Copyright © 2004 McGraw Hill Companies, Inc. All rights reserved. PowerPoint Presentation by Charlie Cook

Gordon WalkerGordon WalkerMcGraw-Hill/Irwin

Chapter 6

Vertical Integration and Outsourcing

Chapter 6

Vertical Integration and Outsourcing

6–2

Theories of Vertical IntegrationTheories of Vertical IntegrationTheories of Vertical IntegrationTheories of Vertical Integration

• Key assumptionsKey assumptions– The employment relationshipThe employment relationship– OwnershipOwnership

• Transaction cost theoryTransaction cost theory

• Theory of property rightsTheory of property rights

6–3

The Employment RelationshipThe Employment RelationshipThe Employment RelationshipThe Employment Relationship

• Employees, unlike market suppliers, give up Employees, unlike market suppliers, give up control over aspects of work that cannot be control over aspects of work that cannot be specified in detail.specified in detail.

• Employee recourse against the firm is Employee recourse against the firm is generally more limited than the recourse of a generally more limited than the recourse of a supplier.supplier.

6–4

Transaction Cost TheoryTransaction Cost TheoryTransaction Cost TheoryTransaction Cost Theory

• Key assumption is that all contingencies in a Key assumption is that all contingencies in a supply relationship cannot be specified:supply relationship cannot be specified:

– Transaction costs in the market increase Transaction costs in the market increase relative to vertical integration as a supplier relative to vertical integration as a supplier invests in assets specialized to the firm.invests in assets specialized to the firm.

– These costs are aggravated by high levels These costs are aggravated by high levels of uncertainty.of uncertainty.

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The Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries Model

Figure 6.1Source: Adapted from Oliver Williamson, “The Economics of Organization: The Transaction Cost Approach,” American Journal of Sociology 87 (1981), p. 560.

6–6

The Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries Model

• Market supply should always be the first Market supply should always be the first consideration when:consideration when:

– The input is not customized for the buyer.The input is not customized for the buyer.

– Transactions with market suppliers are Transactions with market suppliers are more efficient than in-house transactions. more efficient than in-house transactions.

– Production costs are much higher in-house.Production costs are much higher in-house.

6–7

The Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries ModelThe Efficient Boundaries Model

• In-house production becomes more attractive In-house production becomes more attractive when:when:

– Input customization increases and market Input customization increases and market suppliers use their bargaining power to reduce suppliers use their bargaining power to reduce the firm’s surplus from the input.the firm’s surplus from the input.

– In-house transactions are among firm In-house transactions are among firm employees who lack the transacting power of employees who lack the transacting power of suppliers.suppliers.

– The production cost advantage of market The production cost advantage of market suppliers declines with customization due to a suppliers declines with customization due to a lower volume of purchases reducing scale-lower volume of purchases reducing scale-based efficiencies.based efficiencies.

6–8

Property Rights TheoryProperty Rights TheoryProperty Rights TheoryProperty Rights Theory

• A firm vertically integrates because it has A firm vertically integrates because it has more to gain from owning and operating the more to gain from owning and operating the activity than the market supplier.activity than the market supplier.

– This theory is most applicable to resources This theory is most applicable to resources that can be traded.that can be traded.

– It is difficult to separate the value of the It is difficult to separate the value of the asset independently of employees (with asset independently of employees (with specific capabilities) attached to it.specific capabilities) attached to it.

6–9

Strategy and ControlStrategy and ControlStrategy and ControlStrategy and Control

• A firm wants to control investment decisions A firm wants to control investment decisions in supplier resources and capabilities that are in supplier resources and capabilities that are strategically important.strategically important.– Strategically important activities are more Strategically important activities are more

likely to be specialized to the firm as it likely to be specialized to the firm as it becomes more involved in supplier becomes more involved in supplier investment decisions.investment decisions.

6–10

Types of Control ProblemsTypes of Control ProblemsTypes of Control ProblemsTypes of Control Problems

• Distribution of economic gain from the supply Distribution of economic gain from the supply relationshiprelationship– Negotiation over price:Negotiation over price:

» What is the buyer’s surplus? What is the buyer’s surplus?

» What is the supplier’s profit?What is the supplier’s profit?

