Vertical Integration

WHAT IS CORPORATE STRATEGY?

Corporate (or corporate-level) strategies are actions firms take to gain competitive
advantages by operating in multiple markets or industries simultaneously. Thus, they expand
on business-level strategies which focus on gaining competitive advantage in a single market
or industry. Corporate strategy deals with both the form (vertical integration, diversification)
as well as the means (mergers and acquisitions and strategic alliances).

/ Important Point: Corporate level strategy addresses the question: In which

business(es) should the firm operate? Managers use corporate level strategy to help ensure
that the corporation is composed of the optimal mix of businesses.

The corporate-level strategy should create value for the organization:

• such that the value of the corporate whole increases

• such that businesses forming the corporate whole (i.e., the portfolio) are worth more
than they would be under independent ownership
• that equity investors cannot create through portfolio investing (on their own)

Owning a portfolio of businesses comes with a cost – the costs associated with
running a bureaucracy. The benefits should outweigh the costs for corporate-level strategy
to make sense. The benefits typically come in the form of synergies. In the case of vertical
integration, the key benefit comes in the form of value chain economies.

Value Chain Economies: Value chain economies are those economies that are
created by integrating a market transaction into the boundaries of the firm. For example, a
firm that buys one of its suppliers may realize an economy by coordinating the production of
the supply with the needs of the parent firm.

WHAT IS VERTICAL INTEGRATION?

The value chain (primary and support activities) which was discussed earlier can
be thought of as the firm’s internal value chain, while the value chain here is the industry
value chain.

For example, Leprino Foods as the focal firm, point out that backward integration is
going back in the value chain (Leprino Foods buying a dairy producer), while forward
integration is moving forward in the value chain (Leprino Foods getting into the business of
food distribution). At present, Leprino Foods buys milk from dairy companies, makes
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cheese in its facilities, and sells the cheese to large food distributors such as Sysco and
Gordon Foods, who sell to pizza chains such as Pizza Hut and Domino’s. Does it make
sense for Leprino Foods to expand by owing dairy companies or by getting into food
distribution? Leprino Foods has to look at two metrics in making the decision: cost
reduction and revenue enhancement. Synergies may help in cost containment and the ability
to capture above normal profits helps on the income side.

► Example: Amazon and the Publishing Industry

The book publishing industry traditionally was characterized by a long value

chain. The publisher contracted with authors to write books and entered
into agreements with commercial printers (such as R.R. Donnelley and
Quebecor) to print the books. Books were distributed to bookstores
through wholesalers such as Ingram and Baker & Taylor. The major
problem with this value chain was the amount of unsold books returned by
booksellers. Publishers faced return rates as high as 30 percent, which added
significantly to their costs. Seeing this inefficiency as an opening, Amazon
changed the value chain. By going directly to publishers, Amazon was able
to lower costs by cutting out wholesalers. More importantly, they placed
orders with publishers after customers ordered from their website. This
allowed Amazon to reduce drastically the returns to publishers (from 30% to
3%) and use this to bargain for better prices from them. Amazon backward
integrated by bypassing the wholesaler and going directly to the publisher.

(“Amazon your industry: Extracting value from the value chain,” Strategy & Business, First
Quarter 2000)

THE VALUE OF VERTICAL INTEGRATION

The two extremes in economic exchange are the market and integrated economic
exchange (also called the hierarchy). In the market, the focal firm buys the product or service
from outside players or sells its product to outside intermediaries. In integrated economic
exchange, the firm performs these activities internally. Economic exchange should be
conducted in a way that maximizes value for the focal firm. Integration makes strategic sense
when the focal firm can capture more value than a market exchange provides.

