Buy vs. Ally: When to Vertically Integrate

Volatile commodities prices, financially-squeezed suppliers, and the race to find new revenue sources and cost savings have led many firms (including Oracle, ArcelorMittal, and PepsiCo) to embrace a 100-year-old strategy – vertical integration.

Integrating (and in some cases reintegrating) stages of production enables greater flexibility to innovate, access to raw materials, and control over manufacturing and distribution channels.

The preference for owning stages of production peaks and troughs depends on market conditions, corporate strategy trends, and plain old executive preferences and biases.

Downsizing by way of vertical relationships or joint ventures was the dominant trend in the ‘80s and ‘90s. Global competition, oil shocks, floating exchange rates, and better communications provided good strategic reasons to not fully integrate. Flexible supply chains could be established, risk could be shared or transferred, and inputs obtained for less. The first tremors of change were felt when supply tightened in 2007, and then the global financial crisis swallowed up suppliers.

The challenge for most companies (particularly in the current high-stakes environment) is removing emotion and gut instinct from the decision to internalize market functions, and focus decisions on whether they enable the firm to secure a better competitive position and overcome market risk by:

1. Reducing transaction costs,
2. Closing the asymmetric information gap between sellers and buyers,
3. Allowing the firm to capture value-added sales revenue if the firm controls the successive stages of value chain, and
4. Ensuring the company is not vulnerable to supply being withheld or volatile market prices.

Not Simply a Matter of Buy vs. Make

Corporate strategy is concerned with: the Ends (overarching goal), Scope (where the company will and will not play), and Means (how it plans to achieve its ends).

The vertical integration question should force an assessment of trade-offs involving scope and balancing transaction and opportunity costs. Strategists must consider scale efficiencies, specialization, competencies, market structure, barriers to entry, and competition.

There is also the question of administrative costs, which fall under the purview of the Procurement and Shared Services functions that monitor contractors and can help inform vertical integration decisions.

Companies must weigh the value they would get from integration against the cost of organizing a production function within the firm (including the switching costs). Keep in mind that just because transaction efficiencies are greater than administrative costs, it does not necessarily follow that vertical integration is the best move. Opportunity costs make this decision much harder.

It seems there is no easy calculus… or is there?

Backward Integration Is (Almost) as Easy as 1-2-3

Backward integration — when the firm takes ownership control of supply — occurs most often when companies depend on one another for a certain technology or input and find themselves falling prey to monopolistic opportunism (usually accompanied by the threat of supply cutoff). Here’s a rule-of-thumb that Professor Ted Moran of Georgetown University teaches his students to apply when weighing the vertical integration question:

4-4-50 Rule: Companies should consider acquiring critical suppliers when there are fewer than four firms or four countries controlling more than 50% of supply. (Note: the rule is usually applied by leaders of countries considering industrial policy moves.)

What matters most is the number of suppliers; if supply hold-up is a risk, vertical integration may be necessary. If switching costs are low, it is probably best to pass off the risk associated with owning that stage of production. The 4-4-50 rule can be used effectively to argue the devil’s advocate position of the vertical integration question.

This is not to say that supply risk is the primary consideration; backward integration also makes sense when:

• Cost savings arise from the physical integration of processes (e.g., linking two stages of production at a single location to reduce transportation and fuel costs).
• Specific components are needed for which there is not significant demand (e.g., aerospace components).
• One capability builds on another or integration enables adjacent moves.
• Synergies exist between design capacity and manufacturing (e.g., automakers).
• Profit margins in one value chain segment outweigh those in another segment.
• Volatile commodity prices increase the benefit of procuring supply “at cost.”

Though contracts may be written for all of these supply relationships, eventualities cannot be accounted for at the start of the agreed term (e.g., changes to tax code or country-to-country trade agreements that raises the cost of the product to an unmanageable level).

Don’t Throw Capabilities to the Wind

It goes without saying that companies should be integrated around the functions that they are best at, and which differentiate them from competitors.

Corporate Strategy Board research indicates that de-verticalization, the reverse of vertical integration, occurs under twelve conditions. The most important four are 1) value chain modularity, 2) gains from specialization, 3) lower barriers to entry, and 4) product commoditization. Industries that operate under these conditions tend to separate the scalable, commoditized processes from the specialized, high-value processes. The goal for most companies is to find a unique combination of assets that fits into the latter category.

Keep Your Options Open

Vertical integration doesn’t make sense if:

• Flexibility is key to competitiveness (e.g., the electronics industry relies on rapid innovations by contract manufacturers).
• Risk can be compounded and problems at one stage affect the profitability of all others stages of production.
• Stages are too dissimilar and the companies’ respective knowledge base or cultures  are incompatible.
• There is a constant need to invest in building capabilities.
• Cutting edge third-party innovation and entrepreneurial drive is necessary to compete.
• Unpredictable demand makes integration costly and adaptation more difficult.

What does the future hold for business models? It’s hard to say. We are seeing an uptick in merger and acquisition activity in certain sectors and geographies. Companies are spending money both in areas where they fear supply disruption and where they see market entry and adjacency potentials.

The cost of acquisition (and integration) is steep, so keep these considerations in mind even if your gut is telling you to “buy, don’t make.”

Thank you to Ross Katz who contributed to this article.

Related Resources:

• How to Account for Complexity in Decision Making (BusinessWeek)
• Strategists: Don’t Oversimplify Your Scenarios (for clients of the Corporate Strategy Board)
• Acquisition Readiness Maps (for clients of the Corporate Strategy Board)
• DuPont’s Pre-Deal Integration Planning (for clients of the Corporate Strategy Board)
• The Relationship Between Brand and Vertical Integration (for clients of the Corporate Strategy Board)
• Learn how FoodWest navigates M&A strategic decisions (for clients of the Corporate Strategy Board)