Riassunto Corporate Strategy

TROUBLE.5. VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM

From business strategy to corporate strategy: the scope of the firm

Business strategy is concerned with how a firm competes within a particular market. Corporate strategy is concerned with where a firm competes, i.e. the scope of its activities. The dimensions of scope are:

• Vertical scope: Upstream and Downstream
• Geographic scope: Internationalization
• Product scope: Diversification

Firms vs. market transactions

In the market there are independent companies in competition; individuals and firms make independent decisions to buy and sell goods and services: transactions are coordinated by market mechanism (invisible hand). Within the company, there is an administrative mechanism: transactions are coordinated through hierarchy, managers decide all about production and resource allocation. The activities are administered by the market or firm based on relative costs of organizing them, i.e.

transaction vs. administrative costs.

What determines which activities are undertaken within a firm and which through market contracts? According to Coase, if the transaction costs of organizing an activity through the market are more than the administrative costs of organizing it within a firm, we can expect that activity to be encompassed within a firm. Look always at my objective (in terms of profitability, efficient use of resources etc.) using a long-term view. Decide to be vertical integrated is an important choice toward your primal objective.

Vertical specialization vs. Vertical Integration (better make or buy?)

Vertical specialization It is a sort of delegation of responsibilities and duties to others within the same line of authority. Vertical specialization occurs as an organization grows, becoming more complex and requiring additional personnel to cope with the additional workload. A clear example is given by the outsourcing: specialized firms linked by

can compare Harry Potter and Frozen. Frozen is an example of vertical integrated company: film, DVDs, video game, attraction, musical, merchandising, all is produced by Disney. Related to Harry Potter, it is not vertical integrated, because e.g. merchandising and film rights are held by different companies.

Benefits of vertical integration

Firstly, vertical integration offers cost savings that arise from the physical integration of processes. Remind that technology is not a key variable to be vertically integrated. According to Williamson, you have to avoid transaction costs of market contracts in situations where there are:

• Small number of firms;
• Transaction-specific investments;
• Opportunism (hold-up) and strategic misrepresentation;
• Taxes and regulations on market transactions.

When transaction costs are low due to a strong competition, market contracts can be the best solution to operate. Conversely, the pressure of high transaction specific investments encourages

Vertical integration (opportunism). VI serves to limit danger of hold-up, but it doesn't cure agency problems:

• Still need to provide incentives to upstream & downstream managers;
• Dangers in how this is done (e.g., could be a mistake to turn upstream into profit center usually better to make cost center).

Costs of vertical integration

On the other hand, vertical integration imposes an administrative cost. In determining the extent of these costs, we have to consider some critical factors:

• Differences in optimal scale of operation between different stages of production prevent balanced vertical integration;
• àInhibits development of distinctive capabilities Capabilities in different vertical activities are independent of one another and the required capabilities are generic rather than highly customized;
• àDifficulties of managing strategically different businesses Managing business with different features requires different strategic planning systems,

different approaches to control, HR management and different top management styles.

• Incentive problems Lack of "high-powered" incentives;
• Competitive effects For a firm that is not monopolist, vertical integration risks damaging its competitive position in its core business;
• Limits flexibility VI may be disadvantageous in responding quickly to new product development opportunities, to demand fluctuations, to changes in technologies, customer preferences etc; But, may be conducive to system-wide flexibility.
• Investing in unattractive businesses One of the biggest disadvantages of VI is that it may involve investing in an inherently industry;
• Compounding of risk Problems at anyone stage of production threatens production and profitability at all other stages.

Different types of Vertical Relationship

Different vertical relationships offer different combinations of advantages and disadvantages:

• Long-term contracts.

• Vertical Partnership. The greater the difficulties of specifying complete contracts for long-term supplier-customer deals, the greater the advantage of vertical relationships based on trust and mutual understanding. Such relationships can provide the flexibility to meet changing circumstances, and the incentives to avoid opportunism.
• Franchising. A franchise is a contractual agreement between the owner of a business system and trademark (franchiser) that permits the franchisee to produce and market the franchiser's product in a specified area. The main advantage is that this form combines the advantages of vertical integration in terms of coordination and investments with advantages of market.

Contracts in terms of flexibility and separate ownership.

Choosing among alternative Vertical Relationships

Choosing the optimal vertical relationships needs to take account of:

• Resources, capabilities and strategy. Different companies will choose different vertical arrangements according to their reactive resources and capability strengths and the strategies they pursue;
• Allocation of risk. A key feature of any contract is that its terms allocate risks between the parties;
• Incentive structures. Weak performance incentives are a key problem of VI. It seems possible that hybrid and intermediate governance modes offer the best solutions to design of incentives.

Recent trends in Vertical Relationships

• From competitive contracting to supplier partnerships, e.g. in autos;
• From VI to outsourcing, not just regarding to components, also IT, distribution, and administrative services;
• Diffusion of franchising;
• Technology partnerships (e.g. IBM-Apple).

1. Positive aspects of vertical integration:
   • Monitoring process
   • Made in USA Differentiation
   • Control over design and over quality
   • Innovation
   • Easier to create a common corporate culture
2. It depends a lot on your strategy: for example, if you want to control your reputation, your quality, you would be interested in controlling part of the production phases (Nuts-Nutella).
3. Cotton – Benetton: is it better to produce it by yourself or buy it? It is very easy to assess the quality you are looking for in relation to cotton traded on the market. You create value through brand, design, manufacturing, retail.
4. Why not Vertical Integration?
   • Rigidity in terms of technology On the opposite, outsourcing allows faster changes or flexibility: in case of

technological changes, vertical integration is not the best choice. If you outsource, you can easily change your supplier instead of investing in new research and development projects;

2. Out of stock risk If your plant is closed, you have a big problem. On the opposite, if you have suppliers all over the world, you can limit your risk; indeed, it is very difficult that all of your supplier will close at the same time;

3. Higher costs. It is better to be very responsiveness in relation to the market producing in USA or to be efficient importing shirts from emerging economies? (American Apparel Case). In other words, does it make sense to be vertically integrated in the USA.

The second question is: In which stages of the production process do I have to be vertically integrated? Customer should understand that your vertical integration in the USA gives them more value. If the consumer does not perceive any value in relation to 'made in the USA', you should outsource. If I expect

1. Improving effectiveness and efficiency;
2. Retrenchment and core business focus It is probably the easiest one (e.g. you skipthe retail part). Indeed, analyzing economic results divided per areas, you can observethat the international operating income is negative (e.g. In Canada it is equal to 7% ofsales). In USA, you have a better result in wholesales instead that in retail in which AAobtains a negative result; USA strategy is working in the wholesale and not in the retail;
3. Repositioning aa as casual fashion brand It can work but it is diffic