Vertical Vs Horizontal Integration

10 Key excerpts on "Vertical Vs Horizontal Integration"

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  Maximizing Corporate Value through Mergers and Acquisitions

  A Strategic Growth Guide

  • Patrick A. Gaughan(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 6 Vertical Integration

  While horizontal integration refers to combinations between competitors, vertical deals involve companies that have a buy-sell or upstream-downstream relationship. While they may not be as common as horizontal deals, there are still countless examples of vertical integration merger and acquisitions (M&A). The key question is what is the track record of such vertical deals? Unfortunately, too often it is questionable. In some instances and situations, it makes good sense for the companies involved. In these cases, vertical integration may be the best solution to a problem such as having a dependable source of supply. In other instances, it may fail to yield real benefits and result in a waste of corporate resources that could be better applied elsewhere.

  BENEFITS OF VERTICAL INTEGRATION

  The benefits of vertical integration vary depending on the industry. When the deals involve, for example, a manufacturer buying a retailer, the deal may allow the manufacturer to gain better access to the ultimate consumers of their products. Similarly, in the petroleum industry, many of the larger companies have been vertically integrated for many years. It is common to see oil companies be involved, in exploration, transportation, and pipelines and refining, while also owning a large network of gas stations. When they are involved in all these areas, we say they are fully vertically integrated. Whether that is good or not is a debatable issue.

  RISK AND VERTICAL INTEGRATION

  One of the benefits of being vertically integrated is that it can lower some of the risks a company faces in the marketplace. Buying a supplier can allow a company to have greater certainty in access to supplies. It may also allow these supplies to be more dependably available at more predictable prices. When getting access to key supplies is a major risk factor, companies may be able to lower this risk through vertical integration. By acquiring a supplier, they may be able to get a dependable source of inputs while possibly being able to gain a competitive advantage by preventing these supplies from being available to the competition. This competitive advantage may carry with it antitrust ramifications, but as markets have become increasingly globalized, most deals, especially vertical ones, tend to move through the antitrust approval process without a great deal of opposition.

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  Contemporary Strategy Analysis

  • Robert M. Grant(Author)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  D. Chandler, Strategy and Structure (Cambridge: MIT Press, 1962). 238 PART IV CORPORATE STRATEGY the relative efficiencies of firms relative to markets. For most of the 19th and 20th cen- turies, new technologies—including innovations in management and organization— have favored large firms. Around the mid-1970s, this trend went into reverse: a more turbulent business environment and new information and communications technol- ogies favored more focused enterprises coordinated through markets. Yet, during the 21st century, a new phase of global consolidation has seen the traditional benefits of scale and market dominance reasserting themselves. The Benefits and Costs of Vertical Integration So far, we have considered the overall scope of the firm. Let us focus now on just one dimension of corporate scope: vertical integration. The question we seek to answer is this: Is it better to be vertically integrated or vertically specialized? With regard to a specific activity, this translates into: To make or to buy? First, we must be clear what we mean by vertical integration. Vertical integration is a firm’s ownership and control of multiple vertical stages in the supply of a product. The extent of a firm’s vertical integration is indicated by the number of stages of the industry’s value chain that it spans, and can be measured by the ratio of its value added to sales revenue. 4 Vertical integration can be either backward (or “upstream”) into its suppliers’ activ- ities or forward (or “downstream”) into its customers’ activities. Vertical integration may also be full or partial. Some California wineries are fully integrated: they produce wine only from the grapes they grow, and sell it all through direct distribution. Most are partially integrated: their homegrown grapes are supplemented with purchased grapes; they sell some wine through their own tasting rooms but most through independent distributors.

