Determinants of forward vertical integration

Transcription

1 Determinants of forward vertical integration The possibilities and risks for a steel company. Master Thesis University of Amsterdam Faculty of Economics and Business IJmuiden, September 2008 Author: Marieke Nispeling Student Number: Supervisor UvA: Second Reviewer: Supervisors Corus: Dr. A.R. Muller Dr. F.N. Fortanier Drs. M. van der Kar Ir. J.W. Slijkoord

2 Executive summary The main question in this research is whether Corus should vertically integrate with Metal Centres in Germany. The conclusion is that the industry and firm characteristics support this decision. Five industry level factors and three firm level factors are applied to Corus Distribution Europe. The results are that the German demand is predictable and expected to grow. Competition from small-sized stockholders is established and stable and the barriers to enter or exit the market are low. Furthermore, Corus is experienced with Metal Centres in the UK and with the German distribution market. A Metal Centre concept is interesting for Corus in Germany, since it can capture bargaining power and added value, resulting in high margins. The investments and payback ratio are relatively low. It should be taken into account that the favourable environment is not only an advantage for Corus but also for competitors. Furthermore, it should be investigated whether some adaptations of the UK Metal Centre concept should be made, in order to fit in the German steel market. 2

3 Table of content Chapter 1: Introduction...4 Chapter 2: Literature review The supply chain Integration strategy Reasons to integrate; advantages and disadvantages Conditions for vertical integration Conclusion of the literature...24 Chapter 3: The steel industry An introduction in the steel industry The European steel industry Conclusion of the steel industry...34 Chapter 4: Methodology Data collection Conceptual model...37 Chapter 5: The business case Metal Centres The UK and German (steel) market Vertical integration in Germany for Corus...67 Chapter 6: Conclusion...77 Chapter 7: Implementation advise The investment decision for Corus Distribution Europe..Error! Bookmark not defined. 7.2 The Metal Centres...Error! Bookmark not defined. 7.3 The market approach...error! Bookmark not defined. 6.4 Entry modes...error! Bookmark not defined. Acknowledgement...81 References...82 Attachments...87 Attachment 1: The position of the steel supply chain within Stevens model...88 Attachment 2: Gross margins Corus German Steel Service Centres and Distributors Attachment 3: company profiles of Corus Metal Centres and competitors...90 Attachment 4: Turnover of top 30 customers of German distributors and Steel Service Centres...98 Attachment 5: Consumption per product group...99 Attachment 6: Sales per Bundesgroup

4 Chapter 1: Introduction With supply chain management, up- and downstream relationships with suppliers and customers can be managed. It helps a company identifying the activities for which they have unique skills and advantages (Christopher, 2005). The importance of creating advantages in terms of adding value in the supply chain rose, especially for commodity markets where the distinction in products becomes difficult (Christopher,2005). A solution is to compete on value, by creating value advantage, which does not have to consist of technological product improvements but can also be realised by adding intangible benefits for customers like image, service or flexibility (Christopher, 2005; Etgar, 1978). Adding value by service can be done with a differentiation strategy like vertical integration (Etgar, 1978), which is a supply chain management initiatives (Fawsett and Magnan, 2002). There are three different kind of related diversification strategies; horizontal integration and vertical integration, which can be either backward or forward. The scope of this research is on forward integration (or downstream integration), which develops activities concerned with the organisations output further forward in the value chain (Johnson and Scholes, 2001). The difference with backward vertical integration is that forward integration implies entering a new market, while with backward integration a buyer becomes its own supplier (Thorelli, 1986). There are several advantages and disadvantages of forward vertical integration, which relate mainly to production (profit and costs) and competition. Vertical integration can reduce information costs, costs of opportunistic behaviour, the uncertainty or asymmetric information about customer needs and general, administrative or selling costs (de la Fuente et.al., 2007, p. 783; Kotler, 2003, p. 14, D Aveni and Ravenscraft, 1994). Problems of complex control and managerial efficiencies (Johnson and Scholes, 2002, Aaker, 2005; Harrigan, 1986; D Aveni and Ravenscraft, 1994), can lower the profit but on the other hand, vertical integration can be used to gain profit by internalizing margins and gain a larger share of the value-added stream (D Aveni and Ravenscraft, 1994; de la Fuente et.al., 2007, Kotler, 2003). With regard to competition, forward vertical integration allows a firm to serve a different market segment (Bell et.al., 2002). The dilemma is between having a first mover advantage and raking the risks of vertical integration, or avoiding risks with the change of being late and difficulties to enter (Harrigan, 1986). To decide whether vertical integration is recommended, keeping the discussed advantages and disadvantages in mind, a model can be drawn based on several factors or conditions. The way a firm acts, with regard to these conditions, can be conductive to the vertical integration decision. The conditions are split up in five industry level conditions and three firm level conditions and will be tested in a business case. 4

