Tema 24 i CA Vertical Integration

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Economies of Integration versus Bureaucracy Costs: Does Vertical Integration ImprovePerformance?

Author(s): Richard A. D'Aveni and David J. RavenscraftReviewed work(s):Source: The Academy of Management Journal, Vol. 37, No. 5 (Oct., 1994), pp. 1167-1206Published by: Academy of ManagementStable URL: http://www.jstor.org/stable/256670 .

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? Academy of Management Journal1994, Vol. 37, No. 5, 1167-1206.

ECONOMIES OF INTEGRATION VERSUSBUREAUCRACY COSTS: DOES VERTICALINTEGRATION IMPROVE PERFORMANCE?

RICHARD A. D'AVENIDartmouth CollegeDAVIDJ. RAVENSCRAFT

University of North Carolina at Chapel HillThis study tested links between vertical integration, cost structure, andperformance at the line-of-business level of analysis. Major findingswere (1) Vertical integration results in economies even after industryeffects and economies of scope and scale are controlled. Vertically in-tegrated lines of business economized on general and administrative,other selling, advertising, and R&D expenditures but had higher pro-duction costs and thus only marginally better profitability than nonin-tegrated lines of business in the same industry. (2) The higher produc-tion costs were linked to backward vertical integration, suggesting in-sulation from market pressures and lack of incentive to manufacturethe lowest cost inputs. Forward vertical integration was associated withlower transaction-related costs. Thus, evidence of both efficiency effectsand bureaucratic costs emerged, with the benefits of vertical integrationslightly outweighing its costs.

Recently, the usefulness of vertical integration strategies has come un-der attack in the strategy literature. Vertical integration is said to raise costsfor several reasons. Mobility and exit barriers may increase strategic inflex-ibilities that trap firms into keeping obsolescent technologies and strategies(Harrigan, 1985b). Managerial inefficiencies may develop because verticalintegration creates complex problems of control and coordination amonghighly interdependent activities (D'Aveni & Ilinitch, 1992). Underutilizedcapacity may increase costs in some stages of production because through-put is unbalanced if technological factors force firms to build plants of dif-

The views presented here are those of the authors and not necessarily those of the FederalTrade Commission. A review has been conducted to ensure that the data included herein do notidentify individual company's line-of-business data.

For their support on this project we thank the Amos Tuck School of Business Administra-tion, Dartmouth College, the Kenan-Flagler School of Business, University of North Carolina atChapel Hill, the International University of Japan, and the Federal Trade Commission. Wewould also like to thank Jonathan Baker, Donald Hambrick, Kathyrn Harrigan, William Long,Michael Lubatkin, Cynthia Montgomery, Margaret Peteraf, John Shank, Anant Sundaram, andthis journal's anonymous referees for their helpful comments on earlier drafts. George Pascoeprovided valuable programming support.

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1168 Academy of Management Journal October

fering scales at adjacent stages of production (Harrigan, 1983). Moreover,vertical integration may force firms to forgo purchasing at low prices in theopen market (Quinn, Doorley, &Paquette, 1990). Hill and Hoskisson (1987),Jones and Hill (1988), and Mahoney (1992) have proposed other bureaucraticcosts associated with vertical integration.In a multiindustry study of corporate strategy, Rumelt (1974, 1982)found vertically integrated firms to be the poorest performers of all thediversification types in his sample. In a single-industry study of forest prod-uct firms, D'Aveni and Ilinitch (1992) found that vertically integrated firmshad a higher risk of bankruptcy than nonintegrated firms. Similar argumentsand findings have led some authors to recommend that firms "disintegrate"or "de-vertically integrate" (Barreyre, 1988), "outsource" (Harrigan, 1985d;Quinn et al., 1990), form "network" organizations (Miles & Snow, 1986), orenter joint ventures (Harrigan, 1985c).In contrast, the growing theoretical literature in strategy and industrialorganization economics indicates that there is substantial incentive for firmsto vertically integrate. (For good reviews of the theoretical literature on ver-tical integration, see Harrigan [1983], Perry [1989], and Mahoney [1992].)This literature indicates that the incentive to vertically integrate depends onthe type of production involved, the extent of transaction costs, the amountof specialized assets, the degree of market power at each stage of production,the separability of activities, and the amount of uncertainty concerningprices and costs. Costs may be decreased by avoiding market costs (Jones &Hill, 1988), by eliminating the distortion in input costs caused by imperfectcompetition in the upstream market (Vernon & Graham, 1971; Westfield,1981), by reducing transaction costs (Jones & Hill, 1988; Mahoney, 1992;Williamson, 1971), by decreasing uncertainty or asymmetric information,resulting in a more efficient use of inputs (Green, 1974; Riordan & Sapping-ton, 1987), and by protecting proprietary technology (Jones & Hill, 1988).Vertical integration can also increase profits through higher prices by creat-ing barriers to entry (Bain, 1956; Salop & Scheffman, 1983), allowing pricediscrimination (Perry, 1980; Stigler, 1951), reducing service and advertisingexternalities (Jones & Hill, 1988; Perry & Groff, 1985), or providing a firmwith power over buyers or suppliers (Porter, 1980).Despite the substantial theoretical justification for expecting economiesof integration, no empirical work has confirmed the extent of these econo-mies at the line-of-business level of analysis.' (For good reviews of empirical

