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FREDERICK A. WEBSTER

A Model of Vertical Integration Strategy

A long-run, profit-maximizing approach to the implementation

of a veHical integration program, illustrated by

Standard Oil decisions from 1911 to 1963.

FiBMS OPERATING WTTHiN a n e n v i r o n m e n t of

free enterprise often single out profit maximization as their primary long-run target. However, due to the multitude of unconti-ollable forces acting upon firms, the probability of reaching and holding a profit maximization position is low. Nevertheless, managements continue to operate toward this ob- jective with varying degrees of success.

This article is concerned with decisions which re- late to the degree of control that ought to exist over input fiow and/or finished product ffow. If it can be agreed that for some firms ownership control over input/output ffows can facilitate increased profits in the long run,^ then two questions appear important to the individual firm:

^ Should management immediately acquire the nec- essary sources of supply, the input and finished product distribution facilities, as well as the final-sale outlets?

4 Should ownership control over those operations evolve gradually so as to conserve financial resources necessary to implement other important decisions deemed vital to the maximization of profit?

This article proposes a relatively simple norma- tive model describing a long-run profit maximizing

Dr. Webster, Assistant Professor of Com- merce and Business Administration, Univer- sity of British Columbia, has written arti- cles on marketing in Canadian and U.S. jour- nals and is a consultant to several firms.

approach to the implementation of vertical integra- tion programs.

Unfortunately, this approach is not without short- comings. The principal ones are:

• The model does not provide a panacea for all problem areas inherent in vertical integration strategy.

• It does not embrace all of the many subtle con- siderations with which management is concerned.

• No allowances have been made for exceptional situations that may exist between industries or between firms within the same industry.

However, in contrast with those approaches which either have specific applicability to one firm to the exclusion of all others, or become so cumber- some in their attempt to capture every condition and contingency as to become impossible to under- stand, this model has general applicability for cer- tain firms. It is especially useful to those firms whose product assortments are derived directly from a primary raw material, e.g., petroleum refiners, canners of fruits and vegetables, and pro- cessors of forest products.

Supply- and demand-oriented firms. When a firm's inherent specialization is derived from strengths in a particular manufacturing process, or from a specific raw material, or from a unique engi- neering talent, that firm is considered predominate- ly supply-oriented. In such cases, vertical integra- tion programs usually involve some degree of control over functions or fiows located "upstream" from its manufacturing operation.

On the other hand, when a firm's inherent spe- cialization is derived from strengths in specific tar- get markets, or from concentration within selected finished-good distribution patterns, that firm is re- garded as predominately demand-oriented and would be expected to extend control over activities located "downstream" from its manufacturing oper- ation.

However, due to the interdependencies that exist between supply and demand, profit maximization results from countless optimal adjustments in both sectors. Consequently, firms able and willing to en- gage in vertical integration should not concentrate efforts in one sector to the complete exclusion of the other. Instead, they should adjust in order to reach a balance between control over supply flows and control over finished product flows.

Supply to Demand Position

Therefore, a major postulate underlying this model is that the orientation of tlie specialization of a manufacturing firm whose product assortments are derived directly from a primary raw material should shift gradually from a supply to a demand position, and that such firms should emphasize sup- ply-oriented vertical integration initially and de- mand-oriented vertical integration subsequently, until balance in control over the total product flow is achieved in the long run.

The direction of vertical integration activity. Vertical integration may then be defined as control over two or more of the following process bases by a single firm, or, in the case of joint ventures, by two or more firms:

• The manufacturing input source.

• The manufacturing input distribution.

• The manufacturing.

• The finished product distribution.

• The final-scale outlet.

In this model tlie manufacturing process base represents tlie focal point from which all integration decisions are to be viewed. It follows, then, that ex- tension of control over tlie manufacturing input dis- tribution and the manufacturing input source base constitutes backward vertical integration, whereas control over the finished product distribution and the final-sale outlet base results in forward vertical integration.

Control over any or all process bases may result from implementation of one or more of three strat- egies: contractual arrangements, internal plan ex- pansion, or external plant expansion. Each strategy may be used individually or in conjunction with the other two in a "mix."

Contractual arrangements These may result in various degrees of control; however, each degree will have attendant risk^ exposures and cost struc- tures. The outcomes range from a complete or posi- tive control by the contracting party, together with infinite risk and cost, to complete dominance or negative control over the contracting party, with insignificant risk and cost.

