overlapping customer-base across the related markets (home- and target-market) because its decision to actually enter the target market is driven by supply-side considerations of common manufacturing or distribution assets.
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Demand-side diversification vs cross-selling. The concept of cross-selling is a catch-all term for a pervasive corporate phenomenon wherein a firm sells its customers of (say) product A various other related or unrelated products that it produces (e.g. Kamakura, 2007; Li et al., 2010). It does not really have a conceptual underpinning or at least we are not aware of any theory of cross-selling. A large number of professional services firms (e.g. consulting, insurance, financial services, etc.) employ cross-selling (e.g. Li et al., 2010). It is widely prevalent as a sales tool in such industries as financial services, insurance, health care, accounting, telecommunications, airlines, and retailing. For instance, Wells Fargo is considered as one of the most successful practitioner of the “cross-selling” strategy in the financial services sector (Forbes, 2012). Herein, the logic of cross-selling is to sell as many of the bank’s products to a particular customer/ household because even with discount bundles the profit per customer increases in the number of services s/he purchases from a bank. Further, it imposes a great switching cost on the customer/household. Profitable applicability of demand-side strategic assets to new contexts The literature already considers customer-base as a demand-side strategic resource (e.g. Barney, 1986; Dierickx and Cool, 1989; Markides and Williams, 1994; Gupta and Lehmann, 2003, 2006; Zander and Zander, 2005; Gupta, 2009). We build on it further to conceptualize demand-side competences (e.g. Ratchford, 2001; Adner, 2002; Adner and Levinthal, 2001; Zander and Zander, 2005; Adner and Zemsky, 2006). We categorize demand-side competences along two dimensions: knowledge assets (e.g. customer knowledge), and relational assets (customer relationship). We classify all demand-side strategic assets into two categories: demand-side strategic resources (e.g. customer-base); and demand-side competences (e.g. customer knowledge and customer relationship). A firm’s indivisible strategic assets can be profitably applied to new contexts (product markets) if doing so generates economizing effects and/or value generating effects or both. On the one hand, shared demand-side strategic assets provide coherence to multi-product corporations that offer a portfolio of complementary products (Lev, 2001). On the other hand, applying demand-side strategic assets (developed in their home-markets) to new contexts would be subject to various organizational costs: adjustment costs (e.g. Penrose, 1959; Hashai, 2014), and opportunity costs (e.g. Levinthal and Wu, 2010; Wu, 2013). These costs are in turn influenced by the two characteristics of the strategic assets described below. Hence, the applicability of a strategic asset to a new context is constrained by the level of: specificity of the strategic assets with respect to their origin (e.g. Rumelt, 1974); and specificity of the strategic assets with respect to their form (e.g. Teece, 1980, 1982). A customer-centric strategic logic allows multi-product corporations to economize on their organizational costs to the extent that they can outsource supply-side activities required to serve the target markets and yet remain profitable. Context specificity and organizational costs The outward-looking “context-specificity” defines the relationship of the focal strategic asset with the environment in which it originates and/or is deployed by the firm. Either ends of the continuum of context specificity – low or high – might be abstract with no real world examples. A highly context-specific strategic asset cannot be used in contexts beyond that where it originates (e.g. natural gas extraction capabilities such as hydraulic
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fracturing). On the other hand, low-context specificity or generalizability of a strategic asset implies that it can be deployed in various other contexts (e.g. online retailing capabilities). Inarguably the demand-side strategic assets (e.g. customer-base or customer know-how) are characterized by lower context specificity when compared to supply-side capital stock (e.g. plants and equipment and/or technological capabilities). Adjustment costs. The adjustment costs incurred by diversifying firms are influenced by the context specificity of the focal strategic asset. The lower context specificity of demand-side strategic assets (vis-à-vis supply-side strategic assets) with respect to their home-markets renders them amenable to being deployed in markets for complementary products. (However, a high level of context specificity with respect to the geography of their home market implies that such deployment would be restricted to customers in only those geographic markets.) Further, the adjustment cost of deploying its demand-side strategic assets (e.g. customer-base) in new markets for complementary products, which are based on entirely different technologies, should be low. By definition, value-maximizing customers are self-motivated to purchase complements (say B, C, D, etc.) to the product A. The lower context specificity of demand-side strategic assets also implies that they can be readjusted faster in dynamic industry conditions: P1a. Lower context specificity of the demand-side strategic assets translates into lower adjustment costs. Content