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Vertical vs. Horizontal Integration Strategies: Samsung Case

 

An enterprise can get larger by merging with other competing enterprises or integrating related but separate activities. There are two dimensions in which an enterprise can integrate, the horizontal and the vertical:
1. Horizontal integration reflects the range of products or services the enterprise chooses to produce or sell, the so-called ‘portfolio of business units’, and the markets in which it chooses to sell those products or services. However, the existing range may be the result of two factors, a history of long-forgotten decisions to enter new areas and a reluctance to divest any business activity once it is adopted.

2. Vertical integration reflects those parts of the value chain an enterprise wishes to locate in-house. This is the classic ‘make or buy’ decision. The value chain in some cases can be very long indeed, running right through from raw material extraction and refining to the act of retailing the final product to the consumer.
Sometimes it is difficult to distinguish the two, partly because there is no linear sequence of activities, no true value chain. For example, IBM’s decision to become a full-service provider of diversified computer systems could be interpreted as simultaneously promoting both horizontal and vertical integration.
There are two key questions whose answers indicate whether it is beneficial to integrate or not:
1. Is the sum of the parts greater than the whole: in other words does the integration yield profits larger than would exist for two independent enterprises? This is often called super-additivity.
2. Is it possible to write a market contract which would set out the nature of the cooperation needed to yield the additional profit and divide up the potential gain from that cooperation in a way acceptable to the two partners? If this is possible, then there is no reason for integration.

Vertical integration
It is often alleged that the main motive for vertical integration is the removal of competition. However, reducing competition is not a valid motive for integration, if the enterprise is behaving rationally.
There are two reasons for this:
1. It may actually reduce profits. Maximum profit is derived by establishing a monopoly in just one activity, it does not require the creation and control of a monopoly in all downstream or upstream activities; such widespread control would be superflous and likely to be counterproductive. Vertical integration, if it means the exclusion of competitors from access by potential customers to potential sources of supply or potential distributors, can increase costs as a result of the loss of economies of scale, not only for those suppliers or distributors, but also for the monopolist. This principle is well illustrated by the case of Microsoft, which has successfully established a monopoly at a narrow ‘choke’ point, but has an interest in sustaining competition elsewhere.
2. The attempt may have the opposite effect to that desired. An increased price, even if behind the barrier raised around a vertically integrated enterprise, is likely to encourage entry. If new entrants need to be vertically integrated themselves in order to operate within the industry, the overall commitment of resources on entry is massively increased, which itself might constitute a major barrier to entry. Whichever is the stronger tendency – the lure of high profit or the deterrent of greater commitment – if the outcome is a smaller number of players dominating the industry, there is a greater likelihood of collusion between those players in what has become a completely different kind of strategic game.

There are two sources of additional profit which drive the process of vertical integration, namely, joint production economiesand transaction economies. Joint production economies (JPEs) arise from the use of two types of joint or complementary assets shared in producing the different outputs:
1. Economies of scale, which can apply to any of the primary activities in the value chain, for example core activities such as operations and marketing
2. The sharing of support activities among the most significant core activities.
Where there are large and repetitive transactions between different activity areas in the value chain, coordination of these activities by means of some overarching supervision is likely to lead to a reduction in costs of various kinds. Some of the most important examples are:
• a reduction in the need for paperwork and formal record keeping
• the removal of a need for the provision of specific quality control checks as products move between activities
• the avoidance of a long and costly search for suppliers
• the avoidance of costly transport between facilities
• a sharing of administrative facilities.
A minor driver may be the desire for tax minimization which arises when tax rates differ between activities, are progressive in their incidence on enterprises, or asymmetrical, in that losses are dealt with differently from profits, for example if, for some reason, losses cannot be offset against profits.
Transaction economies result from the trade in intermediate products (TIPs) taking place within an organization rather than in the market outside. The existence of a TIP mainly reflects the widespread danger of market failure.

Market failure arises because in any market contract it is impossible to fully specify all contingencies. It is impossible because of the long time perspective of such a contract and the impossibility of anticipating all possible contingencies. The kinds of conditions which are needed in such a contract are those which ensure that each party to the contract has an incentive to honour that contract and that each has agreed, in a transparent way, how to share any revenue or costs which arise from the activities covered by the contract.

The likelihood of market failure, combined with these economies, explains the need for vertical integration. There are many elements which combine to create the likelihood of a significant market failure, but three stand out:
1. Small numbers contracting, in an extreme case, the existence of a bilateral monopoly – there is little or no choice of transaction partner
2. Large-scale asset specificity, which might be a specificity of site, technology or human capital. Assets are extremely limited in their use and have almost no value outside the relevant areas
3. The commitment of significant resources to making the particular relationship work, that is, the assets are developed in a way which is specific to the particular transaction(s).