On the assumption tliat the firm is a rational en- tity, operating in the short run so as to maximize profits in the long run, the model allows for only those contracts where control is either equal to (a mutually satisfying contract), or greater tlian, risk and cost. Thus, contractual arrangements represent a means for effecting control over process bases.

This means of control is far from secure, however, in tliat relative bargaining power may shift during contract periods. That is, even though risk exposure and cost may be relatively low due to contract ter- mination dates, the degree of control that can be exercised may be changeable, tending toward inefficient operations and away from profit maxi- mization in the long run.

Internal plant expansion. From the viewpoint of the individual firm, internal plant expansion repre- sents a high degree of control and results from own- ership in fee simple over certain facilities. However, whenever a firm requires excessive funds to imple- ment control through ownership, risk accompanies control. Risk as defined above may result from re- strictive clauses found in standard term loan agree- ments, whereby additional corporate stock offerings may dilute ownership or require substantial divi- dend commitments that could restrict the level of liquid retained earnings, necessary for subsequent expansion.

Although the degree of control exercised through internal plant expansion is high, relative to that se- cured through most contractual arrangements, the cost and risk may also be high depending on:

^ The nature of the expansion.

^ The competitive technology in tenns of rendering existing facilities obsolete.

^ The financial strength of the firm in question.

50 in MaruiPement Review

External plant expansion. This type of expansion also represents a high degree of control over specific facilities. However, risk and cost in this case are more difficult to appraise. Altliough the ul- timate benefits, in terms of control, to be derived from acquisition and/or merger may prove greater in the long run than those to be derived from either contractual arrangements or internal plant expan- sion, conceivably the cost may also be greater when the amalgamation proves to be a sorry one. The key issue rests on the degree of synchronization (on all fronts) versus the degree of clash that results from such a strategy.

Lease-Cost Strategy Introducing the model. Thus, risk may be low or

high, depending on circumstances which usually prove difficult to appraise until after the fact. Al- though the control to be enjoyed from external plant expansion may be high, the risk and cost may also be high. So high, in fact, that the least costly course of action would be to seek control over pro- cess bases through contractual arrangements first, internal plant expansion second, and external plant expansion last.

The notation used in the model for these three strategy possibilities as well as the five process bases inherent in the model are showna in Figure 1.

FIG. 1.—PROCESS BASES AND STRATEGIES FOR A MODEL OF VERTICAL INTEGRATION

PROCESS BASE I: The Manufacturing Input Source Contractual Arrangements (Strategy M) Internal Plant Expansion (Strategy Q) External Plant Expansion (Strategy W)

PROCESS BASE II: Manufacturing Input Dis- tribution Contractual Arrangements (Strategy L) Internal Plant Expansion (Strategy P) External Plant Expansion (Strategy V)

PROCESS BASE III: Manufacturing Contractual Arrangements (Strategy 7) Internal Plant Expansion (Strategy J) External Plant Expansion (Strategy K)

PROCESS BASE IV: Finished-Product Dis- tribution Contractual Arrangements (Strategy N) Internal Plant Expansion (Strategy R) External Plant Ex-pansion (Strategy Y)

PROCESS BASE V: Final-Sale Outlet Contractual Arrangements (Strategy 0) Internal Plant Expansion (Strategy U) External Plant Expansion (Strategy Z)

Eight specific strategy phases, designated by So, Si, S2, • . . S7, define the course of evolution of an initially supply-oriented manufacturing film's verti- cal integration progi^am. Although these phases possess a chronological dimension, they are not nec- essarily equal time periods. Moreover, it is the nature of the strategy mix that defines the phase, not the reverse.

As a firm evolves from one phase to the next, one would expect tliat its sphere of control over product flow would be enlarged, whether via contractual leverage or through outright ownership. In either case, the size of the firm's operations increases. As a result, firms possessing the willingness to engage in vertical integration may, in some situations, move through the eight phases at an accelerating rate in that ability to evolve from one strategy to the next is partially a function of size.'

Naturally, any firm lacking the willingness and/ or capacity for vertical integration would not be ex- pected to evolve through the complete series of phases, but would remain in that phase which best describes the particular strategy mix in use.