1 A line of business is an operation or set of activities within a company that is focused ona narrow product market defined by a four-digit code drawn from the coding system establishedby the Federal Trade Commission, which is similar to the Standard Industrial Classification(SIC) system of codes. A line of business is not the same as a single business unit (SBU) becausesingle business units can contain several lines of business. Moreover, single business units aredefined by the boundaries of an autonomous organizational subunit, but a line of business neednot have an autonomous subunit. The costs, revenues, and assets of a line of business are

(continued)



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1994 D'Aveni and Ravenscraft 1169studies on vertical integration in the economics literature, see Scherer andRoss [1990] and Mahoney [1992].) Several single-industry studies (e.g.,Mitchell, 1976) have investigated this issue, but their generalizability isuncertain (D'Aveni & Ilinitch, 1992). Although several cross-industry stud-ies have been conducted (e.g., Buzzell, 1983; MacMillan, Hambrick & Pen-nings, 1986; Tucker & Wilder, 1977), they have generally measured the de-grees of integration firms have adopted in different environments and usedaccounting-based measures of the ratio of "value-added" to sales that havebeen heavily criticized because several factors having nothing to do withvertical integration significantly distort them (Adelman, 1955; Burgess,1983; Maddigan, 1981; Maddigan &Zaima, 1985). In addition, these studieshave assumed that cost or risk reduction motivates vertical integration with-out showing any empirical connection between the strategy and costs. OnlyHarrigan (1986) has identified a vertical integration-profit connection at thesingle-business-unit (SBU) level.On net, this discussion leaves the question, Does vertical integrationlower a line of business's costs of operating more than it raises them? In otherwords, does vertical integration improve the performance of a line of busi-ness? We addressed this research question by using the 1976 Federal TradeCommission line-of-business data and a key dimension of vertical integra-tion proposed by Harrigan (1983, 1985a) and Perry (1989). Harrigan calledthis dimension, a measure of the degree to which vertical transfers occurbetween lines of business within a single company, the degree of integration.This study looked for evidence of economies of integration with respectto the advertising, R&D, production, other selling, and general and admin-istrative expenditures of a line of business. Our general hypothesis was that,if a line of business has many intracompany transfers to upstream or down-stream lines of business, it will exhibit lower costs and higher profitabilitythan nonintegrated lines of business in the same industry. This study alsotested a competing hypothesis-that vertical integration raises bureaucraticcosts.

ECONOMIES OF INTEGRATION: THE EFFICIENCY HYPOTHESISVertical integration, defined as a high degree of internal transfers ofgoods, can reduce costs because of the economies firms achieve from avoid-ing transaction costs and market exchanges, exploiting opportunities forcoordinating internal activities, and creating power over buyers and suppli-ers (Harrigan, 1983; Hennart, 1988; Vickers &Waterson, 1991).

established by identifying all operations and activities directed toward a specific marketplace.A line of business is not to be confused with an industry. An industry, unless it is monopolizedby one line of business, is usually composed of several lines of business competing in the sameproduct marketplace. Finally, a parent company may contain many lines of business (or sisters),but these lines of business do not compete in the same product marketplace.



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1170 Academy of Management Journal OctoberEconomies Achieved by Avoiding Transaction Costs andMarket Exchanges

A high degree of internal transfers can confer economies of integrationby reducing transaction costs, including the costs of finding, selling, nego-tiating, contracting, monitoring, and resolving disputes with other firms inopen market transactions (Coase, 1937). Williamson (1971, 1975) exten-sively considered the impact of vertical integration on transaction costs. Hedetailed three main avenues through which vertical integration reducestransaction costs. First, with proper management of business-level manag-ers, corporate managers can use vertical integration to harmonize incentives,replacing profit maximization at individual stages with joint profit maximi-zation. Second, a wide variety of control instruments exists under verticalintegration. In particular, management by fiat (also known as hierarchicalcontrol) can be used to solve problems that might arise from opportunismand market transactions; for instance, the legal costs generated by writingand enforcing contracts can be saved. Third, vertical integration improvesinformation exchange between successive stages of production.Reduced transaction costs can be significant when there is antagonisticbargaining, as occurs in bilateral monopolies or oligopolies; when futureuncertainties make long-term contracts expensive; and when short-term con-tracts are inefficient because equipment is long-lived or "first mover" ad-vantages exist. In addition, transaction costs, such as selling and advertisingexpenses, may be eliminated because product information is transferredthrough internal hierarchies and order taking is also handled administra-tively, rather than through exchange on the open market.Economies Achieved by Coordination of Internal Activities

Extensive internal vertical transfers can confer economies through al-lowing the exploiting of opportunities for administrative coordination andtechnological interdependencies. Such opportunities include productionand inventory scheduling that can substantially reduce a firm's cost by re-ducing unused capacity and inventory carrying costs (Harrigan, 1983). Thesebenefits are especially significant in view of the costs of open market ex-changes between firms not using electronically coordinated just-in-time in-ventory systems. Transportation costs may be reduced by using the samelocation for the production and processing inputs, suggesting that the costsof production will be lower.Opportunities for exploiting technological interdependencies arisewhen a combination of two successive stages of production permits theapplication of an efficient technology and R&Dsharing. Steel manufacturingoffers a classic example. Very high temperatures are required for severalstages of production, so a single integrated plant can achieve cost savings byheating the steel once and performing several steps in the conversion pro-cess (Porter, 1980: 303). Moreover, R&Din one stage of a product may haveimplications that can be shared with other stages of production.



