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  • Published on: 14th September 2019
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2.1 Relationship of Transaction Cost and Vertical Integration

Coase (1937) proposed the transaction cost theory that explains the addition cost a firm incurs when executing an economic trade in the market. For example, opportunism, asymmetric information and bounded rationality in the market could cause the extra cost incurred by the firm. Transaction cost theory suggests that asset specificity could cause market failures; therefore, a global company might want to integrate an alternative strategy to reduce this risk (Williamson, 1991). In 1981, Williamson divided the transaction cost into three types. First, there are the search and information costs that a company incurs in their efforts to research information about the market and exchange information with other companies. A significant amount of time or money is allocated to complete these tasks. Second, when a global company enters into an agreement with another firm, they must negotiate price and quantity with the seller and this incurs bargaining costs. Third, a global company must monitor their business partners to ensure they follow the contract terms, such as tracking products, supervision, and inspection; these items are policing and enforcement costs. In addition, in the event that their business partners breach the contract terms, it will result in extra costs for the global company. Overall, any increase in transaction cost will reduce the profitability of a global company. Thus, the central problem realized by a global company is how to coordinate different business units in the world in order for the firm to increase their performance and gain maximum profit (Alchian and Demsetz, 1972).

A large body of literatures include a case study that supports vertical integration, which applies the economies of scope strategy to manage transaction costs (Alston and Gillespie, 1989; Jones and Pustay, 1988; Klein, 1988; Russo, 1992). Transaction cost theory suggests vertical financial ownership can create specific advantages for a global company. First, vertical integration is the most effective way to achieve maximum profit because it can eliminate the egoism between separate business units and instead, encourages them to work towards achieving the same goal. Secondly, vertical integration firms have greater coordination and control over power. A vertical integration firm can control the opportunistic behaviour between different business units by authority relationship (Dow, 1987). For example, vertical integration firms have internal promotions that encourage division managers to cooperate with each other to achieve maximum profit in the firm. Third, vertical integration firms experience better audit and resource allocation. Williamson (1975) claims firms that adopt vertical integration will have better auditing power over their contracting partner because the firm has the legal right to monitor its divisions but not outside contractors. In addition, the vertical integration firm has internal information to help them allocate resources to their divisions in an appropriate manner. The outsourcing firms did not have the internal system in place to obtain this information, so they cannot manage the resource effectively; consequently, that can incur extra cost to the firm and decrease their profits. In human resources, the vertical integration firm can allocate their employee to the most appropriate position that will expedite the performance of tasks. Fourth, the vertical integration firm can be motivational for employees. Essentially, the vertically integrated firm eliminates the boundaries between different business units; thereby, encouraging human solidarity amongst their employees so they can work together and achieve the same goals (Ouchi, 1980). Moreover, the internal labour markets can increase the trust between employees and they can select, train, and socialize employees to minimize employee conflict (Eisenhardt, 1985). Fifth, the vertical integration firm realizes more effective communication during different business stages because they have an internal communication system that can reduce the risk of opportunism in different firms to increase the stability of their operations (Malmgren, 1961).

A great deal of research by the management team with regard to transaction cost is most important for the vertical integration firm to increase their profit. Williamson (1981) proposed that vertical integration is a strategy that companies could apply to build their own supply chain to manage transaction costs. This effort will decrease their costs and increase their product profits. The vertical integration firm can create an agile supply chain, making them more competitive (Rothaermel, Hitt, and Jobe, 2006). The vertical integration firm can not only increase information sharing between different business units, but it can also build strong relationships between them that improve the sharing of tacit knowledge across different supply chain activities (Teece, 1986). Vertical integration firms have more control over transaction costs and that will eliminate extra costs and increase their profit.

2.2 Relationship of Vertical Integration and Firm Performance

Vertical integration is a strategy that combines two or more different business units of production to become one system (Hill and Jones, 2001).Vertical integration can increase a firm’s internal activities that expands the influence of their own business (Walker and Weber, 1984). Porter (1980) defended the strategy of a vertical integration firm using one system to manage suppliers, manufacturers, distributors, and customers that have different specific skills. In addition, he proposed three different levels of vertical integration strategy. First, the full integration level is when one company has their own supply chain that tracks the product to sale. Second, the tapered integration level is when the company operates most stages of the supply chain by themselves and hires other companies to do the remainder. Third, the quasi integration level is when the firm enters into an agreement with others to build an alliance in order to join different business stages together such as a minority equity investment, loan or loan guarantees, pre purchase credits, exclusive dealing agreements, specialized logistical facilities, and cooperative R&D. Vertical integration strategy can also be divided into backward integration and forward integration. Backward integration involves a purchase of suppliers that not only reduce the supplier dependency of a global company, but also improve the time of delivery, quality, and R&D ability. For example, backward integration can prevent competitive companies from copying their exclusive manufacturing technology and improve product diversification. Forward integration strategy allows a global company to direct distribution to expand and control their products. A global company will potentially realize benefits through shipping products directly to customers and selling their brand in their own stores. For instance, a global company that has their own store can deliver products on time, eliminating the bargaining power of stores, and directly respond to the consumer market, helping them make real time decisions to gain additional profits. Vertical integration can enhance management efforts from manufacturing to selling, which will make the global company become more efficient.

