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 business-level strategy. Our position is
that if a corporate-level 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
Copyright © Houghton Mifflin Company. All rights reserved.
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
109
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.
II.
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.
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
Copyright © Houghton Mifflin Company. All rights reserved.
110
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
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.
III.
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.
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.
Copyright © Houghton Mifflin Company. All rights reserved.
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
111
Show Transparency 59
Figure 9.1: Stages in the Raw Material to Consumer Value Chain
1.
2.
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 rawmaterial-to-consumer chain to compete in.
Another important distinction is the difference between full integration, which occurs when 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 companyowned suppliers or when it disposes of its output through independent outlets in addition to
company-owned outlets.
Show Transparency 60
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.
4.
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 just-in-time inventory
systems. The assumption underlying this argument is that scheduling is somehow more
problematic between freestanding enterprises—an argument that seems rather dubious.
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.
Copyright © Houghton Mifflin Company. All rights reserved.
112
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
a.
IV.
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 company-owned suppliers, in times of low demand it can keep
its in-house 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 company-owned 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.
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 long-term cooperative relationships,
called strategic alliances, with their trading partners.
B.
However, companies will not realize gains from short-term (less than one year) contracts with their
trading partners.
1.
Because it signals a lack of long-term commitment to its suppliers by a company, the strategy of
short-term contracting and competitive bidding makes it very difficult for that company to
realize the gains associated with vertical integration.
2.
This is not a problem when there is minimal need for close cooperation between the company
and its suppliers to facilitate investments in specialized assets, improve scheduling, or improve
product quality. Indeed, in such cases competitive bidding may be optimal. However, a
competitive bidding strategy can be a serious drawback when these considerations do arise.
C.
In contrast to short-term contracts, long-term contracts are cooperative arrangements by which one
company agrees to supply the other, and the other agrees to continue purchasing from that supplier.
1.
In a long-term contract, both parties make a commitment to work together and seek ways of
lowering the costs or raising the quality of inputs.
2.
This stable long-term relationship lets the participating companies share the value that might be
created by vertical integration while avoiding many of its bureaucratic costs. Thus long-term
contracts can be a substitute for vertical integration.
Copyright © Houghton Mifflin Company. All rights reserved.
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
113
STRATEGY IN ACTION 9.3: DAIMLERCHRYSLER’S U.S. KEIRETSU
At one time, Chrysler used lowest-cost competitive bidding to buy components. The quality of the components
wasn’t important, and the relationships were short-term and characterized by mutual distrust. But over the last
decade, Chrysler has built a network of stable long-term relationships with suppliers (which the Japanese call
keiretsu). Suppliers make investments that are specific to Chrysler’s needs, in exchange for long-term contracts
and a share of any benefits that result from process improvements that the suppliers suggest. This aligns
incentives between Chrysler and its suppliers. Chrysler is able, due to these long-term relationships, to gain the
advantages of vertical integration without bureaucratic cost. Benefits include quicker new product development
and a dramatic increase in suggestions from suppliers. Implementation of these suggestions reduces Chrysler’s
costs by millions, or even billions, of dollars annually.
Teaching Note: This case demonstrates how a strategy (lowest-cost competitive bidding) that seems to offer the
most benefits, can in fact lead to few benefits in the long-term. Remind students that this case shows the
importance of asking “And then what happens?” in strategy. Too often, managers (and students) will recommend
solutions without adequate consideration of long-term consequences. You can mention other examples of this in
class, or ask students to think of examples.
D.
V.
Companies can take some specific steps to ensure that a long-term relationship can succeed and to
lessen the chances of one party taking advantage of the other.
1.
One way of designing long-term cooperative relationships to build trust and reduce the
possibility of a company reneging on an agreement is for the company making investments in
specialized assets to demand a hostage from its partner. This occurs when companies both
invest in specialized assets in order to serve each other, and it makes them mutually dependent
and therefore less likely to renege.
2.
A credible commitment is a believable commitment to support the development of a long-term
relationship between companies. Credible commitments involve long-term and substantial
investments, and therefore are believable guarantees of trust.
3.
Building a cooperative long-term relationship is more readily relied upon when a company can
maintain some kind of market discipline on its partner, to ensure that the partner doesn’t lack
incentives to maintain efficiency.
a.
One way of maintaining market discipline is to periodically renegotiate the agreement.
Thus a partner knows that if it fails to live up to its side of the agreement the company
may refuse to renew.
b.
Another way to maintain market discipline is to enter into long-term relationships with
suppliers use a parallel sourcing policy. Under this arrangement, a company enters into
a long-term contract with two suppliers for the same part. The idea is that when a
company has two suppliers for a single part, each supplier knows that it must fulfill its
side of the bargain, lest the company terminate the contract and switch business to the
other supplier.