specificity and organizational costs The inward-looking “content-specificity” refers to the “finite” form or structure that defines the relationship between the constituent elements of the focal capability. For instance, a particular hospital’s capability to perform brain surgery is embodied in equipment, operated by a team comprising surgeons, anesthesiologists, nurses, and so on. High content specificity implies that the use of this surgical team in one engagement restricts their simultaneous use in another (Levinthal and Wu, 2010). Either ends of the continuum of content specificity might be abstract with no real world examples. A highly content-specific strategic asset is subject to form limitations or quantity limits and can either not be allocated simultaneously to produce two distinct goods to be sold in two distinct markets (e.g. capabilities embodied in personnel skills) or allocated in fixed units (e.g. manufacturing capacity allocated to different products). On the other hand, low content specificity implies that the strategic resource is not subject to form limitations (e.g. customer knowledge) or quantity limits (e.g. brand) and can therefore be simultaneously allocated to several uses. Opportunity costs. Levinthal and Wu (2010) and Wu (2013) employ a dichotomy to categorize diversifying firms’ capabilities into two types: scale-free capabilities (e.g. knowledge, reputation, brand name, etc.) and those that are subject to opportunity costs (e.g. managerial attention, product development teams, etc.). However, the seemingly contrived dichotomy raises a few questions. If indeed (sic) “scale-free capabilities” do exist then do they impose any limits as to the extent of diversification? It is obvious that any capability that renders itself amenable to being leveraged for diversifying into new markets would obviously be subject to opportunity costs. Even brands. Even as we disagree with the contrived dichotomy we provide the missing theoretical rationale for explaining the variation in the opportunity costs of applying (sic) “non-scale free” capabilities to new contexts. The opportunity costs of applying demand-side strategic assets (developed in the home-markets) to new contexts are influenced by the content specificity of the focal
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strategic asset. Let us first illustrate this with a supply-side capability. The brain surgery capability of a hospital organization, which Wu (2013) would categorize as “non-scale free,” is highly content-specific in terms of its architecture. While it is also specific to the product-context in terms of the service that can be offered using this capability (brain surgery) it is less specific to the geographic-context in which the service can be offered. A slight adjustment cost would allow this team to perform brain surgery in another geographic area. However, it would be subject to high opportunity cost because the team cannot be at two geographic locations simultaneously. Let us now understand the same in terms of demand-side strategic assets. The lower content specificity of demand-side strategic assets (vis-à-vis supply-side strategic assets) implies that they can be simultaneously deployed in more than one use. For instance, a customer-base, which is a demand-side strategic resource, can be used simultaneously to consume more than one product offered by the focal firm in distinct product markets. For instance, Netflix’s decision to diversify into the internet-based streaming video market from the mail-order DVD market was probably influenced by its confidence in its ability to deploy its customer-base in both markets. We therefore propose: P1b. Lower content specificity of the demand-side strategic assets translates into lower opportunity costs. Multi-product customers and the strategy of multi-product corporations A multi-product customer follows his or her purchase of the basic product A with another purchase of at least one complementary product (say B, C, D, etc.). Even if s/he does not consume all the complements, s/he likes to retain the choice to purchase all complements from the same source. First, transaction costs (e.g. search and negotiation) in the markets for complementary products render it expensive for the multi-product customer to shop anew every time s/he seeks out a complement (e.g. Klemperer and Padilla, 1997; Nalebuff and Brandenburger, 1995; Nalebuff, 2003; Cottrell and Nault, 2004). Second, consumer expectations regarding compatibility of complementary product (say B, C, D, etc.) with the basic product A imply that s/he derives more value by purchasing complements from the same supplier (e.g. Spiller and Zelner, 1997; Priem, 2007; Chatain and Zemsky, 2007; Chatain, 2011). A forward-looking multi-product customer expects to purchase many complements to product A over her lifetime of consuming A. S/he economizes on transaction costs and maximizes her consumption value by being loyal to the focal multi-product corporation. However, this imposes certain amount of switching costs on the multi-product customer. This explains their willingness to pay a premium to purchase both A and its complement B offered by a multi-product corporation. We therefore propose that the forward-looking behavior of a multi-product customer positively influences the competitive position of a multi-product corporation in its home- and target market: P2. A portfolio of complements offered by a multi-product corporation lowers the multi-product customers’ willingness to purchase and pay a premium for a specialized rivals’ products in the home market as well as the target market for complementary products. While consumers value each complementary product differently, they typically reserve the highest valuation for the basic product A. We argue that even if multi-product