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1994 D'Aveni and Ravenscraft 1171Economies Achieved by Creating Power over Buyers and Suppliers

A high degree of backward vertical integration through internal transferscan create economies by ensuring adequate supplies, reducing cost distor-tions from monopolized inputs, and providing access to information aboutinput costs and manufacturing processes. Ensuring supplies reduces costsby eliminating shortages that temporarily increase input costs and by avoid-ing unused capacity in the event of a shortage (Thompson, 1967).Goods transferred internally are sometimes priced at internal marginalcosts. Such pricing lowers reported input prices and raises the profits of adownstream operation (Vernon &Graham, 1971). However, the cost advan-tage to the downstream operation is artificial because the profits of the up-stream operation are lowered. Adjusting transfers to market prices is, there-fore, essential for firms to discover cost advantages that are more than justpaper profits resulting from non-market-based accounting methods.Vertical integration creates a more real cost advantage when it is used toprovide a firm with information about the processes used to make an inputand the marginal costs of producing the input (Harrigan, 1983). This infor-mation improves the firm's ability to negotiate with its suppliers by reducinginformation asymmetries that give the suppliers a bargaining advantage. Theinformation also makes a threat to backward integrate more credible, whichin turn also improves the firm's bargaining power over its suppliers (Porter,1980).Similarly, a high degree of forward vertical integration through internaltransfers can reduce costs by guaranteeing adequate outlets for a firm's out-puts, reducing price distortions caused by powerful dealers or distributors,and providing access to information about upstream profits and manufac-turing processes (Pennings, Hambrick, & MacMillan, 1984). Forward inte-gration eliminates the need to incur advertising and other selling expensesbetween two stages. It provides the firm with information about consumerneeds, and it provides a credible threat that reduces buyers' bargainingpower (Porter, 1980). Therefore, forward integration may reduce a powerfulbuyer's ability to demand cost-increasing product features or special ser-vices (Harrigan, 1983).Specific Cost Reductions from These Economies of Integration

As argued above, the potential efficiency advantages of vertical integra-tion are likely to have a broad impact on the expenses of a line of business.Bargaining power and lower bargaining costs are likely to reduce general andadministrative expenses as well as other selling costs and advertising ex-penditures. Technological interdependencies should result in a more effi-cient use of R&Dexpenditures and lower production costs. Increased infor-mation exchange among internal activities can enhance the productivity ofR&Dexpenditures (Scherer & Ross, 1990).In sum, vertical integration should reduce the ratios of several types ofexpenditures to sales for three reasons: First, integration will eliminate ex-



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1994 D'Aveni and Ravenscraft 1173

integration necessitates that an organization's hierarchy become responsiblefor internally transferring goods that were formerly sold on open markets.Thus, the savings from the reduced selling costs may be partially or totallynegated by increased overhead costs associated with the bureaucracy re-sponsible for increased internal coordination.The cost of implementing vertical integration can be substantial (Hill &Hoskisson, 1987). Vertical expansion increases the size of an organization,implying an increase in the distance of most subordinates from their ulti-mate superiors and, hence, communication distortion (Mahoney, 1992). Asfirms vertically integrate away from their core businesses, they are alsolikely to become involved in tasks that they do not have the knowledge andskills to manage efficiently. Controlling these new operations and commu-nication losses may require new expenditures, and thus more administrativeoverhead, raising the costs of production (Harrigan, 1985d).Moreover, the loss of market pressures for efficiency suggests that in-ternal organization may be more costly than the market mechanism (Ma-honey, 1992; Williamson, 1985). The lack of direct competitive pressure onthe cost of intermediate products may encourage increasing levels of slack(Cyert & March, 1963). Divisions develop norms of reciprocity (Gouldner,1960) that may result in inefficient purchasing of inputs used in production.Thus, vertical integration may force firms to forgo purchasing raw materialsat low prices in the open market (Quinn et al., 1990). Moreover, verticallyintegrated suppliers may be less efficient and more costly than externalsuppliers. Pyrdol (1978) found, for example, that captive coal mines ownedby electric utilities were less productive (in tons per man-day) than noncap-tive mines, perhaps because the former had less incentive to be efficient. Inshort, vertical synergies may be difficult to capture and may not compensatefor the high overhead costs that must be incurred to capture them (Buzzell,1983) or the high production costs resulting from norms of reciprocity andother bureaucratic inefficiencies.Vertical integration may also raise production and overhead costs forseveral other reasons. Because management may wish to protect one sub-sidiary's domain, it may create internal mobility and exit barriers that deterdivestiture and trap firms into keeping obsolescent technologies and man-ufacturing strategies (Duhaime & Grant, 1984; Duhaime & Schwenk, 1985;Harrigan, 1983, 1985b). Managerial inefficiencies may develop because ver-tical integration creates complex problems of control and coordinationamong highly interdependent production activities (D'Aveni & Ilinitch,1992). Production costs may be increased by underutilized capacity in somestages of production because throughput is unbalanced if technological fac-tors force firms to build plants of differing scales at adjacent stages of pro-duction (Harrigan, 1983; Hayes &Wheelwright, 1984). Production costs arealso increased by excessive purchases of specialized assets that increasesunk costs, leading to potential excess capacity and chronic low profitability(Chandler, 1962; Rumelt, 1974).Thus, theory suggests that vertical integration strategies may be associ-



