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^Academy of Management Review. t9S4. VoL 9. Na 4, 638-652.

Formulating Vertical Integration Strategies^ KATHRYN RUDIE HARRIGAN

Columbia University

A framework is proposed that develops the dimensions of vertical integra- tion strategies and proposes key factors that might augment their uses within various scenarios. These represent new hypotheses and conjectures about make-or-buy decisions that require empirical testing. If the framework is valid, strategists could formulate better hybrid vertical integration strategies by recognizing the hypothesized effects of these forces on the industries that might be linked.

Managers need a ready supply of raw materials and services, as well as a ready market for their firms' outputs. The business arrangements that are used to control these risks are forms of vertical integration. They may include vertical acquisitions, or internal development of supplying or distributing units, or other means of extending firms' control over out- siders.

The Phenomenon of Vertical Integration

Vertical integration is a corporate strategy that has been misunderstood. It has long been a key force in the development of high productivity and managerial sophistication in U.S. business (Chandler, 1977). Ver- tically integrated corporations have been key engines of change in the past and have enhanced shareholder wealth (Lubatkin, 1982). Yet earlier findings that "dominant verticals" (Rumelt, 1974) and vertical mergers were least successful as diversifications (Baker, Miller, & Ramsperger, 1981) may have soured managers and academic researchers on the usefulness of this strategy unnecessarily. Oftentimes researchers did not recognize that vertical integration could be an effective strategy, provided it was used prudently, because they often took an overly aggre- gated view of it. Because critics have not discerned how the important dimensions of vertical integration might be adapted over time (as industries change),

'The research was supported by the Strategy Research Center, Columbia University. Comments and criticism from William H. Newman, Ian MacMillan, and Donald C. Hambrick are also gratefully acknowledged. The author is indebted to Donald C. Hambrick for suggesting the graphic configuration in Figure 1.

they have not recognized how to make this a more durable and keen competitive weapon. Because suc- cessful vertical integration strategies require the cooperation of several strategic business units (SBUs), the formulation of such strategies is in the province of the chief executive officer (CEO). In some cases, effective vertical integration may even require temporary subsidization of one business tinit at the expense of another. Decisions regarding such SBU coordination (and resource allocations among them) must be made by the chief strategists. Thus effective vertical integration strategies need to reflect both business unit and corporate level strategy requirements.

This paper proposes a framework for developing effective vertical integration strategies. It was developed by synthesizing the theoretical foundations established by the industrial economics and strategic management literatures with firms' observed behav- iors. Thus it suggests a new way to look at vertical integration and the forces that affect firms' choices concerning vertical linkages. It develops normative propositions concerning which generic vertical strategies might be more appropriate under different competitive circumstances, and it uses examples of firms' successes or failures in using vertical integra- tion to suggest how traditional concepts of this strategy might be amended to refiect effective in- dustry practices. These suggestions are new hypo- theses, which will require empirical testing. Vertical integration is one of the first diversification strategies that firms embrace. Unfortunately, some firms seem to use it in a manner that seems inappropriate for their circumstances. The issue of vertical integration

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deserves additional analysis because it has been misunderstood in the past, and because the develop- ment of a more rigorous means of analyzing this strategy (and the performance it promises) could result in the formulation of more effective industry linkages, more rapid technological improvements, stronger global strategies, and better use of vertical integration. Table 1 summarizes many of the advan- tages and risks associated with vertical integration.

The narrow case in which a firm's major diversi- fication strategy has been only vertical is not the focus of this inquiry. Instead, it considers the larger utiiverse of firms that have linked two or more SBUs through vertical relationships and have diversified in other ways as well. Rumelt (1974) would have found that many of the more diversified firms in his For- tune 500 sample also had vertical transfers of goods or services in-house, had that been the focus of his inquiry. Thus Rumelt reported that 22 percent of the firms in his sample embraced a dominant vertical strategy in 1969 (up from 20 percent in 1949), but vertical linkages also existed within the highly diver-

Table 1 Some Advantages and Disadvantages

of Vertical Integration

Advantages Disadvantages

Internal benefits Integration economies reduce

costs by eliminating steps, re- ducing duplicate overhead, and cutting costs (technology dependent)

Improved coordination of activ- ities reduces inventorying and other costs

Avoid time-consuming tasks, such as price shopping, com- municating design details, or negotiating contracts

Competitive benefits Avoid foreclosure to inputs, ser-

vices, or markets Improved marketing or techno-

logical intelligence Opportunity to create product

differentiation (increased value added)

Superior control of firm's eco- nomic environment (market power)

Create credibility for new prod- ucts

Synergies could be created by coordinating vertical activities skiUfully

Internat costs Need for overhead to coordinate

vertical integration increased costs

Burden of excess capacity from unevenly balanced minimum efficient scale plants (technol- ogy dependent)

Poorly organized vertically in- tegrated firms do not enjoy synergies that compensate for higher costs

Competitive dangers Obsolete processes may be per-

petuated Creates mobility (or exit) bar-

riers Links firm to sick adjacent busi-

nesses Lose access to information from

suppliers or distributors Synergies created through ver-

' tical integration may be over- rated

Managers integrated before thinking through the most ap- propriate way to do so

sified firms he had classified in other ways. If previous studies of vertical integration used classifica- tion rules similar to Rumelt's, they also may have understated its true activity level. For example. Federal Trade Commission data for 1948 to 1972 concerning large acquisitions (assets larger than $10 million) indicate that less than 15 percent of these were vertical mergers; and Salter and Weinhold's (1979) list of $ 1(X) million or more acquisitions made during 1975-1978 indicated that only 4 percent were vertical. Thus an illusion was perpetuated that ver- tical integrations were rare, except in the oil, rubber, basic metals, and forest products industries. But, in fact, acquisitions that are classified as being other- wise "related" to the firm's core businesses may also have provided new distribution channels or other assets that are vertically related to them.

Acquired firms are bundles of assets rather than single business units, as Occidental Petroleum discovered when courting Cities Service (and as Du Pont learned while absorbing Conoco). Acquisitions can offer vertical linkages as well as nonvertical diver- sifications. Corporate strategists must decide whether to retain the business units acquired incidentally in this fashion; and if they are vertically related, strategists must decide whether to encourage intra- firm commerce (subsidy) or demand arms-length transactions between vertical sister units. Thus, more seemingly unrelated mergers have vertical elements to them than is generally recognized, but oftentimes strategists see no advantage to encouraging vertical relationships between in-house units. This may oc- cur because the opportunities for vertical competitive advantage have passed in some industries. In other cases, however, this occurs because managers did not recognize how to exploit the advantages of vertical integration effectively.

