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Vertical scope. What range of vertically linked activities should the firm encompass? Walt Disney Company is a vertically integrated company: it produces ...
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340 PART V CORPORATE STRATEGY
Chapter 2 introduced the distinction between corporate strategy and business strategy. Corporate strategy is concerned primarily with the decisions over the scope of the firm’s activities, including:
l Product scope. How specialized should the firm be in terms of the range of products it supplies? Coca-Cola (soft drinks), SAB Miller (beer), Gap (fashion retailing), and Swiss Re (reinsurance) are specialized companies: they are engaged in a single industry sector. General Electric, Samsung, and Bertelsmann are diversified companies: each spans a number of different industries. l Geographical scope. What is the optimal geographical spread of activities for the firm? In the restaurant business, Clyde’s owns 12 restaurants in the Washington DC areas, Popeye’s Chicken and Biscuits operates throughout the US, McDonald’s operates in 121 different countries. l Vertical scope. What range of vertically linked activities should the firm encompass? Walt Disney Company is a vertically integrated company: it produces its own movies, distributes them itself to cinemas and through its own TV networks (ABC and Disney Channel), and uses the movies’ characters in its retail stores and theme parks. Nike is much more vertically specialized: it engages in design and marketing but outsources many activities in its value chain, including manufacturing, distribution, and retailing.
Business strategy (also known as competitive strategy ) is concerned with how a firm competes within a particular market. The distinction may be summarized as follows: corporate strategy is concerned with where a firm competes; business strategy is con- cerned with how a firm competes. 1 The major part of this book has been concerned with issues of business strategy. For the next four chapters, the emphasis is on corporate strategy: decisions that define the scope of the firm. I devote separate chapters to the different dimensions of scope – vertical scope ( vertical integration ), geographical scope ( multinationality ), and product scope ( diversification ). However, as we shall discover, the key underlying concepts for analyzing these different dimensions – economies of scope in resources and capabilities, transaction costs, and costs of corporate complexity – are common to all three. In this chapter we begin by considering the overall scope of the firm. We then focus specifically on vertical integration, since it takes us to the heart of the determinants of firm boundaries – in particular, the role of transaction costs. Moreover, vertical integration has been a central issue in corporate strategy in recent years as outsourcing, alliances, and e-commerce have caused companies to rethink which parts of their value chains they wish to include within their organizational boundaries.
In Chapter 6, we noted that firms came into existence because they were more efficient in organizing production than were market contracts between independent workers. Let us explore this issue and consider the determinants of firm boundaries.
Although the capitalist economy is frequently referred to as a “market economy,” in fact, it comprises two forms of economic organization. One is the market mechanism , where individuals and firms make independent decisions that are guided and coordin- ated by market prices. The other is the administrative mechanism of firms, where de- cisions over production, supply, and the purchases of inputs are made by managers and imposed through hierarchies. The market mechanism was characterized by Adam Smith, the 18th-century Scottish economist, as the “invisible hand” because its coor- dinating role does not require conscious planning. Alfred Chandler has referred to the administrative mechanism of company management as the “visible hand” because it is dependent on coordination through active planning.^2 Why do institutions called “firms” exist in the first place? The firm is an organiza- tion that consists of a number of individuals bound by employment contracts with a central contracting authority. But firms are not essential for conducting complex economic activity. When I recently remodeled my basement, I contracted with a self- employed builder to undertake the work. He in turn subcontracted parts of the work to a plumber, an electrician, a joiner, a drywall installer, and a painter. Although the job involved the coordinated activity of several individuals, these self-employed
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 341
By the time you have completed this chapter, you will be able to:
l Identify the relative efficiencies of firms and markets in organizing economic activity and apply the principles of transaction cost economics to explain why boundaries between firms and markets have shifted over the past two hundred years.
l Assess the relative advantages of vertical integration and outsourcing in organizing vertically related activities, understand the circumstances that influence these relative advantages, and advise a firm whether a particular activity should be integrated within the firm or outsourced.