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consumers have the choice to purchase the (lower valuation) complements from elsewhere, they prefer to purchase them from the entity that sells them the basic product A. For instance, a customer who visits Barnes and Nobles to purchase books (high-value items) may end up purchasing a coffee (a lower value item) at the on-site coffee shop and even pay a premium for the coffee. On the other hand, a customer who visits Starbucks to purchase a coffee (a lower value item) may not really warm up to the idea of purchasing books (high-value items) at the same location. We now invoke the resource-based view of diversification to explain how the above described multi-product consumers’ preferences influence multi-product firm behavior. A multi-product corporation’s demand-side strategic assets, which underpin its dominance in the home market for product A, motivate it to diversify into related target market(s) for complementary product B. These demand-side strategic assets influence consumers’ willingness to purchase and even pay a premium for the complementary products offered by the corporation. Given that the consumption value for A is higher than that for B, we propose: P3. The likelihood that a corporation offering basic industry product A will diversify to offer complementary product B will be higher than the likelihood that a corporation offering complementary product B will diversify to offer the basic industry product A. In a dynamic setting, a multi-product corporation’s choice and effectiveness of offering a portfolio of complementary products A and B (and C, D, etc.) may be influenced the evolution of the industry for complementary product B (and C, D, etc.). For instance, the horizontal fragmentation of the target industry along the product dimension that manifests as proliferation of within-industry complements to product B (i.e. B1, …, Bk) may prevent diversified firms from capturing economies of scale in advertising/ marketing across different product categories within the target industry. This will negatively influence the theorized performance benefits of demand-side diversification. Alternately, the hypothetical value that a multi-product customer derives from consuming both A and its complement B may decline over time as the market for complementary product B reaches maturity and the product is commoditized. In such case, even forward-looking customers may be tempted to switch to a cheaper provider of complementary product B. However, it may not happen if the multi-product corporation takes suitable action(s) to satisfy the (switching-cost-imposing) assumption of forward-looking customers. In a dynamic setting, a multi-product corporation should continuously introduces new complements (say C, D, E, etc.) to its legacy product A. This strategic decision influences the competitive environment in its home market as well as in the target market(s). By doing so it not only increases its average revenue per customer (and thereby overall revenue) but also stands to increase its profitability per customer (and thereby overall profits): P4. The customer-centric logic of strategic behavior of a multi-product corporation entails that it continuously introduce new complements to its base product A to maximize its enterprise value. A multi-product corporation that seeks to create customer value is obviously motivated to enhance the value of its demand-side strategic assets by leveraging them to enter the markets for complementary products. (In an empirical paper we explain this mechanism in terms of the outward shift of the aggregate demand curve for the complementary products.) However, a multi-product corporation benefits from offering
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a portfolio of complementary products only if it is able to captures a considerable portion of the value it creates for a multi-product customer. How do the shared demand-side strategic assets of a multi-product corporation allow it to capture the customer value created for the multi-product customers as enterprise value? We first invoke the arguments in the bundling literature that explain the anti-competitive effects of bundling and tying (Nalebuff, 2003, 2004; Carlton and Waldman, 2002, 2010). These effects persist as long as the customer prefers to purchase the complementary products from a multi-product corporation as opposed to purchasing them from various specialized sellers. The bargaining power of the multiproduct corporation (say over its technology suppliers) and the horizontal competitive effects ensure that such corporations not only create value but also capture a substantial portion of it for themselves as profits. We now draw attention to the role of demand-side investments and strategic assets in creating customer value. (We do so without taking away anything from the contribution of supply-side investments and strategic assets.) We argue that the customers’ preference to purchase all complements from a multi-product corporation can be understood as an outcome of the latter’s’ demand-side investments (e.g. adverting and marketing expenses). The costs incurred by a multi-product corporation to acquire and retain customers and to influence them to consume additional complements contribute to the development and growth of the corporation’s