Porter (1980) suggests vertical integration has eight benefits for a global company that can improve their performance. First, vertical integration can create economic scale for a global company that will reduce the cost of raw materials in order to increase the overall profitability of the global company. Second, by tapping into technology firms can integrate the know-how from upstream to downstream. Third, firms that apply vertical integration even in the supply of raw materials tightening period can still get the required purchase and during periods that lack demand the firm can still find a way out that will reduce the supply and demand uncertainty in the global market. Fourth, it can offset bargaining power and reduce cost distortions since the firm has their own supply chain so they do not need to engage in bargaining with other suppliers and consumers. Fifth, it can increase the ability to differentiate since firms have information from their own sources that can help them provide differentiated products and services to customers. Sixth, it can improve barriers to entry and movement. Seventh, it can allow them to enter a higher level of investment in the industry, since the firms that have incorporated vertical integration strategy have more potential advantages than new entrants. Eighth, it can prevent the supply of sources or sales channels from closing. However, strategic management researchers found some implementation problems with vertical financial ownership. There are three main problems that are caused by vertical financial ownership, such as bureaucratic costs, strategic costs and production costs. Jones and Hill (1988) suggest the cost of vertical financial ownership may have a negative effect on a global company because the integrated firm increases the size of an organization, which creates many levels of hierarchy. The increased size of the organization creates greater distance between managers and employees, which may cause communication distortion (Cremer, 1980). Williamson (1985) suggests that the integrated firm may cost more than the market mechanism because the integrated firm has their own supply chain that lacks direct competitive pressures and that will cause them to slacken, decreasing the firm’s profits (Cyert and March, 1963). In short, the increased level of hierarchy will cause bureaucratic costs that reduce the profits of a global company (Buzzell, 1983). Also, the integrated firm may have strategic costs because they undertake the roles of suppliers and distributorships themselves, making them lose the  information and tacit knowledge rather than working with other firms that are more experienced in that realm (Harrigan, 1984). Finally, it can reduce production costs. Most suppliers can achieve full economies of scale, but integrated firms cannot. This will be a cost disadvantage to a firm that focuses exclusively on manufacturing (Stigler, 1968).

To sum up, vertical integration strategy improves the trading activities of a global company and makes them internalize and integrate the know how between different process units in order to avoid risks, such as parity and bargaining, while trading in the global market. Also, this strategy can build strong relationships both upstream and downstream in firms, improving the overall performance of a global company (Williamson, 1975). This is especially true when a firm must involve specialized assets in their productivity. In this case, the vertical integration can avoid the opportunistic behaviour that reduces the risks for a global company (Klein, 1988). Moreover, vertical integration can build entry barriers to new competitors and improve the efficiency of specialized assets (Harrigan, 1984). However, there still are some risk associated with vertical integration, such as this strategy requires huge capital investments that increase the capital requirements and fixed costs of a global company (Porter, 1980). Aaker (2001) proposed that management and coordination between different business units can increase the cost of management. The most important factor is that the higher the degree of integration can cause problems for the upstream sector because it becomes harder to know the dynamics of the market that build the barriers between manufacturers and end consumers, which decreases the innovation power of a global company (Harrigan, 1985).

2.3 Vertical Integration Study in Taiwan

Deng and Lee (2009) export the relationship market structure, firm behaviour and operational performance of the Taiwan bicycle industry by using the structure conduct performance theory (S-C-P) developed by Mason-Bain. The objects of this study are the three main bicycle firms in Taiwan that are listed on the stock exchange and over-the-counter market, such as Giant, Merida and Idealbike. The data is collected from the financial reports of Giant, Merida and Idealbike during 1998 to 2007. Then, a two-firm concentration ratio (CR2) and Herfindahl-Hirschman Index (HHI) are used to measure the market concentration rate. Also, an analysis of the market structure of the bicycle market is conducted by SWOT, 4P, and five-force analysis. Moreover, this study used a diamond theory model to measure the firm’s behaviour and their competitive strategy. Then, the financial view was used to evaluate performance indicators to measure the performance changes in the bicycle industry. Finally, case study and economic analysis method was used to explore factors such as R&D and advertising that can affect the performance of the Merida bike industry. The study found that the bicycle industry is a highly concentrated market and it became more concentrated in recent years and the manufacturing operating performance of Giant is better than the others. Also, the manufacturers operating performance of Merida is growing every year. Advertising and R&D can increase the rate of return for Merida, and can also improve their business performance. The recommendations of this study are that Merida should increase their brand awareness and then create their own marketing channels. Also, they need to increase investment in R&D to develop new products in order to gain more profit.

Chu, Teng and Huang (2005) studied the effect of vertical integration and profitability in Taiwan’s integrated circuit industry. The integrated circuit (IC) industry has two different business models. One is vertical integration the other is virtual integration. This study evaluates the revenue of the two different business models using the information and electronics industry listed (cabinet) company financials from Taiwan economic news’s financial ratio databases from 1994 to 2001 as data to measure the performance of these two different business models. This study uses mean difference analysis, F test and multiple regression analysis to examine data. Mean difference analysis uses t-test to compare the profitability between two firms. The F test can compare the profit risk in this two business model. Multiple regression analysis t the relationship between boom cycle and business performance. The result of this study illustrates the two different business models have different Return on Equity (ROE) and Return on Assets (ROA). Virtual integration has better revenue than vertical integration. Also, the profit risk of virtual integration is lower than vertical integration. Thus, the firm that applies the virtual integration business model realizes better business performance than vertical integration firms.

Lin (2007) studied the impact of vertical integration strategy on the Taiwan TFT-LCD industry and used the two biggest TFT-LCD firms, AU Optronics and Chi Mei, as a case study. The researcher used in-depth interviews with secondary data from Taiwan’s economic journal to perform the case study of the two companies in order to evaluate the performance of vertical integration. This study found that in the TFT-LCD industry, vertical integration can reduce costs, prevent out of stock situations, increase profits and bargaining powers. Compared to outsourcing strategy, vertical strategy has better business performance.

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