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Vertical integration

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Mission Objectives

ExternalAnalysis

InternalAnalysis

StrategicChoice

StrategyImplementation

CompetitiveAdvantage

The Strategic Management Process

Corporate LevelStrategy

Which Businessesto Enter?

• Vertical Integration

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Logic of Corporate Level Strategy

Corporate level strategy should create value:

2) such that businesses forming the corporate wholeare worth more than they would be under independent ownership

3) that equity holders cannot create throughportfolio investing

• a corporate level strategy should createsynergies that are not available in equitymarkets

• vertical integration = value chain economies

1) such that the value of the corporate whole increases

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What is Vertical Integration?

Leprino Foods(Mozzarella Cheese)

Where your pizza comes from

Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

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What is Vertical Integration?

Leprino Foods(Mozzarella Cheese)

Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

BackwardVertical

Integration

ForwardVerticalIntegration

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Value Chain Economies

Dairy Farmers(milk)

Food Distributors

BackwardVertical

Integration

ForwardVerticalIntegration

Leprino Foods(Mozzarella Cheese)

The Logic of Value Chain Economies

• the focal firm is able tocreate synergy with theother firm(s)

• the focal firm is able tocapture above normal economic returns(avoid perfect competition)

• cost reduction

• revenue enhancement

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• Begins with the acquisition of raw materials• Ends with the sale of finished goods/services• Includes support services such as Finance and Marketing

• Organizing the vertical chain is an important part of business strategy

Vertical Chain

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• Which steps of the vertical chain are to be performed inside the firm?

• Which steps of the vertical chain to be out-sourced?

• Choice between the “invisible hand” of the market and the “visible hand” of the organization (Make or Buy)

Vertical Boundaries of the Firm

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• Decision depends on the costs and benefits of using the market as opposed to performing the task in-house

• Outside specialists may perform a task better than the firm can

• Intermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)

Make versus Buy

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• Firm should make rather than buy assets that provide competitive advantages

• Outsourcing an activity eliminates the cost of that activity• Backward integration captures the profit margin of the

supplier• Backward integration insures against the risk of high input

prices• It makes sense to tie up the distribution channel in order

to deny access to the rivals

Some Make-or-Buy Fallacies

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• A firm believes that a particular asset is a source of competitive advantage

• It turns out the asset is easily available in the market• The belief regarding competitive advantage will have to be re-

evaluated

• Example: • GM span off Delphi Electronic. Delphi makes parts for cars. GM felt

that if Delphi was competing on the market with other firms, it would be forced to lower its prices. Moreover, Delphi can get scale economies by supplying other firms, thus lowering costs.

Make-or-Buy and Competitive Advantage

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• Outsourcing an activity eliminates the cost of that activity

• It should not matter if the costs of performing an activity are incurred by the firm (Make) or by the supplier (Buy)

• Outsourcing also has its costs. Suppliers also need to make investments and these costs need to be covered. We will see that supplier markets and asset specificity play an important role here.

• Finally, the relevant consideration is whether it is more efficient to make or to buy

Outsourcing and Cost

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• Backward integration captures the profit margin of the supplier

• The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne

• If the supplier is earning economic profit, what is the reason for its persistence?

• Market competition should eventually erode away the economic profit

Backward Integration and Profits

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• Backward integration insures against the risk of high input prices

• Instead of vertical integration, forward or futures contracts can be used to hedge input price risk

• Another possibility is that the capital tied up in vertical integration could be used to set up a self insurance fund

• Vertical integration into a risky activity will add rather than reduce the overall risk

Vertical Integration and Input Price Risk

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Example: Rustic Log Homes

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• It makes sense to tie up the distribution channel in order to deny access to the rivals

• Two possibilities• It may be easy for rivals to open up new channels• If not, the price paid to acquire the channel will reflect the value

• In either case, economic profits do not always flow from the foreclosure of distribution channels

• Example: Intel

Foreclosure of Distribution Channels

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• Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible

• Market firms can achieve economies of scale that in-house units cannot

• Market firms are subject to market discipline, whereas in-house units may be able to hide their inefficiencies behind overall corporate success (Agency and influence costs)

Benefits of Using the Market

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Economies of Scale

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• A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakes

• An outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers

• An automobile manufacturer would rather buy anti-lock brakes from an independent supplier than from a competitor

• Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer

• Will the outside supplier charge c* (its average cost) or c’ (the average cost for the manufacturer for in-house production)?

