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Strategic Management Week 8 – Chapter 8

Vertical Integration

To change the company’s vertical scope

Chapter 8 Learning Objectives

• List the key types of strategies that a can firm can follow. • Define vertical integration, forward vertical integration and backward

vertical integration. • Discuss how vertical integration can create value through capitalization on

resources. • Discuss how vertical integration can create value through flexibility. • Describe conditions under which vertical integration may be rare and costly

to imitate. • Describe how a firm can get organized for vertical integration.

Ethics & Strategy

• Outsourcing/Offshoring • “When done well, outsourcing creates value –

value that firms can share with their owners, their stockholders”

• Expectation of stability: “As long as I do my job well, I will have a job”

• Softening the impact: early retirement, severance payments, outplacement

What Is a Value Chain?

• The activities that must be accomplished to bring a product/service from raw materials to the point that it can be sold to a final customer

BE BETTER THAN COMPETITORS (1) In individual elements of value chain

(2) In coordinating elements of value chain

(3) In selecting elements of value chain (make vs. buy)

X X

“You don’t need to own a dairy to buy milk.”

Ross Perot to GM Management prior to EDS’s acquisition

THREAT OF ENTRY • Erect barriers to entry

by building: – economies of scale – absolute cost

advantages • Influence govt. policy

requirements . . . • Overcome barriers to

entry through: – product

differentiation – . . .

THREAT OF SUBSTITUTES

Improve product’s attractiveness relative to substitutes: • Lower Prices • Product differentiation • Move into new businesses

INDUSTRY COMPETITIVENESS

• Compete on dimensions besides price

• Consolidate ownership • Build a first-mover

advantage . . .

BUYER POWER

Reduce Buyers’ Uniqueness • Forward Vertical Integration • Product Differentiation • Target New Market Segments

SUPPLIER POWER

Reduce Suppliers’ Uniqueness • Backward Vertical Integration • Use Multiple Suppliers

Source: Barney (1997)

Generic Responses to

Industry Forces

Logic of Corporate Level Strategy Corporate level strategy should create value:

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

3) that equity holders cannot create through portfolio investing

• A corporate level strategy should create synergies that are not available in equity markets

- In this pursuit, vertical integration potentially creates value chain economies

1) such that the value of the corporate whole increases

Direction of Vertical Integration

Integration

ForwardBackward

Types of Vertical Integration

• Backward Vertical Integration – Company expands its operations into an industry that produces inputs to the

company’s products. • Forward Vertical Integration

– Company expands into an industry that uses, distributes, or sells the company’s products.

• Full Integration – Company produces all of a particular input from its own operations. – Disposes of all of its completed products through its own outlets.

• Taper Integration – In addition to company-owned suppliers, the company will also use other

suppliers for inputs or independent outlets in addition to company-owned outlets.

Full and Taper Integration

Calculating Vertical Integration

Depreciation + amortization + fixed charges + interest expense + labor & related expenses + pension & retirement expenses

+ income taxes + net income (after tax) + rental expense ][ Net income +income taxes- [ ] Sales Net income +income taxes- [ ]

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

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

Backward Vertical

Integration

Forward Vertical

Integration

What is Vertical Integration?

Dairy Farmers (milk)

Food Distributors

Backward Vertical

Integration

Forward Vertical

Integration

Leprino Foods (Mozzarella Cheese)

The Logic of Value Chain Economies

• the focal firm is able to create synergy with the

other firm(s)

• the focal firm is able to capture above normal

economic returns (avoid perfect competition)

• cost reduction

• revenue enhancement

Value Chain Economies

Perspectives on Vertical Integration

Leverage Capabilities

Manage Opportunism

Exploit Flexibility

Firm capabilities may be sources of competitive advantage in other businesses

Opportunism may be checked by internalizing (TSI)

Internalizing is usually less flexible

If not, then don’t integrate exchange

Internalizing must be less costly than opportunism

Flexibility is prized when uncertainty is high

Perspectives on Vertical Integration

• Managing Opportunism – Opportunism: exploitation of unbalanced knowledge or

investment in relation to an exchange

• Leveraging Capabilities – Target firm has VRIO capabilities/resources – Acquiring firm has necessary VRIO resources/capabilities

to effectively engage in target’s business activities • Exploiting Flexibility

– Flexibility: cost to alter strategic/operational decisions – Uncertainty: value is unknown @ time of decision

Benefits of Vertical Integration

•Economies of combined operations •Economies of internal control and coordination •Assure supply or demand •Better quality control and coordination •Protect proprietary technology •Gain access to information •Avoid costs of dealing with the market •Gain (or offset) market power

•Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

The Costs of Vertical Integration

•Differences between stages in optimal scale of operation •Managing strategically different businesses •Agency costs •Higher capital investment •Reduced Flexibility

– in responding to demand uncertainty – in responding to changes in technology, customer preferences, etc.

