02d75vertical integration

7/31/2019 02d75Vertical Integration

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Amity Business School

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?


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Amity Business SchoolVertical Integration

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


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Amity Business SchoolTo make or buy?

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 thedecisions 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

Classical Market

Contracting

Quasi-Vertical

Integration

(Relational Governance)

Vertical

Integration

Buy Make

Third Party Does it

(for a price) You do it

How does the

the work get done

Their operation (control)

Their gain or loss

Your operation (control)

Your gain or lossThe benefits

The costs

You and third party

share costs and

benefits

Their people

Their money

Their risk

Their responsibility

Your people

Your money

Your risk

Your responsibility


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Amity Business SchoolContd.

At the extreme of buy, manufacturer- distributor arrangementsinvolves 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 themanufacturer when they are actually dealing with a committedthird party

When the argument of integration is not entirely compellingrelational governance or quasi vertical integration should beconsidered. e.g Franchising & close relationships


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Examples of institutions performing some channel functions

Classical Market

Contracting

Quasi-vertical

IntegrationVertical

IntegrationFunction

1) Selling (only) Manufacturers Captive or Exclusive Producer SalesRepresentatives Sales Agency * Force (direct

sales force)

2) Wholesale Independent Distribution Distribution

Distribution Wholesaler Joint Venture Arm of Producer

3) Retail Independent Franchise Company

Distribution (3rd party) Store 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 theirprofits.

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 contractwith the organization to perform channel flows for someeconomic considerations , normally a price.

However, many variations are also possible, e.g. paying a flatfee or reimbursing some of the resellers expenses or somefuture consideration for e.g. right to future business or apercentage of equity in the manufacturer.

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


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Amity Business SchoolWhen to vertically integrate?

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 activitiesTangible 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

Low Specificity High Specificity

Highly Volatile Market

Outsource Distribution

to Retain Flexibility

Until Uncertainty Is

Reduced

Highly P romising

Market

Less Promising

Market

Vertically Integrate

to Gain Control Over

Employees And Avoid

Small-Numbers Bargaining

In Changing Circumstances

Do Not Enter


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Amity Business SchoolWhen to outsource?

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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The effects of

outsourcing

Step 2:Question Outsourcing Where Markets AreNot Competitive:

1) Valuable Company-Specific Capabilitiesare Needed: Know-How Relationships Brand Equity Created by DistributionActivities

Dedicated Capacity Site Specificity Customized Physical Facilities2) Thin Supply

Step 3:Question Outsourcing Where Indicators ofResults Do Not Correspond toPerformance:

Cannot be benchmarked Not Timely Inaccurate

Revenues

DirectCosts

Overhead

+

-

Step 1:Outsourcing Distribution to Benefitfrom Advantages of CompetitiveMarkets:

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

-

-

-

+

+

Step 2:Question Outsourcing Where Markets AreNot Competitive:

1) Valuable Company-Specific Capabilitiesare Needed: Know-How Relationships Brand Equity Created by DistributionActivities

Dedicated Capacity Site Specificity Customized Physical Facilities2) Thin Supply

Step 3:Question Outsourcing Where Indicators ofResults Do Not Correspond toPerformance:

Cannot be benchmarked Not Timely Inaccurate

Revenues

DirectCosts

Overhead

+

-

Step 1:Outsourcing Distribution to Benefitfrom Advantages of CompetitiveMarkets:

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

-

-

-

+

+


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Road map to the vertical integration decision

02d75vertical integration

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