On-Line Seminar Series

1. LGO-SDM ALUMNI On-Line Seminar Series January 18, 2001

2. As You Join the Session. . . • Please answer the following questions and send your response via the “question” window on your screen. • What are you hoping to learn from the presenter and your fellow alums about vertical or virtual integration today?

3. Vertical or Virtual Integration?The Issues and Challenges Sara L. Beckman Haas School of Business University of California, Berkeley beckman@haas.berkeley.edu http://www.haas.berkeley.edu/faculty/beckman.html

4. Objectives: • Provide information on vertical and virtual integration: • Some definitions • Considerations in making vertical/virtual integration decisions • Economic • Strategic • A model for making vertical/virtual integration decisions • Initiate an ongoing conversation on strategic decision making in operations management and test distance learning software as a means of having that conversation

5. Poll: How Vertically Integrated Is Your Firm? • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Highly • Moderately • Somewhat • Not much • Not at all 5

6. There Is a Broad Spectrum of Supplier Relationships; Vertical Integration Defines One Endpoint

7. Poll: Where Would You Place VIRTUAL Integration on That Spectrum? • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • A network of arm's length arrangements • A network of linked agreement arrangements • A network of partnership-based arrangements • A network of suppliers supporting a partially vertically integrated company • A combination of such arrangements 7

8. Where does VIRTUAL integration fall on this spectrum?

9. Virtual Integration Has Become a Real Option in Recent Years Due To: • The evolution of new forms of contracting with suppliers • The advent of new service industries that provide specialized intermediate capability • The development of information technology that supports cross-organizational coordination • 60s/70s mainframe-based MRP • 70s-80s PC-based information access • mid-80s network integration within companies • late 90s Internet integration across firm boundaries

10. In essence, the firm has to answer the following questions to develop a “VI” strategy: • Breadth: In how much of the supply chain does my firm want to be “heavily” involved? • Direction: Do we want to move upstream (backward) or downstream (forward) in our supply chain? (Note: From 1899 to 1948, forward integration was three times more common than backward integration.) • Extent: How far? • Form: What form of relationship do we want to have with our outside resources/suppliers? i.e., How “heavily” will we be involved? • Change: What will trigger us to consider a change in our vertical integration strategy?

11. Poll: Is Your Firm Thinking About: • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Becoming more forward integrated (moving towards the marketplace)? • Becoming more backward integrated (moving towards the supply base)? • Maintaining current levels of integration? • Becoming less forward integrated? • Becoming less backward integrated? 11

12. Typical Considerations in Making a Vertical Integration Decision: • Setup costs • Transaction costs • Risk • Coordination effectiveness

13. Setup Costs VERTICAL INTEGRATION • Capital (e.g., equipment, acquisitions) • Systems development • Training VIRTUAL INTEGRATION • Relationship negotiation • Contract C O S T Arm’s Length Full Vertical Integration

14. Transaction Costs • Information collection and processing • Legal • Sales and purchasing • Physical handling costs C O S T Arm’s Length Full Vertical Integration

15. Risks • Possibility for unreasonable price changes • Supply or outlet foreclosure • Insulation from market • Insulation from technology sources C O S T Arm’s Length Full Vertical Integration

16. Coordination Effectiveness • Run lengths, inventory levels • Capacity utilization • Delivery performance • Quality C O S T Arm’s Length Full Vertical Integration

17. So, What’s Better?

18. Poll: What's better if you want to be an innovative organization? • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Arm’s length arrangements • Linked agreements • Partnerships (virtual organization) • Vertical integration 18

19. What’s Better If You Want to Innovate? • It depends. • Autonomous innovations can be handled in virtual – even arm’s length -- environments • Systemic innovation (e.g., lean manufacturing) is harder • Lack of industry standards favors vertically integrated firms that have the clout to advance new standards • “Virtuous virtuals” are at the center of a network they use to leverage their own capabilities; their unique competencies drive the network’s success

20. Some rough rules of thumb:

21. Poll: What's Better If You Want to Provide a High Degree of Customization? • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Arm's length arrangements • Linked agreements • Partnerships (virtual) • Vertical integration 21

22. Standard Custom Design Design Design Design Design Pure Standardization Segmented Standardization Customized Standardization Tailored Customization Pure Customization Fabrication Fabrication Fabrication Fabrication Fabrication Assembly Assembly Assembly Assembly Assembly Distribution Distribution Distribution Distribution Distribution Customization Strategies

23. Market Structure May Also Suggest Vertical Integration High Trading Risk A firm may want to vertically integrate to defend against market power or to create and exploitit

24. As May Asset Specificity

25. Or, Perhaps It Is Just the Right Time in the Industry Life Cycle Modular product, horizontal industry Integral product, vertical industry Technical advances Niche competitors Supplier market power High-dimensional complexity Proprietary system profitability Organizational rigidities Pressure to disintegrate Pressure to integrate Charles Fine, Clockspeed: Winning Industry Control in the Age of Temporary Advantage

26. To develop your own “VI” strategy: • Step 1: Characterize your present supply chain • Identify all “natural” business units that could not be further disaggregated from an ownership perspective • Assess number and sizes of all participants at each stage • Determine the types of transactions that currently take place among the various members of the chain

27. To develop your own “VI” strategy: • Step 2: Perform a “static” analysis of the chain • Assess degree of asset specificity at each stage • Measure transaction frequency • Estimate economics at each stage • Assess effects if weak and powerful players were to change their position • Identify key sources of technological innovation • Identify key loci for customization

28. To develop your own “VI” strategy: • Step 3: Perform a “dynamic analysis” of the chain • Predict future changes in industry structure • Predict changes in integration strategy by other players • Predict strategic needs for supply chain performance • Technological advancement • Customization

29. To develop your own “VI” strategy: • Step 4: Identify, assess and choose from a set of alternative strategies • Quantify and weigh the setup costs, transaction costs, risks and coordination effectiveness of each option • Assess the strategic implications of each option • Choose one • Develop a (staged) implementation plan

30. Questions?

31. Poll: Would you be interested in an ongoing discussion of this or other operations strategy topics? • [PlaceWare Yes/No Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Yes • No 31

32. Poll: If so, would you want to talk: • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Once/year • Once/quarter • Once/every other month • Once/month 32

33. Poll: What Format Appeals Most? • [PlaceWare Multiple Choice Poll. Use PlaceWare > Edit Slide Properties... to edit.] • Discuss problem company is solving • Discuss new research paper on topic • Have presentation from professor 33

34. Further Information • Papers and theses: http://lfmsdm.mit.edu (password for theses needed: contact pfgallag@mit.edu if you don’t have it) • sbeckman@mit.edu orbeckman@haas.berkeley.edu • (415) 464-0517

35. References • Chesbrough, Henry W. and David J. Teece, “When is Virtual Virtuous? Organizing for Innovation,” Harvard Business Review, January-February, 1996. • Stuckey, John and David White, “When and When Not to Vertically Integrate,” Sloan Management Review, Spring 1993. • Hill, Terry, Manufacturing Strategy: Text and Cases, 2000