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Solution Manual for Strategic Management and Competitive Advantage, 4/E 4th Edition : 013255

6
Vertical Integration

WHAT IS CORPORATE STRATEGY?

The five chapters in Part 3 of the book (chapters 6-10) deal with corporate strategies. It is a
good idea to take a step back and look at the definition of corporate strategy given in chapter
1. Corporate (or corporate-level) strategies are actions firms take to gain competitive
advantages by operating in multiple markets or industries simultaneously. Thus, they expand
on business-level strategies which focus on gaining competitive advantage in a single market
or industry. The instructor can reiterate to students that corporate strategy deals with both
the form (vertical integration, diversification) as well as the means (mergers and acquisitions
and strategic alliances).

 Important Point: Corporate level strategy addresses the question: In which

business(es) should the firm operate? Managers use corporate level strategy to help ensure
that the corporation is composed of the optimal mix of businesses.

Slide 6-2
This slide provides a good overview of this chapter by identifying its place in the strategic
management process.

Students should understand the logic of corporate-level strategy. As the class

discussion transitions from the logic of business-level strategy to that of corporate-level
strategy, it is important that they understand that the move is not just incremental – from
managing one business to managing a set of businesses. Using slide 6.3, the instructor
should take students through the following key points: corporate-level strategy should create
value for the organization:

• such that the value of the corporate whole increases

• such that businesses forming the corporate whole (i.e., the portfolio) are worth more
than they would be under independent ownership
• that equity investors cannot create through portfolio investing (on their own)

Owning a portfolio of businesses comes with a cost – the costs associated with
running a bureaucracy. The benefits should outweigh the costs for corporate-level strategy

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 Chapter 6: Vertical Integration 133

to make sense. The benefits typically come in the form of synergies. In the case of vertical
integration, the key benefit comes in the form of value chain economies.

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.

Slide 6-3
Use this slide to show students the logic of corporate level strategy in general, and vertical
integration in particular. The slide can also be used to introduce students to the fact that
vertical integration deals with value chain economies. It is important that students
understand this logic because it will be referenced throughout the remainder of the course.

WHAT IS VERTICAL INTEGRATION?

Learning Define vertical integration, forward vertical integration, and backward vertical integration.
Objective 1
Value chains were first introduced in chapter 3. To help students get this point clearly, the
instructor can say that the value chain (primary and support activities) of chapter 3 can be
thought of as the firm’s internal value chain, while the value chain in Figure 6.1 is the
industry value chain. The pizza example in slides 6.4 is a great one to use because the
product is very familiar to students. After showing the slide, introduce students to Coase’s
work on firm boundaries. Take students through various possibilities – a pizza chain getting
into the business of food distribution (say, Domino’s Pizza acquiring a food service
company such as Sysco) or a cheese producer (Leprino Foods) acquiring or starting a pizza
chain.

Slide 6-4
This slide uses the example of Leprino Foods, one of the largest producers of mozzarella
cheese in the U.S., to help explain the concept of vertical integration.

Once students understand the basic concept of vertical integration (increasing a

firm’s boundaries to include multiple value chain activities), the instructor can continue with
the pizza example to differentiate between backward and forward integration. Using
Leprino Foods as the focal firm, point out that backward integration is going back in the
value chain (Leprino Foods buying a dairy producer), while forward integration is moving
forward in the value chain (Leprino Foods getting into the business of food distribution).
Pose this question to students: At present, Leprino Foods buys milk from dairy companies,
makes cheese in its facilities, and sells the cheese to large food distributors such as Sysco and
Gordon Foods, who sell to pizza chains such as Pizza Hut and Domino’s. Does it make
sense for Leprino Foods to expand by owing dairy companies or by getting into food
distribution? Leprino Foods has to look at two metrics in making the decision: cost

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134 Chapter 6: Vertical Integration

reduction and revenue enhancement. Synergies may help in cost containment and the ability
to capture above normal profits helps on the income side.

Slides 6-5 and 6-6

These slides will help you introduce the concepts of backward and forward integration using
the pizza example from the previous slide. They also help in providing an overview of the
economic logic of vertical integration. Ask students why Leprino might want to own a
supplier or a distributor. Point out to students that Leprino has become so large that they
now deal directly with some of the national pizza chains rather than going through
distributors. In this regard, Leprino has engaged in a degree of vertical integration.

 Important Point: It is important to reiterate to students that vertical integration

has to be driven by economic concerns. Going back to the logic of corporate-level strategy,
the cost-benefit analysis of owning multiple businesses in the portfolio must be performed.