Once the overall value maximization logic of vertical integration is discussed, the
focus can shift to specifics. Vertical integration can create value – decrease costs or increase
revenues – in three situations:

ƒ to reduce the threat of opportunism

ƒ to leverage firm capabilities
ƒ to remain flexible (possible with vertical integration under certain conditions)
Vertical Integration and the Threat of Opportunism

Opportunism is when a firm is unfairly exploited in an exchange. In other words, one of the
two firms in an exchange holds up the other to the financial benefit of the first firm. The
hold up can occur with regard to price, delivery terms, quality, etc. For the firm that is being
held up, the exchange creates an economic loss. To avoid this, the firm can vertically
integrate. By bringing the activity in-house, the firm controls it and therefore removes the
possibility of opportunistic behavior causing economic losses. The decision to vertically
integrate, though, has to be made by comparing the costs of vertical integration with its
benefits. If the cost of opportunism is less than the cost of vertical integration, then the
decision should be to continue with market exchange.
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. The
example of the oil refinery in the book is a good one to use because it describes a
transaction-specific investment in visual form and examines its effect on value in numerical
form. Once this example is gone through, the instructor can use a second example (given
below) to reinforce the concept.
If the pipeline laying company is the focal firm in the discussion, look at the issue
from its perspective. It costs money to lay the pipeline but it brings value ($750,000) to the
firm. But the value comes with a catch. The full value ($750,000) is only realized in the
specific context of serving the oil refinery. Because of location issues, the value is
diminished considerably (to around $10,000) if the context is changed. If the two firms agree
on a 5-year contract on terms favorable to the oil pipeline company, then the transaction-
specific investment makes strategic sense for the focal firm. But what happens after the
initial contract runs out? That’s when opportunism (or its possibility) comes into play! In
negotiating the second contract, who has the advantage? Obviously it is the oil refinery.
They can bring down the price of the exchange so that they can profit. But the focal firm
stands to lose because of this opportunism. It is likely, then, that the focal firm will not be
motivated to make this investment in the first place. Vertical integration is the recourse for
the oil refinery because it takes care of the opportunism problem.

► Example: Bird’s Eye and the Frozen Foods Industry

Birds Eye, the U.S. frozen foods maker, wanted to expand to the U.K. in the
1950s, attracted by the large market and the absence of a frozen food
industry. One of the first products they sought to introduce in the U.K. was
frozen vegetables. They contracted with farmers to grow vegetables for
them. Their U.S. experience had taught them of the need to process the
vegetables within 90 minutes of harvest. Processing vegetables after 90
minutes typically resulted in the product lacking freshness. Because the
farmlands were on the outskirts of London, there were no processing plants
in existence within the 90 minutes radius. Birds Eye contacted a number of
processors and asked them to invest in a facility near the farmlands. Birds
Eye could not find a single taker. Why would this happen? Investing near
the farmlands is a transaction-specific investment. Its value would be great
only in the context of serving Birds Eye and nobody else. Why would a
processor make such a transaction-specific investment when the possibility
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of opportunistic behavior by Birds Eye is great? After the investment is

made, Birds Eye could take advantage of this sunk cost by paying less to the
processor. Birds Eye was forced to vertically integrate into owning
processing plants because of this problem.

(Birds Eye and the U.K. Frozen Food Industry, Harvard Business School
Case)

Vertical Integration and Firm Capabilities

Reducing the threat of opportunism can be seen as a defensive approach to vertical

integration. Leveraging the focal firm’s capabilities, on the other hand, is a proactive
approach to vertical integration. The logic here is simple: a firm should vertically integrate
into those business activities where they possess valuable, rare, and costly-to-imitate
resources and capabilities. This also means that a firm should not vertically integrate into
activities where they do not have the resources to get a competitive advantage.

► Example

A company that manufacturers seats for auditoriums and stadiums faced a

difficult problem. The company manufactured seats to order and delivered
the seats to firms that specialized in installation. The company won plaudits
for the quality of its seats. However, they faced numerous complaints
regarding poor installation. This motivated the company to consider the
possibility of vertically integrating into the installation activity. When they
analyzed the situation, they realized that none of the capabilities that were
valuable in the manufacturing business (design, quality, etc.) created a
competitive advantage in the installation business. Indeed, they had to
develop new capabilities (managing a temporary, unskilled work force to
generate efficiency, for example) to succeed in the installation business. The
company decided against vertical integration!

