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Vertical Integration

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The most fundamental question to ask when structuring a delivery system :Should only one organization do all the work, thereby vertically integrating into the distribution stage?

Vertical Integration

Amity Business School

To integrate is to become one, or singular When the manufacturer integrates a distribution function; it has integrated forward or downstream from the point of production. It can also occur from downstream direction. Whether the manufacturer integrates forward or downstream channel member integrates backward-it results in one organization doing all the work & the channel is said to be vertically integrated

To make or buy?

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A critical determinant of company competencies. Make-or-buy (vertically integrate or outsource) are critical strategic choices which should be made carefully with emphasis on how they affect a firms future performance path. By way of vertical integration the manufacturer can influence & make an image in the minds of the end users. Also helps in gaining market intelligence. The consequences of vertical integration are great and the decisions are difficult to change.

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Degrees of vertical integration

Under classical market contracts, manufacturers & downstream channel members : Are interchangeable Deal with each other in a completely independent & impersonal fashion Negotiate each transaction as though its the only one Begin & end transactions based solely on the merits of current set of offerings

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THE CONTINUUM OF DEGREES OF VERTICAL INTEGRATION

Buy Classical Market Contracting Quasi-Vertical Integration (Relational Governance) How does the the work get done Make Vertical Integration

Third Party Does it (for a price) Their people Their money Their risk Their responsibility

You do it

The costs

You and third party share costs and benefits

Your people Your money Your risk Your responsibility

Their operation (control) Their gain or loss

The benefits

Your operation (control) Your gain or loss

Contd.

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At the extreme of buy, manufacturer- distributor arrangements involves no sharing, no distinction & no continuity. Buy is a large zone of third party relationships. Often they operate in a manner as though they are a single firm. In fact, customers often believe they are dealing with the manufacturer when they are actually dealing with a committed third party When the argument of integration is not entirely compelling relational governance or quasi vertical integration should be considered. e.g Franchising & close relationships

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Examples of institutions performing some channel functions

Function

Classical Market Contracting

Quasi-vertical Integration

Vertical Integration

1) Selling (only)

Manufacturers Representatives

Captive or Exclusive Sales Agency *

Producer Sales Force (direct sales force)

2) Wholesale Distribution

Independent Wholesaler

Distribution Joint Venture

Distribution Arm of Producer

3)

Retail Distribution

Independent (3rd party)

Franchise Store

Company Store

* Operationally, a sales agency deriving more than 50% of its revenues from one principal

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Costs & benefits of the choice to make

Many a times, the result of vertical integration forward not only fails to improve market share but actually reduced the firms ROI The top mgmt of the vertically integrated firm is responsible for ensuring distribution but often lacks managerial resources for the same. Manufacturers integrate forward when they believe it will increase their profits. They also tap steady flow of maintenance contracts for their long lived products. Often the integrator underestimates the difficulty of assuming the new function and overestimates the benefits of control.

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The choice to buy distribution

In this, typically a third party is sought which will contract with the organization to perform channel flows for some economic considerations , normally a price. However, many variations are also possible, e.g. paying a flat fee or reimbursing some of the resellers expenses or some future consideration for e.g. right to future business or a percentage of equity in the manufacturer.

At times channel members also operate on deferred payments. E.g. French artisan bakers

When to vertically integrate?

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The return on investment : the usual criterion

For vertical integration to be justified , it must somehow increase revenues more than it increases variable costs.

When competition is low

Typically due to company specific capabilities. Six types of company specific capabilities exist in distribution Intangible capabilities Idiosyncratic knowledge Relationships Brand equity that derives from channel members activities Tangible capabilities Customized physical facilities Dedicated capacity Site specificity

When the environment is uncertain Presence of performance ambiguity Thin markets

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How environmental uncertainty impacts vertical integration

Highly Volatile Market

Low Specificity

High Specificity

Outsource Distribution to Retain Flexibility Until Uncertainty Is Reduced

Highly Promising Market

Less Promising Market

Vertically Integrate to Gain Control Over Employees And Avoid Small-Numbers Bargaining In Changing Circumstances

Do Not Enter

When to outsource?

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Little money at stake Resources can be used elsewhere Your business would benefit from six fundamental advantages of an outsider specialist - Motivation -Specialization -Survival of economically fittest - Economies of scale - Heavier market coverage - Independence from any single supplier

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Step 2: Question Outsourcing Where Markets Are Not Competitive:

The effects of outsourcing

Step 1: Outsourcing Distribution to Benefit from Advantages of Competitive Markets: +

1) Valuable Company-Specific Capabilities are Needed: Know-How Relationships Brand Equity Created by Distribution Activities Dedicated Capacity Site Specificity Customized Physical Facilities 2) Thin Supply Step 3: Question Outsourcing Where Indicators of Results Do Not Correspond to Performance:

Revenues +

Motivation Specialization Survival of the Economic Fittest Economies of Scale Heavier Coverage Independence from a Single Producer

Direct Costs

Overhead

Cannot be benchmarked Not Timely Inaccurate

Road map to the vertical integration decision

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