► Example: Amazon and the Publishing Industry

The book publishing industry traditionally was characterized by a long value

chain. The publisher contracted with authors to write books and entered
into agreements with commercial printers (such as R.R. Donnelley and
Quebecor) to print the books. Books were distributed to bookstores
through wholesalers such as Ingram and Baker & Taylor. The major
problem with this value chain was the amount of unsold books returned by
booksellers. Publishers faced return rates as high as 30 percent, which added
significantly to their costs. Seeing this inefficiency as an opening, Amazon
changed the value chain. By going directly to publishers, Amazon was able
to lower costs by cutting out wholesalers. More importantly, they placed
orders with publishers after customers ordered from their website. This
allowed Amazon to reduce drastically the returns to publishers (from 30% to
3%) and use this to bargain for better prices from them. Amazon backward
integrated by bypassing the wholesaler and going directly to the publisher.

(Laseter, Houston, Wright and Park. “Amazon your industry: Extracting

Value from the Value Chain,” Strategy+ Business, First Quarter 2000)

Class Activity
Divide the class into groups of 4-5 students. Assign 2 groups to each
industry and pick a company for each group. For example, in the personal
care industry the two companies can be Procter and Gamble and Colgate-
Palmolive. Have the group go to the company’s web page and to the
financials (in the section of the site marked “Investors.”) Using the formula
given in the book on page 166, have them compute the level of vertical
integration for their firm. If the level of vertical integration is markedly
different for the two firms in an industry, have them discuss the merits and
demerits of their company’s stance on this issue.

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 Chapter 6: Vertical Integration 135

 Teaching Points

• Use examples to help students clearly understand the concept of vertical

integration.
• Once the concept of vertical integration is clearly understood, explain the
difference between backward and forward integration.
• Encourage students to identify reasons why a firm would consider vertical
integration. The Amazon example should help them get started.

THE VALUE OF VERTICAL INTEGRATION

A company’s decision whether or not to vertically integrate must be based on sound logic.
The VRIO framework is once again helpful in this regard.

Slide 6-7
This slide reminds students that the VRIO framework can be applied a firm’s vertical
integration strategy. A vertical integration strategy will only lead to competitive advantage if
the value chain economies achieved meet the VRIO criteria.

The two extremes in economic exchange are the market and integrated economic
exchange (also called the hierarchy). In the market, the focal firm buys the product or service
from outside players or sells its product to outside intermediaries. In integrated economic
exchange, the firm performs these activities internally. Economic exchange should be
conducted in a way that maximizes value for the focal firm. Integration makes strategic sense
when the focal firm can capture more value than a market exchange provides.

Slide 6-8
Use this slide to introduce the two forms of economic exchange and how the decision
should be made on value maximization criterion. Refer to the Leprino example to explain
that when Leprino is buying milk from dairy farmers it is conducting that exchange in a
market. If Leprino were to buy several large dairy farms, we would say that the exchange
had been integrated into the hierarchy of Leprino.

Once the overall value maximization logic of vertical integration is discussed, the
focus can shift to specifics. Vertical integration can create value – decrease costs or increase
revenues – in three situations:

▪ to reduce the threat of opportunism

▪ to leverage firm capabilities
▪ to remain flexible (possible with vertical integration under certain conditions)

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136 Chapter 6: Vertical Integration

Vertical Integration and the Threat of Opportunism

Discuss how vertical integration can create value by reducing the threat of opportunism. Learning
Objective 2
Opportunism is when a firm is unfairly exploited in an exchange. In other words, one of the
two firms in an exchange holds up the other to the financial benefit of the first firm. The
hold up can occur with regard to price, delivery terms, quality, etc. For the firm that is being
held up, the exchange creates an economic loss. 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.
At this point, students may still be vague about opportunism and why it is likely to
occur in an exchange. Introducing the concept of transaction-specific investment using
examples can help in clarifying this important concept.
A transaction-specific investment is any investment in an exchange that has
significantly more value in the current exchange than it does in alternative exchanges. The
example of the oil refinery in the book is a good one to use because it describes a
transaction-specific investment in visual form and examines its effect on value in numerical
form. Once this example is gone through, the instructor can use a second example (given
below) to reinforce the concept.
If the pipeline laying company is the focal firm in the discussion, look at the issue
from its perspective. It costs money to lay the pipeline but it brings value ($750,000) to the
firm. But the value comes with a catch. The full value ($750,000) is only realized in the
specific context of serving the oil refinery. Because of location issues, the value is
diminished considerably (to around $10,000) if the context is changed. If the two firms agree
on a 5-year contract on terms favorable to the oil pipeline company, then the transaction-
specific investment makes strategic sense for the focal firm. But what happens after the
initial contract runs out? That’s when opportunism (or its possibility) comes into play! In
negotiating the second contract, who has the advantage? Obviously it is the oil refinery.
They can bring down the price of the exchange so that they can profit. But the focal firm
stands to lose because of this opportunism. It is likely, then, that the focal firm will not be
motivated to make this investment in the first place. Vertical integration is the recourse for
the oil refinery because it takes care of the opportunism problem.

