The methods organisations use to grow, internal (organic) growth and external growth through horizontal, vertical and conglomerate integration, mergers and takeovers, and methods of contracting such as divestment, demerger and outsourcing.

What this key area is asking

Once a business decides to grow (an objective from the previous key area), it must choose how. The SQA wants you to distinguish internal (organic) growth from external growth, to classify external growth by the type of integration, and to recognise that firms sometimes deliberately get smaller (divestment, demerger, outsourcing). Higher expects the advantages and disadvantages of each, not just definitions.

Internal (organic) growth

Internal growth is steady and lower risk: the firm keeps full control, builds on what it knows, and avoids the cost and culture clash of a takeover. The drawback is that it is slow, may be limited by the size of the market, and requires the business to fund expansion itself. A coffee chain opening 20 new shops a year is growing organically.

External growth and types of integration

External growth means combining with another business to get bigger quickly. It is classified by the relationship between the two firms.

• Horizontal integration quickly grows market share and cuts unit costs, but may attract the attention of competition regulators and can be hard to integrate two cultures.
• Vertical integration secures the supply chain and captures more of the profit, but ties up capital and reduces flexibility.
• Conglomerate integration spreads risk so a downturn in one market does not sink the whole group, but managers may lack expertise in the new, unrelated field.

Mergers and takeovers

External growth is carried out in one of two ways:

• A merger is when two firms agree to join together to form a new, larger company, usually as equals. It is friendly and can combine the strengths of both.
• A takeover (acquisition) is when one firm buys a controlling interest (more than half the shares) in another. It can be friendly (agreed) or hostile (resisted by the target's directors). Takeovers are fast but expensive, risk a clash of cultures, and may lead to job losses and resistance.

Methods of contracting (getting smaller)

The SQA also expects you to know that firms sometimes shrink deliberately to focus, raise cash or improve efficiency:

• Divestment: selling off a part of the business, such as a division or subsidiary, often to raise cash or concentrate on the core activity.
• Demerger: splitting one company into two or more separate companies, for example so each can focus on its own market or be valued separately.
• Outsourcing (subcontracting): paying an outside specialist to carry out an activity (IT, cleaning, payroll, manufacturing) rather than doing it in house, to cut costs and focus on the core business.

Examples in context

Example 1. A supermarket buying a rival (horizontal). When one large supermarket chain acquires another, it grows market share overnight, removes a competitor and spreads fixed costs over more stores (economies of scale). However, the deal may be referred to the competition authorities, and merging two store networks, brands and cultures is difficult, which is the standard evaluation point.

Example 2. A drinks giant diversifying (conglomerate). A large drinks company buying a snacks business is conglomerate integration: the two products are unrelated, so the group spreads risk across two markets, meaning a slump in drinks sales can be offset by snacks. The risk is that the managers know drinks, not snacks, so the acquired firm may underperform without the right expertise.

Try this

Q1. Distinguish between internal and external growth. [2 marks]

• Cue. Internal (organic) growth expands the business from within using its own resources (new outlets, products, markets); external growth combines with another business through a merger or takeover.

Q2. Describe two reasons a business might choose to outsource an activity. [4 marks]

• Cue. To cut costs because a specialist is more efficient; to focus on its core business; to avoid the cost of employing and training staff for the task; to turn fixed costs into variable costs and gain flexibility (any two, developed).