Vertical Integration

AEC 422

See Besanko Ch 3 and Ch 4 ( pp.132-151)

Unit 1Microeconomics of the Firm

Vertical Chain

Begins with the acquisition of raw materials

Ends with the sale of finished goods/services

Can include support services such as Finance and Marketing

Organizing the vertical chain is an important part of business strategy

Channel management

Organization of the Business

Primary activities

Supportactivities

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Firm Infrastructure

Human Resource Management

Technology Development

Procurement

ProfitMargin

Porter’s Organization of the Firm

Supply Chain Management

“upstream” suppliers provide many kinds of resources to operate the firm.

Most firms have many types of suppliers

Scope of activities within a firm can be many Production, research,

packaging, distribution

Many small firms choose to outsource to secure use of certain assets made available in the market by other firms Advertising Tax management Distribution Web management

YOUR FIRM Key CustomerKey Supplier or Partner

Supply Chain Management

“upstream” suppliers provide many kinds of resources to operate the firm.

Scope of activities within a firm can be many Production, research,

packaging, distribution

Many small firms choose to outsource to secure use of certain assets made available in the market by other firms Advertising Tax management Distribution Web management

YOUR FIRM Key CustomerKey Supplier or Partner

Outsourcing and integrating

UPS Supply Chain Solutions

Accountemps - Accounting Staffing AgencyVineyard – wineryWeb designQ-Labs microbial testing

Papa JohnsFoodservice, Inc.

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)

Like criteria for scope economies – which system is cheaper?

Some creative uses of outsourcing – implications for the balance sheet

Make or Buy Continuum

Arm’s length Market Transactions

Less Integrated

Long-Term Contracts

Strategic Alliances/Joint Ventures Vertical Coord.

Parent/Subsidiary Relationship

More Integrated

Perform Activity Internally

Do we make it ourselves or buy it?

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)

Do we make it ourselves or buy it?

Other factorsFrequency and volume of purchase/needUniqueness of the assetProprietary nature of the product

Also relates to the merger & acquisition issue

Sometimes the best strategy is to pursue vertical integration

Grape Sourcing by MidSouth Wineries

Source: 2011 Winery Price and Market Survey

% Grown in own

vineyards

% contracted with other growers

% purchased on spot market

Small Wineries (<3000 cases) 64.1 29.0 6.2Larger Wineries (3000 or more cases) 45.4 41.5 11.9

Elk Creek Winery, KY

Benefits and Costs of Using the Market

BENEFITS: - can be cheaperMarket Firms Can Achieve Economies of Scale:

In-House Production May Be Too LowMarket Firms Must Be Efficient to Survive In The Market

Environment

COSTS: - may be hidden costsCoordination May Be CompromisedPrivate Information May Be LeakedThere May Be High Transaction Costs In The Market

ie, search, paperwork, post-purchase recourse

Benefits of Using the Market

Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible

Market firms can sometimes achieve economies 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)

Often there are choices in channel partners with which to work

Agency Costs

Does the outside firm have the same commitment to the delivery of the product or service needed?Not always - conflicts of interest, other clients

Example: Purity Foods, Inc.Can have internal agency costs, too – managers &

workers knowingly do not act in the best interest of the business

Influence costs

In addition to internal agency costs, performing a task in-house will lead to “influence costs” as well

Influence cost – time consumed by a manager campaigning central management to allocate resources to his/her division

Note – a poor process of external “bidding” can add to the cost of outsourcing, as well. Need to find the right firm the first time.