•Foreclose access to outside information/technology •Dulled incentives •Costs of bureaucratic hierarchy

•Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

The Choice between Market and Hierarchy

BENEFITS

COSTS

MARKET HIERARCHY

Informational Efficiencies

High-Powered Incentives

Transaction Costs

Market Power

Authority

Coordination

Bureaucracy

Agency theory

Source: Collis and Montgomery, Corporate Strategy, 1997

How can you decide whether V.I. Is good? Pros • Economies of combined

operations

• Economies of internal control and coordination

• Assure supply or demand

• Better quality control

• Protect proprietary technology

• Gain access to information

Cons • Differences between

stages in optimal scale of operation

• Managing strategically different businesses

• Higher capital investment • Reduced Flexibility

– in responding to demand cycles

– in responding to changes in technology, customer preferences, etc.

• Compounding of risk

• makes sense when value chain economies can be created and captured

• may allow a firm to leverage capabilities

• may be a response to the threat of opportunism and uncertainty

• as a form of exchange per se, is not rare nor costly to imitate

Vertical Integration I

• is an important consideration in the decision to 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 the benefits outweigh the costs of integration!

Vertical Integration II

Factors that are important in determining the merits of vertical integration compared to market transactions

•How many firms are there in the vertically related activity?

•Do transactions-specific investments need to be made by either party?

•Does limited availability of information provide opportunities to the contracting firm to behave opportunistically (i.e., cheat)? •Are market transactions subject to taxes and regulations?

•How much uncertainty exists with regard to the circumstances prevailing over the period of the contracts?

•The fewer the companies, the greater the attraction of VI.

The greater the requirements for specific investments, the more attractive

is VI. •The greater the difficulty of specifying and monitoring contracts, the greater the advantages of VI.

•VI is attractive if it can circumvent taxes and regulations.

•Uncertainty raises the costs of writing and monitoring contracts, and provides opportunities for cheating, therefore increasing the attractiveness of VI.

But companies can succeed in Corporate Strategy .. With proper analysis

• The Porter Test • The 4 Poles Test • The Combined Acid Test

Basis of Value Creation

Parenting Skills

Scope Modification

Internal Organization

The Poles of Corporate Strategy

• What businesses is this company in?

• How is value created to these businesses? (if at all)

• Why is this value superior to that created by other HQs or stand alone business? (if at all)

• What kind of systems/structures/processes have been put in place to achieve the target value?

• Are the 4 poles consistent?

Porter’s Test

• The attractiveness test • The cost of entry test • The better off test

The Combined Acid Test for Diversification

• Taking a Resource View: • Do we have valuable and rare resources and capabilities that could be

transferred to (or from) or shared with the new unit? • How valuable are these to the new/old unit? • Do we have the Parenting Skills/Internal Organization needed for the

transfer? • Can we build/acquire the valuable (complementary) skills that we are

lacking? • Taking a Market View: • Can we overcome the barriers to entry? • Is this industry attractive?

Costs Versus Benefits

Diversification Based on Activities Sharing: The Acid Test

• Taking a Resource View: • Do we have activities that can be shared among the units? • Will activity sharing reduce costs or differentiation costs? • Could we outsource this activity? Impact on Flexibility? • Do we have the Parenting Skills/Internal Organization needed for effective

activities sharing? • Can we build/acquire the valuable (complementary) resources that we are

lacking? • Taking a Market View: • Can we overcome the barriers to entry? • Is this industry attractive?

Costs Versus Benefits

Vertical Integration?

• In your current markets, what can your company do better than most?

• What strategic assets are needed to succeed in the new market?

• Can we catch up and eventually leap-frog the competitors in the new market?

• Will diversification break-up strategic assets that should be kept together?

