Strategic Management & Competitive
Advantage: Concepts and Cases
Sixth Edition, Global Edition
Chapter 6
Vertical Integration
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Learning Objectives (1 of 2)
6.1 Define corporate strategy.
6.2 Define vertical integration, forward vertical integration,
and backward vertical integration.
6.3 Discuss how vertical integration can create value by:
a. reducing the threat of opportunism;
b. enabling a firm to exploit its valuable, rare, and
costly-to-imitate resources and capabilities;
c. enabling a firm to retain its flexibility.
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Learning Objectives (2 of 2)
6.4 Describe conditions under which vertical integration can
be a source of sustained competitive advantage.
6.5 Describe how the functional organizational structure,
management controls, and compensation policies are used
to implement vertical integration.
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The Strategic Management Process
Business-Level
&
Corporate-Level Strategies
Business-level strategies are actions firms take to gain competitive
advantage in a single market or industry (Cost Leadership & Product
Differentiation).
Corporate-level strategies are actions firms take to gain a
competitive advantages by operating in multiple markets or
industries simultaneously (Vertical Integration, Diversification,
Strategic Alliances & Mergers and Acquisitions)
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The Strategic Management Process
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Logic of Corporate Level Strategy
Corporate level strategy should create value:
1. such that the value of the corporate whole increases
2. such that businesses forming the corporate whole (i.e.,
portfolio) are worth more than they would be under
independent ownership
– A corporate level strategy should create synergies
that are not available in equity markets.
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Vertical Integration and Value Chain Analysis
Value chain is that set of activities that must be
accomplished to bring a product or service from raw
materials to the point that it can be sold to a final
customer.
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Value Chain Analysis
A company’s value chain is a sequence of interrelated activities
for transforming inputs into outputs that customers value. The
process consists of a number of primary activities and support
activities, each of which can add value to the product.
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Value Chain Economies
Value Chain Economies: are those economies that are
created by integrating a market transaction into the boundaries
of the firm. For example, a firm that buys one of its suppliers
may realize an economy by coordinating the production of the
supply with the needs of the parent firm.
– A corporate level strategy should create synergies
that are not available in equity markets.
. • vertical integration = value chain economies
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What Is Vertical Integration? A firm's level of vertical
integration is simply the number of steps in this value chain that a firm accomplishes
within its boundaries.
Where your pizza comes from
Dairy Farmers
(milk)
Seed Companies Pizza Chains
(Alfalfa & Corn)
Leprino Foods
(Mozzarella Cheese)
Crop Farmers
(Alfalfa & Corn) End Consumer
Food Distributors
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Backward Integration is
What Is Vertical Integration? going back in the value
chain (Leprino Foods
buying a dairy producer)
Dairy Farmers
(milk)
Pizza Chains
Seed Companies
(Alfalfa & Corn)
Leprino Foods
(Mozzarella Cheese) End Consumer
http://www.leprinofoods.com/
Crop Farmers
(Alfalfa & Corn)
Forward Integration is
moving forward in the
Food Distributors value chain (Leprino Foods
getting into the business of
food distribution).
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What Is Vertical Integration? (1 of 2)
• A firm’s level of vertical integration is simply the number of
steps in this value chain that a firm accomplishes within its
boundaries. More vertically integrated firms accomplish
more stages of the value chain within their boundaries than
less vertically integrated firms.
• Backward vertical integration: when a firm incorporates
more stages of the value chain within its boundaries and
those stages bring it closer to the beginning of the value
chain, that is, closer to gaining access to raw materials.
• Forward vertical integration: when a firm incorporates
more stages of the value chain within its boundaries and
those stages bring it closer to the end of the value chain;
that is, closer to interacting directly with final customers.
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Value Chain Economies
The Logic of Value Chain Economies
Does it make sense for Leprino Foods to expand by
owing dairy companies or by getting into food
distribution?
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Value Chain Economies
Leprino Foods has to look at two metrics in making the decision:
cost reduction and revenue enhancement.
The Logic of Value Chain
Economies
• The focal firm is able to
create synergy with the
other firm(s).
– cost reduction
– revenue enhancement
• The focal firm is able to
capture above-normal
economic returns.
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Competitive Advantage
If a vertical integration strategy meets the VRIO criteria…
Is it Valuable?
Is it Rare?
Is it costly to Imitate?
Is the firm Organized to exploit it?
…it may create competitive advantage.
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Value of Vertical Integration (1 of 2)
Market vs. Integrated Economic Exchange
• Markets and integrated hierarchies are “forms” in which
economic exchange can take place.