Foundation of Model

The assumptions. Before proceeding to the model per se, certain assumptions need to be stated:

1 / Economies of scale and/or hke product assort- ments from manufacturing input source to final-sale outlet provide oppoitunity for vertical integration.*

2 / Manufacturing firms whose product assortments

WINTER / 1967 51

are derived directly from primary raw material are in- herently supply-oriented and are concerned with rein- forcing their supply positions initially and their demand positions subsequently.

3 / The greater the optimum size of a finn (from a profit-maximizing standpoint) at a given process base, relative to the optimizing size of a finn operating at ad- jacent bases in the course of a given product flow, the higher the probability that the larger firm will integrate into these process bases.

4 / The greater the geographical density of a firm's finished product sales (raw material purchases), the higher the probability that the finn wiU engage in for- ward (backward) vertical integration.^

5 / The cost and risk of vertical integration are gen- erally least when effected through customary contrac- tual arrangements, greater when carried out through internal plant expansion, and often the greatest when accomplished through external plant expansion.

6 / The degree of control over various process bases in a continuous process-flow of raw material to finished product is directly related to cost. Therefore, external plant expansion and internal plant expansion wiU nor- mally effect the greatest control over relevant process bases, contractual arrangements will effect lesser con- trol, and joint ventures would have to be analyzed on an individual basis to arrive at any general conclusion with respect to control exercised.

The rationale. Changes take place in the firm's vertical integration strategy as it moves through various phases along a least-cost course of action designed to reinforce its input market position and, later, its output market position. In phases So through S4, the firm emerges as predominantly supply-oriented. Beginning in phase S5, emphasis is given to demand-oriented strategy. These changes reflect a purposeful shift in the firm's specialization orientation, tliat is, from supply-oriented to demand- oriented position, to arrive at a balanced position in the long run.

Framework of the model. The model suggests a least-cost course of action for a small supply- oriented manufacturing firm (commencing in phase SoY strategizing so as to emerge as a large, profit- maximizing, integrated complex during phase S7.

Strategy phase Si. Before a firm can manufac- ture (and market) a product line it must negotiate with both manufacturing-input supphers and finished-product distributors. Consequently, a small firm whose product is based on primary material will engage in contractual arrangements with inde- pendent middlemen at process bases II and IV, but

will exercise very little leverage in the initial con- tracts. Second-round negotiations during this phase, especially with respect to input distributors, may reveal a more favorable position for the firm, how- ever. Therefore, in phase Si, it is hypothesized that the strategy mix would appear to be:

Strategy phase S2. As time passes (the length being unique to each firm), the manufacturer would be expected to exert more control over supply- oriented process bases. Therefore, it is argued that the firm will purchase transportation carriers and/ or construct storage facilities in order to accommo- date the distribution of at least some key manu- facturing inputs. In these cases, independent whole- sale middlemen would be circumvented. Contrac- tual arrangements with wholesale middlemen for less important or less easily obtainable inputs would continue during this phase (terms should, in many cases, be more favorable to the manufacturer during phase So than was the case in Si). During this phase the manufacturer could enter into direct contrac- tual arrangements with manufacturing input pro- ducers, at least in those situations where the input distributor has been circumvented.

Control "downstream" in the relevant channel(s) of distribution would be nominal, as was the case in phase Si, and represented by bilateral contractual arrangements with wholesalers distributing the firm's finished product(s). It is therefore hypoth- esized that the strategy mix for phase So would be:

la{M)llaciLP)Ul(J)lYaiN)

Strategy phase S3. This phase is characterized by an increasing degree of control over supply-ori- ented process bases on the part of the manufac- turer. Two significant strategy moves are to he noted:

• The finn uses external plant expansion (acquiies independent firms) to effect greater control over the distribution of manufacturing inputs.

• Tbe firm obtains greater control over the manu- facturing input source via internal plant expansion.

It is during this phase that the firm becomes an important operator at supply-oriented process bases. Control over demand-oriented process bases remains contractual and is limited to the distribu- tion of finished products. In essence, the strategy mix for S3 is:

52 California Management Review

Strategy phase S4. This phase describes tbe last wholly supply-oriented thrust, the purpose of which is to secure ownership control over sources of sup- ply and distribution facilities. (Conceivably, hori- zontal integration has taken place so that there may exist multiple manufacturing plants, multiple dis- tribution connections, and ownership over multiple sources of manufacturing inputs.)