The Legacy of Vertical Integration

Vertical integration has been an important mana- gerial irmovation and a necessary technological step in developing certain industries, but it may not be appropriate in the same form under all circum- stances. For example, ownership of ore mines, ships, foundries, rolling mills, and fabricating plants was necessary for steel companies to lower costs and im- prove productivity in the 1890s. In its early years. Ford Motor Company owned and operated every stage of processing from iron ore to finish-and-trim operations (except tires and glass). In these early

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years, suppliers may not have been as willing to share Ford's gamble in persuading consumers to purchase "horseless carriages," so Ford had to develop com- ponents to its specifications for itself. There were substantial economies associated with vertical in- tegration once Ford had overcome the public's resistance to purchasing this novel product, and these cost advantages rewarded Ford's gamble. Ford's in- tegrated strategy and logistical system enabled large numbers of consumers to afford low priced and reliable automobiles in 1910 (Chandler, 1977) because it lowered Ford's costs of procurement, standardized its components, and facilitated an end-to-end pro- duction process. This is the type of vertical integra- tion behavior one might expect within emerging in- dustries where firms must provide their own infra- structures and other supplies.

By 1983, however, the automobile industry had matured such that uncertainties regarding generic product demand were reduced. Ford's outside sup- pliers were willing to invest in tooling and other assets to supply the automakers, and high degrees of inter- nal transfers were no longer necessary if unecono- mic. (And the throughput of U.S. automakers was not large enough for vertical integration to remain as economic as it once was.) The challenge from Japanese automakers was difficult to meet when firms such as Ford were so strategically infiexible. Moreover, vertical integration had lost some of its attraction because managers (who often resented hav- ing to buy from sister units) did not understand the role that vertical integration played in their firm's corporate scheme. Often firms did not have the sup- porting mechanisms needed to reap the maximum synergies that might be available from vertically in- tegrated linkages, or they misapplied them in other ways (Williamson, 1975). In brief, in theory, many firms favor making rather than buying key resources and services, but their inabilities to manage integra- tion taint their appreciation of this strategy. More- over, the use of vertical integration must change with time. The competitive damage created by excessive integration can be substantial, as in the examples of the U.S. automobile and steel industries in 1983.

Antitrust decisions also have created a tarnished image of vertical integration. Economists, who did not consider the particular requisities of diverse firm's corporate strategies, have reinforced a unidimensional view of vertical integration based

on theories of market power and the ideal of perfectly competitive industries (Adelman, 1979; Blair & Kaserman, 1978; Comanor, 1967; Dennison, 1939; Frank, 1925; Jewkes, 1930; and Lavington, 1925). These scholars largely have not recognized that dif- ferent motives for vertical integration—such as technological leadership, to secure access to raw materials, or competitive preemption—might exist within the same industry; nor have they considered the diversity of ways in which vertical integration strategies might be formed (Adams & Dirlam, 1964; Clevenger & Campbell, 1977; Greenhut & Ohta, 1979; Larson, 1978; Mancke, 1972; Perry, 1980). For example, firms vary in how many tasks they perform in-house, in the number of buyer-seller linkages downward in a vertical chain they forge, and in the form of control employed. Few economic scholars, except perhaps Bork (1954), McGee and Bassett (1976), and Porter (1980), have recognized the ways in which vertical integration could make industries more competitive (rather than less so). Most econo- mic scholars have held one view of vertical integra- tion, a view based heavily on the convenient assump- tion of a monopolist, instead of considering how firms might use this strategy differently.

Because industry structures differ, it is not surpris- ing that many approaches to vertical control could satisfy managers' needs for a ready supply of raw materials or a ready market for their factories' out- put. The successes some firms had with strategies of full integration, long vertical chains, and other varia- tions is surprising, however. Some firms, such as Robert Hall or Botany Industries, have suffered notable failures from vertical integration of the wrong type and/or its use at the wrong time (Harri- gan, 1983a). But if managers better understood the many dimensions of vertical integration and the key forces that affect their abilities to execute vertical strategies well, they could better avoid fundamental errors associated with vertical integration and maxi- mize the benefits available in joining dissimilar but related businesses. Briefiy, managers would not at- tempt to create synergies in cases where external forces made integration too risky or their internal systems made communications inadequate.

A New Look at Vertical Integration

The old concept of vertical integration as being 100 percent owned operations that are physically inter- connected to supply 100 percent of a firm's needs is

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outmoded. Under appropriate circumstances, quality control and access to stable supplies can be obtain- ed through quasi-integration arrangements. Firms could contract for R&D services, for example, to utilize the technology of genetic engineering in prod- uct development, or they could form joint ventures to obtain this capability. Firms could have com- ponents engineered to their tight and highly specific instructions by outsiders, as do Japanese automobile manufacturers, for example. And if their bargain- ing power is sufficient, firms can use a kanban or "just in time" system of inventory control that shifts the burden of holding costs to their suppliers (Ohmae, 1982).

If firms prefer not to use outsiders as extensions of their corporate entity, a variety of other vertical arrangements are possible. Some firms may conclude that they need not undertake certciin activities at all. Eli Lilly, for example, uses outsiders exclusively with success to merchandise its ethical Pharmaceuticals. Tandy/Radio Shack, by contract, uses primarily its own retail outlets to distribute personal computers, but it has been increasing its use of outsiders. In other situations, firms may find that they can enjoy the in- tegration economies, uncertainty reduction, compe- titive intelligence, and other benefits that internal ver- tical linkages may provide through outsiders. The key in using vertical integration is recognizing which ac- tivities to perform in-house, how to relate these ac- tivities to each other, how much of its needs the firm should satisfy in-house, how much ownership equity needs to be risked in doing so, and when these dimen- sions should be adjusted to accommodate new com- petitive conditions. Briefiy, the concept of vertical integration should be expanded to encompass a vari- ety of arrangements by which the firm can use out- siders (as well as its own business units) to forge an optimal vertical system for supplying goods, services, and capabilities.