l Identify alternative ways of organizing vertical transactions – including spot market transactions, long-term contracts, franchise agreements, and alliances – and advise a firm on the most advantageous transaction mode given the characteristics and circumstances of the transaction.
costs of the firm as compared with the transaction costs of markets. Two factors have greatly increased the efficiency of firms as organizing devices:
l Technology. The telegraph, telephone, and computer have played an important role in facilitating communications within firms and expanding the decision-making capacity of managers. l Management techniques. Developments in the principles and techniques of management have greatly expanded the organizational and decision-making effectiveness of managers. Beginning with the dissemination of double-entry bookkeeping in the 19th century,^5 and the introduction of scientific management in the early 20th century,^6 the past six decades have seen rapid advances in all areas of management theory and methods. Observing this growth in large corporations at the expense of markets, several leading economists of the late 1960s declared that the market economy had been replaced by a corporate economy. In 1969, J. K. Galbraith predicted that the inherent advantages of firms over markets in planning and resource allocation would result in increasing dominance of capitalist economies by a small number of giant corporations. 7 During the 1980s and 1990s, these predictions were refuted by a sharp reversal of the trend toward increased corporate scope. Although large companies have con- tinued to expand internationally, the dominant trends of the past 20 years have been “downsizing” and “refocusing,” as large industrial companies reduced both their prod- uct scope through focusing on their core businesses, and their vertical scope through outsourcing. The result, as shown in Figure 13.2, was that the largest companies began to play a declining role in the US economy. These changes are associated with the more turbulent business environment that followed the oil shocks of 1973 and 1979, the end of fixed exchange rates (1972), the invention of the integrated circuit, and the upsurge of international competition. The implication seems to be that during periods of instability, the costs of administration within large, complex firms tend to rise as the need for flexibility and speed of response overwhelms traditional manage- ment systems. Let us focus now on just one dimension of corporate scope: vertical integration. The question we will consider is this: is it better to be vertically integrated or verti- cally specialized? To answer this question, we shall draw in particular on Oliver Williamson’s analysis of transaction costs, which forms the basis for a theory of economic organization that is particularly useful in designing vertical relationships.^8
Strategies towards vertical integration have been subject to shifting fashions. For most of the 20th century, the prevailing wisdom was that vertical integration was generally beneficial because it allowed superior coordination and security. During the past 20 years there has been a profound change of opinion and the emphasis has shifted to the benefits of outsourcing in terms of flexibility and the ability to develop spe- cialized capabilities in particular activities. Moreover, it has been noted that most of the coordination benefits associated with vertical integration can be achieved through interfirm collaboration. However, as in other areas of management, fashion is fickle. In the media sector, vertical integration between content and distribution has become viewed as a critical
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 343
advantage in the face of rapid technological change. The resulting wave of mergers between content producers and distributors (TV broadcasters, cable companies, and internet portals) has transformed the industry (see Strategy Capsule 13.1). Our task is to go beyond fads and fashions to uncover the factors that determine whether vertical integration enhances or weakens performance.
Vertical integration refers to a firm’s ownership of vertically related activities. The greater the firm’s ownership and control over successive stages of the value chain for its product, the greater its degree of vertical integration. The extent of vertical integration is indicated by the ratio of a firm’s value added to its sales revenue. Highly integrated companies – such as the major oil companies that own and control their value chain from exploring for oil down to the retailing of gasoline – tend to have low expenditures on bought-in goods and services relative to their sales. Vertical integration can be either backward , where the firm takes over ownership and control of producing its own components or other inputs, or forward , where the
344 PART V CORPORATE STRATEGY
1980 1983 1986 1989 1992 1995 1998 2001 2004
25
20
15
10
5
0
% of total employment
FIGURE 13.2 500 biggest US companies’ share of total US private sector employment
SOURCES:
L. J. WHITE, “WHAT’S BEEN HAPPENING TO AGGREGATE CONCENTRATION IN THE U.S.? (AND SHOULD WE CARE?),” STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY, 2001;
FORBES
500 AND
FORTUNE
1000 (VARIOUS YEARS)
firm takes over ownership and control of activities previously undertaken by its customers. Vertical integration may also be full or partial : l Full integration exists between two stages of production when all of the first stage’s production is transferred to the second stage with no sales or purchases from third parties. l Partial integration exists when stages of production are not internally self-sufficient. Among the oil and gas majors, “crude-rich” companies (such as Statoil) produce more oil than they refine and are net sellers of crude; “crude-poor” companies (such as Exxon Mobil) have to supplement their own production with purchases of crude to keep their refineries supplied.