To elaborate on the vertical moves, however, in terms of primary vertical integration, the firm will reinforce its control over input sources via acquisi- tion of land containing resource reserves, e.g., tim- ber holdings, crude oil fields, agricultural real es- tate, or raw material processing plants at strategic locations with respect to impending marketing triumphs. Additional control will also be secured through contractual arrangements, internal plant expansion, and external plant expansion over activi- ties at the manufacturing input distribution process base. To summarize, the strategy mix for phase S4 would be:

Strategy phase S-,. Although the principal em- phasis placed on vertical integration remains in re- inforcing supply-oriented operations, a manufac- turer by this time will begin to feel considerable pressure to extend control over output markets in order to coordinate more effectively its total prod- uct flow.

Internal plant expansion would be initiated at the finished-product distribution base. Final-sale outlets are contacted and contractual arrangements made to solicit specific wholesalers or retailers to handle the firm's product on either a selective or an exclusive basis. It would be expected that during phase S5 considerable negotiation would take place to ensure a sufficient market share, so as to enjoy the economies of scale developed in the supply-ori- ented operations. The strategy mix for phase S., be- comes:

Strategy phase So. The strategy changes are two- fold:

• External plant expansion takes place to effect greater control over the finished-product distribution process base.

• Internal plant expansion takes place into final-sale outlets.

For strategy phase So, the strategy mix is:

laciMQW)ll,c{LPV)IIUJ)IVcc{NRY)Vac(OU)

Strategy phase S7. The final strategy possibility is effected during this period, namely, external plant expansion over final-sale outlets. In this case, acquisition of existing retail facilities is accom- plished as the firm emerges into a large, fully inte- grated operation at the regional, national, or inter- national level. The strategy mix for phase S7 thus becomes:

Iac{MQW)UaciLPV)lIIc(J)lVac(NR Y) VadOUZ)

The Concept

Conclusions. The rationale behind the above strategy sequence relates directly to the concept of least cost, that is, it is assumed that the cost and risk to engage in contractual arrangements are less than the cost and risk to engage in internal plant expan-

W I N T E R / 1967 53

sion, which in turn are less than those for external plant expansion.

Empirical Data Summary of empirical findings. Standard Oil

Company of California was incorporated as a going concern whose assets and business had been ac- cumulated by several predecessor firms. Although this corporation did not secure its present name until 1926, the analysis of vertical integration deci- sions in Table I commences as of 1911, at which time its parent. Standard Oil Company (Califor- nia) obtained independence from the Standard Oil Trust by court order.

In an attempt to simplify tlie complex operations found in tliis giant corporation, the data have been divided into nine geographical operating areas. The evolution of vertical integration strategy has been calculated for each area.

TABLE I.—SUJMMARY OF VERTICAL INTEGRATION DECISIONS, 1911-1963.*

TABLE I (coni.)

Strategy- Notation

Decision

Area A: California, Oregon, Washington, Nevada, and Hawaii

1911

1912

1913

1914

1915

1926

1929

Ia{M)

IV„(iV)

Contractual control over proven oil property in So. Calif.

Purchase of oil land in L.A. Basin and development of same.

Contractual arrangements with crude oil distributors.

Construction of refinery (El Segundo, Calif.).

Contractual arrangements with finished- product distributors.

Construction of crude oil pipeline from producing fields to refinery.

Acquisition of National Service Supply, Inc. (early service station chain located in So. Calif.).

Construction of service station units (Standard Stations, Inc.).

Acquisition of Pacific Gasoline Co. (re- finers of casinghead gasoline).

Acquisition of Public Service Co. (distrib- utor of manufactured gas in So. Calif.).

* These decisions represent initial vertical integration strategy. No attempt has been made to recreate a history of the firm's operations. All subsequent decisions, such as the construction of a second refinery within a geographical area, have been treated as horizontal extensions of control over the relevant process base.

Strategy Notation Decision

1918

1930

1936

1945

1947

UQ)

IVaiN)

ydu)

IV,(E)

IIUJ)

lUP)

A r e a B : Colorado, Montana, North Dakota, Utah, and Wyoming

1917 Ia(-^^) Contractual control over exploration land in Colo.

Purchase of acreage in Rangely Basin, Colo.