Together these three elements create scope for possible opportunism which would subvert the intent of the two parties in making a market contract. At least one partner has a strong interest in breaking the contract. If the investment in specific assets is asymmetrical, that is, it is much larger by one partner than the other, it makes one partner vulnerable to opportunistic behaviour by the other.
The kind of market failure discussed above is highlighted when, rather than a product, information is the major intermediate good being passed along the value chain. This will mean that there can be extremely ambiguous definitions of what is being exchanged. Moreover, when information becomes public, it loses its value for the generator. It is much easier in the case of information to conceal the level of commitment on either side or even hide what is being exchanged.
The information revolution has made the transfer of information between separate organizations much easier, with more likelihood of transparency in the exchange. Together with the improvement in organization made possible by such a revolution, it has tended to reduce the significance of joint production economies, but has raised the relative importance of non-marketed trade in intermediate productsor services. The latter is rising in relative importance.

Vertical integration does not have to be full equity ownership. It can be what is called taper integration. In such integration the integration is not total. Alternative suppliers or distributors are still used, and the capacity of the integrated enterprise is maintained at below the level of market demand for the services. When demand falls, the alternative suppliers and distributors are the first to lose business. In conditions of frequent market fluctuations, this may be an effective approach to adopt in order to limit any threatened rise in costs and provide flexibility. The integration might also be a quasi-integration, which includes franchises, minority ownership, joint ventures or other similar limited ownership relationships. Most franchising is focused on two main resources which can be combined effectively – the product and/or process of the franchisor and the local knowledge and familiarity with investment opportunities of the franchisee. In this case the range of choice of organizational design is much extended.

Horizontal integration
When should horizontal integration occur? Horizontal integration is another label for diversification. The question is equivalent to asking, when should such diversification occur? As with vertical integration, diversification is only desirable if the benefits outweigh the costs. There are a number of possible areas of benefit:
• A reduction in risk
• The development of potentially profitable new products or markets which require and benefit from the use of the resources, capabilities or competencies already possessed by the enterprise
• A reinforcement or enhancement of the existing asset base of the enterprise and the creation of future innovations which generate increased profit.
Again this is not enough since a strategic alliance could produce the strategic actions which are profitable. The same comments about market failure are relevant. Horizontal integration requires the need to resolve a market failure or a combination of market failures in the same way as vertical integration does.
The enterprise is much more likely to generate new profit opportunities by integrating only products or markets which are in some significant sense related to their existing products, activities or markets. Profit opportunities arise in two cases:
1. Increased efficiency in the use of the existing asset base in producing the existing products. This increased efficiency results from:
• the existence of joint production economies in the way already described for vertical integration
• a complementarity in management skills, particularly those tacit skills which are clearly the least amenable to codification or exact specification
• the avoidance of customer rigidities or switching costs, often associated with the branding of a particular enterprise and its products and the holding of a significant reputation for quality
2. A build-up of new assets, which increases the potential for successful future products.
Putting such activities, products and marketing projects together produces greater value than can arise from their separate existence.

The strategic aim in horizontal integration is to build a portfolio of products or markets which meet the requirements implied above. Such a portfolio will promote the present profitability of the enterprise and healthy growth in the future. It is easy to claim such benefits, much harder to prove their existence in any strategy and realize them as part of that strategy. Size partly reflects the number of different products or business units within an enterprise. How many businesses should an enterprise have and how should they be chosen?
The level of diversification differs markedly from enterprise to enterprise. It is possible to distinguish five different levels of diversification:
1. A very low level of diversification, where a single business unit generates more than 95% of the revenue of the enterprise. This is the situation of Amazon.com in its first years
2. A low level of diversification, where the core business remains dominant, generating, say, 70–95% of the revenue of the enterprise
3. A moderately diversified situation, in that less than 70% of revenue comes from the dominant business, but that all businesses continue to have strong product, technical and distribution linkages
4. A high level of diversification, in that less than 70% of revenue comes from the dominant business but businesses are weakly linked
5. A very high level of diversification, with less than 70% of revenue coming from the dominant business and no links between the businesses. General Electric would qualify a such an enterprise.