Strategic Outsourcing
A. The opposite of integration (a firm’s growth, in number of businesses) is outsourcing value-creation
activities to subcontractors. In recent years there has been a clear move among many enterprises to
outsource noncore or nonstrategic activities.
STRATEGY IN ACTION 9.4: CISCO’S $2 BILLION BLUNDER
Cisco, the largest supplier of Internet hardware such as routers and switches, performs R&D, marketing, and
supply chain management within the organization, and outsources all other functions, including manufacturing.
Cisco claimed that the firm benefited by not investing in capital-intensive manufacturing facilities and by not
maintaining any inventory. The supply chain was a four-level pyramid, with Cisco at the peak and hundreds of
suppliers of commodity inputs at the base. But when demand started to fall in 2001, Cisco found that its system
couldn’t adapt quickly enough, and the company had to write off $2.2 billion in unusable inventory. This occurred
because customers overbooked in the high-demand periods, and then at each level of the pyramid, buyers
overbooked, magnifying the extent of the problem. Cisco’s outsourcing system distanced the company from its
suppliers, with a disastrous loss of communication capability. Since the write down, Cisco has implemented a web
Copyright © Houghton Mifflin Company. All rights reserved.
114
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
site for industry-wide supply chain management that allows firms at all stages of the supply chain to stay in touch
with the true level of demand.
Teaching Note: This cautionary tale shows the pitfalls of outsourcing very clearly. To start a discussion, ask
students to name functions that could be outsourced at their school and describe the benefits that the school would
reap. Then, ask them to describe any potential pitfalls that the school might experience, and describe actions that
would lessen the dangers from those pitfalls.
B.
C.
Any function can be outsourced, if it is not critical to a firm’s success (is not one of its distinctive
competencies).
Outsourcing begins with a identification of a firm’s distinctive competencies—these will continue to
be performed within the company. All other activities are then reviewed to see whether they can be
performed more effectively and efficiently by independent suppliers. If they can, these activities are
outsourced to those suppliers. The relationships between the company and those suppliers are then
often structured as long-term contractual relationships.
Show Transparency 61
Figure 9.4: Strategic Outsourcing of Primary Value Creation Functions
D.
E.
F.
The term virtual corporation has been coined to describe companies that have pursued extensive
strategic outsourcing.
There are several advantages of strategic outsourcing.
1.
First, by outsourcing a noncore activity to a supplier who is more efficient at performing that
particular activity, the company may reduce its own cost structure, enhancing its cost leadership
strategy.
a.
Suppliers may be more efficient due to economies of scale or learning effects.
b.
Suppliers may also be more efficient because of a low-cost location.
2.
By outsourcing a noncore value-creation activity to a supplier that has a distinctive competency
in that particular activity, the company may be able to better differentiate its final product.
3.
A third advantage of strategic outsourcing is that it allows the company to remove distractions,
focusing more resources on strengthening its distinctive competencies.
There are also some risks associated with strategic outsourcing.
1.
There is a risk of holdup, or becoming too dependent on an outsourced activity.
a.
This risk can be reduced by outsourcing from several companies at once, using a parallel
sourcing policy.
b.
Another way to manage this risk is simply to signal to the subcontractors the company’s
willingness to choose a different provider when the contract is up for renewal.
2.
A further drawback of outsourcing is the potential for loss of control of scheduling. This
problem is intensified by a long supply chain, unpredictable demand, and outsourcing to a
number of competing companies, rather than just one.
3.
Another concern is the potential for a loss of important competitive information. This risk can
be managed by ensuring good communication between the subcontractor and the company.
ANSWERS TO DISCUSSION QUESTIONS
1.
Why was it profitable for General Motors and Ford to integrate backward into component-parts
manufacturing in the past, and why are both companies now trying to buy more of their parts from outside?
Back in the 1920s, when Ford and GM originally began to vertically integrate backward, there were two
main reasons for doing so. First, the component supply industry was not well developed, so automakers had
to manufacture some parts themselves. Second, they wanted to achieve tight coordination between adjacent
stages of production to lower their production costs.
By the 1980s, however, conditions had changed. A lack of competitive pressures led to internal suppliers
becoming inefficient (the bureaucratic costs were high). Also, unionization made in-house suppliers’ labor
expenses too high. Furthermore, capacity reductions meant that both companies were experiencing excess
capacity at in-house suppliers. Also, Japanese auto companies had shown that entering into long-term
Copyright © Houghton Mifflin Company. All rights reserved.