The Dimensions of Vertical Strategy

In any vertical integration strategy, conscious (or unconscious) decisions are made regarding: (1) the breadth of integrated activities undertaken; (2) the number of stages of integrated activities; (3) the degree of internal transfers for each vertical linkage; and (4) the form of ownership used to control the vertical relationship.

Breadth of Integrated Activities

The breadth of integrated activities is the number of tiisks that firms perform in-house. Firms perform- ing many upstream or downstream tasks in-house are broadly integrated; firms performing few vertically related tasks are narrowly integrated.

Traditional concepts of vertical integration did not address the number of integrated activities that firms might undertake. Figure 1 contrasts the old view, represented by firm A, with examples of the ex- panded concept of vertical integration proposed here. In Figure 1, firm A is not as broadly integrated as are firms B and C. Circumstances in which firms might choose the broadest integrations successfully are suggested elsewhere.

Stages of Integrated Activities

The number of stages undertaken in the dimension of vertical integration that many traditional views have embraced. Figure 1 shows that firm A has more stages than firms B or C, because its activities extend from ultra-raw materials to retail outlets, but firm C is engaged in a greater number of steps in the ver- tical chain. Although Figure 1 depicts the transfor- mation process as an extension of adjacent stages ac- tivities, it is possible for firms to skip a stage in the chain (by using outsiders for an intermediate process- ing step) in order to monitor costs better, to save on asset investments for facilities that would be under- utilized if brought in-house, or for other reasons.

Degree of Internal Transfers

The degree of integration is the proportion of a resource transferred internally, and fully integrated firms transfer almost 100 percent of a particular ser- vice or material in-house. In Figure 1 only firm C is "taper integrated" with respect to services and materials upstream and downstream. Firms A and B are "fully integrated."

Form of Ownership Arrangement

The form of integrated ownership indicates the proportion of a firm's equity invested in a vertically linked venture, and in some environments carefully specified contracts, franchises, joint ventures, or other forms of quasi-integration can be good alter- natives to wholly-owned ventures. Figure 1 does not illustrate different forms of ownership, but these

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Figure 1 Vertical Integration Configurations

Components The Warehousing Ultra- Product Processed Process and Strategic Assembly in and Physical Raw Development Raw Innovation Finished Business Marketing Downstream Wholesaling Distribution Retail

Materials Services Materials Services Materials Unit Services Product Services Services Outlets

- • •

Key: Solid lines indicate intrafirm transfers. Dotted lines indicate external purchases or sales.

A In A, the strategic business unit is flanked by integrated sister units upstream and downstream. The firm is engaged in many stages of integrated activity, and all transfers of products and services within the vertical chain are made in-house (high degree of integration). The relationship between any two business units in A is "fully integrated."

B In B, the business unit's upstream and downstream sisters engage in many activities. Thus the firm is broadly integrated. The firm is engaged in many stages of integration, but the length ofthe vertical chain differs for various inputs. As drawn, the firm is "fully-integrated" for the inputs it does supply in B because it transfers those inputs in-house.

C In C, the business unit purchases more inputs or services from (or sells more to) outsiders than in B. The firm is less broadly integrated than in B. It is engaged in many stages of activity downstream \or one output. It is taper integrated for many inputs, including product development services, because the business unit purchases some inputs and services from outsiders and sells some outputs to outsiders.

alternatives could be identified by the percentage of total equity firms risked in a particular vertical rela- tionship. There are situations in which partial or no ownership may be preferred to wholly-owned vertical linkages.

Vetical Integration Strategy Alternatives

How can firms best manage their needs for scarce supplies or access to distribution channels? Several alternatives are suggested that encompass the dimen- sions of vertical integration strategy. The mix or com- binations of these approaches are hypothesized to change over time, as industry conditions change or as firms' needs to control adjacent industries tightly change (Sichel, 1973). These alternatives are: nonin- tegration, quasi-integration, taper integration, and full integration. Previous theories of vertical integra- tion did not recognize the different dimensions com- prising it; thus combining their use to create generic strategy alternatives represents a new approach

to thinking about this problem. Nonintegration. Strategies for attaining materials

and markets with no internal transfers and no owner- ship are like contracts. They are especially attractive when firms are reluctant to buy specialized assets, need to lower breakeven points because of underdeveloped demand, or can arrange delivery schedules with suppliers (or distributors) as though they were extensions of the firm's assets. Koppers and Monsanto both used this approach to vertical integra- tion successfully in genetic engineering, in which de- mand was highly uncertain and technological change occurred rapidly, synergies were low with ongoing businesses in 1981, and the figure had high bargain- ing power with respect to upstream and downstream markets. Firms risk the lowest proportion of their assets in vertical arrangements involving notiinte- grated controls.

Quasi-Integration. Quasi-integrated firms need not own 100 percent of the adjacent business units in the vertical chain to enjoy the benefits of bonding their

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interests to other firms' interests. The bond between firms cotild take the form of cooperative ventures, minority equity agreements, loans or loan guarantees, preptirchase credits, specialized logistical facilities or "understandings" concerning customary arrange- ments (Blois, 1972; Porter, 1980). Downstream quasi- integration arrangements enable firtns to retain a net- work of qualified distributors to maintain quality im- ages. Upstream "take-or-pay contracts" and kanban arrangements enable firms to enjoy the advantages of vertical integration without assuming the risks of it. Whiskey distillers used quasi-integration suc- cessfully to penetrate diverse geographical markets, and microcomputer producers used it to obtain soft- ware and distribution of their products. The com- petitive scantling advantages of quasi-integration can be especially effective if firms using it devise in- telligence gathering mechanisms to use the informa- tion that adjacent firms and competitors might provide.

Quasi-integrated arrangements place greater pro- portions of ownership equity at risk, but they also provide greater fiexibility in responding to changing conditions than a contract may provide. The third ownership alternative, full ownership, is most fre- qently observed. It assumes that the firm exerts com- plete control over the activities of the vertically linked businesses. Full ownership risks the greatest propor- tion of equity, but many firms believe it is easier to manage than contractual or quasi-integrated relation- ships and prefer it over them (Harrigan, forth- coming).