► Example: Bird’s Eye and the Frozen Foods Industry

Birds Eye, the U.S. frozen foods maker, wanted to expand to the U.K. in the
1950s, attracted by the large market and the absence of a frozen food
industry. One of the first products they sought to introduce in the U.K. was
frozen vegetables. They contracted with farmers to grow vegetables for
them. Their U.S. experience had taught them of the need to process the
vegetables within 90 minutes of harvest. Processing vegetables after 90
minutes typically resulted in the product lacking freshness. Because the
farmlands were on the outskirts of London, there were no processing plants
in existence within the 90 minutes radius. Birds Eye contacted a number of

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 Chapter 6: Vertical Integration 137

processors and asked them to invest in a facility near the farmlands. Birds
Eye could not find a single taker. Why would this happen? Investing near
the farmlands is a transaction-specific investment. Its value would be great
only in the context of serving Birds Eye and nobody else. Why would a
processor make such a transaction-specific investment when the possibility
of opportunistic behavior by Birds Eye is great? After the investment is
made, Birds Eye could take advantage of this sunk cost by paying less to the
processor. Birds Eye was forced to vertically integrate into owning
processing plants because of this problem.

(Colis and Grant. 1992. Birds Eye and the U.K. Frozen Food Industry,
Harvard Business School Case)

Vertical Integration and Firm Capabilities

Learning Discuss how vertical integration can create value by enabling a firm to exploit its valuable, rare, and costly-to-
Objective 3 imitate resources and capabilities.

Reducing the threat of opportunism can be seen as a defensive approach to vertical

integration. Leveraging the focal firm’s capabilities, on the other hand, is a proactive
approach to vertical integration. The logic here is simple: a firm should vertically integrate
into those business activities where they possess valuable, rare, and costly-to-imitate
resources and capabilities. This also means that a firm should not vertically integrate into
activities where they do not have the resources to get a competitive advantage.

► Example

A company that manufacturers seats for auditoriums and stadiums faced a

difficult problem. The company manufactured seats to order and delivered
the seats to firms that specialized in installation. The company won plaudits
for the quality of its seats. However, they faced numerous complaints
regarding poor installation. This motivated the company to consider the
possibility of vertically integrating into the installation activity. When they
analyzed the situation, they realized that none of the capabilities that were
valuable in the manufacturing business (design, quality, etc.) created a
competitive advantage in the installation business. Indeed, they had to
develop new capabilities (managing a temporary, unskilled work force to
generate efficiency, for example) to succeed in the installation business. The
company decided against vertical integration!

 Important Point: What if the two motivations for vertical integration provide
contrasting results? In other words, what if the opportunism argument points to vertical
integration while the capabilities argument point to a market exchange? The instructor
should help students confront this problem by using the Wal-Mart example in the text.

In its 2009 10-K SEC filing, Hershey Foods indicated that Wal-Mart accounted for
26 percent of total sales in the year 2008 (sales were made to McLane Company, Wal-Mart’s

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138 Chapter 6: Vertical Integration

primary distributor). Wal-Mart was responsible for 15 percent of Procter and Gamble’s
2009 revenues. It is very likely that similar percentages can be found for many of Wal-Mart’s
leading suppliers. Wal-Mart clearly has tremendous bargaining power over these companies.
Many of these companies have well-staffed offices in Bentonville, Arkansas, where Wal-
Mart’s corporate headquarters is located. These are transaction-specific investments made
by these companies to serve one customer, Wal-Mart. The opportunism minimization logic
would indicate that these firms should forward integrate into retailing to reduce the
possibility of losses due to Wal-Mart’s opportunistic behavior. But, do these firms have the
resources to obtain a competitive advantage in retailing? Not likely. So, forward integration
into retailing does not make sense from a capabilities viewpoint.

Vertical Integration and Flexibility

Discuss how vertical integration can create value by enabling a firm to retain its flexibility. Learning
Objective 4
Flexibility pertains to the cost (and time) of changing the strategic and operational decisions
of an organization. A flexible organization can change its strategic/operational choices
quickly. In other words, such an organization can pivot on a dime! Less flexible
organizations find this change difficult and costly. In general, vertical integration reduces a
firm’s flexibility. Why? A vertically integrated organization has expanded its bureaucracy to
include multiple activities. It has changed its structure, control system, and compensation
practices to reflect this increased bureaucracy. Changing these take time.
Flexibility is not always a virtue. 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.

► Example: Intel Capital

Intel, the chip maker, has a venture capital arm called Intel Capital. Its
mission is to identify and invest in promising technology companies
worldwide. Founded in 1991, Intel Capital has invested more than $7.5
billion in approximately 1,000 companies in over 45 countries by 2008.
These investments help Intel in two ways: it allows Intel to profit when
these companies go public or are acquired by other companies. More
importantly, though, these investments give Intel a first right of refusal on
new technologies without the company having to vertically integrate into any
of these when their future is uncertain.

Intel’s web site (www.intel.com)

Applying the Theories to the Management of Call Centers

Call centers in the beginning (because of their novelty) required transaction-specific

investments – physical infrastructure, communications technology, training, etc. Vertical
integration made sense at that time. Changes in information technology, benefits of the
learning curve in terms of employee training, and the ability to cater to multiple customers
from one central location ushered in a huge growth in independent call center companies.

