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

Logic of Corporate Level Strategy Corporate level strategy should create value: 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 • a corporate level strategy should create synergies that are not available in equity markets • vertical integration = value chain economies

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

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

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

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 The third argument may be flawed even if the upstream supplier's profits are high enough to generate substantial positive economic profits. The downstream manufacturer might believe that it could make an input at a cost below the “exorbitant” supply price. Before doing so, however, the manufacturer should ask itself the following: “If the supplier of the input is so profitable, why don't other firms enter the market and drive the price down?” The answer to this question will often dissuade the manufacturer from choosing to vertically integrate. Perhaps it is difficult to obtain the expertise needed to make the desired input, or maybe the existing supplier is the only one large enough to reap economies of scale. In these circumstances, the manufacturer would likely find it cheaper to pay the supplier's high price rather than make the input itself. EDS

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 To illustrate the subtle issues raised by the fourth fallacy, consider a fictitious manufacturer of log homes, Rustic Homes. Rustic Homes sells log cabins that it assembles from specially milled lumber. The market price of this lumber varies from year to year, and for this reason, Rustic's managers are contemplating backward integration into the raising and milling of trees. This is a tempting but fallacious reason for vertical integration. To see why, suppose that Rustic sells its log cabins for $10,000 each. Besides the costs of milled lumber, it incurs $4,000 in labor costs for every cabin it assembles. During the next year, Rustic has 100 confirmed orders for log cabins. It contemplates two options for its raw materials needs: 1. It can purchase lumber in the open market. Rustic believes that there is a chance that the price of the lumber needed to build one cabin will be $7,000, a chance that the price will be $5,000, and a chance that the price will be $3,000. 2. It can backward integrate by purchasing forest land and a lumber mill. To finance the purchase, Rustic can obtain a bank loan that entails an annual payment of $350,000 (or $3,500 per cabin). In addition, the cost of harvesting timber and milling it to produce the finished lumber for one cabin is $1,500. Thus, the effective cost of timber would be $5,000 per cabin. Table 5.2 illustrates Rustic's annual income under these options. Under the vertical integration option, Rustic has an assured annual profit of $100,000. Under the non-integration option, Rustic's net income is uncertain: It could be $300,000, it could be $100,000, or it could be −$100,000. The expected value of this uncertain income is $100,000.6 Even though the vertical integration and nonintegration options entail the same expected profit, it is tempting to argue in favor of vertical integration because it eliminates Rustic's risk of income fluctuations. This is an especially tempting argument if management is concerned that when lumber prices are high ($7,000), Rustic will not have enough cash to cover its loss and thus will go bankrupt. If Rustic is committed to being an ongoing business concern, according to this argument it should vertically integrate to eliminate the risk of being unable to pay its bills. Rustic does not, however, need to vertically integrate to eliminate its income risk. It could counteract price fluctuations by entering into long-term (i.e., futures) contracts with lumber suppliers. This is a practice known as hedging, and businesses whose products depend on raw materials that are subject to price fluctuations employ it all the time. For example, a key input in the production of margarine is soybean oil (it represents 80 percent of total materials costs), and manufacturers of margarine, such as Nabisco (producer of Blue Bonnet and Fleischmann's) and Unilever (producer of Shedd's), hedge against price fluctuations by purchasing soybean oil through futures contracts. Even if Rustic could not hedge, the argument for vertical integration is still flawed. After all, if Rustic could raise the capital to purchase the forest land, it could instead create a capital reserve to weather short-term fluctuations in lumber prices (e.g., perhaps through a line of credit from the same bank that was willing to loan it the money to buy the land and the lumber mill). (Besanko 126) Besanko. Economics of Strategy ISV, 5th Edition. John Wiley & Sons, 38990. VitalBook file.

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 Acquiring vertical partners to tie up channels seems to offer an easy way to increase profits: An upstream firm acquires a monopoly downstream supplier and then refuses to sell to its rivals (or sets a very high price). This strategy has a number of limitations. First, it may run afoul of antitrust laws, which prohibit many forms of vertical foreclosure. Second, the upstream firm must be careful not to pay too much for the acquisition; after all, the downstream firm already has monopoly power and will presumably command a correspondingly high price. Third, the acquirer must consider how difficult it is for competitors to open new channels of distribution. Vertical foreclosure is clearly no panacea. Economists have identified a number of special cases in which foreclosure may succeed. One example involves an upstream monopoly supplier that is unable to commit to a high price when selling to downstream firms. This could occur if, after selling at a high price to one downstream firm, it realizes that it can increase its profits by setting a lower price to other, more price-sensitive buyers. As a result, all buyers, including the first one, may become leery of accepting the monopoly supply price. By forward integrating, the supplier can fully commit to limiting both input supply and output, thereby increasing its profits. Another example is when an upstream firm is “rolling up” (i.e., acquiring) several downstream firms to create a network. As the network grows, the remaining firms may then accept lower prices rather than be left out of the network altogether. Why has Intel never got involved in building computers?