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ated with cost advantages, but supporting empirical evidence is weak andthe applicability of integration economies to production and general andadministrative costs is not clear because vertical integration may increaseproduction and overhead costs. Thus,

Hypothesis 2: Lines of business with high degrees of ver-tical integration will have higher ratios of productioncosts to sales and general and administrative expenses tosales than competing nonintegrated lines of business inthe same industry.In addition, some of these hypothesized bureaucracy costs may becomemore acute when an environment is uncertain. In particular, overhead costs

may increase because unstable or unpredictable demand conditions makemanaging vertical integration more difficult (Jones & Hill, 1988).Although the costs of coordination and scheduling production flowsbecomes more complex when an environment is volatile, vertical integrationmakes it particularly difficult to adapt to changing environmental conditions(D'Aveni & Ilinitch, 1992). As subunits become more vertically interdepen-dent, they cannot adapt to volatile demand, business cycles, seasonality, andother fluctuations creating variation in company sales without extensivelycoordinating transfers from one line of business to another (Harrigan, 1985b,1985d). High unpredictability requires more administrative effort to copewith unused capacity problems in several stages of the value-added chainwhenever there is a downturn in demand and to solve shortage problemsduring periods of peak demand. Inventory buffers can be built betweensubunits by stockpiling excess inventory; however, this solution increasesadministrative costs because firms need more employees engaged in inven-tory management and security and more storage space and insurance.Moreover, environmental uncertainty increases the information-processing needs of organizations (Thompson, 1967). High uncertainty cre-ates need to monitor the environment, to collect information throughout anorganization, and to synthesize it (Galbraith, 1973). For vertically integratedsubunits, this task is particularly important and very difficult. Each line ofbusiness must scan the environment of its own business as well as that of itsvertically related sister, or it must communicate with its vertically relatedsister to obtain the relevant information that the sister has collected. If eachline of business has different information or different beliefs about the en-vironment, they must coordinate with each other.In contrast to vertically integrated firms, nonintegrated firms can re-spond to uncertainty in ways that do not increase bureaucratic overhead(although they may increase other costs). Nonintegrated firms may respondto demand uncertainty by eliminating overhead, decentralizing their organ-izational structures so that they can respond to shifts in market demandmore flexibly and quickly. Vertical coordination in uncertain environments,therefore, presents unique challenges and requires hierarchies that noninte-grated lines of business do not need because they purchase on open markets.



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1994 D'Aveni and Ravenscraft 1175Consequently, uncertain demand requires vertically integrated lines ofbusiness to have more overhead personnel (1) to monitor, collect, and syn-thesize environmental information, (2) to schedule and coordinate produc-

tion activities between vertically integrated sisters, and (3) to manage inven-tory buffers between vertically integrated lines of business. Thus, the impactof vertical integration on general and administrative costs is more likely to bepositive (Hypothesis 2) than negative (Hypothesis 1) when demand is un-certain.Hypothesis 3: When industry demand is uncertain, linesof business with high degrees of vertical integration willhave higher ratios of general and administrative expensesto sales than competing nonintegrated lines of business inthe same industry.In sum, Hypothesis 1 asserts the efficiency effects of vertical integration.Hypotheses 2 and 3 assert the bureaucratic costs of vertical integration.Taken together, the hypotheses addresses the research question stated in theintroduction: Do the economic benefits of vertical integration exceed thebureaucratic costs of the strategy and, hence, does vertical integration im-prove performance?

CONTROLLING FOR ECONOMIES OF SCOPE AND SCALEEconomies of scope and scale confound the effects of economies ofintegration. Diversification at the firm level may allow a line of business toshare overhead costs, such as corporate headquarters expenses and ware-housing, with other lines of business within the same parent company. Theproduction, R&D,and advertising costs of a line of business may be reducedif its sister lines of business share with it skills or resources, such as similarinputs, technologies, or customers (Porter, 1987; Rumelt, 1974). Rumelt