• The answer depends on its degree of competition faced by the supplier

Economies of Scale

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• The incentives to be efficient and innovative are weaker when a task is performed in-house

• Agency costs are particularly problematic if the task is performed by a “cost center” within an organization

• It is difficult to internally replicate the incentives faced by market firms

Agency and Influence Costs

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• Costs imposed by poor coordination• Reluctance of partners to share valuable private

information• Transactions cost that can be avoided by performing the

task in-house• Each problem can be traced to difficulties in contracting

Problems in Using the Market

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• Firms often use contracts when certain tasks are performed outside the firm

• Contracts list• the set of tasks that need to be performed • the remedies if one party fails to fulfill its obligation

• Contracts protect each party to a transaction from opportunistic behavior of other(s)

• Contracts’ ability to provide this protection depends on• the “completeness” of contracts• the body of contract law

Role of Contracts

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• A complete contract stipulates what each party should do for every possible contingency• No party can exploit others’ weaknesses• To create a compete contract one should be able to contemplate all

possible contingencies• One should be able to “map” from each possible contingency to a set of

actions• One should be able to define and measure performances• One should be able to enforce the contract

• To enforce a contract, an outside party (judge, arbitrator) should be able to• observe the contingency• observe the actions by the parties• impose the stated penalties for non-performance

• Real life contracts are usually incomplete contracts

Complete Contract

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• Incomplete contracts• Involve some ambiguities• Need not anticipate all possible contingencies• Do not spell out rights and responsibilities of parties completely

Factors that Prevent Complete Contracting• Bounded rationality• Difficulties in specifying/measuring performance• Asymmetric information

Incomplete Contracts

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• Individuals have limited capacity to• Process information• Deal with complexity• Pursue rational aims

• Individuals cannot foresee all possible contingencies• Example: could we have foreseen the financial crisis in

2008? Few did, but its affects were dramatic.

Bounded Rationality

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• Terms like “normal wear and tear” may have different interpretations

• Performance cannot always be measured unambiguously

• Example: how do you measure the performance of service that is being provided?

Difficulties in Specifying/Measuring Performance

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• Parties to the contract may not have equal access to contract-relevant information

• One party can misrepresent information with impurity

• Example: suppose that Hyundai would like to award TRW Automotive a bonus if TRW maintains stringent quality control in the production of antilock brakes

• How can this be Hyundai be sure that quality is high if TRW carries out the quality controls?

Asymmetric Information

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• For successful coordination one party needs to make decisions that depend on the decision made by others

• A good fit should be accomplished in several dimensions• Timing• Size• Color• Sequence• R & D

Coordination of Production Flows

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• Without good coordination, bottlenecks arise in the vertical chain

• Coordination is especially important when “design attributes” are present

• To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets

Coordination Problems

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• Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value results

• Some examples• Sequencing of courses in MBA curriculum• Fit of auto sunroof glass to aperture• Timely delivery of a critical component

• If coordination is critical, administration control may replace the market mechanism

• Design attributes may be moved in-house

Design Attributes

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• Firms would not want to compromise the source of their competitive advantage, hence some activities cannot be out-sourced

• Sometimes, contracts can be used to protect against leakage of critical information(Example: Non-compete clause for employees)

Leakage of Private Information

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• If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)

• Costs of using the market that are saved by centralized direction – transactions costs

• Out-sourcing entail costs of negotiating, writing and enforcing contracts

• Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior

• Transactions costs explain why economic activities occur outside the price system

Transactions Costs

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• Relation-specific assets are essential for a given transaction

• These assets cannot be redeployed for another transaction costlessly

• Once the asset is in place, the other party to the contract cannot be replaced costlessly, because the parties are locked into the relationship to some degree

Relationship-Specific Assets

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• Relation-specific assets may exhibit different forms of specificity• Site specificity• Physical asset specificity• Dedicated assets• Human asset specificity

Forms of Asset Specificity

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• Assets may have to be located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency• Cement factories are usually located near lime stone

deposits• Can-producing plants are located near can-filling plants

Site Specificity

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• Physical assets may have to be designed specifically for the particular transaction• Molds for glass container production custom made for a

particular user• A refinery designed to process a particular grade of

bauxite ore

Physical Asset Specificity

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• Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable• International systems’ investment in assembly line

making integrated circuits for IBM• A defense contractor’s investment in manufacturing

facility for making certain advanced weapon systems

Dedicated Assets

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• Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information• Clerical workers in a physicians office acquire the skills

to use a particular practice management software• Salespersons posses detailed knowledge of customer

firm’s internal organization

Human Asset Specificity

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• The term ‘rent” denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted

• Quasi-rent is the excess economic profit from a transaction compared with economic profits available form an alternate transaction

Rent and Quasi-rent

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• Firm A makes an investment to produce a component for Firm B after B has agreed to buy from A at a certain price

• At that price A can earn an economic profit of π1

• If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be π2

Rent and Quasi-rent

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• Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1)

