Vertical integration

Vertical integration

The Strategic Management Process External Analysis Strategic Choice Strategy Implementation Competitive Advantage Mission Objectives Which Businesses to Enter? Internal Analysis • Vertical Integration Corporate Level Strategy

1) such that the value of the corporate whole increases 2) such that businesses forming the corporate whole are worth more than they would be under independent ownership 3) that equity holders cannot create through portfolio investing Logic of Corporate Level Strategy Corporate level strategy should create value: • a corporate level strategy should create synergies that are not available in equity markets • vertical integration = value chain economies

Crop Farmers (Alfalfa & Corn) Seed Companies (Alfalfa & Corn) Dairy Farmers (milk) Food Distributors Leprino Foods (Mozzarella Cheese) Pizza Chains End Consumer What is Vertical Integration? Where your pizza comes from

Crop Farmers (Alfalfa & Corn) Seed Companies (Alfalfa & Corn) Dairy Farmers (milk) Food Distributors Leprino Foods (Mozzarella Cheese) Pizza Chains End Consumer What is Vertical Integration? Backward Vertical Integration Forward Vertical Integration

Dairy Farmers (milk) Food Distributors Leprino Foods (Mozzarella Cheese) Value Chain Economies The Logic of Value Chain Economies Backward Vertical Integration • the focal firm is able to create synergy with the other firm(s) • cost reduction • revenue enhancement • the focal firm is able to capture above normal economic returns (avoid perfect competition) Forward Vertical Integration

Vertical Chain • Begins with the acquisition of raw materials • Ends with the sale of finished goods/services • Includes support services such as Finance and Marketing • Organizing the vertical chain is an important part of business strategy

Vertical Boundaries of the Firm • Which steps of the vertical chain are to be performed inside the firm? • Which steps of the vertical chain to be out-sourced? • Choice between the “invisible hand” of the market and the “visible hand” of the organization (Make or Buy)

Make versus Buy • Decision depends on the costs and benefits of using the market as opposed to performing the task in-house • Outside specialists may perform a task better than the firm can • Intermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)

Some Make-or-Buy Fallacies • Firm should make rather than buy assets that provide competitive advantages • Outsourcing an activity eliminates the cost of that activity • Backward integration captures the profit margin of the supplier • Backward integration insures against the risk of high input prices • It makes sense to tie up the distribution channel in order to deny access to the rivals

Make-or-Buy and Competitive Advantage • A firm believes that a particular asset is a source of competitive advantage • It turns out the asset is easily available in the market • The belief regarding competitive advantage will have to be re-evaluated • Example: • GM span off Delphi Electronic. Delphi makes parts for cars. GM felt that if Delphi was competing on the market with other firms, it would be forced to lower its prices. Moreover, Delphi can get scale economies by supplying other firms, thus lowering costs.

Outsourcing and Cost • Outsourcing an activity eliminates the cost of that activity • It should not matter if the costs of performing an activity are incurred by the firm (Make) or by the supplier (Buy) • Outsourcing also has its costs. Suppliers also need to make investments and these costs need to be covered. We will see that supplier markets and asset specificity play an important role here. • Finally, the relevant consideration is whether it is more efficient to make or to buy

Backward Integration and Profits • Backward integration captures the profit margin of the supplier • The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne • If the supplier is earning economic profit, what is the reason for its persistence? • Market competition should eventually erode away the economic profit

Vertical Integration and Input Price Risk • Backward integration insures against the risk of high input prices • Instead of vertical integration, forward or futures contracts can be used to hedge input price risk • Another possibility is that the capital tied up in vertical integration could be used to set up a self insurance fund • Vertical integration into a risky activity will add rather than reduce the overall risk

Example: Rustic Log Homes

Foreclosure of Distribution Channels • It makes sense to tie up the distribution channel in order to deny access to the rivals • Two possibilities • It may be easy for rivals to open up new channels • If not, the price paid to acquire the channel will reflect the value • In either case, economic profits do not always flow from the foreclosure of distribution channels • Example: Intel

Benefits of Using the Market • Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible • Market firms can achieve economies of scale that in-house units cannot • Market firms are subject to market discipline, whereas in-house units may be able to hide their inefficiencies behind overall corporate success (Agency and influence costs)

Economies of Scale

Economies of Scale • A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakes • An outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers • An automobile manufacturer would rather buy anti-lock brakes from an independent supplier than from a competitor • Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer • Will the outside supplier charge c* (its average cost) or c’ (the average cost for the manufacturer for in-house production)? • The answer depends on its degree of competition faced by the supplier

Agency and Influence Costs • The incentives to be efficient and innovative are weaker when a task is performed in-house • Agency costs are particularly problematic if the task is performed by a “cost center” within an organization • It is difficult to internally replicate the incentives faced by market firms

Problems in Using the Market • Costs imposed by poor coordination • Reluctance of partners to share valuable private information • Transactions cost that can be avoided by performing the task in-house • Each problem can be traced to difficulties in contracting

Role of Contracts • Firms often use contracts when certain tasks are performed outside the firm • Contracts list • the set of tasks that need to be performed • the remedies if one party fails to fulfill its obligation • Contracts protect each party to a transaction from opportunistic behavior of other(s) • Contracts’ ability to provide this protection depends on • the “completeness” of contracts • the body of contract law

Complete Contract • A complete contract stipulates what each party should do for every possible contingency • No party can exploit others’ weaknesses • To create a compete contract one should be able to contemplate all possible contingencies • One should be able to “map” from each possible contingency to a set of actions • One should be able to define and measure performances • One should be able to enforce the contract • To enforce a contract, an outside party (judge, arbitrator) should be able to • observe the contingency • observe the actions by the parties • impose the stated penalties for non-performance • Real life contracts are usually incomplete contracts

Incomplete Contracts • Incomplete contracts • Involve some ambiguities • Need not anticipate all possible contingencies • Do not spell out rights and responsibilities of parties completely Factors that Prevent Complete Contracting • Bounded rationality • Difficulties in specifying/measuring performance • Asymmetric information

Bounded Rationality • Individuals have limited capacity to • Process information • Deal with complexity • Pursue rational aims • Individuals cannot foresee all possible contingencies • Example: could we have foreseen the financial crisis in 2008? Few did, but its affects were dramatic.