5 For commodity products exists a higher need to create differential advantage through added value with service rather than through the product per se, especially when this market is mature (Johnson and Scholes, 2002). An example of a commodity market which has also mature businesses is the manufacturing industry with the steel business (Schrorsch, 1994; OECD, 2008). For manufacturers it is important to get closer to the end user, to coordinate demand and supply (Majumdar and Ramaswamy, 1994) and to create unique supply chains (Frohlich and Westbrook, 2001). Both backward and forward integration are regularly employed by manufacturers (Frohlich and Westbrook, 2001). Forward integration facilitates benchmarking the performance of independent retailers, and/or allows the manufacturer to serve a different segment (Bell, et.al., 2002). The steel industry is a mature market with commodity products and a trend of consolidation, where adding value strategies important to remain competitive (Schrorsch, 1994; Etgar, 1978). Generally, the deeper down the chain, the more opportunity there is for value added selling (Vermeij, Eurofer). Therefore, it is a suitable industry for studying the forward vertical integration possibilities. A new opportunity in the route to the market is vertical integration in the form of Metal Centres. Metal Centres are small-sized distribution centres, responding to local demand for a small-sized group of customers. It is a local business and one of the reasons that Corus UK started to implement this concept is the ability to serve local customers and the high margins that are paid. In terms of strategy, exploiting Metal Centres is the application of vertical integration towards the end-user and the critical success factors are: local responsiveness, customer service and customer relationship. The business case in this research discusses the opportunities of exploiting Metal Centres for Corus in Germany. The research question for this research is: What are the opportunities and risks of forward vertical integration? Applying this to the business case, results in the research question of the business case: What are the opportunities and risks for Corus of the implementation of the UK Metal Centre concept in Germany?. Besides investigating these questions, also an implementation advise for Corus will be given. The data analysis for this business case is based on interviews, (internal) documents and field research. This will be applied on the conceptual model with the industry and firm level factors. 5

6 This research consists out of six chapters. The first chapter comprises a literature review, which explains the theoretical framework of this research and results in a conceptual model. This will be followed by a description of the steel industry in general. The fourth chapter explains the methodology of this research, followed by the business case. In the business case the Metal Centre concept is explained and the UK and German market are analysed. Furthermore, the conceptual model is applied on the business case, followed by a short conclusion. Finally the implementation advise gives a practical advise for Corus with regard to the research question. 6

7 Chapter 2: Literature review The main topic of this research is the possibilities of a vertical integration strategy, as well as the supply chain management. Supply chain management can be defined as The management of upstream and downstream relationships with suppliers and customers to deliver superior customer value at less cost to the supply chain as a whole (Christopher, 2005, p. 5). The value chain is the value adding part of the supply chain. There is a commoditization trend in many markets which make it necessary to create differential advantage by adding value (with service), rather than through the product (Johnson and Scholes, 2002). A way of adding value is using a differentiation strategy like vertical integration (Etgar, 1978). Vertical integration has several advantages and disadvantages related to costs, profit and competition. The likelihood that vertical integration takes place and the way these advantages and disadvantages happen is influenced by several factors: five industry level factors and three firm level factors. These factors are named conditions and will be put together in a conceptual model which is the basis for the business case in this research. This is, in short, the theoretical framework which will be further explained below, starting with the supply chain, the value chain and its trends and developments. Next to that, several point of views extracted from the literature about vertical integration and the advantages and disadvantages will be discussed. It should be noted that vertical integration can be either forward or backward, but the scope of this research is on forward vertical integration. Only the literature does not always make a distinction between the two types. This chapter concludes with a conceptual model, after explaining the conditions for vertical integration. 2.1 The supply chain A supply chain is an interaction between marketing, logistics and production from raw materials to components to final products that are carried to final buyers. It manages material, service, wholesalers, retailers and clients to maintain a long-term competitive advantage. The supply chain represents a value delivery system where each company within the supply chain captures only a percentage of the total generated value (de la Fuente et.al., 2007, p. 783; Kotler, 2003, p. 14). A global supply-chain (also referred as a supplier network), is defined by Ellram (1991) as: A set of global enterprises, linked together to collectively transform raw materials into competitive finished products and services with higher value-addition (Ellram 1991, in Gehani, 2000, p.175). These inter-organisational linkages (or value chains) are also expressed as a value system (Huemer, 2006, p. 134). But a value chain has a different 7