The most common approach to articulating the key issue of choice is to use a matrix. There are a number of matrices which have been used to illustrate the relevant problems. The first and best known is the growth share matrix, developed by the Boston Consulting Group. A variant of this is the competitive strength matrix, developed by McKinsey, which broadens the dimensions on the axes. A third one uses the life-cycle stages as an indicator of market strength, dividing products into the four stages – infancy, adolescence, maturity and old age. There is little difference between these matrices and so only the growth share matrix is discussed.

In the allocation of resources between business units, the relevant factors are the competitive strengths of the enterprise, that is, existing market share, and the potential for market growth or industry attractiveness, that is, where it should position itself, and the sales growth of the product category or the GDP growth. The dividing line between high and low market share is taken to fall at the lowest of the two or three largest industrial enterprise shares, and for market growth it is some median in terms of market or GDP growth.

There are clearly units which are marginal, and could either be harvested for a short period before divestment or invested in for a period to see whether they are worth developing. The portfolio should be a balanced one, consisting of cash cows, stars and problem children. As far as possible, dogs should be avoided, stars nurtured, problem children rescued and cash cows safe-guarded as the source of finance to look after the stars and problem children.
It is possible to draw a parallel between a pipeline of drugs at various stages of their life and an enterprise which sells products which are at different points in their life cycle. It is not sensible to have products which are all sold in a mature market, nor is it sensible to have a portfolio of only immature products.
The main difference between a conglomerate and a diversified company is that a conglomerate consists of business units which are independent of each other and a diversified enterprise has businesses which are linked in some way. Most enterprises produce a wide range of related products – either on the demand side or the cost side. On both sides there might be shared value-creating activities, such as R&D or promotion. This means that the costs of this activity can be shared.

Where the business units are related, portfolio choice must be made on different principles. In order to put together such a portfolio, the enterprise has to either develop the productive capacity itself, assumed to be a fairly long process, or acquire the productive capacity by purchasing another enterprise.

Merger& Acquisition Strategy

From a strategic perspective, the underlying rationale for an acquisition should be to acquire assets complementary to those already held by the acquirer. The identification of such assets assumes that there is a clear strategic purpose in the acquisition, which has been carefully thought out beforehand. One motivation may be that vital assets are not otherwise available to the acquiring enterprise. Such assets might include a whole range of resources, which either build on the existing core competency or add a different core competency, such as:
• technical expertise, sometimes formalized in patents
• branded products
• access to particular markets and their distribution systems
• organizational know-how, often tacit.

The acquisition of complementary assets does not preclude the sale of unwanted parts of the acquired enterprise as part of a linked restructuring. Almost all acquisitions are followed by this restructuring, with a varying time delay. Sometimes the restructuring is half-hearted and does not fully integrate the acquired enterprise. In other cases there may be rapid and radical restructuring.
In many cases the exact motivation of the acquisition is not very sophisticated:
• to pre-empt a competitor getting hold of resources
• to discover a short cut to growth
• to purchase an expanded productive facility
• to expand market share, particularly in regional markets to which the enterprise has not previously had access.

If the acquisition extends the range of unrelated products or services in the portfolio of the acquirer, the problem of assimilation may be less. The usual structure of multidivisional enterprises which frequently places strategic business units in different divisions is well suited to acquisitions of new products or services, since the addition of a different product to the portfolio of business assets can be accommodated simply and easily. Within a holding company, such units are managed separately. The sole issue in this case is whether the new business unit offers a good return.

Despite the problems revealed by the history of acquisitions, they continue, particularly in the good times. The simplest explanation is that the managers of an enterprise have an incentive to expand the enterprise since it gives them a better possibility of satisfying all their aspirations for power, status and position. Secondly, the enterprise itself may gain increased political negotiating strength and competitive force from the growth made possible by such acquisitions. Or, the aim may be much more complex than simply maximizing present value. Successful acquisition places the acquirer in a good light and reinforces an apparent momentum of growth.

In scoring a merger there are four main areas to consider:
1. Financial performance. Most mergers or acquisitions are judged in the short term by the impact of the merger on share values and the combined capitalization of the two companies. Initially nearly all acquisitions involve the payment of a premium on market value. The acquiring enterprise often sees a fall in price. Market value usually reflects profit levels and growth. After two or three years the impact of the merger on key indicators such as profit or the rate of growth of net revenue is clearer.
2. Impact of the merger on the range of products or services produced and sold. Many mergers may be designed to diversify either the output or the markets of the company involved. What each company has may be complementary to what the other has. In this case nothing needs to be given up, or is given up, by either company as a result of the merger. When the merger involves similar companies producing competitive products and services, the issue is how far the product range can be rationalized, or who should give up what?
What happens when one gives up a product or service? Are some customers lost?
3. Potential synergies. Does the merger allow a cutting of costs, through the reaping of economies of scale or scope, increased buying power or the avoidance of duplication? Fixed costs may be spread much wider, whether the costs relate to R&D, the system of distribution or promotion. There may be possibilities for cost saving in merging the procurement of the two enterprises, the removal of duplication in staff or facilities. Their joint buying power may give them the opportunity to drive down the prices of components.
4. Significant differences of culture between the two organizations. Are managerial styles compatible? Will staff who are a valuable resource leave because of this?

