PoM L5:

Vertical Integration
What is vertical integration?
 Firm’s ownership of vertically related activities
 An expansion or extension of the firm by integrating preceding or
successive productive process
 Entering activities where the organization is its own supplier or customer
 Vertical integration refers to the process of acquiring business operations
within the same production vertical. A company that opts for vertical
integration takes complete control over one or more stages in the
production or distribution of a product.

Two directions of vertical integration

Raw Materials  Manufacturing of final product  Distribution
-Moving backwards is backward integration
Development into activities
concerned with the inputs into
the company’s current business
 Moving forward is forward integration
Development into activities
concerned with the outputs of
a company’s current business

Where is vertical integration generated from?

 To integrate or to outsource?
 Economic Activities  Transaction via market (market mechanism) -
“Decision making for buying and selling goods and service guided by market
prices”
 Economic Activities  Internalizing within a firm (administrative
mechanism of firms) – “Decision making for production and resource
allocation are made by managers and imposed through hierarchies”
  “The extent of vertical integration (internalizing within a firm) is
determined by leverage between transaction costs associated with market
and administration costs of organizing within firms”
 Market associated Transaction Costs
-e.g., Search costs, costs of negotiating and drawing up contract, costs of
monitoring, and enforcement costs of litigation
 Administration costs of organizing within the firm
- e.g., Executive policy and planning, general administration, budgeting,
accounting, personnel, business services, management analysis, training,
and legal costs

Sources of transaction cost associated with market

(1) Small number of bargaining conditions
-e.g., Bilateral monopolies where a single supplier negotiates with a
single buyer
-Opportunism (Single Supplier  Single Buyer)
Each company seeks to enhance and exploit its bargaining power at the expense
of the other
- Transaction costs↑ = Vertical integration↑

(2) Asset specificity

e.g., Components that are designed to meet the specific needs of
a particular auto manufacturer
 Toyota established an electric component product plant,
Hiroseto, in 1987.
Transaction costs↑ = Vertical integration↑

(3) Heterogeneous (diverse) tax policy across countries

e.g., Control transfer pricing by multinational companies
- “When one subsidiary of a multinational company in one country sells goods,
services or know-how to another subsidiary in another country, the price charged
for these goods or services is called 'transfer price'.”
Case 1: Before controlling transfer pricing
IMP: DIAGRAM IN NOTEBOOK

Sources of administration cost of internalization

(1) Differences in optimal scale between different stages of production
e.g., Does Federal Express produce delivery vans that are designed and
manufactured to meet its particular needs?  No, unless it purchases over
200,000 (minimum efficient scale for van manufacturing) each year

(2) Compounding risk

As problems at any one stage of production threaten production and profitability
at all other stage

(3) Managing strategically different businesses

e.g., Does Federal Express produce delivery vans that are designed and
manufactured to meet its particular needs?  No, because core competencies
required for van manufacturing is very different from those required for express
delivery.
- e.g., Most of the world’s leading retailers – Wal-Mart, Carrefour –do not
manufacture

(4) The incentive problem

Internal supplier-customer relationship under vertical integration
cause low incentive to cost reduction and new product development.  Many
large corporations have created shared service organization (Internal suppliers of
corporate services such as IT, training, and engineering compete with external
suppliers of the same service to Serve internal operating division).

(5) The competitive effect

Vertical integration may make independent suppliers and customers less willing
to do business with the vertically integrated company
- Why? It is perceived as a competitor rather than as a supplier or customer
- e.g., Disney’s acquisition of ABC and less interested in collaborating with
ABC from other studios (e.g., Dreamworks)
(6) Flexibility
Why is there the lack of vertical integration in the construction Industry?
- Due to the need for flexibility in adjusting both to cyclical patterns of
demand and to the different requirements of each project.

Many electronics sectors have been produced by contract manufacturers

- Due to the fast-cycle product development

In some case, vertical integration may allow for speed and coordination in
achieving simultaneous adjustment throughout the vertical chain
- E.g., Zara

Types of vertical integration relationship

IMP: DIAGRAM IN NOTEBOOK

VI. Concluding remarks

Two key questions in conducting vertical integration
-Which activities will we undertake internally and which will we outsource?
- How do we design our vertical arrangements with both external and
internal suppliers and buyers?

The critical issue for a firm’s decision making of vertical relationship

- Evaluation of its strategic needs, its resources and capabilities at different
stages in the value chain, the characteristics of the transactions involved, and
the relative attractiveness of different stages of the value chain.