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Vertical

Integration

Chapter 6

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Vertical Integration

Strategic Management & Competitive Advantage Barney & Hesterly 2


Copyright 2006 Pearson Prentice Hall. All righ ts reserved. Strategic Management &

Competitive Advantage

-

Barney & Hesterly 2

Questions of Outsourcing?

What is offshoring?

Is outsourcing or offshoring good?

What are the ethical implications foroutsourcing?

What are the ethical implications for

offshoring? What are the implications for different

stakeholder groups?

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-

Barney & Hesterly 4

Logic of Corporate Level Strategy

Corporate level strategy should create value:

2) such that businesses forming the corporate whole

are worth more than they would be underindependent ownership

3) that equity holders cannot create through

portfolio investing

a corporate level strategy should create

synergies that are not available in equity

markets

vertical integration = value chain economies

1) such that the value of the corporate whole increases

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-

Barney & Hesterly 5

What is Vertical Integration?

Leprino Foods(Mozzarella Cheese)

Where your pizza comes from

Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

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-

Barney & Hesterly 6

What is Vertical Integration?


Dairy Farmers(milk)

Crop Farmers(Alfalfa & Corn)

Seed Companies(Alfalfa & Corn)

Food Distributors

Pizza Chains

End Consumer

BackwardVertical

Integration

Forward

Vertical

Integration

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Competitive Advantage - Barney & Hesterly 7

Value Chain Economies

Dairy Farmers(milk)

Food Distributors

BackwardVertical

Integration

Forward

Vertical

Integration


The Logic of Value Chain Economies

the focal firm is able to

create synergy with the

other firm(s)

the focal firm is able tocapture above normal

economic returns

(avoid perfect competition)

cost reduction

revenue enhancement

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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 competit ive advantage.

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Value of Vertical Integration

Market vs. Integrated Economic Exchange (Coase, 1937)

economic exchange should be conducted in the formthat maximizes value for the focal firm

markets and integrated hierarchies are forms in which

economic exchange can take place

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

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Value of Vertical Integration

Three Value Considerations

Leverage

Capabilities

Exploit

Flexibility

Manage

Opportunism

firm capabilities

may be sources

of competitive

advantage inother businesses

if not, then dont

integrate exchange

opportunism

may be checked

by internalizing

(TSI)

internalizing must

be less costly than

opportunism

internalizing is

usually less

flexible

flexibility is

prized when

uncertainty is

high

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Rarity of Vertical Integration

Integration vs. Non-Integration

a firms integration strategy may be rare because

the firm integrates or because the firm does not

integrate

thus, the question of rareness does not

depend on the number of forms observed

a firms integration strategy is rare or common with

respect to the value created by the strategy

l

l

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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

small numbers prevent further integration

capital requirements are prohibitive

V i l I i

V i l I i

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Imitability of Vertical Integration

Modes of Entry

acquisition and internal development are alternative

modes of entry into vertical integration

strategic alliances can be viewed as a substitute for

vertical integrationwithout the costs of ownership

thus, one firm may acquire a supplier while acompetitor could imitate that strategy through

internal development

in both cases, the boundaries of the firm would

encompass the new business

V ti l I t ti

V ti l I t ti

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Organizing Vertical Integration

Functional Structure (U-Form)

Accounting Finance Marketing HR Engineering

Conflict

C

onflict

Original

Business

New

Business

Original

Business

New

Business

New

Business

New

Business

New

Business

Original

Business

Original

Business

Original

Business

Cooperation

Coopera

tion

CEOs Role

V ti l I t ti

V ti l I t ti

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Management ControlsWhat needs to be controlled in a vertically integrated

firm?

cooperation and competition among and between

functions

the integration of new businesses into theexisting business

managers efforts to achieve the desired valuechain economies

time horizon of managers

V ti l I t ti

V ti l I t ti

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Management Controls

BudgetsBoard

Committees

separating strategic andoperational budgets

strategic: inputs

& outputs

operational: outputs

provide oversight anddirection to managers

help ensure that strategic

direction is maintained

These mechanisms focus management attention

on achieving value chain economies

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International Expansion

Cost

(Capital at Risk)

ControlExporting

Licensing

Franchising

Strategic All iance

Greenfield Investment

Low High

High

Acquisition

The Cost Control Tradeoff

VerticallyIntegrated

Not Vertically Integrated

Somewhat

Vertically

Integrated



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Summary


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



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Summary


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 costlyintegrate only when the

benefits outweigh the costs of integration!