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 Chapter 6: Vertical Integration 139

This merchant market in call centers meant that firms did not have to vertically integrate into
this activity.
In the early stage, a firm could gain a competitive advantage by operating a call
center. For example, Dell always resonated well with its customers because of the quality of
its customer interaction through its call centers. But, today, almost every company seems to
have one. It is no longer a means to competitive advantage. Besides, companies specializing
in operating call centers developed a number of valuable and costly-to-imitate capabilities. It
made sense for firms to outsource this function.
As communication technology changes rapidly, firms face a lot of uncertainty in this
regard. Investing in one technology to run a call center may put a firm at a disadvantage
because its technology may quickly become obsolete. Outsourcing this function reduces the
uncertainty for firms.

► Example: Call Centers in India

India is a leading player in the call center industry. Companies such as

Daimler-Chrysler, British Telecom, Citigroup, and American Express all do
business with Indian call center companies. GE has gone a step further. It
operates call centers (serving clients) in India. It provides a variety of
services for its clients: transaction processing, help desks, IT-related queries
from U.S. clients, accounting services, etc. Why does India dominate in this
industry? A key reason is that manpower accounts for 55-60 percent of the
cost of running a call center. In India, manpower (particularly tech-savy,
English speaking labor) is available at a fraction of the cost overseas. In
addition, the Indian government provides various incentives for companies
to run call centers.

Outsource India web site (www.outsource2India.com)

 Important Point: It is important for the instructor to reiterate that the three
arguments related to the vertical integration decision may conflict with each other and
confuse decision making. In other words, the opportunism argument may point to vertical
integration, while the capabilities and the flexibility arguments may point to de-integration.
In such cases, the firm has to look at the trade-offs involved and use cost versus benefits to
make the decision. This is also a good occasion to looks at the ethics of outsourcing
discussed in the box on page 191 in the text.

Slide 6-9
Use this slide to take student through the three value considerations in vertical integration.
Emphasize that vertical integration can create value because of any of these issues. A single
vertical integration move could create value for all three reasons.

 Teaching Points

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140 Chapter 6: Vertical Integration

• Ensure that students understand what opportunism is. Use examples to

explain this concept.
• Reiterate to students that leveraging capabilities is a key issue in vertical
integration.
• Point out to students that flexibility is important in today’s business world
and that it may be more vital in some industries than in others.
• At the end of the discussion of this section, take them through a summary of
the three main issues in vertical integration decisions.
• Ask students for examples of vertical integration they have read about in the
business press and use the concepts in this chapter to examine the economic
logic of these moves.

VERTICAL INTEGRATION AND SUSTAINED COMPETITIVE ADVANTAGE

Describe conditions under which vertical integration may be rare and costly to imitate. Learning
Objective 5
This is a good time to go back to the VRIO framework and establish its connection with
vertical integration. In order for vertical integration to be a source of sustained competitive
advantage, it must not only be valuable but also rare and costly to imitate, and the firm must
be organized to implement this strategy.

The Rarity of Vertical Integration

Slide 6-10
Use this slide to look at integration vs. non-integration from a rarity viewpoint. The value
chain economies achieved by a firm through vertical integration may be rare even if many
competitors have vertically integrated. Toyota is a good example of a company that could
have vertically integrated many of its suppliers. However, it has chosen to establish
relationships with suppliers that provide Toyota with many of the value chain economies
that competitors can only get through actually owning suppliers. The point being that the
substance or function of a vertical integration strategy rather than the form of the strategy is
what really matters in terms of rarity.

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 the one firm in the
industry that is not vertically integrated while all others are.
A firm may be able to create value (more than others in the industry) through vertical
integration because of three reasons:

▪ rare transaction-specific investments need to be made that prompts a firm to

vertically integrate
▪ to leverage specific capabilities that would give it a competitive advantage
▪ ability to resolve uncertainty ahead of others in the industry.

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 Chapter 6: Vertical Integration 141

In the first case, the firm has developed a special technology or a new approach to
doing business, while others in the industry have not. Because this special
technology/approach to doing business requires transaction-specific investment, the firm is
vertically integrated, while others in the industry are non-integrated.
In the second case, the firm has a valuable capability that allows it to benefit from
vertical integration. Others do not have this capability and hence are not vertically integrated.
In the third reason, the firm has the ability to resolve the uncertainty that all firms in
the industry face. While others may be non-integrated because of this uncertainty, the focal
firm may be vertically integrated.
In all the cases above, the focal firm decides to vertically integrate while others in the
industry do not. But, there may also be a case where others are vertically integrated while
the focal firm benefits from being de-integrated. It creates value for itself by being able to
manage these market economic exchanges efficiently.

