Scope Extension and Acquisitions

Carrying on the MBA content series, I’m going to talk a little about why a company might want to acquire new capabilities, either by buying companies or creating a competency internally.

So, let’s take the example of a vertical chain (i.e. a chain inside one industry):

Supplier -> Company -> Customer

For example, this could be:

Textile supplier -> Clothing manufacturer -> Retail chain

From here, there’s two things the manufacturer can do. It can buy its supplier (an action called “backward integration”), or it can buy its customer (an action called “forward integration”). Or both, if it’s feeling flush. We’ll look at backwards integration in this example.

Why might this be a good idea?

The first is simple and obvious – you can stop supplying any of your competitors with textiles. A note of caution here – you can usually negotiate an agreement that does the same thing, which is a hell of a lot cheaper.

The second is that it can optimise the chain. It can start to produce just the right sort of textiles – maybe they’re pre-cut into shapes – to fit really well into its manufacturing process. It knows that by getting optimised product, it can streamline its internal operations and save money.

“But hold”, I hear you say. “Why does it need to buy a supplier to do that? Can’t it just ask a supplier to do it? It has a good relationship, right?”

“You’re quite right,” I say. “But there’s a complication.”

The hold-up problem

Let’s say that the textile supplier serves a few different clothing manufacturers. It receives this request for customisation, and it wants to maintain a good relationship, so they think about it. But one manager with his head screwed on straight says, “Hang about – if we customise our product for you, you’ll be able to negotiate really good prices with us, because you know we are depending on you for our business. So I’ve thought about your request, but you can bugger off.”

The reason for this bad language is that there is a difference between market price and price to a specific customer. If the difference is huge, this creates what’s called a hold-up problem. And suddenly, the supply -> manufacture part of the chain is sub-optimal. This is something that extending scope can fix.

As always, there is one exception, which is people (or “human capital” as they call them round here). Supposing there’s one guy who makes cool patterns you put on your clothing in the manufacture process. You can ask him to come and work for you, and work in a specific way that optimises your internal operations. If this guy has his head screwed on straight, he’ll say, “Hang about – if I change the way I work, you’ll be able to negotiate really rubbish pay deals with me, because you know I can now only work at your company. So I’ve thought about your request, but you can bugger off.”

And that’s fair enough, because you can never nail down people in the same way you nail down machines. They will stick it to the man.

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