Strategic Management & Competitive

Advantage: Concepts and Cases

Sixth Edition, Global Edition

Chapter 6
Vertical Integration

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved

 The Strategic Management Process
External
Analysis

Strategic Strategy Competitive

Mission Objectives
Choice Implementation Advantage

Which Businesses
Internal to Enter?
Analysis
Corporate Level • Vertical Integration
Strategy
 What is a Corporate Strategy?

• Corporate strategy is a firm’s

theory of how to gain competitive
advantage by operating in
several businesses
simultaneously.

• Examples include vertical

integration, diversification,
strategic alliances …etc
Logic of Corporate Level Strategy
Corporate level strategy should create value:
1) such that the value of the corporate whole increases

2) such that businesses forming the corporate whole

are worth more than they would be under
independent ownership

3) that equity holders cannot create through

portfolio investing
• A corporate level strategy should create
synergies that are not available in markets.

• vertical integration = value chain economies

What is a value chain?

• A value chain is a set of activities that a firm

operating in a specific industry performs in order
to deliver a valuable product or service for the
market

• Value chain analysis is a strategy tool used to

analyze internal firm activities. Its goal is to
recognize, which activities are the most valuable to
the firm and which ones could be improved to
provide competitive advantage
What is a value chain?
What Is Vertical Integration?

• Vertical integration is a strategy where a company

expands its business operations into different steps on
the same production path, such as when a manufacturer
owns its supplier and/or distributor.
• Types of vertical integration:
– Backward: incorporating more stages of the value chain within its
boundaries and those stages bring it closer to the beginning of
the value chain (i.e. closer to the raw materials)
– Forward: incorporating more stages of the value chain within its
boundaries and those stages bring it closer to the end of the
value chain (i.e. closer to consumers)
– Balanced?
Backward Integration
Backward vertical integration is most effective when:

• There are few suppliers but many competitors

• The industry is expanding rapidly
• The prices of inputs are unstable
• Suppliers earn high profit margins
• The firm has enough resources and capabilities to manage
the new business
Forward Integration
Forward vertical integration is most effective when:

• There are few quality distributors

• Distributors have high profit margin
• Distributors are expensive, unreliable, or can’t meet firms’
needs
• The industry is expected to grow significantly
• There are benefits of stable production and distribution
• The firm has enough resources and capabilities to manage
the new business
 Backward
Vertical
Integration

Forward
Vertical
Integration
 What Is Vertical Integration?
Where does your pizza come from?
What Is Vertical Integration?

Where does your pizza come from?

Value Chain Economies
The Logic of Value Chain Economies
Backward
Vertical
• The focal firm is able to Dairy Farmers Integration
(milk)
create synergy with the
other firm(s).
• cost reduction
Food Company
• revenue enhancement (Mozzarella Cheese)

• The focal firm is able to

capture above normal
economic returns. Forward
Food Distributors
Vertical
Integration
Competitive Advantage

If a vertical integration strategy meets the

VRIO criteria…
Is it Valuable?

Is it Rare?
Is it costly to Imitate?

Is the firm Organized to exploit it?

…it may create competitive advantage.

Value of Vertical Integration
Market vs. Integrated Economic Exchange
• Markets and integrated hierarchies are “forms” in which
economic exchange can take place.

• Economic exchange should be conducted in the form

that maximizes value for the focal firm.

• Thus, firms assess which form is likely to generate

more value.

Integration makes sense when the focal firm can

capture more value than a market exchange provides.
Value of Vertical Integration
Three Value Considerations

Leverage Manage Exploit

Capabilities Opportunism Flexibility

• firm capabilities • opportunism • internalizing is

may be sources may be checked usually less
of competitive by internalizing flexible
advantage in the transaction
other businesses • flexibility is
• internalizing must prized when
• if not, then don’t be less costly than uncertainty is
integrate opportunism high
Rarity of Vertical Integration
Integration vs. Non-Integration
• A firm’s integration strategy may be rare because
the firm integrates or because the firm does not
integrate.

• A firm’s integration strategy is rare or common with

respect to the value created by the strategy.

Example: Toyota’s Choice Not to Integrate Suppliers

Imitability of Vertical Integration
Form vs. Function
• The form, per se, is usually not costly to imitate.

• The value-producing function of integration may

be costly to imitate, if:
• the integrated firm possesses resource
combinations that are the result of:
• historical uniqueness
• causal ambiguity
• social complexity
• Patents
Imitability of Vertical Integration
Modes of Entry

• Acquisition and internal development are alternative

modes of entry into vertical integration.
• Thus, one firm may acquire a supplier while a
competitor could imitate that strategy through
internal development.
• In both cases, the boundaries of the firm would
encompass the new business.

• Strategic alliances can be viewed as a substitute for

vertical integration—without the costs of ownership.
 Organizing Vertical Integration
Functional Structure
CEO’s Role
Cooperation
Accounting Finance Marketing HR Engineering

Cooperation
Conflict

Original Original Original Original Original

Business Business Business Business Business

New New New New New

Business Business Business Business Business

Conflict
Organizing Vertical Integration
Management Controls
What needs to be “controlled” in a vertically integrated
firm?

• managers’ efforts to achieve the desired value

chain economies
• cooperation and competition among and between
functions
• the integration of new businesses into the
existing business
• time horizon of managers
Organizing Vertical Integration
Management Controls
Board
Budgets
Committees
• separating strategic and • provide oversight and
operational budgets direction to managers
• help ensure that strategic
direction is maintained

These mechanisms focus management attention

on achieving value chain economies.
Advantages of Vertical Integration

• Elimination of transactions costs

• Control of the quality of supplies
• The ability to secure critical resources
• Improved coordination in supply chain
• Greater market share
• Secured distribution channels
• Greater investments in facilities
• Developing new competencies
Disadvantages of Vertical Integration

• Higher costs if unable to manage new activities efficiently

• May lead to lower quality of products
• More bureaucracy
• Reduced flexibility
• Higher potential for legal repercussion (i.e. monopoly)
• New competency may clash with the old ones
Summary
Vertical Integration…

• makes sense when value chain economies

can be created and captured

• may allow a firm to leverage capabilities

• may be a response to the threat of opportunism

and uncertainty

• as a form of exchange per se, is not rare nor

costly to imitate
Summary
Vertical Integration…

• is an important consideration in the decision

to expand internationally (range of possibilities)

• makes sense when done for the right reasons,

under the right circumstances

• can be a costly mistake if done wrong

Ownership is costly—integrate only when the

benefits outweigh the costs of integration!
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