Make, Buy or Ally?

Strategic Considerations in Vertical Scope Decisions

November 2010 Rushi Anandan, SP Jain Institute of Management and Research Email:rushi.anandan@spjimr.org

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Make, Buy or Ally? Strategic Considerations in Vertical Scope Decisions

The corporate strategy of the firm involves choices regarding where to compete, in contrast to competitive strategy, how to compete. Determining the boundaries of the firm is, therefore, a key element in crafting corporate strategy. The article enunciates the pros and cons of vertical integration, and discusses how collaborative relationships and alliances can substitute for vertical hierarchies.

Vertical integration means that a company is producing its own inputs (backward or upstream integration) or is disposing of its own outputs (forward or downstream integration). There are four main stages in a typical raw-material-to-consumer production chain: raw materials; component part manufacturing; final assembly; and retail. For a company based in the assembly stage, backward integration involves moving into intermediate manufacturing and raw-material production. Forward integration involves movement into distribution.

At each stage in the chain, value is added to the product. The difference between the price paid for inputs and the price at which the product is sold is a measure of the value added at that stage. Thus, vertical integration involves a choice about which value-added stages of the raw-material-toconsumer chain to compete in.

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Figure 1: The Raw Material to Consumer Value Chain in the Personal Computer Industry

Another important distinction is the difference between full integration, which occurs when a company produces all of its own inputs or disposes of all of its own output, and taper integration, in which a company buys from independent suppliers in addition to company-owned suppliers or when it disposes of its output through independent outlets in addition to company-owned outlets.

Figure 2: Full and Taper Integration

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Firms pursuing a strategy of vertical integration realize some benefits. By vertically integrating backward or forward, a company can build barriers to new entry, limiting competition and enabling the company to charge a higher price and make greater profits. In the sunrise years of the computer industry, IBM manufactured components, undertook design and assembly, wrote the software, and distributed the product directly to consumers. Since the value chain comprised several proprietary elements, in-house production could inhibit rivals access to these, thereby deterring or postponing entry. The strategy was successful till the early 1980s, after which the shift to open standards and increased modularization in the industry neutralized the advantages of verti cal standards.

Vertical integration facilitates investment in specialized assets. A specialized asset is an asset that is designed to perform a specific task and whose value is significantly reduced in its next best use. It may be a tangible or an intangible asset. Specialized assets lower the costs of value creation and provide better differentiation, and thus provide the basis for achieving a competitive advantage. It may be difficult to persuade companies in an adjacent stage of the production chain to invest in specialized assets, because there is a risk that one will take advantage of the other, demanding more favorable terms after the companies commit to the relationship. Oliver Williamson, the Nobel laureate in economics, refers to this phenomenon as the holdup problem. In apprehension of holdup, the company may vertically integrate and invest in specialized assets for itself.

Mazda pioneered the introduction of the Wankel rotary engines for its racing cars. The rotary engine is a piston-less alternative to the dominant design in automotive engines, the reciprocating engine. When Mazda tried to interest vendors for developing its engines, the vendors declined to make the specialized investments required. Since Mazda was the sole possible client for the rotary engine, vendors reasoned that Mazda might use its bargaining power to demand price reductions in the future. Mazda itself realized that if it relied on an outside vendor for such a critical input, it would be difficult to switch suppliers since specialized equipment was required. The vendor might use its bargaining power to demand higher prices in the future. This risk of holdup forced Mazda to

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integrate rotary engine production in-house, as well as providing specialized repair facilities for customers.

Empirical research gives considerable support to these hypotheses. Among automakers, specialized components are more likely to be manufactured in-house than standardized items such as tires and spark plugs. Similarly, in aerospace, company-specific components are more likely to be produced internally rather than purchased externally. In the semiconductor industry, the more technically complex the integrated circuit and, hence, the greater the need for the design and fabrication functions to engage in technical collaboration, the better is the relative performance of integrated producers.

By protecting product quality, vertical integration enables a company to become a differentiated player in its core business. When McDonalds entered Russia, it decided that in light of the low quality of domestic potatoes and milk, the firm would backward integrate and supply its own needs through company-owned dairy farms, vegetable farms and food-processing facilities. Identical product quality across global outlets is a key element of McDonalds differentiation advantage.

The product quality advantage can also translate into a higher willingness -to-pay. Apples pricing power can be attributed partially to the complete control over quality afforded by its vertical structure. For the iPad, Apple designs its own processor, the A4. Apple also makes its own operating-system software for the iPad. Further, both content and apps are primarily available only through Apples iTunes online store. Apple also distributes the iPad through its Apple stores. Hardware manufacturing, the lowest value activity, is outsourced to Chinese manufacturers based on strict specifications provided by the Apple product design team.