(1974, 1982), Christensen and Montgomery (1981), and Palepu (1985) foundthat a firm's diversification must show evidence of relatedness before profitincreases are observed. However, when a focal line of business is embeddedin a highly diversified firm, economies of scope may result from the sharingof generic resources even if the diversification is unrelated (Hitt & Ireland,1986; Luffman & Reed, 1984: 89). For example, office buildings and equip-ment, accounting and payroll systems, telephone and information systems,warehouses and forklift equipment, unspecialized and flexible manufactur-ing equipment, and generalizable labor skills can be used in any line ofbusiness, even unrelated ones. Economies of scope may also arise from a lineof business's being part of a larger firm, whose stature and low risk of bank-ruptcy (a result of largeness) allow the line of business to purchase rawmaterial inputs and services at low cost. Some researchers (e.g., Jose,Nichols, &Stevens, 1986; Michel &Shaked, 1984) have found that the scopeof a firm's diversification, even unrelated diversification, is positively asso-ciated with profitability. Thus, diversification, whether related or unrelated,



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1176 Academy of Management Journal Octobermay reduce production, discretionary, and overhead expenses, leading to acost advantage at the line-of-business level.The market share of a line of business may also yield significant costsavings because it creates economies of scale in operations and power overbuyers and suppliers that improve profitability (Gale &Branch, 1982; Muel-ler, 1986; Ravenscraft, 1983). Economies of scale result from spreading fixedcosts over large volumes, good functional specialization (knowledge), and"learning curve" effects (Hofer &Schendel, 1978: 132-133) that lower over-head and production costs. There may also be economies of scale in adver-tising, other selling, production, and R&D expenses (Boston ConsultingGroup, 1976; Pugel, 1978; Wright, 1985). In sum, because economies of scaleand scope are expected to influence a broad variety of costs, they must becontrolled for in analyses of vertical integration's effects.

METHODSData

Most of the analyses reported in the tables were done using archival datafrom the 1976 Federal Trade Commission line-of-business database. We as-certained the robustness of the 1976 results by using averages for the threeyears 1975 through 1977. These retests (shown in Table 4) yielded substan-tially the same results as the 1976 results (Tables 2 and 3).The Federal Trade Commission (FTC) is the only existing source of datafor intraindustry regression analyses on the strategic and competitive advan-tage variables of interest. The FTC data also allowed us to assess the asso-ciation between vertical integration and the profitability or cost expendi-tures of each line of business. The Profit Impact of Market Strategies (PIMS)database contains some of the same variables but has no transfer pricinginformation. Also, the PIMS sample is smaller, and the data do not permitcomputing detailed intraindustry regression equations.Although the data used herein are from the 1970s, they provided acleaner test of the hypotheses than data from the 1990s would have allowed.Our hypotheses compare the cost benefits of vertical integration against thebenefits open market exchanges provide. In the 1970s, firms' use of severalthen-recent management innovations -including strategic alliances, just-in-time inventory systems, computer-coordinated scheduling, and other inven-tory or resource planning systems-was infrequent, and these innovationswould tend to undermine the purity of the nonvertically integrated, arm's-length market transactions used as comparisons to transactions betweenvertically integrated lines of business. Thus, the data used allowed us tocompare vertical integration to open market exchanges but did not provide

direct evidence about whether new vertical contracting methods of the kinddiscussed by Mahoney (1992) can achieve cost reductions associated withintegration or eliminate bureaucracy costs of vertical integration.The data set included 3,185 manufacturing lines of business from 466large companies that provided information for the FTC's 1976 line-of-



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business database. A line of business refers to a firm's operation in one of 261manufacturing and 14 nonmanufacturing categories defined by the FTC.These firms varied substantially in terms of vertical integration and thecontrol variables studied. The vast majority of the lines of business, 64.7percent, engaged in some vertical transfers. However, in most cases theextent of those ties was small. Still, in 26.6 percent of the lines of business,internal transfers replaced over 5 percent of the potential market exchanges.For 193 lines of business, over one-fourth of each line's inputs and outputswere transferred internally. Integrated lines of business tended to be largerthan nonintegrated lines in these data.In the 466 companies in the line-of-business data set, each companyaveraged 8 manufacturing lines of business and 1 nonmanufacturing line ofbusiness. If we define a line of business as vertically integrated when somecombination of its forward or backward transfers exceeds 10 percent of itssales or cost of sales, then an average 2.5 lines of business per company werevertically integrated. Therefore, approximately 30 percent of each com-pany's diversification tended to be vertical.Dependent Variables

Five cost variables were used as dependent variables in the analyses: aline of business's media advertising to sales ratio, other selling expenses tosales ratio, R&Dto sales ratio, production costs to sales ratio, and overheadcosts to sales ratio.2 Sales was the sum of internal downstream transfers andmarket transactions.3 Other selling expenses consisted mainly of wages forsalespeople and promotional expenditures. Production costs were measuredusing the ratio of cost of sales to sales. Overhead expenses were measured asthe lines of business's ratios of general and administrative expenses to sales.We employed the ratio of expenditures to sales to control for the obviousinfluences of size on expenditures.Two profit margin variables were also used as dependent variables inthe analyses: reported operating income over sales and market-based oper-

2 Ideally, we would have liked to measure process and product R&Dseparately. However,the Federal Trade Commission database does not separate these. Previous work has shown thatthree-fourths of R&D expenditures are product-, not process-related (Scherer, 1984).

