BUS 498 CH8

Vertical value chains (industry value chains)

because they depict the transformation of raw materials into finished goods and services along distinct vertical stages. Each stage of the vertical value chain typically represents a distinct industry in which a number of different firms are competing

Backward vertical integration (ref to graph)

changes in an industry value chain that involve moving ownership of activities upstream to the originating (inputs) point of the value chain

Diversification

encompasses the variety of products and services a firm offers or markets and the geographic locations in which it competes

Vertical integration

refers to the firm's ownership of its production of needed inputs or of the channels by which it distributes its outputs

The advantages and disadvantages of markets include:

▪ High-powered incentives - High-powered incentives of the open market include the entrepreneur's ability to capture the venture's profit, to take a new venture through an initial public offering (IPO), ▪ Increased flexibility. Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers. ▪ Search costs- transacting in markets, rather than owning the various production and distribution activities within the firm itself, entails nontrivial search costs. ▪ Opportunism by other parties. ▪ Incomplete contracting (information asymmetry Situation in which one party is more informed than another because of the possession of private information. _ sellers have better information about products and services than buyer) , ▪ Enforcement of contracts. It often is difficult, costly, and time-consuming to enforce legal contracts

RISKS OF VERTICAL INTEGRATION

▪ Increasing costs. ▪ Reducing quality. ▪ Reducing flexibility. ▪ Increasing the potential for legal repercussions. Ex. Ford experienced diseconomies of scale (see Exhibit 6.5) due to its level of vertical integration and the unwieldy size of its huge plants.

BENEFITS OF VERTICAL INTEGRATION

▪ Lowering costs. ▪ Improving quality. ▪ Facilitating scheduling and planning. ▪ Facilitating investments in specialized assets. ▪ Securing critical supplies and distribution channels.

STRATEGIC OUTSOURCING

- which involves moving one or more internal value chain activities outside the firm's boundaries to other firms in the industry value chain. - Rather than developing their own human resource management systems, for instance, firms outsource these noncore activities to companies such as PeopleSoft (owned by Oracle), EDS (owned by HP), or Perot Systems (owned by Dell), which can leverage their deep competencies and produce scale effects.

Transaction cost economics

-A theoretical framework in strategic management to explain and predict the boundaries of the firm, which is central to formulating a corporate strategy that is more likely to lead to competitive advantage. -Key Q- Given the efficiencies of free markets, why do firms even exist? -different institutional arrangements—markets versus firms—have different costs attached.

Alternatives on the Make-or-Buy Continuum

(Less integration) -short term contracts * sends out requests for proposals (RFPs) to several companies allows a somewhat longer planning period than individual market transaction -strategic alliances *trategic alliances can facilitate investments in transaction-specific assets without encountering the internal transaction costs involved in owning firms (ex. long-term contracts, equity alliances, and joint ventures) - equity alliance—a partnership in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock or assets (in private companies), and thus making an equity investment. -parent subsidiary relationship he parent-subsidiary relationship describes the most-integrated alternative to performing an activity within one's own corporate family (and thus anchors the make-or-buy continuum in Exhibit 8.4 on the "make" side). The corporate parent owns the subsidiary and can direct it via command and control.(More integration)

Transaction costs (occur inside and outside firm)

- costs are all internal and external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets - hows the respective internal transactions costs within Firm A and Firm B, as well as the external transactions that occur when Firm A and Firm B do business with one another.

Factors that help in determining the boundaries of the firm

1. Core competencies are unique strengths embedded deep within a firm, In this perspective, the internally held knowledge underlying a core competency determines a firm's boundaries. 2. Economies of scale occur when a firm's average cost per unit decreases as its output increases. Larger market share, therefore, often leads to lower costs 3. Economies of scope are the savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology 4. Transaction costs are all costs associated with an economic exchange. enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification.

7 reasons why firms need to grow

1. Increase profits.term-6 2. Lower costs. 3. Increase market power. (note. Fewer competitors generally equates to higher industry profitability/larger firms have more bargaining power with suppliers and buyers) 4 Reduce risk. (falling sales and lower performance in one sector (e.g., GE's oil and gas unit) might be compensated by higher performance in another) 5 Motivate management.

ALTERNATIVES TO VERTICAL INTEGRATION

1. Taper Integration 2. Strategic Outsourcing

Corporate strategy determines the boundaries of the firm along three dimensions

1. vertical integration along the industry value chain (chain describes the transformation of raw materials into finished goods and services along distinct vertical stages.) 2. diversification of products and services 3. geographic scope (regional, national, or global markets)

3 Q'S of CORPORATE STRATEGY

1. what stages of the industry value chain should a company participate in? (question 1 2. what range of products and services to offer? 3. where Amazon competes geographically

Taper Integration

A way of orchestrating value activities in which a firm is backwardly integrated but also relies on outside-market firms for some of its supplies and/or is forwardly integrated but also relies on outside-market firms for some of its distribution. Ex. Both Apple and Nike, for example, use taper integration: They own retail outlets but also use other retailers, both the brick-and-mortar type and online. . . -For example, when adjusting to fluctuations in demand, a firm could cut back on the finished goods it delivers to external retailers while continuing to stock its own stores. -It exposes in-house suppliers and distributors to market competition so that performance comparisons are possible.

external transaction costs

Costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

internal transaction costs

Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs. (retaining employees; paying salaries and benefits; setting up a shop floor; providing office space)

Original equipment manufacturing firms (OEMs)

Firms regularly start out as OEMs and then vertically integrate along the value chain in either a backward and/or forward direction. With these moves, former contractual partners to brand-name phone makers such as Apple and Samsung then become their competitors. OEMs are able to vertically integrate because they acquire the skills needed to compete in adjacent industry value chain activities from their alliance partners, which need to share the technology behind their proprietary phone to enable large-scale manufacturing.

note In this figure, note HTC's transformation from a no-name OEM manufacturer in stage 2 of the vertical value chain to a player in the design, manufacture, and sale of smartphones (stages 1 and 3). It now offers a lineup of innovative and high-performance smartphones under the HTC label.30

HTC's (phone) Backward and Forward Integration along the Industry Value Chain in the Smartphone Industr

note- Moving from transacting in the market ("buy") to full integration ("make"), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent-subsidiary relationships.