Samsung Electronics: a strategic turnaround

Samsung is very much a Korean company, and has been, at times, accused of being overly hierarchical and dominated by its founding family. Samsung was an enormous group, comprising 25 different companies and producing a wide range of products, catering mainly for the domestic market. In the area of electronics Samsung was, in the pre-1997 world, by reputation a low-end maker of refrigerators and VCRs and similar products. It was an imitator rather than an initiator. In this it also followed Japan and its pattern of development. Backward engineering allegedly allowed this copying. The competitiveness of products was based on low cost, which reflected the existence of cheap labour. The name of South Korea and its chaebol had almost no brand value, certainly not at the international level. The strategy was very much one of cost or price leadership.

The South Korean economy was badly affected by the Asian economic crisis of 1997. The South Korean currency, the won, experienced a dramatic decline in value, as capital was withdrawn. However, its speed of descent in 1998 was more than matched by the speed of ascent in 2000. Recovery was speedy and dramatic.
Samsung has reinvented itself as a breathtakingly innovative competitor seeking to ‘snatch Sony’s crown’. It has set out to establish a reputation for quality and innovative ability. In doing this it has sought to differentiate its products. The generic strategy adopted now stresses product differentiation as much as cost leadership. It has also focused on certain key markets, principally the largest and most demanding of all markets, the highly developed American market, and also on the fastest growing market, the Chinese market. It has emerged as a top three player in a host of product areas and as a top five receiver of patents on a worldwide basis.
The new strategy
The strategy which was adopted in the recovery is distinctive, partly because it differs significantly from that of its main competitors. The strategy has been focused on five main aspects:
• Hardware, rather than software, despite the general belief that profit margins are wider and lead times longer in the latter. The company believes it is much better off buying the software rather than the hardware from outside. In this emphasis, Samsung is different from its main competitor Sony. The strategy does lay it open to a problem of getting the software needed.
• Vertical integration, producing rather than buying the chips and display screens required for its consumer electronics. This has meant that it has invested vast sums in investment in new productive facilities and has had to maintain a wider range of competencies than other companies operating in its markets. For example, over the last five years Samsung has put over $19 billion into new chip facilities, which are getting more expensive and more competitive.
• A so-called ‘nomadic’ strategy. On the hardware side prices are falling relentlessly and the life cycle of products is short. However, something like 90% of the cost of most digital devices are accounted for by the chips and displays. Getting the cheapest but best-practice inputs is important. Samsung believes it can outcompete others through a nomadic strategic, that is, a strategy wherein it moves on when the area becomes overpopulated. A stress on technical advance allows it to do this. A stream of improvements and innovations will support such a strategy.
•Product differentiation, aiming to increase prices and profit margins by going upmarket, selling high-quality products and gaining a reputation for doing this. It has not only put an emphasis on new technology but also on design. It needs a strategy of successful disruptive innovation, a stream of new and exciting products. CEO Yun has decreed that Samsung will sell only high-end goods, so it is investing an enormous amount in research in order to place it at the cutting edge of best practice.
This applies not only to final consumer products, but to the necessary inputs. By going upmarket Samsung is able to ride the recession better than its competitors. For example, in 2002 Samsung sold more memory chips than Micron Technology, Hynix Semiconductor and Infineon Technologies combined, each of which made a loss. Samsung’s memory-chip business produced as much as US$2 billion in profit. Samsung has succeeded by avoiding the mass market and going for niches that command higher prices and larger profit margins. Something like 70% of profits comes from specialty products: graphics chips for game consoles, highdensity memory modules for powerful servers and flash memory chips for hand-held computers, mobile phones and camcorders. Whereas Samsung gets two-thirds of its memory business from DRAM, its competitors get as much as 90%. Diversity has helped Samsung in difficult times.

