Vertical Integration - Corporate Strategy PDF

Unit 2. Vertical Integration Corporate Strategy Pág. 1 Contents 2.1 2.2 2.3 2.4 The boundaries of What is vertical Advantages and risks Alternatives to the firm...

Unit 2. Vertical Integration Corporate Strategy Pág. 1 Contents 2.1 2.2 2.3 2.4 The boundaries of What is vertical Advantages and risks Alternatives to the firm integration? of vertical vertical integratio integration Bibliografía: Grant, R. (2022) Navas y Guerras (2022). Rothaermel (2024) Unit 2. Vertical integration Pág. 2 2.1 The boundaries of the firm Pág. 3 2.1 The boundaries of the firm Make or buy First relevant dimension of business growth: the degree of vertical integration of the company. The degree of vertical integration of a company is indicated by the number of stages of the industry value chain that it covers: In which activities does it actively participate (ownership and control) and in which ones does it not? The decision on the degree of integration of the company will mark the boundaries between what is done within that company (integration) and what is done outside (outsourcing). Unit 2. Vertical integration Pág. 4 2.1 The boundaries of the firm Make or buy The theory of transaction costs helps us to define these boundaries of the company. In this theory, the market (price) and the company (hierarchy and contractual relations) are presented as two alternatives to carry out any activity (i.e., economic transaction) Example: a marketing campaign, the production of a new product, hiring new employees… The limits of companies vary between countries and between industries (even between links in the industry value chain) Example: South Korea or the computer industry Unit 2. Vertical integration Pág. 5 2.1 The boundaries of the firm Make or buy Fuente: Grant (2018) Unit 2. Vertical integration Pág. 6 2.1 The boundaries of the firm Make or buy Is it better to carry out a certain activity within the company or go to the market? Neither of the two alternatives is free of costs. The theory of transaction costs helps us to answer that question. To do so, we must compare the magnitude of two types of transaction costs: Internal transaction costs: These arise as a consequence of organizing an economic exchange within the company (integration). For example, the administrative cost of coordinating that activity, the time and resources used to carry it out (opportunity cost), the economic cost of the resources used...) External transaction costs: These arise when going to the market to carry out that activity. For example, the cost of looking for someone to do it, the economic cost of subcontracting that activity, the cost of making the contract, of negotiating it, and/or enforcing it (in case of non-compliance) Unit 2. Vertical integration Pág. 7 2.1 The boundaries of the firm Make or buy If external costs > internal costs: Integration (company) If internal costs > external costs: Outsourcing (market) Firm Market - Command and control - High-powered Incentives - Coordination - Flexibility Advantages - Transaction-specific investments - Community of knowledge - Administrative Costs - Search cost - Low-powered incentives - Opportunism Disadvantages - Principal-agent problem - Incomplete contracts - Enforcement of contracts Source: Rothaermel (2024) Unit 2. Vertical integration Pág. 8 2.1 The boundaries of the firm Make or buy Previous options are ‘extreme’ solutions. There are other alternatives that happento be more often. Strategic Alliances Short-term Parent- BUY Long-term Equity Joint subsidiary MAKE contracts contracts alliances ventures relationship Source: Rothaermel (2024) Unit 2. Vertical integration Pág. 9 2.1 The boundaries of the firm Make or buy A. Short-term contracts Contracts lasting less than a year Companies make several exchanges with the same agent within the time horizon set out in the contract, instead of making these exchanges in isolation (market). Advantage: having the transaction (supply, sales channel, etc.) secured for a period of time Disadvantage: due to their short duration, they do not encourage specific investments Example: General Motors Unit 2. Vertical integration Pág. 10 2.1 The boundaries of the firm Make or buy B. Strategic alliances* Voluntary agreements between companies that generate an exchange (transaction) of knowledge, resources, and/or capabilities between the companies involved. They facilitate the realization of specific investments without encountering the disadvantages of vertically integrating the company. Within strategic alliances, we find different types: long-term contracts alliances with capital Exchange (equity alliances) joint-ventures *(will be seen in depth in Topic 4) *(se verán en profundidad en el Tema 4) Unit 2. Vertical integration Pág. 11 2.1 The boundaries of the firm Make or buy C. Parent-subsidiary relationship This is the closest agreement to vertical integration, since the parent company gives direct orders to the subsidiary. However, the subsidiary still maintains its autonomy Example: Stellantis with Opel; Volkswagen with SEAT... All these alternatives between the market and the company try to overcome some of the disadvantages of the two extremes Unit 2. Vertical integration Pág. 12 2.2 What is vertical integration? Pág. 13 2.2 What is vertical integration § In which stages of the industry value chain should the Raw materials company participate? BACKWARD Components § Deciding between making or VERTICAL buying the different activities of INTEGRATION Intermediate goods the value chain of that industry. Final Assembly § The degree of vertical Manufacturing integration will be greater when the company FORWARD incorporates more activities of VERTICAL Marketing that chain. INTEGRATION Sales § Integration can be forward or After-sales service backward. Example: Apple and support Unit 2. Vertical integration Pág. 14 Fuente: Rothaermel (2024) 2.2 What is vertical integration? Raw materials: chemicals, ceramics, metals, oil (for plastics), etc. These