PowerPoint Presentation by Charlie Cook Gordon Walker McGraw-Hill/Irwin Copyright © 2004 McGraw Hill Companies, Inc. All rights reserved. Chapter 6 Vertical Integration and Outsourcing

6–2 Theories of Vertical Integration Key assumptions Key assumptions –The employment relationship –Ownership Transaction cost theory Transaction cost theory Theory of property rights Theory of property rights

6–3 The Employment Relationship Employees, unlike market suppliers, give up control over aspects of work that cannot be specified in detail. Employees, unlike market suppliers, give up control over aspects of work that cannot be specified in detail. Employee recourse against the firm is generally more limited than the recourse of a supplier. Employee recourse against the firm is generally more limited than the recourse of a supplier.

6–4 Transaction Cost Theory Key assumption is that all contingencies in a supply relationship cannot be specified: Key assumption is that all contingencies in a supply relationship cannot be specified: –Transaction costs in the market increase relative to vertical integration as a supplier invests in assets specialized to the firm. –These costs are aggravated by high levels of uncertainty.

6–5 The Efficient Boundaries Model Figure 6.1 Source: Adapted from Oliver Williamson, “The Economics of Organization: The Transaction Cost Approach,” American Journal of Sociology 87 (1981), p. 560.

6–6 The Efficient Boundaries Model Market supply should always be the first consideration when: Market supply should always be the first consideration when: –The input is not customized for the buyer. –Transactions with market suppliers are more efficient than in-house transactions. –Production costs are much higher in-house.

6–7 The Efficient Boundaries Model In-house production becomes more attractive when: In-house production becomes more attractive when: –Input customization increases and market suppliers use their bargaining power to reduce the firm’s surplus from the input. –In-house transactions are among firm employees who lack the transacting power of suppliers. –The production cost advantage of market suppliers declines with customization due to a lower volume of purchases reducing scale-based efficiencies.

6–8 Property Rights Theory A firm vertically integrates because it has more to gain from owning and operating the activity than the market supplier. A firm vertically integrates because it has more to gain from owning and operating the activity than the market supplier. –This theory is most applicable to resources that can be traded. –It is difficult to separate the value of the asset independently of employees (with specific capabilities) attached to it.

6–9 Strategy and Control A firm wants to control investment decisions in supplier resources and capabilities that are strategically important. A firm wants to control investment decisions in supplier resources and capabilities that are strategically important. –Strategically important activities are more likely to be specialized to the firm as it becomes more involved in supplier investment decisions.

6–10 Types of Control Problems Distribution of economic gain from the supply relationship Distribution of economic gain from the supply relationship –Negotiation over price: »What is the buyer’s surplus? »What is the supplier’s profit? Supplier investment decisions are focused on value and cost Supplier investment decisions are focused on value and cost –Assets and activities –Human resources –Management processes

6–11 Types of Control Problems (cont’d) Supplier handling of strategically sensitive information about the firm: Supplier handling of strategically sensitive information about the firm: –Technological –Strategic

6–12 Strategic Sourcing Framework Figure 6.2

6–13 Patterns of Vertical Integration I Initial market purchase of a standard input Initial market purchase of a standard input –Low buyer competence –Low strategic importance Rising strategic importance of the input Rising strategic importance of the input –Low buyer competence –High strategic importance Supplier unable to give the firm the control it needs Supplier unable to give the firm the control it needs –Partnering fails

6–14 Patterns of Vertical Integration I (cont’d) The firm vertically integrates as it invests in building capabilities to increase its competence. The firm vertically integrates as it invests in building capabilities to increase its competence. –High buyer competence –High strategic importance Key point: The firm has a strong incentive to continue investing in the activity since it is strategically important. Key point: The firm has a strong incentive to continue investing in the activity since it is strategically important.

6–15 Patterns of Vertical Integration II Initial market purchase of a standard input Initial market purchase of a standard input –Low buyer competence –Low strategic importance The firm’s competence rises due to unrelated investments in capabilities. The firm’s competence rises due to unrelated investments in capabilities. –High buyer competence –Low strategic importance The firm vertically integrates even though the input is not strategically important. The firm vertically integrates even though the input is not strategically important.

6–16 Patterns of Vertical Integration II Key point: the firm has no incentive to continue investing in the activity since it is not strategically important. Key point: the firm has no incentive to continue investing in the activity since it is not strategically important.

6–17 Patterns of Outsourcing I Producing a specialized input in a firm Producing a specialized input in a firm –High buyer competence –High strategic importance The firm’s competence relative to competitors decreases. The firm’s competence relative to competitors decreases. –Low buyer competence –High strategic importance The firm’s partnership with a market supplier gives it control over investment decisions to support the firm’s market position. The firm’s partnership with a market supplier gives it control over investment decisions to support the firm’s market position.

6–18 Patterns of Outsourcing I (cont.) The partner fails to cooperate effectively The partner fails to cooperate effectively –The firm invests in new capabilities to increase its competence and vertically integrates the activity. –The firm reduces the strategic importance of the activity and sources the input from a standard market supplier.

6–19 Patterns of Outsourcing II Initial purchase of a specialized input Initial purchase of a specialized input –High buyer competence –High strategic importance Strategic importance of the input decreases Strategic importance of the input decreases –High buyer competence –Low strategic importance The firm disinvests in the activity The firm disinvests in the activity –Low buyer competence –Low strategic importance The firm outsources to a competent supplier The firm outsources to a competent supplier

6–20 Key Points Control needs dominate vertical integration decisions. Control needs dominate vertical integration decisions. Control and buyer competence affect outsourcing. Control and buyer competence affect outsourcing. Vertical integration almost always involves a change in the way the activity is executed. Vertical integration almost always involves a change in the way the activity is executed. –Otherwise there would be no benefit from increased control.

6–21 The Problem of Uncertainty Areas of significant uncertainty: Areas of significant uncertainty: –The level of demand for the organization’s product –The long-term viability of the organization’s product or process technology –The price of labor and other inputs to the organization’s production process. Types of uncertainty Types of uncertainty –Volume –Technological –Supplier input costs »Labor and materials

6–22 The Problem of Uncertainty (cont’d) Focus on volume and technological uncertainty Focus on volume and technological uncertainty –Volume uncertainty »Generally, higher volume uncertainty leads to higher levels of vertical integration. –Technological uncertainty »Higher levels of technological uncertainty lead to lower levels of vertical integration, especially if the market is competitive.

6–23 The Problem of Consistency Gains from consistency among activities determine in part the firm’s need for control over them. Gains from consistency among activities determine in part the firm’s need for control over them. System-wide benefits from coordination inhibit the outsourcing of a single activity. System-wide benefits from coordination inhibit the outsourcing of a single activity.

6–24 Strategic Boundaries Over the Industry Life Cycle Stigler’s theory Stigler’s theory –In the early stages of industry development, firms are integrated because their demand for inputs is too small to attract entry of suppliers. –As the industry grows and matures, suppliers enter and produce inputs for many firms. –Firms engage in outsourcing to gain benefits from lower supplier costs. –As demand drops due to rising substitutes, suppliers exit and industry firms re-integrate production.

6–25 Strategic Boundaries Over the Industry Life Cycle (cont’d) Caveats to Stigler’s theory Caveats to Stigler’s theory –Stigler’s theory only works for inputs that: »Are specific to the new industry. »Require supplier investment in specialized production technology. –Otherwise, suppliers may use parts of existing production technology to make the new input.

6–26 Make or Buy Software Figure 6.3