Lecture Outline

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Lecture Outline
Strategic Management and Competitive
Advantage Jay B. BarneyWilliam S. Hesterly
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Chapter 6
Vertical Integration
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Chapter Objectives (1 of 2)

• Define vertical integration, forward integration,
  and backward vertical integration.
• Describe how vertical integration can create
  value by reducing the threat of opportunism.
• Discuss how vertical integration can create value
  by enabling a firm to exploit its valuable, rare,
  and costly-to-imitate resources and capabilities.
• Discuss how vertical integration can create value
  by enabling a firm to retain its flexibility.

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Chapter Objectives (2 of 2)

• Describe conditions under which vertical
  integration may be rare and costly to imitate.
• Describe how the functional organization
  structure, management controls, and compensation
  policies are used to implement vertical
  integration.
• Describe different degrees of vertical
  integration in an international context.

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The Strategic Management Process
External Analysis
Strategic Choice
Strategy Implementation
Competitive Advantage
Mission
Objectives
Which Businesses to Enter?
Internal Analysis
Vertical Integration
Corporate Level Strategy
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Types of Corporate Level Strategies
Strategic Alliances
Vertical Integration
Corporate Level Strategy
Mergers Acquisitions
Corporate Diversification
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Logic of Corporate Level Strategies

• Corporate Level Strategy Should Create Value
• Such that the value of the corporate whole
  increases
• Such that businesses forming the corporate whole
  are worth more than they would be under
  independent ownership
• That equity holders cannot create though
  portfolio investing
• A corporate level strategy should create
  synergies that are not available in equity markets

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Vertical Integration(Corporate Strategy 1)

• Vertical Integration
• A firms level of vertical integration is simply
  the number of steps in the value chain that a
  firm accomplishes within its boundaries.
• Vertically integrated companies are united
  through a hierarchy and share a common owner.
• Usually each member of the hierarchy produces a
  different product or service, and the products
  combine to satisfy a common need.

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Example Oil Companies
Exploring for crude oil
Drilling for crude oil
Pumping crude oil
Shipping crude oil
Buying crude oil
Refining crude oil
Selling refined products to distributors
Shipping refined products
Selling refined products to final customers
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Types of Vertical Integration

• Backward Vertical Integration
• The company sets up subsidiaries that product
  some of the inputs used in the production of its
  products.
• For example, an automobile company may own a tire
  company, a glass company, and a metal company.
• Control of these three subsidiaries is intended
  to create a stable supply of inputs and ensure a
  consistent quality in their final product.

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Types of Vertical Integration

• Forward Vertical Integration
• The company sets up subsidiaries that distribute
  or market products to customers or use the
  products themselves.
• An example is a movie studio that also owns a
  chain of theaters.

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What Is Vertical Integration?(1 of 2)
Where your pizza comes from
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What is Vertical Integration(2 of 2)
Backward Vertical Integration
Forward Vertical Integration
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Value Chain Economics
The Logic of Value Chain Economies
Backward Vertical Integration
the focal firm is able to create synergy with
the other firm(s)
cost reduction
revenue enhancement
the focal firm is able to capture above normal
economic returns (avoid perfect competition)
Forward Vertical Integration
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The Case for Vertical Integration(The Threat of
Opportunism)

• The Threat of Opportunism
• Vertical integration can mitigate the threat of
  opportunism.
• Opportunism exists when a firm is unfairly
  exploited in an exchange.
• Examples of opportunism include when a party to
  an exchange expects a high level of quality in a
  product it is purchasing, only to discover it has
  received a lower level of quality than it
  expected.
• One way to reduce the threat of opportunism is to
  bring an exchange within the boundaries of a
  firm, that is, to vertically integrate into this
  exchange.
• Of course, firms should only bring market
  exchanges within their boundaries when the cost
  of vertical integration is less than the cost of
  opportunism.

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The Case for Vertical Integration(The Threat of
Opportunism)

• When Is the Threat of Opportunism the Highest?
• The threat of opportunism is the highest when a
  party to an exchange has made what are called
  transaction-specific investments.
• A transaction specific investment is any
  investment in an exchange that has significantly
  more value in the current exchange than it does
  in alternative exchanges.
• Oil refinery and pipeline example.

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The Case for Vertical Integration(Firm
Capabilities)
Should Vertically Integrate
Shouldnt Vertically Integrate
Firms should vertically integrate into those
business activities where they possess valuable,
rate, and costly-to-imitate resources and
capabilities.
Firms should not vertically integrate into
business activities where they do not possess the
resources necessary to gain competitive
advantages.
This explains why PG doesnt vertically
integrate into the retail store industry
This may explain why GM vertically integrated
into transmissions
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The Case for Vertical Integration(Firm
Capabilities)
Tension
Opportunism vs. Firm Capabilities Should
Wal-Marts Suppliers Vertically Integrate or Not?
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The Case for Vertical Integration(Flexibility)

• Flexibility
• Refers to how costly it is for a firm to alter
  its strategic and organizational decisions.
• Flexibility is high when the cost of changing
  strategic choices is low flexibility is low when
  the cost of changing strategic choices is high.
• Flexibility and Vertical Integration
• In general, vertically integrating is less
  flexible than not vertically integrating.
• The cost of existing a non-vertically integrated
  business is generally much lower than the cost of
  exiting a vertically integrated business.

