Vertical integration has important generic benefits and costs which need to be considered in any decision but whose significance will depend on the particular industry. They apply to both forward and backward integration, with the necessary changes in perspective. I will discuss these generalized benefits and costs here, saving for la-ter sections an examination of some issues peculiar to a company in-tegrating forward or one integrating backward. For purposes of this discussion, the upstream firm is the selling firm and the downstream firm is the buying firm in the vertical chain.
1. VOLUME OF THROUGHPUT VERSUS EFFICIENT SCALE
The benefits of vertical integration depend, first of all, on the volume of products or services the firm purchases from or sells to the adjacent stage relative to the size of the efficient production fa-cility in that stage. For ease in exposition let us take the case of a firm integrating backward. The volume of purchases of the firm contemplating backward integration must be large enough to sup-port an in-house supplying unit large enough to reap all economies of scale in producing the input, or the firm faces a dilemma. Either it must accept a cost disadvantage in producing the input internally, or it must sell some of the production of the upstream unit in the open market. As will be discussed extensively later, selling extra output on the open market may be difficult because the firm might have to sell to its competitors. If the firm‘s needs do not exceed the scale of an ef-ficient unit, the firm faces one of two costs of integrating, which must then be figured against the benefits. Either it builds an ineffi-ciently small facility that meets only its needs, or it builds an effi-cient facility and must bear the possible risk of sales or purchases on the open market.
2. STRATEGIC BENEFITS OF INTEGRATION
ECONOMIES OF INTEGRATION
If the volume of throughput is sufficient to reap available econ-omies of scale,2 the most commonly cited benefit of vertical integra-tion is the achievement of economies, or cost savings, in joint pro-duction, sales, purchasing, control, and other areas.
Economies of Combined Operations. By putting technologi-cally distinct operations together, the firm can sometimes gain effi-ciencies. In manufacturing, for example, this move can reduce the number of steps in the production process, reduce handling costs, re-duce transportation costs, and utilize slack capacity which arises from indivisibilities in one stage (machine time, physical space, maintenance facilities, etc.). In the classic case of the hot rolling of steel, the steel billet need not be reheated if the steelmaking and roll-ing operations are integrated. Metal may not have to be treated with a finish to prevent oxidation before the next operation; slack inputs such as the capacity of particular machines can be used on both processes. Facilities can be located in close proximity to each other, as is the case with the many large sulfuric acid users (fertilizer com-panies, oil companies) who have established backward integration into sulfuric acid production. This step eliminates transportation costs, which are substantial for a hazardous and difficult to handle product like sulfuric acid.
Economies of Internal Control and Coordination. The costs of scheduling, coordinating operations, and responding to emergen-cies may be lower if the firm is integrated. Adjacent location of the integrated units facilitates coordination and control. There is also likely to be more trust placed on an insider to keep the needs of its sister unit in mind, and therefore, less slack built into the business to cope with unforeseen events. Steadier supply of raw materials or the ability to smooth deliveries may result in better control of produc-tion schedules, delivery schedules, and maintenance operations. This is because the revenue foregone by suppliers who fail to deliver may be much less than the cost of disruption, and hence their motivation to deliver punctually is hard to assure. Styling changes, product re-design, or introduction of new products may also be easier to coordi-nate internally, or coordination may occur more rapidly. Such econ-omies of control can reduce idle time, the need for inventory, and the need for personnel in the control function.
Economies of Information. Integrated operations may reduce the need for collecting some types of information about the market, or more likely, may reduce the overall cost of gaining information. The fixed costs of monitoring the market and predicting supply, de-mand, and prices can be spread over all parts of the integrated firm, whereas they would have to be borne by each entity in an uninte– grated firm.3 For example, the integrated food processor can use sales projections for the final product in all segments of the vertical chain. Similarly, market information may well flow more freely through an organization than through a series of independent par-ties. Integration may thus allow the firm to obtain faster and more accurate information about the marketplace.
Economies of Avoiding the Market. By integrating, the firm can potentially save on some of the selling, price shopping, negotiat-ing, and transactions costs of market transactions. Although there will usually be some negotiating in internal transactions, its cost should not be nearly as great as that of selling to or purchasing from outside parties. No sales force and no marketing or purchasing de-partments are needed. Moreover, advertising is unnecessary, as are other marketing costs.
