Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing1
CHAPTER 9
Corporate Strategy: Horizontal Integration, Vertical Integration, and Strategic Outsourcing
Synopsis of Chapter
This chapter and Chapter 10 concern corporate-level strategy. This chapter focuses on the different strategic choices that companies make with regard to horizontal and vertical integration. In particular, we consider the arguments for and against horizontal and vertical integration and examine strategic alliances and strategic outsourcing as alternatives. In the next chapter, the focus is on the strategies that companies use to enter and exit businesses.
Successful corporate strategy adds value by enabling the company to perform one or more of the value-creation functions at a lower cost or in a way that allows differentiation and brings a premium price. For a company to be successful, its corporate strategy must assist in the process of establishing a distinctive competency at the business level.
To a certain extent, this view conflicts with the received wisdom of the strategic management literature. It is often claimed that a company’s corporate-level strategy sets the context for its businesslevel strategy. Our position is that if a corporatelevel strategy is to succeed, the reverse should be the case. That is, the process of establishing a sustainable competitive advantage at the business level defines the set of appropriate corporate-level strategies.
Another theme stressed in the chapter is that the existence of bureaucratic diseconomies implies a fundamental limit to the profitable pursuit of horizontal and vertical integration. As companies become more diversified or vertically integrated, top management begins to lose control, leading to the dissipation rather than the creation of value.
A final theme of this chapter is that strategic alliances and strategic outsourcing are often viable alternatives to horizontal and vertical integration. That is, these strategies can achieve many of the same benefits without encountering the same bureaucratic costs.
Teaching Objectives
1.Familiarize students with the range of corporate-level strategies open to a company.
2.Illustrate how horizontal integration can create value for a company and show the bureaucratic limits to the profitable pursuit of horizontal integration.
3.Illustrate how vertical integration can create value for a company and show the bureaucratic limits to the profitable pursuit of vertical integration.
4.Show how strategic alliances can be used instead of horizontal and vertical integration, and describe the limitations of alliances.
5.Show how strategic outsourcing can be used instead of horizontal and vertical integration, and describe the limitations of outsourcing.
Opening Case: The Rise of WorldCom
Through the 1980s and 90s, WorldCom grew to be the second-largest telecommunications provider, behind number-one AT&T. To speed growth, the company acquired many smaller providers, including MCI, financing the deals with stock and debt. WorldCom CEO Bernie Ebbers knew that growing would help the firm to realize economies of scale and also increase its ability to offer a bundle of related telecom services. However, when WorldCom made a bid for Sprint, U.S. and European antitrust regulators opposed the deal because of the high industry concentration. The firm abandoned the acquisition, and began a long plunge toward failure. Along the way, the stock price fell, a long-distance services price war erupted, and the debt burden crushed profits. The final blow was a 2002 audit that showed the company had overstated earnings and understated expenses by billions of dollars. In July 2002, the firm declared bankruptcy.
Teaching Note: This case shows the inherent dangers in an acquisition strategy—high costs of debt, failure to realize potential savings, and overcapacity. Although it is still unclear at this time whether there was deliberate fraud at WorldCom, its clear that their acquisition strategy was out of control, moving too fast, and focused too little on integration and realization of cost savings. Ask students to discuss the extent to which, in hindsight, there were warning signs of trouble at WorldCom. Ask the students what they should look for in other companies to avoid making the same mistakes again?
Lecture Outline
I.Overview
A.The principal concern of corporate strategy is identifying the business areas in which a company should participate, the value creation activities it should perform, and the best means for expanding or contracting businesses, in order to maximize its long-run profitability.
B.To add value, a corporate strategy should enable one or more of a company’s business units to perform one or more of the value-creation functions at a lower cost or perform them in a way that allows differentiation and brings a premium price.
II.Horizontal Integration
A.Horizontal integration is the process of acquiring or merging with industry competitors to achieve the competitive advantages that come with large scale and scope.
B.Horizontal integration may be achieved by acquisition, as when a company purchases another company, or by a merger, meaning an agreement by which equals pool their operations and create a new entity.
1.Horizontal integration has been a popular strategy since the early 1990s. The trend toward horizontal integration peaked in 2000 and has fallen off somewhat since then.
2.The net result of all the horizontal integration has been to increase the consolidation in many industries.