Strategic advantages arise from the superior system-wide planning, coordination, and scheduling of adjacent processes made possible in vertically integrated organizations. The dominant model in fashion clothing is for retail and manufacture to be undertaken by different companies. In contrast,

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the Spanish fashion company Zara manufactures half of the clothing sold in its retail stores and undertakes all of its own distribution from manufacturing plants to ret ail outlets. Zara has succeeded by creating a vertically integrated system where the disadvantages of vertical integration (higher costs of manufacturing in Europe, lack of flexibility in shifting plant locations, etc.) are offset by the unprecedented speed and design flexibility that the tightly coordinated vertical system permits. Thus, Zaras highly compressed product development cycle would be impossible for any other retailer relying on contract manufacturing.

However, vertical integration has some disadvantages, and the benefits are not always as substantial as they might seem initially. Although often undertaken to gain a production cost advantage, vertical integration can raise costs if a company becomes committed to purcha sing inputs from company-owned suppliers when low-cost external sources of supply exist. Companyowned suppliers might have high operating costs relative to independent suppliers because they know that they can always sell their output to other parts of the company (captive consumption). The fact that they do not have to compete for orders with other suppliers reduces their incentive to minimize operating costs. GM became the carmaker with the highest cost structure because it made two-thirds of its components itself. Comparatively, Toyota only produced a quarter of its components. The unionized workforce at GM earned $35 per hour, while competitors could source components from specialists like TRW or Robert Bosch paying half GMs wages.

The problem may be ameliorated, however, when the company pursues taper, rather than full, integration, because the need to compete with independent suppliers can produce a downward pressure on the cost structure of company-owned suppliers. Large refiners like Shell have a refining capacity double that of their internal production. They make significant open -market purchases of oil, which impels their internal production units to remain cost -competitive with outside oil suppliers.

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Another factor that increases the cost structure of vertically-integrated firms is the disadvantage in scale economies. Specialists can spread their fixed costs over larger volumes compared with an in house manufacturer. Consider again the example of GM and an auto component specialist like Delphi. If GM makes a standardized component like anti-lock brakes, it is unlikely that competitors would be willing to buy their brakes from GM, apprehensive that GM may disrupt supplies during periods of peak demand, or gain secret information about planned production levels. On the other hand, because Delphi does not face any such bottlenecks, it can sell its brakes to many carmakers, thereby achieving higher volumes and a lower unit cost.

A greater concern is that vertical integration may make independent suppliers and customers unwilling to transact with the vertically integrated company, because it is now perceived as a competitor rather than as a supplier or customer. After Disneys acquisition of ABC, other studios like DreamWorks became less interested in developing new TV programming for ABC. P epsi sought to enhance fountain beverage sales through its acquisition of KFC, but this drove KFC competitors like Wendys to switch fountain purchases from Pepsi to Coke.

When technology is changing rapidly, vertical integration poses the hazard of tying a company to an obsolescent technology. Vertical integration can inhibit a companys ability to change its suppliers or its distribution systems to match the requirements of changing technology. The inability of integrated steel mills to successfully withstand the disruption of steelmaking cost structures by mini-mill technology pioneered by challengers like Nucor stemmed from the sunk costs of integration. Radio manufacturers that integrated upstream by acquiring vacuum tube manufacturers found themselves locked in when transistors supplanted vacuum tubes in radio architecture.

Vertical integration can be risky in unstable or unpredictable demand conditions, because it may be difficult to achieve close coordination among vertically integrated activities. The resulting inefficiencies can give rise to significant bureaucratic costs. The problem involves balancing

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capacity among different stages of a process. For example, if demand falls, the company may be locked into a business that is running below capacity. Clearly, this would not be economical. If demand conditions are unpredictable, taper integration might be somewhat less risky than full integration. When the company provides only part of its total input requirements from companyowned suppliers, in times of low demand, it can keep its in-house suppliers running at full capacity by ordering exclusively from them.

Bureaucratic costs include the costs arising from the lack of incentive on the part of companyowned suppliers to reduce their operating costs and from a possible lack of strategic flexibility in the face of changing technology or uncertain demand conditions. Bureaucratic costs place a limit on the amount of vertical integration that can be profitably pursued. The farther a company moves from its core business, the more marginal the economic value and the higher the bureaucrati c costs. Given their existence, it makes sense for a company to integrate vertically only when the value created by such a strategy exceeds the bureaucratic costs associated with expanding the boundaries of the organization to incorporate additional upstream or downstream activities.

