Corporate Level Strategy

Horizontal Integration, Vertical Integration and

Strategic Outsourcing

Narmin Tartila Banu

MGT 489
Chapter Agenda
• To understand three corporate level strategies that
can improve the performance of a firm’s current
business.
 Horizontal Strategy
• Horizontal Strategy: Acquiring or merging with
industry competitors to achieve the competitive
advantages that arise from a large size and
scope of operations.
• Acquisition: Company uses its capital resources
to purchase another company
• Merger: Agreement between two companies to
pool their resources and operations and join
together to better compete in a business or
industry
Merger between United and Continental airlines in order to
rationalize the number of flights offered between destinations
and increase their market power.
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Pfizer acquired Warner-Lambert to become the largest
pharmaceutical firm

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 Benefits of Horizontal Integration

1. Reduces rivalry within the industry

2. Increases bargaining power over
suppliers and buyers
3. Lowers the cost structure
4. Increases product differentiation
 Lowers cost structure
• Horizontal integration can lower a company’s cost structure because
it creates increasing economies of scale as output increases.
• Example 1: In the telecommunications industry, for example, the fixed
costs of building advanced 4G and LTE broadband networks that offer
tremendous increases in speed are enormous, and to make such an
investment profitable, a large volume of customers is required. Thus,
companies such as AT&T and Verizon purchased other
telecommunications companies to acquire their customers.
Example 2: The fixed costs of building a nationwide pharmaceutical
sales force are enormous, and pharmaceutical companies such as
Pfizer and Merck must possess a wide portfolio of drugs to sell to
effectively make use of their sales forces.
 Lowers cost structure
• A company can also lower its cost structure when
horizontal integration allows it to reduce the
duplication of resources between two companies,
such as by eliminating the need for two sets of
corporate head offices, two separate sales teams,
and so forth.
 Increased Product Differentiation
• Horizontal integration may also increase
profitability when it increases product
differentiation, for example, by increasing the flow
of innovative new products that a company’s sales
force can sell to customers.
 Increased Product Differentiation
• Horizontal integration may also increase differentiation
when it allows a company to combine the product lines of
merged companies so that it can offer customers a wider
range of products that can be bundled together.
– cross-selling: when a company takes advantage of or “leverages”
its established relationship with customers by way of acquiring
additional product lines or categories that it can sell to customers.
In this way, a company increases differentiation because it can
provide a “total solution” and satisfy all of a customer’s specific
needs.
 Vertical Integration: Entering new industries to
strengthen the “core” business model
• Vertical Integration: When a company expands its
operations either backward or forward into an
industry
– Backward vertical integration - Produces inputs for the
company’s products
– Forward vertical integration - Uses, distributes, or sells
the company’s products.
Stages in the Raw-Materials-to-Customer Value-
Added Chain
The Raw-Materials-to-Customer Value-Added
Chain in the PC Industry
 Advantages of Vertical Integration
• Vertical integration increases product
differentiation, lowers costs, and reduces industry
competition when it:
1. Facilitates investments in efficiency-enhancing
specialized assets
2. Protects and enhances product quality.
3. Results in improved scheduling.
 investments in efficiency-enhancing specialized
assets
• It is often necessary that suppliers invest in specialized
assets to produce the inputs that a specific company needs.
• By investing in these assets, a supplier can make higher-
quality inputs that provide its customers (the
manufacturers) with a differentiation advantage, or inputs
at a lower cost so it can charge its customers a lower price
to keep their business.
• This can be achieved through vertical integration as the
manufacturer itself invests in specialized assets to supply
components derived from specialized assets.
• Example: ford can make it’s own energy saving electrical
engine which can increase fuel efficiency and differentiation
 investments in efficiency-enhancing specialized
assets
• Tapered Integration: When a firm uses a mix of
vertical integration and market transactions for a
given output. In other words, a firm will make their
own supplies while also purchasing supplies from
suppliers.
• This has some advantages:
– Reduces bargaining power of suppliers.
– Which will lead to lower cost of supplies.