demand-side strategic assets. Multi-product corporations that offer a portfolio of complementary products exploit indirect network effects (e.g. Katz and Shapiro, 1985; Farrell and Saloner, 1986; Tanriverdi and Lee, 2008). The presence of demand-side externalities renders their demand-side assets very valuable. Hence, a multi-product corporation’s diversification choices based on a customer-centric strategic logic ensures that their demand-side investments are subject to increasing returns (e.g. Arthur, 1989). (The returns to a firm’s investments that exceed its discounted cost of capital contribute to its enterprise value.) We now arrive at the central proposition of the customer-centric logic of strategic behavior of a multi-product corporation: P5. The increasing returns to demand-side investments in excess of the discounted cost of capital will be higher (lower) for multi-product corporations that follow a customer-centric (product-centric) strategy. Discussions and conclusions The customer-centric logic of strategic behavior of multi-product corporations proposed herein contributes to the emerging demand-side perspective within the strategy literature, in general, and to the two streams of diversification literature that have evolved in response to the “scope” and “corporate strategy” question, respectively, in particular. First, it bridges the divide between the two streams within the emerging demand-side perspective – one that invokes the value-based strategy to explain how firms create customer value and compete to appropriate the returns to the value so created and the other that invokes the RBV to explain – that explain the demand-side drivers. Second, it complements the product-centric logic of supply-side relatedness featured in the resource-based view of diversification. It takes two to tango – the seller and the buyer. Yet, the product-centric logic of related diversification exclusively focusses on the diversifying firm and its supply-side strategic assets while ignoring its – demand-side strategic assets and the – customers. Third, it serves as the locus for
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a theory of demand-side diversification. This theory explains how the shared demandside resources (e.g. customer-base) and demand-side competences (e.g. customer knowledge and customer relationship) positively influence consumers’ willingness to purchase and in some cases willingness to pay a premium for the diversified firms’ products vis-à-vis those offered by their single-business rivals. In doing so this theory not only explains the diversifying firms’ motivation to leverage demand-side strategic assets to enter new markets (Manral and Harrigan, 2015) but also the performance benefits of sharing these assets across the portfolio markets (Manral and Harrigan, 2016). The proposed customer-centric logic, which underpins the concept of demand-side relatedness, makes two significant contributions to a theory of demand-side diversification. First, a more comprehensive concept of relatedness accounts for the “missing” supply-side strategic assets across the seemingly “unrelated” businesses of many multi-product corporations. Typically, the businesses in two industries (for product A and complementary product B) are considered unrelated (when viewed from the supply-side lens of related diversification) because the technologies required to produce the products A and B are totally different and they do not share common production inputs. The portfolios of such multi-product corporations can now be explained by our theory of demand-side diversification. For instance, over the years Google has amazed its critics for its seemingly “unrelated” diversification as it developed a large array of new products and services to complement its core online advertising business. These new products and services seem unrelated when viewed through the extant product-centric and supply-side logic of relatedness. Second, the concept of demand-side relatedness contributes toward a more stable basis for determining ex ante relatedness under dynamic industry conditions wherein the market structure of the multi-product corporations’ home- and target-markets may be continuously evolving. The heterogeneous evolution of industrial market structure of various product markets served by multi-product firms poses a strategic dilemma for such firms. A product-centric diversification framework characterized by supply-side relatedness does not resolve the strategic dilemma posed by dynamic industry conditions. For instance, supply-side strategic assets that may be profitably applicable in a hypothetical target market at a certain period may not be so in the next period. It would be presumptuous to assume that two businesses related at a particular time (say due to common technological inputs) will remain related in the future as well (when they use different technological inputs). However, the relatedness of two businesses (e.g. computer hardware and software) defined in terms of common customer-base will persist even as the products (and their underlying technological architecture) change from one generation to the next. Further, the adjustment cost of deploying its customers in new markets for complementary products, which are based on entirely different technologies, should be low. The proposed customer-centric logic will expectedly make a significant contribution to the empirical literature that often struggles with the challenge of a product-centric diversification framework underpinned by supply-side relatedness: do moderately diversified firms perform better: because they diversify into “related businesses” that require common inputs; or because they share common inputs once they diversify into “related businesses”? It has therefore been subject to criticisms that the empirical exercise is often a post hoc rationalization of certain common characteristics shared by business units of successful diversified firms. We expect that our theoretical framework to stimulate empirical inquiry into the role of various types of demand-side