Analysis of the benefits of vertical integration has traditionally emphasized the tech- nical economies of vertical integration: cost savings that arise from the physical integration of processes. Thus, most steel sheet is produced by integrated producers in plants that first produce steel, then roll hot steel into sheet. Linking the two stages of production at a single location reduces transportation and energy costs. Similar technical economies arise in pulp and paper production and from linking oil refining with petrochemical production. However, although these considerations explain the need for the co-location of plants, they do not explain why vertical integration in terms of common ownership is necessary. Why can’t steel and steel sheet production or pulp and paper production be undertaken by separate firms owning facilities that are physically integrated with one another? To answer this question, we must look beyond technical economies and consider the implications of linked processes for transaction costs.
Consider the value chain for steel cans, which extends from mining iron ore to delivering cans to food processing companies (see Figure 13.3). Between the pro- duction of steel and steel strip, most production is vertically integrated. Between the production of steel strip and steel cans, there is very little vertical integration: can producers such as Crown Holdings and Ball Corporation are specialist packaging companies that purchase steel strip from steel companies on contracts. 9
346 PART V CORPORATE STRATEGY
people who proclaimed the AOL–Time Warner deal a marriage made in heaven. And it was revealed with Damascene force to Jean-Marie Messier, a humble French water carrier. But activities can converge without requir- ing that the companies that undertake them
converge. The erstwhile maître du monde might have drawn a useful lesson from his ex- perience at Compagnie Générale des Eaux be- fore his apotheosis as chief executive of Vivendi Universal: sewers and the stuff that goes down them do not need common ownership.
The predominance of market contracts between steel strip production and can pro- duction is the result of low transaction costs in the market for steel strip: there are many buyers and sellers, information is readily available, and the switching costs for buyers and suppliers are low. The same is true for many other commodity products: few jewelry companies own gold mines; few flour-milling companies own wheat farms. To understand why vertical integration predominates across steel production and steel strip production, let us see what would happen if the two stages were owned by separate companies. Because there are technical economies from hot-rolling steel as soon as it is poured from the furnace, steel makers and strip producers must invest in integrated facilities. A competitive market between the two stages is impossible; each steel strip producer is tied to its adjacent steel producer. In other words, the market becomes a series of bilateral monopolies. Why are these relationships between steel producers and strip producers prob- lematic? To begin with, where a single supplier negotiates with a single buyer, there is no equilibrium price: it all depends on relative bargaining power. Such bargaining is likely to be costly: the mutual dependency of the two parties is likely to give rise to opportunism and strategic misrepresentation as each company seeks to both enhance and exploit its bargaining power at the expense of the other. Hence, once we move from a competitive market situation to one where individual buyers and sellers are locked together in close bilateral relationships, the efficiencies of the market system are lost. The culprits in this situation are transaction-specific investments. When a can maker buys steel strip, neither the steel strip producer nor the can maker needs to invest in equipment or technology that is specific to the needs of the other party. In the case of the steel producer and the steel roller, each company’s plant is built to match the other party’s plant. Once built, the plants have little value without the existence of the partner’s complementary facilities. Once transaction-specific investments are significant then, even though there may be a number of suppliers and buyers in the market, it is no longer a competitive market: each seller is tied to a single buyer, which gives each the opportunity to “ hold up ” the other.
