Past Performance of the Lego Company - Essay Example

Lego Mindstorms Introduction Normally diversification strategies can lead to strategic competitiveness and above-average returns. In general firms using related diversification strategies outperform those employing unrelated diversification strategies. At some point of time the firms can become over-diversified. The level at which over-diversification occurs varies across companies, because each firm has different capabilities to manage diversification. Irrespective of the type of diversification strategies implemented declines in performance result from over-diversification. Even when a firm is not over-diversified a high level of diversification can have a negative impact on the long term performance of a firm. For instance the scope created by additional amounts of diversification often cause managers to rely on financial control rather than strategic controls to evaluate business units’ performance. Without a clear understanding of the objectives and strategies of the business the top level executives tend to rely on financial controls. Though this will ensure short-term gains are generated it may have a severe impact on the long-term investments and prospects of the firm. (Hitt, Ireland and Hoskinsson (2005) Lego – an Overview on the Past Performance In the case of Lego several mistakes in its history of last twenty and odd years and the biggest of such mistakes were to confuse growth with success. The sales growth of Lego was phenomenal during the 10 year period from1978 to 1988 with the sales increasing from Danish Kroner 1 billion to 5 billion which is a five fold increase. This sales growth made Lego look great. While during the 1980s VCRs, video games, cable Television and computers started to have their influence on the children Lego was busy expanding its sales to its target market across the world. The main problem with the operations of Lego was that the company became a slow company with its complacency. For instance the company formed an association with MIT in 1984 but until ten years later the company could not invent any ‘intelligent brick’. Though the programmable brick became popular the company could not market it as a mass market product since the company was unable to reduce the price. The real problem was that Lego lost its audience who the children loved at one point of time. It seems that the company had a core play values ‘encouraging the imagination and putting the child in charge’. Now what is interesting is that “Lego the company needs to learn to be more like its core product, Lego the brick: nimble, adaptable, plastic -- but fundamentally unchanged -- no matter what kind of creation it is a part of.” (Charles Fishman) Changes in Corporate Level Strategy Product diversification a primary corporate level strategy concerns the scope of the industries and markets in which the firm competes as well as “how managers buy, create and sell different businesses to match skills and strengths with opportunities presented to the firm”. (Bergh) Successful diversification is expected reduce variability in the firm’s profitability in that earnings are generated from several different business units. (Kim et al 2001) In the case of Lego the corporate level of strategy of creating the ‘new business’ division could not match the skills and strengths with the opportunities presented to the firm against its core products. The diversification in to theme parks, lifestyle business and media could not match with the core strengths of the firm and hence these diversifications did not present the company the anticipated growth in business and earnings as against the core business line. Reasons for Diversification There are many reasons the firms use a corporate-level diversification strategy. Typically a diversification strategy is used to increase the firm’s value by improving its overall performance. Value is created either through related diversification or through unrelated diversification when the strategy allows a company’s business units to increase revenues or reduce costs while implementing their business level strategies. Another reason for diversification is to gain market power relative to competitors. Other reasons for using a diversification strategy may not increase the firm’s value; in fact diversification could have neutral effects, increase costs or reduce a firm’s revenue and its value. (Hitt, Ireland and Hoskinsson (2005) The proposition of diversification postulates that both related and unrelated diversification should allow the business units of the firm to increase revenues or reduce costs. But the diversification activities undertaken by Lego did not produce the desired result of enhancing the earnings. Instead the company once profitable started to make losses, as the diversifications have been undertaken for reasons based the belief of Kristiansen that the Lego name was a universal concept which should refer to “idea, exuberance and value”. The objective for diversification therefore was more emotional and the feeling of the management that they have succeeded in the business. They could not identify the difference between growth and success. The theory suggests that if diversification is undertaken for reasons other than maximizing value or for gaining market power against competitors such diversification may result in reduced revenue and value of the firm. This is what exactly had happened in the case of Lego. Related Diversification With the related diversification corporate-level strategy the firm builds upon or extends its resources, capabilities, and core competencies to create value. (Doukas & Lang, 2003) The firm using the related diversification strategy wants to develop and exploit economies of scope between its business units available to companies operating in multiple industries or product markets. (Porter, 1985) ‘Economies of scope’ implies the cost savings that the firm creates by successfully transferring some of its capabilities and competencies that were developed in one of its businesses to another of its business. Operational Relatedness: Sharing Activities Operational relatedness can be created by the firms by sharing either a primary activity such as inventory delivery system or a support activity; for instance purchasing activities. Sharing activities is found to be quite common among related constrained firms. Example can be had from Proctor & Gamble’s paper towel business and baby diaper business as both use paper products as a primary input to the manufacturing process. The firm’s paper production plant produces inputs for both the divisions and this is an example of a shared activity. Firms expect activity sharing among units to result in increased strategic competitiveness and improved financial returns. Although activity sharing among divisions in business carries some risk since business units can create links between outcomes, researches have proved that it can create value (Hitt, Ireland and Hoskinsson (2005). Corporate Relatedness: Transferring Core Competencies Over a period of time the intangible resources of a firm such as know-how, becomes the foundation of the firm. Corporate core competencies are complex set of resources and capabilities that link different businesses, primarily through managerial and technological knowledge, experience and expertise. (Kotabe et al 2003) One of the corporate capabilities that have been suggested by research is the ability to price new products irrespective of the business line of origin (Dutta et al 2003). Related linked firms often transfer competencies across businesses thereby creating value in at least