CHANGING CORPORATE STRATEGIES: RESTORING COMPETITIVE ADVANTAGE THROUGH VERTICAL DISINTEGRATION.

INTRODUCTION

Since the early 1980s the U.S. manufacturing sector has been swept by corporate restructuring. As corporate restructuring encompasses significant and rapid changes in firms' assets, capital structure or organizational structure (Singh, 1993), it represents a major shift in strategy. Arguably, such changes may be the result of the increased competition, that the U.S. manufacturing companies have been facing for about three decades. According to Chandler (1990), beginning in the 1960s, competition intensified because of inter-industry and international competition. Companies that built powerful organizational capabilities in their industries started to use them to compete in related (and later in unrelated) industries. Likewise, companies that developed organizational capabilities in their home countries started to use them to compete in other countries, primarily in the U.S. The intensification of competition in turn posed significant challenges to U.S. companies. As highlighted by the research on the U.S. manufacturing decline (e.g., Dollar & Wolf, 1988; Rodwin & Sazanami, 1989), a slow-down in productivity growth rates started to occur in the mid-1970s. At about the same time, several firms began to experience performance problems (Duhaime & Grant, 1984; Hamilton & Chow, 1993). U.S. companies responded to these challenges by restructuring (Hoskisson & Turk, 1990; Singh, 1993). Some firms restructured,by engaging in mergers and acquisitions or management buyouts. Several firms restructured, however, by divesting many of their horizontal and/or vertical lines of businesses. The selling off of horizontal lines of businesses is not a new phenomenon, though it has intensified. But the selling off of vertical lines of businesses, widely called vertical disintegration, reverses a long-time established trend toward high levels of vertical integration (Harrigan, 1984; Steingraber, 1990). The purpose of this article is to discuss competitive problems caused by overintegration, and how the strategy of vertical disintegration can be used to solve those problems and thus to restore competitive advantage.

OVER-INTEGRATION

The management culture that came to dominate the corporate environment was to grow in size and achieve the multidivisional structure in order to realize competitive advantage (Chandler, 1962, 1990). The typical growth path was from vertical integration to related diversification (Jones & Hill, 1988), and Chandler and other economic historians (e.g., Herman, 1981) argue that vertical integration was the dominant growth strategy from the emergence of the modern enterprise until the middle of the twentieth century. One reason why companies pursued vertical integration was to lower transaction costs caused by opportunistic suppliers from the market (Williamson, 1971, 1974). Other reasons were to achieve market power by denying competitors access to inputs and outlets or to raise entry barriers to prevent potential competitors from entering the industry (Baldwin, 1987; Chandler, 1962).

As Robins (1993) suggested, vertical integration is an efficient strategy as long as its benefits are higher than its costs. Following the argument that average costs are U-shaped (Chamberlain, 1962; Coase, 1937), it can be suggested that the extent to which a company can increase its levels of vertical integration is limited by rising costs. Thus, companies would cease to perform further vertical integration once over-integration--that is, the levels of vertical integration at which the costs are higher than the benefits--has been reached. The irony, however, is that over-integration seems to have occurred in several U.S. companies (e.g., D'Aveni & Ravenscraft, 1994; Hoskisson, Johnson, & Moesel, 1994; Markides, 1992; Stuckey & White, 1993).

The literature advances two main reasons why many companies systematically over-integrated. The first reason pertains to agency considerations. Agents tend to maximize their own interests (e.g., compensation) rather than the maximization of shareholder value (Markides, 1992), because at least some of them are given to opportunism (Williamson, 1981). Since compensation is linked to the size of the organization, companies were likely to invest in the growth strategy of vertical integration, even if its net value was less than zero (Markides, 1992). The second reason is related to the reduction in the optimal levels of vertical integration. The levels at which vertical integration is no longer efficient have gone down as a result of both intense competition and higher environmental uncertainty (Markides, 1992; Stuckey & White, 1993).

