Vertically Integrated Supply Chains

Stephen DeAngelis

July 11, 2012

Andrew Parker and James Shotter report, “Airbus and Boeing are pushing their large suppliers to buy smaller ones because of fears that weaknesses in the supply chain could undermine the aircraft makers’ ambitious plans to increase production of passenger jets.” [“Airbus and Boeing push supply mergers,” Financial Times, 8 July 2012] Parker and Shotter further state that Airbus and Boeing “each have an order backlog of more than 4,000 passenger jets” and they are worried that production and delivery of these aircraft “could be jeopardised by weak suppliers.” According to the article, the aircraft manufacturers feel so “in extremis” they are considering “buying suppliers, or provid[ing] them with financing, but their strong preference is for the supply chain to consolidate.”

Should this consolidation take place, it would move both manufacturers closer to having a vertically integrated supply chain. As noted in Wikipedia, “Vertically integrated companies in a supply chain are united through a common owner. Usually each member of the supply chain produces a different product or (market-specific) service, and the products combine to satisfy a common need.” The article credits nineteenth-century steel tycoon Andrew Carnegie with introducing the concept and implementation of vertical integration. Although vertical integration does promote efficiency and cut costs, it can also lead to monopoly concerns. As Kofi Bofah writes, “Vertically integrated companies may expose themselves to consumer outrage if they appear to operate as a price gouging monopoly.” [“What Is the Vertical Integration of Supply Chain Management?”]

Setting aside monopoly concerns, Dustin Mattison writes, “Companies hope to gain more control over materials, manufacturing and distribution through vertical integration.” [“The Case for Supply Chain Vertical Integration,” Dustin Mattison’s Blog, 15 December 2011] Clearly, Airbus and Boeing want to achieve just that — more control over material, manufacturing, and distribution. Parker and Shotter indicate that Boeing’s desire is strongly motivated by past experience. They report that “an attempt to increase production in 1997 ran into severe difficulties, with Boeing plunging to a net loss and its factories and supply chain struggling to cope.” Both Boeing and Airbus hope that supplier mergers can prevent this from happening again. Parker and Shotter explain:

“This time around, Airbus and Boeing want to see consolidation between aerostructures suppliers, which make parts of fuselages and wings. Aerostructures companies can have markedly lower profitability compared with suppliers of equipment such as engines, because these latter groups, which include Rolls-Royce, boost their earnings by also servicing their products. Fabrice Brégier, Airbus’s new chief executive, told the Financial Times: ‘Probably there is a need for further consolidation [between aerostructures companies]. We support some consolidations … to try to have a leader emerge.’ Tom Williams, Airbus’s head of aircraft programmes, said that the European company was encouraging suppliers to ‘bulk up’ through acquisitions or partnerships, ‘so that they get big enough and have a strong enough balance sheet’.”

It’s clear that neither Airbus nor Boeing is seeking to develop a completely integrated vertical supply chain but both companies are moving in that direction “because of concern[s] that the supply chain may not be able to cope” with increased demand. Parker and Shotter report, “Boeing and Airbus each have about 1,500 suppliers ranging from so-called tier one companies providing aerostructures or equipment for jets to smaller tier two and three groups making components. The second and third-tier suppliers are the obvious candidates for consolidation.” Airbus and Boeing are looking at upstream consolidations (i.e., at suppliers), but some analysts believe that downstream integration is also important.

Bill Leber, a business development manager with Swisslog, told Dustin Mattison that he expects to see more movement towards downstream vertical integration because companies that “choose to outsource distribution and logistics are giving up more than they think, including control.” Mattison continues:

“Relying on third party performance, [Leber] warns, can put companies at a strategic disadvantage to their competitors. … ‘People have maxed out on outsourcing,’ Bill said, ‘we’ve heard a lot, in the last three years, about how to pick the best vendor, how to manage vendors and how to get closer to vendors, but there is a limit to that.’ Bill Leber would like more companies to think about the tradeoff involved with choosing to outsource — ‘Your vendor is selling you on the fact that they can deliver better economy of scale and more expertise, but they also need a revenue stream out of the work they’re doing for you,’ he warned.”

Back in 2009, Ben Worthen, Cari Tuna, and Justin Scheck reported that companies were looking more closely at vertical integration. [“Companies More Prone to Go ‘Vertical’,” Wall Street Journal, 30 November 2009] They wrote:

“Larry Ellison, … the billionaire chief executive of software maker Oracle Corp., … is among the executives reviving ‘vertical integration,’ a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co. The reasons vary. Arcelor, the world’s largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed. ‘The pendulum has shifted from disintegration to integration,’ says Harold Sirkin, global head of the Boston Consulting Group’s operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue — challenges exacerbated by the recession.”