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  Foundations of Strategy

  • Robert M. Grant, Judith J. Jordan, Phil Walsh(Authors)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  VERTICAL INTEGRATION Defining Vertical Integration Vertical integration is the extent to which a firm owns vertically related activities. The greater a firm’s ownership extends over successive stages of the value chain for its prod- uct, the greater its degree of vertical integration. The extent of vertical integration is indi- cated by the ratio of a firm’s value added to its sales revenue: the more a firm makes rather than buys, the lower are its costs of bought-in goods and services relative to its final sales revenue. Vertical integration can be either backward, where the firm acquires ownership and control over the production of its own inputs, or forward, where the firm acquires own- ership and control of activities previously undertaken by its customers. Vertical integration may be full or partial. Some Canadian wineries (typically the smaller ones) are fully integrated: they produce wine only from the grapes they grow and sell it all directly to final customers. Most are partially integrated: their homegrown grapes are supplemented with purchased grapes and they sell some wine through their own tasting rooms, with distributors taking the rest. The Benefits and Costs of Vertical Integration Strategies toward vertical integration have been subject to shifting fashions. For most of the twentieth century, the prevailing wisdom was that vertical integration was generally beneficial because it allowed superior coordination and reduced risk. During the past 30 years there has been a profound change of opinion: outsourcing, it is claimed, enhances flexibility and allows firms to focus on their “core competencies.” Moreover, many of the coordination benefits traditionally associated with vertical integration can be achieved through collaboration between vertically related companies. However, as in other areas of management, fashion is fickle.

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  Strategic Management

  Concepts and Cases

  • Jeffrey H. Dyer, Paul C. Godfrey, Robert J. Jensen, David J. Bryce(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  What Is Vertical Integration? 119 This chapter will examine why companies choose to conduct an activity within the firm; the benefits of outsourcing, and the conditions when it might be advantageous; and the dan- gers of outsourcing as well as the risks of vertical integration. In the Strategy Tool at the end of the chapter, we provide a tool, the “Make Versus Buy Assessment,” that can be used to decide whether to make versus buy. The Value Chain The different aspects of the value chain have been covered in earlier chapters, but they warrant a more in-depth discussion here as a clear understanding of the value chain is critical to the “make versus buy” decision. The value chain for an industry is the sequence of activities that transforms raw materials into finished products. Each key activity “adds value” to the prior activity—hence the term value chain. 9 To illustrate, let’s walk through the industry value chain for gasoline. To get gasoline to the consumer, we first need to explore for crude oil, then drill, then ship, then refine the crude into gasoline, then ship again, then finally sell gasoline to the end consumer, as outlined in Figure 7.1. Companies have their own value chains that are usually distinct from an industry value chain. Companies that participate in many or all stages of the industry value chain from explo- ration to final sale are highly vertically integrated. 10 Companies that participate in only one activity (such as shipping crude oil) are vertically specialized. 11 Activities closer to the beginning of the industry value chain, or the raw materials used to create a product, are referred to as upstream activities and those toward the end, or final products that consumers purchase, are downstream activities. 12 Forward Integration and Backward Integration If a company wants to grow by moving forward in the value chain—that is, downstream—we say that company engages in forward integration.

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  Strategic Management

  Theory & Cases: An Integrated Approach

  • Charles Hill, Melissa Schilling, Gareth Jones(Authors)
  • 2019(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Horizontal integration often significantly improves the competitive advantage and profitability of companies whose managers choose to stay within one industry and focus on managing its competitive position to keep the company at the value creation frontier. 9-3a Benefits of Horizontal Integration In pursuing horizontal integration, managers invest their company’s capital resources to purchase the assets of industry competitors to increase the profitability of its single-business model. Profitability increases when horizontal integration (1) lowers the cost structure, (2) increases product differentiation, (3) leverages a competitive advantage more broadly, (4) reduces rivalry within the industry, and (5) increases bargaining power over suppliers and buyers. Lower Cost Structure Horizontal integration can lower a company’s cost structure because it creates increasing economies of scale . Suppose five major competitors e op-erate a manufacturing plant in some region of the United States, but none of the plants operate at full capacity. If one competitor buys another and closes that plant, it can operate its own plant at full capacity and reduce its manufacturing costs. Achiev-ing economies of scale is very important in industries that have a high-fixed-cost struc-ture. In such industries, large-scale production allows companies to spread their fixed costs over a large volume, and in this way drive down average unit costs. In the tele-communications industry, for example, the fixed costs of building advanced 4G and LTE broadband networks that offer tremendous increases in speed are enormous, and to make such an investment profitable requires a large volume of customers. Thus, AT&T and Verizon purchased other telecommunications companies to ac-quire their customers, increase their customer base, increase utilization rates, and reduce the cost of servicing each customer.