Economies of Stable Relationships. Both upstream and down-stream stages, knowing that their purchasing and selling relationship is stable, may be able to develop more efficient, specialized proce-dures for dealing with each other that would not be feasible with an independent supplier or customer—where both the buyer and the seller in the transaction face the competitive risk of being dropped or squeezed by the other party. Specialized procedures for dealing with customers or suppliers can include dedicated, specialized logistical systems, special packaging, unique arrangements for record keeping and control, and other potentially cost-saving ways of interacting.
It is also possible that stability of the relationship will allow the upstream unit to tune its product (in quality, specifications, etc.) to the exact requirements of the downstream unit, or for the down-stream unit to adapt itself more fully to the characteristics of the upstream unit. To the extent that such adaptation would lock inde-pendent parties into each other, its occurrence without vertical inte-gration may require payment of a risk premium, which raises costs.
Characteristics of Vertical Integration Economies. Economies of integration are at the core of the analysis of vertical integration, not only because they matter in and of themselves, but also because they contribute to the significance of some other issues in integration to be discussed below. Clearly their importance varies from firm to firm in an industry, depending on each firm‘s strategy and its strengths and weaknesses. A firm with a strategy of low-cost produc-tion may place a greater value on achieving economies of all types, for example. Similarly, a firm with a weakness in marketing may save more by avoiding market transactions.
TAP INTO TECHNOLOGY
A second potential benefit of vertical integration is a tap into technology. In some circumstances it can provide close familiarity with technology in upstream or downstream businesses that is cru-cial to the success of the base business, a form of economy of infor-mation so important as to deserve separate treatment. For example, many mainframe computer and minicomputer firms have instituted backward integration into semiconductor design and manufacturing to gain a better understanding of this essential technology. Manufac-turers of components in many areas integrate forward into systems to develop a sophisticated understanding of how the components are used. Often, if not usually, integration to tap into technology is ta-pered, or partial, integration because full integration carries with it some technological risks.
ASSURE SUPPLY AND/OR DEMAND
Vertical integration assures the firm that it will receive available supplies in tight periods or that it will have an outlet for its products in periods of low overall demand. Integration only assures demand to the extent that the downstream unit can absorb the output of the upstream unit. The ability of the downstream unit to do so clearly depends on the effect of competitive conditions on the demand of the downstream unit. If demand is down in the downstream indus-try, the sales of the internal unit may also be low, and its needs for the output of its internal supplier corresponding low. Thus integra-tion may only reduce the uncertainty that the firm will be arbitrarily cut off by its customers rather than assure demand in the literal sense.
Although vertical integration can reduce the uncertainty of sup-ply and demand, and hedge the firm against fluctuations in prices, this does not mean that internal transfer prices should not reflect market disturbances. Products should pass from unit to unit within the integrated company at transfer prices reflecting market prices to insure that each unit will manage its business properly. If transfer prices diverge from market prices, one unit will be subsidizing the other compared to what it could achieve on the open market (one unit will be better off and the other worse off). Then the manage-ments of the upstream and downstream units may make decisions based on these artificial prices which reduce the efficiency and harm the competitive position of their units. For example, if an upstream unit supplies a downstream unit at prices significantly lower than those it could receive on the open market, the corporation as a whole will probably suffer. The downstream manager, acting on the basis of the artificially low prices, may well seek to expand the market po-sition of the downstream unit—which will then require the upstream unit to supply more subsidized products.
Assurance of supply and demand should thus not be viewed as complete protection from ups and downs in the market but rather as reducing uncertainty about their effects on the firm. Both the up-stream and downstream unit should be able to plan better with lower risks of interruptions, elimination of changes in suppliers or custom-ers, and lower risks of being caught in a situation in which prices in excess of average market prices must be paid to meet an emergency. This reduction of uncertainty is especially important when one or both stages is capital intensive. The assurance of supply and demand has been mentioned prominently as a motivation for integration in such industries as petroleum, steel, and aluminum.
OFFSET BARGAINING POWER AND INPUT COST DISTORTIONS
If a firm is dealing with suppliers or customers who wield signif-icant bargaining power and reap returns on investment in excess of the opportunity cost of capital, it pays for the firm to integrate even if there are no other savings from integration. Offsetting bargaining power through integration may not only lower costs of supply (by backward integration) or raise price realization (by forward integra-tion) but also allow the firm to operate more efficiently by eliminat-ing otherwise valueless practices used to cope with the powerful sup-pliers or customers. The bargaining power of suppliers or customers will be determined by the structure of their respective industries relative to the firm‘s industry.