3 There is a potential bias in these cost variables because transfers that are not priced atmarket levels are included in their denominators. Fortunately, however, transfer prices tend tounderstate market prices (Ravenscraft, 1981). Thus, the cost variables should tend to overstatethe costs of integrated lines of business, providing us with a conservative test of the hypotheses.For the ratio of the cost of sales to sales and profitability, transfer prices affect both the numer-ator and denominator. However, the impact on cost of sales over sales was much smaller thanthe impact on income over sales because income over sales is a much smaller number. The otherfour cost variables were almost totally unaffected because transfer prices had a very negligibleeffect on total sales. Still, we performed some sensitivity tests to confirm that our results wereunaffected. Results indicated that our findings were robust. In addition, we adjusted the mostsensitive dependent variables (cost of sales over sales and profitability) to market prices when-ever noted in the text and tables using the method described in Appendix A.



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ating income over market-based sales. We used return on sales instead ofreturn on assets because measuring assets requires a lot of common assetallocations among lines of business, increasing the measurement error forreturn on assets. In both variables, income was pretax, preinterest expenseincome from operations for a line of business. The latter variable was theratio of reported operating income to sales adjusted for transfer prices. TheFederal Trade Commission allowed companies to set transfer costs using amarket, cost, cost-plus, or other valuation method. Only roughly half thefirms chose market transfer prices. It was important to estimate the impact oftransfer prices on profit margins because moving from cost to market priceswould have a big percentage impact on income. Appendix A reports ourmethod for estimating the impact of transfer prices on profit margins.

Under the rules of full absorption accounting, cost of sales includespayroll, raw material, factory depreciation, and rental expenses incurred inthe manufacturing of a product. We adjusted the cost of raw materials tomarket prices using methods similar to those used for adjusting reportedoperating income to market prices (Appendix A). However, the ratios of thereported and market-adjusted costs of sales to sales were not affected assignificantly by the adjustment as operating income was because the cost ofsales to sales ratios were much larger than the operating income to salesratios. In fact, the reported and market-adjusted cost of sales to sales ratioswere so highly correlated that both measures yielded substantially the sameresults.Finally, to prevent a bias toward finding a relationship between verticalintegration and expenditure over sales, the FTC included all nontraceablecosts in the measures of the five cost variables. Thus, all expenses borne bycorporate headquarters and shared facilities are allocated among each firm'slines of business using the allocations the companies themselves provided tothe Federal Trade Commission. This procedure eliminates the possibilitythat vertically integrated lines of business will show lower costs becausecosts are shifted on the books to corporate headquarters or shared facilities.In most cases, however, the effects of this allocation on the individuallines of business were negligible. The amount of untraceable R&D is zero forall lines of business in the data set, and the amount of untraceable mediaadvertising and other selling costs is zero for over two-thirds of them. Theamount of untraceable general and administrative costs is zero for only aquarter of the lines of business but, for most lines, only small percentages ofthe total amount are untraceable according to the FTC's Statistical Report:Annual Line of Business Report, 1977.Independent Variable

Because vertical integration is a multidimensional construct (Harrigan,1983, 1985a), researchers should use theory to select the dimension appro-priate to their work to avoid distortion of results. Since our purpose was totest for the extent of economies gained from substituting internal control formarket exchange (Harrigan, 1985d; Perry, 1989; Williamson, 1971), we mea-



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sured a line of business's internal flow of goods relative to the goods ex-changed in the open market.To test the hypotheses, we constructed a measure of total integration foreach line of business using the Federal Trade Commission's line-of-businessdata regarding the dollar amounts of intracompany transfers between a focalline of business and the other lines held by its parent company. To lookbehind the hypotheses at the type of integration that might explain theobserved results, we also computed the degree of forward and backwardintegration for each line of business. The degree of forward integration wasdefined as the ratio of the dollar value of internal downstream transfers tototal sales (i.e., external sales plus transfers out of the line of business). Thedegree of backward integration was the ratio of the dollar value of internaltransfers received by the line of business to the cost of sales. The overalldegree of integration, labeled degree of total integration, was the simpleaverage of the two subtypes.Several complications are associated with these measures of degree ofintegration. Fortunately, these complications tend to lead to underestima-tion of the degree of integration, providing us with a conservative test of thehypotheses. Appendix B contains a discussion of these issues.Control Variables

For each line of business, we measured two control variables: its marketshare within its industry, and the parent company's scope of diversification.Market share was taken from the Federal Trade Commission line-of-businessdatabase and was computed by dividing the line of business's sales by anadjusted census value of shipments.4 We calculated the scope of diversifi-cation measure for each line of business using a Herfindahl index of diver-sification first used by Berry (1975: 62). This index was based on the sales forthose lines of business held by the parent company of a focal line of businesswhose degree of total integration with the focal line of business was less than5 percent. A zero coding indicated a single-product firm or a firm with onlyvertically integrated lines of business. Higher values resulted when a par-ent's sales were widely diversified over large numbers of nonvertical lines ofbusiness. Appendix C contains more details concerning this measure.Entropy measures of the degree of a firm's total diversification, like theone used in this study, contain both related and unrelated diversificationcomponents (Palepu, 1985). Montgomery (1982) found a strong relationshipbetween entropy measures of the degree of a firm's diversification and re-latedness. Chatterjee and Blocher (1992) found that continuous measures ofdiversification (like the Herfindahl measure) demonstrate their best predic-tive validity for accounting measures of performance, the type used in thisstudy.

