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Formulating Vertical Integration Strategies^ KATHRYN RUDIE HARRIGAN Columbia University

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Formulating Vertical Integration Strategies^ KATHRYN RUDIE HARRIGAN Columbia University Hevkn 1994, Vbt 9. Na 4. 63&4SS2. Formulating Vertical Integration Strategies^ KATHRYN RUDIE HARRIGAN Columbia University A framework is proposed that develops the dimensions of vertical integra- tion strated and proposes key factors that might augment their uses within various scenarios. These represent new hypotheses and conjectures about make-or-buy decisions that require empirical testing. If the framework is valid, strategists could formulate better hybrid vertical integration strategies by recogniang the hypothesized effects of these forces on the industries that might be linked. Managers need a ready supply of raw matoials and tbey have not recognized how to make this a more services, as wdl as a ready market for their firms' durable and keen competitive weapon. Because suc- outputs. The business arratigements tbat are used to cessful vertical integration strategies require the control tbese risks are forms of vertical integration. cooperation of several strategic business units Tbey tnay include vertical acquisitions, or intemal (SBUs), the formulation of such strategies is in the devdo{«ient of supplying or distributing units, or province of the chief executive officer (CEO). In otber means of extending firms' control over out- some cases, effective vertical integration may even siders. require temporary subsidization of one business unit at the expense of another. Decisions regarding sucb The Phenomenon of Vertical Integration SBU coordination (and resource allocations among Vertical integration is a corporate strategy tbat has them) must be made by the chief strategists. Tbus been misunderstood. It has lotig been a key force in effective vertical integration strategies need to refiect tbe development of bigb productivity and managerial botb business unit and corporate level strategy scqibistication in U.S. business (Cbandler, 1977). Ver- requirements. tically integrated corporations bave been key engines Tbis paper proposes a framework for developing of cbange in tbe past and bave enbanced sbarebolder effective vertical integration strategies. It was wealtb (Lubatkin, 1982). Yet earUer findings tbat developed by syntbesizing tbe tbeoretical foundations "dominant verticals" (Rumelt, 1974) and vertical establisbed by tbe industrial economics and strategic mergers were least successful as diversifications management literatures witb firms' observed behav- (Baker, Miller, & Ramsperger, 1981) may bave iors. Thus it suggests a new way to look at vertical soured mana^rs and academic researcbers on tbe integration and the forces that affect firms' cboices usefulness of tbis strategy unnecessarily. Oftentimes concerning vertical linkages. It develops normative researcbas did not recognize tbat votical integration propositions conceming wbicb generic vertical could be an effective strategy, provided it was used strategies migbt be more appropriate under different pnutently, because tbey often took an overly aggre- competitive circumstances, and it uses examples of gated view of it. Because critics bave not discemed firms' successes or failures in using vertical integra- bow tbe impOTtant dimensions of vertical integraticm tion to suggest bow traditional concepts of this be adapted over time (as industries cbange). strategy mi^t be amended to refiect effective in- dustry practices. These suggestions are new hypo- theses, which will require empirical testing. Vertical 'The research was st^iported by tbe Strategy Researcb Center, Cdurabia University. Comments and oitidsm from William H. integration is one of tbe first diversification strategies Newman, Ian MacMillan, and Donald C. Hambrick are also tbat firms embrace. Unfortunatdy, some firms seem graulaHy acknowledged. The author is indebted to Donald C. to use it in a manner that seems inappropriate for I&iabrick for suggesting the graphic configuration in Fipire 1. tbdr circumstances. Tbe issue of vertical inte^ation 638 deserves additional analysis because it bas been sified firms he bad classified in otber ways. If misunderstood in tbe past, and because tbe develop- previous studies of votical inte^ation used dassifica- ment of a more rigorous means of analyzitig this tion rules simiiar to Rumelt's, tbey also may bave strategy (and the performance it promises) cotild understated its tme activity level. For example. result in the formulation of more effective industry Federal Trade Commission data for 1948 to 1972 linkages, more rapid technological improvements, conceming large acquisitions (assets larger tban $10 stronger global strategies, and better use of vertical million) indicate tbat less than 15 percent of these integration. Table 1 summarizes