There was a deliberate attempt to upgrade the general image of Samsung, particularly in the USA. In this Sony was used as the benchmark model. In the words of Idei, Sony’s CEO, Samsung ‘found Sony a model or a benchmark of their brand image’. Sony sees Samsung rather as a supplier, from whom it can purchase semiconductors or display units, rather than as a threat or a competitor. This view seems to be a mistaken one, and represents a basic misunderstanding of what Samsung is trying to do.
• A ‘digital-convergence strategy’, which again is similar to the goal of Sony and other operators in the area of electronic products. It appears that Samsung may win the race.
How coherent is this strategy? How risky is this strategy? What are the sources of incoherence or risk?

Realizing the strategy
The first step in the rebranding of Samsung Electronics was to reduce the 55 advertising agencies working for Samsung to just one. Samsung signed a $400 million contract with a Madison Avenue firm, Foote, Cone & Belding Worldwide, whose task was to create a global brand image for Samsung Electronics. An expensive marketing campaign was undertaken, the cost of which in 2002 was $450 million. The aim was to take Samsung upmarket, rebrand it as a maker of stylish best-practice products. Samsung pulled out of the cheap distribution outlets, such as Wal-Mart and Target, and moved upmarket to chains such as Best Buy and Circuit City.
Why is it important to have just one company controlling all the aspects of brand creation? At the same time there was a move to effect a partnership with American technology, or the main purveyors of American technology. At the beginning of 1997 Samsung had almost no presence in mobile phones outside South Korea, but later that year Samsung won an order for 1.8 million handsets worth $600 million from Sprint PCS Group, an order which most might have expected to go to Nokia or Ericsson. The service was based on the CDMA standard in which Samsung had an early lead due to a strategic alliance with Qualcomm Inc. Not only did Samsung complete the order but it did it in 18 months, half the contracted time. Its silver, clamshellshaped model the SCH-3500 was an instant hit and Samsung became world leader in CDMA technology. As a consequence the partnership with Sprint has grown, involving the new 3G Sprint wireless system. Samsung now has a reputation for high-end mobile handsets. It is growing in importance as a supplier in this industry.

Several years ago Samsung had no significant retail presence in the USA. It has changed that by forging new partnerships, like those with Best Buy, Radio Shack and Circuit City. In these stores there are often lavish displays highlighting Samsung’s products.

The company has succeeded in upgrading the brand name of Samsung very well. Samsung, for example, became a regular and reliable supplier to the main computer companies in the USA, supplying digital components to Dell and forming a $US16 billion R&D partnership with that company, supplying set-top boxes to AOL Time Warner, digital products to Microsoft and components to both the giants, IBM and Hewlett-Packard/ Compaq. These links have helped Samsung stay at the frontier of best-practice technology.

The key to success has been design. Samsung sought to rank alongside Sony and Motorola as premier brands, not to out-compete them by undercutting them through price. Its technology and design have been excellent. Over the past few years only Apple has won as many design awards as Samsung. Even with the TVs and the DVDs it has deliberately moved upmarket. As early as 1996, but accelerated by the crisis of 1997, it has aimed to differentiate its products on the basis of design. There are 300 talented designers in Seoul and four design bureaus in the USA, Europe and Japan. The emphasis has been on style, best practice, simplicity and a quick response to market changes.

The company pivots and produces quickly, coming out with a variety of devices. It sees what the market responds to, pushes successes, and kills failures. And now, rather than just providing a cheaper and lesser iPhone, it’s differentiated itself with larger screens, different features, successful marketing, and delivering what consumers want.
The Note is a perfect example. The company found through market research that Asian-language speakers in particular wanted a device that they could hand-write on, because drawing characters is easier with a pen. The result was a combination phone/tablet (“phablet”) that’s been an unexpected hit.
The company combines market research and unparalleled execution with, despite its reputation, a lot of innovation of its own. Samsung was second only to IBM in the number of U.S. patents filed last year

The key test of whether Samsung can move from a close-and-gaining second to becoming truly dominant is whether it can deliver products that are truly game-changing. To really start pulling customers away from iPhones in droves, it needs to differentiate itself beyond marketing and a bigger screen. It’s aggressively investing in Silicon Valley with several big campuses to help it start to lead in software as it already does with hardware.

In many ways Samsung is trying to repeat the success of Sony in generating a whole range of disruptive innovations in the period up to the 1980s. It is trying to retain the emphasis on hardware and technology.
Can this be done in the changed conditions of the current business context? Can it be done at the new level of technology? Is Samsung trying to do too much in vertically integrating and producing itself many of the basic inputs in the digital world of communication, despite the high cost of R&D and investment in manufacturing? Is the strategy of going upmarket likely to stave off the impact of commoditization?

 

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