Strategic Analysis - Vertical Integration Part II Notes

Recap: Reasons to Buy from the Market

  • Market firms benefit from economies of scale and learning.

  • Market firms experience fewer bureaucratic constraints (influence costs and agency costs).

Recap: Reasons to Make (Vertical Integration)

  • Relationships with market firms can lead to costs due to poor coordination in the vertical chain.

  • Trading partners may be reluctant to develop and share valuable information.

  • Transaction costs are a significant factor.

Transaction Costs

  • Transaction costs are the expenses of using the market, which can be eliminated by using the firm

  • Important concepts from transaction-costs economics:

    • Relationship-specific assets

    • Rents and Quasi-rents

    • Holdup problem

Rents and Quasi Rents

  • Scenario: A company builds a factory to produce cup holders for Audi automobiles.

    • Production: 1 million holders per year.

    • Average variable cost: CC per unit.

    • Annual mortgage payment: II

    • Total cost: I+1,000,000CI + 1,000,000C dollars per year.

  • The factory is built specifically for Audi, expecting a profitable price.

  • Alternative: Selling to jobbers who modify and resell to other manufacturers.

Rents and Quasi Rents (Continued)

  • Market price from jobbers = PmP_m

  • Total revenue from jobbers: 1,000,000Pm1,000,000P_m

  • If Pm > C, selling to jobbers is viable (profit: 1,000,000(P</em>m−C)1,000,000(P</em>m - C)), but the annual investment cost I > 1,000,000(P_m – C), the investment may not be recovered.

  • Relationship-Specific Investment (RSI): The portion of investment unrecoverable if the deal with Audi falls through.

    • RSI=I−1,000,000(Pm−C)RSI = I - 1,000,000(P_m - C)

Rents and Quasi Rents (Continued 2)

  • RSI is the unrecoverable investment if business with Audi doesn't occur.

    • Example: If I = $8,500,000, C = $3, and P_m = $4, then RSI = $8,500,000 – 1,000,000 * (4-3) = $7,500,000

  • Rents: Audi agrees to buy 1 million holders per year at P^* > P_m

    • Expected total revenue from Audi: 1,000,000P∗1,000,000P^*

  • If I < 1,000,000(P^* - C), building the plant is justified.

  • Rent: The expected profit when the plant is built as planned.

    • Rent=1,000,000(P∗−C)–IRent = 1,000,000 (P^* - C) – I

Rents and Quasi Rents (Continued 3)

  • If the deal with Audi falls apart after the factory is built, selling to jobbers is still viable since 1,000,000 * (P_m - C) > 0.

  • Quasi-Rent: The difference between profit from selling to Audi and profit from selling to jobbers.

    • QuasiRent=[1,000,000(P∗−C)–I]–[1,000,000(P<em>m−C)–I]=1,000,000(P∗−P</em>m)Quasi Rent = [1,000,000 (P^* - C) – I] – [1,000,000 (P<em>m - C) – I] = 1,000,000 (P^* - P</em>m)

  • Quasi Rent is the extra profit if the deal proceeds as planned compared to the next best alternative.

Holdup Problem

  • If an asset wasn't relationship-specific, the firm could get the same profit in its best and next-best alternatives, so the quasi-rent would be 0.

  • If quasi-rent is large, a firm could lose a lot if it has to switch to its second-best alternative.

  • The trading partner could exploit this quasi-rent through holdup.

  • A firm holds up its trading partner by trying to renegotiate the deal's terms.

  • A firm can profit by holding up its trading partner when contracts are incomplete and when the deal generates quasi-rents for its trading partner.

Holdup Problem II

  • Example: Audi knows the cup holder company has sunk investment in the plant, so even though Audi promised to pay P<em>P^<em>, it knows the company would accept any amount > PmPm. Thus Audi could break the contract and offer a price between P^ and P</em>mP</em>m.

  • Audi could also get away with it if the contract is incomplete.

  • By failing to keep the original contract, Audi has «held you up» and has transferred some of your quasi-rent to itself.

Holdup Problem III

  • Suppose P^* = $12 per unit, P_m = $4 per unit, C = $3 per unit and I = $8,500,000.

    • Original Rent: 1,000,000 * (12-3) – 8,500,000 = $500,000 per year

    • Quasi-Rent: 1,000,000 * (12-4) = $8,000,000 per year

  • Audi renegotiates the contract down to $8 per unit: Audi increases its profits by $ 4 mln per year and will have transferred half of your quasi-rents to itself.

  • Profit after hold up: (8-3) * 1,000,000 – 8,500,000 = -$3,500,000, losing money on the factory.

Holdup Problem IV

  • If the firm had anticipated the hold-up, it might not have made the investment to begin with.

  • Problematic when rent is small, but quasi-rent is large.

    • Rent: [1,000,000*(12-3) – 8,500,000] = $500,000

    • Quasi-Rent: [1,000,000 * (12-4)] = $8,000,000

  • Fear of hold-up may deter firms from investing in relationship-specific assets.

  • Audi may have to find another supplier or make the cup holders itself.

Holdup Problem and Transaction Costs

  • The holdup problem increases the cost of transacting through market exchanges in four ways:

    1. More difficult contract negotiations and more frequent renegotiations.

    2. Investment to improve ex post bargaining positions.

    3. Distrust.

    4. Reduced investment in relationship-specific investments.

Make or Buy Decision Tree

  • Summarizing the frameworks: an issue tree.

  • Managers must answer a series of questions before making make-or-buy decisions.

  • The decision depends on factors like economies of scale, execution capabilities, relationship-specific assets, coordination problems, information leakage, contracting feasibility, and potential of intermediate arrangements.

  • Options include using the market, vertical integration, alliances, joint ventures, or other close-knit non-ownership arrangements..

