Business strategy: integrate processes or outsource them?

In recent decades there have been fashions management processes in which the management of a part of the business process is outsourced to a third party (the outsourcing) has been safe recipe for success. But the decisions of outsourcing or vertical integration must be subject to permanent review by companies.

A strategy to gain competitiveness

Vertical integration is a business strategy that seeks to increase the competitiveness of products and services by incorporating activities that until now were delegated to third parties. this can be backward (incorporating the manufacturing of inputs for its products) or forward (incorporating the distribution or marketing of the products it manufactures).

Based on the analysis of vertical integration decisions in a well-defined Spanish agro-industrial sector and with a very extensive database (Rioja Qualified Denomination of Origin wineries), we make an empirical contribution on the subject.

To do so, we examine the relative importance of prescriptions associated with strategic direction knowledge, transaction cost economics, and the resource-based approach. This, with the aim of explaining how companies establish their vertical limits and resolve the possible conflicts of the different theoretical explanations.

A review

Alternative explanations of vertical integration decisions have been published from the academic world.

Michael Porter, one of the classic authors on strategic management, already argued in 1980 that, for quality control and innovation, it is important that there is a high degree of vertical integration between the links of the value chain (that is, that the company controls the maximum number of steps in the manufacturing of the good or service until it reaches the hands of the customer). Thus, it will be a wise decision to favor the competitive advantage of a company.

For Oliver Williamson, winner of the Nobel Prize in Economics in 2009, vertical integration decisions seek to reduce the transaction costs implicit in the price mechanism. As the specificity of the assets involved becomes significant, vertical integration will be relatively more efficient due to ease of coordination and to avoid opportunism.

On the other hand, according to University of Utah strategic management professor Jay Barney, the resource-based view suggests that a company can embrace vertical integration to create competitive advantage and increase the chances of appropriating economic rents and protecting rare resources, difficult to imitate and expensive.

In this brief review of academic positions, three points of view are presented that have contributed to the understanding of the vertical limits of a company. But each approach offers management suggestions that, by themselves, are incomplete. Each explanation could lead to a better result if followed in isolation, by ignoring relevant factors in the decision of the companies.

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Outsourced or integrated?

Understand the factors that are important when deciding what kind of activities companies should do themselves (do) and which ones to leave to others (to buy) allows them to make long-term decisions.

In our analysis of the vertical integration processes in the wineries of the Rioja Qualified Denomination of Origin, we were able to verify that the predictions coming from these three theoretical approaches were verified (value chain-Porter, transaction costs-Williamson, available resources-Barney ).

But an additional result was obtained, which was the one that linked the type of strategy with which the company competes in the market with the vertical integration decisions.

With the same environmental factors and the same technology (for studying a sector in a very specific geographical area), competitive strategy is a behavioral variable that determines integration decisions.

Vertical integration

The wineries that are committed to higher quality wines coincide with those that use their own vines to stock up on grapes. Companies that seek to differentiate their product to achieve a greater competitive advantage are more likely to opt for vertical integration in their supplies of raw materials.

Thus, the vertical differentiation strategy (measured by quality attributes) helps explain vertical integration or internalization decisions.

To what extent can this result be extrapolated in the form of a prescription for other industrial sectors?

transaction costs

In the production of wine, although the grape is not the only supply of raw material, it does represent a transcendental component of the final quality of the product.

Although having its own vineyard allows the winery greater control of the activities of the wine value chain, such as the use of fertilizers or pruning, it is perfectly feasible to carry out effective controls on these aspects through intermediate figures (between manufacturing or buying) such as long-term contracts.

The determinants that are collected by the theory of transaction costs (such as the specificity of the assets) are the ones that best explain this integration decision. But it is observed that the decision to integrate vertically is also conditioned by the desire to preserve strategic resources or own capabilities.

Available resources

Companies that are committed to higher quality in their products (vertical differentiation) will possess or pursue singular capabilities on which to rely (because otherwise they would be imitable and, therefore, would not have that competitive advantage).

Vertical integration in your supplies, when these are part of the core of your product’s value chain, can have several beneficial effects related to reducing opportunistic costs and other risks, but also contributes to preserving and growing these distinctive resources. .

Companies may be able to preserve these resources or protect themselves from such risks through long-term alliances (hybrid formulas in the vertical chain) but, in this case, trust and reputation come to play a determining role.

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