1. Chapter 6
Vertical Integration

2. 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

3. 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

4. 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

5. 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

6. 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

7. End Segment 1

8. Section 2
Competitive Advantage in Vertical Integration

9. 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.

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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
New
Business
New
Business
New
Business
New
Business
New
Business
Conflict

16. 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

17. 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
• operational: outputs
These mechanisms focus management attention
on achieving value chain economies

18. Organizing Vertical Integration
Compensation
Salary
Integration
Opportunism
Cash Bonus: Individual
Stock Grants: Individual
Cooperation
Leveraging
Capabilities
Cash Bonus: Group
Stock Grants: Group
Stock Options: Individual
Exploiting
Flexibility
Time Horizon
Stock Options: Group

19. 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

20. 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!

21. Segment 3
Scope of the firm

22. Transactions Costs and the Scope of the Firm
VerticalScope
ProductScope
Geographical Scope
[A] Single
Integrated
Firm V1 V2 V3 P1 P2 P3 C1 C2 C3
[B] Several
Specialized
Firms Linked
by Markets V1 P1 P2 P3 C1 C2 C3 V2 V3
In situation [A] businesses 1, 2 & 3 are integrated within a single firm.
In situation [B] businesses 1, 2 & 3 are independent firms linked by markets.
Which situation is more efficient? Depends upon whether the administrative costs of the integrated firm are less than the transaction costs of markets? 35

23. Currently In favor of: Against
Effective outsourcing firms
Contingent contracts
Against
Rise of “ecosystem” product models
…. Apple
It is not quite an either/or choice anymore. Theory has not gotten too far away from the make/buy distinction but frequently firms do both.

24. When is Vertical Integration More Attractive than Outsourcing?
How many firms are available The fewer the companies to transact with? the more attractive is VI Is transaction-specific investment If yes, VI more attractive needed? Does limited information permit VI can limit opportunism cheating? Are taxes or regulation imposed VI can avoid them on transactions? Are future market conditions uncertain? Uncertainty favours VI Do the different stages have similar Greater the similarity, the optimal scales of operation? more attractive is VI Are the two stages strategically Strategic similarity favors VI Is continued investment required Investment needs favor VI in each activity Is entrepreneurial initiative required If so, VI may blunt high- powered profit incentives, How uncertain is market demand? Greater the unpredictability —the more costly is VI Are risks compounded by VI increases risk. linkages between vertical stages