/ Important Point: What if the two motivations for vertical integration provide
contrasting results? In other words, what if the opportunism argument points to vertical
integration while the capabilities argument point to a market exchange?

In its 2004 Annual Report, Hershey Foods indicated that Wal-Mart accounted for 22
percent of total sales in the year 2003. Wal-Mart was responsible for 16 percent of Procter
and Gamble’s 2004 revenues. It is very likely that similar percentages can be found for many
of Wal-Mart’s leading suppliers. Wal-Mart clearly has tremendous bargaining power over
these companies. Many of these companies have well-staffed offices in Bentonville,
Arkansas, where Wal-Mart’s corporate headquarters is located. These are transaction-
specific investments made by these companies to serve one customer, Wal-Mart. The
opportunism minimization logic would indicate that these firms should forward integrate
into retailing to reduce the possibility of losses due to Wal-Mart’s opportunistic behavior.
But, do these firms have the resources to obtain a competitive advantage in retailing? Not
likely. So, forward integration into retailing does not make sense from a capabilities
viewpoint.

Vertical Integration and Flexibility

Flexibility pertains to the cost (and time) of changing the strategic and operational decisions
of an organization. A flexible organization can change its strategic/operational choices
quickly. In other words, such an organization can pivot on a dime! Less flexible
organizations find this change difficult and costly. In general, vertical integration reduces a
firm’s flexibility. Why? A vertically integrated organization has expanded its bureaucracy to
include multiple activities. It has changed its structure, control system, and compensation
practices to reflect this increased bureaucracy. Changing these take time.
Flexibility is not always a virtue. It is important to be flexible when the future is
uncertain. In such situations, alternatives to vertical integration, particularly strategic
alliances, may be better options.

► Example: Intel Capital

Intel, the chip maker, has a venture capital arm called Intel Capital. Its
mission is to identify and invest in promising technology companies
worldwide. Founded in 1991, Intel Capital has invested more than $4 billion
in approximately 1,000 companies in over 30 countries. These investments
help Intel in two ways: it allows Intel to profit when these companies go
public or are acquired by other companies. More importantly, though, these
investments give Intel a first right of refusal on new technologies without the
company having to vertically integrate into any of these when their future is
uncertain.

Intel’s web site (www.intel.com)

Applying the Theories to the Management of Call Centers

Call centers in the beginning (because of their novelty) required transaction-specific

investments – physical infrastructure, communications technology, training, etc. Vertical
integration made sense at that time. Changes in information technology, benefits of the
learning curve in terms of employee training, and the ability to cater to multiple customers
from one central location ushered in a huge growth in independent call center companies.
This merchant market in call centers meant that firms did not have to vertically integrate into
this activity.
In the early stage, a firm could gain a competitive advantage by operating a call
center. For example, Dell always resonated well with its customers because of the quality of
its customer interaction through its call centers. But, today, almost every company seems to
have one. It is no longer a means to competitive advantage. Besides, companies specializing
in operating call centers developed a number of valuable and costly-to-imitate capabilities. It
made sense for firms to outsource this function.
As communication technology changes rapidly, firms face a lot of uncertainty in this
regard. Investing in one technology to run a call center may put a firm at a disadvantage
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because its technology may quickly become obsolete. Outsourcing this function reduces the
uncertainty for firms.

► Example: Call Centers in India

India is a leading player in the call center industry. Companies such as

Daimler-Chrysler, British Telecom, Citigroup, and American Express all do
business with Indian call center companies. GE has gone a step further. It
operates call centers (serving clients) in India. It provides a variety of
services for its clients: transaction processing, help desks, IT-related queries
from U.S. clients, accounting services, etc. Why does India dominate in this
industry? A key reason is that manpower accounts for 55-60 percent of the
cost of running a call center. In India, manpower (particularly tech-savy,
English speaking labor) is available at a fraction of the cost overseas. In
addition, the Indian government provides various incentives for companies
to run call centers.

