A company has more control over suppliers and distributors that it owns, but is it a good idea to own other links in the supply chain? (full length article)
Chocolate producers have a big problem: chocolate consumption has almost doubled in the last half dozen years but supplies of cocoa are declining. Price controls in some of the producing countries are encouraging farmers to abandon cocoa for more profitable crops, crop yield is very weather dependent making supplies volatile, and several diseases threaten cocoa trees, reducing production in some regions by 10 to 20% per year. Unsurprisingly, cocoa prices are volatile, and availability is difficult to predict. 
A worldwide shortage of cocoa beans is predicted to hit by 2020. Chocolate makers are taking steps to insure the supply of this critical raw material. Cadbury Schweppes, for example, has launched a global 10-year, $490 million investment into sustainable cocoa production, mainly around the Asia Pacific region.
When a manufacturer also owns or controls suppliers and/or distribution resources, that’s called vertical integration. While common practice a century ago, vertical integration has fallen out of favor. More companies are selling off divisions outside of their central business area, and outsourcing anything beyond core competencies. Known in the industry as horizontal or lateral integration, this partnership approach to the supply chain is considered to be more flexible and more agile although there is arguably more risk than there is with wholly owned suppliers and distributors.
As with most business approaches, the pendulum tends to swing back and forth between these two opposing strategies as companies find reasons to move in one direction or the other. In fact, the move toward re-shoring might be just such an opportunity. Companies deciding to no longer outsource manufacturing to the Far East once again face make-or-buy decisions on products and components that have clearly been “buy” items for decades.
It’s all about control
As in the cocoa example, the move toward vertical integration is often driven by a need to control the availability, quality, or cost of a supply (vertical integration applies to distribution resources as well but this discussion is focused on supply). The decision to outsource, however, is almost always financially based.
Picture a brand-new industry just beginning to build volume and become a fixture in the market. There aren’t a lot of existing suppliers or infrastructure and no real distribution resources that can handle the demands of this new industry. The manufacturer has little choice but to do it all themselves. They secure the raw materials, manufacture the parts and assemblies, put the product together and ship it to their own warehouses and outlets, and maybe even finance the purchase and service the product after the sale. That is why vertical integration was so popular in the early days of industrialization and during the emergence of major new industries like the automotive segment in the early years of the twentieth century.
In most cases, however, there is a choice; established manufacturers and suppliers are available that can provide the needed parts or products. And because they are already in business, they can usually bring the product to market more quickly and can offer it at an attractive price due to economies of scale – they are already making similar products for other customers and this is just incremental business. A supplier that specializes in the type of manufacturing required is also likely to be able to offer the benefit of their experience and expertise to improve the design or manufacture and produce a better product. Often, outside suppliers offer an unbeatable combination of price, availability, and quality that make outsourcing very attractive.
Thus, as industries evolve and mature, vertical integration gives way to horizontal integration. Companies choose to buy rather than make components or complete products because it usually reduces time-to-market and eliminates the capital investment required to build plants and acquire equipment needed to begin production.
So why wouldn’t a company outsource everything? There are several good reasons for vertical integration, including the need to preserve intellectual property (designs, formulas, trade secrets or techniques), insure reliable supplies, or to reduce overall cost-to-produce.
Make or buy
Each newly designed product or component must be sourced, either internally or from an outside supplier. The first check point on that decision path is whether the company has the capability or is willing to develop the capability to produce it. Once it is determined that internal production is even possible, the next questions will explore whether it makes sense to make it yourself:
- Is the product or process strategically important? Regardless of capabilities or efficiencies, it may be risky to rely on outside supplies for products or components that are strategic – vital – to the success of the business. If the item or product is not high risk because of its importance, ask the next question:
- Is there intellectual property that would be at risk if outsourced? KFC would never release the list of 11 secret herbs and spices that make its fried chicken products unique. Is there something about the design, formula, content, or the manufacturing process that must be protected from becoming available to the outside world and possible future competitors? If not, there’s one more check point before moving on to the make-or-buy decision:
- Are there (internal) operational capabilities or efficiencies that an outside supplier is unlikely to be able to provide or surpass? Is there some kind of ‘secret sauce’ in your production capabilities that surpasses what an outside supplier can deliver? Can you produce more efficiently or more economically than the outside resource? In the absence of a special capability, it’s reasonable practice to shop around and see if an outside supplier has capabilities that would allow them to produce your part or product more efficiently than you can yourself.
If your exploration gets to this point – ‘no’ answers to all of the above qualifying questions – then consider outsourcing on an economic basis. If the supplier can deliver the product on your schedule, at an attractive cost, outsourcing is a viable option. But you must still consider the rest of the relationship – quality, delivery reliability, ongoing improvement, and supply chain risk.
Re-shoring
Over the past several decades, many parts and products that were formerly made in-house in U.S. factories have been outsourced to suppliers based in China and other developing areas. This great migration of manufacturing was driven by simple economics – with comparatively low labor rates, Chinese factories could produce virtually any product with significant labor content at a fraction of the cost to produce in the West. But things change.
Chinese labor rates have increased at an average of about 20% per year recently (from 2002 to 2008, hourly labor costs in the manufacturing sector in China grew 100%, according to the U.S. bureau of Labor Statistics) while advances in automation have decreased the labor content of many products making labor less of a concern. Combined with currency exchange rate fluctuations, increased (and volatile) transportation costs, the costs and risks of having higher inventories to compensate for long lead times, and a heightened awareness and concern about quality, reliability and supply chain risk, the economic differences (between Chinese and U.S. production) are much smaller than they were – and shrinking. Various studies have now concluded that the cost of products made in Mexico (considering all of the above) are now on a par with China and U.S. production, all things considered, is only a little bit more costly – and a lot more flexible and reliable. Experts expect to acquisition costs for many products to be equal (comparing Chinese and U.S. production) within the next year or so for many kinds of products.
