Particular Strategic Issues in Forward Integration

In addition to the benefits and costs of integration previously discussed, there are some particular issues raised by forward integra-tion.

Improved Ability to Differentiate the Product. Forward inte-gration can often allow the firm to differentiate its product more successfully because the firm can control more elements of the pro-duction process or the way the product is sold. For example, Texas Instruments’ forward integration into consumer products such as watches and calculators allowed it to develop a brand name, whereas its electronic components were essentially commodities. Monfort, a cattle feedlot operator, has forward integrated into meat-packing and distribution in part to develop a brand name at least with re-tailers.

Providing service for a product as well as selling the product it-self may allow a company to differentiate itself even though its prod-uct is not superior to that of competitors. Forward integration into retailing sometimes allows the firm to control the salesperson’s pre-sentation, the physical facilities and image of the store’s location, the incentives of the salesperson, and other elements of the retail sell-ing function that help differentiate its product. The basic idea of in-tegration in all these cases is to increase value added to provide a basis for differentiation that was unavailable or difficult in the unin- tegrated unit. In increasing product differentiation, the firm may at the same time increase mobility barriers as well.

Access to Distribution Channels. Forward integration solves the problem of access to distribution channels and removes any bar-gaining power the channels have.

Better Access to Market Information. In a vertical chain the underlying demand for the product (and the decision maker who ac-tually makes the choices among competing brands) often are located in a forward stage. This stage determines both the size and the com-position of demand of the upstream stages of production. For exam-pie, the demand for alternative construction materials is determined by the contractor or developer who balances customers’ desires with the quality and cost of the materials available. The stage in which these key market decisions are made will be referred to here as the demand leading stage.

Forward integration toward or into the demand leading stage can provide the firm with critical market information, that allows the entire vertical chain to function more effectively. On the simplest level, it may allow the firm to determine the quantity of demand for its products sooner than if it had to infer it indirectly from orders by its customers. The interpretation of customers’ orders is complicated by the presence of inventories held by each intervening stage. Earlier market information allows better adjustment of production levels and reductions in the costs of overages and under ages.

Informational benefits may also be more subtle than simply the receipt of timely information on the size of the demand. By compet-ing in the demand leading stage, the firm can gain, firsthand, timely information about the optimal product mix, trends in buyer tastes, and competitive developments that will ultimately affect its product. This information can facilitate rapid adjustments in product charac-teristics and mix in the upstream stages and lower the costs of adjustment.

A number of companies have followed implicit or explicit strat-egies of integration to the demand leading stage in all their busi-nesses. Genstar Ltd., a leading Canadian firm, integrated forward into housing construction and heavy construction from its cement and building materials businesses. Indal Ltd., another Canadian firm, has a policy of going forward into final fabrication from its metal rolling, extruding, and coating businesses. Both companies place heavy weight on market information as a justification for for-ward integration.

The benefits of forward integration for this purpose depend on the degree to which market conditions are unstable or changing in the demand leading stage, whether production is to inventory or to order, and also on the ability of the firm to gain forward market in-formation without resorting to integration. In both construction and metal fabricating, final demand is highly cyclical and its composition often rapidly changes. Cyclical, erratic, and changing demand increases the benefits of timely market information. If final demand is highly stable, market information gained from customers may be more than sufficient.

The degree to which accurate information can be gained from customers depends on the industry. Although it is hard to generalize, if there are many small customers, informal sampling probably gives an accurate indication of the situation in forward markets. The pres-ence of a few large customers (particularly if they are powerful), on the other hand, means that accurate forward information may be hard to obtain. The consequences of changes in a particular cus-tomer’s specifications or mix are much greater in this situation as well.

Higher Price Realization. In some cases forward integration can allow the firm to realize higher overall prices by making it possi-ble to set different prices for different customers for essentially the same product. The problem with this practice is that arbitrage may occur, and the practice can be illegal in some cases under the Robin- son-Patman Act. If the firm integrates into the businesses that should be charged with the lower price because its demand is more elastic, it may realize higher prices on sales to other customers. How-ever, other firms selling the product must also be integrated, or the firm‘s product must be differentiated so that customers will not ac-cept competitors’ products as perfect substitutes.

Another practice is to integrate in order to allow the prices to be better matched to the elasticities of demand of the firm‘s ultimate customers. Some consumers may be willing to pay more for a prod-uct because they use it more intensively than others, for example. A firm may have difficulty in matching prices to different usage rates, however, because it cannot measure usage. But if it also provides service for a fee or sells supplies that must be used with the product, it can set the basic product price low and recoup the benefits of dif-fering elasticities of demand through the sale of these associated products. This sort of approach has been employed in copiers and computers. As long as the buyer is not compelled to purchase the as-sociated products from the firm as a condition of purchasing the basic product, this practice is legal under the antitrust statutes.

Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.

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