Vertical and Horizontal Integration - Essay Example

? Vertical and horizontal integration Task: Vertical and horizontal integration Introduction Companies, especially in the technology industry, are continuously reorganizing and restructuring. This is in order to keep their relevance in a field that HP’s CEO cites as ruthless (Idea 2011). The technology industry has continuous consumer shifts, new inventions, and these present risks for redundancy. Companies that manufacture hardware in previous years are now acquiring the production of software. Companies that only dealt with software are acquiring hardware production facilities in a bid to stay afloat; this occurred in the case of HP and Google. HP has been, since its inception, manufacturing hardware, but in 2011, it acquired Autonomy, a software maker (Idea 2011). In the case of Google, in has since acquired Motorola, which deals with handset manufacturing (Blodget 2011). Other industries seem to be inclined to this restructuring. For example in the fashion industry, due to strict employment law and labor intensive nature of the apparel industry, companies had shifted to offshore production in a bid to diminish costs and elevate returns margins. Nevertheless, an internalized company, Zara, bypassed the companies that operated using this model, in size and profitability. Zara is the current leader in apparel retailing, overtaking GAP and H&M. Inditex, which owns Zara, oversees the production of cotton, its processing and final conversion to fashion goods. This happens in its more than 100 companies dealing with different levels of production. Oversea production compromised lead-time (time taken for goods to reach consumers and responsiveness to customer needs. This led to higher levels of inventory cost; this was absent in Zara’s model, which controlled its production, designing, making and retailing of its products. This allows for lower inventory costs, increased lead-time, and efficiency (Grant 2005, p. 398-399). Numerous apparel companies, for example, GAP, are returning to local production to balance their market competitiveness in an industry, which moves, terribly fast. Another industry with a similar trend is the oil and gas industry. In this segment, companies with gross market shares, for example, BP and ExxonMobil control and invest in petroleum exploration, mining, transportation, processing, supply, and retailing of petroleum goods. These structural adjustments are not without controversies and questions. Regulating body determine whether, apart from the companies’ increased revenues, there are benefits to consumers. For example, authorities and litigators have extensively questioned and subjected to investigations, the move by Google. This write up will evaluate the definition and implications of the two distinct structural models, their advantages and limitations. Defining the concepts: Vertical integration Vertical integration refers to a form of management control. Companies using this model, have other affiliated companies, either in upstream or downstream, which a common owner as their basis of unity. This is achieved through mergers or acquisition of companies at different levels of production. Vertical integration refers to a company’s ownership of vertically related activities. The greater the firm’s tenure over successive stages of the value chain for its creations, the greater the extent of vertical integration. This index depends on the ratio of the company’s value added to its sales revenue. In the technology industry, specifically PC industry, these levels of production may be categorized as follows; raw materials, which mainly include plastic, silicon and other metals. Components parts manufacturing follow, examples in this category include Intel and micron technology. The next level is the final assembly done by corporations including HP and Dell. The last stage involves delivery to customers through retailers such as OfficeMax and CompUSA. In the apparel industry, the above stages would be divisible into cotton growing or petroleum processing to produce synthetic fiber, processing, and manufacture of fabrics, designing, implementing the designs, and retailing the finished products. Most industry can easily be categorized into different levels of production. As cited by analysts, firms before 1990 extensively embraced vertical integration in order to gain control access to scarce corporeal resources. In the 1990s, companies shifted drifted to internal and external disintegration. During this period, alliances, joint ventures, and outsourcing increased (Idea, 2009). In the technology industry, one such company was Dell. Dell established closer linkage with the suppliers of the parts they used to assemble their computers. Dell called it virtual integration. Other companies, which prior to the 1990s embraced the vertical integration model, included the ford company. Ford opted to own mines, forests, rubber trees, trains, and everything required to make a car. Currently numerous companies are returning to vertical integration models; for example, Google, Apple and HP. The smart phone giant utilized software from other companies and developed fashionable handsets. In a recent move, it acquired an Israel company that manufactured flash memory technology utilized in many of their goods. This was a significant investment ($ 0.5 billion) in a company that is not a direct competitor, and in a non-core business with regard to Apple. Other acquisitions include those of NeXT, PA Semi, and Quattro Wireless. In regard with Google, their motive in the acquisition of Motorola seems to be a bid to progress to the manufacture of their own handsets utilizing their Android OS. There are drives that make these companies adopt the model, and this forms the basis of the next evaluation. Why vertical integration To evaluate the reasons for vertical integration, Grant compares the production chain leading up to steel cans and that of wheat to flour. He observes that, between ore mining and production of tin strips, the industry has vertical integration; but between the tin strip and the production of cans, there exists little vertical integration (Grant 2005, p. 394). To explain this, he points out to