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) DSM and Chemalot

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 Example of Delphi

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? Even if the parties can foresee the contingencies and specify and measure the relevant performance dimensions, a contract may still be incomplete because the parties do not have equal access to all contract-relevant information. If one party knows something that the other does not, then information is asymmetric, and the knowledgeable party may distort or misrepresent that information. For example, suppose that Hyundai would like to award TRW Automotive a bonus if TRW maintains stringent quality control in the production of antilock brakes. Because TRW is responsible for quality control, it is the only one that can verify that appropriate measures have been taken. If the antilock brakes did not perform as expected, TRW could claim that it took the required steps to assure durability even when it did not. TRW might even claim that the fault lay in an associated electronics system manufactured by another firm. Understanding TRW's self-interest, Hyundai might protest these claims. To enforce this contract, a court would have to look at evidence (e.g., an independent quality audit or testimony from each party) to ascertain whether the contract was fulfilled. But given the complexity of automotive braking systems, this evidence may well be inconclusive, and the court would have little basis on which to resolve the dispute. Under these circumstances, Hyundai and TRW may be unable to contract for “quality control.”

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 • Timing fit. The launch of a Heineken marketing campaign must coincide with increased production and distribution by its bottlers. • Size fit. The sunroof of an automobile must fit precisely into the roof opening. • Color fit. The tops in Benetton's spring lineup must match the bottoms. • Sequence fit. The steps in a medical treatment protocol must be properly sequenced.

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) Firms may find it especially difficult to protect critical information that it must share with employees. Urban legend has it that the secret formula to Coca-Cola is known to only two executives, and each only knows one-half! (The reality is that a small handful of Coke execs know the entire formula.) Professional services firms that jealously guard privileged information about research, data, and even client lists often require new workers to sign noncompete clauses. These clauses state that should the individual leave the firm, he or she may not directly compete with it for several years. Protected by the noncompete clause, the firm can reveal important competitive information. In practice, many firms find it difficult to enforce noncompete clauses, making employment hardly more effective at protecting information than contracting with independent workers. Give example of Oliver’s paint company SICPA security inks

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 Three important theoretical concepts from transactions-costs economics: relationship-specific assets, quasi-rents, and the holdup problem.

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 Could ask the students to think of relationship assets between them and their suppliers or buyers.

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 Site specificity refers to assets that are located side-by-side to economize on transportation or inventory costs or to take advantage of processing efficiencies. Traditional steel manufacturing offers a good example. Side-by-side location of blast furnaces, steelmaking furnaces, casting units, and mills saves fuel costs, as the pig iron, molten steel, and semifinished steel do not have to be reheated before being moved to the next process in the production chain.

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 Physical asset specificity refers to assets whose physical or engineering properties are specifically tailored to a particular transaction. For example, glass container production requires molds that are custom tailored to particular container shapes and glass-making machines. Physical asset specificity inhibits customers from switching suppliers.

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 A dedicated asset is an investment in plant and equipment made to satisfy a particular buyer. Without the promise of that particular buyer's business, the investment would not be profitable. The government-run Associated British Ports (ABP) often invests in dedicated facilities to serve the specific needs of import and/or export customers. For example, one facility might be designed with specialized bagging equipment to accommodate construction materials, whereas another may be equipped with concrete batching machines to handle marine aggregates (sand and gravel). ABP usually requires long-term contracts from its customers before making these multimillion-pound investments.

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 Human asset specificity refers to cases in which a worker, or group of workers, has acquired skills, know-how, and information that are more valuable inside a particular relationship than outside it. Human asset specificity includes not only tangible skills, such as expertise with company-specific software, but also intangible assets. For example, every organization has unwritten “routines” and “standard operating procedures.” A manager who has become a skillful administrator within the context of one organization's routines may be less effective in an organization with completely different routines. For example, as hospitals develop new treatment protocols, the training of nurses and other specialized staff will become more firm-specific. Training of aides and orderlies, on the other hand, will remain transferable to other hospitals.