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
115
contractual relationships with component suppliers was a viable low-cost alternative to formal vertical
integration.
2.
Under what conditions might horizontal integration be inconsistent with the goal of maximizing
profitability?
Horizontal integration is not consistent with maximizing stockholder wealth when there are no appropriate
prospective targets. This might occur, for example, if prospective targets have organizational cultures or
business practices that differ sharply from the firm’s, then post-merger integration of the two firms may be
very difficult or impossible; or, if there simply are no rivals that offer complementary skills or assets.
Another drawback to horizontal integration is the possibility of antitrust regulation. When a firm already
dominates a significant market share, it may not be possible to increase that share by merger or acquisition
due to the opposition of regulatory agencies.
Finally, there are a number of reasons that a company might pursue horizontal integration, in spite of its
drawbacks. But if these reasons are not present, then a company should not consider horizontal integration.
These reasons include the need to realize increased economies of scale or the need to acquire additional
assets in order to be competitive in the industry.
3.
What value creation activities should a company outsource to independent suppliers? What are the risks
involved in outsourcing these activities?
Companies should consider strategic outsourcing of functions that do not form the basis of its competitive
advantage. Thus, universities may outsource food preparation, but a restaurant should not.
Companies should outsource when there are a number of independent suppliers that can provide the
activities more efficiently or more effectively than the firm can. Many companies outsource functions such
as janitorial services, payroll, or hiring temporary personnel.
Companies should outsource when there is a low risk of the firm becoming too dependent on its supplier.
The high number of suppliers for corporate legal counsel makes it unlikely that the firm would become
overly dependent on any one supplier.
Risks of outsourcing include loss of ability to learn from that activity and loss of the opportunity to
transform that activity into a distinctive competence. A further drawback of outsourcing is that the company
may become too dependent upon a particular supplier. Another concern is that in its enthusiasm for strategic
outsourcing, a company might go too far and outsource value creation activities that are central to the
maintenance of its competitive advantage.
4.
What steps would you recommend that a company take in order to build long-term cooperative relationships
with its suppliers that are mutually beneficial?
The main objective in building long-term stable relationships must be the establishment of mutual trust.
Therefore, the company should consider actions such as the creation of liaison roles in both the firm and the
supplier, with an emphasis on open, friendly communication. The firm should ensure that all parties are
aware of the opportunities for mutual benefit, and then design a system that rewards innovations and
suggestions. The firm must then follow through in investigating and responding to suggestions, and
appropriately rewarding those responsible for any resulting improvements.
The other important consideration is to ensure that the supplier does not exploit the relationship for its
exclusive benefit. This can be accomplished by creating a hostage through mutual investment in specialized
assets. Credible commitments, periodic contract renegotiation, and parallel sourcing policies can also be
used to ensure equity in the relationship.
SMALL-GROUP EXERCISE: COMPARING VERTICAL INTEGRATION
STRATEGIES
Students are asked to break into small groups and read a short case about Quantum Corporation and Seagate
Technologies. They are then asked to describe the costs and benefits of a vertical integration strategy, as
Copyright © Houghton Mifflin Company. All rights reserved.
116
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
illustrated in the case. The students also should recommend a strategy for firms in the computer disk drive
industry.
Teaching Note: Quantum uses a vertical integration approach to the manufacture of disk drives, which gives the
firm control over proprietary technology and product quality, as well as enabling better coordination between
steps. However, the firm faces high bureaucratic costs from that coordination, high operating costs due to lack of
competitive pressures, and risks of technological obsolescence. Seagate outsources mass market production to an
overseas supplier, which reduces costs and allows the company to focus on what it does best, which is R&D.
However, Seagate risks loss of control over scheduling and costs and also risks losing its proprietary technology.
ARTICLE FILE 9
Students should find an example of a company whose vertical integration or diversification strategy appears to
have dissipated rather than created value. They should determine why this has happened and what the company
should do to rectify the situation.
Teaching Note: Students should examine companies that have undergone a recent merger or acquisition to find
good candidates for this exercise. The students can evaluate the success of a merger or acquisition by looking at
profitability before and after the merger. If this proves difficult, another, perhaps easier way to examine
performance is to look at stock price over time. If the stock price declines after the merger, then the market values
the merged companies less. Investors can be wrong about a firm’s future performance, however, so use stock
valuation cautiously.
STRATEGIC MANAGEMENT PROJECT: MODULE 9
This module requires students to assess the vertical integration and diversification strategy being pursued by their
companies. Students should describe the current level of horizontal and vertical integration, and explain the
reasons why the company integrated. They also must assess the potential for vertical integration. The students
then evaluate the company’s outsourcing and strategic alliances, making recommendations for improvements in
both areas.
