vertical integration copyright © 2008 pearson prentice hall. all rights reserved. 6-1 chapter 6

Vertical Vertical IntegrationIntegration

Chapter 6Chapter 6

Vertical Integration

Strategic Management & Competitive Advantage – Barney & Hesterly 2

Vertical IntegrationVertical Integration

Mission Objectives

ExternalAnalysis

InternalAnalysis

StrategicChoice

StrategyImplementation

CompetitiveAdvantage

The Strategic Management Process

Corporate LevelStrategy

Which Businessesto Enter?

• Vertical Integration

Logic of Corporate Level Strategy

Corporate level strategy should create value:

2) such that businesses forming the corporate wholeare worth more than they would be under independent ownership

3) that equity holders cannot create throughportfolio investing

• a corporate level strategy should createsynergies that are not available in equitymarkets

• vertical integration = value chain economies

1) such that the value of the corporate whole increases

What is Vertical Integration?

Leprino Foods(Mozzarella Cheese)

Where your pizza comes from

Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

What is Vertical Integration?

Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

BackwardVertical

Integration

ForwardVerticalIntegration

Value Chain Economies

Dairy Farmers(milk)

Food Distributors

BackwardVertical

Integration

ForwardVerticalIntegration

The Logic of Value Chain Economies

• the focal firm is able tocreate synergy with theother firm(s)

• the focal firm is able tocapture above normal economic returns(avoid perfect competition)

• cost reduction

• revenue enhancement

Competitive Advantage

If a vertical integration strategy meets theVRIO 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

• economic exchange should be conducted in the formthat maximizes value for the focal firm

• markets and integrated hierarchies are ‘forms’ in whicheconomic exchange can take place

• thus, firms assess which form is likely to generatemore value

Integration makes sense when the focal firm can capture more value than a market exchange provides

Value of Vertical Integration

Three Value Considerations

LeverageCapabilities

ExploitFlexibility

ManageOpportunism

• firm capabilitiesmay be sourcesof competitiveadvantage inother businesses

• if not, then don’tintegrate exchange

• opportunismmay be checkedby internalizing (TSI)

• internalizing mustbe less costly thanopportunism

• internalizing isusually lessflexible

• flexibility is prized whenuncertainty ishigh

Rarity of Vertical Integration

Integration vs. Non-Integration

• a firm’s integration strategy may be rare becausethe firm integrates or because the firm does notintegrate

• thus, the question of rareness does notdepend on the number of forms observed

• a firm’s integration strategy is rare or common withrespect 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 maybe costly to imitate, if:

• the integrated firm possesses resourcecombinations 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 alternativemodes of entry into vertical integration

• strategic alliances can be viewed as a substitute forvertical integration—without the costs of ownership

• thus, one firm may acquire a supplier while acompetitor could imitate that strategy throughinternal development

• in both cases, the boundaries of the firm wouldencompass the new business

Organizing Vertical Integration

Functional Structure (U-Form)

Accounting Finance Marketing HR Engineering

Conflict

OriginalBusiness

NewBusiness

OriginalBusiness

NewBusiness

OriginalBusiness

Cooperation

CEO’s Role

Management Controls

What needs to be ‘controlled’ in a vertically integratedfirm?

• cooperation and competition among and betweenfunctions

• the integration of new businesses into the existing business

• managers’ efforts to achieve the desired valuechain economies

• time horizon of managers

Management Controls

BudgetsBoard

Committees

• separating strategic andoperational budgets

• strategic: inputs& outputs

• operational: outputs

• provide oversight and direction to managers

• help ensure that strategicdirection is maintained

These mechanisms focus management attentionon achieving value chain economies

CompensationSalary

Cash Bonus: Individual

Stock Grants: Individual

Cash Bonus: Group

Stock Grants: Group

Stock Options: Individual

Stock Options: Group

Opportunism

LeveragingCapabilities

ExploitingFlexibility

Cooperation

Time Horizon

Integration

International Expansion

Cost(Capital at Risk)

ControlExporting

Licensing

Franchising

Strategic Alliance

Greenfield Investment

Low High

Acquisition

The Cost – Control Tradeoff

VerticallyIntegrated

Not Vertically Integrated

SomewhatVerticallyIntegrated

Summary

Vertical Integration…

• makes sense when value chain economiescan be created and captured

• may allow a firm to leverage capabilities

• may be a response to the threat of opportunismand uncertainty

• as a form of exchange per se, is not rare norcostly to imitate

Summary

Vertical Integration…

• is an important consideration in the decisionto 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 thebenefits outweigh the costs of integration!

vertical integration copyright © 2008 pearson prentice hall. all rights reserved. 6-1 chapter 6

vertical integration

vertical integration

vertical integration

value integration

function of integration

firms integration strategy

pearson prentice hall

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