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IE 463 Lecture 6

BOUNDARIES, FLOWS and INTEGRATION

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BOUNDARIES of the FIRM

Main Question: What activities does the firm do itself or leave to the market?

Firms organize activities internally or through markets for reasons of;• efficiency (cost management, TCE etc.)• strategic positioning (strategic management, RBV etc.)

external supplier/ customer

systems unit

internal supplier/recipient

firm

internal transaction

external transaction

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1. Horizontal boundaries: Quantities and varieties of goods and services produced by a firm (scale and scope of activities)

Firm horizontal boundaries are determined by the following questions:• What market size is right for the firm? • Which market is right for the firm? (The fit between firm

size and market structure may depend on the market) • Which cost or efficiency advantages of economies of

scale/scope are important to the firm?

Economies of Scale (quantity): declining of average cost when a larger volume of goods/services are producedEconomies of Scope (variety): cost savings obtained when different goods/services are produced

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2. Vertical boundaries: activities in the vertical chain (value chain) performed by a firm (internal production, external supplier, internally and externally disposed outputs)Activities in the value chain include primary activities like,• acquisition of raw materials, production, sale of final goods/services and after sale services as well as support activities such as, • finance, marketing or human resource management

Value Chain: The value chain categorizes the generic value-adding activities of an organization, representing a business as a chain of value creating activities that transform inputs into outputs It can apply to whole supply chains and distribution networks.

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Basic sources of the customer value:• activities that differentiate the product• activities that lower its cost• activities that meet the customer’s need

R&D productionmarketing and sales

service

support activities

primary activities

inputs outputs

Firm Value Chain (Porter’s Generic Value Chain)

backward, upstream forward, downstream

Firm InfrastructureHuman Resource Management

Technology DevelopmentProcurement

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Often, chain activities ranging from product design, production of components and final assembly to delivery to the final customer are not done by a single firm but by different firms which become members of a value system.

supplier value chains

distribution/marketing channel value chains

firm value chain

customers

Distribution / Marketing Channel: Marketing organizations (individuals, systems and tools) responsible for the flow of goods and services from the producer to the end consumer.

Linkages between different value chains

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• Inbound Logistics: the receiving and warehousing of raw materials, and their distribution to manufacturing• Operations: the processes of transforming inputs into finished products and services• Outbound Logistics: the warehousing and distribution of finished goods• Marketing & Sales: the identification of customer needs and the generation of sales• Service: the support of customers after the sale of products and services

Primary Activities

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Firm vertical boundaries are determined by the following

questions:• Which activities in the value (vertical) chain are to be

performed inside the firm?• Which activities in the value (vertical) chain are to be

out-sourced?

If many of the value chain steps are performed in-house,

the firm is vertically integrated.

Example: Goodyear

If many of the value chain steps are out-sourced, the firm

becomes vertically disintegrated.

Example: Dell, Nike

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THE BLURRING OF BOUNDARIES

Customer

flow of products, services andinformation

extended firm production system

externalsuppliers

internal production

system

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INTEGRATION

Question: What is the appropriate scale and scope of an

enterprise?

Firms grow externally through;• vertical integration• horizontal integration• conglomerate merger (merger or takeover of firms in

different lines of business)

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VERTICAL INTEGRATION

Vertical integration is the merger or takeover of firms (activities) which are at different stages of a value chain. It is a strategy to acquire control over additional links in value chain of producing and delivering products/services.Through vertical integration, a business expands its control over other businesses that are part of its overall manufacturing process. Firm can aim at either full or partial integration

Ex: An oil refining business would be vertically integrated if it owned or controlled pipeline companies, railroads, barrel manufacturers, etc.

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1. Backward integration: moving closer to sources by

acquiring resource suppliers or manufacturing the

components needed for the final product. Firm reduces

dependency on suppliers by purchasing them.

Ex: A construction company buying a construction

materials producer.

2. Forward integration: moving closer to end-user (market). Firm expands its products/services to related areas in order to more directly fulfill the customer's needs.

Ex: A manufacturer buying a transportation fleet.