• Economic exchange should be conducted in the form that
maximizes value for the focal firm.
– Thus, firms assess which form is likely to generate
more value.
Integration makes sense when the focal firm can
capture more value than a market exchange provides.
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When Vertical Integration can create value
for a firm
Vertical integration can create value—decrease costs
or increase revenues—in three situations:
1. to reduce the threat of opportunism
2. to leverage firm capabilities
3. to remain flexible (possible with vertical integration
under certain conditions)
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Value of Vertical Integration
1. Threat of Opportunism
• Opportunism is when a firm is unfairly exploited in an
exchange (price, delivery terms, quality)
• To avoid this, the firm can vertically integrate.
By bringing the activity in-house, the firm controls it
and therefore removes the possibility of opportunistic
behavior causing economic losses.
• The decision to vertically integrate, though, has to be
made by comparing the costs of vertical integration
with its benefits. If the cost of opportunism is less
than the cost of vertical integration, then the decision
should be to continue with market exchange.
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Value of Vertical Integration
2. Leverage Firm Capabilities
This approach has two broad implications.
• A firm should vertically integrate into those business
activities where they possess valuable, rare, and
costly-to-imitate resources and capabilities.
• A firm should not vertically integrate into activities
where they do not have the resources to get a
competitive advantage.
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Value of Vertical Integration
3. Exploit Flexibility
Flexibility pertains to the cost (and time) of changing the
strategic and operational decisions of an organization.
In general, vertical integration reduces a firm’s flexibility.
Why? A vertically integrated organization has changed
its structure, control system, and compensation
practices. Changing these takes time.
It is important to be flexible when the future is
uncertain. In such situations, alternatives to vertical
integration, particularly strategic alliances, may be better
options.
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Value of Vertical Integration (2 of 2)
Three Value Considerations
Leverage Capabilities Manage Opportunism Exploit Flexibility
• firm capabilities may • opportunism may be • internalizing is
be sources of checked by usually less
competitive internalizing (TSI) flexible
advantage in other
• internalizing must be • flexibility is
businesses
less costly than important when
• if not, then don’t opportunism uncertainty is
integrate exchange high
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Rarity of Vertical Integration
Integration vs. Nonintegration
A firm’s vertical integration strategy is rare when few competing firms
can create value by vertically integrating in the same way.
Rarity in vertical integration may be because of one of two
things:
• A firm is rare in being able to operate its vertically
integrated units very efficiently.
• Or, it could be the one firm in the industry that is not
vertically integrated while all others are.
A firm’s integration strategy is rare or common with respect
to the value created by the strategy.
Example: Toyota’s Choice Not to Integrate Suppliers
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Imitability of Vertical Integration (1 of 2)
Form vs. Value creation potential
• The form, per se, is usually not costly to imitate.
• The value-producing function of integration may be costly to imitate, if:
– the integrated firm possesses resource combinations that are the
result of:
▪ historical uniqueness
▪ causal ambiguity
▪ social complexity
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Imitability of Vertical Integration (2 of 2)
Modes of Entry
• Acquisition and internal development are alternative
modes of entry into vertical integration.
– Thus, one firm may acquire a supplier while a
competitor could imitate that strategy through internal
development.
– In both cases, the boundaries of the firm would
encompass the new business.
• Strategic alliances can be viewed as a substitute for
vertical integration—without the costs of ownership.
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Organizing Vertical Integration (1 of 4)
Functional Structure (U-Form)
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Organizing Vertical Integration (2 of 4)
Management Controls
What needs to be “controlled” in a vertically integrated
firm?
• managers’ efforts to achieve the desired value chain
economies
– cooperation and competition among and between
functions
– the integration of new businesses into the existing
business
– time horizon of managers
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Organizing Vertical Integration (3 of 4)
Budgets Board Committees
• separating strategic • provide oversight and
and operational direction to managers
budgets
• help ensure that strategic
• strategic: inputs and direction is maintained
outputs
• operational: outputs
These mechanisms focus management attention on
achieving value chain economies.
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Organizing Vertical Integration (4 of 4)
Compensation
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Summary (1 of 2)
Vertical Integration…
• makes sense when value chain economies can be
created and captured
• may allow a firm to leverage capabilities
• may be a response to the threat of opportunism and
uncertainty
• as a form of exchange per se, is not rare nor costly to
imitate
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Summary (2 of 2)
• is an important consideration in the decision to expand
internationally (range of possibilities)
• makes sense when done for the right reasons, under the
right circumstances
Ownership is costly—integrate only when the benefits
outweigh the costs of integration!
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