Ch 7: Vertical Integration and Outsourcing

Bus 401 Cal Poly Slo

What is outsourcing?

the process where a firm contracts out a business process or activity to an external supplier

What is vertical integration?

bringing business processes or activities previously conducted by outside companies in-house

What is the value chain?

the sequence of all the activities that are performed by a firm to turn raw materials into the finished product that is sold to the buyer

*you are buying someone’s margin

In vertical integration:

every step in the value chain is controlled by a single company

In horizontal integration:

companies focus on doing one step and doing it very well, focuses on one step in the ladder

What are the 3 reasons companies choose to vertically integrate?

capabilities, coordination, and control

What is meant by capabalities?

when a firm has or can develop better capabilities than other firms to perform specific activities or functions more effectively.

What is meant by coordination?

effective and tight integration of the activity (different advantages)

What is meant by control?

controlling scarce inputs, critical raw materials, and specialized assets to ensure reliability and reduce dependence on external suppliers.

What are some advantages of outsourcing? (taking something out of the value chain)

• flexibility

• lower cost/better performance

• minimizes capital investment

How we decide depends on the type of work we want to do

requires low teamwork

Vertical integration requires high or low teamwork?

it requires high teamwork

How do companies prevent subcontractors from becoming a competitor?

• by building barriers to imitation

• don’t allow them to to know everything about making a product

• by using multiple subcontractors

Once outsourced

it is hard to bring in-house

can set in motion the loss of capabilities, it is not always the answer

companies that participate in many or all steps in the value chain are

highly vertically integrated

companies that participate in only one activity

are vertically specialized

Upstream activities

beginning of the value chain

backwards integrating

Downstream activities

end of the value chain

forward integration

The key question of whether we make it or buy it depends on

whether the company can build the capability to do a better job itself

Capabilities:

can the firm build that capabilities to perform it better than others

e.g. Nike does not manufacture its shoes, they outsource to Indonesia and China at a lower costs

Coordination

can the firm better coordinate the activity with other activities in the firm when both are conducted internally

When does it make sense to vertically integrate?

when there is greater interdependence

What are the 3 types of interdependence?

• modular

• sequential

• reciprocal

Modular interdependence

activities that are pooled together

do not require a high level of coordination

Sequential interdependence

when one firm can’t perform its task until the another firm has completed their task and passed on the results

they must meet together consistently to coordinate

Reciprocal interdependence

close coordination with other team members because they can complete their task only through a process of iterative knowledge sharing

Control

maintaining control over a valuable activity or input of the value chain

• scarce and valuable resources

• assets or equipment

What are some of the dangers of vertical integration?

flexibility to quickly make changes is lost

loss of focus; too difficult for managers to focus on many different activities at once

What are some of the benefits of outsourcing?

greater flexibility (when new technologies are being outsourced)

allows firms to focus their attention on being good at a narrower range of activities

minimizes capital investment required to grow

What are some of the dangers of outsourcing?

loss of capabilities and lack of control over critical assets/activities

fewer capabilities to innovate and differentiate

suppliers gain bargaining power