many ofthe advan- were vertical mergers; and Salter and Wdnhold's tages and risks associated with vertical integration. (1979) list of $100 million or more acquisitions made The narrow case in which a firm's major diversi- during 1975-1978 indicated that only 4 percent were fication strategy has been only vertical is not the focus vertical. Thus an illusion was perpetuated that ver- of this inquiry. Instead, it considers the larger tical integrations were rare, except in the ral, mbber, universe of firms that have linked two or more SBUs basic metals, and forest products industries. But, in through vertical relationsbips and bave diversified in fact, acquisitions that are classified as bdng other- otber ways as well. Rumeh (1974) would bave found wise "related" to tbe firm's core businesses may also tbat many of tbe more diversified firms in his For- bave provided new distribution cbannds or other tune 500 sample also bad vertical transfers of goods assets that are vertically related to them. or services in-bouse, bad tbat been tbe focus of bis Acquired firms are bundles of assets rather than inquiry. Tbus Rumelt reported tbat 22 percent of tbe single business units, as Ocddental Petroleum firms in bis sample embraced a dominant vertical discovered when courting Cities Service (and as Du strategy in 1969 (up from 20 percent in 1949), but Pont learned while absorbing Conoco). Acquisitions vertical linkages also existed witbin tbe bighly diver- can offer vertical linkages as wdl as nonvertical diver- sifications. Corporate strategists must dedde whether to retain the business units acqtiired inddentally in Table 1 this fashion; and if tbey are vertically rdated, Some Advantages and Disadvantages strategists must dedde wbetber to encourage intra- of Vertical Integration firm commerce (subsidy) or demand arms-length transactions between vertical sister units. Thus, more seemingly unrelated mergers bave vertical elements Advantages Disadvantages to tbem tban is generally recognized, but oftentimes Internal benefits Internat costs strategists see no advantage to encouraging vertical Integration econoniies reduce Need for overbead to coordinate relationsbips between in-bouse units. Tbis may oc- costs by eliminating steps, re- vertical integration increased ducing duplicate overbead, costs cur because tbe opportunities for vertical competitive and cutting costs (tecbnology Burden of excess capacity from advantage bave passed in some industries. In otber dependent) unevenly balanced tninimum Iniproved coorditiation of activ- efficient scale plants (technol- cases, bowever, tbis occurs because managers did not ities reduces inventorying and ogy dependent) recognize bow to exploit tbe advantages of vertical other costs Poorly organized vertically in- Avoid time-consuming tasks, tegrated firms do not enjoy integration effectively. such as price shopping, com- sipergies tbat compensate for municating design details, or bigber costs negotiating contracts The Legacy of Vertical Integration Cortipetitive benefits Competitive dangers Avoid forecbsure to inputs, ser- Obsolete processes may be per- Vertical integration bas been an important mana- vices, or markets petuated gerial innovation and a necessary technological step Improved marketitig or techno- Creates mobility (or exit) bar- logical intelligence riers in developing certain industries, but it may not be Opportunity to create product links firm to sick adjacent busi- appropriate in tbe same form under all circum- differentiation (increased value added) Lose access to itiformation from stances. For example, ownership of ore mines, ships, Superior control of firm's eco- suppliers or distributors foundries, rolling mills, and fabricating plants was nomic environment (market Synergies created through ver- power) ' tical im^ration may be over- necessary for steel companies to lower costs and im- Create credibility for new prod- rated prove productivity in the 1890s. In its early years. ucts Managers integrated before Ford Motor Company owned and operated every Synergies could be created by tbinking tbrough the most ap- coordinatbig vertical activities propriate way to do so stage of processing from iron ore to Hnisb-and-trim skillfully operations (except tires and glass). In these early 639 years, suppliers may not have berai as willing to share on tbeories of market power and tbe ideal of perfectly Ford's gamble in persua^ng consumers to purcbase competitive industries (Addman, 1979; Blair & "horsdess carriages," so Ford bad to devdop com- Kaserman, 1978; Comanor, 1967; Dennison, 1939; ponraits to its spedfications for itsdf. Tliere were Frank, 1925; Jewkes, 1930; and Lavington, 1925). substantial economies assodated with vertical in- Tbese scholars largely have not recognized that dif- tegration once FOTd bad overcome the public's ferent motives for vertical integration—such as resistance
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