on-line seminar series

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On-Line Seminar SeriesOn-Line Seminar Series

January 18, 2001

LGO-SDM ALUMNI

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As You Join the Session. . .As You Join the Session. . .• Please answer the following questions and send your

response via the “question” window on your screen.

• What are you hoping to learn from the presenter and your fellow alums about vertical or virtual integration today?

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Vertical or Virtual Vertical or Virtual Integration?Integration?

The Issues and ChallengesThe Issues and ChallengesSara L. Beckman

Haas School of BusinessUniversity of California, Berkeley

[email protected]://www.haas.berkeley.edu/faculty/beckman.html

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Objectives:Objectives:• Provide information on vertical and virtual integration:

– Some definitions– Considerations in making vertical/virtual integration

decisions• Economic• Strategic

– A model for making vertical/virtual integration decisions• Initiate an ongoing conversation on strategic decision

making in operations management and test distance learning software as a means of having that conversation

Poll: How Vertically Integrated Is Your Poll: How Vertically Integrated Is Your Firm?Firm?

• [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.]

• Highly• Moderately• Somewhat• Not much• Not at all

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There Is a Broad Spectrum of There Is a Broad Spectrum of Supplier Relationships; Vertical Supplier Relationships; Vertical Integration Defines One EndpointIntegration Defines One Endpoint

Arm’s Length

Linked Agreements

Partnerships Partial Vertical Integration

Full Vertical Integration

TraditionalCost-based“Free market”Short durationPurchase-order driven

Long-term supply contractsValue-added services (e.g., supplier managed inventories)

Joint development or optimization of products and/or processesEquity stake often involved

Firm owns some, but not enough capacity in a given process; outsources the rest

Firm owns all the capacity required to meet its own internal demand

Poll: Where Would You Place VIRTUAL Poll: Where Would You Place VIRTUAL Integration on That Spectrum?Integration on That Spectrum?


• A network of arm's length arrangements• A network of linked agreement arrangements • A network of partnership-based arrangements• A network of suppliers supporting a partially vertically

integrated company• A combination of such arrangements

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Where does VIRTUAL integration Where does VIRTUAL integration fall on this spectrum?fall on this spectrum?

Arm’s Length

Linked Agreements

Partnerships Partial Vertical Integration

Full Vertical Integration

TraditionalCost-based“Free market”Short durationPurchase-order driven

Long-term supply contractsValue-added services (e.g., supplier managed inventories)

Joint development or optimization of products and/or processesEquity stake often involved

Firm owns some, but not enough capacity in a given process; outsources the rest

Firm owns all the capacity required to meet its own internal demand

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Virtual Integration Has Become a Real Virtual Integration Has Become a Real Option in Recent Years Due To:Option in Recent Years Due To:

• The evolution of new forms of contracting with suppliers

• The advent of new service industries that provide specialized intermediate capability

• The development of information technology that supports cross-organizational coordination– 60s/70s mainframe-based MRP– 70s-80s PC-based information access– mid-80s network integration within companies– late 90s Internet integration across firm boundaries

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In essence, the firm has to answer the In essence, the firm has to answer the following questions to develop a “VI” following questions to develop a “VI” strategy:strategy:

• Breadth: In how much of the supply chain does my firm want to be “heavily” involved?– Direction: Do we want to move upstream (backward) or

downstream (forward) in our supply chain? (Note: From 1899 to 1948, forward integration was three times more common than backward integration.)

– Extent: How far?• Form: What form of relationship do we want to have with our

outside resources/suppliers? i.e., How “heavily” will we be involved?

• Change: What will trigger us to consider a change in our vertical integration strategy?

Poll: Is Your Firm Thinking About:Poll: Is Your Firm Thinking About:


• Becoming more forward integrated (moving towards the marketplace)?

• Becoming more backward integrated (moving towards the supply base)?

• Maintaining current levels of integration?• Becoming less forward integrated?• Becoming less backward integrated?

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Typical Considerations in Making Typical Considerations in Making a Vertical Integration Decision:a Vertical Integration Decision:

• Setup costs• Transaction costs• Risk• Coordination effectiveness

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Setup CostsSetup CostsVERTICAL INTEGRATION• Capital (e.g., equipment,

acquisitions)• Systems development• TrainingVIRTUAL INTEGRATION• Relationship negotiation• Contract

COST

Arm’sLength

Full VerticalIntegration

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Transaction CostsTransaction Costs• Information collection and

processing• Legal• Sales and purchasing• Physical handling costs

C

O

S

T

Arm’sLength


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RisksRisks• Possibility for unreasonable

price changes• Supply or outlet foreclosure• Insulation from market• Insulation from technology

sources

C

O

S

T

Arm’sLength


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Coordination EffectivenessCoordination Effectiveness• Run lengths, inventory levels• Capacity utilization• Delivery performance• Quality

C

O

S

T

Arm’sLength


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So, What’s Better?So, What’s Better?Virtual Integration Vertical Integration

Setup Costs

Transaction Costs

Risk

Coordination Effectiveness

Poll: What's better if you want to be an Poll: What's better if you want to be an innovative organization?innovative organization?