• Quasi-rent is the economic profit in excess of the minimum needed to retain A in the selling relationship with B (π1- π2)

Rent and Quasi-rent

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• Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itself

• A complete contract will not permit the breach• With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

The Holdup Problem

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• The holdup problem raises the cost of transacting exchanges• Contract negotiations become more difficult• Investments may have to be made to improve the ex-

post bargaining position• Potential holdup can cause distrust• There could be underinvestment in relation specific

assets

Effect on Transactions Costs

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• Relation-specific assets support a particular transaction

• Redeploying to other uses is costly• Quasi rents become available to one party and there is incentive for a holdup

• Potential for holdups lead to• Underinvestment in these assets• Investment in safeguards• Reduced trust

Asset Specificity and Transactions Costs

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Power Barges

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Competitive Advantage

If a vertical integration strategy meets theVRIO criteria…

Is it Valuable?

Is it Rare?

Is it costly to Imitate?

Is the firm Organized to exploit it?

…it may create competitive advantage.

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Value of Vertical Integration

Market vs. Integrated Economic Exchange

• economic exchange should be conducted in the formthat maximizes value for the focal firm

• markets and integrated hierarchies are ‘forms’ in whicheconomic exchange can take place

• thus, firms assess which form is likely to generatemore value

Integration makes sense when the focal firm can capture more value than a market exchange provides

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Value of Vertical Integration

Three Value Considerations

LeverageCapabilities

ExploitFlexibility

ManageOpportunism

• firm capabilitiesmay be sourcesof competitiveadvantage inother businesses

• if not, then don’tintegrate exchange

• opportunismmay be checkedby internalizing (TSI)

• internalizing mustbe less costly thanopportunism

• internalizing isusually lessflexible

• flexibility is prized whenuncertainty ishigh

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Rarity of Vertical Integration

Integration vs. Non-Integration

• a firm’s integration strategy may be rare becausethe firm integrates or because the firm does notintegrate

• thus, the question of rareness does notdepend on the number of forms observed

• a firm’s integration strategy is rare or common withrespect to the value created by the strategy

Example: Toyota’s Choice Not to Integrate Suppliers

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Imitability of Vertical Integration

Form vs. Function

• the form, per se, is usually not costly to imitate

• the value-producing function of integration maybe costly to imitate, if:

• the integrated firm possesses resourcecombinations that are the result of:

• historical uniqueness

• causal ambiguity

• social complexity

• small numbers prevent further integration

• capital requirements are prohibitive

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Imitability of Vertical Integration

Modes of Entry

• acquisition and internal development are alternativemodes of entry into vertical integration

• strategic alliances can be viewed as a substitute forvertical integration—without the costs of ownership

• thus, one firm may acquire a supplier while acompetitor could imitate that strategy throughinternal development

• in both cases, the boundaries of the firm wouldencompass the new business

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Organizing Vertical Integration

Functional Structure (U-Form)

Accounting Finance Marketing HR Engineering

Conflict

Con

flict

OriginalBusiness

NewBusiness

OriginalBusiness

NewBusiness

NewBusiness

NewBusiness

NewBusiness

OriginalBusiness

OriginalBusiness

OriginalBusiness

Cooperation

Cooperation

CEO’s Role

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Organizing Vertical Integration

Management Controls

What needs to be ‘controlled’ in a vertically integratedfirm?

• cooperation and competition among and betweenfunctions

• the integration of new businesses into the existing business

• managers’ efforts to achieve the desired valuechain economies

• time horizon of managers

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Organizing Vertical Integration

Management Controls

BudgetsBoard

Committees

• separating strategic andoperational budgets

• strategic: inputs& outputs

• operational: outputs

• provide oversight and direction to managers

• help ensure that strategicdirection is maintained

These mechanisms focus management attentionon achieving value chain economies

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Organizing Vertical Integration

CompensationSalary

Cash Bonus: Individual

Stock Grants: Individual

Cash Bonus: Group

Stock Grants: Group

Stock Options: Individual

Stock Options: Group

Opportunism

LeveragingCapabilities

ExploitingFlexibility

Cooperation

Time Horizon

Integration

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Summary

Vertical Integration…

• makes sense when value chain economiescan be created and captured

• may allow a firm to leverage capabilities

• may be a response to the threat of opportunismand uncertainty

• as a form of exchange per se, is not rare norcostly to imitate

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Summary

Vertical Integration…

• is an important consideration in the decisionto expand internationally (range of possibilities)

• makes sense when done for the right reasons,under the right circumstances

• can be a costly mistake if done wrong

Ownership is costly—integrate only when thebenefits outweigh the costs of integration!