Backward integration to offset bargaining power has other po–tential benefits. Internalizing the profits earned by suppliers of an input can reveal the true costs of that input. The firm then has the choice of adjusting the price of its final product to maximize overall profits of the two entities before integration. The fact that the firm knows the true cost of inputs also means that it might improve effi-ciency by changing the mix of the various inputs used in the down-stream business’ production process.4 This move can also increase total profitability.
Although the benefits of adjusting to the true opportunity costs of inputs are clear from the perspective of the corporation, it is im-portant to note that conventional transfer pricing policies work against reaping these benefits. If external suppliers of an input have bargaining power, internal transfers at the market price will occur above the true opportunity cost of the input. However, transfers at market price can have administrative benefits in terms of managerial incentives.
ENHANCED ABILITY TO DIFFERENTIATE
Vertical integration can improve the ability of the firm to differ-entiate itself from others by offering a wider slice of value added un-der the control of management. This aspect can, for example, allow better control of channels of distribution in order to offer superior service or provide opportunities for differentation through in-house manufacture of proprietary components. The effect of vertical inte-gration on differentiation will be discussed further below.
ELEVATE ENTRY AND MOBILITY BARRIERS
If vertical integration achieves any of these benefits, it can raise mobility barriers. The benefits give the integrated firm some com-petitive advantage over the unintegrated firm, in the form of higher prices, lower costs, or lower risk. Thus the unintegrated firm must integrate or face a disadvantage, and the new entrant into the busi-ness is forced to enter as an integrated firm or bear the same conse-quences. The more significant the net benefits of integration, the greater the pressure on other firms to also integrate. If there are sig-nificant economies of scale or capital requirements barriers to inte-gration, the compulsion to integrate will raise mobility barriers in the industry. If scale economies and capital requirements are not sig-nificant, on the other hand, then the compulsion to be integrated will have little competitive significance.
ENTER A HIGHER-RETURN BUSINESS
A firm may sometimes increase its overall return on investment by vertically integrating. If the stage of production into which inte-gration is being contemplated has a structure that offers a return on investment greater than the opportunity cost of capital for the firm, then it is profitable to integrate even if there are no economies of in-tegration per se. Of course the integrating firm must include the cost of overcoming entry barriers into the adjacent stage in its calculation about the return on investment to be earned in the adjacent industry, and not just consider the returns being earned by incumbents. Thus, as will be discussed in Chapter 16, it must have some potential ad-vantages over other potential entrants.
DEFEND AGAINST FORECLOSURE
Even if there are no positive benefits of integration, it may be necessary to defend against foreclosure of access to suppliers or cus-tomers if competitors are integrated. Widespread integration by competitors can tie up many of the sources of supply or the desirable customers or retail outlets. In this case the unintegrated firm faces the grim prospect of having to scramble for the remaining suppliers or customers and bears the risk that they may be inferior to those captured by integrated firms. Foreclosure thus raises the mobility barrier of access to distribution channels or the absolute cost barrier of access to favorable suppliers of raw materials.
For defensive purposes, a firm may have to integrate or face a disadvantage from foreclosure, the disadvantage being more serious the greater the percentage of customers or suppliers who are fore-closed. These same considerations mean that the new entrant must enter the business on an integrated basis. Need for integration will raise mobility barriers in the same way previously described if there are significant economies of scale or capital requirements involved. The foreclosure problem has triggered much defensive integration in such U.S. industries as cement and shoes.
3. STRATEGIC COSTS OF INTEGRATION
The strategic costs of vertical integration basically involve entry cost, flexibility, balance, ability to manage the integrated firm, and the use of internal organizational incentives versus market incen-tives.
COST OF OVERCOMING MOBILITY BARRIERS
Vertical integration obviously requires the firm to overcome the mobility barriers to compete in the upstream or downstream busi-ness. Integration is, after all, a special case (though a common one) of the general strategic option of entry into a new business.5 Because of the internal buying and selling relationship implied by vertical in-tegration, the integrating firm can often readily surmount some mo-bility barriers into the adjacent business, such as access to distribu–tion channels and product differentiation. However, overcoming barriers caused by cost advantages from proprietary technology or favorable sources of raw materials can be a cost of vertical integra-tion, as can overcoming other sources of mobility barriers, such as economies of scale and capital requirements. As a result, vertical in-tegration occurs most frequently in industries like metal containers, aerosol packaging, and sulfuric acid, in which the technology is well known and the minimum efficient scale of a plant is not great.