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Organizing to

Implement

CorporateDiversification

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Chapter 8

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Organizing to Implement Corporate Diversification

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Implementation Issues

How Information Flows

Where and By Whom are Decisions Made

How to Influence the Behavior of People

how can the interests of employees

be aligned with the interests of the firm?


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The Need for Organizational Structure

Information Processing Requirements

as organizations become larger and more complex,

information processing requirements exceed

individual capacity

bounded rationality

satisficing

organizational structure divides information

processing into manageable blocks (span of control)


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The Agency Relationship

A Trade Off

M-Form Structure

Divides Information

Processing Requirements

Into Manageable Blocks

Divides Owners

From Managers

Interests of Owners and

Managers May Diverge


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Individual

Shareholders

Institutional

Shareholders

Senior

Executives

Corporate

Staff

Division

General

Managers

SharedActivity

Managers

The Agency Relationship

Board

Of

Directors

Managing Agency

Dual

Role

Principals Monitors Agents


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The Office of the President

Chairmanof the

Board(monitoring)

ChiefExecutive

Officer(strategy formulation)

Chief

Operating

Officer(strategy implementation)


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Organizing to Implement orporate Diversification


Information Filtering

information about the divisions businesses

is filtered as it rises to the senior executive

the senior executive can manage the informationflow

information flow should not exceed the

bounded rationality of managers at any

level in the organization

information should flow should be matched

with decision-making authority

The Office of the President

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g g p p


Refocusing

Corporate level strategy may call forexiting a business

a conglomeration discount may exist

the corporation may lack necessary skills

expected economies of scope may not exist

the corporation may need funds for core activities

Divest

AssetsSpin-offor,

MBO

IPO


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g g p p


International Implementation

Global

Strategy Multi-DomesticStrategy

Centralized Hub:

facilitates globalintegration

exploits a

global product

exploits scale

economies

Decentralized Federation:

highly autonomous units very responsive locally

Coordinated Federation:

less autonomous

some shared activities

between divisions


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g g p p


International Implementation

Transnational

Structure

facilitates both local responsiveness

and global integration

country managers are responsible for

exploiting economies of scope

corporate HQ constantly scans the

globe looking for best practices


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Strategic Management & Competitive Advantage Barney & Hesterly 14Copyrigh t 2006 Pearson Prenti ce Hall. All right s reserved. Strategic Management & Competiti ve Advantage - Barney & 8-14

Summary

Successful implementation is a matter of:

appropriately breaking information processing

into manageable blocks

aligning the interests of owners and managers

These can be accomplished through:

Organizational Structure

Management Controls

Compensation Policies

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Strategic

Alliances

Chapter 9

Strategic Alliances

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Strategic Management & Competitive Advantage Barney & Hesterly 22Copyright 2006 Pearson Prentice Hall. All righ ts reserved. Strategic Management &

Competitive Advantage - Barney & Hesterly

Mission Objectives

External

Analysis

Internal

Analysis

Strategic

Choice

Strategy

Implementation

Competitive

Advantage

The Strategic Management Process

Corporate Level

Strategy

Which Businesses

to Enter?


Diversification

Strategic Alliances

mode of entry

Strategic Alliances

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Strategic Alliances Defined

Strategic Alliance:

Any cooperative effort between two or more

independent organizations to develop,

manufacture, or sell products or services

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Strategic Alliances

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Three Types

Of

Alliances

Nonequity

Alliance

Contracts

licensing supply &

distribution

agreements

Joint

Venture

Equity

Alliance

Cross Equity

Holdings

partners own

stakes in

eachother

Joint Equity

Holdings

independent

firm is

created

Strategic Alliances

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How Strategic Alliances Create Value

Improve Current Operations

Shaping the Competitive Environment

Facilitating Entry and Exit

Value

Creation

Strategic Alliances

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Improving Current Operations