the accessibility of many buyers and suppliers in steel strips, and the accessibility of information. This results in low switching costs. In the same line, he observes the infeasibility of a competitive steel industry. This is due to the efficiency of investing in integrated mills, which utilize the hot ore after its processing. This lack of competitive market results in the loss of market efficiency leading to vertical integration. Therefore, vertical integration is likely to occur in industries whose market efficiency has been limited by the presence of bilateral relationships between buyers and sellers. Advantages In situations involving a single buyer negotiating with a single supplier, there is no balanced price. It is dependent on the bargaining power of the parties. Such dealings are inclined towards elevated costs. This is due to possible opportunism and strategic misrepresentation, as the companies compete to out-run each other’s bargaining power. In some instances, new products at one level require innovative approaches in the next production level. For example, companies that deal with designing are better suited to fabrication of their new designs. These companies operate efficiently with a level of vertical integration. Intel, which is the leader in the semiconductor industry, maintains a level of vertical integration; they design and fabricate their circuits making motherboards and microchips. Where new semiconductor designs require innovatory approaches to fabrication, complementarities exist between design and manufacturing that make vertical integration desirable (Grant 2005, p. 396). Vertical integration results in flexibility. A clear example is in the apparel industry is Zara. While many of its competitors opted for offshore production of their goods, Zara designed and produced most of its goods in Spain. The motivation in offshore production was diminishing production costs due to low labor costs in Asian countries. However, at home, Zara was utilizing the flexibility created by their vertical integration model. For example, the process from designing to retailing could be done in two weeks, compared to at least three months for other companies such as H&M and GAP to receive their shipment. This allowed Zara to change their designs fortnightly, creating their characteristic scarcity sale strategy (Vitzthum 2001). Vertical integration also forms prospects for increased revenues. For example, Apple is integrated upwards, running about 300 hundred outlets for its products. This has enabled it to achieve lower introductory prices for goods formerly slotted for the high end market. The low price, due to direct retailing, cuts off competitors such as Motorola, and increases sales volume. Disadvantages Internalization has significant administrative costs. Although companies bypass transactional costs by integrating vertically, they incur extra costs in new administrative requirements. Internalization means acquiring new facilities, new managers, and new employees. For example, in the acquisition of Motorola, Google has added19, 000 people to its workforce. Compared to its 29,000 employees, this is a 60% increase in the workforce. Such a large number of employees present new challenges to the company. The management of such a large number of employees is a challenge. In Google, culture is extremely valued; integrating such a large number of new employees into the culture will be a challenge (Blodget, 2011). Another challenge is differences in optimal scale between different stages of production. For example, if a logistics company acquires 40,000 new trucks each year for its business, and it decides on avoiding the transactional costs incurred in buying the trucks, the other option is to make their own, integrating downstream. However, how efficient would this be? The minimum efficient scale of an assembly line is 200,000. The 40,000 trucks the company requires each year would not be enough to warrant efficiency in a truck manufacturing venture. Compared to specialized companies in the business, for example, Toyota sold 8.4 million vehicles in 2010; this would be an inappropriate move (Sullivan 2012). One of the advantages of specialization compared to vertical integration is the ability of specialized companies to develop distinctive competences. Empirically, vertically integrated companies, for example, firms dealing in both hardware and software rarely outdo those specialized in one of the two areas in their capabilities. The ability of specialized companies to deal with varied customers with varied needs stimulates learning and innovation. For example, in the semiconductor industry, Intel makes one of the most sophisticated circuitry in the world used in almost all computers, servers, consumer electronics and communication devices (Chen 2012 and Sakuma 2011). Their interaction with the varied companies is a key stimulator for their innovativeness. Vertical integration requires venture into distinctively different fields or subsectors of the same industry, possibly design and manufacture or manufacture and retailing. However, designing, manufacturing and retailing require different organizational capabilities, tactical planning coordination, different approaches to control and HR management. Further, it requires different top management styles and skills. This explains why companies such as Zara and Gucci with integrated design, production and vending, are rare (Grant 2005, p. 396). These challenges have led to many companies de-integrating; these include Whitbread pl. Whitbread plc sold off its brewing business in 2000 to Interbrew S.A. In the following year, they offloaded the beer led pubs and concentrated on upscale and budget hotels. Analysts argue that vertical integration degrades the incentives between vertically related ventures. Where market forces are allowed to rule, the buyer and the seller form tacit contracts regarding the quality of their services. The seller aspires to improve the quality of his merchandise in order to retain the customer. The customer profit driven motives are to secure the best deal from the seller. These complementary incentives create what Grants terms as high-powered incentives. Incase of vertical