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 347
Iron ore Steel^
Steel strip Cans
Sale to canners of food, Iube oil, drinks, etc.
MARKET CONTRACTS
VERTICAL INTEGRATION
MARKET CONTRACTS
FIGURE 13.3 The value chain for steel cans
bottles like Anheuser Busch or SAB Miller. Dedicated can-making plants involve specific investments, creating problems of opportunism that vertical integration can avoid. However, small brewers simply do not possess the scale needed for scale efficiency in can manufacture.
specialized in a few activities is its ability to develop distinctive capabilities in those activities. Even large, technology-based companies such as Xerox, Kodak, and Philips cannot maintain IT capabilities that match those of IT services specialists such as EDS, IBM, and Accenture. The ability of these IT specialists to work with many different customers stimulates learning and innovation. If General Motors’ IT department only serves the in-house needs of GM, this does not encourage the rapid development of its IT capabilities. However, this assumes that capabilities in different vertical activities are independ- ent of one another. Where one capability builds on capabilities in adjacent activities, vertical integration may help develop distinctive capabilities. Thus, IBM’s half-century of success in mainframe computers owes much to its technological leadership in semi- conductors and software. The efficiency of Wal-Mart’s retailing operations depends critically on specialized IT and logistics from its in-house departments.
in optimal scale and developing distinctive capabilities may be viewed as part of a wider set of problems – that of managing vertically related businesses that are strate- gically very different. A major disadvantage to FedEx of owning a truck-manufacturing company is that the management systems and organizational capabilities required for truck manufacturing are very different from those required for express delivery. These considerations may explain the lack of vertical integration between manufacturing and retailing. Integrated design, manufacturing, and retailing companies such as Zara and Gucci are comparatively rare. Most of the world’s leading retailers – Wal-Mart, Gap, Carrefour – do not manufacture. Not only do manufacturing and retailing re- quire very different organizational capabilities, they also require different strategic planning systems, different approaches to control and human resource management, and different top management styles and skills. Strategic dissimilarities between businesses have encouraged a number of compan- ies to vertically de-integrate. Marriott’s decision to split into two separate companies, Marriott International and Host Marriott, was influenced by the belief that owning hotels is a strategically different business from operating hotels. Similarly, Britain’s major brewing companies have all de-integrated: Whitbread plc divested its breweries and specialized in pubs, restaurants, and hotels; Scottish & Newcastle sold off most of its pubs and hotels to become a specialist brewer.
tically related businesses. Where a market interface exists between a buyer and a seller, profit incentives ensure that the buyer is motivated to secure the best possible deal and the seller is motivated to pursue efficiency and service in order to attract and retain the buyer. Thus, market contracts gives rise to what are termed high-powered incen- tives. Under vertical integration there is an internal supplier–customer relationship that is governed by corporate management systems rather than market incentives. Per- formance incentives exist, but these are low-powered incentives – if Shell’s tanker fleet
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 349
is inefficient and unreliable, then employees will lose their bonuses and the head of shipping may be fired. However, these consequences tend to be slow and undramatic. One approach to creating stronger performance incentives within vertically integ- rated companies is to open internal divisions to external competition. As we shall ex- amine more fully in Chapter 16, many large corporations have created shared service organizations where internal suppliers of corporate services such as IT, training, and engineering compete with external suppliers of the same services to serve internal operating divisions.
used vertical integration as a means of extending their monopoly positions from one stage of the industry to another. The classic cases are Standard Oil, which used its power in transportation and refining to foreclose markets to independent oil pro- ducers; and Alcoa, which used its monopoly position in aluminum production to squeeze independent fabricators of aluminum products to advantage its own fabrica- tion subsidiaries. Such cases are rare. As economists have shown, once a company monopolizes one vertical chain of an industry, there is no further monopoly profit to be extracted by extending that monopoly position to adjacent vertical stages of the in- dustry. A greater concern is that vertical integration may make independent suppliers and customers less willing to do business with the vertically integrated company, because it is now perceived as a competitor rather than as a supplier or customer. After Disney’s acquisition of ABC, other studios (e.g. Dreamworks) became less interested in collaborating with ABC in developing new TV programming.