4 Adjustments were made because sales and value of shipments are sometimes defineddifferently. Ravenscraft (1983) gives details on this adjustment procedure.



15/41

1180 Academy of Management Journal OctoberTo be sure that we controlled for the effects of related diversification, weused a different measure of diversification in separate analyses not reportedhere. This measure, which is shown in Appendix C, was an entropy measure

based on sister lines of business that were in the same two-digit SIC categoryas a focal line of business. Substituting this measure for the scope of totaldiversification as a control variable had no effect on the signs of any of thetotal vertical integration coefficients. With the exception of those resultingfrom the advertising regression equation, the vertical integration coefficientsmaintained or increased their significance.Industry Contingency Factor: Demand Stability

Our measure of demand stability in the industry of each line of businesswas based on data on shipments recorded in the Annual Survey of Manu-facturers. Demand stability was measured as the R2 derived from regressingindustry sales from 1972 through 1976 against a time variable (year 1through year 5). We also used the R' derived from regressing industry salesfrom 1972 through 1980 against time from year 1 through year 9. These R2'smeasured the explained variance in or the predictability of demand overtime. Both stability measures yielded the same results.Statistical Analyses

For each expenditure category and profit measure, we regressed theratio of expenditures (or profits) to sales on one of the measures of verticalintegration and a measure of market share and scope of diversification. Weconducted this analysis in two ways, first using a cross-sectional model withfixed industry effects and then an intraindustry model. For the cross-sectional model, we combined all 3,185 lines of business into one regressionequation, controlling for differences in industries by including a dummyvariable for each industry. For the intraindustry model, we divided the 3,185lines of business into 200 industries, computing a separate equation for eachindustry using only the lines of business within that industry.5 The respec-tive equations for the cross-sectional and intraindustry models were:200

Yi= aj x INDij + bi x VERTi + b2 x DIVi + b3 X MSi + Eij=1for i = 1, 2,... ,3185 (1)

To ensure even a minimum of two degrees of freedom for these within-industry regressionequations, we had to combine some of the 261 Federal Trade Commission manufacturingindustry categories. Wherever possible, an industry was combined with its closest counterpartin a three-digit SIC category. We lost 6 of the original 3,185 lines of business because twoindustry categories had no lines of business with vertical ties. There were only 198 industriesfor R&D over sales because there were no positive R&D expenditures for any of the lines ofbusiness in two industries.



16/41


Yij= aj + bj1 x VERTij+ bj2 x DIVij + bj3 x MSij + Eijfori= 1,2,... , Nj. (2)

Y represents one of the seven dependent cost or profit variables. VERT is ameasure of total, forward, or backward vertical integration. DIV is a Herfin-dahl measure of related or unrelated diversification. MS is market share. INDrepresents the industry dummy variables. The subscript j represents an in-dustry. In the cross-sectional regression (Equation 1), i represents a line ofbusiness. In the intraindustry model, i represents a firm. Both equationsyield individual industry estimates of the constant term. The major differ-ence between the equations is the way the coefficients for the three inde-pendent variables were estimated for each. For each independent variable,the cross-sectional regression (Equation 1) estimated a single coefficient. Foreach independent variable, the intraindustry regression (Equation 2) esti-mated a coefficient for each industry. We then averaged the 200 within-industry coefficients and tested this average for the significance of its dif-ference from zero. To prevent a few large but insignificant coefficients fromdominating the averages, we weighted each coefficient by its standard error.Thus, the most significant coefficients received the most weight.6Each method has a specific strength. By comparing degrees of verticalintegration within an industry, the intraindustry regression equations avoidthe "apples and oranges" comparison problem. For example, the GeneralMotors Corporation's vertical integration is compared to that of other auto-mobile companies; Exxon's integration is evaluated relative to other oil com-panies; and Georgia-Pacific's integration is contrasted with that of otherforest product firms. The cross-sectional regression equation directly com-pares all integration regardless of industry. The disadvantage of the intrain-dustry equation is that each coefficient is estimated with a small number ofdegrees of freedom. On average, each regression equation had only 12 de-grees of freedom. Although the weighting procedure helped mitigate this

6 The use of coefficients from intraindustry regressions with limited degrees of freedomrequires care to make sure outliers do not dominate the results. The generalized-least-squares(GLS) procedure we employed, which weights each coefficient by its standard error, controls formost outliers. Large insignificant coefficients are given little weight relative to more reasonablesignificant coefficients. To take an added precaution, we performed a number of sensitivitytests. Deletion of the seven largest (in absolute value) coefficients on vertical integration, totaldiversification, and market share had little impact on the findings since all the outlier coeffi-cients had large standard errors. Deleting the ten largest and ten smallest profit outliers resultedin only one substantive change. The significance of the positive relationship between verticalintegration and market-based operating income over market-based sales increased from the .10level to the .01 level. For almost all industries, there was sufficient variation on the market shareand total diversification variables to yield reasonable coefficients. In 23 industries, however, noline of business had a vertical integration value over 5 percent. Discarding these industries hadthe same effect as eliminating the profit outliers. Finally, following the methodology outlinedin Appendix A, we computed a market-based cost-of-sales measure. This measure did not yieldappreciably different results from those based on the ratio of the reported cost of sales to sales.