Moving from transacting in the market ("buy") to full integration ("make"), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent-subsidiary relationships.

On the other end of the spectrum are firms that are more or less vertically disintegrated with a low degree of vertical integration. These firms focus on only one or a few stages of the industry value chain. Apple, for example, focuses only on design, marketing, and retailing; all other value chain activities are outsourced.

On the other end of the spectrum are firms that are more or less vertically disintegrated with a low degree of vertical integration. These firms focus on only one or a few stages of the industry value chain. Apple, for example, focuses only on design, marketing, and retailing; all other value chain activities are outsourced.

Stages of industry value chain

Stage 1. Raw Materials Stage 2. Components/Intermediate Goods (touchscreens,displays) Stage 3. Final Assembly/Manufacturing (typically assemble cell phones under contract for consumer electronics like apple) Stage 4 and 5 Marketing/Sales After-Sales Service and Support

Strategy formulation centers around the key questions of where and how to compete. Business strategy concerns the question of how to compete in a single product market.

Strategy formulation centers around the key questions of where and how to compete. Business strategy concerns the question of how to compete in a single product market.

corporate strategy

The decisions that senior management makes and the goal-directed actions it takes to gain and sustain competitive advantage in several industries and markets simultaneously.

specialized assets

Unique assets with high opportunity cost: They have significantly more value in their intended use than in their next-best use. They come in three types: site specificity, physical-asset specificity, and human-asset specificity. . . ▪ Site specificity—assets required to be co-located, such as the equipment necessary for mining bauxite and aluminum smelting. ▪ Physical-asset specificity—assets whose physical and engineering properties are designed to satisfy a particular customer. Examples include the bottling machinery for E&J Gallo. Given the many brands of wine offered by E&J Gallo, unique equipment, such as molds and a specific production process, is required to produce the different and trademarked bottle shapes. ▪ Human-asset specificity—investments made in human capital to acquire unique knowledge and skills, such as mastering the routines and procedures of a specific organization, which are not transferable to a different employer.

FIRMS VS. MARKETS: MAKE OR BUY?

When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market (Cin-house < Cmarket), then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs.

vertical market failure

When the markets along the industry value chain are too risky, and alternatives too costly in time or money. occurs for example, few clothing-makers want to own textile factories, with their pollution risks and slim profits -findings suggest that when a company vertically integrates two or more steps away from its core competency, it fails two-thirds of the tim

Why is the Coca-Cola Co. forming an equity alliance with Monster Beverage Corp. and not just entering a short- or long-term contract, such as a distribution and profit-sharing agreement? One reason is that an equity investment in Monster might give Coca-Cola an inside look into the company. Gaining more information could be helpful if Coca-Cola decides to acquire Monster in the future. Gaining such private information might not be possible with a mere contractual agreement. Buying time is also helpful so Coca-Cola Co. can see how the wrongful death lawsuits play out

Why is the Coca-Cola Co. forming an equity alliance with Monster Beverage Corp. and not just entering a short- or long-term contract, such as a distribution and profit-sharing agreement? One reason is that an equity investment in Monster might give Coca-Cola an inside look into the company. Gaining more information could be helpful if Coca-Cola decides to acquire Monster in the future. Gaining such private information might not be possible with a mere contractual agreement. Buying time is also helpful so Coca-Cola Co. can see how the wrongful death lawsuits play out

In an effort to secure supplies and reduce the costs of jet fuel, Delta was the first airline to acquire an oil refinery. In 2012, it purchased a Pennsylvania-based facility from ConocoPhillips. Delta estimates that this backward vertical integration move not only will allow it to provide 80 percent of its fuel internally, but will also save it some $300 million in costs annually

in an effort to secure supplies and reduce the costs of jet fuel, Delta was the first airline to acquire an oil refinery. In 2012, it purchased a Pennsylvania-based facility from ConocoPhillips. Delta estimates that this backward vertical integration move not only will allow it to provide 80 percent of its fuel internally, but will also save it some $300 million in costs annually

Opportunism

is defined as self-interest seeking with guile.37 Backward vertical integration is often undertaken to overcome the threat of opportunism and to secure key raw materials.

Forward vertical integration (ref to graph)

moving ownership of activities closer to the end customer

Advantages and disadvantges of organizing economic activity within firms include:

▪ The ability to make command-and-control decisions by fiat along clear hierarchical lines of authority. ▪ Coordination of highly complex tasks to allow for specialized division of labor. ▪ Transaction-specific investments, such as specialized robotics equipment that is highly valuable within the firm, but of little or no use in the external market. ▪ Creation of a community of knowledge, ▪ Administrative costs because of necessary bureaucracy. ▪ Low-powered incentives, such as hourly wages and salaries. These often are less attractive motivators than the entrepreneurial opportunities and rewards that can be obtained in the open market. ▪ The principal-agent problem. (It can arise when an agent such as a manager, performing activities on behalf of the principal (the owner of the firm), pursues his or her own interests, ne potential way to overcome the principal-agent problem is to give stock options to managers, thus making them owners.)