with regard to different types of flexibility. Where the required flexibility is rapid re- sponsiveness to uncertain demand, there may be advantages in market transactions. The lack of vertical integration in the construction industry reflects, in part, the need for flexibility in adjusting both to cyclical patterns of demand and to the different requirements of each project. Vertical integration may also be disadvantageous in responding quickly to new product development opportunities that require new combinations of technical capabilities. Some of the most successful new electronic products of recent years – Apple’s iPod, Microsoft’s X-box, Dell’s range of notebook computers – have been produced by contract manufacturers. Extensive outsourcing has been a key feature of fast-cycle product development throughout the electronics sector. Yet, where system-wide flexibility is required, vertical integration may allow for speed and coordination in achieving simultaneous adjustment throughout the vertical chain. American Apparel is probably the fastest growing clothing manufacturer in the US with an internationally known brand – especially for T-shirts. Its tightly coordin- ated vertical integration from its Los Angeles design and manufacturing base to its 160 retail stores allows a super-fast design-to-distribution cycle. Vertical integration is also a central theme of brand identity. Figure 13.4 shows one of its advertisements. Zara is another fashion clothing business that has cut cycle times and maximized market responsiveness through a vertically integrated strategy that challenges the industry’s dominant model of contract manufacture (see Strategy Capsule 13.2).
internal suppliers, vertical integration represents a compounding of risk insofar as problems at any one stage of production threaten production and profitability at all
350 PART V CORPORATE STRATEGY
352 PART V CORPORATE STRATEGY
Zara’s success is based on a business system that achieves a speed of response to market demand that is without precedent in the fast- moving fashion clothing sector. Zara’s cycles of design, production, and distribution are substantially faster than any of its main com- petitors. For most fashion retailers there is a six-month lag between completing a new design and deliveries arriving at retail stores. Zara can take a new design from drawing board to retail store in as little as three weeks. Products are designed at the Inditex head- quarters in La Coruna on the northwest tip of Spain. Over 40,000 garments are designed annually with about one-quarter entering pro- duction. Designs are sketched, committed to the CAD system, then a sample is handmade by skilled workers located within the design facility. Working alongside the designers are “market specialists” who monitor sales and market trends in a particular country or region, and “buyers” who handle procurement and production planning. The three groups coordin- ate closely and jointly select which products go into production. Close to half of Zara’s products are manu- factured within Zara’s local network, which comprises Zara’s own factories and subcon- tractors who undertake all sewing opera- tions. The rest is outsourced to third-party manufacturers. For its own production, 40% of fabric re- quirements are supplied by Comidex – a wholly owned subsidiary of Inditex. Most fabric is sup- plied undyed. Postponing dying until later in the production process allows colors to be changed at short notice. Finished products are ironed, labeled (in- cluding tags with prices in local currencies), bagged in boxes or on hangers ready for retail display, then transferred by monorail to the La Coruna distribution center. Each retail store submits its orders twice a week and receives
shipments twice a week. Orders are dispatched within eight hours of receipt and are delivered within 24 hours in Europe, 48 hours in the US, and 72 hours in Japan. Zara owns and manages almost all its retail stores. This allows standardized layout and window displays and close communication and collaboration between store managers and headquarters. Zara’s tightly coordinated system allows quick response to market demand. At the beginning of each season only small numbers of each new item are produced and are placed in a few lead stores. According to market re- sponse, Zara then adjusts production. Typically, Zara’s products spend no more than two weeks in a retail store. Product market specialists pro- vide critical feedback that is used both to adjust production levels and to make design or color modifications to existing items. The close, informal information networks within Zara are critical to product design. Although designers begin working on new designs some nine months before each new season, continuous adjustments to designs are made in response to new information on fashion trends and customer preferences. De- signers and market specialists are encouraged to be alert to the new ranges released by the fashion houses of Milan, Paris, London, and New York; to the styles worn by trendsetters on TV, in popular music, and in the leading-edge clubs; and to feedback from store managers and other employees. Zara’s compressed product cycles have induced changes in customers’ retail buying behavior. Zara customers make more frequent visits to their local stores than is typical for other fashion retailers. They also make faster pur- chase decisions in the knowledge that garments move quickly and are unlikely to be restocked. Sources: Kasra Ferdows, Jose Machuca, and Michael Lewis, Zara , EECH Case Number 602-002-01, 2002; www.inditex.com.
