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					VERTICAL INTEGRATION IN DISTRIBUTION

Chapter 9

Prof. Aisha Zahid

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Outline
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Introduction The costs and benefits of vertical integration in marketing channels Deciding when to vertically integrate forward Vertical integration forward when competition is low Vertical integration to cope with environmental uncertainty Vertical integration to reduce performance ambiguity Summary of the decision framework Vertical integration as an observatory on the market or as an option Zahid Prof. Aisha

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Distribution Networks: Activities
1) Hold the goods (storage, delivery costs) 2) Own the goods (inventory carrying costs) 3) Promote (sell, advertise, public relations, trade deals) 4) Negotiate (takes time and money)
Prof. Aisha Zahid 3

Distribution Networks: Activities
5) Finance (credit, terms and conditions of sale) 6) Assume risks (price guarantees, warranties, insurance, repair, after-sales service) 7) Assume costs of processing orders (often greater than cost of items!) 8) Handle payment (collection, bad debt)
Prof. Aisha Zahid 4

What Value Does Distribution Provide?
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Conventional wisdom: not much
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Assumption: most of the value added is in production Goods and services “appear”
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Most buyers (and managers!) don’t see the elaborate structure of distribution that makes transactions happen
Prof. Aisha Zahid 5

Distribution: The Real Value
Solve customer’s problem Gain producer knowledge

Gain customer knowledge

Solve producer’s problem

What Distribution Really Does
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Solve problems for prospective buyers Thereby solve problems for prospective sellers
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Make markets
Help define needs  Find provider-customer matches  Facilitate transactions
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Prof. Aisha Zahid

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It’s A Big Industry
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The sales side alone
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1 in 10 jobs worldwide is in sales and related industries
The world’s largest company is a retailer

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Business-to-Consumer (B2C)
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Business-to-Business
Independent wholesalers alone  1 in 20 jobs in the U.S. throughout the last century

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Wholesaling is a key industry to mergers and acquisitions specialists
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Consolidation due to opportunities to achieve advantage through massive information technology and logistics investments
Prof. Aisha Zahid 8

And It’s Not Easy
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Getting it right
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intricate, detailed

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and getting costs down
Is a challenge

Distribution is a competence in itself
New Institutional Economics has a great deal to say about how to contract for this competence
Prof. Aisha Zahid 9

Vertical Integration Defined
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A channel member assumes responsibility for additional channel flows rather than have them performed by other channel members
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Acquire other channel members “Make or buy” Forward integration Backward integration Flow by flow
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Not a binary decision of fully integrating or fully Prof. Aisha Zahid outsourcing

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The costs and benefits of Vertical Integration in Marketing Channels
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Degree of Vertical Integration
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Classical Market Contracting (Outsourcing) Quasi-Vertical Integration (Relational
Governance)

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Vertical Integration

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Costs and benefits of the Choice to Make The choice to buy distribution : The terms of payments to third parties
Prof. Aisha Zahid 11

Buy Classical Market Contracting Quasi-Vertical Integration (Relational Governance) How does the the work get done

Make Vertical Integration

Third Party Does it (for a price) Their people Their money Their risk Their responsibility

You do it

The costs

You and third party share costs and benefits

Your people Your money Your risk Your responsibility

Their operation (control) Their gain or loss

The benefits

Your operation (control) Your gain or loss

The Continuum of vertical integration

Costs and benefits of the Choice to Make
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All accounting costs of distribution, which includes the cost of personnel and channel flow costs. Heaviest cost is the opportunity cost of the personnel Control; it has no value unless it improves profits A business Proposition
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To cut cost To explore new opportunities Existing operations loosing their attractiveness

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Theoretically integrated entity is better off financially , weighing total returns against total assets employed , adjusting for the risk assumed.
Prof. Aisha Zahid 13

Some Channel Functions
Market Contracting
Selling (only) Manufacturers’ Representatives

Quasi-vertical Integration
“Captive” Sales Agency

Vertical Integration
Company Sales Force (direct salespeople) Distribution Arm Company Stores

Wholesale Distribution Retail Distribution

Independent Wholesaler Independent (3rd party) Stores

Distribution Joint Venture Franchise Store

Prof. Aisha Zahid

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The choice to buy distribution :
The terms of payments to third parties

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Price:
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Margins Commission A percentage of reseller’s business Functional discount Rights to future business Percentage of equity in the manufacturer

Prof. Aisha Zahid

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Deciding when to vertically Integrate Forward:
An economical Framework
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Return on Investment: The usual Criterion Outsourcing as a starting point Six reasons to outsource distribution

Prof. Aisha Zahid

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Deciding When To Integrate Forward
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Preliminary decision: outsource, do not integrate Then challenge preliminary decision Criterion: long-run ROI  Compare ROI for integrating versus outsourcing Revenues – Direct Costs Overhead Net Effectiveness = Overhead = Efficiency
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Compare ROI for integrating with ROI for other possible investments  Integrating as a “business opportunity”
Prof. Aisha Zahid 17

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“Control” has no economic value

Outsourcing as a starting point
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The fundamental rationale is that under normal circumstances in a developed economy , markets for distribution services are efficient.