8 emphasis than a (value-added) supply chain. While the supply chain focuses on material flows and inter-organisational logistics, the value chain focuses on competences (Gehani, 2000, p.175). Gersch and Goeke (2007) explain the value chain of a firm as their relevant value adding part of the supply chain. The coordination of a single level in a supply chain is named a market. In each market, a player will define value chain stages within their multistage supply chain as their relevant market. Connecting these relevant markets or supply chain stages horizontally and/or vertically, results in an industry. The value chain, where value refers to customer value, consists of primary and supportive activities. Value refers to customer value. The primary (or discrete) activities are directly related to creating a product or service (Johnson and Scholes, 2002, pp ). According to Gersch and Goeke (2007), the costs and value of these activities determine whether best value products or services are developed, which can influence the competitive advantage of the firm (Gersch and Goeke, 2007). The supportive activities can improve the effectiveness or efficiency of the primary activities. The effectiveness is determined by the ability to meet customer requirements on product features and has some implications. A customer will pay a premium for features that they especially value (Johnson and Scholes, 2002, pp ). The efficiency is determined by economies of scale, supply costs, product/process design and experience (Johnson and Scholes, 2002, pp ). The secondary activities are supportive to the primary activities (Porter, 1991 and Johnson and Scholes, 2002, pp ). This is shown in Porter s value chain model (figure 2.1). 8

9 Figure 2.1: Porter s value chain model. The architecture of the supply chain must derive from its strategy-critical activities and corecapabilities that drives its key success factors (Gehani, 2000). To conserve the rare resources of an enterprise, non-core competencies might be outsourced to more efficient and trustworthy suppliers or sub-contractors. A global enterprise can enhance its competitive advantage by gaining additional valuable capabilities via collaborative partnerships and strategic alliances with other enterprises in its supply chain (Gehani, 2000). Regarding to this outsourcing decision, Christofer (2005, p. 14) advises a firm to assess whether they have a real competitive advantage of each activity in their value chain. If this is not the case, the firm should consider outsourcing (Christofer, 2005, p. 14). Supply chain management (SCM) helps a company identifying the activities for which they have unique skills and advantages. Integrating or outsourcing resources to increase the value are examples of supply chain management initiatives (Fawsett and Magnan, 2002). A more narrow definition of supply chain management is the following: the integration of the various functional areas within an organization to enhance the flow of goods from immediate strategic suppliers through manufacturing and distribution chain to the end user (Houlihan, 1987 in Tan, 2001, p.40). Christopher (2005) defines supply chain management from a cost perspective as: The management of upstream and downstream relationships with suppliers and customers to deliver superior customer value at less cost to the supply chain as a whole (Christopher, 2005, p. 5). These definitions suggest the relation between SCM and value delivery, e.g. through integration. 9

10 Trends in the value chain According to Christopher (2005) each customer group assigns different importance to values. Finding and satisfying distinct value segments requires a more segmented approach to the market. This is why Christopher (2005) calls supply chain management also demand change management, suggesting a market-driven supply chain where the first step is to identify the value segments, i.e. what the customers exactly values. Secondly, these requirements have to be translated into an offer. In figure 2.2 four markets are represented. There is a trend in many markets towards a decline in the strength of a brand and a consequent move towards a commodity market status (Christopher, 2005, p.9). In commodity products the product distinction becomes difficult and consumers perceive product equality (Christopher,2005); for example because of a lack of physical differences or because consumers do not perceive any physical differences as significant (Etgar, 1978). Products in this market are indistinguishable and do not have a cost advantage. Therefore, the customer will tend to purchase their products from the cheapest supplier and their brand loyalty might decline. A firm has two solutions to this problem; compete either on price or on value. First, they can compete on price and deliver a cost advantage (Christopher, 2005). With regard to figure 2.2, a firm would move to the right towards cost leadership, by making major cost reductions through re-engineering the logistic process. The second solution is to compete on value, by creating value advantage (Christopher, 2005; Etgar, 1978). A value advantage does not have to consist of technological improvements of a product, but also can be realised by adding intangible benefits for customers like image, service or flexibility. The firm would move towards service leadership (figure 2.2) by improving responsiveness to the customer and reliability. Some ways to realise this are, for example, reducing lead times, just-in-time (JIT) delivery and value added services. The trend towards a commodity market raised the importance of creating value advantage. Because it became more difficult to only compete on brand or image, winning an order is now more service-based than product-based (Christopher, 2005). In mature markets, the cost leadership route will be difficult to achieve. In these markets it is hard to achieve a larger market share and new technologies are often also available to competitors. Nevertheless, the ultimate challenge for logistics and supply chain management is to take the organisation to the cost and service leadership, i.e. the top right hand corner in figure 2.2 (Christopher, 2005, pp. 9-13). 10

11 Figure 2.2: competitive advantage matrix. (low) Value advantage (high) Service leader Commodity market Cost and service leader Cost leader (low) Cost advantage (high) Source: Christopher, Summarizing theory (Christopher, 2005), the trend towards commodity markets pushed firms to compete on adding value. Because in mature markets cost leadership is difficult, firms can add value by being a service leader. Etgar (1978) emphasized that adding value by service can be done with a differentiation strategy like vertical integration. 2.2 Integration strategy Integration is a diversification strategy and a form of related diversification. Diversification aims at taking the organisation away from its current markets, products or competences. Related diversification realizes this, but within the value chain and is defined as: strategy development beyond current products and markets but within the value system or industry in which the company operates (Johnson and Scholes, 2002, p. 297). The value system is the set of inter-organisational links and relations, or an interconnected system of the earlier explained value chains. Both, value system and value chain refer to something that is necessary to create products or services. The value chain describes the activities within and around an organisation, and the value system describes the relations (Johnson and Scholes, 2002, p. 161). 11

