Chapter 14: The Strategic Analysis of Vertical Integration
Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Chapter 14: The Strategic Analysis of Vertical Integration p. 300
Vertical integration refers to a type of organization structure where a firm combines the various functions of a business such as supply, production, selling, distribution, and/or other economic processes. Although vertical integration is often viewed in terms of a "make vs. buy" decision, these decisions involve a much broader group of strategic issues than the financial considerations involved in the typical make or buy calculation. The purpose of this chapter is to present a framework for examining the economic and administrative consequences of vertical integration that will aid firms in balancing the cost and benefits of tapered, full, or quasi integration.
Strategic Benefits and Costs of Vertical Integration p. 302
This section includes a discussion of some important generic benefits and costs of vertical integration where the upstream firm refers to the selling firm, and the downstream firm refers to the buying firm.
Volume of Throughput versus Efficient Scale p. 302
The benefits of vertical integration depend on whether the volume of throughput (i.e., the products or services sold or purchased by upstream or downstream units) is large enough to obtain the economies of scale needed to support an efficient unit. If the volume is below an efficient unit's volume, the firm will either have to build a small inefficient unit, or build an efficient unit that may have to sell to its competitors.
Strategic Benefits of Integration p. 303
Economies of Integration - Economies of integration refers to the benefits obtained when the volume of throughput is large enough to support economies of scale in the integrated units.
Economies of Combined Operations - Benefits may include a reduction in the number of steps required, a reduction in handling and transportation costs, and the utilization of slack capacity.
Economies of Internal Control and Coordination - Benefits may include less slack and idle time, steadier supply, smoother deliveries, less inventory, better control and coordination of schedules, maintenance, styling and design changes.
Economies of Information - Integration may reduce the cost of obtaining information about demand, supply, and prices.
Economies of Avoiding the Market - Integration can provide savings in the cost related to selling, shopping for and negotiating prices, and other cost of market transactions.
Economies of Stable Relationships - Integration may enable units of the firm to develop specialized procedures and systems, e.g., dedicated logistical systems, special packaging, and special procedures for record keeping and control.
Characteristics of Vertical Integration Economies - The economies mentioned above are also important because they can support a firm's strategy in other ways, e.g., provide support for a low-cost production strategy.
Tap Into Technology - Firms may integrate forwards or backwards to better understand the technology of components going into their products, or to understand the technology related to how their products are used.
Assure Supply and/or Demand - Vertical integration reduces the uncertainty related to the risk associated with interruptions, changes in suppliers or customers, and prices. However, transfer prices should reflect market prices to insure both upstream and downstream units are managed properly. (Transfer pricing is a complex topic. See Martin, J. R. Chapter 14).
Offset Bargaining Power and Input Cost Distortions - Vertical integration can also lower supply costs and reveal the true cost of inputs (through backward integration), or increase price realization (through forward integration). However, transfer pricing policies can work against obtaining these benefits.
Enhanced Ability to Differentiate - Vertical integration can enable the firm to provide superior service and differentiate in other ways such as producing in-house proprietary components.
Elevate Entry and Mobility Barriers - The advantages of integration like those mentioned above add entry barriers for new entries or unintegrated firms who must integrate to become competitive.
Enter a Higher Return Business - In some cases integration may offer a higher return on investment where the return from the adjacent stage is greater than the firm's current stage and high enough to offset any entry barriers.
Defend Against Foreclosure - The unintegrated firm may have to integrate when competitors are integrated to maintain access to suppliers and customers.
Strategic Costs of Integration p. 309
The strategic costs of integration include the cost of entry, flexibility, balance, management ability, and internal organization incentives.
Cost of Overcoming Mobility Barriers - The cost of overcoming entry barriers can be a significant cost of integration unless proprietary technology and sources of raw materials are not significant barriers, and the scale required for an efficient integrated unit is not prohibitive.
Increased Operating Leverage - Vertical integration increases the firm's proportion of fixed cost and operating leverage, adding a greater risk from fluctuations in the business cycle.
Reduced Flexibility to Change Partners - In cases where a supplier or customer is no longer suitable, vertical integration increases the costs of changing suppliers or customers relative to contracting with independent entities.
Higher Overall Exit Barriers - Any of the exit barriers described in Chapter 12 may be increased by vertical integration.