Taper Integration. When firms are backward or forward integrated but rely on outsiders for a por- tion of their supplies or distribution, they are "taper integrated." Such firms can monitor the R&D de- velopments of outsiders, reduce vulnerability to strikes and shortages within their systems, and ex- amine the products of competitors while enjoying the lower costs and greater advantages (and profit mar- gins) or vertical integration. Under certain circum- stances taper integration is not necessary and firms can add substímtial value through upstream or down- stream activities, taper integration can be used effec- tively, as American Cyanamid did in ethical phar- maceuticals by supplying basic and finished chemicals to its Lederle Laboratories subsidiary when it was

' convenient to do so but relying on outsiders to supply chemicals in other cases. Similarly Amoco (Standard Oil of Indiana) and many other petroleum refiners

, found that upstream taper integration arrangements

provided them with access to enough crude oil to keep their plants running economically, and that sell- ing a portion of their primary petrochemicals to other firms allowed them to gain scale economies through specialization in processing downstream. Taper inte- gration represents a useful compromise between de- sires to control adjacent businesses and needs to re- tain strategic fiexibility.

Full Integration. Physically interconnected technologies usually involve high degrees of internal transfers, but full integration also can be used effec- tively if price competition is not fierce, diseconomies from temporary imbalances are not significant, and little hardship occurs from being cut off from out- side market or technological intelligence. Transfer- ring all of the firm's needs for a particular good or service in-house exposes it to increased risks of ex- cess capacity, competitive inflexibility, and loss of information concerning customer or competitive changes. Firms also face higher capital costs and higher exit barriers with this strategy (Harrigan, 1981, 1983b). Nevertheless, Brooks Brothers sells its own tailored suits with success, Courtaulds used its own rayon fiber in textiles, and PPG Industries used its own synthetic soda ash to make glass. These firms were fully integrated with respect to the materials named above without encountering the problems other firms have faced with this strategy alternative. In general, it would seem that full integration works best within stable environments, but for corporate strategy reasons it may be necessary if outside sup- pliers or distributors are inadequate. Although it seems generally wise to have competitive antennae collecting intelligence upstream and downstream by engaging in some commerce with outsiders, taper in- tegration may not be necessary in some settings in which full integration is the more profitable strategy.

Breadth and Stages of Integration. Firms that per- form many activities involved in making a particular product (such as Pfizer in Pharmaceuticals and Ten- neco in coal gasification) may enjoy synergies with their other businesses. Being broadly integrated also offers them opportunities to capture large profit margins by adding more value themselves. Firms that engage in several veriical stages for each integrated activity they undertake (such as Texas Instruments in microcomputers and Mobil in petroleum refining) can enjoy these synergies at several diverse levels within their organizations. They also can control crucial aspects of their products' quality by par-

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ticipating at several stages in the chain of process- ing. Although it seems evident that integrating broad and long ranging operations could be complex and costly, it is hypothesized that in some cases it could be highly rewarding because such strategies leverage firms' abilities to enter new markets, exploit new technologies, and evaluate the impact of evolutionary changes faster.

Particular combinations of the breadth of activities integrated, number of stages undertaken, degree of internal tremsfers, and form of ovmership control are more likely to be successful for certain firms than others, depending on: (1) the uncertainty surround- ing sales growth, industry infrastructure, and other market traits; (2) the likelihood that the industry in question will undergo radical technological change, severe price warfare, or other struettiral changes caus- ing competition to be volatile; (3) the power of firms to bargain, cajole, or pressure suppliers (or distribu- tors) into performing value adding tasks for them; and (4) firms' strategy needs. (For example, more in- tegration might be used if the firm's CEO concluded that it needed greater control over adjacent parties to attain technological leadership or other objectives.) It is important to note that the most appropriate ver- tical integration strategies will change over time as industry conditions change, as corporate strategy needs change, and as firms' capabilities evolve. The CEO must assess the relative worth of the strategy alternatives sketched above in light of the forces that key factors exert on the dimensions of vertical integration.

Factors Affecting Vertical Strategies

Four key factors are hypothesized to affect the ver- tical integration strategies that firms embrace: (1) forces propeUing industry evolution and exacer- bating demand uncertainty; (2) the nature of com- petition in the linked industries; (3) the bargaining power of suppliers or distributors (and customers); and (4) corporate strategy requirements. Table 2 details the effects of these factors on the dimensions comprising vertical strategy alternatives. From this presentation and the discussion below, certain com- binations of these dimensions are shown to be more appropriate than others when the key factors occur together in certain ways.

Forces Propelling Industry Evolution

Industries evolve in structure as firms make diverse

investments in them and overcome customers' reluc- tance to adopt new products (or new generations of products). Technological innovation is a major cause of accelerated industry evolution and of increased de- mand uncertainty. Different vertical integration strategies will be more appropriate if technology changes rapidly (or slowly), depending on whether firms would be technological leaders or followers. Pioneering firms would be more likely to integrate than would technological followers. With this excep- tion, however, less vertical integration is expected early (and late) in an industry's evolution in contrast with the scenario Stigler (1951) envisioned, because of (1) the risks of demand uncertainty and (2) dif- fering needs to prove a new product's worth. There- fore, the most likely pattern of integration behavior one might expect to see overtime (holding other fac- tors constant) is an inverted U-shape.

Demand Uncertainty. When demand conditions become stable, higher degrees of internal integration might be undertaken with ease because one firm's sales volumes can become large (and regular) enough to absorb the output of adjacent plants without in- curring costly excess capacity penalties. Because it would take time for the experience spurring sales growth to occur, one would not expect firms within many embryonic industries (as well as declining in- dustries) to be broadly integrated or engaged in many stages of integrated operations. Demand for products in embryonic and declining settings may be highly uncertain. The chief strategist may elect for the firm to undertake more activities or more integrated stages in settings in which pioneering investments are nec- essary to achieve other corporate objectives, such as the creation of infrastructures, particularly if existing distribution channels are blocked or inappropriate for the firm's needs.

