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Vertical Integration vs Outsourcing

Popularity 3Viewed 6930 times 2014-7-2 11:54 |Personal category:Economics|System category:Economy| efficiency, companies, industry, business, examples

Vertical integration helps companies save the cost and enhance efficiency. A company becomes vertically integrated when its business is expended into other stages of the production, like a manufacturer merges its distributor or supplier or both. There are some vertical integration examples in smartphones industry:
(Source: Vertical Integration, 15 Apr. 2013)
Vertically integrated firms like Samsung undertake almost all the tasks in the vertical chain in-house. Contrary to vertical integration, outsourcing is a practice used to reduce costs by contracting outside suppliers to do a particular task rather than completing it internally. A typical example is Nike, it outsources most of the production from other vendors. Some companies even outsource components from competitions, for example, Apple outsources iPhone’s battery, touchscreen, processor... from its competitors like Samsung and Sony. However, it might be in firms’ interests to rely on their competitors with expertise and economies of scale, rather than be vertically integrated. This controversial “make or buy” issue will be argued below with examples mainly from the smartphones industry.

Vertical Integration (Make)

Due to eliminated market transaction cost, vertically integrated companies are able to control the cost using their own supply and distribution channels where there is no mark-up. Moreover, by selling the products directly to the consumer without third-party involved, companies can minimize the distribution cost and possibly obtain more profit. For example, almost every multinational corporation in the smartphones industry has their own online store selling all kinds of their products. Companies like Apple and Samsung even have their own physical stores in the densely-populated areas. According to “The Apple Store–International” published by Apple Inc., Apple now has 425 retail stores in 16 countries and an online store available in 43 countries. It is opening new stores every year as well.

Weapon Against Competitors
Components business can be used as a competitive weapon. Jack Tong, president of HTC North Asia, shared a story of how Samsung sets barriers to its competitors. HTC Desire, which was using an AMOLED screen produced by Samsung, had a great performance in the market in 2010. Samsung then stopped supplying the display to HTC with no reasons are given. 

Samsung supplies key components like touchscreen and processing chips to apple as well. An analyst at KDB Daewoo Securities in Korea once told Reuters that Apple needs Samsung to make the iPhone and iPad, Samsung might be considering lots of options to leverage its components business' importance and pressure Apple. As a leader in hardware manufacturing for mobile devices, Samsung supplies components to almost every device manufacturers. The likely monopoly enables Samsung to set high barriers to new entrants and charge a premium for its products. 

Secured Supply
Another advantage of vertical integration is take more control over the supply and distribution, there are more uncertainties when a company outsource from another company, esp. when the company is also the competitor. Once a company controls its supply chain, it can always ensure its own sufficient supply. Samsung’s two types of mobile memory DRAM and NAND flash had dominated the market in 2010, where it has 41 percent and 37 percent of the market respectively, according to IHS. Samsung also manufactures application processors and the RF chips that are made for mobile devices. The biggest customers for those products are Apple and Samsung itself, according to Francis Sideco, senior principal analyst at IHS. It puts Apple at a disadvantage in the competition with Samsung in terms of the stability of the supply.

Outsourcing (Buy)

Cost-effectiveness and Time-effectiveness, 
Components in iPhone are not assembled by Apple, but are outsourced to contract manufacturers like China-based companies Foxconn and Pegatron. Even though the base salary of Foxconn's front-line workers has been lifted to RMB 4400 ($700) at the end of 2013,it is still much lower than the average salary in America. Apple benefits from the cheap labor and economics of scale, and its transportation fees are reduced as the assembling plants in China are closer to the main component suppliers in Korea and Japan, hence Apple is able to minimize the its products’ cost by outsourcing. In addition, it also helps Apple to save the cost and time of recruitment.

More Focus on Core Activities
Giving away some responsibilities to other companies with expertise and economies of scale, the companies that outsource components are able to have more focus on the core activities. Although Apple is not the one makes iPhone’s processor, it takes the design in-house, which is much more important than the manufacture. iPhone is also one of few mobile phones that use the processor developed in-house and its latest processor A7 is one of the fastest processors designed for the phone (Marie Brewis, PC Advisor). Apple has introduced a lot of game-changing features like IOS, Siri and fingerprint lock, and those features made iPhone unique and stand out in the competition. Apple obviously prefers to spend more time on new technologies rather than manufacture components.

Lose Control
The dominance in the phone component market, especially the key components, makes Samsung have the power demand the price for its products. Again, Samsung is the supplier of Apple as well as a competitor. Inevitably, Samsung took advantage of it by charging Apple a premium for a component that Apple had long purchased for them. There was a sudden 20% markup for the hardware without notice, and Apple had no choice but to pay it. The hidden cost is what Apple cannot control.

Unlike vertical integration, outsourcing leads to poor supervision over the supply chain. Apple has revealed child labour in iPhone supply chain in its Supplier Responsibility repost for 2013. More than 100 cases of child workers were involved in the year. It is not the first time though. Since 2009, similar cases have been reported. Besides, other incidents happened to Apple’s suppliers harmed its reputation again and again. For example, 61 workers were injured in a gas explosion in Shanghai, four workers died and 18 injured in dust explosion at Foxconn factory that produces iPad parts in Chengdu... All those negative media exposures of Apple’s suppliers put Apple in trouble but it is difficult for Apple to control.

The advantages of vertical integration indicate the disadvantages of outsourcing. Similarly, the advantages of outsourcing also indicate the disadvantages of integration. It is difficult to determine which one is better between vertical integration and outsourcing. It always depends case by case. Vertical integration is hard to implement successfully. It is usually expensive and difficult to reverse. The vertically integrated giants IBM, Digital and Burroughs went into a downfall at the end of the 1970s. Meanwhile Apple formed a network of independent specialists that produced machines more efficiently than the do-it-all giants. All in all, with all these pros and cons mentioned to be considered before actually approaching a component supplier, it is necessary to specifically evaluate the circumstances. 


(Opinions of the writer in this blog don't represent those of China Daily.)




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