Definition of vertical integration

The merger with or acquisition of a company that performs a different role in the same industry - for instance, when the producer of a good buys the distributor of the same product. This contrasts with horizontal integration, which involves combining with a company that has the same role in the same industry. [1]

Vertical integration does not necessarily require a merger or acquisition. It is often the result of internal development. The choice between outsourcing and vertical integration is a crucial decision for most companies.

A company should use vertical integration when there is a threat of being unfairly exploited by its supplier. When there is a small number of suppliers, there is a possibility that these suppliers may take advantage of their clients’ dependence to behave opportunistically.  By using vertical integration instead of outsourcing, a firm can totally avoid this threat. 

Outsourcing has disadvantages that include losing control over the outsourced activity or even exposing clients to the potential opportunism of suppliers.  For instance, they may charge excess fees for services that are not included in the contract. They may also make promises knowing well that they will break these in an instant, should the benefits from breaking these promises exceed the costs or disadvantages.

On the other hand, outsourcing is more flexible than vertical integration because suppliers make investments. It is preferable to let suppliers make investments when the environment is uncertain because if the investments go wrong or the assets become obsolete, then the supplier will bear the cost and not the client.  This makes outsourcing less risky than vertical integration.

A company should use vertical integration for activities with high strategic value.  These are activities based on resources and capabilities that generate a competitive advantage. For instance, product design is an activity that has high strategic value for Apple.

If organisations do not possess the resources and capabilities that can provide them with a competitive advantage, there is a risk that they will become “hollow” corporations. These are companies that have outsourced most of the resources and capabilities necessary to enjoy a competitive advantage and they generally fail.

Only activities with limited strategic value can (and should) be outsourced.

The Disney-Pixar relationship between 1991 and 2006 illustrates the move from outsourcing to vertical integration. Disney outsourced the production of 3D animated films to Pixar in 1991 because there was a lot of uncertainty around the potential of 3D animation. At the time it was not clear whether 3D animated films would be successful or at least as successful as 2D animated films. In addition, 2D animation capabilities were far more likely than 3D animation capabilities to generate a competitive advantage.

By 2006, vertical integration had become necessary for Disney because Pixar was taking advantage of Disney’s dependence to constantly renegotiate the contract.

For instance, after the success of Toy Story (1995), Steve Jobs, who was chief executive of Pixar at the time, threatened to end the relationship with Disney unless the contract terms were adjusted in Pixar’s favour. Michael Eisner, chairman and chief executive of Disney, eventually agreed to renegotiate the contract in favour of Pixar in exchange for an extended duration.

Moreover, the uncertainty surrounding 3D animation had disappeared and this film technique had become essential to the competitive advantage of the animation film industry. [2]

Barthélemy, J. (2011), “The Disney-Pixar relationship dynamics: Lessons for outsourcing vs. vertical integration”, Organizational Dynamics, 40: 43-48.

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