Creating Credibility for New Industries. Vertical integration behaviors in new industries would be ex- pected to differ from those in established industries and to differ from behaviors within embryonic indus- tries that began in the previous century. There were significant differences in the need for infrastruc- tures—channels of distribution, standard means of assessing quality, and so on—supporting the develop- ment of the embryonic steel, automobile, and tobac- co industries of the last century compared with those surrounding the embryonic industries of the 1980s. In newly developing countries and earlier in the development of U.S. business, it frequently was

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Table 2 An DIustration of the Strategic Framework

Strategy Defining Characteristics When Appropriate Advantages Risks

Degree of integration Full

integration

Tapered integration

All of a particular in- put (or output) is trans- ferred in-house to a sister business unit. Often ad- jacent, integrated stages are in balance in their throughput volumes.

Some portion (but not all) of firm's require- ments for an input is sup- plied in-house or some portion of outputs is sold (consumed) in-house.

Nonintegra- No internal transfers tion of inputs (or outputs) to

in-house sister units

In mature and stable environ- ments protect proprietary pro- cesses from espionage

Maintain tight quality control at all stages

If firm seeks technological or quality leadership position

Diseconomies from imbal- ance are not significant

Technological changes occur slowly

Physical interconnection un- necessary

Diseconomies in minimum efficient scale plant that are un- derutilized are substantial

If firm seeks technological, quality, or market share leader- ship in volatile competitive set- tings

New products needing expla- nations or infrastructure no out- siders provide

If firm desires to prod in- house units

Better quality/prices avail- able from outsiders

Costs of investing to make components is too formidable or volume consumed is too low (and selling t o outsiders would be difficult or a serious diversi- fication from core business of firm)

If technology is changing rapidly

If price competition (and other competitive tactics) causes market shares to fluctuate wild- ly

If demand is highly uncertain

Superior control of economic environment

Avoid foreclosure to Inputs or markets

Guarantee quality is consis- tent with corporate image

Capture Integration econo- mies (especially advantageous if market share leader)

Enables firm to monitor out- side R&D and marketing prac- tices. Could Incorporate out- siders' innovations while gain- ing capability in-house, as well

Enables firm to understand suppliers' (or distributors') cost structures and profit margins

Increases bargaining power (implied threat of full integra- tion)

Same as full integration with less risk

No penalties from underuti- lized plants

Avoids purchasing highly specific assets (avoids inflexibil- ity)

Avoids purchasing large ca- pacity when firm's needs are small

Lowers overhead and break- even points

Allows preplanned delivery schedules to reduce inventory- ing costs (kanban)

Breadth of integration Broadly Many activities (in-

integrated puts, services, or chan- nels of distribution or consumption) related to the needs of a particular business unit are engaged in. (Broadly integrated strategies need not in- volve many vertical stages of processing.)

Narrowly Few activities (inputs, integrated services, or channels) are

engaged in.

Decreases market power Technology does not provide

many integration economies Asset inflexibility Price renegotiations difficult Minimum efficient scale

plants are rarely the same up- stream and downstream, thus some portion of linkage is like- ly to be out of balance

Subcontractors will not be available to absorb fluctuations in production and demand

Access to best suppliers (or distributors) will be cut off (competitive foreclosure)

Pay premiums for access to outsiders' goods and services

Lower priority as a customer (or vendor), because outsiders are overflow outlets primarily

Same as full integration but more advantageous

Quality control may not be as high and market power of firm may be unable to exert control over adjacent firms through contract

Subcontractors will not be available to perform needed tasks

Firm loses cost advantages of integration economies (where these exist)

Product differentiability is high

No outsiders yet produce goods or services needed

Industry structures becoming established and economies be- coming apparent

When industry structure is embryonic, demand is highly uncertain, or industry is declin- ing

When firm's requirements for a particular good or service are low

Maintains intelligence con- cerning component costs and ways to streamline product de- sign (experience curve)

Maintains product quality and design secrecy

No scale economies available at the small volumes needed for in-house (and market) con- sumption

Costly setup costs associated with short production runs for disparate components

No penalties from frequent setups or other production costs

Access to the innovations of outside suppliers or distributors

Lower mobility (or exit bar- riers)

Loss of access to supplies or other scarce resources

Less control over product specifications and quality (un- less contracts can be used to control suppliers or distributors satisfactorily)

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Table 2 (continued)

Strategy Defining Characteristics When Appropriate Advantages Risks

Stages of integrated activity Many stages Firm is engaged in

many vertically related activities—from ultra- raw materials to distribu- tion to final consumers— in which the buyer-seller relationships could

Few stages Firm is engaged in few vertically related activi- ties in the chain from ultra-raw materials tc distribution

Form of ownership Wholly- Businesses are wholly-

owned owned by firm.

Quasi- integration

Less than full owner- ship and control. Could include joint ventures, franchises, minority equity investments, loan guarantees, or an "un- derstanding" regarding customer relationships

When product (or compo- nents) are state of the art and firm seeks technological leader- ship

When life of product is ex- pected to be eight years or longer

When firm is foreclosed by competitors

When firm seeks quality lead- ership

When technological or cus- tomer scanning is less important

When product lives are ex- pected to be short or the new obsolescing technology will be very unlike past processes

When product is very young or industry structure is embry- onic

When demand is declining When physical interconnec-

tions are few or not necessary

When contracts or other quasi-integrated forms of con- trol are inadequate

When firm desires to protect technology or trade secrets from outsiders

When demand is declining (except as a "phase-out" tactic)

If risk of failure and invest- ment costs are high

If economies of integration are insignificant but need for control is strong

Technology changes rapidly Industry structures are still

embryonic To transfer ownership of an

undesirable business unit to out- siders

If corporate mission does not require tight control over qual- ity

If competition is volatile

Captures more of value add- ed in vertical chain of process- ing

Firm can create substantial improvements in supplying technology or distribution prac- tices

Could create highly differen- tiated and high quality products

Preempt nonintegrated com- petitors by forcing industry structures to evolve to firm's ad- vantage

Control proprietary advan- tages

Reach ultimate consumers more effectively

Outsiders' innovations can be harnessed to improve product quality or design

Firm can piggyback on the marketing or brand image ex- penditures of outsiders

Proceeds from investment need not be shared with others

Greater strategic flexibility because business units are fully owned and controlled

Reduces asset investments Allows firm to create

"spider's web" of quasi-ime- grations to sample several firms' approaches to a technological or marketing problem

Creates bargaining power over adjacent business units

Improves access to new mate- rials or processes

Scanning advantages of taper integration with less asset risk

Integration economies of taper integration (provided firm manages quasi-integrated rela- tionship effectively)

