Lecture 6.

Vertical Integration

Dr Khurshid Djalilov
Senior Academic
kdjalilov@bournemouth.ac.uk
 The Scope of the Firm
and Vertical Integration

OUTLINE

• Transactions costs and the scope of the firm

• The costs and benefits of vertical integration

• Designing vertical relationships

 The Strategic Management Process
External
Analysis

Strategic Strategy Competitive

Mission Objectives
Choice Implementation Advantage

Which Businesses
Internal to Enter?
Analysis
Corporate Level • Vertical Integration
Strategy
 From Business Strategy to Corporate
Strategy: The Scope of the Firm

• Business Strategy is concerned with how a firm

competes within a particular market

• Corporate Strategy is concerned with where a firm

competes, i.e. the scope of its activities
o The dimensions of the scope are:
 Vertical scope
 Geographical scope
 Product scope
 Corporate strategy directions
(Ansoff New
Existing Matrix)
Existing Regular cola Coke Zero
New Vanilla cola (same T shirt (with
market) brand)

Source: Adapted from H.I. Ansoff, Corporate Strategy, Penguin, 1988, Chapter 6 . Ansoff originally had a matrix with four separate boxes, but in practice strategic directions involve
more continuous axes. The Ansoff matrix itself was later developed – see Reference 1.
 Market penetration
Market penetration implies increasing share of
current markets with the current product range.
This strategy:
• builds on established strategic capabilities
• means the organisation’s scope is unchanged
• leads to greater market share and increased power vis-à-vis buyers and
suppliers
• provides greater economies of scale and experience curve benefits.
 Consolidation and retrenchment
• Consolidation refers to a strategy by which an organisation
focuses defensively on their current markets with current
products.

• Retrenchment refers to a strategy of withdrawal from marginal

activities in order to concentrate on the most valuable segments
and products within their existing business.
 Product development
Product development is where an organisation delivers modified
or new products (or services) to existing markets.
This strategy:
• involves varying degrees of related diversification (in terms of products)
• can be expensive and high risk
• may require new strategic capabilities
• typically involves project management risks.
 Market development
Market development involves offering existing products to
new markets.
This strategy involves:
• product development (e.g. packaging or service)
• new users (e.g. extending the use of aluminium to the automobile industry)
• new geographies (e.g. extending the market to new areas – international markets
being the most important)
• meeting the critical success factors of the market
• new strategic capabilities (e.g. in marketing).
 Conglomerate diversification
Conglomerate (or unrelated) diversification
takes the organisation beyond both its existing
markets and its existing products and radically
increases the organisation’s scope.
Potential benefits to an acquired business is that it
gains from the reputation of the group and
potentially lowers financing costs.
Potential costs arise because there are no obvious
ways to generate additional value.
 Transaction Costs and the
Scope of the Firm

In situation [A] businesses 1, 2 & 3 are integrated within a single firm.

In situation [B] businesses 1, 2 & 3 are independent firms linked by markets.
Which situation is more efficient? —Depends upon whether the administrative costs of the integrated
firm are less than the transaction costs of markets?
11
Aggregate Concentration in US
Manufacturing, 1947-97

Key
observation:
Throughout the
20th century,
firms grew in
scale and scope.
This trend went
into reverse
during the late
1970s
 The Shifting Boundary Between
Firms and Markets
Time Main Trend Factors Changing the Relative Efficiency
Period of Firms and Markets
1800- Expanding the Administrative costs of firms fall due to:
1975 scale and scope of • Advancing technology in transport,
firms communication, and IT
• Advances in management—accounting
systems, scientific management,
organizational innovations

1976- Biggest firms • More turbulent external environment

1995 downsize: increases administrative costs of big firms.
outsourcing; • New digital technologies available to small
refocusing on core firms and individuals as well as big
business corporations