Difficulties in Specifying/Measuring Performance • Terms like “normal wear and tear” may have different interpretations • Performance cannot always be measured unambiguously • Example: how do you measure the performance of service that is being provided?

Asymmetric Information • Parties to the contract may not have equal access to contract-relevant information • One party can misrepresent information with impurity • Example: suppose that Hyundai would like to award TRW Automotive a bonus if TRW maintains stringent quality control in the production of antilock brakes • How can this be Hyundai be sure that quality is high if TRW carries out the quality controls?

Coordination of Production Flows • For successful coordination one party needs to make decisions that depend on the decision made by others • A good fit should be accomplished in several dimensions • Timing • Size • Color • Sequence • R & D

Coordination Problems • Without good coordination, bottlenecks arise in the vertical chain • Coordination is especially important when “design attributes” are present • To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets

Design Attributes • Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value results • Some examples • Sequencing of courses in MBA curriculum • Fit of auto sunroof glass to aperture • Timely delivery of a critical component • If coordination is critical, administration control may replace the market mechanism • Design attributes may be moved in-house

Leakage of Private Information • Firms would not want to compromise the source of their competitive advantage, hence some activities cannot be out-sourced • Sometimes, contracts can be used to protect against leakage of critical information(Example: Non-compete clause for employees)

Transactions Costs • If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase) • Costs of using the market that are saved by centralized direction – transactions costs • Out-sourcing entail costs of negotiating, writing and enforcing contracts • Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior • Transactions costs explain why economic activities occur outside the price system

Relationship-Specific Assets • Relation-specific assets are essential for a given transaction • These assets cannot be redeployed for another transaction costlessly • Once the asset is in place, the other party to the contract cannot be replaced costlessly, because the parties are locked into the relationship to some degree

Forms of Asset Specificity • Relation-specific assets may exhibit different forms of specificity • Site specificity • Physical asset specificity • Dedicated assets • Human asset specificity

Site Specificity • Assets may have to be located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency • Cement factories are usually located near lime stone deposits • Can-producing plants are located near can-filling plants

Physical Asset Specificity • Physical assets may have to be designed specifically for the particular transaction • Molds for glass container production custom made for a particular user • A refinery designed to process a particular grade of bauxite ore

Dedicated Assets • Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable • International systems’ investment in assembly line making integrated circuits for IBM • A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems

Human Asset Specificity • Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information • Clerical workers in a physicians office acquire the skills to use a particular practice management software • Salespersons posses detailed knowledge of customer firm’s internal organization

Rent and Quasi-rent • The term ‘rent” denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted • Quasi-rent is the excess economic profit from a transaction compared with economic profits available form an alternate transaction

Rent and Quasi-rent • Firm A makes an investment to produce a component for Firm B after B has agreed to buy from A at a certain price • At that price A can earn an economic profit of π1 • If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be π2

Rent and Quasi-rent • Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1) • Quasi-rent is the economic profit in excess of the minimum needed to retain A in the selling relationship with B (π1- π2)

The Holdup Problem • Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itself • A complete contract will not permit the breach • With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

Effect on Transactions Costs • The holdup problem raises the cost of transacting exchanges • Contract negotiations become more difficult • Investments may have to be made to improve the ex-post bargaining position • Potential holdup can cause distrust • There could be underinvestment in relation specific assets

Asset Specificity and Transactions Costs • Relation-specific assets support a particular transaction • Redeploying to other uses is costly • Quasi rents become available to one party and there is incentive for a holdup • Potential for holdups lead to • Underinvestment in these assets • Investment in safeguards • Reduced trust

Power Barges

Competitive Advantage If a vertical integration strategy meets the VRIO criteria… Is it Valuable? Is it Rare? Is it costly to Imitate? Is the firm Organized to exploit it? …it may create competitive advantage.

Value of Vertical Integration Market vs. Integrated Economic Exchange • markets and integrated hierarchies are ‘forms’ in which economic exchange can take place • economic exchange should be conducted in the form that maximizes value for the focal firm • thus, firms assess which form is likely to generate more value Integration makes sense when the focal firm can capture more value than a market exchange provides

Leverage Capabilities Manage Opportunism Exploit Flexibility Value of Vertical Integration Three Value Considerations • internalizing is usually less flexible • firm capabilities may be sources of competitive advantage in other businesses • opportunism may be checked by internalizing (TSI) • flexibility is prized when uncertainty is high • internalizing must be less costly than opportunism • if not, then don’t integrate exchange

Rarity of Vertical Integration Integration vs. Non-Integration • a firm’s integration strategy may be rare because the firm integrates or because the firm does not integrate • thus, the question of rareness does not depend on the number of forms observed • a firm’s integration strategy is rare or common with respect to the value created by the strategy Example: Toyota’s Choice Not to Integrate Suppliers

Imitability of Vertical Integration Form vs. Function • the form, per se, is usually not costly to imitate • the value-producing function of integration may be costly to imitate, if: • the integrated firm possesses resource combinations that are the result of: • historical uniqueness • causal ambiguity • social complexity • small numbers prevent further integration • capital requirements are prohibitive

Vertical integration