12 There are three different kind of related diversification strategies; horizontal integration and vertical integration, which can be either backward or forward. 1) Horizontal integration has nothing to do with integration within the value system, but refers to activities which are competitive or complementary to the firm s current ones. An example of this, is exploiting activities into new markets (Johnson and Scholes, 2002, pp ). Because of the scope of this research horizontal integration will not be explained further. Besides horizontal integration, exists vertical integration, which is defined as: the overall degree to which different business activities in a value chain are brought under the management of a single entity (Majumdar and Ramaswamy, 1994, p. 119). Vertical integration can be either backward or forward. 2) Backward integration, also named upstream integration, has the aim to develop activities concerned with the inputs of the organisations business, i.e. further back into the value chain (Johnson and Scholes, 2002, pp ). Because access to supply of raw materials is a key success factor of this type of integration (Aaker, 2005, p. 255) and it becomes a motivation factor for backward vertical integration to control sources of raw materials (Etgar, 1978). 3) Forward integration, also named downstream integration, develops activities concerned with the organisations output, further forward in the value chain (Johnson and Scholes, 2001), or integrating the forward physical flow of deliveries between suppliers, manufacturers and customers. Other possibilities is exploiting third-party logistics (Frohlich and Westbrook, 2001), e.g. transport, distribution and service (Johnson and Scholes, 2002, pp ). The difference between the two vertical integration strategies according to Thorelli (1986), is that forward integration implies entering a new market, while with backward integration a buyer becomes its own supplier. Therefore, Thorelli (1986) emphasizes that forward integration is more difficult than backward integration. Earlier research about vertical integration According to Frohlich and Westbrook (2001) creating unique supply chains emerged as an important element for manufacturing companies. This can be realized by integrating the internal processes to external suppliers and customers, i.e. applying backward and forward integration. A combination of these two types of integration is named an outward-facing supply chain and this is for some industries emphasized to be the best overall approach (Frohlich and Westbrook, 2001, pp ). On the other hand, Tan (2001) emphasized that a value chain is to complex to fully integrate all business entities. An organization should therefore only focus on integrating strategically important suppliers in the value chain because full integration would be too complex (Tan, 2001). This implies that one of the 12

13 decisions for a company is which kind of integration to implement and refers back to the supply chain management. Majumdar and Ramaswamy (1994) did a study on downstream (or forward) integration and explained forward integration as organisations undertaking their distribution activities inhouse rather than using agents or distributors. Etgar (1978) is even more rigid by emphasizing that to associate a higher service level with the brand, even exclusive distribution should be established by selling only the brand of one supplier. Contrary to that, there was a trend in the manufacturing industry of partial forward integration, which means that a manufacturing reaches its end users through both independent and company-owned retailers (Bell, 2002). Frohlich and Westbrook (2001) designed a figure about the extend of integration and call this the arc of integration, varying from narrow to broad (figure 2.3). Figure 2.3: The arc of integration. Source: Frohlich and Westbrook (2001). In accordance with these studies a firm has a choice about the type and the intensity or degree of integration. Additionally, Harrigan (1986) adds two other choices by emphasizing that a vertical integration strategy is a combination of four decisions. The first choice is how much of the good or service to integrate (the degree). Full integration is integrating 95% of the activities or more, while taper integration refers to integrating only a proportion of the activities. The second choice is how far the integration strategy will be implemented in the chain of activities (the stages). The third choice refers to the breath of their activities in each production stage. Finally, the fourth decision is about the form of ownership, i.e.; how much equity should they hold in a business unit (Harrigan, 1986). The added value by in-house processing at any particular stage depends on the activity s so-called 'value-adding potential'. This is the proportion of outputs transferred in-house and the breadth of tasks performed at 13