Decision Guide for Vertical Scope Decisions Table 1 Decision Variable How many firms are available to undertake the activities? Is investment in specialized assets needed? Can secrecy create entry barriers against new entrants? Do the different businesses have similar optimal scales of operation? Are they strategically similar? Is product or service quality difficult to codify through contracts with suppliers and distributors? How great is the need for continual upgrading of capabilities? How uncertain is the trajectory in the underlying technology of the business? Are outside market specialists able to realize greater scale economies relative to the firm? Are taxes or regulation imposed on transactions? Implication The fewer the companies, the more attractive is VI If yes, VI is more attractive VI can create value Greater the similarity, the more attractive is VI Greater the difficulty, the more attractive is VI Greater the need, the greater the disadvantages of VI Greater the uncertainty, the more costly is VI VI is more costly VI can avoid them

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Alternatives to Vertical Integration: Collaborative Relationships

Under certain conditions, companies can realize the gains associated with vertical integration without having to bear the associated bureaucratic costs, if they enter into long-term collaborative relationships with their transaction partners. However, companies will not realize gains from shortterm (less than one year) contracts with their trading partners. Because it signals a lack of longterm commitment to its suppliers by a company, the strategy of short-term contracting and competitive bidding makes it very difficult for that company to realize the gains associated with vertical integration. This is not a problem when there is minimal need for close cooperation between the company and its suppliers to facilitate investments in specialized assets, improve scheduling, or improve product quality. Indeed, in such cases, competitive bidding may be optimal. However, a competitive bidding strategy can be a serious drawback when these considerations do arise. In 1992, GM mandated an across-the-board price cut of 10% on its suppliers, despite previous pricing contracts in place. The resultant loss of trust manifested itself in suppliers reducing research expenditure on future GM components, and reaching out to Ford and Chrysler as clients for their new design knowledge. While GM realized short-term cost reductions from its actions, it sustained a severe blow to its long-term competitive advantage.

In contrast to short-term contracts, long-term contracts are collaborative arrangements by which one company agrees to supply the other, and the other agrees to continue purchasing from that supplier. In a long-term contract, both parties make a commitment to work together and seek ways of lowering the costs or raising the quality of inputs. This stable long-term relationship lets the participating companies share the value that might be created by vertical integration while avoiding many of its bureaucratic costs. Thus long-term contracts can be a substitute for vertical integration. Chrysler introduced its SCORE (Supplier Cost Reduction Effort) program in 1990, aimed at collaboration with suppliers to identify process improvement opportunities. In five years, Chrysler implemented 5300 supplier-generated suggestions, resulting in $1.6 billion cost savings. The firm

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continues to pursue a goal of its suppliers taking over a substantial portion of car-making activities, so that Chrysler can limit its competency to car design.

Companies can take some specific steps to ensure that a long-term relationship can succeed and to lessen the chances of one party taking advantage of the other. One way of designing long-term collaborative relationships to build trust and reduce the possibility of a company reneging on an agreement is for the company making investments in specialized assets to demand a hostage from its partner. This involves both companies investing in specialized assets in order to serve each other, and it makes them mutually dependent and therefore less likely to renege. The alliance between Boeing and Northrop is a good example. Northrop supplies components to Boeings commercial aircraft business that requires specialized investments by Northrop. The sunk costs represented by these investments may ordinarily render Northrop vulnerable to opportunistic behavior by Boeing (the threat of switching suppliers to force prices down). Northrop, however, protects itself by making Boeing a subcontractor providing specialized components to Northrops Stealth bomber product line. The specialized investments required of Boeing makes the two firms mutually dependent.

A credible commitment is a believable commitment to support the development of a long-term relationship between companies. Credible commitments involve long-term and substantial investments, and therefore are believable guarantees of trust. Equity-based alliances are the most common form of credible commitments. Pharmaceutical companies often acquire equity stakes in the biotech companies that undertake much of their R&D; oilfield services companies are increasingly equity partners in upstream projects.

Building a collaborative long-term relationship is more readily relied upon when a company can enforce some kind of market discipline on its partner, to ensure that the partner doesnt lack incentives to maintain efficiency. One way of maintaining market discipline is to periodically

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renegotiate the agreement. Thus a partner knows that if it fails to live up to its side of the agreement the company may refuse to renew.

Another way to maintain market discipline is to enter into long-term relationships with suppliers using a parallel sourcing policy. Under this arrangement, a company enters into a long-term contract with two suppliers for the same part. The idea is that when a company has two suppliers for a single part, each supplier knows that it must fulfill its side of the bargain, lest the company terminate the contract and switch business to the other supplier.

References

Johnston R. and Lawrence P. R. Beyond Vertical Integration: The Rise of Value Adding Partnerships. Harvard Business Review, 1988 Macher J. T. Technological Development and the Boundaries of the Firm: A Knowledge-based Examination in Semiconductor Manufacturing. Management Science, 2006 Masten S. The Organization of Production: Evidence from the Aerospace Industry. Journal of Law and Economics, 1984 Monteverde K. and Teece J. J. Supplier Switching Costs and Vertical Integration in the Automobile Industry. Bell Journal of Economics, 1982 Rothaermel, F. T., Hitt, M. A. and Jobe, L. A. Balancing vertical integration and strategic outsourcing: effects on product portfolio, product success, and firm performance. Strategic Management Journal, 2006 Stuckey J. and White D. When and When not to Vertically Integrate, Sloan Management Review, 1993 Williamson O. E. Credible commitments: Using hostages to support exchange. American Economic Review, 1983 Williamson O. E. Markets and Hierarchies: Analysis and Antitrust Implications. Free Press, 1975

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