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Competitive Advantage

• If the Vertical Integration Strategy Meets the
  VRIO criteria
• Is it valuable?
• Is it rare?
• Is it costly to imitate?
• ..it may create competitive advantage

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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 maximizes value for the focal firm
• Integration Makes Sense When the Focal Firm Can
  Capture More Value Than a Market Exchange Provides

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Value of Vertical Integration
Three Value Considerations
internalizing is usually less flexible
firm capabilities may be sources of
competitive advantage in other businesses
opportunism may be checked by internalizing
(TSI)
flexibility is prized when uncertainty
is high
internalizing must be less costly
than opportunism
if not, then dont integrate exchange
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Vertical Integration and Sustained Competitive
Advantage
In order for vertical integration to be a source
of sustained competitive advantage, not only must
it be valuable
because it responds to threats of opportunism
enables a firm to exploit its own or other firms
valuable, rare and costly-to-imitate resources,
or because it gives a firm flexibility
it must also be rare and costly to imitate, and a
firm must be organized to implement it correctly
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Rarity of Vertical Integration

• Rarity and Vertical Integration
• A firms vertical integration strategy is rare
  when few competing firms are able to create value
  by vertically integrating in the same way.
• A firms vertical integration strategy can be
  rare because it is one of a small number of
  competing firms that are able to vertically
  integrate efficiently or because it is one of a
  small number of firms that are able to adopt a
  non-vertically integrated approach to managing an
  exchange.

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Rare Vertical Integration
Rare Transaction Specific Investments Dell Call
Center Example
Rare Capabilities and Vertical Integration MTV
and India Example
Rare Uncertainty and Vertical Integration Manufact
uring Example
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Rare Vertical Dis-Integration

• Outsource
• Firms can also gain competitive advantage through
  their decision to dis-integrate, or to outsource
  some of their functions.
• A Firm May Outsource a Function As the Result of
  One or More Of the Following Realizations
• The level of specific investment required to
  manage an economic exchange is not longer high
• A particular exchange is no longer rare or costly
  to imitate
• The level of uncertainty about the value of the
  exchange has increased

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The Imitability of Vertical Integration

• No Direct Duplication
• Some of the resources that might enable a firm to
  implement a valuable and rare vertical
  integration strategy might not be susceptible to
  direct duplication.
• These might include a firms ability to analyze
  the attributes of its economic exchanges and its
  ability to conceive of and implement vertical
  integration strategies.
• Both of these capabilities may be socially
  complex and path dependentbuilt up over years of
  experience.

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Rarity of Vertical Integration

• Integration vs. Non-Integration
• A firms 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 firms integration strategy is rare or common
  with respect to the value crated by the strategy

Example Toyotas Choice Not to Integrate
Suppliers
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Imitability of Vertical Integration(1 of 2)

• 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
• Capital requirements are prohibitive

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Imitability of Vertical Integration(2 of 2)

• 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 integrationwithout the costs of
  ownership

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Organizing Vertical Integration(1 of 4)
Functional Structure (U-Form)
CEOs Role
Cooperation
Accounting
Finance
Marketing
HR
Engineering
Original Business
Original Business
Original Business
Original Business
Original Business
Conflict
Cooperation
New Business
New Business
New Business
New Business
New Business
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Organizing Vertical Integration(2 of 4)

• Management Controls
• What needs to be controlled in a vertically
  integrated firm?
• Managers efforts to achieve the desired value
  chain economics
• Cooperation and competition among and between
  functions
• The integration of new businesses into the
  existing businesses
• Time horizon of managers

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Organizing Vertical Integration(3 of 4)
Management Controls
separating strategic and operational budgets
provide oversight and direction to managers
help ensure that strategic direction is
maintained
strategic inputs outputs
operational outputs
These mechanisms focus management attention on
achieving value chain economies
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Organizing Vertical Integration(4 of 4)
Compensation
Salary
Cash Bonus Individual
Stock Grants Individual
Cash Bonus Group
Stock Grants Group
Stock Options Individual
Stock Options Group
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International Expansion
The Cost Control Tradeoff
Cost (Capital at Risk)
High
Greenfield Investment
Vertically Integrated
Acquisition
Strategic Alliance
Somewhat Vertically Integrated
Franchising
Licensing
Not Vertically Integrated
Exporting
Control
Low
High
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Summary(1 of 2)
Vertical Integration
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Summary(2 of 2)
Vertical Integration
Ownership is costlyintegrate only when
the benefits outweigh the costs of integration!