two ways. First the expense of developing a competence has been incurred in one unit. Transferring it to a second business unit eliminates the need for the second unit to allocate resources to develop the competence. Resource intangibility is the second source of value creation through corporate relatedness. Intangible resources are difficult for competitors to understand and imitate. Because of this difficulty the unit receiving a transferred competence often gains an immediate competitive advantage over its rivals. The operational and corporate relatedness will have their own impact on the results of diversification as shown in the figure below. The figure illustrates how firms seek to create value from economies of scope attain through two basic kinds of operational economies: sharing activities (operational relatedness) and transferring skills or corporate core competencies (corporate relatedness). The difference between sharing activities and transferring competencies is based on how separate resources are jointly used to create economies of scope. Figure Value –Creating Strategies of Diversification: Operational and Corporate Relatedness High Sharing: Operational Relatedness Between Businesses Low Low High Corporate Relatedness: Transferring Skills into Businesses through Corporate Headquarters Source: Hitt, Ireland and Hoskinsson (2005) In order to maximize economies of scope tangible resources like plant and equipments or other business-unit physical assets often must be shared. Less tangible resources such as manufacturing knowhow can also be shared. In the case of Lego the diversification could not bring synergies for the following reasons 1. If the’ new business’ and Lego Mindstorms are considered as related diversification then there is neither the operational relatedness in the form of sharing activities nor corporate relatedness in the form of transfer of skills between units. This is evident from the fact that the ‘new business’ division from the beginning operated in ways very different from the core business. Obviously there could not have been any relatedness either at the operational level or at the corporate level. 2. In the case of Lego Mindstorms the R&D and marketing development division was located in the US instead of in the Head office in Denmark. Therefore in the case of the product Mindstorms also there was no way the company could maximize the economies of scope through relatedness. The division could not be connected to the rest of the organization due to the fact there existed fundamental differences between orderly core business that was servicing an existing market on the one hand and the newer more chaotic team trying to create a new market on the other. Therefore Lego could not derive the economies of scope and synergies of diversification. 3. The fundamental difference between the core business and the new business is; while the core business followed ‘go it alone’ orientation, the Mindstorm team established tight and equal relations with many of its alliance partners. Therefore an alignment of the values and competencies could not be transferred to the new divisions to derive the synergies. In fact the Mindstorms division could not convince the staff of the core business to join its team as they were reluctant to take risk associating with the new product. Recommendations A Business Portfolio Matrix as suggested by Boston Consulting Group (BCG) would throw light on the relative position of each of the divisions of Lego, that will enable the management to take a decision for the future directions of the company. Figure Business Portfolio Matrix (BCG) – Lego High Business Growth Rate Low Low High Relative Competitive Position (Market Share) From the above figure it can be observed that business divisions of Legoland Theme parks, Lego lifestyle and Lego Media are having low market share and a low growth rate and thus cannot generate large cash and do not consume large amount of cash. However there is the potential danger of these activities becoming cash traps and the company should immediately divest from these divisions. It may be noted all these divisions along with Lego Mindstorm could produce only 25% of the total revenues of the company for the year 1998. In the case of Lego Mindstorms the company has spent considerable sums of money in developing the product and market. Therefore the suggestion here is to make a complete restructuring the division so that there can be sharing of the activities as well as the core competencies of the core business. The cooperation and involvement of the staff and managers of core business can be enlarged perhaps by shifting the R&D and marketing offices to the head office in Denmark. It is advisable to keep this division as question mark which has a potential to gain a market share and become a star in due course. Conclusion Core business lines of Lego can be classified as cash cows which represent as market leader enjoying significant market share and this division can exhibit a return on assets much greater than the market growth rate. Consequently the core business lines may generate cash more than they consume. This business can be ‘milked’ extracting the profits investing as little as possible. Therefore Lego should focus on aggressive marketing and reviving of its core products. From the discussion it can be observed that using a single- or dominant- business corporate level strategy may be preferable to seeking a more diversified strategy, unless a corporation can develop economies of scope or financial economies between businesses or unless it can obtain market power through additional levels of diversification. These economies and market power are usually the main sources of value creation when the firm diversifies. As far as Lego is concerned as discussed in the text the firm could not derive either financial economies (since the firm made huge loss in 1999) nor there was any increase in the market power. Alternatively only the core businesses showed considerable improvements in performance. Moreover related diversification normally creates value through the sharing of activities or the transfer of core competencies. It is also observed in the theory that sharing activities usually involves sharing tangible resources between businesses and transferring core competencies involves transferring core competencies developed in one business to another one. In the case of Lego there was no possibility of either sharing of activities or transfer of core competencies and hence the diversification had not resulted in any financial economies to the business. Therefore it is reiterated that the company follows the suggestions based on the business portfolio matrix analysis outlined above. References Bergh, D.D. (2001). Diversification strategy research at a crossroads: Established, emerging and anticipated paths. In M. Hitt, R. Freeman, and J. Harrison (Eds.), Handbook of Strategic Management (pp. 362-383) Oxford, UK: Blackwell Publishers. Charles Fishman (2001) ‘Why Can’t Lego Click’ Fast Company Issue 50 viewed 4 December 2008 http://www.fastcompany.com/magazine/50/lego.html?page=0%2C5 Doukas J A & Lang L H P (2003) ‘Foreign direct investments, diversification and firm performance’ Journal of International Business Studies Issue 34 pp 153-172 Dutta S Zbaracki, & Bergen M (2003) ‘Pricing process as a capability: A resource –based perspective’ Strategic Management Journal Issue 24 pp 615-630 Hitt A Michael, Ireland R Duane, Hoskisson E Robert (2005) ‘Strategic Management: Competitiveness and Globalization’ Edition VI Thomson South-Western Kim. 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