other stages. When union workers at a General Motors brake plant went on strike in 1998, GM’s 24 US assembly plants were quickly brought to a halt. When technology or customer preferences are changing quickly it is especially likely that poor decisions at one stage have knock-on effects throughout the firm.
Is vertical integration a beneficial strategy for a firm to pursue? As with most questions of strategy – it all depends. We have observed that there are costs and benefits associated with both vertical integration and with market contracts between firms. The value of our analysis is that we are in a position to determine the factors that will determine the relative advantages of the two approaches to managing vertical rela- tionships. Table 13.1 summarizes some of the key criteria. Yet, even within the same industry, different companies can be successful with very different degrees of vertical integration. Thus in low-end fashion clothing, Zara is much more vertically integrated than either Hennes & Mauritz or Gap, while in designer clothing, Armani is more ver- tically integrated than Donna Karan. The key issue here is that, even when external circumstances are the same, the fact that different companies have different resources and capabilities and pursue different strategies means that they will make different decisions with regard to vertical integration.
Our discussion so far has compared vertical integration with arm’s-length relationships between buyers and sellers. In practice, there are a variety of relationships through which buyers and sellers can interact and coordinate their interests. Figure 13.5 shows a number of different types of relationship between buyers and sellers. These rela- tionships may be classified in relation to two characteristics. First, the extent to which the buyer and seller commit resources to the relationship: the arm’s-length nature of
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 353
Low
Fo
rmalization
Low
Spot sales/ purchases
High Degree of Commitment High
Long-term contracts
Agency agreements Franchises
Joint ventures
Vertical integration
Informal supplier/ customer relationships (^) Supplier/ customer partnerships
FIGURE 13.5 Different types of vertical relationship
spot contracts means that there is no significant commitment; vertical integration involves substantial investment. Second, the formalization of the relationship: long- term contracts and franchises typically involve complex written agreements; spot contracts may involve little or no documentation, but are bound by common law; collaborative agreements between buyers and sellers are by definition informal, while the formality of vertical integration is at the discretion of the firm’s management.
