MAN4001 –

S T R AT E G I C
MANAGEMENT

Competitiveness & Globalization

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 Learning Objectives

1. Define vertical integration, forward vertical

UNIT5 : integration, and backward vertical integration.
V E RT I C A L 2. Discuss how vertical integration can create value by
I N T E G R AT I O N reducing the threat of opportunism.

3. Discuss how vertical integration can create value by

enabling a firm to exploit its valuable, rare, and
costly-to-imitate resources and capabilities.

4. Discuss how vertical integration can create value by

enabling a firm to retain its flexibility.

5. Describe conditions under which vertical integration

may be rare and costly to imitate.

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What is Corporate Strategy
Business strategy is a firm’s theory of how to gain competitive advantage in a
single business or industry.
o cost leadership
o product differentiation

Corporate strategy is a firm’s theory of how to gain competitive advantage by

operating in several businesses simultaneously.

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What is Vertical Integration
Reminder - a value chain is that set of activities that must
be accomplished to bring a product or service from raw
materials to the point that it can be sold to a final customer

Vertical integration is a strategy used by a company to

gain control over its suppliers or distributors in order to
increase the firm’s power in the marketplace, reduce
transaction costs and secure supplies or distribution
channels.

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Vertical vs Horizontal Integration
Horizontal – firm acquires or merges with a competitor in the same industry.
Example - a company competing in raw materials industry and buys another
company in the same industry rather than trying to expand to intermediate goods
industry.

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Backward & Forward Vertical Integration
Backward vertical integration when it incorporates
more stages of the value chain within its boundaries and
those stages bring it closer to the beginning of the value
chain

Forward vertical integration when it incorporates more

stages of the value chain within its boundaries and those
stages bring it closer to the end of the value chain

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Example of 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

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Example of Vertical Integration Where your pizza comes from
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
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The Value of Vertical Integration
The question of vertical integration—which stages of the value chain should be
included within a firm’s boundaries and why?

Two issues have to be considered before integration:

o Costs - An organization should vertically integrate when costs of making the
product inside the company are lower than the costs of buying that product in the
market.
o Scope of the firm - A firm should consider whether moving into new industries
would not dilute its current competencies. New activities in a company are also
harder to manage and control.
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Value Chain Economies - The Logic of Value Chain Economies

Backward
 the firm is able to create synergy with Vertical
the other firm(s) Dairy Farmers Integration
(milk)
o cost reduction
o revenue enhancement

Leprino Foods
(Mozzarella Cheese)
 the firm is able to capture above
average returns

Food Distributors Forward

Vertical
Integration
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When to Integrate Backward
o Firm’s current suppliers are unreliable, expensive or cannot supply the
required inputs.
o There are only few small suppliers but many competitors in the industry.
o The industry is expanding rapidly.
o The prices of inputs are unstable.
o Suppliers earn high profit margins.
o A company has necessary resources and capabilities to manage the new
business.

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When to Integrate Forward
o Few quality distributors are available in the industry.
o Distributors or retailers have high profit margins.
o Distributors are very expensive, unreliable or unable to meet firm’s
distribution needs.
o The industry is expected to grow significantly.
o There are benefits of stable production and distribution.
o The company has enough resources and capabilities to manage the new
business.

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Advantages of Vertical Integration
o Lower costs due to eliminated market transaction costs;
o Improved quality of supplies;
o Critical resources can be acquired through VI;
o Improved coordination in supply chain;
o Greater market share;
o Secured distribution channels;
o Facilitates investment in specialized assets (site, physical-assets and human-
assets);
o New competencies
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Disadvantages of Vertical Integration
o Higher costs if the company is incapable of managing new activities
efficiently;
o The ownership of supply and distribution channels may lead to lower quality
products and reduced efficiency because of the lack of competition;
o Increased bureaucracy and higher investments leads to reduced flexibility;
o Higher potential for legal repercussion due to size (An organization may
become a monopoly);
o New competencies may clash with old ones and lead to competitive
disadvantage
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VRIO & Vertical Integration

If a vertical integration strategy meets the VRIO criteria, it may create competitive advantage

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Vertical Integration and the threat of opportunism
Valuable focuses on using vertical integration to reduce the threat of
opportunism.
Opportunism exists when a firm is unfairly exploited in an exchange.
Examples
o Low quality goods from suppliers
o Late delivery of product or service
o Supplier demands higher price than agreed

A firm would vertically integrate if the cost of vertical integration is less than the
cost of opportunism

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Vertical Integration and Firm Capabilities
Firms should vertically integrate into those business activities where they possess
valuable, rare, and costly-to-imitate resources and capabilities. If not – then don’t
integrate
Example when not to integrate
o Firms that produce goods for Walmart could sell directly to customers but because
Walmart’s resources and capabilities are so extensive and costly to imitate it would be a
loss for the suppliers.
Suppliers usually make transaction-specific investments based on a specific
relationship/ agreement with the firm they supply. Ex. Production facility set up
specifically to produce a product for a firm and cannot be used or transferred to
another product for another firm.
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Vertical Integration and Flexibility
o Flexibility refers to how costly it is for a firm to alter its strategic and
organizational decisions.
o Flexibility is high when the cost of changing strategic choices is low;
o Flexibility is low when the cost of changing strategic choices is high.
o Vertically integrating is less flexible than not vertically integrating

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Example - Vertical Integration and Flexibility

o A vertically integrated firm decides to get out of a particular business. the firm
will have to sell or close its factories, alter its supply relationships, hurt
customers that have come to rely on it as a partner, and change its internal
reporting structure.
o In contrast, if a non-vertically integrated firm decides to get out of a business,
it simply stops. It cancels whatever contracts it had in place and ceases
operations.
o The cost of exiting a non-vertically integrated business is generally much
lower than the cost of exiting a vertically integrated business.

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Vertical Integration and Sustained Competitive
Advantage
A firm’s vertical integration strategy is rare when few competing firms are able
to create value by vertically integrating in the same way.
Only a small number of competing firms is able to vertically integrate efficiently
Rare Transaction-Specific Investment -
o Example -Dell brought back its technical call center for business customers back
from India and re-vertically integrated it into its business function. It is much more
difficult to provide call-center employees with the training they need to address
corporate problems

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Vertical Integration and Sustained Competitive
Advantage

Rare capabilities - If capabilities are valuable and rare, then vertically

integrating into businesses that exploit these capabilities can enable a firm to
gain at least a temporary competitive advantage
Rare Uncertainty - a firm may be able to gain an advantage from vertically
integrating when it resolves some uncertainty it faces sooner than its
competition.
o Example – A firm would not vertically integrate into the manufacturing of a
particular technology until its designs and features are stabilized and market
demand for the technology is well established.

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Vertical Integration and Sustained Competitive Advantage

Rare Vertical Dis-Integration - firms can also gain competitive advantages

through their decisions to vertically dis-integrate, that is, through the decision to
outsource an activity that used to be within the boundaries of the firm.

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The Imitability of Vertical Integration

Direct duplication occurs when competitors develop or

obtain the resources and capabilities that enable another
firm to implement a valuable and rare vertical integration
strategy.

Substitutes for Vertical Integration - Strategic Alliances

(Unit 8)

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Organizing to Implement Vertical Integration
Organizing to implement vertical integration involves
the same organizing tools as implementing any business
or corporate strategy: organizational structure,
management controls, and compensation policies.

Unit 10 – Strategic Leadership

Unit 11 – Organizational Structure & Control

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 THE END!

Next class:
Unit 6 – Diversification

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