Contractual arrangements with indepen- dent distributors of finished products (refining operations located in Calif.).

Standard Stations, Inc. extended opera- tions into Area B.

Establishment of company-owned finished product distribution facilities.

Construction of refinery at Salt Lake City, Utah.

Construction of crude oil pipeline from Rangely Basin field to refinery.

Area C: Western and Northern Texas, New Mexico,

and Oklahoma

Contractual control secured over explora- tion land in Texas.

Purchase of some 45,000 acres of explora- tion land in Texas.

Acquisition of Underwriters Producmg and Refining Co., Colorado City, Texas.

Contractual arrangements with crude oil distributors.

Contractual arrangements with finished- product distributors.

Construction of refinery at El Paso. Construction of crude oil pipeline from

producing fields to El Paso refinery. Construction of service station units in

northern and western Texas. Establishment of corporation's own fin-

ished product distribution facilities.

Area D : Western Alaska

1922 Ji{M) Contractual control secured over explora- tion land in Alaska through joint ven- ture.

1962 IIIc(.7) Constraction of refinery at Nikiski, Alaska. 1962 lla{L) Contractual arrangements with crude oil

distributors. 1962 IVa(iV) Contractual arrangements with finished-

product distributors. 1963 TVo{R) Establishment of finished-product distri-

bution facilities. 1963 ^aiO) Contractual arrangements with indepen-

dent service stations secured.

California Management Review

1922

1922 iciQ)

1923 IIIc(/v)

1923 Jla{L)

1923

1927 nic(./) 1928 IIc(P)

1935

1945 TVc{R)

TABLE I (cont.) TABLE I (cont.)

Strategy Notation

Decision

Area D (cont.)

1963 Vc(f7) Construction of service station imits in western Alaska.

Area E : Mexico, Central America, and South America

1922 la{M)

1922

1936

1951

1958

1960

1961

IIh{K)

1926 IVc(iV)

1935 i n c ( J ) 1935 IIc(-P)

1935 IVa(iV)

1935

1936 1939

1941 Vc(Z)

1945 IVc{R)

Contractual control secured over explora- tory lands in Mexico, Argentina, Venezuela, Colombia, and Ecuador.

Acquisition of the Latin American Petro- leum Corp. of Colombia.

Contractual arrangements with crude oil distributors.

Contractual arrangements with finished- product distributors in El Salvadore and Guatemala.

Establisliment of finished-product dis- tribution facilities in Puerto Rico.

Arrangements completed to acquire ser- vice station sites and to develop dealer organization in Central America.

Acquisition of a 35% interest in a refinery at Conchan, Peru.

Construction of a marine terminal at San Juan, Puerto Rico.

Area F : Western Canada

Establishment of finished-product distri- bution facilities via tanker from Calif, to Dominion Oil Co.'s facilities in British Columbia.

Constructionof refinery at Burnaby, B.C. Establishment of crude oil distribution

facilities via tanker from Calif, to refinery.

Contractual arrangements secured with finished product distributors.

Establishment of service stations in the Vancouver-Victoria area.

Acquisition of Dominion Oil Co. Contractual control secured over explora-

tory land in Alberta. Acquisition of Signal Oil Co., Ltd., opera-

tor of service stations in B.C. Establishment of corporation's own fin-

ished-products distribution facilities throughout B.C.

Area G: Bahrein Island, Saudi Arabia, and Iran

1930 IQ(M) Contractual control secured over explora-

WINTER / 1967

Strategj' Notation

Decision

1936 1936 IVbiR)

Area G (cont.)

tory lands on Bahrein I. in Persian Gulf.

Construction of refinery on Bahrein I. Entered joint venture (Cal-Tex with

Texas Co.) to consolidate Bahrein Petroleum Co., Ltd. (refinery) with marketing system of finished products throughout Eastern Hemisphere.

Establishment (joint venture) of crude oU distribution facilities between Saudi Arabia and Bahrein I. refinery.

Acquisition of 7% interest in land hold- ings of the Consortium in Iran.

Acquisition of 7% interest in refinery constructed at Abadan, Iran.

Contractual arrangements secured with crude oil distributors.