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manufacturing

engineering and design

retail stores

raw materials

after-sale service

forward integration

backward integration

manufacturing

retail stores

firm A

firm B

vertical integration

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VERTICAL INTEGRATION AND ASSET OWNERSHIP

Possible Organizational Arrangements:

When firms are not integrated they remain independent. Each firm controls its own assets and makes its own operating decisions. When they are integrated;

• Forward Integration: Firm A owns the assets of Firm B and Firm A has control over both sets of operating decisions

• Backward Integration:: Firm B owns the assets of Firm A and Firm B has control over both sets of operating decisions

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Bac kw

ardF

orward

PCManufacturer

ChipCompany

PC Retail

100%

full backward integration PC manufacturer buys 100% of the product utilized and the Chip Company sells 100% of the product produced.

PCManufacturer

ChipCompany

PC Retail

50%

partial backward integration PC manufacturer buys <100% of the product utilized and the Chip Company sells <100% of the product produced.

50%

50%OutsideChip

OutsideManuf.

Takeover of a Chip Company by a PC Manufacturer

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Advantages of Vertical Integration

• Cost reductions (eg. transportation costs) when activities take place in close geographic proximity

• Improved supply chain coordination• More product/service differentiation by means of

increased control over inputs• Improved downstream and upstream profit margins• Increased entry barriers to potential competitors, for

example, if the firm can gain monopoly control of a market or a scarce resource

• Gain access to downstream distribution channels • Investment in highly specialized assets which otherwise

would not be made by other players in the value chain• Expansion of core competencies

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Disadvantages of Vertical Integration

• Capacity balancing issues for downstream and upstream activities (eg. the need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions).• Potentially higher costs due to low efficiencies resulting from lack of supplier competition.• Decreased flexibility due to previous forward or backward investments (however, the flexibility to coordinate vertically-related activities may increase).• Decreased ability to increase product variety if significant in-house development is required.• Difficulty of developing new core competencies when the existing competencies are deep rooted in the value chain.• Increased bureaucratic costs.

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Horizontal integration is the merger or takeover of firms at the same stage of the value chain. A firm growing by the acquisition of a competitor will increase its market share with new products that are similar to its current lines. It can be a strategy to sell one type of product in numerous markets.

Ex: A media company's ownership of radio, television, newspapers, books, and magazine.

HORIZONTAL INTEGRATION

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manufacturing

engineering and design

retail stores

raw materials

after-sale service

horizontal integration

manufacturer A manufacturer B

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Advantages of Horizontal Integration

• Economies of scale, acheived by selling more of the same product, for example by geographic expansion.

• Economies of scope, achieved by sharing resources common to different products (commonly referred to as "synergies“).

• Increased market power (over suppliers and downstream channel members).

• Reduction in the cost of international trade by operating factories in foreign markets.

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Disadvantages of Horizontal Integration

• Significant concentration of industry by a single firm may create legal issues like anti-trust.

• The anticipated economic gains will not always materialize, nor the expected synergies will exist (eg. computer hardware manufacturers who entered the software business on the premise that there were synergies between hardware and software may realize that a connection between two products does not necessarily imply realizable economies of scope).

• Even when the potential benefits of horizontal integration exist, they do not materialize spontaneously (there must be an explicit horizontal strategy in place).

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BUYER- SUPPLIER RELATIONSHIP : SPECTRUM

Confrontation Arm’s LengthRelationship

Acceptance ofMutual Goals

FullPartnership

Traditional Relationship

ConfrontationSuspicionOutsourcing

New Relationship

CooperationTrustOutpartnering

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RELATIONSHIP WITH SUPPLIER

OUTSOURCING OUTPARTNERING

Product (capacity) Buys: A relatively low-cost, high-quality purchase of

inputs from external suppliers, as a substitute for internal production

Process (capability) Buys: A purchase that results from an intimate

relationship between the knowledge bases, capabilities, and

processes of the two firms

Product (capacity) buysReduced direct costs ExpertiseFlexibilityName recognitionRationalization

Process (capability) buysAccess to technical market informationNew technology/processesRationalization

