Unit 4 Week 4 Discussion 2 MBA695

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Strategic Management

Jeff Dyer

Third Edition

Chapter 7

Vertical Integration and Outsourcing

Professor’s Goals for this Lecture

There are many types of problems that can be solved for a company by doing a cost analysis. A cost analysis can be used to solve problems as diverse as marketing (e.g., how much to spend to acquire additional customers) or HR (how much labor costs go down per unit with increases in volume). The principle tools to be learned in this chapter are designed to help the student examine the relationship between a company’s size (measured in volumes produced or market share) and cost per unit. This is primarily reinforced by teaching students how to create a scale/experience curve (both done in the same way with “cost per unit” on the “Y” axis but the scale curve uses volume for a given year on the “X” axis whereas the experience curve uses cumulative volume on the “X” axis. The students will have the opportunity to examine the relationship between scale/experience in the following assignments:

- the homework assignment involving calculating an experience curve in semiconductors

- Fry’s Credit Card Mini-case (in lecture); considers the relationship between total number of subscribers (X axis) and cost per subscriber (Y axis)

- the Southwest Case (after lecture); considers the relationship between total passengers flown (or market share) and performance (profitability) in the industry

What is Vertical Integration?

Outsourcing- The process where a firm contracts out a business process or activity to an external supplier.

Vertical Integration (or insourcing)- Bringing business processes or activities previously conducted by outside companies in-house.

Value Chain- The sequence of all activities that are performed by a firm to turn raw materials into the finished product that is sold to a buyer.

Reasons for Vertical Integration 3C’s

CAPABILITIES

COORDINATION

Conduct the activity internally when effective coordination and tight integration of the activity with other firm activities provides product performance (differentiation) advantages.

CONTROL

Conduct the activity internally to control scarce inputs (e.g., Alcoa integrates back into bauxite to secure scarce and critical raw material for aluminum) or to control co-specialized asset investments (e.g., oil refinery controlling the pipeline).

Conduct the activity internally when the firm has or can develop better capabilities to perform it than other firms.

The reasons for vertical integration. The chapter talks about three C’s. One is capabilities, the second is coordination and the third is control. If you feel like that you need to build a capability in a particular area to help you be distinctive for one reason or another, than this is an area you want to invest. We often think about those capabilities as competencies or capabilities but things that you think you need to do well in order to differentiate your product or service or to create barriers to imitation. Now those are things that you want to do internally. This assumes that you can do it better than everybody else. You’ve got to figure out whether or not you can perform a certain activity better than anybody else out there in the world but you really want to be world class. Today with a global economy you’ve got to be very good if you’re going to be in a particular activity or in a particular business.

Second reason that you would want to vertically integrate is to coordinate. This would be coordinating two activities where there’s a high degree of interdependence or we would think about it as reciprocal interdependence as you read about in a chapter on vertical integration. The greater the interdependence, the more likely you are to want to have both activities conducted inside your firm and have control over them.

The third reason that you would want to vertically integrate is for control. By conducting internally, you now control the prior steps or the next steps which gives you access to either critical raw materials like Alcoa was able to get when it backward integrated and it started to buy up large areas of land that were known to be rich in boxite, a key raw material that is needed to make aluminum and so, by backward integrating and by buying it, they knew that they were going to have access to that and have control over that key raw material.

Or it could be forward integrating like Apple did with their Apple stores. Which now puts you in direct contact with the customer. You don’t have to rely on Best Buy or Walmart or another retailer to make sure your customer gets good service. You now can control the customer experience in a way that you couldn’t if you’re using other retailers to sell your product or service.

Dangers of Vertical Integration

2F’s

Loss of Flexibility to move the activity to a company or supplier that offers lower costs or better technology.

Loss of Focus associated with managing too many activities may result in poor performance because the firm can’t do them all well.

Advantages of Outsourcing

Flexibility to move to new suppliers that offer lower costs or better technology.

Focus: Keeps the firm focused on a narrower set of core competencies

Lower costs or better performance from a company that specializes in that activity and benefits from economies of scale.

Minimizes capital investment

Vertical Integration

Who Let

Intel Inside?

Outsourcing isn’t always the answer

Dangers of Outsourcing

Loss of Control/Power. May give an outside supplier undue power or control if the outsourced activity is critical to success.

Loss of Capabilities. May set in motion the loss of capabilities that may be important for the future—and create a future competitor.

Outsourcing can set in motion the loss of capabilities—and creation of a competitor

Dell v. AsusTek

How to Prevent a Subcontractor from Becoming a Competitor

Build barriers to imitation

Brand, annual design changes, processes to develop relationships w/ athlete endorsers, distribution

Don’t allow subcontractor to know everything about making a product

Produce a key component or separate production of components or subsystems of the product to multiple suppliers

Do a joint venture or take a minority equity stake

Like IBM could have done with Intel

Use multiple subcontractors; don’t let any one get too big.

(Choose the best answer given the information above and explain your choice)

a) Make the part and capture the profits

b) Buy the part on the market

c) Make some parts and buy some parts to keep leverage over your suppliers

d) None of the above

Mini-Case: Should you Make or Buy?

You have to decide whether to make or buy a component (part) that is an input for a product that you sell for $49.95. Your analysis shows that based upon the estimated volume of parts you will require, your variable costs per unit will be $.50 and given estimated volumes, your fixed (plant and equipment) cost per unit is $.48 per unit. A quick bid in the market suggests that you can currently buy the same part from two suppliers for $1.00 (another supplier bid $1.01). You should:

There was a sidebar in the chapter that looked at this classic mistake. This mistake happens all the time. People will look at it and say, but we can make it for less than we can buy it. That doesn’t mean you have a cost advantage. If you can make it for less, you better be able to make it for significantly less. You should ask, “Are we good enough to sell this product on the market?” Are you good enough at an activity that you should actually be thinking that, we’re so good at this we could actually sell this product on the market ourselves.

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