– Evaluate the cost and quality of the supplied components
because now the firm has insights into the supplier’s
industry.
 Enhancing Product Quality
• Enhancing Product Quality: By entering industries at other
stages of the value-added chain, a company can often
enhance the quality of the products in its core business and
strengthen its differentiation advantage.
• For example the ability to control the reliability
and performance of complex components such as engine and
transmission systems may increase a company’s competitive
advantage in the luxury sedan market and enable it to charge
a premium price.
• Another Example: The same considerations can promote
forward vertical integration. Ownership of retail outlets may
be necessary if the required standards of after-sales service
for complex products are to be maintained.
 Improved Scheduling
• Improved Scheduling: Sometimes important strategic
advantages can be obtained when vertical integration makes
it quicker, easier, and more cost-effective to plan, coordinate,
and schedule the transfer of a product, such as raw materials
or component parts, between adjacent stages of the value
added chain.
– Also improves scheduling while delivering products to the end
consumers.
• Such advantages can be crucial when a company wants to
realize the benefits of just-in-time (JIT) inventory systems.
 Problems with Vertical Integration
• There are three fundamental challenges of vertical
integration:
1. Increasing cost structure
2. Disadvantages that arise when technology is
changing fast
3. Disadvantages that arise when demand is
unpredictable
• This can result in vertical disintegration: When a
company decides to exit industries either forward or
backward in the industry value chain to its core
industry to increase profitability.
 Problems with Vertical Integration: Increasing
Cost Structure
• Continuing to purchase inputs from company-owned
suppliers when low-cost independent suppliers that can
supply the same inputs exist.
• Thus, vertical integration can be a major disadvantage
when company-owned suppliers develop a higher cost
structure than those of independent suppliers. Why would
a company owned supplier develop such a high cost
structure?
• Example: GM’s company owned suppliers made more
than 60% in the required components. Later on they went
through a process of disintegration because of high cost
structure.
 Problems with Vertical Integration: Increasing
Cost Structure
• This results in more transfer price and
reduction of profitability: The price that one
division of a company charges another
division for its products, which are the inputs
the other division requires to manufacture its
own products.
 Problems with Vertical Integration: Technological
Change
• When technology is changing fast, vertical
integration may lock a company into an old,
inefficient technology and prevent it from changing
to a new one that would strengthen its business
model.
• Example: SONY unable to embrace new LCD
technology because they were locked into the
outdated CRT (cathode ray tubes) technology.
• Thus, vertical integration can pose a serious
disadvantage when it prevents a company from
adopting new technology.
 Problems with Vertical Integration: Demand
Unpredictability
• vertical integration can be risky when demand is
unpredictable because it is hard to manage the
volume or flow of products along the value-added
chain.
• This can lead to inefficiency and higher cost
structure.
• However, this challenge is avoided when vertical
integration is not pursued as the manufacturer
will not purchase any supplies when demand is
low.
 Alternative to Vertical Integration: Co-operative
Relationships
• Quasi Integration: The use of long-term
relationships, or investment into some of the
activities normally performed by suppliers or
buyers, in place of full ownership of operations
that are backward or forward in the supply chain.
 Alternative to Vertical Integration: Co-operative Relationships:
Short Term contracts and competitive bidding

• Short Term contracts and competitive bidding

• Competitive bidding strategy - Independent component
suppliers compete to be chosen to supply a particular
component.
• Short-term contracts - Last for a year or less
• Example: GM typically solicits bids from global suppliers to
produce a particular component and awards a 1-year
contract to the supplier that submits the lowest bid. At the
end of the year, the contract is once again put out for
competitive bid, and once again the lowest-cost supplier is
most likely to win the bid.
– Does not result in specialized investments
– Signals a company’s lack of long-term commitment to its suppliers
 Alternative to Vertical Integration: Co-operative Relationships:
Strategic Alliances and Long Term Contract

• Strategic Alliances and Long Term Contract

• Strategic alliances: Long-term agreements between two or
more companies to jointly develop new products or
processes that benefit all companies that are a part of the
agreement.

