vertical expansion

7/30/2019 Vertical Expansion

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Lecture 6

Sources and Limits of Value Creation

in Vertical Mergers

Dr. Sangeeta Yadav


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What are the vertical boundariesof a firm?

What are Make or Buy-decisionsand what

factorshave to be considered?

What is the trade-off in vertical integration,I.e. in MoB (Make or Buy)-decisions?

Are there alternatives to the complete

internalisation and externalisation of activities?

Learning outcomes


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Entering New Industries to strengthen the

core business model

Vertical integration is a corporate level strategy.

It improves the competitive position of firm and

strengthen the business model.

Vertical integration- a multi business model-afirm enters new industries to support its core

industry (primary source of its competitive

advantage and profitability).

This multi business model is to add value to iits

core products- increases product differentiation

and/or lowers cost structure.


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Vertical Integration

Backward integration-expansion into an

operation that produces inputs for the companys

products

Forward integration-expansion into an industrythat uses, distributes or sells companys

products.

Vertical Integration- either through organic

growth- or through merger/acquisition.

E.g steel company, PC maker, Apple computers,

Dell, IBM.


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Value Chain Porter


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Vertical Chain Production of furniture

Raw Inputs: Tree, Iron

Retailers: Furniture Stores

Intermediate Goods Preprocessors

(e.g. Metalworking Shops)

Assemblers: FurnitureManufacturers

Transportationand Warehousing

Support ServicesProcessing and handling

Transportationand Warehousing

AccountingFinanceHRMLegal SupportMarketingPlanning

Other Support Services


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Value Chain

At each stage value is added to the product-

each stage of value added chain is a separate

industry or industries in which many different

companies my be competing. Every company has a value chain- value

creation activities like R&D, production,

marketing, customer service etc.


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Decide which steps of the value added chain areto be performed inside the firm and which to beout-sourced (Make or Buy)

Vertically integrated/disintegrated firms

Intermediate solutions are possible. Examples:

Strategic alliances with suppliers, Jointventures

Vertical Boundaries of the Firm


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Benefits of buying from market

Cheapest supplier if market is competitive

Supplier is able to reap economies of scale and

learning economies

Increasing division of labour and specialisation

Motivated to enhance efficiency

Supplier has high incentive to keep up with new

technology Avoids internal coordination costs


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Costs of buying from market

Quality and delivery uncertainty

Suppliers products if branded, too costly

Suppliers of specialized products very few and

hence costly

Problems in coordinating production flows

Leakage of private information to supplier and to

possibly rivals Transaction costs high relative to internal

production


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Solution lies in long term contracts

Long term contracts

Benefits of contracts gives supplier incentive to make specific investment, to keep

up with technology, allows closer coordination, risk indisposal of residual assets rests with supplier

Costs of Contracts Incomplete contracts, suppliers opportunism (due to asset

specificity), costs of monitoring performance, costs of

contract enforcement and dispute resolution


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Benefits of Vertical Integration

Facilitates investment in specialized assets A specialized asset (site specific, physical characteristics

specific, dedicated assets, human specific)is one that is

designed to perform a specific task and whose value is

reduced in its next best use- could be a piece of equipment,know how or employee skills

Company invests in specialized assets to lower

manufacturing product and to improve quality of product.

If company buys from market then the supplier needs to

invest in specialized assets. But it is difficult to convinceoutsider to invest in specialized asset-creates dependency of

supplier for business-this puts buyer in a strong bargaining

positionso supplier declines to invest in a specialized asset.


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Buyer also considers that getting the specialized asset from

an independent supplier creates dependency on supplier.

This creates a situation of mutual dependence leads to hold

up problem (that is each party can take advantage once the

investment in specialized asset is made)leads to lack of

trust amongst the two so only way out is to go for VI rather

than market transaction.

E.g. automobile companies have historically integrated

backwards to make component parts, steel into production of

iron, computers into chip production ,aluminum companies

into bauxite production due to hold-up problem.


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Enhancing product quality General Mills backward integration into banana plantations

In 1920s Kodaks forward integration into retail outlets for

distributing photographic equipment, in 1930 they withdrew

since good retailers were available by then.

Better co-ordination and scheduling Leads to quicker, easier and more cost effective planning, co-

ordination, scheduling and transfer of product possible.

Just in time inventory systems Allows better response to sudden changes in demand


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Control over key raw material

sensitive private information protected

Some transactions costs avoided by

performing the task in-house


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Market firms can achieve economies of scale

and learning economies that in-house units

cannot (specialization)

Market firms are subject to market discipline. In-house units may be able to hide their

inefficiencies behind overall corporate success

(Agency and influence costs).

Disadvantages of Vertical Integration


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The incentives to be efficient and innovativeare weaker when a task is performed in-house -

It is difficult to internally replicate the incentives

faced by market firms. Internal Capital Markets allocates scarce

capital. Allocations can be favorably affected by

influence activities - Resources consumed by

influenceactivities represent influence costs.

Agency and Influence Costs


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Higher costs due to Failure to achieve maximum economies of scale

Captive buying and selling within the divisions of firm

Higher administrative and agency costs.

Limited Marketing reach- which holds back sales

and profit potential

Exposure to Cyclical and Secular downturns.

Disadvantages of Vertical Integration


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Using the market improves technical efficiency(least cost production)

Vertical integration improves agency efficiency

(coordination, transactions costs) Firm should economize - choose the bestpossible combination of technical and agencyefficiencies

Tradeoff in Vertical Integration


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The combined (market over vertical integration)

differential efficiency will be negatively related to

asset specificity

At high levels of assets specificity verticalintegration is more efficient

At low levels of assets specificity outsourcing

wins

Efficiency Tradeoff


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Inputs in the form of routine products and

services are likely to be procured in the market

(suppliers economies of scale)

When a firms product market activities is large inscale, it is likely to be vertically integrated

Presence of relationship-specific assets will tilt

the advantage in favor of vertical integration

Conclusions From the

Efficiency Tradeoff Model


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Tapered integration (making some and buying

the rest)

Joint ventures and strategic alliances

Long term collaborative relationships

Implicit contracts between firms

Alternatives to Vertical Integration


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Thank You!

Dr. Sangeeta Yadav

vertical expansion

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