Worthen, Tuna, and Scheck report that there is a difference between the current trend toward integration and the vertical integration introduced by Carnegie. They explain:

“Such steps don’t necessarily portend a return to the early-20th-century vertical conglomerates of Andrew Carnegie and Henry Ford. Then, Carnegie Steel Co. and Ford Motor Co. each owned iron-ore mines, while controlling everything from manufacturing to sales. ‘The historical view of vertical integration was that you had complete control of the supply chain and that you could manage it the best,’ says Bain & Co. consultant Mark Gottfredson. Today’s approach is more nuanced. Companies are buying key parts of their supply chains, but most don’t want end-to-end control.”

In a more recent article, Ali Hortacsu, a professor of economics at the University of Chicago, and Chad Syverson, a professor of economics at the University of Chicago’s Booth School of Business, report that some integration might be taking place, but it remains more “the exception rather than the rule.” [“Why Companies Acquire Their Supply Chains,” Bloomberg, 11 January 2012] They write:

“In a recent study, we tracked the flow of products through the economy using data on millions of individual shipments of goods from tens of thousands of U.S. firms. This detailed information comes from the Commodity Flow Survey. It lets us see who makes what; how much it is worth; and where it is sent. In particular, it shows whether the upstream units of vertically integrated companies did, in fact, send their output to their downstream units for further processing.”

They indicate that they “were surprised to find that instead of keeping those potential inputs inside the company, the upstream units sell the vast majority of what they make to others.” They explain:

“It wasn’t just that the vertically integrated companies make more inputs than they need and sell the remainder. Those selling their upstream production would simultaneously buy similar products from others to use as inputs for their downstream operations. For example, some construction-products companies made both cement and concrete products (cement is an input in concrete production). Yet those companies sent most of the cement they made to other concrete producers while purchasing much of their own cement needs from other firms. We found that vertically integrated companies sell more than 80 percent of what they make by way of inputs to other firms, rather than using those products themselves.”

Hortacsu and Syverson report that “about 40 percent of vertically integrated firms use none of their own upstream production, choosing instead to procure their inputs from outsiders.” You have to admit that those facts are startling. As a result, the professors ask, “If most vertically integrated companies aren’t supplying themselves, then why do they own production chains?” They try and explain:

“It is harder to get a clear answer to this question from the data, but there are some clues to an explanation. Trying to understand why companies own production chains by looking at the way goods flow along the chain could be misleading. Instead, it might be the things we can’t see — managerial oversight, marketing know-how, customer contacts, intellectual property, and other information-based capital — that drive most vertical integration. By integrating, companies can spread these types of capital over the production chain. Integrated firms appear to let the market and contracted suppliers handle most of the flow of tangible goods along the chain, while using control through ownership to apply the necessary intangible capital, which is by nature harder to write contracts over. We found some evidence for this sort of spreading of intangible capital. When ownership of a business establishment (a manufacturing plant, say) changes hands, the plant reorients its activity toward its new owner. It sells less to its old customers and more to those that its acquirer had already been serving.”

They note that an acquired company paying more attention to its new owner’s customers is “not completely surprising.” They also note that acquired companies often stop making old products and start manufacturing “the types of products its new firm specializes in.” So what does this have to do with vertical integration? Apparently not a lot. Hortacsu and Syverson explain that what first appears to be a case of vertical integration turns out to be a case of vertical expansion. They explain:

“This sort of transformation of the very purpose of the plant almost surely requires some sort of intangible capital inputs from the acquirer. If this explanation for integration is correct, companies’ expansions along production chains may not be altogether different than their horizontal expansions, which occur when firms start operating in markets related to their current lines of business with the hope that their capital can be applied profitably to the new markets. Vertical expansions may operate under the very same principle. After all, industries that supply a firm’s inputs are clearly related lines of business. Some companies may expand into them in the same way they would enter a new product market. In other words, companies choose to grow in all sorts of directions. Some happen to do it along supply chains, but they are essentially doing it for the same reason as all the others. We shouldn’t expect that the classic ‘make or buy’ input decision is always part of the consideration. And the data show that, indeed, it usually isn’t.”

Although Hortacsu’s and Syverson’s discussion of vertical expansion is interesting, it doesn’t seem to apply to the Airbus/Boeing situation or other situations where “control” is the primary objective. In those cases, vertical integration does hearken back to “the notion that companies vertically integrate so they can ensure ready supplies of key inputs” or control over product distribution. This kind of integration may remain the exception rather than the rule, but there does appear to be a trend in this direction.