Lowers fixed costs while pro- viding access to adjacent firms' intelligence and skills

Synergies foregone if com- munications systems do not ex- ploit these linkages well

Creates exit barriers due to obsolescence

Risks of throughput imbal- ance magnified for each stage added to vertical chain

Subcontractors needed to al- leviate imbalances in through- put (due to technology or changing demand) will not be available

Costly and inefficient if firms do not manage complexity well

Involves firms in very diverse activities that may be far from its core strengths

Firm's product perceived as a "me-too" entry

Integrated competitors will enjoy superior cost structtires and inteihgence

Same risks as being too inte- grated on other strategy dimen- sions above; risk exposure is maximum

Could create mobility or exit barriers if partners are impor- tant to other businesses of the firm

Costs of managing quasi-in- tegrated relationship exceed benefits of this control systetn

Contractual problems couJd stymie strategic flexibility and run up administration costs

necessary for firms to undertake many stages of in- tegrated activities (and to provide the necessary in- frastructures) in order to help an industry to develop. But now many new industries can use the same in- frastructures developed in an earlier era by firms that

once integrated vertically to build them. The major reason for pioneering firms within embryonic indus- tries to undertake many stages of integrated activitiy now would be to create credibility for a radical new industry. This was once the case in persuading textile

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firms to use rayon as well as cotton and wool on their looms; and Celanese forward integrated from rayon to yarn, textiles, and garment manufacture to prove to consumers, as well as textile firms, that its new fiber (rayon acetate) was viable. Similariy ALCOA once forward integrated beyond its current number of integrated stages to fabricate aluminum products to sell to consumers when other metals fabricators would not use its new metal. In the 1980s, however, there seem to be few new industries (except, perhaps, genetic engineering) for which this need to create new market conduits is as high as it was in earlier eras.

When the risks of launching an embryonic industry are quite high, firms can form joint ventures to link supplies and distribution channels; and when demand conditions become stable and certain patterns of competition are recognized as being more successful than others, more internal integration can be safely undertaken. When demand is declining, however, the first linkage that firms in declining industries might be expected to sever are those with owned distribu- tion channels, because making demand dependent on an independent market enables firms to assess more clearly whether pockets of enduring demand exist for the product in question (Harrigan, 1980). This is what Celanese did in acetate. Diamond Shamrock did in acetylene, and Brown Shoe did in leather tanning. In summary, except for the unique situations men- tioned above, specialized suppliers or distributors are better suited to provide goods and services to firms in embryonic industries on a contractual basis until uncertainties concerning demand and competitive viability are resolved.

Volatility of Competition

Individual business units would not be expected to favor vertically integrated strategies in settings in which industry structures exacerbate the likelihood of price warfare and depressed profit margins. Be- cause volatile industry structures increase the likelihood that competition will degenerate into the use of tactics that devastate long term profitability and sap the innovative resourcefulness of firms, ver- tical integration generally should be avoided in such settings. Other things held constant, the greatest number of successful linked stages and the greatest successful breadths of integrated activities would be expected within settings in which competition is stable. The characteristics of hostile industry struc-

tures have been developed in detail elsewhere (Har- rigan, 1980; Porter, 1980). The elements of industry structure that affect vertical integration include: pro- duct traits, supplier traits, consumer traits, manufac- turing technology traits, and competitor traits.

Product Traits. Because differentiated products can justify higher prices (Bain, 1968), higher degrees of internal transfer can be undertaken for such prod- ucts with greater success even when integration economies are not substantial. In choosing which components or services to produce in-house, how- ever, it is important to understand which attributes of a product create those qualities for which con- sumers are willing to pay a premium. Noncritical components and services (and those offering poor economics) could be purchased from outsiders and sensitive components and services (and those offer- ing the best economics) produced in-house. By free- ing plant space and resources that formerly were devoted to noncritical and uneconomic components and services, firms can undertake a more profitable mix of activities with their resources while tying up the assets of outsiders for low profit activities.

If trade secrets protect some aspect of a firm's products, higher degrees of integration are necessary, as in the case of Polaroid, which stopped purchas- ing its negative materials from Kodak when its ins- tant photography patent expired. (Too much pro- prietary information was contained there to let com- petitors produce it.) Similarly, Schlumberger ac- quired its own custom logic semiconductor house (Fairchild Camera & Instrument) to protect its pro- prietary knowledge concerning well-logging services, and Dow Chemical often is fully integrated to pre- vent other firms from learning too much about its processes and designs.

Supplier Traits. The principal motives for firms to integrate backward often include capturing high pro- portions of value added, controlling product quality (and proprietary knowledge), or overcoming compe- titors' advantages if the best suppliers are already under contract to others. If competition is escalating on the basis of innovations, however, firms should be wary about embracging high degrees of internal transfers because they cut off their access to the benefits of outsiders' innovations in an environment in which flexibility is crucial to competitive ability. In such settings, it may be desirable to help create another new supplier (through quasi-integration ar- rangements, which allow the new entity to serve others as well as sponsoring taper integration firm)

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rather that fall into the trap of technological inflexi- bility by fully owning such suppliers and buying in- puts only from them.

Consumer Traits. The principal reasons to in- tegrate forward often include capturing high propor- tions of value added, controlling the quality and im- age of one's products, and raising customers' switch- ing cost barriers (Porter, 1980). Complex products that require substantial demonstration or explana- tions and servicing (as microcomputers did in 1978) are strong candidates for downstream linkages. In doing so, firms must be cautious to ensure: (1) that they are not overly dependent on in-house merchan- dise for resale and (2) that they do not stay forward integrated after the advantages of being so integrated have expired. When products become successful enough to create high customer switching costs, the need for forward integration is lowered, and firms should move away from battlefronts unless they are well positioned to win price wars.

Manufacturing Technology Traits. The technology used in manufacturing must offer substantial integra- tion economies in order for vertical integration to be advantageous (Khandwalla, 1974). Because the mini- mum efficient scale of some technologies is so much larger than firms' needs for that component, firms that integrate such activities may be forced to enter merchant sales to dispose of their unused outputs from the oversized plant (or run the plant at uneco- nomic volumes). Integration should be avoided if the costs of excess capacity cannot be offset by charg- ing premium prices. Instead, firms shotild use sub- contractors to perform those tasks that require assets that most firms would use infrequently at present operating scales. Thus, producers of solar collector panels send out for chrome plating, and ethical pharmaceutical firms send out for the bromine chemistry step in production.