Exploiting economies of scale

a partner brings increased market share

and/or manufacturing capacity

Learning from partners

a partner brings technology and/or

market knowledge

Risk and cost sharing

a partner bears a portion of the risk and/or

cost of the alliance

Strategic Alliances

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Creating a Favorable Competitive Environment

Facili tating technology standards

Facilitating tacit collusion

partners may agree on a standard and avoid

a market battle for the standard

partners may communicate within an alliance

in subtle, legal ways whereas the same

communication between competitors outside

an alliance would be illegal

Network Industries

increasing returns to scale

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Strategic Alliances

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Challenges to Value Creation and Allocation

Incentives to Misappropriate Value (Cheat)

An alliance is an exchange context in which:

partner inputs may be difficult to monitor

actual value creation may be difficult to monitor

value appropriation (allocating the value) may be:

difficult to monitor

subject to power dynamics

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Strategic Alliances

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Sustained Competitive Advantage

Are strategic alliances rare?

As a form of organizing economic exchange, NO!

The sources of value creation within alliances

may be rare.

However,

firms may form a combination of complementary

resources within an alliance that is rare

the stock of such complementary resources may

be limited so that first movers have a rare combination

Strategic Alliances

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Are strategic alliances costly to imitate?

As a form of organizing economic exchange, NO!

However,

The resource combinations that create value in

alliances may be very costly, if not impossible,

to imitate if:

the organizational form per se is easily duplicated

the value creating combination depends on

social complexity (trust), causal ambiguity,

and/or historical uniqueness

Strategic Alliances

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Are strategic alliances substitutable?

Substitutes forStrategic Alliances

Internal

Development:

Going It Alone

Mergers &

Acquisitions

If: no partner

is available

transaction-specific

investment is high

low uncertainty about

the investment

If: there are no

anti-trust issues

low uncertainty about

the investment

firms can be

integrated easily

value of combined firms is

not tied to independence

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Strategic Alliances

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Trust Firm Reputations

Informal

Organizing Strategic Alliances

Governance Responses to the Challenges of

Value Creation and Allocation

the shadow of the

future constrainscheating

may allow partners

to exploit opportunitiesthat would be infeasible

with other mechanisms

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Strategic Alliances

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International Expansion

Alliances may be attractive because:

local market knowledge is usually critical

governments may require a local partner

international expansion may be:

fraught with uncertainty

high risk

expensive

alliance investment may be more easily reversed

than internal development or acquisition

Strategic Alliances

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Summary

create alliances that will produce gains

from tradecomplementary resources

identify the sources of value creation

assess the likelihood of challenges to value

creation and allocation

adopt appropriate governance responses tothe challenges to value creation and allocation

Successful alliance managers will:

Strategic Alliances

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Summary

Alliances may generate competitive advantage if: combinations of complementary resources

meet the VRIO criteria

governance responses meet the VRIO criteria

The Big Challenge of Strategic Alliances:Maximizing gains from trade while

minimizing the threat of cheating

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Mergers and

Acquisitions

Copyright 2006 Pearson Prentice Hall. All righ ts reserved. Strategic Management &Competitive Advantage - Barney & Hesterly 10-1

Chapter 10

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Mergers & Acquisitions

Mergers and Acquisitions

Logic of Corporate Level Strategy Applies

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Strategic Management & Competitive Advantage Barney & Hesterly 3Copyright 2006 Pearson Prentice Hall. All righ ts reserved. Strategic Management &Competitive Advantage - Barney & Hesterly 10-3

Logic of Corporate Level Strategy Applies

Corporate level strategy should create value:

2) such that businesses forming the corporate wholeare worth more than they would be underindependent ownership

3) that equity holders cannot create throughportfolio investing

1) such that the value of the corporate whole increases



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Mergers & Acquisitions Defined

Mergers Acquisitions

two firms are combined ona relatively co-equal basis

one firm buys anotherfirm

the words are often used interchangeably even

though they mean something very different

merger sounds more amicable, less threatening



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parent stocks are usuallyretired and new stock issued

name may be one of theparents or a combination

can be a controllingshare, a majority, orall of the target firmsstock

can be friendly orhostile

Mergers Acquisitions


usually done througha tender offer

one of the parents usuallyemerges as the dominantmanagement



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Types of M&A Activity

FTCCategories

Vertical

Horizontal

Product Extension

Market Extension

Conglomerate

suppliers or customers

competitors

complementary products

complementary markets

everything else

Related

Unrelated

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Do Mergers and Acquisitions Create Value?