Capital Investment Requirements - Vertical integration can drain capital away from where it is needed and expose the firm to greater risk in other areas of the business. Thus, the return from integration should be above the firm's opportunity cost of capital, adjusting for the benefits previously discussed.
Foreclosure of Access to Supplier or Consumer Research and/or Know-How - Vertical integration may cut off access to supplier or customer technology because it puts the firm in competition with those entities.
Maintaining Balance - Balancing internal demand and supply to avoid excess capacity may be difficult when there are technological, product mix or quality changes in one stage that creates unequal capacity. This situation may require the firm to sell or buy from competitors who might be reluctant to cooperate.
Dulled Incentives - Integrated units of a firms may not bargain as well with each other, and in some cases may attempt to support an unhealthy sister unit because of a sense of fairness and comradeship.
Differing Managerial Requirements - Integrated units of a business may require very different organization structures, management skills, controls, incentives and other techniques. For this reason, the need to learn how to properly manage integrated units can add considerable cost and risk to the vertically integrated firm.
Particular Strategic Issues in Forward Integration p. 315
There are a number of additional issues related to forward integration.
Improved Ability to Differentiate the Product - Forward integration such as adding distribution and retail units can provide a basis for differentiation by providing a basis for controlling the sales presentation, customer service, image of the store location, and other elements of the customer relationship.
Access to Distribution Channels - Forward integration removes the bargaining power of distribution channels.
Better Access to Market Information - Forward integration into the demand leading stage (where the demand originates) can provide critical market information that is needed to avoid the cost of overages and underrages resulting from cyclical or erratic demand. (See The Beer Game for an illustration of what happens with limited market information).
Higher Price Realization - Forward integration may allow a firm to charge different prices to different customers resulting in higher overall prices, although arbitrage may occur, and the practice may be illegal in some cases. For example, a firm might set the price of a basic product low for some customers that also buy associated products that allows the firm to recoup the basic price difference. This is legal if the buyer is not required to purchase the associated products as a condition for purchasing the basic product.
Particular Strategic Issues in Backward Integration p. 317
Some additional issues in backward integration include the following:
Proprietary Knowledge - Integrating with a firm's suppliers can avoid providing proprietary information to outside suppliers who would have considerable bargaining power and pose a threat of entry.
Differentiation - Integrating backward to gain control over the production of key inputs may improve the final product and/or distinguish it from competitors' products.
Long-Term Contracts and the Economics of Information p. 318
Some of the economies of vertical integration can be gained by contracting with independent firms (e.g., locating plants next to each other), but such contracts may expose the firm to the risk of being locked-in and post contract haggling. In any case, this option should be considered, especially when the cost and risk of integration are significant.
Tapered Integration p. 319
Tapered integration refers to partial backward or forward integration where the firm purchases the remainder of its needs on the open market. For tapered integration to be advantageous, the firm's product or service demands need to be large enough to support an efficient size in-house facility and still require additional product or service from the market.
Tapered Integration and the Costs of Integration - Tapered integration requires less fixed costs, helps guard against the imbalances between stages, and reduces the risk of being completely locked-in to a single supplier or buyer. A disadvantage is that it requires the firm to buy from, or sell to competitors.
Tapered Integration and the Benefits of Integration - Tapered integration gives the firm bargaining power with suppliers and customers without the necessity of full integration, and also allows the firm to gain detailed knowledge of the operating costs of the integrated industry.
Quasi-Integration p. 321
Quasi-integration includes arrangements such as minority equity investments, loans or loan guarantees, prepurchase credits, exclusive dealing agreements, specialized logistical facilities, and cooperative R&D. Quasi-integration can provide lower cost than full integration, eliminate the need to commit to the full supply or demand of an adjacent unit, avoid the investment required for integration, and avoid the need to manage the adjacent business. However, an analysis of quasi-integration is needed to determine if the potential benefits exceed those that could be obtained by full or partial integration.
Illusions in Vertical Integration Decisions p. 322
There are several misperceptions related to vertical integration:
1. Integration extends a strong market position in one stage to the integrated stage.
2. It is always cheaper to do things internally.
3. It frequently makes sense to integrate into a competitive business.
4. It can save a strategically sick business.
5. Experience in one part of a vertical chain qualifies management to manage upstream or downstream units.
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