Outsource India web site (www.outsource2India.com)

VERTICAL INTEGRATION AND SUSTAINED COMPETITIVE ADVANTAGE

In order for vertical integration to be a source of sustained competitive advantage, it must
not only be valuable but also rare and costly to imitate, and the firm must be organized to
implement this strategy.

Rarity in vertical integration may be because of one of two things: a firm is rare in being
able to operate its vertically integrated units very efficiently. Or, it could the one firm in the
industry that is not vertically integrated while all others are.
A firm may be able to create value (more than others in the industry) through vertical
integration because of three reasons:

ƒ rare transaction-specific investments need to be made that prompts a firm to

vertically integrate
ƒ to leverage specific capabilities that would give it a competitive advantage
ƒ ability to resolve uncertainty ahead of others in the industry.

In the first case, the firm has developed a special technology or a new approach to
doing business, while others in the industry have not. Because this special
technology/approach to doing business requires transaction-specific investment, the firm is
vertically integrated, while others in the industry are non-integrated.
In the second case, the firm has a valuable capability that allows it to benefit from
vertical integration. Others do not have this capability and hence are not vertically integrated.
In the third reason, the firm has the ability to resolve the uncertainty that all firms in
the industry face. While others may be non-integrated because of this uncertainty, the focal
firm may be vertically integrated.
In all the cases above, the focal firm decides to vertically integrate while others in the
industry do not. But, there may also be a case where others are vertically integrated while
the focal firm benefits from being de-integrated. It creates value for itself by being able to
manage these market economic exchanges efficiently.

The Imitability of Vertical Integration

The ability to create value through vertical integration (or by de-integration) may not be rare
for too long if it can be imitated. Imitation can be through direct duplication or through
substitution.
Direct duplication of a firm’s vertical integration involves two things: copying the
form and copying the value creation potential. While copying the form may not be costly,
copying the value creation potential may be costly because of factors such as historical
uniqueness, causal ambiguity, and social complexity. Imitation may also be difficult if there
are not very many firms to acquire in order to vertically integrate (the small numbers
problem) or where entry barriers are quite high.
An imitator may choose not to directly duplicate the value creation potential of
another firm’s vertical integration strategy. Instead, it may choose substitute modes that give
it the same benefit. Internal development and strategic alliances are two important substitute
modes.

ORGANIZING TO IMPLEMENT VERTICAL INTEGRATION

A firm must have the appropriate infrastructure – organizational structure, management
controls, and compensation policies to successfully implement a vertical integration strategy.

Organizational Structure and Implementing Vertical Integration

Management Controls and Implementing Vertical Integration

As vertical integration strategies typically require that one business be integrated with an
existing business (in the case of acquisition). Such integration presents some potentially
challenging management issues. These issues revolve around aligning the interests of
managers, new and existing, with the interests of the newly combined firm.
Once in implementing a vertical integration strategy is established, the discussion
should turn to management control processes. Two key ones need to be addressed here:

ƒ budgets
ƒ management committees

Budgets help in the control process by identifying the metrics by which performance
is to be measured. A vertically integrated firm may develop budgets in a variety of areas:
sales, costs, etc. Typically budgets are tied into the compensation process, in that managers
may receive bonuses depending on how close they are to their budget. While budgets help
in the control process, they may have serious downsides. Primary among them is the fact
that budgets are likely to promote short-term behavior (controlling expenses today to meet
budget but not preparing for the future) at the cost of long-term actions. Involving
managers in the budgeting process and using qualitative measures in addition to quantitative
ones can help in this regard.
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Internal management committees that meet periodically also help in the control
process. Two common ones (though they may go by different names in organizations) are:

ƒ the executive committee

ƒ the operations committee

The difference between the two types of committees is essentially in their focus:
the executive committee tends to focus on short-term firm performance while the
operations committee has a long-term view of firm performance. Both committees are
staffed by the CEO and key functional area managers. They meet regularly (typically,
weekly for the executive committee and monthly for the operations committee) to
identify problems and come up with solutions. Such committees also help in reducing
the conflicts among departments.

