Backward Integration at Starbucks

Source: Wall Street Journal

The Wall Street Journal reports that Starbucks has acquired a 600 acre coffee farm in Costa Rica.  You might ask: Why is Starbucks backward integrating?  They probably do not think they can operate the supply chain more efficiently through vertical integration.   They certainly aren't going to obtain a significant amount of coffee beans through one 600 acre farm.  What are they doing?

They are learning, experimenting, and innovating.  It's a terrific reason to engage in partial/limited backward integration.   Starbucks CEO Howard Schultz explained, "We are talking about doing innovative things we would not be able to do without this farm."   Craig Russell, a Starbucks senior vice president, explained that the company would try to identify ways to address a fungus problem that is affecting coffee farm yields in Central America: "It's a dynamic situation and we will absolutely use this farm for testing different methodologies and ways to use new types of coffee trees we've developed that have become more disease- and rust-resistant."   Finally and most importantly, Starbucks intends to share what they learn about the fungus with other farmers, so that coffee bean production improves overall for the industry.   

This example demonstrates that a small bit of vertical integration (backward) can be very effective as a means of innovation and experimentation.  Many companies simply view vertical integration from the perspective of its immediate effect on the bottom line.   Ironically, many of those efforts actually decrease profits much to the chagrin of senior executives.   Of course, many of those efforts are not small experiments.  They are bold moves down without a good pilot to test the concept.  In this case, a small bit of experimentation could yield large improvements in profits over time.  

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JC Penney vs. Zara: How to Reduce Markdowns

Frequent markdowns can eat into a retailer's margins quite substantially.  No wonder, then, that Ron Johnson - the CEO of JC Penney has tried to wean the department store off of its reliance on discounts and sales.  We all know, however, that he has had limited success to date.  In fact, sales have plummeted as customers have revolted at the dramatic reduction in sales and markdowns. 

Let's compare JC Penney to Zara for a moment.  Zara is a Spanish apparel retailer that has done remarkably well over the past decade or so.   Zara manages to offer fewer markdowns than many rivals, and when it does discount its clothing, they price reductions are smaller than those offered by competitors.  How does Zara do it?  They pursue a "fast fashion" strategy, whereby they make smaller batches of fashion items - a substantial percentage of which they make in their own factories.  They change their product mix often, and they react quickly to changing trends and consumer tastes.  Customers know that many lines of clothing will have limited numbers of items, and that those items may not be on the shelf one month later.  As a result of this nimble strategy, Zara minimizes the downside of "fashion misses" in their product line.  Because they don't produce huge runs of some of these items, they have much less inventory left over if a new product is not a hit with consumers.  Therefore, they have less of a need to mark down those clothes.  

In short, Zara has reduced its dependency on markdowns, but they have not done it simply by declaring that there will be less discounts.  They have built an entire strategy that makes it much less likely that they will need to discount items.  JC Penney hasn't yet built that comprehensive strategy to support its  new pricing policy.  As a result, JC Penney has struggled. 

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Google, Motorola, and Android

When Google purchased Motorola's cellphone business, it became vertically integrated.  In other words, it now owns produces the mobile phone hardware and the software, much like Apple.   We all know that Steve Jobs extolled the benefits of vertical integration in the various businesses in which Apple competes.  He believed fervently that one could only produce a "magical" device if you made both the operating system and the hardware.  

Vertical integration has many benefits, but it also comes with certain challenges.  In particular, it can be quite challenging when you start out competing in one portion of the value chain and then enter a downstream business.  Google did so when it began by making Android and then acquired a cellphone maker.  In so doing, Google now has entered into competition with its customers.  After Google's customers for its Android software include Motorola's competitors: Samsung, HTC, and the like.  That competition with customers can be a tricky thing to navigate at times. 

According to this article in Fast Company by Farhad Manjoo, Google has chosen to deal this sticky situation by "erecting a firewall between Android and its new Motorola division. The new rules ensure that Motorola's hardware teams get no more access to Android's engineering teams than any other device maker would."   Surely, the firewall helps allay customer concerns that Google may be favoring its internal Motorola division over other cellphone makers.  On the other hand, such a firewall clearly diminishes the very benefits of vertical integration that presumably drove Google to make the deal in the first place!   What's the explanation here?  Could Google have underestimated the push-back from customers when they made the acquisition?  Or has Google chosen this firewall strategy as a temporary transition mechanism as they work through customer relationship issues?  Surely they won't leave the firewall in place forever, will they?  If so, then why buy Motorola at all?  What value does owning the hardware business bring if you don't make the software and the mobile device work together harmoniously?