The Imitability of Vertical Integration

The ability to create value through vertical integration (or by de-integration) may not be rare
for too long if it can be imitated. Imitation can be through direct duplication or through
substitution.
Direct duplication of a firm’s vertical integration involves two things: copying the
form and copying the value creation potential. While copying the form may not be costly,
copying the value creation potential may be costly because of factors such as historical
uniqueness, causal ambiguity, and social complexity. Imitation may also be difficult if there
are not very many firms to acquire in order to vertically integrate (the small numbers
problem) or where entry barriers are quite high.

Slide 6-11
Use this slide to identify the factors involved in direct duplication of a firm’s vertical
integration strategy. Remind students that the cost of duplicating the actual value chain
economies is a more important consideration than the cost of simply duplicating the form.

An imitator may choose not to directly duplicate the value creation potential of
another firm’s vertical integration strategy. Instead, it may choose substitute modes that give
it the same benefit. Internal development and strategic alliances are two important substitute
modes.

Slide 6-12
Remind students that the logic of vertical integration is to choose the most efficient form of
exchange. Firms can choose from the market (no vertical integration), an acquisition (fully
integrated), internal development (fully integrated), or a strategic alliance (partial vertical
integration). Of course, the specific conditions of any given situation dictate which form is
most appropriate.

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142 Chapter 6: Vertical Integration

 Teaching Points

• Reiterate the importance of using the VRIO framework to evaluate the

strategy of vertical integration.
• Encourage students to examine the rarity and imitability questions relative to
the value chain economies achieved by firms rather than relative to the form
of the exchange per se.
• Emphasize that in analyzing a firm’s vertical integration strategy one would
want to ask the question: Can competitors imitate the value chain economies
of the firm through alternate vertical integration strategies?

ORGANIZING TO IMPLEMENT VERTICAL INTEGRATION

Describe how the functional organization structure, management controls, and compensation policies are used Learning
to implement vertical integration. Objective 6

Organizing to implement a vertical integration strategy is the last step, the “O” in the VRIO
framework that looks at how vertical integration can create a sustained competitive
advantage. A firm must have the appropriate infrastructure – organizational structure,
management controls, and compensation policies to successfully implement a vertical
integration strategy.

Organizational Structure and Implementing Vertical Integration

The functional or U-form structure allows the firm to implement a strategy of vertical
integration.

Slide 6-13
Explain that the CEO’s responsibilities usually become much more complex as a result of
vertical integration. The functions of the new business must be integrated with the
functions of the existing business. Point out that the achievement of the desired value chain
economies depends on the ability of the CEO and other managers to integrate the functions
of the new and existing businesses.

As the slide indicates, the function brought within the firm’s boundaries because of
vertical integration is “folded in” to the same function already existing in the organization.
For example, if a company manufacturing a consumer product vertically integrates into
manufacturing its packaging products, the packaging product’s manufacturing function is
folded in with the consumer product’s manufacturing function.
The CEO in this vertically integrated U-form has the same responsibilities as
identified in chapter 4: strategy formulation and strategy implementation. An added
dimension in a vertically integrated firm is to continually assess the value creation potential
of vertical integration. In addition, the CEO has also to resolve conflicts arising among the
various functions.
Since each function in a U-form organization functions in a silo, their perspective is
likely to be very narrow. This could lead to conflicts among functions. This is a good time

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 Chapter 6: Vertical Integration 143

for the instructor to point out to students that, depending on their major, they are likely to
view an organization from different perspectives. Accountants typically are obsessive about
cost control, while marketers and R&D people may not have the same attention to cost
control. Sales and manufacturing always seem to have conflicts – manufacturing blaming
sales for poor sales forecasts that leaves a lot of unsold goods in inventory and so on. It is
important for the instructor to go back to slide 6.13 and point out that the CEO’s job
involves facilitating cooperation among functions and minimizing the ill effects of conflicts
among these functions.

Management Controls and Implementing Vertical Integration

As indicated above, vertical integration strategies typically require that one business be
integrated with an existing business (in the case of acquisition). Such integration presents
some potentially challenging management issues. These issues revolve around aligning the
interests of managers, new and existing, with the interests of the newly combined firm.

Slide 6-14
This slide provides some context for a discussion of management controls. Emphasize that
the need for management controls arises because the achievement of value chain economies
depends on managers behaving in certain ways. Managers from the new business and
managers from the existing business must be able to get along with each other. Managers
usually need to be given incentives to adopt a long term focus so that the integrated firm can
achieve value chain economies over the long run.

Once the U-form structure’s importance in implementing a vertical integration

strategy is established, the discussion should turn to management control processes. Two
key ones need to be addressed here:

▪ budgets
▪ management committees

Budgets help in the control process by identifying the metrics by which performance
is to be measured. A vertically integrated firm may develop budgets in a variety of areas:
sales, costs, etc. Typically budgets are tied into the compensation process, in that managers
may receive bonuses depending on how close they are to their budget. While budgets help
in the control process, they may have serious downsides. Primary among them is the fact
that budgets are likely to promote short-term behavior (controlling expenses today to meet
budget but not preparing for the future) at the cost of long-term actions. Involving
managers in the budgeting process and using qualitative measures in addition to quantitative
ones can help in this regard.
Internal management committees that meet periodically also help in the control
process. Two common ones (though they may go by different names in organizations) are:

▪ the executive committee

▪ the operations committee

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144 Chapter 6: Vertical Integration

The difference between the two types of committees is essentially in their focus: the
executive committee tends to focus on short-term firm performance while the operations
committee has a long-term view of firm performance. Both committees are staffed by the
CEO and key functional area managers. They meet regularly (typically, weekly for the
executive committee and monthly for the operations committee) to identify problems and
come up with solutions. Such committees also help in reducing the conflicts among
departments.