• Supplier investment decisions are focused on Supplier investment decisions are focused on value and costvalue and cost– Assets and activitiesAssets and activities– Human resourcesHuman resources– Management processesManagement processes

6–11

Types of Control Problems (cont’d)Types of Control Problems (cont’d)Types of Control Problems (cont’d)Types of Control Problems (cont’d)

• Supplier handling of strategically sensitive Supplier handling of strategically sensitive information about the firm:information about the firm:– TechnologicalTechnological– StrategicStrategic

6–12

Strategic Sourcing FrameworkStrategic Sourcing FrameworkStrategic Sourcing FrameworkStrategic Sourcing Framework

Figure 6.2

6–13

Patterns of Vertical Integration IPatterns of Vertical Integration IPatterns of Vertical Integration IPatterns of Vertical Integration I

• Initial market purchase of a standard inputInitial market purchase of a standard input– Low buyer competenceLow buyer competence– Low strategic importanceLow strategic importance

• Rising strategic importance of the inputRising strategic importance of the input– Low buyer competenceLow buyer competence– High strategic importance High strategic importance

• Supplier unable to give the firm the control it Supplier unable to give the firm the control it needsneeds– Partnering failsPartnering fails

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Patterns of Vertical Integration I Patterns of Vertical Integration I (cont’d)(cont’d)

Patterns of Vertical Integration I Patterns of Vertical Integration I (cont’d)(cont’d)

• The firm vertically integrates as it invests in The firm vertically integrates as it invests in building capabilities to increase its building capabilities to increase its competence.competence.– High buyer competenceHigh buyer competence– High strategic importanceHigh strategic importance

• Key point: The firm has a strong incentive to Key point: The firm has a strong incentive to continue investing in the activity since it is continue investing in the activity since it is strategically important.strategically important.

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Patterns of Vertical Integration IIPatterns of Vertical Integration IIPatterns of Vertical Integration IIPatterns of Vertical Integration II

• Initial market purchase of a standard inputInitial market purchase of a standard input– Low buyer competenceLow buyer competence– Low strategic importanceLow strategic importance

• The firm’s competence rises due to unrelated The firm’s competence rises due to unrelated investments in capabilities.investments in capabilities.– High buyer competenceHigh buyer competence– Low strategic importanceLow strategic importance

• The firm vertically integrates even though the The firm vertically integrates even though the input is not strategically important.input is not strategically important.

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Patterns of Vertical Integration IIPatterns of Vertical Integration IIPatterns of Vertical Integration IIPatterns of Vertical Integration II

• Key point: the firm has no incentive to Key point: the firm has no incentive to continue investing in the activity since it is not continue investing in the activity since it is not strategically important. strategically important.

6–17

Patterns of Outsourcing IPatterns of Outsourcing IPatterns of Outsourcing IPatterns of Outsourcing I

• Producing a specialized input in a firmProducing a specialized input in a firm– High buyer competenceHigh buyer competence– High strategic importanceHigh strategic importance

• The firm’s competence relative to competitors The firm’s competence relative to competitors decreases.decreases.– Low buyer competenceLow buyer competence– High strategic importance High strategic importance

• The firm’s partnership with a market supplier The firm’s partnership with a market supplier gives it control over investment decisions to gives it control over investment decisions to support the firm’s market position.support the firm’s market position.

6–18

Patterns of Outsourcing I (cont.)Patterns of Outsourcing I (cont.)Patterns of Outsourcing I (cont.)Patterns of Outsourcing I (cont.)

• The partner fails to cooperate effectivelyThe partner fails to cooperate effectively

– The firm invests in new capabilities to The firm invests in new capabilities to increase its competence and vertically increase its competence and vertically integrates the activity.integrates the activity.

– The firm reduces the strategic importance The firm reduces the strategic importance of the activity and sources the input from a of the activity and sources the input from a standard market supplier.standard market supplier.