Now that simple economics is no longer driving manufacturing automatically to China, companies are revisiting those earlier outsourcing decisions, putting more emphasis on the non-economic factors like delivery reliability, quality, lead time, supply risk, and flexibility. There have been lots of headlines over the last few years about high-profile producers “re-shoring” or bring production back from China to the U.S. But the process of re-shoring production has proven to be a lot more difficult than it might at first appear.
When a company changes from domestic production to off-shore outsourced production, the domestic production capabilities might closed down. Whether previously made in-house or domestically sourced, the tools and equipment, facilities and skilled workers that used to product the product are all scrapped, sold off, or dispersed. Skilled workers retire or find other employment. Decades later, when the company wants to bring that work back, there are no resources available. So they once more have a choice: develop the wherewithal make it in-house, encourage a supplier to develop the capability, or perhaps acquire a plant that can be converted to the needed capability. The first and third alternatives are effectively vertical integration.
Integrate for control
Yet another alternative to try to resolve the challenges of off-shore production is to acquire the off-shore factory in order to gain control over quality, delivery performance, and to insure availability of the parts or products that were made by this supplier. In fact, the strongest reason to vertically integrate the supply chain is for control and this is often done despite financial or economic disadvantages of owning key suppliers.
In theory, a company has more control and more influence over a division or subsidiary than it does over an independent supplier. The captive supplier can be restricted from doing business with competitors, it is conceivably easier to control proprietary information and intellectual property, and considerable pressure can be brought to bear to insure quality and adherence to delivery schedules. But it doesn’t always work out that well. Freed from the market imperatives of supply/demand and price/value, subsidiaries can sometimes be less than ideal suppliers. And it might not be entirely their fault if performance is lacking. The parent company can easily become insensitive to the stresses and restrictions of the captive supplier – changing requirements within lead times, for example, or being less than willing to pay what the subsidiary requires to remain a profitable division within the enterprise.
The APICS education materials describe vertical integration as the highest level of strategic partnership in the spectrum of supplier relationships. Ranging from arms-length purchase-and-sale transactional relationships through on-going business (blanket orders, volume purchase agreements), to contractual partnerships and strategic relationships with shared data, joint planning and collaborative product design and process improvement, relationships with suppliers can take many forms. Marching upward from arms-length to strategic partnership follows the evolutionary levels of organizational maturity and supply chain development. The next step after that collaborative strategic relationship is acquisition or merger – similar to the transition from being engaged to getting married.
Vertical Integration Challenges
Vertically integrated organizations evolved in the early days of industrialization because they represented the best way, and perhaps the only way in many cases, to secure the needed materials and parts for successfully bringing products to market. They grew over time because of the need for control, because competitive, reliable suppliers were not available. The very existence of these wholly-owned suppliers was self-perpetuating. It discouraged the development of alternate sources and the corporate owners simply couldn’t consider going outside if it would bankrupt their own supplier divisions.
But concern for the welfare of those existing facilities can threaten the very existence of the entire enterprise. With rapidly changing technologies and customer tastes, the existing investment in plant and technology can lead to a form of blindness to disruptive shifts that are far more likely to come from independent sources unburdened by “the way it’s always been done”. If a company is buying the parts or materials from an outside supplier and a new, better idea comes along, there is little to prevent the company from switching. With a captive supplier, that new entrant might be seen as a threat to be resisted rather than an opportunity to move the market.
These are the forces that spelled doom for the vertically integrated industrial giants of the last century. Many of those industrial giants still exist, but they are now horizontal enterprises, relying on an army of suppliers for everything from IT services, marketing and logistics to parts, materials and even entire products. Some big “name” brand companies actually do little more than design and market while outsourcing everything else including manufacturing and distribution. Others manufacture someone else’s designs or distribute someone else’s products. They focus only on their core competency and find partners whose core competences complement their own.
Vertical Integration Today
Leading edge companies in fast-changing markets may, in fact, operate much like a movie-maker. The producer does not write the script, run the cameras, act the roles, or market the film. The producer assembles a team with the right skills and capabilities for each of these functions; a collection of “suppliers” makes and distributes the movie, then take on the next job from whatever producer needs their particular contribution. The producer’s next project may use the same cinematographer or editor but an entirely different cast – or the same leads but a different director. The right resources are brought in for each project (or product), with no concern for sunk cost or existing infrastructure. This kind of opportunistic, ad hoc partnership is the direction for today’s agility, responsive supply chain in fast-moving industries.
But remember that there are still film studios with massive sound stages, crews, and equipment just as there are vertically integrated enterprises that are thriving in their defined markets. They just have to be always on guard for threats from developing technologies and market shifts, and willing to go outside of their own internal supply chain when necessary to remain viable in their chosen market. And if they can lead those markets despite the threat to parts of their own enterprise, that is all the better. But it is a difficult challenge that takes vision and guts – the accountants, board of directors and stockholders will likely be concerned if management wants to buy from a competitor when they are capable of producing in their own plants, effectively putting that portion of their own organization out of business.
The automotive industry, among others, addressed this dilemma by spinning-off major supplier divisions as independent entities – General Motors’ Delphi Automotive and Chrysler’s Mopar division, for example, are now independent suppliers, competing for business at GM, Chrysler, Ford and other automotive OEMs.
Vertical integration is no longer considered the key to success in many industries that it once was because it has repeatedly proven to be relatively unyielding and unable to adapt to changing market demands or emerging technologies. But vertical integration does have its place, especially where control becomes a driving factor due to the importance of quality, availability, or protection of intellectual property / trade secrets. And because of recent trends in relative acquisition costs, the economics of outsourcing are no longer such a strong factor against internal or domestic production.
