Advanced Corporate Strategy

ST104x

How does vertical integration destroy value?

Let’s now discuss how does vertical integration destroys value.

Using the same criteria, vertical integration destroys value when firms vertically integrate in
the following conditions.

a) The market for intermediate goods is mature and there are many suppliers
available to produce these products competitively
b) The intermediate products are not critical to quality and could be manufactured
through generic investments by competitive suppliers; and
c) The outsourcing contracts are easy to govern.

Apart from these, vertical integration adds significant overhead costs in terms of bureaucratic
costs of coordination; and eliminates market discipline in within-corporation transactions.
Both of these might lead to significant value erosion.

There are also situations of rapid technology change, and the firm being stuck with legacy
technology due to large investments for vertical integration. In contrast, firms that outsource
could easily upgrade to latest technologies than those that have sunk their investments.

Additionally, vertical integration might destroy value through inefficient transfer prices across
business units. Such transfer prices might be sub-optimal to market prices due to the absence
of market discipline in transactions between the units. Without market discipline and no
option for switching partners, it is imperative that the units clearly define service level
agreements for exchange of products and services.

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