Factors Influencing Vertical Integration Decision

Deciding among vertical integration, virtual integration or a more arm lengths relationship requires consideration of three sets of factors:

  • capabilities / resources
  • coordination requirements
  • strategic control and risks

All three are examined next. One of the first issues a company must face in developing a vertical integration strategy is a need to assess its resource constraints and the limits of its organizational and operating capabilities. In some cases vertical integration is not feasible because the company simply lacks the financial resources to acquire or build the required assets. This is an extremely common situation for start-up companies. In the biotechnology industry, the enormous costs of building development infrastructure have led many companies to rely on contract research organizations or partnerships with established pharmaceutical companies for drug development. However, such constraints are not limited to start-ups. Consider one of the largest manufacturers in the world: Boeing. Because the development of a new generation aircraft costs upwards of $ 10 billion, even a company as large as Boeing must rely on an extensive array of subcontractors to develop and manufacture major portions of the aircraft. Boeing focuses most of its resources on the aircraft’s design, the manufacture of its avionics and its final assembly.

Capability limits also play an important role. No company can do all things well. Intel is clearly a very technically skilled organization with vast   financial resources, but it has chosen to let other organizations develop the equipment it uses in manufacturing semiconductors. Indeed, Intel even makes substantial investments in applied research focused on advancing the technology of photolithography but it does this by funding carried out by universities and outside partners. One of the reasons for such a strategy is that the design of semiconductor devices requires a very different set of technical skills than does equipment design. In wire-less communications, developing mobile phones that can access the Internet has become a major area of activity. A company like Motorola is adept at developing such devices, but it lacks capabilities to develop the tailored Web browsers and Internet user interfaces needed to make such a product useful.

In arenas such as the Internet or pharmaceuticals, technological advance is so rapid and so dispersed among organizations that it is simply infeasible for any one enterprise no matter how large or skilled to be the world’s expert at everything.

The time required to build or acquire a certain set of capabilities can also impose a hard constraint on a company’s vertical integration strategy. In the short term, a company might simply be unable to vertically integrate regardless of its strategic desirability. In rapidly evolving environments,   the time required to build or even acquire certain capabilities may be prohibitive. In those cases, the company needs to craft alternative arrangements such as virtual integration.
Just because a company can do something however does not mean that it should. Investing in building one new set of capabilities detracts resources and management attention from other potentially high value possibilities. And conversely, just because a company lacks the capabilities in the short term to vertically integrate does not mean that   over the long run it should not be building those capabilities.
To get a sense of direction about where vertical integration might be most valuable one need to consider the other two sets of factors: coordination and strategic control and risks.
Historically, the arguments for vertical integration were rooted in the need to carefully coordinate activities and assets. Henry Ford created a fully integrated supply chain in 1920s because his production system required a high degree of design and scheduling coordination between raw material processes, component  fabrication, and final assembly. The need for coordination in and of itself, however, does not automatically warrant common ownership of assets.

Vertical integration, longer term partnerships and alliances, and arms- length relationships all can achieve various degrees of coordination. Each, however, is more effective at addressing different types of coordination problems and challenges. In designing a vertical integration strategy the objective is to choose the governance structure that best addresses the specific types of coordination that need to be provided.
Coordination requires information exchange. The Internet has clearly been a powerful force in enabling organizations that are geographically dispersed to quickly and efficiently exchange certain types of information that are vital for coordinating their operations. This has had two effects. In some cases, it has enabled companies to forge tighter operational links with their suppliers and customers.  Dell Computer has utilized the Internet very effectively to achieve a high degree of coordination throughout its supply chain without extensive vertical ownership. In this case, the Internet has facilitated virtual integration.

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