Vertical Integration

Question 1

Vertical Integration

Answer 1

a type of organization structure where a firm combines the various functions of a business such as supply, production, selling, distribution, and/or other economic processes.

Question 2

Vertical integration 2

Answer 2

in terms of a “make vs. buy” decision

Question 3

“make vs. buy” decision

Answer 3

these decisions involve a much broader group of strategic issues than the financial considerations involved in the typical make or buy calculation.

Question 4

Economies of Integration

Answer 4

Economies of integration refer to the benefits obtained when the volume of throughput is large enough to support economies of scale in the integrated units

Question 5

Economies of Combined Operations

Answer 5

Benefits may include a reduction in the number of steps required, a reduction in handling and transportation costs, and the utilization of slack capacity.

Question 6

Economies of Internal Control and Coordination

Answer 6

Benefits may include less slack and idle time, steadier supply, smoother deliveries, less inventory, better control and coordination of schedules, maintenance, styling, and design changes.

Question 7

Economies of Information

Answer 7

Integration may reduce the cost of obtaining information about demand, supply, and prices.

Question 8

Economies of Avoiding the Market

Answer 8

Integration can provide savings in the cost related to selling, shopping for, and negotiating prices, and other costs of market transactions.

Question 9

Economies of Stable Relationships

Answer 9

Integration may enable units of the firm to develop specialized procedures and systems, e.g., dedicated logistical systems, special packaging, and special procedures for record-keeping and control.

Question 10

Fit to Overall Strategy

Answer 10

The economies mentioned above are also important because they can support a firm’s strategy in other ways, e.g., provide support for a low-cost production strategy.

Question 11

Tap Into Technology

Answer 11

Firms may integrate forwards or backward to better understand the technology of components going into their products, or to understand the technology related to how their products are used.

Question 12

Assure Supply and/or Demand

Answer 12

Vertical integration reduces the uncertainty related to the risk associated with interruptions, changes in suppliers or customers, and prices. However, transfer prices should reflect market prices to ensure both upstream and downstream units are managed properly. (Transfer pricing is a complex topic.)

Question 13

Offset Bargaining Power and Input Cost Distortions

Answer 13

Vertical integration can also lower supply costs and reveal the true cost of inputs (through backward integration), or increase price realization (through forwarding integration). However, transfer pricing policies can work against obtaining these benefits.

Question 14

Enhanced Ability to Differentiate

Answer 14

Vertical integration can enable the firm to provide superior service and differentiate in other ways such as producing in-house proprietary components.

Question 15

Elevate Entry and Mobility Barriers

Answer 15

The advantages of integration like those mentioned above add entry barriers for new entries or unintegrated firms who must integrate to become competitive.

Question 16

Enter a Higher Return Business

Answer 16

In some cases, integration may offer a higher return on investment where the return from the adjacent stage is greater than the firm’s current stage and high enough to offset any entry barriers.

Question 17

Defend Against Foreclosure

Answer 17

The unintegrated firm may have to integrate when competitors are integrated to maintain access to suppliers and customers.

Question 18

Cost of Overcoming Mobility Barriers

Answer 18

The cost of overcoming entry barriers can be a significant cost of integration unless proprietary technology and sources of raw materials are not significant barriers, and the scale required for an efficient integrated unit is not prohibitive.

Question 19

Increased Operating Leverage

Answer 19

Vertical integration increases the firm’s proportion of the fixed cost and operating leverage, adding a greater risk from fluctuations in the business cycle.

Question 20

Reduced Flexibility to Change Partners

Answer 20

In cases where a supplier or customer is no longer suitable, vertical integration increases the costs of changing suppliers or customers relative to contracting with independent entities.

Question 21

Higher Overall Exit Barriers

Answer 21

Any of the exit barriers may be increased by vertical integration.

Question 22

Capital Investment Requirements

Answer 22

Vertical integration can drain capital away from where it is needed and expose the firm to greater risk in other areas of the business. Thus, the return from integration should be above the firm’s opportunity cost of capital, adjusting for the benefits previously discussed.

Question 23

Foreclosure of Access to Supplier or Consumer Research and/or Know-How

Answer 23

Vertical integration may cut off access to the supplier or customer technology because it puts the firm in competition with those entities.

Question 24

Maintaining Balance

Answer 24

Balancing internal demand and supply to avoid excess capacity may be difficult when there are technological, product mix, or quality changes in one stage that creates unequal capacity. This situation may require the firm to sell or buy from competitors who might be reluctant to cooperate.

Question 25

Dulled Incentives

Answer 25

Integrated units of firms may not bargain as well with each other, and in some cases may attempt to support an unhealthy sister unit because of a sense of fairness and comradeship.

Question 26

Differing Managerial Requirements

Answer 26

Integrated units of a business may require very different organization structures, management skills, controls, incentives and other techniques. For this reason, the need to learn how to properly manage integrated units can add considerable cost and risk to the vertically integrated firm.