14 that particular stage. If firms are engaged in many activities at each integrated stage of processing, each strategic business unit s breadth of integration is high (Harrigan, 1986). 2.3 Reasons to integrate; advantages and disadvantages The likelihood that vertically integration is implemented depends on several conditions, which are split up in industry level and firm level conditions. The respond of a firm to these conditions brings advantages or disadvantages and a dilemma whether or not to integrate. These (dis-)advantages are mainly concern production (costs and profit) and competition. In this sense vertical integration can be a strategic response of a firm to the market and its competitors (Majumdar and Ramaswamy, 1994). First, these advantages and disadvantages be explained, followed by the conditions for vertical integration. Costs The possible cost advantages of vertical integration concern transaction costs and production costs. It is assumed that markets are imperfect and that organizing transactions does generate costs; transaction costs (Majumdar and Ramaswamy, 1994). Arrow (1969) defined transactions costs as "the cost of organizing the economic system" (in: Levy, 1985). Within imperfect markets, bringing together various businesses with vertical integration can lower marginal costs of intra-firm coordination. The trade-off that has to be made here is the intrafirm coordination costs versus the costs of managing contractual relations (or transaction costs) on market level (Majumdar and Ramaswamy, 1994; Levy, 1985). Contraction costs are a kind of transaction costs, caused by market imperfections. Mainly human factors such as bounded rationality and the complexity and uncertainty of the environment make contracting costly and raises the potential of information asymmetry. Transaction costs primarily concerns information costs, because monitoring performance and bargaining is needed to ascertain the quality of transaction. These tasks have an information element that can create moral hazard and adverse selection problems (Majumdar and Ramaswamy, 1994). Vertical integration can reduce these information costs by the internal transaction of information. Sharing information and optimizing material flows results in a more efficient and effective company and eliminates failing processes (de la Fuente et.al., 2007, p. 783; Kotler, 2003, p. 14). Furthermore, vertical integration reduces uncertainty or asymmetric information about customer needs (D Aveni and Ravenscraft, 1994). Johnson and Scholes (2002) agree with the efficiency advantage through information sharing, but on the other hand they mention that a possible reluctance to share information can cause problems. This implies that the willingness to share information is important. Besides, exists a chance that complex problems of control 14

15 and coordination might develop managerial inefficiencies (Aaker, 2005; Harrigan, 1986; D Aveni and Ravenscraft, 1994). Vertical integration also leads to economies of integration in terms of significantly lower general, administrative and selling costs, which can be linked to increased profitability. The conditions are certain or growing demand and a line of business with a small number of very large plants. Because then production planning and scheduling is relatively easy (D Aveni and Ravenscraft, 1994). Contrary to that, Levy (1985) emphasizes that when industry demand is expected to grow, prospects for entrants are improved and bargaining power of established firms are constrained. Therefore, vertical integration in this situation is less immediate. This will be further explained at the first industry level factor in the next paragraph. Next to the cost savings, also additional bureaucracy costs are created by vertical integration in terms of production costs. Mainly the cause is the lack of market pressure on internal suppliers to keep their cost low, although this is especially expected with backward vertical integration. Production costs can also increase by purchases of specialized assets that increase sunk costs and underutilized capacity by an unbalanced throughput. These kinds of production costs are linked to lower profit, but D Aveni and Ravenscraft (1994) emphasize that the economies of integration will still dominate these bureaucracy costs. Overall, D Aveni and Ravenscraft (1994) provided evidence that vertical integration lowers costs in a wide variety of industries, arising from reduced transaction costs, shared common costs and enhanced productivity. The reason of using vertical integration is also the cost advantages (D Aveni and Ravenscraft, 1994). Furthermore, vertical integration could solve problems with regard to opportunistic behaviour (Hobbs, 1996; Majumdar and Ramaswamy,1994). Opportunism is defined by Williamson (1979, p. 234) as: a self-interest seeking with guile. This implies that parties can act in their own interest. This raises transaction costs and the risk on transaction failures. Furthermore it can lock-in the two parties, since buyers have no alternative suppliers and the supplier cannot find alternative buyers. With vertical integration these problems could be solved (Majumdar and Ramaswamy, 1994). Profit Costs reductions are related to increased profits, but there are also direct influences of vertical integration on profit. Vertical integration can be used to gain profit by internalizing margins that are normally paid to the distributor (D Aveni and Ravenscraft, 1994; de la Fuente et.al., 2007). Pricing at internal marginal costs lowers input prices and raises profits of the downstream operation. This replaces the profit from the upstream to the downstream 15