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strategic assets. To begin with researchers can ex ante identify the properties of demand-side strategic assets that either render them more (profitably) applicable or preclude their (profitable) applicability to novel contexts (e.g. new product- or geographic- markets). A fertile area of inquiry is to ex ante identify properties of demand-side strategic assets that render them as better sources of economies of scope or value generation vis-à-vis supply-side capital. Another fertile area of inquiry is to ex ante identify the structural conditions under which demand-side strategic assets are superior (or inferior) to supply-side strategic assets as motivators to diversify. Yet another fertile area of inquiry is to explain the extent or limits of diversification in terms of the properties of the demand-side strategic assets identified ex ante. Basically, are some demand-side strategic assets more widely applicable than others thereby contributing to a broader scope of firms that possess such strategic assets? References Adner, R. (2002), “When are technologies disruptive: a demand-based view of the emergence of competition”, Strategic Management Journal, Vol. 23 No. 8, pp. 667-688. Adner, R. and Levinthal, D. (2001), “Demand heterogeneity and technology evolution: implications for product and process innovation”, Management Science, Vol. 47 No. 5, pp. 611-628. Adner, R. and Zemsky, P. (2006), “A demand-based perspective on sustainable competitive advantage”, Strategic Management Journal, Vol. 27 No. 3, pp. 215-239. Akcura, T.M. and Srinivasan, K. (2005), “Research note: customer intimacy and cross selling strategy”, Management Science, Vol. 51 No. 6, pp. 1007-1012. Anderson, M.C., Banker, R.D. and Janakiraman, S.N. (2003), “Are selling, general, and administrative costs ‘Sticky’?”, Journal of Accounting Research, Vol. 41 No. 3, pp. 47-63. Arthur, W.B. (1989), “Competing technologies, increasing returns, and lock-in by historical events”, The Economic Journal, Vol. 99 No. 394, pp. 116-131. Barney, J. (1986), “Strategic factor markets: expectations, luck, and business strategy”, Management Science, Vol. 32 No. 10, pp. 1231-1241. Berry, C.H. (1975), Corporate Growth and Diversification, Princeton University Press, Princeton, NJ. Bolton, P. and Scharfstein, D.S. (1990), “A theory of predation based on agency problems in financial contracting”, American Economic Review, Vol. 80 No. 1, pp. 93-106. Brandenburger, A.M. and Stuart, H. (1996), “Value-based business strategy”, Journal of Economics & Management Strategy, Vol. 5 No. 1, pp. 5-24. Carlton, D.W. and Dana, J.D. (2008), “Product variety and demand uncertainty: why markups vary with quality”, The Journal of Industrial Economics, Vol. 56 No. 3, pp. 535-552. Carlton, D.W. and Waldman, M. (2002), “The strategic use of tying to preserve and create market power in evolving industries”, RAND Journal of Economics, Vol. 33 No. 2, pp. 194-220. Carlton, D.W. and Waldman, M. (2010), “Competition, monopoly, and aftermarkets”, Journal of Law, Economics, and Organization, Vol. 26 No. 1, pp. 54-91. Caves, R.E. (1981), “Diversification and seller concentration: evidence from change”, Review of Economics and Statistics, Vol. 63 No. 2, pp. 289-293. Chatain, O. (2011), “Value creation, competition, and performance in buyer-supplier relationships”, Strategic Management Journal, Vol. 32 No. 1, pp. 76-102. Chatain, O. and Zemsky, P. (2007), “The horizontal scope of the firm: organizational tradeoffs vs buyer-supplier relationships”, Management Science, Vol. 53 No. 4, pp. 550-565.
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Further reading Bowman, W.S. (1957), “Tying arrangements and the leverage problem”, Yale Law Journal, Vol. 67, November, pp. 19-36. Director, A. and Levi, E. (1956), “Law and the future: trade regulation”, Northwestern University Law Review, pp. 281-296. Katz, M.L. and Shapiro, C. (1986), “Technology adoption in the presence of network externalities”, The Journal of Political Economy, Vol. 94 No. 4, pp. 822-841. Posner, R.A. (1976), Antitrust Law: An Economic Perspective, University of Chicago Press, Chicago, IL. Prahalad, C.K. and Bettis, R. A. (1986), “The dominant logic: a new linkage between diversity and performance”, Strategic Management Journal, Vol. 7 No. 6, pp. 485-501. Rajan, R., Servaes, H. and Zingales, L. (2000), “The cost of diversity: the diversification discount and inefficient investment”, Journal of Finance, Vol. 55 No. 1, pp. 35-80. Rawley, E. (2010), “Diversification, coordination costs and organizational rigidity: evidence from microdata”, Strategic Management Journal, Vol. 31 No. 8, pp. 873-891. Servaes, H. (1996), “The value of diversification during the conglomerate merger wave”, The Journal of Finance, Vol. 51 No. 4, pp. 1201-1225. Shleifer, A. and Vishny, R.W. (1991), “Takeovers in the ‘60s and ‘80s: evidence and implications”, Strategic Management Journal, Vol. 12, pp. 51-59. Stigler, G.J. (1968), The Organization of Industry, Irwin, Homewood, IL.
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