Vertical Boundaries of a firm

The vertical boundaries of the firm illustrate which activities the firm would perform itself and which it would leave to the market.

Vertical Boundaries of a Firm

The production of any good or service usually requires a wide range of activities organized in a vertical chain.  Production activities are said to flow from upstream suppliers of raw inputs to downstream manufacturers, distributors and retailers. 

Activities in the chain include processing and handling activities, which are associated directly with the processing and distribution of inputs and outputs, and professional support activities, such as accounting and planning.  Another set of questions that may arise when managers/firm operators attempt to define their firm is to ask:  What activities do we do?  What do we leave to the market?  This is known as the “make-or-buy” problem.

Most Common Make-or-buy Fallacies

1.   Buy to avoid the costs of making.  This argument ignores the fact that the firm it buys from will have to incur these costs and will charge accordingly. That is, whoever manufactures the product bears the risk of fluctuating volumes; if it's costly for you, then it is probably costly for others as well. Moreover, an outside firm may be able to have a greater number of suppliers for its product or it may simply be more efficient than your firm.

Example: Intel licenses production to outside firms. Does this avoid cost? Only if the outside firms offer some advantage. In this case, the outside firms can better handle capacity due to scope economies.

2.   Make to avoid paying profits to others.  It is useful to consider where profits are coming from: 1) Profit may be the normal risk adjusted return to the “maker.” That is, profits may represent the return necessary to attract investments and would be required of the firm that makes internally just as they are required of independent firms; or 2) Profit may come from monopoly power. If a supplier charges $300,000 for a product that costs $200,000 to produce, why doesn't someone else enter the market? Without an answer to this question, you can't be so sure of the savings of making yourself.

3.   Assure supply and avoid fluctuating prices during peak demand or short supply.  If you start to manufacture, you actually start to play the role of commodity speculator.

Reasons to Buy

1.   A market specialist sells to many buyers and can better take advantage of economies of scale and scope than an in-house department could if it produced only for its own needs. If there are economies of scale then, the make-or-buy decision can be resolved by determining whether the firm or its independent suppliers are better able to achieve them. Economies of scale are present whenever costs fall as volume increases. These economies are usually associated with fixed investments.

·         If Q > Minimum Efficient Scale (MES), then make. This situation can be seen in Campbell's decision to backward integrate into soup can production.

·         If Q < MES, then buy. Costs can be decreased if there is additional production. Who is more likely to take on added production, the firm or its partner? We generally observe that it is easier and more likely for the independent partner to grow.

The importance of economies of scale in defining the boundaries of the firm also extend to individual activities (The division of labor is limited). Adam Smith wrote about a pin factory in which some workers only made straight parts, some made the crowns, and some put them together. This process made sense because 1) Economies of Scale--routinization of two factors improved the productivity of the specialists, and 2) Large Demand--there was enough demand for pins that each worker could be kept busy doing just one task. Smith described this division of labor as natural in any market as volume increases enough to justify specialists.

2.   Efficiency and Incentives. Independent firms may have more incentive to innovate than a division within a firm because departments can never be sure if they are making /losing money. That is, the owner of an independent firm faces stern discipline from the market and keeps every dollar he makes. Conversely, it is harder to match pay to performance for individual managers of internal divisions. Efficiency and incentive concerns include:

·   Transfer pricing--it is hard to determine the appropriate prices to charge internal divisions. For example, how should we charge for IT in each division?

·         Equity concerns

·  Influence costs--lobbying for resources may lead to biased information and destructive competition within the firm; internal divisions may lobby each other, raising the cost of production. Using independent firms allows you to keep these issues distinct.

3.   Culture. Consolidation of independent firms can also create legendary culture clashes.

In summary, the market is a powerful force for technical efficiency and independence/autonomy is a powerful motivator. These forces must be weighed against those that favor integration (outlined below).

Reasons to Make

1.   Coordination Costs. The steps in the vertical chain must fit together. Fit can be along any number of dimensions:

·         Time: movies should be released to theaters at same time as advertising

·         Size: O rings on space shuttle, stamped parts for automobiles

·         Color: Bennetton's spring line-up

·         Sequence: Curriculum within a university

Fit can be attained through either doing tasks in-house or through contract.  Contracts often stipulate bonuses for performance exceeding expectations or penalties for failing to meet specified criteria.

·         Highway construction on Chicago's Dan Ryan Expressway: bonuses were given to construction firms to finish the job early

·         Silicon chip production: tolerance penalties assessed

Alternatives to Make-or-buy

There are alternatives to either making or buying.  One such alternative is long-term contracting. This option eliminates some flexibility that is especially important in declining economies (where you may not know if the firm will be around in the long-term). Such flexibility is not as critical in growing economies where all the players are expected to continue to do well (Japanese Keiretsu).

The Value Chain

Michael Porter introduced the concept of the value chain in 1985. His scheme takes the vertical chain and puts dollar values to it. This helps to identify those steps in the vertical chain where the most value is added. The value chain is critical to the concept of positioning (how the firm chooses to create value/differentiate itself for customers). The value chain is a tool that portrays the firm as being made up of a set of value-creating activities. The value of a good as it moves through the value chain is equal to the price it can be sold for in the market. When the chain consists of independent firms, these prices are easily identified. When the chain consists of consecutive steps done within the same firm, these prices may or may not be identified. These are called transfer prices--a price that tries to measure what a fair market price would be for a good passed through an internal market. These prices are often based on comparisons with similar goods sold in the outside market.

Porter's chain has five primary activities:

Purchasing/inventory handling

Production

Distribution

Sales/marketing

Customer service

Three support activities:

Human resources management

Research and development/design

Corporate infrastructure