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The Logic

Related M&A Activity

value creation would be expected due tosynergies between divisions

economies of scale

economies of scope

transferring competencies

sharing infrastructure, etc.




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The Empirical Evidence

this reflects the markets assessment of theexpected value of the merger or acquisition

these studies look at what happens to the price

of both the acquirers stock and the targets stock

thus, we can see who is capturing any expectedvalue that may be created

Research is based on stock market reaction to theannouncement of M&A activity




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The Empirical Evidence

Acquiring

Firms

Target

Firms

M&A Activity creates value, on average, as follows:

no value created value increases byabout 25%

related M&A activity creates more value thanunrelated M&A activity

M&A activity creates value, but target firms capture it



Entrepreneurship in M & As (p 318)

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Entrepreneurship in M & As (p.318)

Business Angels

Venture Capital Firms (VC)

Initial Public Offering (IPO)

Cashing Out

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Why is M&A Activity So Prevalent?

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If managers know that acquiring firms do notcapture any value from M&As, why do theycontinue to merge and acquire?

AgencyProblems

ManagerialHubris

managers benefit from increases in size managers benefit from diversification

managers believe they can beat the odds




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If managers know that acquiring firms do notcapture any value from M&As, why do theycontinue to merge and acquire?

Above NormalProfits

proposed M&A activity may satisfy

the logic of corporate level strategy

managers may see economies thatthe market cant see

some M&A activity does generateabove normal profits (expected andoperational over the long run)



Competit ive Advantage

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Yes, if managers abilities meet VRIO criteria


Can an M&A strategy generate sustained

competitive advantage?

2 Managers may be good at doing deals

1 Managers may be good at recognizing & exploitingpotentially value-creating economies with other firms

3 Managers may be good at both

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Recognizing and Exploiting Economies of Scope

Costly-to-ImitateEconomies

Firm A

Firm B

Firm C

Bidders Target

if the economybetween A & Cis costly to imitate,it doesnt matter

if other firms know

Firm A can still earna $2,000 profit




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Recognizing and Exploiting Economies of Scope

Firm A

Firm B

Firm C

Bidders Target

UnexpectedEconomies

Firm C has a marketvalue of $10,000

Firm A buys Firm Cfor $10,000

Firm C turns out to beworth $12,000




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p g

Doing the Deal

Bidding FirmsPerspective

Search forRare Economies

Limit Information

to Other Bidders

Limit Informationto the Target

Avoid BiddingWars

Close theDeal Quickly

Seek Thinly

Traded Markets




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p g

Doing the Deal

Target FirmsPerspective

Seek Informationfrom Bidders

Invite Other Bidders toJoin in Bidding Contest

Delay, But Do NotStop the Acquisition




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Structure, Control, and Compensation

M&A activity requires responses to these issues:

m-form structure is typically used

management controls & compensation policiesare similar to those used in diversification strategies

Managers must decide on the level of integration:

target firm may remain somewhat autonomous

target firm may be completely integrated

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Target Response Strategies to a

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g p gTakeover Attempt

Reduce the wealth of target firm equity holders. Greenmail

Standstill Agreements

Poison Pills Do not affect wealth of target firm equity holders.

Shark Repellents

Pac Man Defense

Crown Jewel Sale Law Suits

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International Issues

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Cultural Issues

Time OrientationLong-term Short-term

Goal OrientationAggressive Passive

Uncertainty OrientationAcceptance Avoidance

Power Orientation ToleranceRespect

Social OrientationIndividualism Collectivism

(Hofstede, 1980)



Summary

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M&A activity is a mode of entry for vertical

integration and diversification strategies

M&A activity can create economic value atannouncement, but target firms usually capturethat value

A firms M&A strategy should satisfy thelogic of corporate level strategy

M&A activity can create value over the long term

exam 2 chap6-10

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