KD

Chapter 7 - Vertical Integration

Corporate Level Strategy Logic

  • Aim: Create value such that the collective worth of businesses exceeds individual ownership.

  • Synergies must be unattainable through market equity investing.

  • Vertical integration generates value chain economies which enhance the value of the corporate whole.

Definition of Vertical Integration

  • Example Case: **Leprino Foods (Mozzarella Cheese)

    • Chain Overview:

      • Dairy Farmers (supply milk)

      • Crop Farmers (grow alfalfa & corn)

      • Seed Companies (supply seeds)

      • Food Distributors

      • Pizza Chains

      • End Consumers

Types of Vertical Integration

  • Backward Vertical Integration: Involves the acquisition of suppliers.

  • Forward Vertical Integration: Involves the acquisition of distribution channels or customers.

Value Chain Economies

  • Key Elements:

    • Synergies: The focal firm aligns to enhance collaboration and reduce costs.

    • Economic Returns: Capture above-normal returns to avoid perfect competition.

    • Cost Reduction: Streamline operations.

    • Revenue Enhancement: Boost sales through more efficient processes.

Competitive Advantage through Integration

  • Must meet VRIO Criteria:

    • Is it Valuable?

    • Is it Rare?

    • Is it costly to Imitate?

    • Is the firm Organized to exploit it?

  • If these criteria are satisfied, it may lead to a competitive advantage.

Value Comparison: Market vs. Integrated Economic Exchange

  • Economic exchanges should maximize firm value.

  • Different forms of exchange (markets vs. integrated hierarchies) must be evaluated based on value generation.

  • Integration is favorable when greater value than market exchange can be captured.

Three Value Considerations

  1. Leverage Capabilities: Use strengths from one area to improve others.

  2. Exploit Flexibility: Maintain adaptability in changing environments.

  3. Manage Opportunism: Reduce risks from market opportunism by internalizing operations; must be cost-effective.

Rarity in Vertical Integration

  • Integration strategies may be rare based on how a firm chooses to integrate or not integrate.

  • Rarity not only considers the number of integrations but also the value borne from such strategies.

  • Example: Toyota's choice against supplier integration.

Imitability in Vertical Integration

  • Form vs. Function:

    • Form is often imitable.

    • Function may be costly to replicate if it relies on:

      • Historical uniqueness

      • Causal ambiguity

      • Social complexity

      • Resource limitations

      • High capital costs

Modes of Entry for Vertical Integration

  • Acquisition and Internal Development: Paths to vertical integration.

  • Strategic Alliances: Offer alternatives to ownership without commitments and costs.

Organizing for Vertical Integration

  • Functional Structure (U-Form):

    • Includes departments such as Accounting, Finance, Marketing, HR, Engineering.

    • CEO plays a crucial role in controlling operations and fostering cooperation among functions and businesses.

Management Controls

  • Essential controls include:

    • Cooperation and competition management amongst functions.

    • Integration of new businesses into existing operations.

    • Monitoring managerial efforts towards achieving value chain economies.

Budgets and Oversight

  • Separated into strategic and operational budgets for clarity and effectiveness.

  • Strategic Budgets: Focus on long-term inputs & outputs.

  • Operational Budgets: Oversee short-term outputs.

  • Board Committees: Provide oversight, ensuring alignment with strategic direction.

Compensation and Incentives

  • Different compensation structures incentivize cooperation:

    • Salary and cash bonuses influenced by individual or group performance.

    • Stock options for individual and group performance.

Summary of Vertical Integration

  • Core Insight: Vertical integration is viable when it can create and capture value chain economies.

  • Facilitates leveraging capabilities and mitigating opportunism and uncertainty.

  • It’s not inherently rare or costly to imitate; careful evaluation is critical.

Additional Summary Points

  • Vertical integration is vital in international expansion discussions.

  • It must be predicated on appropriate justifications and circumstances to avoid costly errors.

  • Ownership carries costs; thus, integration should only occur if benefits outweigh those costs.