Slide 6-15
Explain that strategic budgets are used to encourage investment that will benefit the firm in
the long run. For example, a strategic budget may set aside capital to be invested in a new
plant or for the hiring of new R&D engineers. The purpose of a strategic budget is to
separate strategic investment from normal operating spending. This is one way to remove
the incentive for managers to curtail strategic investment so that they can meet short term
financial targets. A strategic budget is concerned with the inputs, i.e. spending on strategic
initiatives, and outputs, i.e. performance of the investment. Operational budgets cover
normal operations. Point out that board committees may also play a role in helping to focus
management attention on the issues necessary to achieve the desired value chain economies.

Compensation in Implementing Vertical Integration Strategies

Compensation is the third piece of the “Organizing” puzzle. As such it complements both
structure and control systems and helps guide behavior toward desired ends. The three
explanations for vertical integration (opportunism, capabilities, and flexibility) have
important compensation implications. The instructor should structure this discussion
around this idea.
Very often employees make firm-specific investments of their own. They expend
energy cultivating skills valuable to the organization, imbibe the organizational culture and
establish contacts within and outside the firm. Such investments are valuable only in the
context of the firm, in that, once the employee leaves the firm, much of the investment
declines in value. Employees know that if they make such firm-specific investments, they are
vulnerable because the firm can treat them badly without worrying that the employee will
seek employment elsewhere. So how should an organization encourage its employees to
invest in firm-specific skills in light of this possibility? They should do it by providing
incentives as part of their compensation.
While the previous paragraph talked about providing incentives for individuals to
invest in firm-specific skills, there is also the fact that groups of employees make firm-
specific investments. Very often, it is the tacit collective knowledge of these groups of
employees that give the firm valuable costly-to-imitate capabilities. The firm’s compensation
policy must encourage such collective firm-specific investment.
Compensation practices must also take into account the importance of flexibility.
Employees must be encouraged to engage in activities that allow the firm to be flexible in
order to take advantage of opportunities.
Table 6.1 in the text portrays the various aspects of compensation aligned with the
three explanations for vertical integration. The instructor should use this table to tie the
compensation challenges in vertical integration with specific alternatives. It is important to
reiterate that the opportunism explanation calls for individual rewards – salary, cash bonus

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 Chapter 6: Vertical Integration 145

for individual performance, and stock grants for individual performance – while the
capabilities explanation suggests group-based rewards. The flexibility explanation suggests
covering the downside risk for employees but provide stock grants for upside potential.

Slide 6-16
This slide depicts how various compensation alternatives can be used in an effort to achieve
value chain economies by aligning the interests of managers with the interests of the
organization. Point out that how people are compensated can change their incentives to
work together with others, to focus on the long term versus the short term, etc.

 Teaching Points

• Explain that organization is a vital part of a successful vertical integration

strategy.
• Reiterate the importance of the three explanations for vertical integration by
tying them to the discussion on organization.
• Use Table 6.1 to summarize this section by taking students through the
various compensation options as they relate to the three explanations for
vertical integration.

SUMMARY OF VERTICAL INTEGRATION

It is a good idea to summarize the discussion on vertical integration by stating this:

historically, the default was vertical integration. That is, firms were vertically integrated into
performing multiple value chain activities unless there were compelling reasons not to do so.
Gigantic oil companies such as Standard Oil and Exxon were almost fully vertically
integrated. Today, the pendulum has shifted to the opposite side. Firms are typically non-
integrated unless there is a compelling reason to be vertically integrated.
Reiterating the conditions under which vertical integration makes sense is important
at this point. Reducing/preventing opportunism, leveraging capabilities, and increasing
flexibility are good reasons under certain conditions for vertical integration.

Slide 6-17
Use this slide to remind students that vertical integration makes sense under certain
conditions. Call attention to the fact that a vertical integration strategy is a matter of
deciding which form of economic exchange is the most efficient. Point out that a vertical
integration strategy that is not valuable, rare, and costly-to-imitate is unlikely to generate
competitive advantage.

The instructor should close this chapter by pointing the important caveat with
respect to vertical integration – it is costly and so it is necessary to weigh the costs and
benefits before making the decision.

Slide 6-18

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146 Chapter 6: Vertical Integration

Remind students that vertical integration is an element of corporate level strategy. As such,
a vertical integration strategy should create value according to the logic of corporate level
strategy. Use this slide to reiterate that ownership comes with a price and so caution must
be applied in making the decision to vertically integrate.