Contractual arrangements secured with finished-product distributors.

1938 II(,(P)

1956

1956 IIl6(iv)

1956

1956 IV6(A0

IbiQ)

Ila(i)

IVb{Y)

Area H : The Gulf Coast and Southeastern United States

Contractual control secured over explor- atory land in Louisiana.

Acquired a one-half interest in lease of exploratory offshore land on joint ven- ture basis.

Purchased 32,000 acres of exploratory land in Galveston Bay in joint venture.

Construction of refinery at Pascagoula, Miss.

Contractual arrangements secured with crude oil distributors.

Acquisition of Plantation Pipeline Co. (27% interest) to operate finished- product line from Baton Rouge to points in southeastern U. S.

Acquisition of Standard Oil Company (Kentucky)—major service station chain in southeastern U. S.

Construction of Cal-Ky crude oil pipeline between producing areas in Aj-ea C and refinery at Pascagoula, Miss.

Area I : Northeastern United States

Acquisition of interest in asphalt refinery located at Perth Amboy, N. J.

Contractual arrangements secured with finished-product distributors.

Contractual arrangements secured with raw material distributors.

1936

1938

1961

1961 Vc(2)

1962 UciP)

1945 IIIi(iiO

1945

TABLE I (cont.)

Strategy Notation Decision

Area I (cont.)

1945 IVc(i?) Establishment of company-owned fin- ished product-distribution facilities.

1949 Vc(?7) Gonstruction of company-owned service stations in northeastern U. S.

1950 V(;(Z) Acquisition of major service station chain in N. J.

Differences from Model

Exceptions to the model. Although tlie evolution of vertical integration strategy within the corpora- tion generally approximates that suggested in the model, certain exceptions do exist and must be reckoned with.

The model states that operations of manufactur- ing firms commence at the manufacturing process base; however, operations for the corporation ac- tually commenced at the manufacturing input source. It certainly could be argued that a firm is not a manufacturer until it manufactures; nevertlie- less, in those geographical areas where operations did commence at the input source, refineries were soon constructed to process the crude oil. Neverthe- less, the first instance of owTiership control was at the manufacturing process base.

Another exception to the model relates to the fact that ownership control extended over facilities de- signed to distribute the finished product before con- tractual arrangements were effected. This situation, no doubt, was an outgrowth of the merger between Pacific Coast Oil Company and Standard Oil Com- pany (Iowa) which created Standard Oil Company (California). Had such a merger not taken place, the operations of the corporation presumably would have conformed more closely to the model in this respect.

Perhaps the major exception to the theory was the initial acquisition of a final-sale outlet chain which preceded any internal plant expansion at tliis pro- cess base. Although ownership conti-ol extended over all supply-oriented bases before the decision was made to effect this acquisition, this move did represent a higher order form of control than ex-

pected at this time. The conditions surrounding this move perhaps justify the steps taken and include:

• The service station, as a marketing institution, captured the fancy of the motorist literally overnight, thereby abruptly and without warning disrupting dis- tribution patterns then in existence.

• A few major petroleum firms opportunistically at- tempted to capitalize upon tliis "innovation" by acquir- ing existing service station chains.

• Most firms responded with parallel action, includ- ing the coiporation.

Agreements with Model

Regularities in strategies. Although Standard Oil Company (California) has not followed the specified sti-ategic steps in precisely the same order of arrangements as outlined in the model, it appears evident that supply-oriented activities preceded de- mand-oriented efforts in the corporation's quest for a vertically integrated unit.

The following summary of findings indicates some regularity in vertical integration strategy as carried out by the corporation:

• In all areas, except F and I, supply-oriented activity preceded any demand-oriented activity. (In western Ganada [Area F] marketing operations preceded any emphasis on supply control. However, supply-oriented facilities were in operation in an adjacent area [Gali- fornia] and were used to support the "marketing beach- head" in western Ganada. Therefore, from a total cor- porate standpoint, no exception exists.)

• In all areas, except D, F, and I, ownership control over the manufacturing input source preceded owner- ship control over final-sale outlets. (The capital expen- diture for manufacturing and marketing facilities is enormous in the petroleum industry; however, the level of outlay for exploration, development, and production is considerably more. A critical requirement for the successful operation of an integrated petroleum concern appears to be ownership control over raw material at the source.)