3.The popularity of this strategy is due to the benefits that horizontally integrated firms realize.
a.Horizontal integration allows companies to grow, and therefore to realize economies of scale. This is especially important in industries with high fixed costs.
b.Another benefit of horizontal integration is the cost savings due to reducing duplication between the two companies, for example, eliminating duplicate headquarter offices.
c.In addition, horizontal integration can allow the company to offer a wider range of products that can be sold together for a single price, a strategy called product bundling. Customers value the convenience of bundled products, leading to differentiation.
d.Horizontal integration facilitates another strategy, similar to bundling, called a “total solution.” This is an important strategy, for example, in the computer industry, where corporate customers prefer the ease and coordination of purchasing all their hardware and service from a single source.
e.Horizontal integration also aids in value creation by supporting cross selling, as occurs when a company tries to leverage its relationship with customers by acquiring additional product categories that can be sold to them. Again, customers’ preference for convenience leads to differentiation.
f.Horizontal integration helps companies manage industry rivalry by reducing excess capacity in the industry.
g.Horizontal integration also reduces the number of players in an industry, thus making it easier to implement tacit price coordination.
Running Case: Beating Dell: Why Hewlett-Packard Wanted to Acquire Compaq
Dell’s dominance of the PC industry has had terrible consequences for rival Compaq, and Dell announced its plans to then go after the lucrative printer market, currently dominated by Hewlett Packard. HP and Compaq decided to merge, in order to better combat this threat. HP CEO Carly Fiorina believed the merger would bring cost savings by eliminating duplication and by increasing economies of scale. Fiorina also claimed the merger gives the combined company a broader expertise in both hardware and services. This should enable the firm to differentiate and reduce the threat from cost-leader Dell, as well as to better compete with other service providers, such as IBM and EDS. Critics of the merger pointed out that the merged firms still can’t compete with Dell’s efficient supply chain management, and that Dell’s success with a no-services strategy demonstrates that providing services is not necessary for profitability. The proposed merger ran into opposition, and while Fiorina and the two firms were distracted, Dell continued to gain market share.
Teaching Note: The HP-Compaq merger was made for a number of sound reasons, such as to increase market size and power, to expand the firm’s product lines, to support cross-selling, to bundle products, to realize economies of scale, to reduce duplication and to reduce excess capacity. But will that be enough to defeat powerful rival Dell? Ask students to debate this issue in class.
h.Companies gain bargaining power over buyers and suppliers through horizontal integration, because industry consolidation increases the remaining firms’ power. This is called market power, or monopoly power.
Strategy in Action 9.1: Horizontal Integration in Health Care
Health maintenance organizations (HMOs) are health insurance companies that act as middlemen between patients and providers, and they profit when they are able to enroll many patients and negotiate low prices from providers. In trying to maximize profits, HMOs have caused health care providers to try horizontal integration. For example, in Massachusetts there are few HMOs but many hospitals, giving power to the HMOs. They used that power to demand discounted prices and threatened to remove hospitals from approved providers lists if discounts weren’t granted. In response, hospitals began to merge. As their power grew, hospitals refused to offer discounts. When HMOs retaliated by removing those hospitals, patients protested and eventually forced the HMO to accept the higher prices. Bargaining power is now shifting to the providers.
Teaching Note: This case can be used for class discussion, by asking students to consider the shifting balance of power between HMOs and providers, from the patient’s point of view. Many of the students will be aware of this issue, and perhaps have personal experiences. Starter questions might include: “Is it better for patients when HMOs are in power or when hospitals are in power?” and “Is it possible to both increase patients’ choices and reduce costs simultaneously?” Students may be inclined to side with the providers, but you can point out that the providers’ historically high fees led to this situation in the first place. Also ask students to consider the costs of any of the solutions they proffer.
1.However, horizontal integration also has some drawbacks and limitations.
a.Mergers and acquisitions are difficult to implement successfully, and therefore may destroy value rather than creating it. Problems include disparate cultures, high management turnover, an underestimation of integration expenses, and a tendency to overestimate the expected benefits and to overpay. This topic is discussed in more detail in Chapter 10.
b.Antitrust law is designed to provide protection against the abuse of market power and tends to favor industries with numerous, smaller companies rather than consolidated industries. The U.S. Justice Department sometimes blocks proposed mergers and acquisitions because of these concerns about reducing competition and raising prices for consumers.
III.Vertical Integration
A.Vertical integration means that a company is producing its own inputs (backward or upstream integration) or is disposing of its own outputs (forward or downstream integration).
B.There are four main stages in a typical raw-material-to-consumer production chain: raw materials; component part manufacturing; final assembly; and retail. For a company based in the assembly stage, backward integration involves moving into intermediate manufacturing and raw-material production. Forward integration involves movement into distribution. See Figure 9.1 for details.
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Figure 9.1: Stages in the Raw Material to Consumer Value Chain
1.At each stage in the chain value is added to the product. The difference between the price paid for inputs and the price at which the product is sold is a measure of the value added at that stage. Thus, vertical integration involves a choice about which value-added stages of the raw-material-to-consumer chain to compete in.