• Arm’s length arrangements• Linked agreements• Partnerships (virtual organization)• Vertical integration

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What’s Better If You Want to What’s Better If You Want to Innovate?Innovate?

• It depends.– Autonomous innovations can be handled in virtual

– even arm’s length -- environments– Systemic innovation (e.g., lean manufacturing) is

harder– Lack of industry standards favors vertically

integrated firms that have the clout to advance new standards

• “Virtuous virtuals” are at the center of a network they use to leverage their own capabilities; their unique competencies drive the network’s success

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Some rough rules of thumb:Some rough rules of thumb:Autonomous Innovation

Systemic Innovation

Capabilities exist outside

Go virtual Ally with caution, probably tighter

alliances

Capabilities must be created

Ally or bring in house

Bring in house

Poll: What's Better If You Want to Provide a Poll: What's Better If You Want to Provide a High Degree of Customization?High Degree of Customization?


• Arm's length arrangements• Linked agreements• Partnerships (virtual)• Vertical integration

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Pure Customization

Design

Fabrication

Distribution

Assembly

Tailored Customization

Fabrication

Distribution

Design

Assembly

Customized Standardization

Design

Fabrication

Distribution

Assembly

Segmented Standardization

Design

Fabrication

Assembly

Distribution

Pure Standardization

Design

Fabrication

Distribution

Assembly

Custom

Standard

Customization StrategiesCustomization Strategies

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Market Structure May Also Market Structure May Also Suggest Vertical IntegrationSuggest Vertical Integration

One Buyer Few Buyers Many Buyers

One Seller Sellers dominate

Few Sellers Sellers dominate

Many Sellers Buyers dominate

Buyers dominate

No one dominates

High TradingRisk

A firm may want to vertically integrate to defend against market power or to create and exploit it

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As May Asset SpecificityAs May Asset SpecificityLow Asset Specificity, Durability and Intensity

High Asset Specificity, Durability and Intensity

Low Transaction Frequency

Detailed, standardized contracts (e.g., office lease, credit sale arrangements)

Detailed, probably unique contract (e.g., major public construction projects)

High Transaction Frequency

Standardized transactions (e.g., groceries)

Vertical integration (e.g., bauxite, specialized auto components)

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Or, Perhaps It Is Just the Right Or, Perhaps It Is Just the Right Time in the Industry Life CycleTime in the Industry Life Cycle

Pressure todisintegrate

Pressure to integrate

Integralproduct,verticalindustry

Modularproduct,

horizontalindustry

Nichecompetitors

High-dimensionalcomplexity

Technicaladvances

Organizationalrigidities

Suppliermarket power

Proprietarysystem

profitability

Charles Fine, Clockspeed: Winning Industry Control in the Age of Temporary Advantage

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To develop your own “VI” To develop your own “VI” strategy:strategy:

• Step 1: Characterize your present supply chain– Identify all “natural” business units that could not

be further disaggregated from an ownership perspective

– Assess number and sizes of all participants at each stage

– Determine the types of transactions that currently take place among the various members of the chain

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• Step 2: Perform a “static” analysis of the chain– Assess degree of asset specificity at each stage– Measure transaction frequency– Estimate economics at each stage– Assess effects if weak and powerful players were

to change their position– Identify key sources of technological innovation– Identify key loci for customization

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• Step 3: Perform a “dynamic analysis” of the chain– Predict future changes in industry structure– Predict changes in integration strategy by other

players– Predict strategic needs for supply chain

performance • Technological advancement• Customization

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• Step 4: Identify, assess and choose from a set of alternative strategies– Quantify and weigh the setup costs, transaction

costs, risks and coordination effectiveness of each option

– Assess the strategic implications of each option– Choose one– Develop a (staged) implementation plan

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Questions?Questions?

Poll: Would you be interested in an ongoing Poll: Would you be interested in an ongoing discussion of this or other operations strategy topics?discussion of this or other operations strategy topics?

• [PlaceWare Yes/No Poll. Use PlaceWare > Edit Slide Properties... to edit.]

• Yes• No

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Poll: If so, would you want to talk:Poll: If so, would you want to talk:


• Once/year• Once/quarter• Once/every other month• Once/month

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Poll: What Format Appeals Most?Poll: What Format Appeals Most?


• Discuss problem company is solving• Discuss new research paper on topic• Have presentation from professor

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Further InformationFurther Information• Papers and theses:

http://lfmsdm.mit.edu (password for theses needed: contact [email protected] if you don’t have it)

• [email protected] [email protected]

• (415) 464-0517

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ReferencesReferences• Chesbrough, Henry W. and David J. Teece, “When is

Virtual Virtuous? Organizing for Innovation,” Harvard Business Review, January-February, 1996.

• Stuckey, John and David White, “When and When Not to Vertically Integrate,” Sloan Management Review, Spring 1993.

• Hill, Terry, Manufacturing Strategy: Text and Cases, 2000

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