integration, units at lower levels in production know that the products will be assimilated by the company in the next level. Though issues of quality may be addressed, there are no driving motives apart fro company policy. The lack of external competition creates lethargy in implementing quality policies. Horizontal integration In this form of structural form, companies concentrate their efforts in one level of production. Expansion involves the acquisition of facilities or other companies within the same level. Such companies include MacDonald’s and Wal-mart. Macdonald’s focuses on global, fast foods while Wal-mart focuses on discount retailing. Advantage Staying within the precincts of one industry allows a company to focus their managerial, financial, technological and functional resources and capabilities on gaining competitive lead in one area. Such focus enables the company to achieve this fast and to a higher degree. This is imperative in fast growing industries which are resource intensive, and where increased competitive edge translates in increased revenues. Additionally, staying inside an industry reduces the risks of venturing into new areas where the company has no experience (Hill & Jones 2009, p. 286). Hill and Jones opine that the benefits of the horizontal model are only realized in the event the company, through the model, achieves lower costs, increases product differentiation, replicates the business model, reduces competition and increases bargaining power over suppliers and buyers (Hill & Jones 2009, p. 288). Horizontal integration can increase the operating efficiency of a company. For example, if two companies compete in the same industry, they may be operating their facilities below capacity. If, however, one of the companies acquires the other, then it can run all its facilities after closing one facility; thereby increasing efficiency and reducing costs. For example, in the telecommunications industries, the cost of installing an advanced internet network is immense. These costs can only be repaid by having a large customer base, thus reducing the cost of providing services to one customer. Companies in this industry, therefore, seek to increase their customer bases. This is done through acquisition of smaller companies providing the same services. The target is not their infrastructure, but the customers. Increased customers lower the unit cost of services. Through the acquirement of companies in the same industry, a company can increase its products differentiation. This allows companies to offer their customers all the products they need. For example, Oracle, a database software company acquired 14 different suppliers of corporate software. These acquired companies dealt with different segments of the software market. PeopleSoft dealt with HRM while Siebel systems dealt with CRM and others in different niches. These acquisitions made Oracle create an integrated software suite providing software in CRM, HRM, accounting, marketing and sales. In the process, this led to an increased customer base. Disadvantages According to a study conducted by KPMG evaluating the effect of mergers and acquisitions in 700 companies, it revealed that 30% of the mergers increased profitability while 31% reduced profitability and the rest were non-effectual (Hill & Jones 2009, p. 292). Implementing horizontal integration requires a high level of managerial dexterity. Challenges include merging different cultures, management turnover in hostile takeovers and elevated benefit postulates while being oblivious of the challenges. Another problem created by horizontal integration is the collision with antitrust authorities. When companies expand and reduce competition from others, there are possibilities of abuse of market power. Authorities such as FTC keep an eye on such companies to ensure that consumers are not disadvantaged. Conglomerations and acquisitions are, therefore, under watch and often result in rigorous litigation. Conclusion The value of both vertical and horizontal integration in business is a debatable issue. However, the evaluation of these models is dependent on the costs and benefits associated with each model in a certain industry. Varied companies have utilized vertical integration and succeeded, such as Zara in the apparel industry. Some like Google and apple are integrating vertically, and there are signs of early success. Other companies are horizontally integrated and doing well; such include Oracle and Microsoft. Each model has its associated strengths and weaknesses. Vertical integration may reduce motivation towards innovativeness brought about by competition. It may increase management requirements due to increased workforce. Positively, it may increase flexibility making the company gain a competitive edge, for example, Zara. It may reduce transactional costs and increase profit margins. Horizontal integration may enable the company to focus resources on one area and elevate vale. It may also increase product differentiation like Oracle. Horizontal integration may also enable a company to reduce operational costs, for example, AT & T in communication. These advantages are, however, not guaranteed. Studies indicate many companies in horizontally integrating via acquisitions lower their profitability. Works cited Blodget, H 2011, Google’s Motorola deal: proof that Apple’s model is better? Viewed 20 January 2012, Chen, B 2011, Why nobody can match the ipad’s price, Gadget Lab, viewed 20 January 2012, Idea, 2009, Vertical integration, The Economist, viewed 20 january 2012, Idea, 2011, The test of time, The economist, viewed 20 January 2012, Grant, R 2005, contemporary strategy analysis, Blackwell Publishing, Malden. Hill, C, Jones, G 2010, Strategic management: an integrated approach, Cengage Learning, Mason Tara, P 1995 , Whitbread PLC Expands into Leisure As Traditional Beer Market Contracts, Wall Street Journal, August 9, p. A6. Vitzthum, C., (2001).“Zara's Success Lies in Low-Cost Lines and a Rapid Turnover of Collections”, The Wall Street Journal, viewed 20 January 2012, Sakuma, P 2012, Intel Corporation, New York Times, viewed 20 January 2012, Sullivan, J 2012, Ford Motor Company, New York Times, Viewed 20 January 2012, . Read More