2.Another important distinction is the difference between full integration, which occurswhen a company produces all of its own inputs or disposes of all of its own output, and taper integration, in which a company buys from independent suppliers in addition to company-owned suppliers or when it disposes of its output through independent outlets in addition to company-owned outlets.
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Figure 9.3: Full and Taper Integration
3.Firms pursuing a strategy of vertical integration realize some benefits.
a.By vertically integrating backward or forward, a company can build barriers to new entry, limiting competition and enabling the company to charge a higher price and make greater profits.
b.Vertical integration facilitates investment in specialized assets. A specialized asset is an asset that is designed to perform a specific task and whose value is significantly reduced in its next best use. It may be a tangible or an intangible asset.
(1)Specialized assets lower the costs of value creation and provide better differentiation, and thus provide the basis for achieving a competitive advantage.
(2)It may be difficult to persuade companies in an adjacent stage of the production chain to invest in specialized assets, because there is a risk that one will take advantage of the other, demanding more favorable terms after the companies commit to the relationship.This is referred to as holdup.
(3)Instead, the company may vertically integrate and invest in specialized assets for itself.
Strategy in Action 9.2: Specialized Assets and Vertical Integration in the Aluminum Industry
Aluminum refineries are designed to refine bauxite ore and produce aluminum. Refinery designs are very specialized—each factory must be designed for a particular type of ore, which is produced only at one or a few bauxite mines. Using a different type of ore would raise production costs by 50 percent. Therefore, the value of the aluminum company’s investment is dependent on the price it must pay the bauxite company. Recognizing this, once the aluminum company has made the investment in a new refinery, the bauxite company can raise prices to holdup the refiner. The aluminum company can reduce this risk by purchasing the bauxite company. Vertical integration, by eliminating the risk of holdup, makes the specialized investment worthwhile.
Teaching Note: The case reports that over 90 percent of aluminum refiners own the bauxite mine. Ask students to consider whether there are any other effective methods of reducing holdup. If so, what are they? If not, why not?
c.By protecting product quality, vertical integration enables a company to become a differentiated player in its core business, leading to more pricing options.
d.Strategic advantages arise from the easier planning, coordination, and scheduling of adjacent processes made possible in vertically integrated organizations. This can be particularly important in companies trying to realize the benefits of justintime inventory systems. The assumption underlying this argument is that scheduling is somehow more problematic between freestanding enterprises—an argument that seems rather dubious.
4.However, vertical integration has some disadvantages. Because of these disadvantages, the benefits of vertical integration are not always as substantial as they might seem initially.
a.Although often undertaken to gain a production cost advantage, vertical integration can raise costs if a company becomes committed to purchasing inputs from company-owned suppliers when low-cost external sources of supply exist.
(1)Company-owned suppliers might have high operating costs relative to independent suppliers because they know that they can always sell their output to other parts of the company. The fact that they do not have to compete for orders with other suppliers reduces their incentive to minimize operating costs.
(2)The problem may be less serious, however, when the company pursues taper, rather than full, integration, because the need to compete with independent suppliers can produce a downward pressure on the cost structure of company-owned suppliers.
b.When technology is changing rapidly, vertical integration poses the hazard of tying a company to an obsolescent technology. Vertical integration can inhibit a company’s ability to change its suppliers or its distribution systems to match the requirements of changing technology.
c.Vertical integration can be risky in unstable or unpredictable demand conditions, because it may be difficult to achieve close coordination among vertically integrated activities. The resulting inefficiencies can give rise to significant bureaucratic costs.
(1)The problem involves balancing capacity among different stages of a process. For example, if demand falls, the company may be locked into a business that is running below capacity. Clearly, this would not be economical.
(2)If demand conditions are unpredictable, taper integration might be somewhat less risky than full integration. When the company provides only part of its total input requirements from companyowned suppliers, in times of low demand it can keep its inhouse suppliers running at full capacity by ordering exclusively from them.
d.Bureaucratic costs are the costs of running an organization. They include the costs arising from the lack of incentive on the part of companyowned suppliers to reduce their operating costs and from a possible lack of strategic flexibility in the face of changing technology or uncertain demand conditions.
(1)Bureaucratic costs place a limit on the amount of vertical integration that can be profitably pursued. The farther a company moves from its core business, the more marginal the economic value and the higher the bureaucratic costs.
(2)Given their existence, it makes sense for a company to integrate vertically only when the value created by such a strategy exceeds the bureaucratic costs associated with expanding the boundaries of the organization to incorporate additional upstream or downstream activities.
IV.Alternatives to Vertical Integration: Cooperative Relationships
A.Under certain conditions, companies can realize the gains associated with vertical integration without having to bear the associated bureaucratic costs, if they enter into longterm cooperative relationships, called strategic alliances, with their trading partners.
B.However, companies will not realize gains from shortterm (less than one year) contracts with their trading partners.