Chapter 9Vertical Integration in

Distribution

Classical MarketContracting

Quasi-VerticalIntegration

(Relational Governance)

VerticalIntegration

Buy Make

Third Party Does it(for a price)

You do itHow does the the work get done

Their operation (control)Their gain or loss

Your operation (control)Your gain or loss

The benefits

The costs

You and third partyshare costs and

benefits

Their peopleTheir money

Their riskTheir responsibility

Your peopleYour money

Your riskYour responsibility

FIGURE 8.1: CONTINUUM OF DEGREES OF VERTICAL INTEGRATION

3

The Continuum of Interfirm Exchange Format*

Hierarchy(within firm)

Franchise Systems

BuyingGroups

Market Setting(outside firm)

Classical MarketContracting

Quasi-verticalIntegration

VerticalIntegrationFunction

1) Selling (only) Manufacturers’ “Captive” or Exclusive Producer SalesRepresentatives Sales Agency * Force (direct

sales force)

2) Wholesale Independent Distribution Distribution Distribution Wholesaler Joint Venture Arm of Producer

3) Retail Independent Franchise CompanyDistribution (3rd party) Store Store

* Operationally, a sales agency deriving more than 50% of its revenues from one principal

TABLE 8.2: EXAMPLES OF INSTITUTIONS PERFORMING SOME CHANNEL FLOWS

66

Distribution ObjectivesDistribution Objectives

Economic Theories of Vertical Integration

1.Transaction Cost Analaysis

2.Control Rights Theory

6

Transaction Cost Analysis (TCA)• Focus: Economic Efficiency

• Costs occur whenever firms perform “functions”– Fixed and variable components.

• TCA states that firms should purse the most efficient channel arrangement based on cost avoidance.– “Make” = Direct channel = Vertical Integration– “Buy” = Indirect channel

7

Key Assumptions and Conditions for TCA*

• Channel members negotiate, monitor, and enforce exchange aspects by considering:– Bounded rationality– Opportunism– Uncertainty (Internal and External)– Specificity of assets– Frequency of transactions

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Internal versus External Transactions

• Conditions for choosing hierarchy (Internal) over market (external):– A high level of environmental uncertainty should exist in

the transaction cost assessment.– The assets involved should be highly specialized and

unique to the exchange process.– The transaction should occur frequently.

• Examples: Sherwin-Williams; Curtis Mathes

• Third Breed: Clan Mechanism

Low Specificity High Specificity

Highly Volatile Market

Outsource Distributionto Retain FlexibilityUntil Uncertainty Is

Reduced

Highly PromisingMarket

Less PromisingMarket

Vertically Integrateto Gain Control OverEmployees And Avoid

Small-Numbers BargainingIn Changing Circumstances

Do Not Enter

FG 7.2: HOW ENVIRONMENTAL UNCERTAINTY IMPACTS VERTICAL INTEGRATION

Consider overturning outsource presumption:

Vertical Integration,increasingly attractive

Presume outsourcing is more attractive than vertical integration

Examine how function will develop

Outsourcing remains attractive

Will substantial company-specific

investments accrue?

Volatile, uncertain environment(accelerates effect of company-

specific investments)

GO!

Outsourcingpreferable

Is potential business major or substantial?

Will performance ambiguity be high?

Start here

(Take both roads and see where they go)

NO

YES

NO NO

YESYES

FIGURE 7.4: ROAD MAP TO THE VERTICAL INTEGRATION DECISION

II. Control Rights Theory (Jensen and Meckling 1976)

1. Two Types of Knowledge- General Knowledge: Easy to transfer- Specific Knowledge: Costly to transfer

2. Channel Organizing Principle: - Ownership is not the focus - Collocate control with knowledge

Chapter 8Strategic Alliances in Distribution Skip!

Motivating the Channel Members

99Major Topics for Motivating Major Topics for Motivating

Channel MembersChannel Members

1. General Discussion2. Finding out Channel Member

Needs 3. Three Types of Programs that

Motivate Channel Members*4. Another Approach on Channel

Member Motivation*

Motivation Management:

Motivation ManagementMotivation Management

The actions taken by the manufacturers tofoster channel member cooperation inimplementing the manufacturer’s distribution objectives

Motivating Channel Motivating Channel MembersMembers

Basic Framework

1.Find out the needs and problems of channel members.

2.Offer support to the channel members that matches with their needs and problems.

3.Provide leadership through the effective use of power.

Supporting Channel Members*Supporting Channel Members*99

3 Types of

ChannelTrade

Programs

2. Partnership or strategic alliance

3. Distribution programming

1. Cooperative Arrangements

991. Cooperative Arrangements1. Cooperative Arrangements

Focuses on channel member needs & problems

Simple & straightforward

Conveys a clear sense of mutual benefit

99Cooperative ArrangementsCooperative Arrangements

Typical types of cooperative programsprovided by Manufacturers to channel

members• Cooperative advertising allowances• Payments for interior displays• Contests for buyers, salespeople, etc.• Allowances for warehousing functions• Payments for window display space• Detail men who check inventory• Demonstrators• Coupon-handling allowance• Free goods= A Common Element of above

programs?

992. Partnerships & Strategic 2. Partnerships & Strategic AlliancesAlliances

Focus on a continuing and mutuallysupportive relationship between themanufacturer and its channel members

Partnerships & Strategic Partnerships & Strategic AlliancesAlliances

99

Three basic phases

1. Manufacturer should make explicit statement of policies in areas such as product availability,

technical support, pricing, etc.

2. Manufacturer should assess all existing distributors as to their capabilities for fulfilling their roles

3. Manufacturer should continually appraise the appropriateness of the policies guiding his or her relationship with the channel members

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Strategic Distribution Alliance • Characteristics

– Enduring connections– Substantial connections

• What sets SDA apart from others– Trust– Commitment– Like Marriage?

• Building Commitment– Expectation of continuity– Bilateral communication– Balanced Power between the two

• Commitment is mutual

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Strategic Distribution Alliance •

How to gauge the commitment by the other side?

– Previous relationship– Actions

• A word of caution: Not for every relationship– One side has special needs– The other side has the capability to meet those needs– Each side faces exit barriers

3. Distribution Programming3. Distribution Programming 99

A comprehensive set of policies for the promotionof a product through the channel

Developed as a joint effort between the manufacturer and the channel members

to incorporate the needs of both

Distribution ProgrammingDistribution Programming 99

Steps for developing a program:

1. Analysis of marketing objectives & the kinds of levels of support needed from channel members• Ascertains channel members’ needs &

problem areas

2. Formulate specific channel policies that offer:• Price concessions to channel members• Financial advice• Some kind of protection for channel members

3. An Example: Category Management

Relationship DifferencesRelationship Differences99

Cooperative Arrangements

Intermittent interactions between manufacturer& channel members

Partnerships & Strategic Alliances

Continuing & mutually supportive relationship

Distribution Programming

Deals with virtually all aspects of the channel relationship

99Another Approach on Motivating

Channel Members*Theoretical foundation: Agency

theory1. Before you begin…

1. Screening and Qualification2. Selection

2. As you begin…1. Role Specification2. Joint Planning

99

Another Approach (Cont’d)

3. After You Begin…1. Channel Incentive: More than $$$!2. Monitoring: Outcome Monitoring

Behavior Monitoring 3. Enforcement:

Legal Enforcement Market Enforcement Self Enforcement

* Is this all?