Prof. Aisha Zahid

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THE EFFECTS OF OUTSOURCING not given in the book
Step 2: Question Outsourcing Where Markets Are Not Competitive:

Step 1: Outsourcing Distribution to Benefit from Advantages of Competitive Markets:

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1) Valuable Company-Specific Capabilities are Needed: • Know-How • Relationships • Brand Equity Created by Distribution Activities • Dedicated Capacity • Site Specificity • Customized Physical Facilities 2) Thin Supply Step 3: Question Outsourcing Where Indicators of Results Do Not Correspond to Performance:

Revenues +

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• • • • • •

Motivation Specialization Survival of the Economic Fittest Economies of Scale Heavier Coverage Independence from a Single Producer

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Direct Costs

-

Prof. Aisha Zahid

Overhead

• Cannot be benchmarked • Not Timely • Inaccurate

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Six Reasons To Outsource Distribution
1.
2. 3. 4. 5.

6.

Motivation Specialization Survival of the economically fittest Economies of scale Heavier market coverage Independence from any single manufacturer
Prof. Aisha Zahid 20

Vertical Integration Forward When Competition Is Low
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Vertical Integration always involves substantial set up costs and overheads; therefore it is only worth considering if a substantial amount of business is at stake It is only worth considering if the firm is prosperous enough to be able to muster the necessary resources-and does not have a better use for them
Prof. Aisha Zahid 21

Vertical Integration Forward When Competition Is Low
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Company specific capabilities Six types of company specific capabilities in distribution
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Specific assets can change to general purpose assets Switching Cost

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Rarity vs. Specificity
Prof. Aisha Zahid 22

Company specific capabilities
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Idiosyncrasies Greater the value of company specific capabilities , greater the economic rationale for the manufacturers to vertically integrate forward into the distribution Irreplaceable nature of holders of capabilities To cope with shirking, misrepresenting the products, unethical behaviors, falsifying expense accounts and demands for more compensation to do the same work Vertical integration creates an administrative mechanism . Vertical integration gives the ability to employ negative sanctions Vertical integration leads to the control of monetary and non monetary compensations Threat of vertical integration will improve the performance of distributors.

Prof. Aisha Zahid

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Company specific capabilities Cont…
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Two benefits of Vertical Integration are : The producer can make sure its employees really do make the investment and acquire the needed capabilities The producer can show potential customers and other constituents (investors ) that it is dedicated to the markets and its products
Prof. Aisha Zahid 24

Company specific capabilities Cont…
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Assets : tangible or intangible can be used to create economic value Specific: made to specifications , customized, tailored, particular to , or idiosyncratic.

Prof. Aisha Zahid

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Six types of company specific capabilities in distribution
Idiosyncratic knowledge  Relationship  Brand equity that drives from the channel’s partner activities  Customized physical facilities  Dedicated capacity  Site specificity
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Prof. Aisha Zahid

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Six types of company specific capabilities in distribution Cont…
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Specific assets can change to general purpose assets
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Innovative products Entering Foreign Markets

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Competitors copy the products and practices which change the company specific assets to general purpose assets.
Prof. Aisha Zahid 27

Six types of company specific capabilities in distribution Cont…
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Switching Cost
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Creative solutions:
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These are the one time losses incurred in taking down the current operations and setting up a new operation Terminating position

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Switching cost give late movers an advantage over established firms.
Prof. Aisha Zahid

Transfer of personnel Setting up former employees as third party providers of distribution services Setting up independent agencies

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Rarity vs. Specificity
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Selling Ability and Technical Competences Consolidation of industries

Prof. Aisha Zahid

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HOW ENVIRONMENTAL UNCERTAINTY IMPACTS VERTICAL INTEGRATION

Prof. Aisha Zahid

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HOW ENVIRONMENTAL UNCERTAINTY IMPACTS VERTICAL INTEGRATION Cont…
Highly Volatile Market

Low Specificity

High Specificity

Outsource Distribution to Retain Flexibility Until Uncertainty Is Reduced

Highly Promising Market

Less Promising Market

Vertically Integrate to Gain Control Over Employees And Avoid Small-Numbers Bargaining Prof. Aisha In Changing Circumstances Zahid

Do Not Enter

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ROAD MAP TO THE VERTICAL INTEGRATION DECISION

Prof. Aisha Zahid

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posted:7/30/2009
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