17/41


problem, the roughly 3,000 degrees of freedom in the cross-sectional regres-sion is a statistically attractive feature. Table 2 reports the total verticalintegration regression results using the cross-sectional regression approach.Table 3 reports the aggregated intraindustry findings for the total verticalintegration regressions. Table 4 shows the results using the 1975-77 data ina cross-sectional model with fixed industry effects.7 We emphasize resultsthat are consistent across methods and time periods. Fortunately, almost allthe findings are robust.Analyses subsequent to those whose results are shown in Table 4 em-ployed coefficients from the intraindustry regression approach. This ap-proach allowed us to directly test three different interpretations of the co-efficients, looking for cost leadership, product differentiation, or productiv-ity improvements (Table 6). For the one analysis in which both approachescould be used (reported in Table 5), we provide the intraindustry findings,but discrepancies with the cross-sectional results are noted in the text andthey are very minor.The final set of tests we performed also used the parameters from thewithin-industry regression analyses. In this test, we looked at the results tosee whether characteristics of a focal line of business's industry affected theimpact of total, forward, and backward integration on costs. Appendix Dreports these tests, which indicated the broad generalizability of our results.

RESULTSDescriptive Statistics

Table 1 displays descriptive statistics for the variables used in thisstudy. The table shows a very high correlation (r = .98, p < .001) betweenthe two profit measures, both used as dependent variables in separate re-gression models, indicating that transfer pricing significantly altered thereported profitability in only a small number of lines of business. The tablealso shows numerous positive correlations among the nonproduction costvariables, suggesting that cost leadership strategies may involve a consistentpattern of lowering all these costs. The correlations among the independentand control variables shown in Table 1 indicate that (1) lines of businesswith high market shares tend to be embedded in portfolios that are forward

7Two issues limit the 1975-77 data. First, transfers cannot be adjusted to market prices forthe reasons stated in Table 4. Second, the independent variables are 1976 variables because theydo not change much between 1975 and 1977, so we used the midpoint year. Also, verticalintegration is derived from the footnotes in the firm's Federal Trade Commission reports. Thesefootnotes are not reported annually and, therefore, vertical integration cannot be averaged overthe three years. These limitations are not serious. With respect to the first limitation, transfer-pricing methods rarely changed between 1975 and 1977. Thus, any bias from transfer pricingshould be constant over this period. With respect to the second limitation, most of the variationacross time is in the dependent variables. The results are robust to averaging the dependentvariables over three years, increasing our confidence that the results would be robust to aver-aging the independent variables with their lower time-series variance.



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TABLE1

Descriptive

Statisticsand

Correlationsa

Pearson

Correlation

Coefficients

Variables

Means

s.d.

1

2

3

4

5

6

7

8

9

10

11

Independent

1.

Degreeoftotalverti-

cal

integration

5.34

10.06

2.

Degreeof

forward

integration

6.43

15.68

.80***

3.

Degreeof

backward

integration

3.42

9.70

.63***

.05**

Control4.

Marketshare

3.66

6.36

.10***

.01

.15***

5.Scopeoftotaldiver-

sification

68.11

24.82-

.28***

-.17***

-.25***

-.16***

Dependent6.

Media

advertisingxpenditures/sales

1.44

3.21-

.13***

-.13***

-.06***

.09***

-.02

7.R&D

expenditures/

sales

1.41

2.78

-.05*

-.04*

-.03t

.06***

-.04*

.04**

8.

Reportedcostof

sales/salesb

77.46

16.57

.18***

-.09***

.17***-

.09***

-.08***

-.38***

-.01

9.Other

sellingex-

penses/sales

7.07

6.50

-.22***

-.20***

-.12***

-.00

.09***

.33***

.13***

-.46***

10.

Generaland

adminis-

trative

expenses/sales

6.95

5.32-

.20***-

.16***-.14***-

.06***

.01

.15***

.27***

-.30***

.21***

11.

Reported

operatingincome/sales

7.08

14.00

-.00

-.03

-.00

.11***

.04*

.01

-.16***

-.77***

-.07***

-.16***

12.

Market-based

operat-

ing

income/market-

basedsales

7.34

14.10

.03

.08***-

.08***

.09***

.02

.00

-

.16***-

.74***-.08***-.17***

.98***

aAll

variable

valuesarefor

1976.N=

3,185.

Where

appropriate,

meansarein

percentageform.

b

This

variableisnot

adjustedformarket

pricesbut

yielded

correlationsvery

similartothoseforthe

market-adjusted

measure.

tp

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Tema 24 i CA Vertical Integration

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