INCREASED OPERATING LEVERAGE
Vertical integration increases the proportion of a firm‘s costs that are fixed. If the firm was purchasing an input on the spot mar-ket, for example, all the costs of that input would be variable. If the input is produced internally, the firm must bear any fixed costs in-volved in its production even if a downturn or some other cause re-duces the demand for it. Since the sales of the upstream business are derived from the sales of the downstream business, factors that cause fluctuations in either business cause fluctuations in the whole chain. Fluctuations can be caused by the business cycle, by competi-tive or market developments, and so on. Thus integration increases the operating leverage of the firm, exposing it to greater cyclical swings in earnings. Vertical integration thereby increases business risk from this source, though the net effect of integration on risk depends on whether it decreases business risk in other dimensions, as has been discussed. The degree to which integration will increase op-erating leverage in a particular business clearly depends on the amount of fixed costs present in the business in which integration oc-curs. If the business has low fixed costs, for example, the effective increase in operating leverage can be minor.
A good example of the risk of operating leverage created by ex-tensive vertical integration is the Curtis Publishing Company. Curtis built an immense vertical enterprise to supply its relatively few mag-azines, primarily the Saturday Evening Post. When the magazine ran into difficulty in the late 1960s, the impact on the financial per-formance of Curtis was disastrous.
REDUCED FLEXIBILITY TO CHANGE PARTNERS
Vertical integration implies that the fortunes of a business unit are at least partly tied to the ability of its in-house supplier or cus-tomer (who might be its distribution channel) to compete success-fully. Technological changes, changes in product design involving components, strategic failures, or managerial problems can create a situation in which the in-house supplier is providing a high-cost, in-ferior, or inappropriate product or service or the in-house customer or distribution channel is losing position in its market and thus its suitability as a customer. Vertical integration raises the costs of changeover to another supplier or customer relative to contracting with independent entities. For example, Imasco, a leading Canadian cigarette producer, backward integrated into the packaging material used in its manufacturing process. However, technological change made this form of packaging inferior to other varieties, which the captive supplier could not produce. The supplier was eventually di-vested after many difficulties. Robert Hall‘s difficulties in the men’s clothing business may have been caused in part by its total reliance on internally produced merchandise.
The extent of this risk depends on a realistic assessment of the likelihood that the in-house supplier or customer will get into trou-ble, and the likelihood of external or internal changes that will re-quire adaptation by the sister unit.
HIGHER OVERALL EXIT BARRIERS
Integration that further increases the specialization of assets, strategic interrelationships, or emotional ties to a business may raise overall exit barriers. Any of the exit barriers (described in Chapter 12) can be affected.
CAPITAL INVESTMENT REQUIREMENTS
Vertical integration consumes capital resources, which have an opportunity cost within the firm, whereas dealing with an indepen-dent entity uses investment capital of outsiders. Vertical integration must yield a return greater than or equal to the firm‘s opportunity cost of capital, adjusting for the strategic considerations discussed in this chapter, in order for integration to be a good choice. Even if there are substantial benefits to integration, they may not be enough to raise the return from integrating above the corporate hurdle rate when the firm is contemplating integration into potentially low-re-turn businesses like retailing or distribution.
This issue can manifest itself in the appetite for capital of the upstream or downstream business into which integration is contem-plated. If its capital needs are likely to be great relative to the ability of the firm to raise funds, the need to reinvest funds in the integrated unit can expose the firm to strategic risks elsewhere. That is, integra-tion can drain capital needed elsewhere in the company.
Integration can reduce the flexibility with which the firm al–locates its investment funds. Since the performance of the entire ver-tical chain is dependent on each of its pieces, the firm may be forced to invest in marginal pieces to preserve the overall entity rather than allocate capital elsewhere. For example, it appears that some of the large, integrated firms that supply raw materials have been stuck in low-return businesses because they lacked the capital to diversify. Their capital-intensive, integrated operations have consumed most of the funds available for investment just to preserve the value of the assets in these operations.
FORECLOSURE OF ACCESS TO SUPPLIER OR CONSUMER RESEARCH AND/OR KNOW-HOW
By integrating, the firm may cut itself off from the flow of tech-nology from its suppliers or customers. Integration usually means that a company must accept responsibility for developing its own technological capability rather than piggybacking on others. How-ever, if it chooses not to integrate (whereas other firms do), suppliers are often willing to support the firm aggressively with research, engi-neering assistance, and the like.
Foreclosure of technology can be a significant risk when there are numerous independent suppliers or customers doing research or where suppliers or customers have large-scale research efforts or have particular know-how difficult to replicate. This risk is inherent in integrating to provide a direct tap into technology in adjacent businesses, though it may be counterbalanced by the risk of not inte-grating for this reason. Even if the firm only integrates partially, still buying or selling some product in the open market, it may risk fore-closing technology because it puts itself in competition with its sup-pliers or customers (see below).