16 organization which makes the cost advantage is artificial. To check more than these paper profits, transfers should be against market prices (D Aveni and Ravenscraft, 1994). Kotler (2003) emphasizes that the company can gain a larger share of the value-added stream with vertical integration. By manipulating prices and costs in the value chain, profits are gained where the taxes are low. Next to that, profits increase because of higher prices created by entry barriers, price discrimination or providing power over buyers and suppliers. In this sense, vertical integration can be used to create market imperfections and entry barriers for other competitors in order to achieve monopolistic power (Etgar, 1978; D Aveni and Ravenscraft, 1994). On the other hand, transaction or contracting costs of a firm that are caused by markets imperfections can be lowered with vertical integration (Etgar, 1978). Concluding, vertical integration can be used defensive and aggressive with regard to market imperfections and competition. Furthermore, vertical integration can improve distributive performance and thereby also the profitability of a firm. In a competitive industry vertical integration can be applied to differentiate on a distributive level by delivering more service. With this a firm can command premium prices and more market power can be created. Hereby the distributive performance, in terms of profit, can be improved (Etgar, 1978). Competition Forward vertical integration can be a source of potential competition by allowing a firm to serve a different market segment (Bell et.al., 2002) or by product differentiation. Instead of using vertical integration for cost advantages, it can also be used for product differentiation. This increases the added value, which is an advantage and can not be replicated easily by competitors. Other competitive benefits of vertical integration are improved marketing and technological intelligence (Harrigan, 1986). On the other hand, vertical integration may also have competitive disadvantages. The creation of mobility or exit barriers can cause strategic inflexibilities for the firm. This in turn raises production and overhead costs and could keep firms into keeping obsolete technology and manufacturing strategies (Aaker, 2005; Harrigan, 1986; D Aveni and Ravenscraft, 1994; Thorelli, 1986). Besides, exists the danger of being cut off from outside linkages or information from suppliers or distributors (Harrigan, 1984). There even can arise antitrust problems if the firm would create a bottleneck to exclude competitors from a crucial source (Harrigan, 1986). Furthermore, the company can be locked up by committing there selves to a highly specialized capital-intensive activity (Thorelli, 1986). These problems will be discussed in the next paragraph. 16

17 Harrigan (1986) emphasizes that competitive conditions are very important to assess which type of vertical integration strategies fits to the organization. Picking the right form will help the organization to compete effectively (D Aveni and Ravenscraft, 1994). Next to that, it provides a credible threat that reduces the buyers bargaining power (Porter, 1980). Therefore, forward integration may reduce the ability of powerful buyers to demand cost-increasing product features or special services (Harrigan, 1983). Existing explorative studies on vertical integration discuss some difficulties related to vertical integration and competition. First of all, it could cause the dilemma between having a first mover advantage and raking the risks of vertical integration, or avoiding risks with the change of being late and difficulties to enter. Pioneering can be done with a high degree of not so risky internal transfers with, when the industry is stable. But, a vertical integration strategy brings on costs. In order to the vertical integration decision, a firm should scan outsiders frequently whether they can organize their activities more cheaply in stead of bringing them in-house. Besides economic advantages, also strategic advantages can be gained with vertical integration. When neither economic, nor strategic advantages can be achieved, the risks should be shifted to outsiders (Harrigan, 1986). 2.4 Conditions for vertical integration Besides advantages, there are also disadvantages of vertical integration. The question is when vertical integration brings advantages and can be recommended, and when it is the other way around. Therefore, the existing literature describes several conditions for vertical integration. These can be categorized as either industry level factors or firm level factors and will be explained below, followed by an overview in the form of a conceptual mode. Industry level factors 1) Uncertainty of demand and technology High degrees of vertical integration and the needed investments will be more risky when there is a high uncertainty of demand and when tech technologies are expected to change rapidly (Harrigan, 1986). The reason that vertical integration is not recommended with uncertain demand is because there are several risks. First, uncertain demand causes costs that are related to unused capacity or supply shortages. As discussed at the topic about costs, a certain and growing demand makes production planning and scheduling relatively easy (D Aveni and Ravenscraft, 1994). 17

18 (D Aveni and Ravenscraft, 1994). Next to that, adapting, scheduling, managing and controlling unpredictable demand makes managing vertical integration difficult and expensive. Furthermore, because of the strategic inflexibility that may accompany vertical integration it is difficult to adapt to changes. This raises bureaucracy costs and reduces the value of integration. (Harrigan, 1986). This implies that for successful vertical integration a certain and growing demand and technology is preferred. Demand uncertainty can be measured by the change (%) in sales growth. Table 2.1 shows the change in sales growth in relation with the recommended vertical integration. Full integration is recommended only when the uncertainty of demand is low. This is typical for industries in a growing or mature stage. Otherwise taper-integration is recommended. Forward taper integration, which would be relevant for this case, involves providing some output to a firms own operations and selling the remainder to outsiders (Sportleder, 1992). With a high uncertainty it is advised against vertical integration. Highly uncertain demand is typical for industries in an embryonic or declining stage. Table 2.1: Uncertainty of demand (Source: compiled by the author, based on Harrigan, 1986) % change in sales growth Vertical integration advise Less then 5% Full integration Between 5 and 10 % Taper integration More then 10% Vertical integration is risky A rapidly changing technology is unattractive for vertical integration because of the obsolescence processes (Harrigan, 1984). As Balakrishnan and Wernerfelt (1986) explain, in an environment with rapidly changing technology, an investment in a (specialized) asset might be less profitable than expected in the long-run. Thus, investing in a rapidly changing technology causes the risk that this investment becomes worthless (Harrigan, 1984). On the other hand, Majumdar and Ramaswamy (1994) emphasize that when major technological changes are applied in products, the output of a firm can be uncertain. This makes it difficult to deal with third parties and therefore in this situation vertical integration is recommended. The change in technology can be measured by the years that technology is obsolete. When there are maximum 5 years of obsolete technology, it is rapidly changing (Harrigan, 1986). 18