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The system of suppliers, manufacturers, transportation, distributors, and vendors that exists to transform raw materials to final products and supply those products tocustomers, containing;• raw materials, work-in-process, and finished goods in

inventory• information, money, and people associated with this

system• value flow, logistics and distribution channels

SUPPLY CHAIN

materials, parts, sub-assembliesand services

finished goods, end products and services

package and delivery satisfaction with quality,price, delivery and service

suppliers manufacturer distributor retailer customer

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BASIC SUPPLY CHAIN and DOMINANT FLOWS

manufacturing planning and

control

physical supply

physical distribution

manufac-turer

distribution system

supplier

customer

flow of products and services

flow of order and cash

information

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Flows:

1. Downstream flows

• Information: Capacity, promotion plans, delivery schedules• Materials: Raw materials, intermediate products, finished goods • Finance: Credits, consignments, credit terms, invoice

2. Upstream flows

• Information: Sales, orders, inventory, quality, promotion plans• Materials: Returns, repairs, servicing, recycling, disposal• Finance: Payments, consignments

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DEMAND CHAINA demand chain is composed of the enterprises that sell a business’s goods or services. It transfers demand from markets to suppliers. For example, a demand chain may be composed of; • buyers who initiate the sales transaction, the resellers who sell the manufacturer’s goods, and the manufacturer who creates the goods • resellers who sell a manufacturer’s goods, the manufacturer who makes the goods, and the distributors who supply the manufacturer’s goods to the resellers

Ex: A retailer's demand chain would consist of assortment planning (deciding what to sell), inventory management (deciding the quantity of supplies needed), and procurement (deciding the other details of the actual purchase)

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The demand chain, together with the supply chain form

the “demand- supply chain”. They are linked in two places,

• the supply-fulfillment point (SFP) and • the demand-offering point (DOP).

• The SFP is the place in the supply chain where the supplier allocates the goods ordered by the customer.

• The demand-offering point (DOP) is where the supplier fulfills demand in the customer's demand chain.

INTEGRATING DEMAND AND SUPPLY

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Often, companies focus on either the supplier base or the

customer side, but not both. For the integration of supply

and demand management;• focus on customer’s demand chain (e.g., assortment planning, inventory management, and procurement) • determine optimal linkage point between demand chain (DOP) and supply chain (SFP)• the further back SFP is in the supply chain, the more challenging it becomes to fulfill orders promptly (e.g., “build to order” vs. “build to forecast”) • moving DOP further back in the demand chain toward customer largely benefits the customer and requires more work by the supplier. This means, instead of “fulfilling orders from wholesalers, fulfilling orders by going to the end consumer (customised service)

1. Offer to purchase

In the conventional, arm's-length buyer-seller relationship, the DOP is the purchasing department, which accepts an "offer to purchase" by choosing the supplier and deciding when goods are needed.

2. Offer to manage inventory

DOP is moved further back in the demand chain. By carefully monitoring the customer's inventory levels, a supplier can cut down on stock that is unlikely to sell and ensure that the customer never runs out of goods that move briskly. These benefits, however, mean more work for the supplier, since it must now have a separate inventory control process for each customer.

3.Offer to plan

DOP is moved back to merchandizing (in the case of retailing) or production (e.g., automotive and computing industries). In other words, by joining forces to analyze the consumer demand categories served by products from the supplier, both retailer and supplier can avoid new products or promotions that lack a significant market. Suppliers are 33

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also expected to use this kind of collaboration to improve their delivery performance. The result is a more profitable use of retail space by retailers, but unless suppliers can charge a premium or increase their sales through this kind of collaboration, they do not benefit from it.

4. Offer to end useAn example is Dell Computer's direct sales model for business clients. Rather than fulfill orders from wholesalers (an offering to purchasing), Dell went all the way back in the demand chain to the end consumer by fulfilling orders for customized PCs-complete with software and network configuration. All employees have to do is turn on their machines. Corporate customers reap an enormous advantage: the ability to eliminate half of their PC support teams, which spend most of their time setting up computers.

Although moving the DOP back in the demand chain appears to be in the customer’s interest, the supplier can benefit if it simultaneously moves the SFP. By coordinating movements in both the demand and supply chains, suppliers improve their customer’s performance and at the same time generate efficiency in their own operations.