6–19

Patterns of Outsourcing IIPatterns of Outsourcing IIPatterns of Outsourcing IIPatterns of Outsourcing II

• Initial purchase of a specialized inputInitial purchase of a specialized input– High buyer competenceHigh buyer competence– High strategic importanceHigh strategic importance

• Strategic importance of the input decreasesStrategic importance of the input decreases– High buyer competenceHigh buyer competence– Low strategic importance Low strategic importance

• The firm disinvests in the activity The firm disinvests in the activity – Low buyer competenceLow buyer competence– Low strategic importanceLow strategic importance

• The firm outsources to a competent supplierThe firm outsources to a competent supplier

6–20

Key PointsKey PointsKey PointsKey Points

• Control needs dominate vertical integration Control needs dominate vertical integration decisions.decisions.

• Control and buyer competence affect Control and buyer competence affect outsourcing.outsourcing.

• Vertical integration almost always involves a Vertical integration almost always involves a change in the way the activity is executed.change in the way the activity is executed.– Otherwise there would be no benefit from Otherwise there would be no benefit from

increased control.increased control.

6–21

The Problem of UncertaintyThe Problem of UncertaintyThe Problem of UncertaintyThe Problem of Uncertainty

• Areas of significant uncertainty:Areas of significant uncertainty:– The level of demand for the organization’s The level of demand for the organization’s

productproduct– The long-term viability of the organization’s The long-term viability of the organization’s

product or process technologyproduct or process technology– The price of labor and other inputs to the The price of labor and other inputs to the

organization’s production process.organization’s production process.

• Types of uncertaintyTypes of uncertainty– VolumeVolume– TechnologicalTechnological– Supplier input costsSupplier input costs

» Labor and materialsLabor and materials

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The Problem of Uncertainty (cont’d)The Problem of Uncertainty (cont’d)The Problem of Uncertainty (cont’d)The Problem of Uncertainty (cont’d)

• Focus on volume and technological Focus on volume and technological uncertaintyuncertainty– Volume uncertaintyVolume uncertainty

» Generally, higher volume uncertainty leads to Generally, higher volume uncertainty leads to higher levels of vertical integration.higher levels of vertical integration.

– Technological uncertaintyTechnological uncertainty» Higher levels of technological uncertainty lead to Higher levels of technological uncertainty lead to

lower levels of vertical integration, especially if the lower levels of vertical integration, especially if the market is competitive.market is competitive.

6–23

The Problem of ConsistencyThe Problem of ConsistencyThe Problem of ConsistencyThe Problem of Consistency

• Gains from consistency among activities Gains from consistency among activities determine in part the firm’s need for control determine in part the firm’s need for control over them.over them.

• System-wide benefits from coordination System-wide benefits from coordination inhibit the outsourcing of a single activity.inhibit the outsourcing of a single activity.

6–24

Strategic Boundaries Over Strategic Boundaries Over the Industry Life Cyclethe Industry Life Cycle

Strategic Boundaries Over Strategic Boundaries Over the Industry Life Cyclethe Industry Life Cycle

• Stigler’s theoryStigler’s theory– In the early stages of industry development, In the early stages of industry development,

firms are integrated because their demand for firms are integrated because their demand for inputs is too small to attract entry of suppliers.inputs is too small to attract entry of suppliers.

– As the industry grows and matures, suppliers As the industry grows and matures, suppliers enter and produce inputs for many firms.enter and produce inputs for many firms.

– Firms engage in outsourcing to gain benefits Firms engage in outsourcing to gain benefits from lower supplier costs.from lower supplier costs.

– As demand drops due to rising substitutes, As demand drops due to rising substitutes, suppliers exit and industry firms re-integrate suppliers exit and industry firms re-integrate production.production.

6–25

Strategic Boundaries Over Strategic Boundaries Over the Industry Life Cycle (cont’d)the Industry Life Cycle (cont’d)

Strategic Boundaries Over Strategic Boundaries Over the Industry Life Cycle (cont’d)the Industry Life Cycle (cont’d)

• Caveats to Stigler’s theoryCaveats to Stigler’s theory– Stigler’s theory only works for inputs that:Stigler’s theory only works for inputs that:

» Are specific to the new industry.Are specific to the new industry.

» Require supplier investment in specialized Require supplier investment in specialized production technology .production technology .

– Otherwise, suppliers may use parts of Otherwise, suppliers may use parts of existing production technology to make the existing production technology to make the new input.new input.

6–26

Make or Buy SoftwareMake or Buy SoftwareMake or Buy SoftwareMake or Buy Software

Figure 6.3