19 2) Stability of the linked industry. Vertical integration is more attractive when the linked industry of a SBU is stable in terms of competition. This implicates high entry barriers, but low exit barriers, unsophisticated customers, imperfect substitutes and competitors who are not inclined to use price cutting for increasing their market share (Harrigan, 1986). In concentrated industries firms are more likely to use vertical integration to prevent entry into the industry or to protect and extend their market power (D Aveni and Ravenscraft, 1994). While a volatile industry structure has a price-cutting competition. The risks and higher over head associated with vertical integration gets worse because of this competition. Besides, it is possible that these firms have an inflexible reaction on competition (Harrigan, 1984). The competitive volatility can be measured by the industry concentration and the exit barrier height. When the industry concentration is high, the four firm concentration should be greater than 40% or medium between 25-40% (Harrigan, 1986). Furthermore, entry and exit barriers arise from a firms investments in specific resources. These investments protect the entry of competitors. On the other hand the investments limit a firm to exit because these might be less worth in their next use (Dewitt, 1998, D Aveni and Ravenscraft, 1994). A measurement of the exit barrier height is the assets as a percentage of sales. When these are between 5 and 10% the exit barrier is medium, while a percentage lower than 5% means low exit barriers and vertical integration is recommended (Harrigan, 1986). 3) The bargaining power of the firm, suppliers and customers. When a firm itself has strong bargaining power they do not need their own suppliers, customers or distributors to enjoy benefits of vertical integration. But with low bargaining power, vertical integration can buffer demand uncertainties. Vertical integration can be used as a defensive strategy (Harrigan, 1986) or to avoid bargaining problems related to for example market transactions. This relates to the cost advantage of vertical integration because bargaining problems causing transaction costs can be avoided (Levy, 1985). This research has a focus on forward vertical integration. Therefore only the bargaining power downwards, towards the customers, are relevant. For backward vertical integration the bargaining power towards suppliers would have been relevant. The bargaining power of a firm towards it customers can be measured as follows. When a large portion of the sales (more than 15%) of a business unit is represented by a single customer, or when there are less alternative customers, the business unit is highly dependent upon their customer and has to deal with strong customer bargaining power (Harrigan, 1986). Majumdar and Ramaswamy (1994) support this and state that with a small number of end- 19

20 users, a firm has a thin market. The bargaining power of the end-users will increase and the bargaining power of the firm decreases. This causes behaviour uncertainty for the manufacturer and downstream vertical integration can be a solution to reduce this uncertainty. A small number of end-users or less alternative customers is defined by Harrigan (1986) as less than 20, while Majumdar and Ramaswamy (1994) emphasize less than ) A higher physical- and intangible asset specificity. Assets specificity is defined by Leiblein and Miller (2003) as: the degree to which the assets in an exchange are more valuable in their current application than in their next best use (Leiblein and Miller, 2003, p. 844). There are two kinds of asset specificity which are conditions for vertical integration; physical assets and intangible assets. Physical asset specificity implicates that products are customized and made in order for individual customers (Majumdar and Ramaswamy, 1994). Customized products require specialized knowledge and physical assets, like transaction-specific relationship, human assets and tacit knowledge. When specialized physical assets are needed, like specific machines or systems for a job, there is a high physical asset specificity. For example when a machinery is produced that ha sonly scrap value elsewhere. Vertical integration can save the gains that are raised by these asset specific exchanges (Majumdar and Ramaswamy, 1994). Intangible assets refer to relationship-driven assets. Exchanging parties may have spent much time in building a relationship that is transaction-specific and the benefits are not easily usable elsewhere. Although a product might not be customized, the involvement of the manufacturer with the end-user is important and the specificity of relational-driven intangible assets will be higher. When a customer needs a large proportion of the produced good, the incentive to build and develop this relation and to understand the end-users business is even bigger. The benefits of these specific relationships cannot easily be used elsewhere. The higher the proportion of the end-users total annual purchases is sold by the firm, the higher the relational intangible asset is expected (Majumdar and Ramaswamy, 1994). Both physical specificity and relation-driven intangible specificity could cause opportunistic behaviour between an intermediary and the end-user. When a firm has invested in specific assets for a particular customer, the asset specificity is high. Because the firm is therefore locked into the exchange, the customer could act opportunistically (Hobbs, 1996). Vertical integration can be a solution to this opportunistic behaviour is therefore recommended when a firm has a high asset specificity. Furthermore, vertical integration can be used to safeguard the gains from 20