Teaching Note: Students will be able to find about a company’s recent merger and acquisition activity by
examining the web site. An organization chart will show the current levels of integration. The remaining questions
are opinion questions, and students should be encouraged to look closely at the material in this chapter for help in
answering them.
EXPLORING THE WEB: VISITING MOTOROLA
This exercise asks students to visit Motorola’s web site (www.motorola.com) to investigate its vertical integration.
They are also asked to evaluate the vertical integration’s contribution to competitive advantage. In the General
Task, students are asked to choose a company that is using strategic outsourcing and to evaluate its contribution to
profitability.
Teaching Note: Motorola is highly vertically integrated and uses a divisional structure to group task and
coordinate functions. For example, in the telecommunications industry, the company designs and manufactures
basic components, assembles those into finished products, develops software for the products, sells and delivers
the products and software to consumers, and provide after-sale service. These activities give Motorola a
substantial competitive advantage because they are able to control product quality and to develop complementary
products and sell them in product bundles. However, Motorola must pay high bureaucratic costs to coordinate all
of these units. Also, the company must guard against losing its technological advantage.
In the General Task, students should readily find examples of firms that are using strategic outsourcing. They may
not be able to find detailed financial information about the costs and benefits of the outsourcing, so allow them to
answer this question in general or speculative terms.
Copyright © Houghton Mifflin Company. All rights reserved.
Chapter 9: Corporate Strategy: Horizontal and Vertical Integration, and Outsourcing
117
CLOSING CASE: AOL TIME WARNER: HORIZONTAL AND VERTICAL
INTEGRATION
AOL, the largest provider of online services, merged with Time Warner, a broadcasting and publishing firm, in
2001. Although Time Warner has a much longer history and contributes 80 percent of the revenues of the
combined firm, AOL is the dominant partner. Forward vertical integration occurred because AOL gained access
to Time Warner’s large base of installed cable TV systems, which AOL will use to offer cable modem Internet
connections to cable subscribers. Backward vertical integration also occurred, because AOL is able to offer Time
Warner’s content on its delivery system. The proposed merger ran into antitrust regulatory concerns, but when
Time Warner agreed to offer subscribers access to other online service providers through its cable system, the deal
was approved.
Teaching Note: This case shows that the AOL Time Warner merger was completed both to differentiate products
as well as to reduce costs. It provides a clear example of the ways in which companies can use vertical integration
to manage their supply chain. Based on what students learned from this chapter, ask them to anticipate some of
problems that the new firm might encounter. Or, if they have been following this company in the press, ask them
to report on the challenges the new firm is facing.
Answers to Case Discussion Questions
1.
What aspects of the AOL Time Warner merger can be considered horizontal integration? What aspects can
be considered vertical integration?
Both firms are in the business of providing entertainment content to subscribers, through very different
delivery systems. This is an example of horizontal integration.
As stated in the summary, “Forward vertical integration occurred because AOL gained access to Time
Warner’s large base of installed cable TV systems, which AOL will use to offer cable modem Internet
connections to cable subscribers. Backward vertical integration also occurred, because AOL is able to offer
Time Warner’s content on its delivery system.”
2.
What are the benefits associated with this merger? How might it boost the profitability of the combined
unit? Can you see any risks here?
The merger allows AOL to reach more customers and improve its service to them (through use of a faster
delivery method), enabling differentiation. Also, it gives AOL access to unique content, further extending
differentiation. The merger allows Time Warner to increase the number of product offerings to its current
customers, helping to differentiate in the cable industry. The merger allows both firms these things at a
lower cost than what would be required to develop them independently, reducing expenses. Through higher
sales and premium pricing, and lower costs, the combined firm should be more profitable.
Risks include the difficulties of blending two very different organizations, with different cultures, policies,
systems, assets, business models, etc. In addition, the concessions that the firm made to gain FTC approval
might hinder the firm’s competitive strategy in the future.
3.
Why do you think the FTC was concerned about the competitive implications of the merger? Were the
FTC’s concerns reasonable?
The FTC is charged with ensuring that free markets remain competitive, that is, that one company does not
have the power to monopolize an industry. The primary concern is that monopoly industries are bad for
customers, with poor service, high prices, and little innovation, due to the lack of competitive pressure. In
this case, the FTC was concerned that the post-merger firm would control the subscriber lines that are
necessary for any firm to compete in this industry. The concerns were reasonable, however, the solution
seems to provide a compensating mechanism that could ensure access to competing firms. Only time will
tell if the solution does in fact open up the market to increased competition.
Copyright © Houghton Mifflin Company. All rights reserved.