Post on 24-Dec-2015
Vertical Integration
AEC 422
See Besanko Ch 3 and Ch 4 ( pp.132-151)
Unit 1Microeconomics of the Firm
Vertical Chain
Begins with the acquisition of raw materials
Ends with the sale of finished goods/services
Can include support services such as Finance and Marketing
Organizing the vertical chain is an important part of business strategy
Channel management
Organization of the Business
Primary activities
Supportactivities
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Firm Infrastructure
Human Resource Management
Technology Development
Procurement
ProfitMargin
Porter’s Organization of the Firm
Supply Chain Management
“upstream” suppliers provide many kinds of resources to operate the firm.
Most firms have many types of suppliers
Scope of activities within a firm can be many Production, research,
packaging, distribution
Many small firms choose to outsource to secure use of certain assets made available in the market by other firms Advertising Tax management Distribution Web management
YOUR FIRM Key CustomerKey Supplier or Partner
Supply Chain Management
“upstream” suppliers provide many kinds of resources to operate the firm.
Scope of activities within a firm can be many Production, research,
packaging, distribution
Many small firms choose to outsource to secure use of certain assets made available in the market by other firms Advertising Tax management Distribution Web management
YOUR FIRM Key CustomerKey Supplier or Partner
Outsourcing and integrating
UPS Supply Chain Solutions
Accountemps - Accounting Staffing AgencyVineyard – wineryWeb designQ-Labs microbial testing
Papa JohnsFoodservice, Inc.
Vertical Boundaries of the Firm
Which steps of the vertical chain are to be performed inside the firm?
Which steps of the vertical chain to be out-sourced?
Choice between the “invisible hand” of the market and the “visible hand” of the organization (Make or Buy)
Like criteria for scope economies – which system is cheaper?
Some creative uses of outsourcing – implications for the balance sheet
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
Do we make it ourselves or buy it?
Decision depends on the costs and benefits of using the market as opposed to performing the task in-house
Outside specialists may perform a task better than the firm can
Intermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)
Do we make it ourselves or buy it?
Other factorsFrequency and volume of purchase/needUniqueness of the assetProprietary nature of the product
Also relates to the merger & acquisition issue
Sometimes the best strategy is to pursue vertical integration
Grape Sourcing by MidSouth Wineries
Source: 2011 Winery Price and Market Survey
% Grown in own
vineyards
% contracted with other growers
% purchased on spot market
Small Wineries (<3000 cases) 64.1 29.0 6.2Larger Wineries (3000 or more cases) 45.4 41.5 11.9
Benefits and Costs of Using the Market
BENEFITS: - can be cheaperMarket Firms Can Achieve Economies of Scale:
In-House Production May Be Too LowMarket Firms Must Be Efficient to Survive In The Market
Environment
COSTS: - may be hidden costsCoordination May Be CompromisedPrivate Information May Be LeakedThere May Be High Transaction Costs In The Market
ie, search, paperwork, post-purchase recourse
Benefits of Using the Market
Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible
Market firms can sometimes achieve economies that in-house units cannot
Market firms are subject to market discipline, whereas in-house units may be able to hide their inefficiencies behind overall corporate success (Agency and influence costs)
Often there are choices in channel partners with which to work
Agency Costs
Does the outside firm have the same commitment to the delivery of the product or service needed?Not always - conflicts of interest, other clients
Example: Purity Foods, Inc.Can have internal agency costs, too – managers &
workers knowingly do not act in the best interest of the business
Influence costs
In addition to internal agency costs, performing a task in-house will lead to “influence costs” as well
Influence cost – time consumed by a manager campaigning central management to allocate resources to his/her division
Note – a poor process of external “bidding” can add to the cost of outsourcing, as well. Need to find the right firm the first time.
Problems in Using the Market: Lack of Control
Costs imposed by poor coordinationReluctance of partners to share valuable
private informationTransactions cost that can be avoided by
performing the task in-houseEach problem can be traced to difficulties
in contracting
New Product DevelopmentStages
Buyer Involved
Buyer Not
InvolvedSupplierInvolved
SupplierNot
Involved
months of development time
Concept Search 1.9 2.4 2.0 2.3
Concept Screening 2.5 0.6 1.3 0.7
Concept Testing 1.6 0.7 1.5 0.8
Business Analysis 2.9 1.7 2.2 1.8
Product Development 3.4 3.0 3.0 2.0
Product Testing 2.3 0.9 1.2 0.7
Commercialization 3.3 2.1 2.3 1.9
Candy New Product Development
…..outsourcing generally adds to development time.Source: Woods and Spaulding, J Food Distr Research 2006
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
Complete Contract
A complete contract stipulates what each party should do for every possible contingency
No party can exploit others’ weaknessesTo create a complete contract one should be able to
contemplate all possible contingenciesOne should be able to “map” from each possible
contingency to a set of actionsOne should be able to define and measure
performancesOne should be able to enforce the contract
Complete Contract (Continued)
To enforce a contract, an outside party (judge, arbitrator) should be able toobserve the contingencyobserve the actions by the partiesimpose the stated penalties for non-
performance
Real life contracts are usually incomplete contracts
Incomplete Contracts
Incomplete contractsInvolve some ambiguitiesNeed not anticipate all possible contingenciesDo not spell out rights and responsibilities of
parties completely
Factors that Prevent Complete ContractingBounded rationalityDifficulties in specifying/measuring
performanceAsymmetric information
Bounded Rationality
Individuals have limited capacity toProcess informationDeal with complexityPursue rational aims
Individuals cannot foresee all possible contingencies
Specifying/Measuring PerformanceTerms like “normal wear and tear” may have
different interpretationsPerformance cannot always be measured
unambiguously
Asymmetric InformationParties to the contract may not have equal
access to contract-relevant informationOne party can misrepresent information
Limitations of Contract Law
Doctrines of contract law are in broad language that could be interpreted in different ways
Litigation can be a costly way to deal with breach of contractLitigation can be time consumingLitigation weakens the business relationship
Coordination of Production Flows
For successful coordination one party needs to make decisions that depend on the decision made by others
A good fit should be accomplished in several dimensionsTimingSizeColorSequenceR & D
Case in point: Private Label Grocery Products
Private Label Share by Department
Source: IRI 2012, Multi-outlet supermarkets, drug stores, mass market retailers
Coordination Problems
Without good coordination, bottlenecks arise in the vertical chain
Coordination is especially important when “design attributes” are present
To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets
Design Attributes
Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value results
Some examplesSequencing of courses in AEC degreeFit of auto sunroof glass to apertureTimely delivery of a critical component
Design Attributes
If coordination is critical, administration control may replace the market mechanism
Design attributes may be moved in-housePepsi-Cola and its Bottlers
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
Alternatives to Vertical Integration
Tapered integration (making some and buying the rest)
Joint ventures and strategic alliancesLong term collaborative relationships Implicit contracts between firms
Tapered Integration in Gasoline Retailing
Major oil refiners sell through their own service stations and through independently owned stations
As gas stations have moved away from auto repair and maintenance services, the proportion of company owned stations are growing
Transaction based Alliance basedShort-term relationships
Multiple suppliers
Adversarial relationships
Price dominates
Minimal investment from suppliers
Minimal information sharing
Firms are independent
Minimal interaction between respective functional areas
Long-term relationships
Fewer suppliers
Cooperative partnerships
Value-added services dominate
High investment for both buyer and supplier
Extensive product, marketing, and logistics information sharing
Firms are interdependent with joint decision making
Extensive interaction between buyer and supplier functional areas
Source: D. Ross: Competing Through Supply Chain Management, 1999
Alliance Relationships