1996- Global consolidation • Globalization of markets

2007 of many industries: • Big corporations more effective at
(e.g. steel, oil, beer, reconciling complexity with responsiveness
banking)
Logic of Corporate Level Strategy
Corporate level strategy should create value:
1) such that the value of the corporate whole increases

2) such that businesses forming the corporate whole

are worth more than they would be under
independent ownership

3) that equity holders cannot create through

portfolio investing
• A corporate level strategy should create
synergies that are not available in equity
markets.
• vertical integration = value chain economies
What Is Vertical Integration?
Where your pizza comes from

Dairy Farmers
(milk)

Seed Companies Pizza Chains

(Alfalfa & Corn)

Leprino Foods
(Mozzarella Cheese)

Crop Farmers
(Alfalfa & Corn) End Consumer

Food Distributors
What Is Vertical Integration?
Backward
Vertical
Dairy Farmers Integration
(milk)

Seed Companies Pizza Chains

(Alfalfa & Corn)

Leprino Foods
(Mozzarella Cheese)

Crop Farmers
(Alfalfa & Corn) End Consumer

Food Distributors Forward

Vertical
Integration
Value Chain Economies
The Logic of Value Chain Economies
Backward
Vertical
• The focal firm is able to Dairy Farmers Integration
(milk)
create synergy with the
other firm(s).
• cost reduction
Leprino Foods
• revenue enhancement (Mozzarella Cheese)

• The focal firm is able to

capture above normal
economic returns Forward
Food Distributors
(avoid perfect competition). Vertical
Integration
 Types of Vertical Integration Strategies

Vertical Integration
Choices

Full Partial Tapered

Integration Integration Integration
 Types of Vertical Integration Strategies

♦ Full Integration
● A firm participates in all stages
of the vertical activity chain.
♦ Partial Integration
● A firm builds positions only in selected
stages of the vertical chain.
♦ Tapered Integration
● Involves a mix of in-house and
outsourced activity in any stage of the
vertical chain.
 Weighing the Pros & Cons of Vertical Integration

♦ Can vertical integration enhance the performance

of strategy-critical activities in ways that lower cost,
build expertise, protect proprietary know-how, or
increase differentiation?
♦ What is the impact of vertical integration on
investment costs, flexibility and response times,
and the administrative costs of coordinating
operations across more vertical chain activities?
♦ How difficult it will be for the company to acquire
the set of skills and capabilities needed to operate
in another stage of the vertical chain.
Competitive Advantage

If a vertical integration strategy meets the

VRIO 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
• Markets and integrated hierarchies are “forms” in which
economic exchange can take place.

• Economic exchange should be conducted in the form

that maximises value for the focal firm.

• Thus, firms assess which form is likely to generate

more value.
Value of Vertical Integration
Three Value Considerations

Leverage Manage Exploit

Capabilities Opportunism Flexibility

• firm capabilities • opportunism • internalising is

may be sources may be checked usually less
of competitive by internalizing flexible
advantage in
other businesses • flexibility is
• internalising must prized when
• if not, then don’t be less costly than uncertainty is
integrate exchange opportunism high
Rarity of Vertical Integration
Integration vs. Non-Integration
• A firm’s integration strategy may be rare because
the firm integrates or because the firm does not
integrate.
• Thus, the question of rareness does not
depend on the number of forms observed.

• A firm’s integration strategy is rare or common with

respect to the value created by the strategy.
Imitability of Vertical Integration
Form vs. Function
• The form, per se, is usually not costly to imitate.

• The value-producing function of integration may

be costly to imitate, if:
• the integrated firm possesses resource
combinations that are the result of:
• historical uniqueness
• causal ambiguity
• social complexity
• small numbers prevent further integration
Imitability of Vertical Integration
Modes of Entry

• Acquisition and internal development are alternative

modes of entry into vertical integration.
• Thus, one firm may acquire a supplier while a
competitor could imitate that strategy through
internal development.
• In both cases, the boundaries of the firm would
encompass the new business.