Firms must keep aware of their distinctive compe- tences in production to ensure that: (1) their critically skilled laborers—scientific researchers and en- gineers—are employed (lest they be hired away by competitors), and (2) they avoid being stuck with ob- solete assets. If firms are constrained by plant space, it tnay be wise to purchase simple or low volume com- ponents from outsiders. Critically skilled employees thereby can be kept busy on difficult (but challeng- ing) tasks that leverage firms' future capabilities to compete, and the burden of their salaries can be spread over high volume supplying activities. Finally, if technology is changing rapidly, using outsiders to

perform key intermediate processing steps reduces the likelihood that firms will be stuck with vertical resources that become high exit barriers. As long as demand is increasing and firms can avoid price wars in selling their output, vertical linkages will not ex- acerbate the tendency for competition to become vo- latile; but unless special efforts are made to overcome these forces, vertical linkages can become high exit barriers as industries mature (Harrigan, 1983b).

Competitor Traits. Efforts made to diminish the pressures of other structural traits toward price war- fare can be done by competitors who (1) compete on the basis of price or (2) use vertical integration as a means of foreclosure. "Dominant verticals," the group of narrowly diversified, integrated firms that Rumelt (1974) identified, are most likely to possess the types of strong commitments to vertical integra- tion strategies that function like exit barriers, caus- ing them to act irrationally, by cutting prices to main- tain high throughputs in their integrated facilities to the detriment of other competitors.

Firms that use their vertical linkages as a means of foreclosing nonintegrated firms from access to materials, markets, innovations, and competitive in- telligence also are damaging competitors because they can escalate the evolution of the industry towards defensive vertical integrations. When many firms have integrated, all face similar pressures to keep their vertical chains efficiently utilized, and price competition becomes more likely than if noninte- grated firms were allowed to supply or purchase ex- cess volumes of materials and services to alleviate im- balances in vertically related technologies. Thus it may be preferable for an industry to have some non- integrated firms to absorb other firms' excess capac- ity, lest industry bloodshed result instead.

In summary, high degrees of internal transfer, long vertical chains, and many integrated activities are ex- pected in settings in which industry structures do not exacerbate price warfare or rapid rates of change in products or processes. Because competitors must be able to change tactics rapidly in turbulent industry settings, a highly integrated posture in such settings could reduce a firm's maneuverability and damage its profitability. Even the partial reprieve of substan- tial integration economies or the ability to charge premium prices to pay for costly idle capacity may not offset the long term corporate damage that being too highly integrated in such settings could create. The tradeoffs that firms will make depend on their overall strategies and market power.

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Bargaining Power

Firms that possess the bargaining power needed to obtain secure access to suppliers and distribution channels without damaging their strategic flexibility cotild reduce their asset exposure and inflexibility by reducing ownership stakes in supplying or distribut- ing business units. Another way is to use the firm's bargaining power to persuade sequent businesses to assume the duties that a firm wishes to avoid (Mac- Millan, Hambrick, & Pennings, 1982).

The most important determinants of bargaining power are: (1) product specificity to the industry in question; (2) existence of alternative outlets or sources of suppliers; (3) abihty to self-manufacture the good/service in question; and (4) dependence of the supplier (or distributor) on the business unit (Porter, 1976a). If firms possess the power to leverage their market positions, they could use this power to control adjacent firms' assets without owning them. Firms that control brand names or patents, for ex- ample, could hire outsiders to market their products if communications with downstream parties are less important than other advantages that such arrange- ments might provide. But if firms' suppliers or dis- tributors possess bargaining power (and if they can- not be persuaded to perform useful services for firms) then those activities may have to be undertaken in- house in order to attain the control that some firms desire. If this situation occurs in settings in which de- mand is unstable and competition is volatile, the out- come of doing so could be disastrous.

G>rporate Strategy Needs

The foregoing arguments that less integration is preferable to more must be moderated by considera- tions of corporate strategy needs. Because vertical in- tegration can be costly if used imprudently, corporate strategists must scrutinize the advantages they hope to capture by condoning (or denying) the creation of certain vertical relationships. Vertical integration may be part of a larger strategy involving shared resources and experience curve economies for some businesses, for example, requiring the firm to sustain relation- ships that the strategy framework otherwise would not recommend.

Some vertical integrations promise to improve long term synergies for the entire firm, although they ai> pear to penalize a particular business unit. Supply side economies, for example, could be gained by sharing manufacturing facilities for components that

could be used in several dissimilar products. Also, vertical integration strategies that increase or enhance innovations by sharing technological information common to separate stages of integration may require more integration than the framework suggests.

The number of stages undertaken, for example, would be expected to be highest if significant synergies are gained or other corporate needs are served. The key determinants of whether (or not) a firm should skip a particular stage in its integrated chain of activities are the task's importance to its cor- porate mission and the quality of goods or services provided by outsiders. A firm's position within its industry also suggests how many integrated stages it would perform, and firms on the fringes of an in- dustry would be more likely to purchase (rather than produce) materials or services from leader firms whose upstream plants produce in excess of their downstream plants' capacities.

Although firms will vary considerably in which tasks they choose to do in-house, their needs to cap- ture more value added would mean that they per- formed in-house those tasks for which their expen- sive and critical resources were best suited. Firms also will integrate those tasks that would enable them to enjoy synergies with other business units, those that are important to their business missions, or that of- fer high profit margins for them. They most likely would own outright those aspects of their businesses that were most important to them, and they would pool the risks (or extend their control over adjacent firms) for less critical activities supplied by outsiders through quasi-integration arrangements.

The most scarce resource that firms possess is their entrepreneurial ability. Rather than seeing their mix of businesses as streams of cash flows, chief execu- tives should consider them as reservoirs of capabili- ties. Thus vertical integration strategies would en- courage activities and relationships for which person- nel with crucial skills (or other scarce capabilities) might otherwise not be retained.