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• Dell provides excellent direct service to the end user because it moved its “supply-fulfillment” back in the supply chain by assembling to order

• College textbook industry:

McGraw-Hill moved its “demand-offer” from bookstore to the instructor, and its “supply-fulfillment” from the warehouse to the retailer. McGraw-Hill’s Primis system (electronic-publishing system) allows instructors to customize “textbooks” with reading & complementary materials from a variety of sources

- materials are combined into a single package that is

printed and bound in the bookstore

- benefits: faster delivery time to end user, no excess

inventory, no returns, better product (i.e., no “unused”

portions of textbook), lower costs for all parties

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DEMAND - SUPPLY CHAIN

SUPPLY CHAIN

DEMAND CHAIN

DEMAND- SUPPLY CHAIN

+

satisfy and manage demand for products and services

create, develop and sustain demand for products and services (R&D, marketing, sales, after sales services, customer relations, ...)

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VALUE NETWORKING

suppliers manufac- distributors retailers customers turers

Network Infrastructur

e

Logistics & Operations

Value Strategy

suppliers manufacturers distributors retailer s customer

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Supply network (also called supply chain network) is an extension where components and prosesses are connected in parallel in the full supply chain environment (different tiers and vendors working together). It is a network of facilities that performs functions of;• procurement of materials• transformation of materials to intermediate and finished

products• distribution of products to customers.In this network of autonomous entities, • similar concepts • principles• problems• tasksare organized to improve network productivity.

SUPPLY NETWORK

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The purpose of a supply network is to transform

incomplete information about the market and resources

into coordinated plans for production and replenishment

of goods and services in the network of cooperating

entities,• synchronization among multiple autonomous entities

(coordination between and within members)

• reduction in lead times and costs, alignment of

interdependent decision processes, improvement in the overall performance of each member as well as the network

Lead Time: The total time a customer, internal or external, must wait to receive a product after placing an order (time it takes a supplier to deliver goods after receipt of order)

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CASE : NIKE

High End: refers to the best and generally most expensive of a class of goods or services.

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AUTOMOTIVE INDUSTRY

OEM - Original Equipment Manufacturer: Firm that uses unbranded supply products and brands the final product

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INTER- FIRM CHAIN LINKS

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Suppliers

ManufacturerEnd User

Distributor

Retailer

Value-AddedReseller

CorporateReseller

THE TRANSITION IS FROM LINEAR SUPPLY CHAIN…

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Suppliers

ManufacturerEnd User

Distributor

Retailer

FinancingProvider

Publisher

Value-AddedReseller

CorporateReseller

TO DYNAMIC SUPPLY (CHAIN) NETWORKS!

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VERTICAL COLLABORATION

Vertical collaboration is formed between firms that use their complementary capabilities and skills to create value at different stages of the value chain. It includes distribution, supplier or outsourcing partnerships where firms rely on upstream or downstream partners in a chain to build competitive advantage.

Supplier-side Value Chain

Buyer-side Value Chain

Firms combine their complementarities to supply the overall production activity in a value chain. As the supplier and customer interact along the chain, the market type input/output relationship allows firms’ knowledge creation.

vertical collaboration

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HORIZONTAL COLLABORATION

Horizontal collaboration is formed between firms that combine their similar capabilities and skills to create value at the same stage of the value chain. Even though the partners may actually are or become competitors in the business;• firms can focus on long-term product development and

distribution opportunities,• achieve economies of scale,provided that a great deal of trust exists between them.

Firms with similar capabilities and chain activities can learn from each other more effectively. Learning from rivals stimulates innovation and its diffusion.

Partner 1-sideValue Chain

Partner 2-sideValue Chain

horizontal collaboration

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DIMENSIONS OF SUPPLY CHAIN INTEGRATION

Dimension Exchanges How

information integration

information, knowledge

information sharing, knowledge sharing

coordination, resource sharing

decisions, work decision delegation, work realignment, outsourcing

organizational relationship linkage

accountability,

risks/costs/gain

extended communication and performance metrics, incentive realignment

Metric: A standard of measurement of performance