Portfolio Management
Vertical Integration Strategies
Vertical integration strategies are "make or buy" decisions. Should a company manufacture goods or provide services that are available from the market? The traditional economic model would suggest that a company ought not be able to acquire goods or services more efficiently that is available from the "market", that is from other competing firms. Yet, as we shall se, corporations do diversify vertically and achieve economies that are not available from the market.
There are numerous examples where corporations have pursued vertical strategies only to exit the strategy either to gain market efficiencies or other advantages. For example, Coca cola historically owned many of its bottlers and also used franchised bottlers. More recently, Coca Cola has spun off the bottling facilities as an independent firm. Bottling and distribution are competencies better mastered by other firms. Coca Cola is better at manufacturing and innovating soft drink concentrates. PepsiCo offers a similar lesson. Having build a strong fast food restaurant business (Pizza Hut, KFC, and Taco Bell), PepsiCo divested these buyers from its portfolio to concentrate on, well, concentrates.
Vertical integration strategies make sense, when the businesses can also be seen in connected stages of production:
VERTICAL INTEGRATION IN THE
STYRENE CARTON INDUSTRY
The decision to vertically integrate is driven by:
1. Captive Markets - the firm depends upon and utilizes most of what it produces
2. Outside markets - the firm is able to sell surplus or excess supply
3. Strategically - backward vertical integration reduces the power of suppliers - low level of competition in the supplying industry. Forward integration reduces the power of buyers.
4. What are the costs/benefits of vertical integration can be a firm specific analysis
5. Tax policy benefits - by shifting supplies of highly profitable production divisions to less profitable divisions, taxes can be reduced through vertical integration
EXAMPLE: Alaska taxes oil at the well head. The well head price is the market prices of oil minus its transportation costs. In Alaska the transportation costs of oil are the costs of transporting oil through the Alaskan oil pipe. The oil pipe line is owned by the companies that drill the oil. Taxes on the pipeline's profits are low. So, the oil companies charge themselves a high rate for using the pipe line - take high profits in transporting oil - and pay the Alaskan oil tax on oil that is cheap (the price being the market price of oil minus transportation costs). Vertical integration for oil companies - forward to channels of distribution - make tax sense and enables firms to shift profits from the oil business to their pipe line business.
6. There is an economy in vertical integration - non-integrated firms incur costs in searching and in contracting with suppliers - lower transactions costs
7. Asset specificity can encourage use of vertical integration - For example: timber and pulp industry. Paper manufacturing requires a commitment to specific plant assets and technology. It also is dependent upon specific raw materials - Pulp. Paper manufacturing is a two phased process: conversion of wood into pulp; and conversion of pulp into paper. Both processes are specific to the other, An economy of scale is yielded by integrating the two processes.
8. Information - reliance on inside producers enable the parent to monitor its costs of production of raw materials and distribution costs in ways that the non-integrated firm cannot - opportunistic behavior is reduced (agency problem).
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