MAINTAINING BALANCE
The productive capacities of the upstream and downstream units in the firm must be held in balance or potential problems arise. The stage of the vertical chain with excess capacity (or excess de–mand) must sell some of its output (or purchase some of its inputs) on the open market or sacrifice market position. This step in such a circumstance may be difficult because the vertical relationship often compels the firm to sell or buy from its competitors. They may be re–luctant to deal with the firm for fear of getting second priority or to avoid strengthening their competitor’s position. If excess output can be readily sold on the open market or excess demand for inputs readily satisfied, on the other hand, the risks of imbalance are not great.
Vertical stages go out of balance for a variety of reasons. First, efficient increments to capacity are usually unequal for the two stages, creating temporary periods of imbalance even in a growing market. Technological change in one stage may require changes in methods that effectively increase its capacity relative to the other stage; or changes in product mix and quality may affect effective ca-pacity in the vertical stages unequally. The risk of imbalance will de-pend on predictions about the likelihood of these factors.
DULLED INCENTIVES
Vertical integration means that buying and selling will occur through a captive relationship. The incentives for the upstream busi-ness to perform may be dulled because it sells in-house instead of competing for the business. Conversely, the business buying inter-nally from another unit in the company may not bargain as hard as it would with outside vendors. Thus, dealing in-house can reduce in-centives. A related point is that internal projects to expand capacity, or internal contracts to buy or sell, may get less stringent review than external contracts with customers or suppliers.
Whether or not these dulled incentives actually reduce perform-ance in the vertically integrated firm is a function of the managerial structure and procedures that govern the relationship between the administrative units in the vertical chain. One often reads policy statements concerning internal transactions that give managers the freedom to use outside sources or to sell outside if the inside unit is not competitive. The mere presence of such procedures is not enough, however. The use of an outside instead of an inside source often places the burden of proof on the unit manager and requires an explanation to top management; most managers may well try to avoid interacting with top management on such a basis. Also there is a sense of fairness and comradeship within an organization that may make strictly arms-length agreements difficult, especially if one unit or the other is earning very low returns or otherwise is in serious trouble. Yet this is where arms-length relationships are the most nec-essary.
The difficulty just discussed, leads to the “bad apple” problem. If the upstream or downstream unit is sick (strategically or other-wise), its problems may spill over to its healthy partner. One unit can be pressured or even voluntarily attempt to rescue the troubled unit by accepting higher-cost products, products of inferior quality, or lower prices on internal sales. This situation can damage the healthy unit strategically. If the corporate parent seeks to help the troubled unit, it will do better to subsidize or support the unit directly rather than indirectly through its sister unit. Even if top management rec-ognizes this point, however, human nature will make it difficult for the healthy unit to take a ruthless attitude toward the sick unit (al–though this does happen in some companies). Thus the presence of the sick unit can insidiously poison the healthy one.
DIFFERING MANAGERIAL REQUIREMENTS
Businesses can be different in structure, technology and man-agement despite having a vertical relationship. Primary metal pro-duction and fabrication are quite different, for example; one is ex-tremely capital intensive and the other, which is not, demands close supervision of production and a decentralized emphasis on service and marketing. Manufacturing and retailing are fundamentally dif-ferent. Understanding how to manage such a different business can be a major cost of integration and can introduce a major element of risk in the decision.6 A management capable of operating one part of the vertical chain very well may be incapable of effectively managing the other, to put the point in its most extreme form. Thus a common managerial approach and a common set of assumptions can be quite counterproductive for vertically related businesses.
Since vertically linked businesses transact business with each other, however, there is a subtle tendency to view them as similar from a managerial point of view. Organizational structure, controls, incentives, capital budgeting guidelines, and a variety of other man-agerial techniques from the base business may be indiscriminately applied to the upstream or downstream business. Similarly, judg-ments and rules that have grown from experience in the base busi-ness may be applied in the business into which integration occurs. This tendency to apply the same managerial style to both elements of the chain is another risk of integration.
When assessing the strategic benefits and costs of vertical inte-gration, one must examine them in terms not only of the current en-vironment but also of probable changes in industry structure in the future. Economies of integration that seem small today, for exam-ple, may be large in a more mature industry; or industry growth and resulting company growth may mean that the firm will soon be able to support an internal unit of efficient scale. Or slowing down of technological change can reduce the risk of being locked into the in-ternal supplier.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.