Question 27

Strategic Benefits of Integration

Answer 27

Economies of Integration
Economies of Combined Operations 
Economies of Internal Control and Coordination
Economies of Information
Economies of Avoiding the Market
Economies of Stable Relationships
Fit to Overall Strategy
Tap Into Technology
Assure Supply and/or Demand
Offset Bargaining Power and Input Cost Distortions
Enhanced Ability to Differentiate
Elevate Entry and Mobility Barriers 
Enter a Higher Return Business
Defend Against Foreclosure

Question 28

Particular Strategic Issues in Forward Integration

Answer 28

Improved Ability to Differentiate the Product
Access to Distribution Channels
Better Access to Market Information
Higher Price Realization

Question 29

Improved Ability to Differentiate the Product

Answer 29

Forward integration such as adding distribution and retail units can provide a basis for differentiation by providing a basis for controlling the sales presentation, customer service, image of the store location, and other elements of the customer relationship.

Question 30

Access to Distribution Channels

Answer 30

Forward integration removes the bargaining power of distribution channels.

Question 31

Better Access to Market Information

Answer 31

Forward integration into the demand leading stage (where the demand originates) can provide critical market information that is needed to avoid the cost of overages and underrages resulting from cyclical or erratic demand.

Question 32

Higher Price Realization

Answer 32

Forward integration may allow a firm to charge different prices to different customers resulting in higher overall prices, although arbitrage may occur, and the practice may be illegal in some cases. For example, a firm might set the price of a basic product low for some customers that also buy associated products that allows the firm to recoup the basic price difference. This is legal if the buyer is not required to purchase the associated products as a condition for purchasing the basic product.

Question 33

Particular Strategic Issues in Backward Integration

Answer 33

Proprietary Knowledge

Differentiation

Question 34

Proprietary Knowledge

Answer 34

Integrating with a firm’s suppliers can avoid providing proprietary information to outside suppliers who would have considerable bargaining power and pose a threat of entry.

Question 35

Differentiation

Answer 35

Integrating backward to gain control over the production of key inputs may improve the final product and/or distinguish it from competitors’ products

Question 36

If the volume is below an efficient unit’s volume

Answer 36

the firm will either have to build a small inefficient unit, or build an efficient unit that may have to sell to its competitors.

Question 37

The benefits of vertical integration depend on

Answer 37

on whether the volume of throughput (i.e., the products or services sold or purchased by upstream or downstream units) is large enough to obtain the economies of scale needed to support an efficient unit.

Question 38

Economies of scale

Answer 38

Economies of scale are cost advantages reaped by companies when production becomes efficient. Companies can achieve economies of scale by increasing production and lowering costs.

This happens because costs are spread over a larger number of goods. Costs can be both fixed and variable.
The size of the business generally matters when it comes to economies of scale. The larger the business, the more the cost savings.

Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors.

Question 39

Economies of Scope

Answer 39

An economy of scope means that the production of one good reduces the cost of producing another related good. Economies of scope occur when producing a wider variety of goods or services in tandem is more cost-effective for a firm than producing less of a variety, or producing each good independently. In such a case, the long-run average and marginal cost of a company, organization, or economy decrease due to the production of complementary goods and services.

Question 40

Economies of scale Vs. Economies of Scope

Answer 40

While economies of scope are characterized by efficiencies formed by variety, economies of scale are instead characterized by volume. The latter refers to a reduction in marginal cost by producing additional units. Economies of scale, for instance, helped drive corporate growth in the 20th century through assembly-line production.

Question 41

Pareto Principle

Answer 41

The Pareto Principle, named after esteemed economist Vilfredo Pareto, specifies that 80% of consequences come from 20% of the causes, asserting an unequal relationship between inputs and outputs. This principle serves as a general reminder that the relationship between inputs and outputs is not balanced. The Pareto Principle is also known as the Pareto Rule or the 80/20 Rule.

Question 42

Pareto Principle 2

Answer 42

The Pareto Principle can be applied in a wide range of areas such as manufacturing, management, and human resources. For instance, the efforts of 20% of a corporation’s staff could drive 80% of the firm’s profits.

Question 43

Parkinson’s law

Answer 43

Is the adage that “work expands so as to fill the time available for its completion”.[1] It is sometimes applied to the growth of bureaucracy in an organization.

Question 44

Peter Principle

Answer 44

The Peter Principle is thus based on the paradoxical idea that competent employees will continue to be promoted, but at some point will be promoted into positions for which they are incompetent, and they will then remain in those positions because of the fact that they do not demonstrate any further competence that would get them recognized for additional promotion.

Question 45

Peter Principle 2

Answer 45

According to the Peter Principle, every position in a given hierarchy will eventually be filled by employees who are incompetent to fulfill the job duties of their respective positions.