1. MKTG 450 Selected Topic in Marketing: Distribution Management Spring 2009, Dr. Stefan Wuyts Vertical integration

2. Structure: Channel functions 1. Channel Management Channel design
Vertical integration
Contracts
Partnerships
Dark sides
Power
Connectivity and control
1. Channel Management
Retailing
Private labels
Retail assortments
Cooperation in retail
Pricing
Price promotions
2. Retail Management
New trends
Collaboration and competition in retail
3. New insights

3. Topics Outsourcing versus vertical integration Transaction Cost Theory
* Relationship-specific investments
* External uncertainty
* Internal uncertainty
(Readings: Book chapter 7)

4. How to coordinate a marketing channel?
Vertical
integration
Outsourcing
Contracts
Partnerships

5. The ‘make-or-buy’ decision How does the work get done?
Vertical
integration
Outsourcing
A third party does it
How does the work get done?
You do it
Their people
Their money
Their risk
Their responsibility
Your people
Your money
Your risk
Your responsibility
The costs
Their gain or loss
The benefits
Your gain or loss

6. Forward vs. backward MANUFACTURER DISTRIBUTORS END USERS forward

7. An important decision Vertical integration …
is difficult to implement successfully
is difficult to reverse
has serious financial consequences

8. Why vertical integration? Transaction cost theory (TCT)
Economic theory that explains when activities (e.g., distribution functions) should be integrated vs. outsourced (market contracting)
Criterium:
Efficiency = revenues – variable costs
fixed costs
Choose outsourcing unless
EfficiencyVertical Integration > EfficiencyOutsourcing

9. TCT: Outsourcing as the default
Outsourcing as the default: outsourcing is more efficient because of the benefits of competition
5 advantages of outsourcing
1. Motivation
A third party has stronger incentives to perform because it (a) wants to make a profit and (b) is easy to replace
2. Specialization
3. ‘Survival of the economically fittest’
4. Economies of scale
5. Heavier market coverage

10. But then … Why not always outsource?
“Market failure”
Relationship-specific investments
External uncertainty
Vertical integration
Internal uncertainty

11. Relationship specific investments (1)
Definition
Distributor investments that are tailored to a particular manufacturer and that cannot be easily redeployed outside the relationship
Five types
Site specificity
Physical asset specificity
Dedicated asset specificity
Human asset specificity
Goodwill asset specificity (“brand equity”)

12. Relationship specific investments (2)
Site specificity
= Investments in a location close to a manufacturer and far from other manufacturers
Physical asset specificity
= Distributor investments in e.g. machinery, equipment, computer systems that are difficult to redeploy to another relationship
Dedicated asset specificity
= Expansion of distribution capacity just for one specific manufacturer and that by itself represents overcapacity

13. Relationship specific investments (3)
Human asset specificity
= Distributor investments in knowledge that cannot be readily redeployed to another relationship
Remark:
industry knowledge in general
Goodwill asset specificity
= Brand equity that is largely created by distributors
 brand equity independent of distributors’ actions (= power of manufacturer over distributors)

14. Problem caused by relationship specific investments
Relationship-specific investments cause a market to be no longer perfectly competitive
 Distributors cannot be replaced easily/cost-free
 Distributors can behave opportunistically1
e.g. - perform worse
- ask higher compensation for the same level of performance
- cheat
 Manufacturer wants to avoid this
1 Self-interest seeking in a deceitful or dishonest manner

15. Solution for this problem
Vertical integration1
 More control over employees than over independent parties
 Less opportunistic behavior
1 Or extensive contracting or partnerships … see later

16. Vertical integration: When?
Relationship specific investments
External uncertainty
Vertical integration
Internal uncertainty

17. External uncertainty Definition
= Uncertainty w.r.t. circumstances that can occur in the environment
= An environment that is difficult to forecast
Two types
Volume uncertainty
Technological uncertainty

18. Problems caused by external uncertainty
Volume uncertainty
Can you forecast sales accurately?
No  Vertical integration
Why? Difficult to predetermine everything in advance in a contract
Technological uncertainty
Can you predict technological changes accurately?
No  Market
Why? Stay flexible

19. Vertical integration: When?
Relationship specific investments
External uncertainty
Vertical integration
Internal uncertainty

20. Internal uncertainty Definition
= Uncertainty about performance of distributors
Causes:
- No performance measures
- Bad performance measures
e.g. no benchmarks, not up-to-date, inaccurate

21. Problem caused by internal uncertainty
Can you evaluate performance accurately?
No  Vertical integration
Why? If you cannot assess outputs, you should monitor inputs (= effort). You can only do this for your own employees.

22. Other, sometimes valid, reasons to integrate
Market failure
Reasons to
vertically
integrate
Reaction to market power
Creation of entry barriers
Market development

23.  Vertical integration
Advantages of vertical integration
Eliminates the problem of relationship-specific investments
Facilitates coping with volume uncertainty
Reduces performance ambiguity
Disadvantages of vertical integration
High costs  vertical integration is not always possible/efficient
The market mechanism is eliminated: it is more difficult to motivate employees than it is to motivate independent distributors

24.  The market mechanism Advantages of the market
Independent distributors want to make profit  highly motivated to perform well
Disadvantages of the market
Independent distributors maximize own profit
Independent distributors are not always willing to invest in relationship-specific investments

25.  Compromising solutions: Hybrid forms
Market Hybrid Vertical
forms integration
2 strategic choices
Extensive contracts
Partnerships

26. Conclusion Vertical integration: only when it is absolutely necessary
Remember that there are also other mechanisms to cope with market failure
Contracts  next class
Partnerships  next week