Different types of vertical relationship offer different combinations of advantages and disadvantages. Consider for example the following:
l Long-term contracts. Market transactions can be either spot contracts – buying a cargo of crude oil on the Rotterdam petroleum market – or long-term contracts that involve a series of transactions over a period of time and specify the terms of sales and the responsibilities of each party. Spot transactions work well under competitive conditions (many buyers and sellers and a standard product) where there is no need for transaction-specific investments by either party. Where closer supplier–customer ties are needed – particularly when one or both parties need to make transaction-specific investments – then a longer term contract can help avoid opportunism and provide the security needed to make the necessary investment. However, long-term contracts introduce their own problems. In particular, they cannot anticipate all the possible circumstances that may arise during the life of the contract and run the risk either of being too restrictive or so loose that they give rise to opportunism and conflicting interpretation. The inflexibility problems of long-term contracts are particularly evident in IT outsourcing when the agreement may be for a period of 10 years or more.^13 l Vendor partnerships. The greater the difficulties of specifying complete contracts for long-term supplier–customer deals, the more likely it is that vertical relationships will be based on trust and mutual understanding. Such relationships can provide the security needed for transaction-specific investments, the flexibility to meet changing circumstances, and the incentives to avoid opportunism. Such arrangements may be entirely relational contracts with no written contract at all. The model for vendor partnerships has been the close collaborative relationships that many Japanese companies have with their suppliers. During the late 1980s, Toyota and Nissan directly produced about 20 to 23% of the value of their cars, whereas Ford accounted for 50% of its production value and GM for about 70%. Yet, as Jeff Dyer has shown, the Japanese automakers have been remarkably successful in achieving close collaboration in technology, quality control, design, and scheduling of production and deliveries. 14 l Franchising. A franchise is a contractual agreement between the owner of a trademark and a business system (the franchiser) that permits the franchisee to produce and market the franchiser’s product or service in a specified area. Franchising brings together the brand, marketing capabilities, and business systems of the large corporation with the entrepreneurship and local knowledge of small firms. The franchising systems of companies such as McDonald’s, Century 21 Real Estate, Hilton Hotels, and Seven-Eleven
CHAPTER 13 VERTICAL INTEGRATION AND THE SCOPE OF THE FIRM 355
convenience stores facilitate the close coordination and investment in transaction-specific assets that vertical integration permits with the high- powered incentives, flexibility, and cooperation between strategically dissimilar businesses that market contracts make possible.
Designing vertical relationships is not just a “make or buy” choice. Between full ver- tical integration and spot market contracts, there is a broad spectrum of alternative organizational forms. Choosing the most suitable vertical relationship depends on the economic characteristics of the activities involved, legal and fiscal circumstances, and the strategies and resources of the firms involved. Even within the same industry, what is best for one company will not make sense for another company whose strategy and capabilities are different. While most food and beverage chains have expanded through franchising, Starbucks, anxious to replicate precisely its unique “Starbucks experience,” directly owns and manages its retail outlets. While most banks have been outsourcing IT to companies such as IBM and EDS, US credit card group Capital One sees IT as a key source of competitive advantage: “IT is our central nervous system... if we outsourced tomorrow we might save a dollar or two on each account, but we would lose flexibility and value and service levels.” 15 In addition to the factors that we have already considered, the design of vertical relationships needs to take careful account of the following:
1 Allocation of risk. Any arrangement beyond a spot contract must cope with uncertainties over the course of the contract. A key feature of any contract is that its terms involve, often implicitly, an allocation of risks between the parties. How risk is shared is dependent partly on bargaining power and partly on efficiency considerations. In franchise agreements, the franchisee (as the weaker partner) bears most of the risk – it is the franchisee’s capital that is at risk and the franchisee pays the franchiser a flat royalty based on sales revenues. In oil exploration, outsourcing agreements between the oil majors (such as Chevron, Exxon Mobil, and ENI) and drilling companies (such as Schlumberger and Halliburton) have moved from fixed-price contracts to risk-sharing agreements where the driller often takes an equity stake in the project. 2 Incentive structures. For a contract to minimize transaction costs it must provide an appropriate set of incentives to the parties. Thus, unless a contract for the supply of ready-mixed concrete to construction projects specifies the proportions of cement, sand, and gravel, there is an incentive to supply substandard concrete. However, achieving completeness in the specification of contracts also bears a cost. The $400 toilet seats supplied to the US Navy may reflect the costs of meeting specifications that filled many sheets of paper. Very often, the most effective incentive is the promise of future business. Hence, in privatizing public services – such as passenger rail services or local refuse collection – the key incentive for service quality is a fixed-term operating contract with regular performance reviews and the prospect of competition at contract renewal time. Toyota and Marks & Spencer’s vendor partnerships depend on the incentive that satisfactory performance will lead to a long-term business relationship.
356 PART V CORPORATE STRATEGY
