Costing of Vertical Integration

However, as with most strategic decisions, the issue is more complex than it first appears. There are also costs and risks associated with outsourcing and many counter examples to the outsourcing success stories. Drawing general conclusions about the relative success or failure of vertical integration, based on what is working or not working in a particular industry at a particular time; is dangerous. There are many examples of industries where the relative merits of vertical integration versus outsourcing have changed over time. The disk drive industry provides a good example. Until the late 1970s vertically integrated firms dominated that industry. Non-integrated disk firms then gained the upper hand from the late 1970s through the early 1990s. Today, vertically integrated disk drive manufacturers appear to be gaining competitive advantage once again. Similarly, in the early 1980s, IBM was widely praised for outsourcing both the microprocessor (to Intel) and the operating system (to Microsoft) of its then fledging Personal Computer. By the early 1990s, the strategic wisdom of that choice began to look quite suspect.

In the 1980s a new breed of semiconductor companies, such as Weitek and LSI Logic, which specialized in chip design and contracted out all manufacturing were widely touted to provide models of the new IC industry. This view changed in the early 1990s however, when manufacturing capacity in the industry became tight and the fabless found themselves unable to line up contractors to meet their delivery commitments. Fabless design firms also discovered that some of their customers were deciding that it was just as easy for them to perform their own design in-house and secure their own manufacturing contractors. In contrast, Intel has long pursued a strategy of vertical integration. It carries out all major operating functions R&D manufacturing and marketing in-house and is vertically integrated into chipsets and subassemblies. Similarly, during the early years of the twenty first century, Samsung emerged as a market leader in several high technology markets, including digital cell phones, LCD displays, DRAMs and large screen TVs, while following a vertical integration strategy. Its CEO in fact, asserted If we get out of manufacturing we will lose. On the other hand, Taiwan Semiconductor Manufacturing Company (TSMC), which specializes in contract manufacturing, is one of the fastest growing semiconductor companies in the world.

It also should be recognized that vertical dis-integration by one set of firms may on the flip side, lead to increasing vertical integration by those firms’ suppliers.
As electronic companies changed their strategies to focus on final systems design and assembly, Solectron saw an opportunity to vertically backward into the design of components and subassemblies. Recently, it has chosen to integrate further into procurement and logistics. In the drug industry, contract research organizations (CROs) initially only conducted clinical trials under drug companies. Increasingly, however, CROs are vertically integrating into the other aspects of the drug development process, including process development, manufacturing and even earlier stage pre- clinical development. Even the Internet world is not as virtual as it seems. Amazon, for instance, has built up a vast infrastructure of warehouses and logistical operations to support its online retail operations.

The complexities of a vertical integration strategy can be seen in the January 2000 merger of America On-line (AOL), the largest Internet subscriber service, and Time Warner, an owner of cable services and major news publications. It needed to offer high speed broadband Internet services and a vast array of content (e.g. CNN online). Other media companies had followed a similar strategy of acquiring content providers. It is important to note, however, that vertical integration through merger is just one possible way for a company like AOL to access broadband cable infrastructure and content. A plausible alternative might have been to form some type of long term contractual alliance with Time Warner that fell short of outright acquisition Licensing content and contracting for access to a cable infrastructure was another alternative. Each approach, of course, involves its own set of challenges and risks. As AOL Time Warner and other media companies have learned, acquisition is only the first step toward integration; getting all the various units to work together can be a more serious challenge. Alliances and licensing, however, also involve potential risks. For all challenges of getting newly acquired units to cooperate, it may be even more difficult to achieve cooperation across independently owned companies.
These examples suggest that one best way prescriptions about vertical integration are misleading. There are situations where vertical integration is more appropriate than outsourcing and conversely where outsourcing is more appropriate.

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