21 these specific physical and tangible assets (Majumdar and Ramaswamy, 1994; D Aveni and Ravenscraft, 1994). 5) The frequency of transactional interactions by a single end-user. With a lot of transactions made by a lot of customers, the transaction frequency of a single end-user will be low and the possibility of opportunistic behaviour will be higher (Hobbs, 1996). Furthermore it can lock-in the two parties, since buyers have no alternative suppliers and the supplier cannot find alternative buyers. With vertical integration these problems could be solved (Majumdar and Ramaswamy, 1994). How opportunistic behaviour is caused will be explained below. Information asymmetries arises when there is besides public information, also private information available to only selected parties. First, information (e.g. failures) can be hidden prior to a transaction (ex ante). This is known as adverse selection. Secondly, information can be hidden after a transaction (ex post). A party could act opportunistically to increase their economic welfare, because their actions are not directly observable by others (Hobbs, ). All parties involved in a transaction do not posses the same level of information and this can cause opportunistic behaviour (Hobbs, 1996). Both types of information asymmetry can cause opportunistic behaviour, which implicates that a party will act in its own interest at the expense of the party that developed the asset. One party acts in favour of the other party and this raises transaction costs and the risk on transaction failures. The chance that opportunistic behaviour will occur is bigger when there are not a lot of transactions between parties. Business that are involved in a higher purchase frequency of a single end-user are not expected to vertically integrate downstream. When there are frequent transaction between two parties, both will keep their reputations high and therefore do not wish to act opportunistically. Furthermore, with frequent transactions, more information is exchanged and the information asymmetries will be less (Hobbs, 1996). Frequent transaction imply less asymmetric information, less opportunistic behaviour and therefore less reasons to vertically integrate On the other hand, with frequent purchases the interjection of a third party might be disturbing (Majumdar and Ramaswamy, 1994). 21

22 Firm-level factors 6) Corporate strategy requirements. As explained before, a vertical integration decision involves both business unit and corporate level. Even when the competitive condition of a business units argues against vertical integration, firms might still decide to vertically integrate intending long-term benefits (Harrigan, 1986). There are several strategic objectives of vertical integration. First, vertical integration is used to protect or enhance the product quality, complexity or specific knowledge. Therefore, vertical integration is often applied in firms with high quality or complex products and where specific knowledge is captured. Second, forward integration can be successful when the added value by the distributor (upstream) or customer (downstream) can be captured. With regard to the scope of this research, the downstream added value by customer is relevant. According to Harrigan (1986) a the added value is high when it s more then 40%. In between 20 and 40% added value is called medium. Next to these strategic objectives, Harrigan (1986) emphasizes that firms with global strategies often sustain higher breaths and stages of vertical diversification. Especially when they have a worldwide market position. A global strategy is different from a multinational strategy. In a multinational strategy different strategies are developed for different countries and are implemented autonomously, while a global strategy represent a worldwide perspective. It requires coordinated facilities on various national fronts and the interrelationships between countries create advantages, e.g. synergies, cost advantages because of low cost production, economies of scale and strategic flexibilities. Furthermore, in a global strategy investments and operation can be shifted throughout the world (Aaker, 2005, pp ). The competition of global strategies is no longer on a market-to-market basis, but should specify how sourcing, R&D, manufacturing and marketing activities should be coordinated worldwide (Zou and Cavusgil, 1995). 7) Experience According to Leiblein and Miller (2003) fabrication and sourcing experience have an influence on vertical integration. Firstly, the greater the firm s fabrication experience to use the relevant technology, the more learning opportunities the firm had. This enhances the larger the likelihood of vertical integration in the production process. The experience can be estimated by the number of similar products manufactured by the firm in the last 5 years. Secondly, the greater the firms sourcing experience regarding to outsourcing relationships or partnerships with suppliers of a particular process technology, the smaller the likelihood will 22

23 be to vertically integrate. Repeated transactions provide understanding between partners and better cooperation. Firms with sourcing experience will select better suppliers and create better relationships with partners. Therefore, sourcing experience will enhance the likelihood that activities will be outsourced. Sourcing experience is defined as the number of unique sourcing relationships over the last 5 years with firms, having the ability to produce at the relevant process. This can be estimated by the number of unique sourcing relationships (Leiblein and Miller, 2003). 8) Product-market diversification The strategy of product-market diversification is associated with a higher likelihood that production is internalized and therefore vertically integrated. First of all, more productmarkets reduce the risk of investing in a production facility. In the case of uncertain demand, the production facility might be underutilized but can be used for another product-market. Secondly, firms with a broader scope have the advantage to respond to market changes by using its applications. This is especially the case in industries with short technology-cycle times. The product-market diversification strategy enables the firm to switch across productmarkets when needed, which makes the investment in vertical integration less risky. The product-market diversification can be measured by the number of product-markets subfields where the firm sells its products or the number of product-markets where the firm is active itself (Leiblein and Miller, 2003). 23