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  Contemporary Strategy Analysis

  • Robert M. Grant(Author)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  Vertical integration may also be full or partial . Some California wineries are fully integrated: they pro-duce wine only from the grapes they grow, and sell it all through direct distribution. Most are partially integrated: their homegrown grapes are supplemented with pur-chased grapes; they sell some wine through their own tasting rooms but most through independent distributors. Strategies toward vertical integration have been subject to shifting fashions. For most of the 20th century, the prevailing wisdom was that vertical integration was beneficial because it allowed superior coordination and reduced risk. Yet, by the 1990s, opinions had changed. In 1992, management guru Tom Peters observed: “The idea of vertical integration is anathema to an increasing number of companies.” 5 Outsourcing could reduce cost, enhance flexibility and allow firms to concentrate on those activities that they performed best. Moreover, many of the benefits of vertical integration could be achieved through collaboration with suppliers and buyers. Inevitably, the truth is more nuanced. Even within the same industry, companies make different choices over vertical integration and outsourcing. Strategy Capsule 10.2 compares Disney’s vertical integration between content production and distribution with the system of licensing contracts with which J. K. Rowling’s Harry Potter is com-mercialized through multiple channels. Our task is to identify the factors that determine whether vertical integration or out-sourcing is the better strategy for a particular company in a particular situation. The Benefits from Vertical Integration Technical Economies from the Physical Integration of Processes Proponents of vertical integration have often emphasized the technical economies it offers: cost savings that arise from the physical integration of processes. Thus, most steel sheet is produced by integrated producers in plants that first produce steel and then roll hot steel into sheet.

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  Strategic Networks

  Creating the Borderless Organization

  • J. C. Jarillo(Author)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  But vertical integration may also have an insidious, long-term effect: it may hinder a company's ability to learn, which is its only assurance of continued success. It is well established that the main sources of innovation are a company's customers and suppliers. 1 By integrating verti-cally, one ensures that many of the activities of the business system don't have direct access to them. Although at the time of the integration the technology used may be start of the art, it is a matter of time before, devoid of the main creative stimulus, the part of the company that performs the isolated activity will fall behind. This is compounded by the not-invented-here syndrome, which easily creeps into integrated companies. When the Strategie Networks corporate incentives go to 'doing things our way', it is extremely easy to try to reinvent the wheel at every turn, at a great cost in terms of efficiency. Again, companies that enjoy a very robust source of profits (de jure or de facto monopolies or oligopolies in some activities) can indulge in that behav-iour, but they carry a huge liability for the day things change, as they always end up doing. Guidelines for decision-making on vertical integration To summarize our previous discussion: vertical integration makes sense if and only if it lowers the costs in some of the activities, somehow improves the company's performance in them, or affords better coordination than what could be achieved in an open market. In all other circumstances it is not only not helpful, it is positively harmful. In this context, how do you make a decision on vertical integration? Although obviously every case is different, a few questions can give orientation. What are the real advantages being sought? First we must expect any possible vertical integration to bring with it one or some of the benefits or advantages detailed before, whether they are real savings in costs or competitive gains.