Alternatives to Vertical Integration: Cooperative Relationships

• Short-term contracts and competitive bidding – May signal a company’s lack of commitment to its supplier

• Strategic alliances and long-term contracting – Enables creation of a stable long-term relationship – Becomes a substitute for vertical integration – Avoids the problems of having to manage a company located in an adjacent industry

• Building long-term cooperative relationships – Hostage taking – creating a mutual dependency – Credible commitments – a believable promise or pledge – Maintaining market discipline – power to discipline supplier

• Periodic contract renegotiation � Parallel sourcing policy

Strategic Alliances are long-term agreement between two or more companies to jointly develop new products or processes that benefit all companies concerned.

Strategic Outsourcing

• Company is choosing to focus on a fewer number of value-creation activities Ä In order to strengthen its business model

• Company’s typically focus on noncore or nonstrategic activities Ä In order to determine if they can be performed more effectively

and efficiently by independent specialized companies

• Virtual Corporation Ä Describes companies that have pursued extensive strategic

outsourcing

Strategic Outsourcing allows one or more of a company’s value-chain activities or functions to be performed by independent specialized companies that focus all their skills and

knowledge on just one kind of activity.

Intermediate Forms of Organization: A Continuum of Governance Arrangements

SPOT MARKET

INTERNAL HIERARCHY (full integration)

RANGE OF INTERMEDIATE FORMS

LONG-TERM CONTRACTS

STRATEGIC ALLIANCES

JOINT VENTURES

QUASI- VERTICAL

INTEGRATION (PARTIAL

OWNERSHIP)

Intermediate relationships may combine the benefits of both market transactions and internalization

Spot sales/ purchases

Long-term contracts

Agency agreements

Franchises

Vertical integration

Joint ventures

Informal supplier/ customer

relationships Supplier/ customer

partnerships

Low Degree of Commitment High

Low

High

Fo rm

al iz

at io

n Different Types of Vertical Relationships

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

Action Steps in Scope of Firm Decisions

•Step 1: Disaggregate the Industry Value Chain •Step 2: Competitive Advantage

– Do you have a competitive advantage in the performance of the activity?

•Step 3: Market Failure – Is there a clear market failure? Are the costs of market governance

extremely high? Can dominant firms exercise market power?

•Step 4: Need for Coordination – Is there an ongoing need for intensive coordination? Are continual

and integrated changes required? Is there a distinct interface between activities?

•Source: Collis and Montgomery, Corporate Strategy, 1997

Action Steps (cont’d)

•Step 5: Importance of Incentives – How high are agency costs inside the hierarchy? How much do

worker skill and effort affect outcomes? Can an effective incentive scheme be designed? Which is more important: coordination or high- powered incentives?

•Source: Collis and Montgomery, Corporate Strategy, 1997

(1) In determining whether activities should be internal or external:

Summary: Creating Value in Vertical Activities

(2) In coordinating these activities along the value chain:

External Customer

Internal ActivitiesExternal Supplier

Be Better Than Competitors

Rarity of Vertical Integration

• a firm’s integration strategy may be rare because the firm integrates or because the firm does not

integrate • thus, the question of rareness does not depend on the number of forms observed

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

Example: Toyota’s Choice Not to Integrate Suppliers

Imitability of Vertical Integration Form vs. Function

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

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

• the integrated firm possesses resource combinations that are the result of:

• historical uniqueness •causal ambiguity •social complexity

• small numbers prevent further integration • capital requirements are prohibitive

Imitability of Vertical Integration Modes of Entry

• acquisition and internal development are alternative modes of entry into vertical integration

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

• thus, one firm may acquire a supplier while a competitor could imitate that strategy through

internal development • in both cases, the boundaries of the firm would

encompass the new business

International Expansion The Cost – Control Tradeoff

Cost (Capital at Risk)

Control Exporting

Licensing

Franchising

Strategic Alliance

Greenfield Investment

Low High

High

Acquisition

Vertically Integrated

Not Integrated

Some Integration

Organizing Vertical Integration

Accounting Finance Marketing HR Engineering

Conflict

C on

fli ct

Original Business

New Business

Original Business

New Business

Original Business

Cooperation

C ooperation

CEO’s Role

Organizing Vertical Integration

Management Controls

Budgets Board

Committees

• separating strategic and operational budgets

• strategic: inputs & outputs

• operational: outputs

• provide oversight and direction to managers

• help ensure that strategic direction is maintained

These mechanisms focus management attention on achieving value chain economies