• In all areas where exploration, development, and production were successful, contractual arrangements at the source preceded ownership control. (From a least- cost approach, control over prospecting land which is unproven is not as vital as control over proven oil de- posits; therefore, investment to secure control is tem- pered with the needs for control.)

• In all areas, except B, F, and G, contractual con- trol over the distribution of raw material preceded ownership control over such facilities. (In areas B, F, and G, sufficient crude oil reserves were proven at the

56 California Management Review

outset to justify the construction of major pipelines from producing areas.)

i> In aU areas, control over the manufacturing process base was effected by ownership.

I Ownership control over final-sale outlets may not be particularly desirable when such units are geograph- ically widespread and located within several foreign countries.

^ Control of the manufacturing process base begets a desire for ownership control over the ffow of raw ma- terial into, and a flow of finished product from, that base.

I In all areas, except F, G, and H, contractual ar- rangements over the distribution of finished product preceded ownership control over such facilities.

^ No pattern is distinguishable in terms of the nature of initial control over the final-sale outlet process base. However, it is Interesting to note that in those areas far removed from Area A (the center of operations for the corporation), contractual control over final-sale out- lets preceded ovraership control, and in Areas A, B, C, and F (those developed early), ownership control pre- ceded contractual control.

I • Joint ventures appear to be appropriate whenever '• operations are located at considerable distance from

established corporate activity and may be an appropria- . ate strategy when dealing with a broad front in terms . of a continuous set of process bases.

I % When "shocks" or sudden disturbances occur, there i is a strong propensity to accelerate the normal strategy

sequence and/or to engage in higher-order forms of control over a given process base prior to engaging in certain lowei-order forms of control.

REFERENCES

1. For a discussion of the multiple advantages (both revenue-increasing and/or cost-decreasing) of vertical integration, see Nugent Wedding, ed.. Vertical Integra- tion in Marketing (Urbana: University of Illinois, 1952).

2. Risk, in this sense, may be defined as a threat to the firm's freedom of action. Therefore, negative control of the 7ith degree implies the complete elimination of any freedom of action in that the firm would be under the absolute dominance of the contracting party. Posi- tive control of the nth degree would imply that, as far as the relationship between the contracting parties is concerned, tliat firm enjoying the controlling position has complete freedom of action.

Lesser risks, resulting from government regulation, say, would restrict the behavior of the firm in certain ways, as would risks emanating from other sources, e.g., competition.

3. Small firms tend to possess a low capacity for ex- ercising effective leverage in the market and may face undue difficulty in attempting to control two or more process bases. This would be especially true in the event that either the manufacturing input source or the final-sale outlet bases were located at a great distance

WINTER / 1967 57

from the manufacturing plant. On the other hand, large firms would be more likely to possess suflBcient re- sources to control manufacturing input sources, ware- house and transportation facilities, and final-sale outlet systems.

4. Adapted from Fred E. Balderston, "Theories of Marketing Structure and Channels," in Delbert J. Dun- can, ed.. Proceedings: Conference of Marketing Teach- ers from Far Western States (Berkeley: University of California, Sept. 8-10, 1958), pp. 134-145.

5. Adapted from Richard H. Holton, "The Role of Competition and Monopoly in Distribution: The Expe- rience in the United States," in John Perry Miller, ed., Competition, Cartels and their Regulation (Amsterdam: North Holland Publishers, 1962), pp. 263-305.

6. Phase SQ represents initial activity on the part of the firm, e.g., defining objectives, raising capital funds, securing key personnel, constructing a manufacturing

plant. As such this period gives no evidence of any vertical integration activity. The notation for phase SQ is: 111,(7).

To explain, the "III" represents process base III (manufacturing); subscript "c" connotes ownership over activities performed at that base; the "/" defines the control strategy, which in this case implies internal- plant expansion. No vertical integration activity is suggested during phase So in that the notation accounts for only one process base.

7. The notation specifies that, in terms of primary vertical integration, a firm: (a) exerts some control over process base II (manufacturing input distribution) through contractual arrangements; (b) controls process base III (manufacturing) via ownership in fee simple resulting from internal plant expansion; and (c) holds nominal control, if any, over process base IV (finished- product distribution) through contractual arrange- ments.

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58 California Management Review