COSTS OF OVER-INTEGRATION

Not surprisingly, over-integration has been costly. Companies that over-integrated have faced both managerial diseconomies of scale, and strategic problems. According to Coase (1937) and Williamson (1974), at higher levels, vertical integration will cause managerial costs of coordination to substantially rise and offset its benefits. These increasing costs are referred to as managerial diseconomies of scale. Several factors lead to managerial diseconomies of scale. First, additional hierarchical levels would be required to manage high levels of vertical integration. The distance that is thus created between superiors and subordinates would make it necessary to put in place costly control mechanisms that will help to detect opportunism (Fama, 1980; Jensen & Meckling, 1976). Second, the combination of several production stages will result in conflicting manufacturing tasks and inconsistent manufacturing policies which will lead to high production costs (Skinner, 1974). Third, excessive vertical integration is likely to bring together several plants with differing scale efficiencies at adjacent stages of production (D'Aveni & Ravenscraft, 1994). In turn, differing scale efficiencies will lead to costly problems of unbalanced throughput and underutilized capacity (Casson, 1984). Last, due to the lack of competitive pressure, vertical integration is likely to raise the costs of inputs because companies will forgo purchasing at low prices in the open market (D'Aveni & Ravenscraft, 1994).

Over-integration can also lead to significant strategic problems. Strategic problems are essentially related to the lack of innovation and flexibility. One of the main features of highly competitive environments is increased uncertainty (Fisher, Hammond, Obermeyer & Raman, 1994). To adequately respond to such uncertainty, companies would have to engage into strategies aimed at achieving both innovation and flexibility (Miles & Snow, 1978; Miller & Friesen, 1983). Over-integrated firms operate in several production stages. Unfortunately, however, it is very difficult to maintain excellence in several stages, because of the inability of a single company to have the full range of skills and expertise in all those stages (Quinn, Doorley & Paquette, 1990; Stuckey & White, 1993). As a result, over-integrated companies are likely to lack both strategic flexibility and innovative capability. Lack of flexibility occurs because vertical integration tends to lock companies into a massive and inflexible commitment to a highly specialized capital-intensive activity (Thorelli, 1986), increase strategic inertia (Hitt, Hoskisson, & Harrison, 1991; Keats & Hitt, 1988), and inhibit effective adaptation (D'Aveni & Ilinitch, 1992, Simerly, 1992). Over-integrated companies also lack the innovative capability because the complex division of labor and bureaucratic structures that result from high levels of vertical integration will reduce the ability to innovate and make necessary changes in products and processes (Skinner, 1974; Steingraber, 1990).

OCCURRENCE OF VERTICAL DISINTEGRATION

This paper contends that vertical disintegration is one appropriate response to the difficulties caused by the costs of over-integration. It will reduce or eliminate managerial diseconomies of scale, and improve flexibility and innovative capability. But first, it seems necessary to discuss the trends of vertical integration. Preliminary results of an ongoing research on vertical integration strategies suggest the existence of three trends of vertical integration: increase, decrease, and no change in the levels of vertical integration. The decrease in the levels of vertical integration is referred to as vertical disintegration.

Tables 1 and 2 summarize the types of change in the levels of vertical integration, respectively, at the industry and the company levels. At both levels, vertical disintegration is significant: 33% of industries and 44% of companies have experienced a decline in the levels of vertical integration. These results support an argument increasingly made by several researchers (e.g., Boone & Verbeke, 1991; D'Aveni & Ravenscraft, 1994; Stuckey & White, 1993) that there is a trend toward vertical disintegration. Thus it can reasonably be implied that by disintegrating, companies are seeking to restore their competitive advantage.

VERTICAL DISINTEGRATION AND COMPETITIVE ADVANTAGE

This paper attempts to relate vertical disintegration to competitive advantage. It suggests that vertical disintegration may help companies lower their costs or improve their responsiveness to environmental uncertainty.

Companies have two possible sources of competitive advantage: cost leadership and differentiation (Bourgeois, 1996). Cost leadership is a business strategy in which a company sets out to become the low-cost producer in its industry (Porter, 1985). To achieve a cost leadership position, a company must have the ability to exploit several sources of low-cost advantage. Differentiation is a business strategy in which a company seeks to be unique in its industry along some attributes that are widely valued by buyers (Porter, 1985). To achieve a differentiation advantage, a company must have the capability to uniquely position itself to meet the needs of those attributes. Vertical disintegration can help achieve both low-cost and differentiation advantages.

Vertical Disintegration And Low-Cost Advantage

The pursuit of vertical integration results in the addition of businesses and hierarchical levels that cause costly organizational bureaucracies and higher overhead (Quinn, Doorley & Paquette, 1990). In his research, Burgess (1983) found that highly integrated petrochemicals companies became very complex, in some instances adding 40 to 50 businesses, and 50 to 60 links. For several scholars (Boone & Verbeke, 1991; Hoskisson & Hitt, 1994; Simerly, 1992; Stuckey & White, 1993), it is evident that vertical disintegration is a restructuring strategy adopted to lower managerial diseconomies of scale by bringing vertical integration down to levels that are under managerial capabilities. Specific managerial diseconomies of scale that can be significantly reduced include bureaucratic, production and input costs. By reducing vertical links, vertical disintegration decreases the distance between managers and subordinates. Based on agency cost theory, it can be said that the need to coordinate and monitor subordinates will be substantially lessened. Therefore, costly bureaucratic controls as well as other overhead costs will go down (Quinn & Paquette, 1990).