In previous sections, less vertical integration has been anticipated within turbulent settings, particular- ly those in which technological change occurs rapidly. Firms purstling technological leadership strategies of- fer an important exception to this hypothesis, how- ever, because they often are willing to endure the tem- porary imbalances of full integration when produc- ing sensitive components, and they are willing to ab- sorb the risks of many integrated stages (as detailed in Table 2) in order to be poised to exploit the next

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generation of technological innovation. Contrast, for example, the different vertical integration strategies observable in the electronics industry for creating new generations of microprocessors and for producing semiconductor memory chips. Firms will purchase components that are not close to their technological cores if better prices are available from outsiders. Yet they often continue to make some of these com- ponents in-house, even if they do not have cost ad- vantages, in order to carry over knowledge to the next generation of active components for which they might seize preemptive or cost advantages (Mac- Millan, 1983). In Figure 2, firms seeking technolo- gical, quality, or market share leadership are grouped in the lower rows of the strategy matrix, and those pursuing a generic "focus" strategy (Porter, 1980) are grouped in the top rows. Briefiy, in an emerging industry, such as semiconductors, leadership objec- tives require a greater degree (and more stages) of vertical integration than do focused market niche ob- jectives, because leadership is attained through at- tainment of integration economies (cost leadership) or command of proprietary knowledge (technological leadership).

Figure 2 An Illustration of

the Strategy Framework for Vertical Integration in Emerging Industries

Focus

Strategy Objectives

Leadership

Quasi-Integration (with few in- ternal transfers)

Taper Integration

Taper Integration

(Full Integration)

Quasi-lntegration

Taper Integration

Taper Integration

Full Integration

Volatile Stable Industry Traits Affecting Competitive Conditions

Finally, it is useful to recognize that any corporate scheme to force vertically related business units to deal with each other without the benefit of "open market" equivalents (for the purposes of transfer pricing and maintaining competitive fiexibility) is penalizing one party to the transaction for the sake of the other. Subsidization of uneconomic and non- competitive business units for the sake of ephemeral corporate advantages is a strategic trap that should be carefully scrutinized, lest the advantages gained in such subsidization arrangements be outweighted

by the impairments to competitive fiexibility that result. Global competition on several national fronts through an integrated, worldwide logistical system is one example of situations in which the benefits of encouraging vertical linkages are substantial and cross-subsidization may be necessary. Under such cir- j cumstances the linkages should be retained while a I worldwide market position is being won.

Applications of the •» ^ Vertical Strategy Framework

Analysis of the forces identified above that make vertical integration more (or less) successful could be applied in portfolio rationalizations and in the tim- ing of key changes in vertical strategies. In cases in which firms gain bundles of assets through acquisi- tions, including businesses that may be vertically related to ongoing businesses, they could apply this framework to determine how best to use the new sup- plier/distributor relationship potential created by joining the two firms. In particular, the framework calls attention to situations in which strategists might divest vertical units and deploy released resources elsewhere, because it asks hard questions about the true nature of synergies and the place of vertical in- tegration in corporate strategies.

The generic strategies suggested above and detailed in Table 2 are not intended to be static suggestions to gain access to resources, capabilities, and knowl- edge. As competitive conditions change, so too must the firm's vertical integration strategy. In particular, changes must refiect revisions in the strategic rela- tionships that strategists envision among their business units. For example, GTE (a telecommunica- tions firm that once had a significant electronics posi- tion but divested its semiconductors around 1969) purchased EMI Semi Inc. in 1979 because it recog- nized its need again for custom integrated circuit designs. Similarly, Tandy/Radio Shack adjusted its ' distribution policies to refiect new market realities in 1982 by selling some of its microcomputers through outsiders. Hoffman-LaRoche reduced its wholesaling activities (switching exclusively to o u t # ' Í siders); and Exxon brought its U.S. crude oil refin- ing and production capacity back into balance with each other as competitive conditions changed. |

When the "strategic window" that favored inte- gration has closed (Abell, 1978) and the cost of emulating competitors' integrated strategies is no longer justified, prudent firms will uncouple their in-

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tegrated linkages in a timely fashion—before other firms reach similar conclusions about the merits of integration—to dispose of their assets in a healthy market. Firms attempting late disintegrations will face greater exit barriers than will early firms and will realize less value for their assets when they finally do locate a buyer for them (Harrigan, 1980; Porter, 1976b). A key review point for deciding whether to reduce integration is when cash outlays would be re- quired to upgrade vertically integrated technologies. Strategists must recognize that business units that are viable only if they have a guaranteed market (or source of supply) can become cash traps if they are not cut off at that time.

In summary, firms can form vertical joint ventures to obtain the distribution skills and resources they lack, they can purchase marketing contracts, or otherwise avoid risking too many assets in businesses whose product demand is highly uncertain // they possess the market power needed to take a position in businesses they deem too risky to wholly-own. They can use the leverage of their bargaining posi- tions to shift risks to outsiders in a preemptive fashion if they can identify and link up with the best partners for joint ventures, contract processing, or sourcing arrangements. Firms could increase or decrease their breadth of integrated activities or their degree of internal transfers in a timely fashion if they have accurately diagnosed the forces that make ver- tical integration strategies work well within some set- tings but not well within others. The key to successful

use of vertical integration is recognizing when and where it offers significant competitive advantages and forging the necessary vertical linkages without creating excessive risks.

Vertical integration can offer temporary state-of- the-art advantages that must be weighed against the advantages of being flexible to exploit the next tech- nological innovation. Firms that commit early to ver- tical integration, linking themsleves in a highly in- flexible fashion to a particular technology, risk be- ing wrong, and the cost could be substantial. But if these pioneers are right, vertical integration can be a rationalizing device that forges order in chaotic en- vironments, establishes industry standards, or lowers operating costs significantly. Then the harm of late entry can be substantial. Thus, firms should build pilot plants early to learn about suppliers and dis- tributors before competitors can match these intelli- gence gains with their own experience. (They could consider the investment a form of R&D.)

Vertical integration is not a costless strategy. Rec- ognizing when outsiders can be entrusted with ac- tivities that firms might otherwise perform internal- ly is desirable when firms must ration funds, seek di- vestiture (or liquidation) candidates, or otherwise consolidate their business units' activities, as well as when they enter new businesses. The problem is a complex one, but the framework proposed herein of- fers one way of analyzing firms' vertical integration capabilties and improving their strategies.

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