Problems in Using the Market: Lack of Control

Costs imposed by poor coordinationReluctance of partners to share valuable

private informationTransactions cost that can be avoided by

performing the task in-houseEach problem can be traced to difficulties

in contracting

New Product DevelopmentStages

Buyer Involved

Buyer Not

InvolvedSupplierInvolved

SupplierNot

Involved

months of development time

Concept Search 1.9 2.4 2.0 2.3

Concept Screening 2.5 0.6 1.3 0.7

Concept Testing 1.6 0.7 1.5 0.8

Business Analysis 2.9 1.7 2.2 1.8

Product Development 3.4 3.0 3.0 2.0

Product Testing 2.3 0.9 1.2 0.7

Commercialization 3.3 2.1 2.3 1.9

Candy New Product Development

…..outsourcing generally adds to development time.Source: Woods and Spaulding, J Food Distr Research 2006

Make or Buy Continuum

Arm’s length Market Transactions

Less Integrated

Long-Term Contracts

Strategic Alliances/Joint Ventures Vertical Coord.

Parent/Subsidiary Relationship

More Integrated

Perform Activity Internally

Complete Contract

A complete contract stipulates what each party should do for every possible contingency

No party can exploit others’ weaknessesTo create a complete contract one should be able to

contemplate all possible contingenciesOne should be able to “map” from each possible

contingency to a set of actionsOne should be able to define and measure

performancesOne should be able to enforce the contract

Complete Contract (Continued)

To enforce a contract, an outside party (judge, arbitrator) should be able toobserve the contingencyobserve the actions by the partiesimpose the stated penalties for non-

performance

Real life contracts are usually incomplete contracts

Incomplete Contracts

Incomplete contractsInvolve some ambiguitiesNeed not anticipate all possible contingenciesDo not spell out rights and responsibilities of

parties completely

Factors that Prevent Complete ContractingBounded rationalityDifficulties in specifying/measuring

performanceAsymmetric information

Bounded Rationality

Individuals have limited capacity toProcess informationDeal with complexityPursue rational aims

Individuals cannot foresee all possible contingencies

Specifying/Measuring PerformanceTerms like “normal wear and tear” may have

different interpretationsPerformance cannot always be measured

unambiguously

Asymmetric InformationParties to the contract may not have equal

access to contract-relevant informationOne party can misrepresent information

Limitations of Contract Law

Doctrines of contract law are in broad language that could be interpreted in different ways

Litigation can be a costly way to deal with breach of contractLitigation can be time consumingLitigation weakens the business relationship

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 dimensionsTimingSizeColorSequenceR & D

Case in point: Private Label Grocery Products

Private Label Share by Department

Source: IRI 2012, Multi-outlet supermarkets, drug stores, mass market retailers

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 examplesSequencing of courses in AEC degreeFit of auto sunroof glass to apertureTimely delivery of a critical component

Design Attributes

If coordination is critical, administration control may replace the market mechanism

Design attributes may be moved in-housePepsi-Cola and its Bottlers

Make or Buy Continuum

Arm’s length Market Transactions

Less Integrated

Long-Term Contracts

Strategic Alliances/Joint Ventures Vertical Coord.

Parent/Subsidiary Relationship

More Integrated

Perform Activity Internally

Alternatives to Vertical Integration

Tapered integration (making some and buying the rest)

Joint ventures and strategic alliancesLong term collaborative relationships Implicit contracts between firms

Tapered Integration in Gasoline Retailing

Major oil refiners sell through their own service stations and through independently owned stations

As gas stations have moved away from auto repair and maintenance services, the proportion of company owned stations are growing

Transaction based Alliance basedShort-term relationships

Multiple suppliers

Adversarial relationships

Price dominates

Minimal investment from suppliers

Minimal information sharing

Firms are independent

Minimal interaction between respective functional areas

Long-term relationships

Fewer suppliers

Cooperative partnerships

Value-added services dominate

High investment for both buyer and supplier

Extensive product, marketing, and logistics information sharing

Firms are interdependent with joint decision making

Extensive interaction between buyer and supplier functional areas

Source: D. Ross: Competing Through Supply Chain Management, 1999

Alliance Relationships

Supply Chain Management

Integration (make or buy) ultimately about the structure that delivers the greatest value

Internal vs external economies

YOUR FIRM Key CustomerKey Supplier or Partner