• Both companies agree to make specialized investments

and work jointly to find ways to lower costs or increase
product quality so that both gain from their relationship.

• Component suppliers benefit because their business and

profitability grow as the companies they supply grow
 Alternative to Vertical Integration: Co-operative Relationships:
Strategic Alliances and Long Term Contract

• Starbucks partnered with Barnes and Nobles bookstores in 1993 to

provide in-house coffee shops, benefiting both retailers.
• In 1996, Starbucks partnered with Pepsico to bottle, distribute and
sell the popular coffee-based drink, Frappacino.
• A Starbucks-United Airlines alliance has resulted in their coffee
being offered on flights with the Starbucks logo on the cups
• a partnership with Kraft foods has resulted in Starbucks coffee being
marketed in grocery stores.
 Alternative to Vertical Integration: Co-operative Relationships:
Strategies to build long term co-operative relationships

• Strategies to build long term co-operative

relationships
• Hostage taking: Means of exchanging valuable resources to
guarantee that each partner to an agreement will keep its side of the
bargain.
• Credible commitment: Believable promise or pledge to support the
development of a long-term relationship between companies. A
contractual agreement of 10 years or above.

• Each company should possess a kind of power to discipline its partner,

if the need arise.
– Parallel sourcing strategy: A policy in which a company enters into long-term
contracts with at least two suppliers for the same component to prevent any
problems of opportunism.
 Strategic Outsourcing
• Strategic Outsourcing: Decision to allow one or
more of a company’s value-chain activities to be
performed by independent, specialist companies.
• For example 1: Microsoft and Dell have outsourced
their customer support to India.
• For example 2: Apple has outsourced their
production to China.
• For example 3: American Express outsourced it’s
entire IT function to IBM.
 Strategic Outsourcing
• Managers systematically review whether independent
companies that specialize in those activities can perform
them more effectively and efficiently.
• Because these companies specialize in particular activities,
they can perform them in ways that lower costs or improve
differentiation.
• If managers decide there are differentiation or cost
advantages, these activities are outsourced to those
specialists.
• virtual corporation has been coined to describe companies
that have pursued extensive strategic outsourcing to the
extent that they only perform the central value creation
functions that lead to competitive advantage
 Benefits of Strategic Outsourcing
• Lowest Cost Structure: Outsourcing will reduce
costs when the price that must be paid to a
specialist company to perform a particular value
chain activity is less than what it would cost the
company to internally perform that activity in-
house.
– Can be because of lower wages.
– Can also be because they are more efficient.
 Benefits of Strategic Outsourcing
• Enhanced Differentiation: the quality of the activity
performed by specialists must be greater than if
that same activity was performed by the company.
• For example, the excellence of Dell’s U.S. customer
service is a differentiating factor, and Dell
outsources its PC repair and maintenance function
to specialist companies.

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 Benefits of Strategic Outsourcing
• Focus on Core Business: it allows managers to
focus their energies and their company’s resources
on performing those core activities that have the
most potential to create value and competitive
advantage.
• In other words, companies can enhance their core
competencies and are able to push out the value
frontier and create more value for their customers.
• For example: Focus on designing better innovative
products or coming up with innovative production
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processes.
 Risks of Outsourcing
• Holdup
– Risk that a company will become too dependent upon
the specialist provider of an outsourced activity. The
outsourced company may increase prices.
• Increased competition
– Building of an industry-wide resource that lowers the
barriers to entry in that industry.
• Loss of information and forfeited learning
opportunities: A company that is not careful can
lose important competitive information when it
outsources an activity. For example: customer
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support.
Thank you