CHALLENGE QUESTIONS

1. Some firms have engaged in backward vertical integration strategies in order to

appropriate the economic profits that would have been earned by suppliers selling to
them. How is this motivation for backward vertical integration related to the
opportunism logic for vertical integration described in this chapter? (Hint: Compare the
competitive conditions under which firms may earn economic profits to the competitive
conditions under which firms will be motivated to avoid opportunism through vertical
integration.)

Take the case of an auto manufacturer who is currently sourcing, say, rear-
view mirrors from an outside supplier. It is clear to the manufacturer that the
mirror supplier is making enormous profits in this transaction. Now, let’s say
that the manufacturer is making a new type of vehicle that calls for a
significantly new type of mirror. The mirror manufacturer has to make
significant transaction-specific investment for this deal. The auto
manufacturer is unlikely to get the mirror manufacturer to make the
investment for fear of opportunistic behavior by the auto manufacturer. The
auto manufacturer can now avoid opportunism and increase its profits by
vertically integrating into making its own mirrors. However, the other
explanations for vertical integration (capabilities and flexibility) must also be
factored into this decision.

2. You are about to purchase a used car. What kinds of threats do you face in this
purchase? What can you do to protect yourself from these threats? How is buying a car
like and unlike vertical integration decisions?

A buyer of a used car has options with regards to how he/she is going to go
through the process. The buyer could go to a local car dealer who sells
“certified pre-owned” cars. In doing this, the buyer relies on the dealer
doing all the diagnostic tests to ensure that the used car is in good condition.
Also, the paperwork that accompanies the purchase is all done within
minutes in the dealership. The buyer saves time and uses the dealer’s
infrastructure to make the whole exchange easier. On the other hand, the
buyer could search through the “classifieds” in the local newspaper or do an
online search for a seller. But this approach requires the buyer to do a lot
more work (in a sense vertically integrate) than the dealership route. The
buyer has to get the car tested (at an independent repair shop) and get the
paperwork done at the government office that deals with car registrations.
The amount of time spent is greater as is the amount of responsibility
undertaken by the buyer. But, chances are that the price will be more

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 Chapter 6: Vertical Integration 147

attractive for the buyer. If the buyer wants to protect himself/herself from
the possibility of buying a lemon, the dealership route is more attractive
because the dealer is likely to offer a limited warranty and there is somebody
to go to and demand answers if the car has problems. Not so in the case of
the individual seller, who will offer no warranty and is not likely to answer
questions after the sale.

3. What are the competitive implications for firms if they assume that all potential exchange
partners cannot be trusted?

The principal option for such a firm is to vertically integrate into all activities
of the value chain. This way they do not have to work with outside partners
and thereby completely avoid the trust issue. The other option is to write
ironclad contracts for lengthy periods of time. Such contracts cover every
possible contingency so that the firm is protected from adverse actions of
exchange partners.

4. Common conflicts between sales and manufacturing are mentioned in the text. What
conflicts might exist between R&D and manufacturing? Between finance and
manufacturing? Between marketing and sales? Between accounting and everyone else?
What could a CEO do to help resolve these conflicts?

R&D may develop a product without any regard to the difficulties in the
manufacturing process. For example, R&D may design a product with
tremendously low tolerances for some of the components. This may be
difficult to manufacture. Manufacturing may demand improvements in their
plants or the construction of new plants to take care of capacity issues.
Finance may balk at these proposals because organizational capital may be
limited and there are other demands on it. Marketing and sales may have
conflict over any of the 4 Ps – product, pricing, promotion, and place
(distribution). As salespeople, they may want lower prices to meet their sales
quotas and additional marketing; the marketing function may insist on
sticking to their original marketing plan. Accountants are record keepers,
they love paper trails because it protects them during audits. The other
functions may not pay as much attention to records. Accountants may also
insist on cutting costs and staying within budgets; the other functions may
chafe at this close monitoring. The CEO can resolve these conflicts by
stating clearly his/her expectations for each function and by promoting the
well-being of the organization as a whole as the paramount goal. Insisting on
regular cross-functional meetings also helps. Finally, having liaisons who act
as internal boundary spanners and coordinate activities between functions
can help everybody see the same big picture.
5. Under what conditions would you accept a lower-paying job instead of a higher-paying
job? What implications does your answer have for your potential employer’s
compensation policy?

One would accept a lower paying job over a higher paying job if the lower
paying has tremendous upside to it. In other words, if the job is more

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148 Chapter 6: Vertical Integration

challenging and rewarding in a non-monetary way. Also, if the higher paying

job requires the employee to invest tremendous amount of time in learning
skills specific to this employer (transaction-specific investment), the
employee may fear opportunistic behavior by the employer in terms of future
compensation. The organization’s compensation policy must take these
issues into consideration to attract capable employees.