Compensation in Implementing Vertical Integration Strategies

Compensation is the third piece of the “Organizing” puzzle. As such it complements both
structure and control systems and helps guide behavior toward desired ends. The three
explanations for vertical integration (opportunism, capabilities, and flexibility) have
important compensation implications. The instructor should structure this discussion
around this idea.
Very often employees make firm-specific investments of their own. They expend
energy cultivating skills valuable to the organization, imbibe the organizational culture and
establish contacts within and outside the firm. Such investments are valuable only in the
context of the firm, in that, once the employee leaves the firm, much of the investment
declines in value. Employees know that if they make such firm-specific investments, they are
vulnerable because the firm can treat them badly without worrying that the employee will
seek employment elsewhere. So how should an organization encourage its employees to
invest in firm-specific skills in light of this possibility? They should do it by providing
incentives as part of their compensation.
While the previous paragraph talked about providing incentives for individuals to
invest in firm-specific skills, there is also the fact that groups of employees make firm-
specific investments. Very often, it is the tacit collective knowledge of these groups of
employees that give the firm valuable costly-to-imitate capabilities. The firm’s compensation
policy must encourage such collective firm-specific investment.
Compensation practices must also take into account the importance of flexibility.
Employees must be encouraged to engage in activities that allow the firm to be flexible in
order to take advantage of opportunities.

VERTICAL INTEGRATION IN AN INTERNATIONAL CONTEXT

When a firm outsources an activity (such as running a call center) to an international firm, it
is de-integrating. A firm may choose to do the opposite, i.e., vertically integrate across
borders. A firm may choose to import/export and thus do business across countries. In
such cases, an option for the firm would be to use, for example, a marketing agency in a
foreign country to sell its goods in that country. Thus, a U.S. manufacturer may enter into a
contract with a Japanese selling agency to sell its products in Japan. This is a low cost entry
mode for the U.S. firm because it uses the already established infrastructure – warehouse,
sales force, channel contacts – of the Japanese company. Firms are likely to use the
importing/exporting mode when they are unsure about the market potential or when they
discover that they do not have the capabilities and resources to compete in these markets.
Intermediate forms – between the two extremes of non-integration and vertical
integration – exist for doing business across countries. Principal among them are licensing
and strategic alliances. In a licensing agreement, the licensor grants the rights to the product
(design, brand name, etc.) to a licensee in return for licensing fees. The licensee makes the
investment necessary to make the product in the specific country. Strategic alliances (and
joint ventures) involve partnerships with one or more firms to enter foreign markets.
Foreign direct investment is when a firm chooses to be vertically integrated in
operating in multiple markets. It either acquires a firm in the foreign country (such as when
Coca-Cola acquired a local beverage company in India) or forms its own local subsidiary
(PepsiCo in India). Needless to say, the political and economic risks must be considered
before a substantial foreign direct investment is made.

SUMMARY OF VERTICAL INTEGRATION

It is a good idea to summarize the discussion on vertical integration by stating this:

historically, the default was vertical integration. That is, firms were vertically integrated into
performing multiple value chain activities unless there were compelling reasons not to do so.
Gigantic oil companies such as Standard Oil and Exxon were almost fully vertically
integrated. Today, the pendulum has shifted to the opposite side. Firms are typically non-
integrated unless there is a compelling reason to be vertically integrated.
Reiterating the conditions under which vertical integration makes sense is important
at this point. Reducing/preventing opportunism, leveraging capabilities, and increasing
flexibility are good reasons under certain conditions for vertical integration.