Production costs will also be affected by vertical disintegration. Following Skinner's (1974) focused factory, an argument can be made that vertical disintegration eliminates most of the conflicting manufacturing tasks and inconsistent manufacturing policies. This is because the number of productive plants that are combined in one company will be decreased. Such decrease will result in fewer unmanageable problems of production such as unbalanced throughput and underutilized capacity.

Finally, vertical disintegration can be related to the costs of inputs. Every activity employs inputs of some kind, ranging from raw materials used in production to services, office space, and capital goods (Porter, 1985). So the costs of inputs can be a large percentage of a company's costs. The cost of purchased inputs can be lower than that of inputs that are internally produced. Vertical integration constitutes an inefficient supply of inputs because the company forgoes purchasing at low prices in the open market (D'Aveni & Ravenscraft, 1994). When vertical disintegration takes place, input costs can be saved in a number of ways. Disintegrated companies can take advantage of external vendors' economies of scale (Quinn, Doorley & Paquette, 1990). Disintegrated companies can also reduce input costs by avoiding idle capacity in periods of serious drops in demand and by freeing management from spending substantial resources dealing with support activities (Quinn, Doorley & Paquette, 1990). Further, vertical disintegration can help decrease capital investments (Welch & Nayak, 1992). In sum, the effects of vertical disintegration on bureaucratic, production and input costs can lead to a significant decrease in overall costs and help achieve and sustain competitive advantage. Vertical disintegration can also help improve strategic flexibility and innovative capability and lead to the creation of a differentiation advantage. This argument is discussed next.

Vertical Disintegration And Differentiation Advantage

As explained earlier, to better respond to high environmental uncertainty, companies need to emphasize strategic flexibility and innovative capability. This is hardly possible if the levels of vertical integration are high, because a single company cannot have the skills and expertise required in several areas. Vertical disintegration, however, allows internal operations to focus on a few critical core businesses where companies have distinctive competencies (Prahalad & Hamel, 1990). When a company operates in the few areas it has distinctive competencies, it can better achieve strategic flexibility and innovation necessary to competitively keep pace with changing environments (Drtina, 1994; Simerly, 1992). Vertical integration leads to a lack of strategic flexibility because it raises exit barriers that cause technological obsolescence (Balakrishnan & Wernerfelt, 1986; Buzzell, 1983). Since vertical disintegration removes those exit barriers, a company can improve its flexibility by quickly changing its strategic posture (Harrigan, 1985b; Mahoney, 1992).

To be credible in today's environments, companies are required to innovate by frequently introducing new products to satisfy changing customer needs (Fisher et al., 1994; Steingraber, 1992). Companies that disintegrate increase their ability to develop new products or processes, because not only are they likely to have a competitive edge in their core businesses (Prahalad & Hamel, 1990; Robins, 1993), but they will also free substantial resources that can subsequently be invested in research and development to increase the innovative capability (Hoskisson & Johnson, 1992). Last, by outsourcing, which normally follows vertical disintegration, companies will have access to external vendors' invention and innovation (Quinn, Doorley, Paquette, 1990).

CONCLUSION

This paper attempted to link vertical disintegration to competitive advantage. It argued that vertical disintegration provides numerous cost and strategic benefits. Cost benefits include a reduction in bureaucratic, production and input expenses. Strategic benefits are improvements in flexibility and innovative capability. The existence of these benefits may be the reason why vertical disintegration seems to be a strategy that is increasingly adopted by U.S. manufacturing companies to restore their competitive advantage. Though vertical disintegration takes place in part because markets have become more efficient, a contention can be advanced that more and more disintegrated companies use quasi-integration strategies, for example, by engaging in networks of collaborative arrangements with their suppliers. It is believed that quasi-integration strategies help take advantage of outsourcing while avoiding problems of open markets. Further research is needed to establish a clear relationship between vertical disintegration and quasi-integrations strategies. But several strategy researchers have proposed that the 1980s and 1990s would be known as the decades of large scale vertical disintegration and strategic networks (Miles & Snow, 1986; Thorelli, 1986).

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Richard T. Mpoyi is an Assistant Professor of Management at Middle Tennessee State University