Vertical Integration and Outsourcing

Last Updated: 12 May 2020
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The outsourcing phenomenon started 30 years back when large companies started giving out their work to other small and big companies. The paper examines the factors that influence outsourcing and vertical integration and examine the factors that prompt organizations to outsource their work. DISCUSSION The author has given examples of Eastman Kodak, which sold its mainframe computers to IBM and signed a 10-year contract with IBM. In return, IBM undertook the data processing, took responsibility of the Kodak data centre, provided the operating software and hardware and took responsibility for maintaining the backups and file protection.

The author reports that this was the first instance where two very large companies had helped each other. The author reports that outsourcing soon became a very big business and the outsourcing business was worth 170 billion USD in 2003 (p. 563). The author has reported further outsourcing activities in which IBM was involved. In 1998, IBM developed and managed a procurement system for United Technologies (UT) who make the Pratt and Whitney Aircraft engines, Carrier ACs, Otis Elevators and others.

UT managed to save about 750 million USD in procuring costs and IBM was involved in creating the online purchasing system and payments and in negotiating and handling contracts with suppliers. The author reports that in addition to IT services, services that are outsourced include trucking, catering, copying and accounting. In 1992, Du Point sold its copy machines to Lanier and contracted with the company to provide meals for the 40,000 employees at its headquarters in Rochester. In 1992, Kodak sold this operation to the Marriott Corporation.

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Reebock one of the leading manufacturers of athletic shoes owned no plants but it contracted out all footwear production to suppliers in various Asian countries. Chrysler bought about 70% of its parts from external suppliers in 1999. The author has argued that Outsourcing involves a fundamental change in organization architecture and that is reassigns decision rights relating to certain assets and employees from one firm to another. The companies that have taken up the outsourced work are able to work in a much more efficient manner and instil their own rewards and recognition system. (p: 563).

The author speaks of the vertical chain in which consumer goods are produced through a series of steps that is called the vertical chain of production. Giving an example of PC, the author has pointed out that raw materials such as chemicals, metals, rubber, etc. are transported to processors who make the intermediate products which are then again transported to the assemblers who assemble the final product and later sold. Firms can be located at different positions along the vertical chain and when a firm participates in more than one successive stage in the vertical chain, it is said to be vertically integrated.

The degree is vertical integration varies with different companies and while Dell out sources most of the components, IBM makes quite a few of the,. The degree of integration may change over time. A firm that begins to produce its own inputs in engaged in backward or upstream integration while an organization that begins to market its own products or to conduct additional finishing work is engaged in forward or downstream integration. The author has given an example of Lincoln Electric that integrated backward and began manufacturing certain inputs for its won welding machines (p. 564).

The author has written about long-term contracts and how firms choose among spot markets, contracts and vertical integration. Long term contracts can take a variety of form such as the standard supply and distribution contracts; joint ventures where a new firm is formed that is jointly owned by two or more independent firms; lease contracts where a firm acquires an asset such as a machine or a building; franchise agreements which grant an independent business person the rights to use the parents proven brand; strategic alliance where firms cooperate in the development and marketing of products.

The author has given the example of Taiwan Semiconductor Manufacturing Company (TSMC) that has taken up outsourced work for Motorola. As part of the expanded outsourcing program, TSMC would double the chip capacity by 2006 and also offer semiconductor design services and design complex semiconductors. Giving another example, the author has mentioned Deere & Co. the farm and equipment manufacturer that uses Ryder System, the truck rental company to move parts to its stores, label and package tractor repair kits that are sent to farmers. (p: 565-567).

The author has written about the benefits that are accrued from Outsourcing. Production occurs at the lowest possible average cost per unit, price equals the average cost and buyers acquire the cost that includes a normal rate of return on investment. Overtime, suppliers adopt a technological advances that lower the cost of production and or enhance the quality of the product. Lower costs are passed to buyers in the form of lower prices. The analysis suggests that when competitive outside markets are available to purchase goods and services, firms should use them.

The author has mentioned that a key problem for internal production is to generate sufficient volume to take advantage of scale of economies in production. Another concern with non-market procurement is the cost of motivating efficient production. Divisions within large firms can be inefficient yet continue to survive as long as they are subsidized by more profitable units within the firms, Firms must adopt costly incentive and control systems to motivate internal managers to engage in efficient production.

Asserting further, the author argues that parties to a long tern supply contract must be motivated to carry out their parts of the agreement. The author has given the example pf Merck and Astra that formed a 50-50 American joint venture called Astra Merck in which Astra gave the new business all its US business and helped Astra to market and win regulatory approval in the US. The joint venture has been beneficial for all.. (p: 567- 568).

The author has pointed out three reasons as to why firms undertake non market transactions to acquire inputs and downstream services and these are contracting costs, market power and taxes and regulations. Drawing caution on fraudulent claims by companies that outsource their products and label them as Made in USA, the author has cited the examples of New Balance Shoes and Hyde Athletic Industry Inc, that import many of the components but perform gluing and stitching operations in US.

The author has suggested that such issues could affect companies such as Dell, General Motors and many others. The author has also mentioned factors that firm specific assets that influence outsourcing and these include site specificity, physical asset specificity, human asset specificity and dedicated assets. The author also speaks of certain preferred alternatives that depend on the relative costs of vertical integration versus contracting and these include measuring quality, controlling externalities, extensive coordination and others.

The author has suggested that firms with market power may use vertical integration to increase profits in many different ways and these include taxes and regulation (p: 569-575). CONCLUSION The paper has discussed the modalities of outsourcing and vertical integration with illustrative examples and has analysed various reasons as to why companies take up outsourcing. The paper has also discussed various forms of long term contracts and factors that motivate such operations.


Chapter 19. Vertical Integration and Outsourcing. Pp: 554-575

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Vertical Integration and Outsourcing. (2018, Oct 02). Retrieved from

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