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 The Fundamental Transformation The need to create relationship-specific assets transforms the relationship as the transaction unfolds. Before individuals or firms make relationship-specific investments, they may have many alternative trading partners and can choose to partner with those that afford the highest possible profit. But after making relationship-specific investments, they will have few, if any, alternatives. Their profits will be determined by bilateral bargaining. In short, once the parties invest in relationship-specific assets, the relationship changes from a “large numbers” bargaining situation to a “small numbers” bargaining situation. Oliver Williamson refers to this change as the fundamental transformation.21

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) • Your quasi-rent is the difference between the profit you get from selling to Audi and the profit you get from your next-best option, selling to jobbers. That is, quasi-rent is [1,000,000(P* − C) − I] − [1,000,000(Pm − C) − I] = 1,000,000(P* − Pm). • In words: Your quasi-rent is the extra profit that you get if the deal goes ahead as planned, versus the profit you would get if you had to turn to your next-best alternative (in our example, selling to jobbers). When an asset is not relationship specific, the quasi rent is 0. When you add relation specific assets, you create quasi rents.

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 If the quasi rent is large a firm could lose a lot. This gives an incentive a trading partner to lower price, to capture your quasi rent. If contracts are not complete, they can do this. You might have to accept a lower price because the quasi rent is so big, you stand to lose a lot if the deal does not go through. Essentially, if quasi rents are high, and it is difficult to make a complete contract, then you should integrate vertically.

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 How do you solve a problem like power generation

Power Barges Energy supply is often a problem in developing countries. Investments are high and specific and countries default. The solution is to make them less relationship specific through putting a power station on a boat.

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

Value of Vertical Integration Three Value Considerations Leverage Capabilities Manage Opportunism Exploit Flexibility • firm capabilities may be sources of competitive advantage in other businesses • opportunism may be checked by internalizing (TSI) • internalizing is usually less flexible • 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

Imitability of Vertical Integration Modes of Entry • acquisition and internal development are alternative modes of entry into vertical integration • thus, one firm may acquire a supplier while a competitor could imitate that strategy through internal development • in both cases, the boundaries of the firm would encompass the new business • strategic alliances can be viewed as a substitute for vertical integration—without the costs of ownership

Organizing Vertical Integration Functional Structure (U-Form) CEO’s Role Cooperation Accounting Finance Marketing HR Engineering Original Business Original Business Original Business Original Business Original Business Conflict Cooperation The idea here is that when you integrate, the vertical part just drops into one of the silos. However, this is the case with the U form. Seems to me a divisional form would be better. New Business New Business New Business New Business New Business Conflict

Organizing Vertical Integration Management Controls What needs to be ‘controlled’ in a vertically integrated firm? • managers’ efforts to achieve the desired value chain economies • cooperation and competition among and between functions • the integration of new businesses into the existing business • time horizon of managers

Organizing Vertical Integration Management Controls Board Committees Budgets • separating strategic and operational budgets • provide oversight and direction to managers • strategic: inputs & outputs • help ensure that strategic direction is maintained The difference between the two types of committees is essentially in their focus: the executive committee tends to focus on short-term firm performance while the operations committee has a long-term view of firm performance. Both committees are staffed by the CEO and key functional area managers. They meet regularly (typically, weekly for the executive committee and monthly for the operations committee) to identify problems and come up with solutions. Such committees also help in reducing the conflicts among departments. • operational: outputs These mechanisms focus management attention on achieving value chain economies

Organizing Vertical Integration Compensation Salary Integration Opportunism Cash Bonus: Individual Stock Grants: Individual Cooperation Leveraging Capabilities Cash Bonus: Group Reward systems are always difficult to manage. Refer back to the case of EDS. Stock Grants: Group Stock Options: Individual Exploiting Flexibility Time Horizon Stock Options: Group

Summary Vertical Integration… • makes sense when value chain economies can be created and captured • may allow a firm to leverage capabilities • may be a response to the threat of opportunism and uncertainty • as a form of exchange per se, is not rare nor costly to imitate

Summary Vertical Integration… • is an important consideration in the decision to expand internationally (range of possibilities) • makes sense when done for the right reasons, under the right circumstances • can be a costly mistake if done wrong Ownership is costly—integrate only when the benefits outweigh the costs of integration!