• Strategic alliances can be viewed as a substitute for

vertical integration—without the costs of ownership.
 OUTSOURCING STRATEGIES

♦ Outsourcing
● Involves farming out value chain activities to outside
vendors.
♦ Outsource an Activity When It:
● Can be performed better or more cheaply by outside
specialists.
● Is not crucial to achieving sustainable competitive
advantage and does not hollow out the firm’s core
competencies.
● Improves organizational flexibility and speed time to
market.
● Reduces risks due to new technology and/or buyer
preferences.
● Assembles diverse kinds of expertise speedily and
efficiently.
● Allows a firm to concentrate on its core business, leverage
key resources, and do even better what it does best.
 The Risks of Outsourcing Value Chain Activities

♦ Hollowing out the resources and capabilities that

the firm needs to be a master of its own destiny.
♦ Loss of control when monitoring, controlling, and
coordinating activities of outside parties by means
of contracts and arm’s-length transactions.
♦ Lack of incentives for outside parties to make
investments specific to the needs of the
outsourcing firm’s value chain.
 Organising Vertical Integration
Functional Structure (U-Form)
CEO’s Role
Cooperation
Accounting Finance Marketing HR Engineering

Cooperation
Conflict

Original Original Original Original Original

Business Business Business Business Business

New New New New New

Business Business Business Business Business

Conflict
Organising Vertical Integration
Management Controls
What needs to be “controlled” in a vertically integrated
firm?

• managers’ efforts to achieve the desired value

chain economies
• cooperation and competition among and between
functions
• the integration of new businesses into the
existing business
• time horizon of managers
Organising Vertical Integration
Management Controls
Budgets
• separating strategic and
operational budgets
• strategic: inputs
and outputs
• operational: outputs
Board
Committees
• provide oversight and
direction to managers
• help ensure that strategic
direction is maintained

These mechanisms focus management attention

on achieving value chain economies.
Organising Vertical Integration
Compensation
Salary
Integration
Opportunism Cash Bonus: Individual

Stock Grants: Individual

Leveraging Cash Bonus: Group Cooperation

Capabilities
Stock Grants: Group

Stock Options: Individual

Exploiting Time Horizon
Flexibility Stock Options: Group
Designing Vertical Relationships: Long-Term
Contracts & Quasi-Vertical Integration

• Choices not limited to vertical integration or arms’-

length contracts:
o Several intermediate types of vertical relationship:
these may combine benefits of both market
transactions and internalization
• Key issues in designing vertical relationships:
o No generic solution: depends upon the resources,
capabilities and strategy of the individual firm
o How is risk to be allocated between the parties?
o Are the incentives appropriate?
 Recent Trends in Vertical Relationships
• From competitive contracting to supplier
partnerships, e.g. in autos
• From vertical integration to outsourcing (not just
components, also IT, distribution, and
administrative services)
• Diffusion of franchising
• Technology partnerships (e.g. IBM- Apple;
Canon- HP)
• Inter-firm networks

General conclusion: Boundaries between firms and

markets becoming increasingly blurred
Summary
Vertical Integration…

• is an important consideration in the decision

to 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 the

benefits outweigh the costs of integration!
Summary
Vertical Integration…

• makes sense when value chain economies

can be created and captured

• may allow a firm to leverage capabilities

• may be a response to the threat of opportunism

and uncertainty

• as a form of exchange per se, is not rare nor

costly to imitate
 References:
Essential:
Grant, R.M. (2015). Contemporary Strategy Analysis (8th Ed.).
John Wiley and Sons ltd. Ch 11.

Additional:
Barney J.B. and Hesterly W.S. (2015). Strategic Management and
Competitive Advantage. Concepts and Cases. Pearson Education
Limited, Ch 6.
Thompson, A. A., Peteraf, M., Gamble, J. E., Strickland, A. J.,
III, Janes, A., & Sutton, C. (2013). Crafting & Executing
Strategy: The Quest for Competitive Advantage (European ed.).
London: McGraw-Hill Irwin, Ch. 6.