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  Strategic Management

  Concepts and Cases

  • Jeffrey H. Dyer, Paul C. Godfrey, Robert J. Jensen, David J. Bryce(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  The need to coordinate these activities effectively leads to vertical integration of these activities. Control The third C is control, which refers to a firm’s desire to maintain control over a valuable activity or input in the value chain. In other words, an organization’s leaders must ask: To what extent should we maintain control over a crucial step in the value chain by conducting this activity ourselves? A company might want to vertically integrate in order to control some scarce and valu- able resource, particularly if it is a differentiator of its final product. 26 The choice to backward integrate might be made in order to control access to important raw materials or inputs that are highly customized to downstream activities. Some producers of aluminum have purchased land that is rich in bauxite—a key raw material that is necessary to make aluminum. They want to ensure that they have control of that key input so they developed bauxite-mining operations. In a similar vein, it might make sense to maintain control over investments in assets or equip- ment that provide key inputs at lower cost. For example, suppose that crude oil is best shipped to an oil refinery through a pipeline. Let us say the cost of shipping a barrel of crude oil by truck is $1.00 per barrel, whereas transporting by pipeline would be only $0.50 per barrel. Once built, the owner of the pipeline could opportunistically raise the shipping price up to $0.99 since the only real alternative is to ship the crude in trucks. Likewise, the owner of the refinery could refuse to pay a fair price to the pipeline owner—or any price, for that matter—if there is no other alternative use for the pipeline. In this case, the pipeline is a transaction-specific asset, meaning it is specialized or custom- ized to a particular transaction (transporting oil to the refinery) and has little value when redeployed to its next-best use.

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  21st Century Management: A Reference Handbook

  • Charles Wankel, Charles B. Wankel(Authors)
  • 2007(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  For example, a low-com-plexity product with low margins designed and manufac-tured by a company with high infrastructure costs may be outsourced. Comparatively, a highly complex product with high margins and high infrastructure costs may have value added by a strategy that attracts services from a customer, thereby adding further value to itself. Hayes, Wheelwright, and Clark (1988) stated that the most important step in developing and pursuing an integra-tion strategy is to identify the capabilities that are required to support the firm’s desired competitive advantage. In for-mulating its strategy, a firm must position itself along two key dimensions—one relating to products and the other to production processes. This approach assigns dimensions to decision making along one axis only—horizontal. Hill took this theory further by pointing out the impor-tance of process positioning, which considers the width of a firm’s internal span of process, the degree and direc-tion of vertical-integration alternatives, and its links and relationships with suppliers, distributors, and customers. The introduction of directional vertical integration and the incorporation of customers and distributors are in line with the concept of the horizontal axis having a relationship with both the upstream and downstream vertical axis. Lehtinen (1999) pointed out that the literature on process positioning had until this point concentrated on the prob-lems of make or buy decisions (upstream vertical), largely ignoring the managerial questions, which followed from the changes in a firm’s span of process (product range). He further pointed out that changes in the span of process would invariably lead to a change in the total management task within a business and that changes to span of process would bring corresponding changes in the task of manufac-turing management (infrastructure). This further reiterated the relationship between the vertical and horizontal axes.

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  The Econometrics of Energy Systems

  • Jacques Girod, Jan Horst Keppler, R. Bourbonnais(Authors)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Conclusions In this study we investigate the ability of vertical integration and horizontal diversification to create value for US energy firm shareholders. Our results are mixed and appear to partially confirm the postulations of industrial organization, as far as the first type of corporate strategy is concerned, and of financial economics, with respect to fuel diversification. On the one hand, vertical integration within energy portfolios seems to produce little risk-adjusted return performance for all types of energy firms. For industrial organization theory this may, perhaps, indicate that asset speci- ficity and the possibility of opportunistic behaviour across various stages of production are not a sufficient cause to release material synergies as a result of upstream or downstream integration. Across the various types of energy, this is all the more true for the natural gas industry, a type of activity which, as a result of vertical integration, has experienced the worst results in the time window considered. Only power utilities seem to partially escape this reality, possibly because of their ability to create value by being integrated 250 Vertical Integration and Horizontal Diversification upstream into generation – a relatively small industry (see Figure 11.2) that, in isolation, has experienced the best equity performance among all energy portfolios. US antitrust authorities, in both their praxis and their periodical reports, treat energy industries as relatively non-concentrated. Accordingly, they have largely permitted the significant wave of corporate restructuring through mergers and acquisitions that reshaped the US energy sector during the last decade. Given the linkage between concentration and opportunistic behaviour (see Section 11.2), industrial structure may, therefore, be the cause of the contained performance of vertical integration in the sector.

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