Problem Set

1. Which of the following two firms is more vertically integrated? How can you tell?

a. Firm A has included manufacturing, sales, finance, and human resources within
its boundaries and has outsourced legal and customer service.
b. Firm B has included manufacturing, sales, legal, and customer service within its
boundaries and has outsourced finance and human resources.

2. What is the level of transaction specific investment for each firm in the following
transactions? Who in these transactions is a greater risk of being taken unfair advantage of?

a. Firm I has built a plant right next door to Firm II. Firm I’s plant is worth $5
million if it supplies Firm II. It is worth $200,000 if it does not supply Firm II.
Firm II has three alternative suppliers. If it receives supplies from Firm I, it is
worth $10 million. If it does not receive supplies from Firm I, it is worth $9.8
million.
b. Firm A has just purchased a new computer system that is only available from
Firm B. Firm A has redesigned it entire production process around this new
computer system. The old production process is worth $1 million; the new
process is worth $12 million. Firm B has several hundred customers for its new
computer system.

c. Firm Alpha, a fast food restaurant company, has a contract with Firm Beta, a
movie studio. After negotiating with several other potential partners, Firm alpha
agreed to a contract that requires Firm Alpha to pay Firm Beta $5 million per
year for the right to use characters from Firm Beta’s movies in its packaged
meals for children. Demand for children’s movies has recently dropped.

d. Firm I owns and runs a printing press. Firm J uses the services of a printing
press. Historically, Firm I has sold its services to many customers. However, it
was recently approached by Firm J to become its exclusive supplier of printing
press services. Currently, Firm I is worth $1 million. If it became the sole
supplier to Firm J, it would be worth $8 million. To complete this deal, Firm I
would have to stop supplying its current customers and modify its machines to
meet Firm J’s needs. No other firm needs the same services as Firm J. Firm J
contacted several other suppliers who said they would be willing to become a
sole supplier for Firm J before deciding to propose this arrangement with Firm I.

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 Chapter 6: Vertical Integration 149

3. What recommendation would you make in each of these situations, vertical integration
or not vertical integration and why?

a. Firm A needs a new and unique technology for its product line. There are not
substitute technologies. Should Firm A make this technology or buy it?

b. Firm I has been selling its products through a distributor for some time. It has
become the market share leader. Unfortunately, this distributor has not been
able to keep up with the evolving technology and customers are complaining.
There are no alternative distributors available. Should Firm I keep its current
distributor or should it begin distribution on its own?

c. Firm Alpha has manufactured its own products for years. Recently, however,
one of these products has become more and more like a commodity. Several
firms are now able to manufacture this product at the same price and quality as
Firm Alpha. However, they do not have Firm Alpha’s brand name in the market
place. Should Firm Alpha continue to manufacture this product or should it out-
source it to one of these other firms?

d. Firm I is convinced that a certain class of technologies holds real economic

potential. However, it does not know, for sure, which particular version of this
technology is going to dominate the market. There are eight competing versions
of this technology currently, but ultimately, only one will dominate the market.
Should Firm I invest in all eight of these technologies itself? Should it invest in
just one of these technologies? Should it partner with other firms that re
investing in these different technologies?
Answer 1

Firm A appears to be more vertically integrated. Students should provide an analysis that
examines the level of vertical integration from both a backward and forward perspective. In
the backward vertical integration situation, the firm has integrated aspects of its value chain
that are closer to the supplier side; in the forward vertical integration situation, the firm has
integrated aspects of its value chain that are closer to its customers.

Answer 2

The level of transaction specific investment is higher for Firm I than it is for Firm II.
Firm I is the party that has a greater risk of being taken unfair advantage of.

Firm A has the higher level of transaction specific investment. Firm B has the lower
transaction specific investment given the many customers. Firm A has the greater risk.

Due to the decrease in demand for children’s movies, it could be argued that Firm Beta
has the higher level of transaction specific investment.

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Solution Manual for Strategic Management and Competitive Advantage, 4/E 4th Edition : 013255

150 Chapter 6: Vertical Integration

Firm I clearly has the higher level of transaction specific investment risk. Firm I will be
the exclusive supplier for Firm J and for no other firms. Firm J has already
contacted other potential sources for its supplies.

Answer 3

a. Firm A could consider vertically integrating by purchasing the technology. This

would fall under “firm capabilities” where the technology is rare and costly to
imitate.

It could decide to forwardly integrate by developing distribution capabilities. However,

the flexibility here is rather low (costs are high). One would have to weigh the
relative “costs” associated with customer dissatisfaction and whether or not there are
substitute products/services that its existing customers could pursue.

If Firm Alpha continues to have strong presence in the market and holds the dominant
market position, it should continue to manufacture the product with its own brand.
There does not appear to be any cost advantage to outsourcing as the other firms
have the same capabilities.

It would probably be more cost effective to partner, in the short term, with other firms
that are investing in the different technologies.

Note to Instructor: In each of the above cases, you may wish to ask students to provide a
value-chain projection to support their analyses.

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