Make or Buy Fallacies

  • Common – but incorrect – arguments:

    1. Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm.

    2. Firms should buy, rather than make, to avoid the cost of making the product.

    3. Firms should make, rather than buy, to avoid paying a profit margin to independent firms.

    4. Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply.

    5. Firms should make, rather than buy, to tie up a distribution channel.

Make or Buy Fallacies I

  • Fallacy 1: Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm;

  • If it is cheaper to obtain an asset from the market than to produce it internally, the firm should do the former.

  • If the firm thinks that the asset is a source of competitive advantage, yet it can be easily obtained from the market, then the firm should think twice!

Make or Buy Fallacies II

  • Fallacy 2: Firms should buy, rather than make, to avoid the cost of making the product;

  • Choosing to buy, rather than make, does not eliminate the expenses of the associated activity.

  • The independent distributor will have to purchase trucks, hire drivers and will then charge the manufacturer to cover the associated expenses.

Make or Buy Fallacies III

  • Fallacy 3: Firms should make, rather than buy, to avoid paying a profit margin to independent firms;

  • Difference between accounting and economic profit.

    • Accounting profit = revenues – expenses

    • Economic profit = accounting profits from a given activity - accounting profits from investing the same resources in the most lucrative alternative activity.

  • Even if a firm backwards integrate it does not imply that it could increase economic profits!

  • Also, maybe it is difficult to obtain the expertise needed to make the desired output, or the existing supplier may obtain economies of scale.

Make or Buy Fallacies IV

  • Fallacy 4: Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply;

  • Example. Rustic Homes sells log cabins that assembles from specially milled lumber.

  • Rustic’s managers are thinking about vertically integrating backward in the raising and milling of trees.

  • Suppose that Rustic sells its cabins for $ 10,000 each and sustain – in addition to the cost of lumber – the labor cost of $ 4,000 for each cabin.

Make or Buy Fallacies V

  • During the year, Rustic has 100 confirmed orders for log cabins.

  • Option 1: It can purchase lumber in the open market. Rustic believes that there is a chance that the price of the lumber needed to build one cabin will be $ 7,000, a chance that will be $ 5,000, a chance that will be $ 3,000.

  • Option 2: It can backward integrate by purchasing forest land and a mill. To finance the purchase, it asks an annual bank loan of $ 350,000 ($ 3,500 per cabin) + the cost to produce the finished lumber for one cabin that is $ 1,500 = total cost of timber would be $ 5,000 per cabin.

    • Annual Income Non Integration: uncertain, could be $ 300,000, $ 100,000 or - $100,000.

    • Annual Income Integration: certain $ 100,000

Make or Buy Fallacies VI

  • Even if VI and non VI entail the same expected profit, it is tempting to argue in favor of VI as it eliminates the risk of income fluctuation.

  • However, there are other strategies to eliminate this risk, i.e. hedging

  • ENTERING INTO LONG-TERM (i.e. futures) contracts with lumber suppliers.

  • FUTURES: establish a priori the price and quantity of the good provided.

  • The input supplier agrees (with a contract) to provide a certain quantity of the good at a certain price within a certain date.

Make or Buy Fallacies VII

  • Fallacy 5: Firms should make, rather than buy, to tie up a distribution channel.

  • An upstream firm acquires a monopoly downstream suppliers and then refuses to sell to its rivals (or sets very high price).

  • This strategy has limitations:

    1. May go against antitrust laws.

    2. The upstream firm has to pay attention to do not overpay for the acquisition.

    3. It may be easier than expected for rivals to open new distribution channels.

Vertical Integration: Dimensions

  • Dimensions:

    • Degree

    • Direction

    • Breadth

    • Stage

Vertical Integration: Direction

  • Backward Integration: Acquiring a supplier.

  • Forward Integration: Acquiring control/ownership of consumers.

Vertical Integration: Direction Example

  • Car buyers (forwards).

  • Garage owners.

  • Car importers.

  • Car manufacturers.

  • Suppliers (backwards).

  • Commodity producers (horizontal).

Vertical Integration: Degree

  • The degree indicates the involvement of the company for each input – output important for the firm

    • Total integration: companies own 100% the activities of the value chain of an input/output

    • Near Integration: companies don’t own all the activities of the value chain of an input/output

Vertical Integration: Degree (Continued)

  • Conic Integration: Companies become dependent on external sources for part of the input/output supply.

  • Quasi Integration: Firms achieve control through long-term relationships.

  • No or (DE)integration: Companies depend totally on external sources.

Vertical Integration: Stage and Breadth

  • Stage: No. of steps in the chain of processing which a firm engages in (from raw material to final consumer).

  • Breadth: No. of activities firms perform in-house at any particular level of the vertical chain.

Vertical Integration Examples

  • Ferrero buys Turkish hazelnut company Oltan.

  • The business of «dark kitchens>>.

Outsourcing

  • A common alternative to vertical integration.

  • Strategic choice to externalize certain activities to external companies.

  • Organizations enter into a contractual agreement involving an exchange of services and payments.

    • Firm does not own specific competences

    • Firm can not exploit certain production economies

Outsourcing vs Offshoring

  • Outsourcing: The organization hands over part of the value chain (e.g., an activity, such as textile production) to a different firm.

  • Offshoring: Occurs when part of the value chain moves to another geography, usually one with lower cost. It may or may not involve outsourcing.

Ethical Considerations

  • To ensure responsible outsourcing and offshoring:

    • Explain business purpose and reasons to offshore and outsource.

    • Explain the use of revenues and margins from offshore and outsource activities.

    • Set policies that assure decent working conditions and respect of human rights; implement systems and processes in education and training.

    • Ensure quality in their offering with other countries inputs – whether complying with legal requirements or following self-imposed quality standards.