commodities are manufactured by companies such as DuPont (US), BASF (Germany), Kyocera (Japan) or ExxonMobil (US) Intermediate goods and components: integrated circuits, screen, camera, battery. Possible suppliers: Jabil Circuit (US), Intel (US), LG Display (Korea), Altek (Taiwan), BYD China) Assembly: Flextronics (Singapore), Foxconn (China), which carry out the task for companies such as Ericsson (Sweden), Motorola (US), Nokia (Finland), RIM (Canada), Apple (US) or Samsung (Korea) Telecom services: AT&T, Vodafone, Movistar, T-Mobile, Orange Unit 2. Vertical integration Pág. 15 2.2 What is vertical integration? Types of vertical integration The degree of vertical integration of companies is usually very different: some companies participate in only one stage, while others are involved in almost all of them Few companies are fully vertically integrated; most prefer to concentrate on one or two stages, seeking to be more efficient and have better results (not all stages are equally profitable for a given company). The selection of stages is usually related to the core competencies of each company Example: Apple Unit 2. Vertical integration Pág. 16 2.2 What is vertical integration? Design Apple, Google, HTC, Huawei, LG, Samsung, Xiaomi BACKWARD Manufacturing VERTICAL Flextronics, Foxconn, HTC, Inventec INTEGRATION FORWARD Marketing & Sales VERTICAL INTEGRATION Apple, Google, HTC, Huawei, LG, Samsung, Xiaomi After-sales service and support AT&T, Google, T-Mobile, HTC, Verizon Source: Rothaermel (2024) Unit 2. Vertical integration Pág. 17 2.2 What is vertical integration? From… To… Forward vertical integration Unit 2. Vertical integration Pág. 18 2.2 What is vertical integration? …From To… Integración vertical hacia detrás Unit 2. Vertical integration Pág. 19 2.3 Advantages and risks of vertical integration Pág. 20 2.3 The advantages and risks of vertical integration Vertical integration – benefits/advantages The main benefits are: Reducing costs Improving quality Facilitating planning Facilitating investment in specific assets Assets that have a high opportunity cost (their value changes greatly if they are used for another purpose) They can be (1) specific due to their location, (2) specific physical assets and (3) specific human assets. They can give rise to opportunistic behavior from the other contracting party. Securing the supply of provisions and distribution channels Unit 2. Vertical integration Pág. 21 2.3 The advantages and risks of vertical integration Risks of vertical integration The main risks of vertical integration are: Increased costs Reduced quality Reduced flexibility Risk of legal repercussions/implications: uncompetitive mergers Given that vertical integration has benefits and risks, when does it make sense? Weigh the advantages and disadvantages of vertical integration versus the market alternative Evaluate intermediate alternatives to the two options such as short-term contracts, strategic alliances or parent- subsidiary relationships, which allow for a better balance of advantages and disadvantages Unit 2. Vertical integration Pág. 22 2.3 The advantages and risks of vertical integration To consider – Make or Buy (Part 1) Factors Implications How many companies are operating in + companies -> - advantages the stage the firm wants to integrate? Is it necessary to make specific + specific investments -> + advantages investments to perform that activity? Ithere a need of high degree of + coordination -> + advantages coordination between stages? Is there uncertainty in the market of + uncertainty - -> adavantages those activities? Is the efficient scale similar in each - Similar -> - advantages stage? Source: Grant (2018) Unit 2. Vertical integration Pág. 23 2.3 The advantages and risks of vertical integration To consider – Make or Buy (Part 2) Factors Implications Are the skills and capabilities similar? + similarity -> + advantages Is it necessary to update resources or + update -> - advantages skills frequently? How uncertain is the demand? + uncertainty -> - advantages ¿Cómo de incierta es la demanda? Source: Grant (2018) Unit 2. Vertical integration Pág. 24 2.4 Alternatives to vertical integration Pág. 25 2.4 Alternatives to vertical integration Alternatives to vertical integration The best alternative would be one that would allow taking advantage of the benefits of vertical integration, minimizing its risks. Two additional alternatives: 1. Mixed integration 2. Strategic outsourcing External supplier Firm’s supplier External Firm’s manufacturer manufacturing External Firm’s distributor distributor Source: adaptaded from Rothaermel (2024) Unit 2. Vertical integration Pág. 26 2.4 Alternatives to vertical integration Alternatives to vertical integration Mixed integration The company participates in some (or all) activities in the value chain but also relies on external sources for those same activities (they can be both supply and distribution) Examples: Apple, Lego... Benefits of mixed integration It compares external agents (suppliers, manufacturers, distributors...) with the company itself and allows the company to improve its supply, production or distribution management capabilities It improves the company's flexibility The company can combine the use of internal and external knowledge (open innovation), increasing the possibilities of innovation Unit 2. Vertical integration Pág. 27 2.4 Alternatives to vertical integration Alternatives to vertical integration Strategic outsourcing Involves moving one or more activities in the value chain outside the boundaries of the company (not one-off transactions), reducing its level of vertical integration It implies analyzing all the activities in the value chain (both primary and support) and assessing whether any of them might make sense to move outside the company Example: companies that, instead of having their own human resources department, rely on external companies Unit 2. Vertical integration Pág. 28 Unit 2. Vertical integration Corporate Strategy Pág. 29