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Vertical Integration at Lenovo vs. Outsourcing at Rivals

The Wall Street Journal has an article today about Lenovo's vertical integration strategy.  That strategy stands in stark contrast to many of the firm's rivals in the computer business (including Apple), which have outsourced many aspects of the manufacturing process.   Lenovo CEO says, "Selling PCs is like selling fresh fruit.  The speed of innovation is very fast, so you must know how to keep up with the pace, control inventory, to match supply with demand and handle very fast turnover."  Lenovo's SVP of supply chain says, "Three years ago the whole industry was saying everyone should outsource, that's the future.  [We] came to the conclusion that even though all our other competitors are going in the other direction…we can move faster if we're more vertically integrated." 

I'm surprised by the comments, and frankly, by the strategy.   Most people would agree that Apple is one of the most innovative and highly differentiated companies in the computer industry.  If Apple can achieve that type of rapid innovation without being completely vertically integrated, then why can't Lenovo?  Apple pursues vertical integration on selected components, most importantly on its operating system.  However, Apple does not keep all manufacturing in-house.   Lenovo chooses to use outsiders for its operating system (Microsoft Windows for its PCs and Google's Android for its new tablets).    Yet, Lenovo is manufacturing many hardware components in-house.   Time will tell if the strategy will pay off.   One wonders if the path to successful innovation, though, has more to do with company culture, leadership, and new product development processes, rather than with the extent of vertical integration. 

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Microsoft Surface: What's the Strategy?

Microsoft's decision to build its own tablet computer (called Surface) has raised some interesting questions about the firm's strategic intent.   Has the firm finally acknowledged that Steve Jobs was correct when he said that you had to be vertically integrated to produce something as terrific as the iPad?  In other words, did the same firm have to make the hardware and the software, because complex integration was needed to deliver a exceptional customer experience?   Jobs, of course, believed that Android devices could not match the iPad experience because they lacked such sophisticated integration (since the hardware makers were simply licensing the Android system). 

A recent New York Times story suggests an alternative hypothesis:  Has Microsoft decided to move temporarily into the tablet hardware business so as to drive the type of innovation that could lead to lucrative tablet operating system and software sales down the road?   Toward the end this New York Times article, MIT Professor Michael Cusumano offers his take on Microsoft's latest move.  Here is the excerpt from the article:

Some who study the technology industry still believe Microsoft will get out of the business of selling its own tablet computer as soon as it can persuade other hardware companies to build compelling devices of their own. “I think once they jump-start it, they plan to make money the way they always have — from licensing software,” said Michael A. Cusumano, a management professor at M.I.T. 

I found this hypothesis quite intriguing.  I can think of at least one other example of a company choosing to vertically integrate on a "temporary" basis.   Coke and Pepsi both chose to forward integrate into bottling and distribution some years ago, and then they divested those units.  Why the back-and-forth?  Some (including HBS Prof. David Yoffie) would argue that Coke and Pepsi forward integrated  so that they could acquire and consolidate their distribution network, driving economies of scale throughout the channel.  They also wanted control of the channel at times as their product strategies shifted.   However, the firms didn't want to have all those assets on their books for the long haul, given the returns in bottling and distribution are much lower than in concentrate production.   Of course, both chose to forward integrate once again more recently, and now we hear rumblings (particularly at Pepsi) of the possibility of another divestiture down the road.  Again, forward integration may have served a distinct strategic purpose, but the firms may find themselves questioning the returns on the distribution businesses. 

Similarly, Microsoft may not want to be in the hardware business long term, as the returns are likely to be lower than in the software business (at least if the tablet market operates in a manner consistent with returns in the personal computer market).   However, "temporary" vertical integration may be their way of shaping the industry in the way that will be positive for them in the long term.   We'll see which hypothesis turns out to be correct.  It should be fascinating, and of course, it will depend on how well customers receive the Surface product. 

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Made in the USA: Can it be a Differentiator?

How does a furniture maker compete with low-cost rivals producing goods in China?  It has several options.  It could outsource to China itself, so as to make its furniture more economically.  Alternatively, it could continue to produce in the USA, but try to differentiate its product so as to justify a significant price premium.  The latter strategy can be very successful in some product categories, but it has been difficult in a category such as furniture.   The Wall Street Journal reports, however, that one crib manufacturer is trying to produce a premium product right here in the US.  The Stanley Furniture Company hopes to persuade customers that they can worry less about product safety recalls if they buy from a company producing cribs in the US.   They also offer a wide variety of colors and designs, many more than can typically be provided by a firm producing its cribs off-shore.   However, Stanley charges a significant price premium - $700 vs. roughly $400 for many cribs made in Asia. Stanley is counting on the fact that customers are less sensitive to price when it comes to their infants.  Moreover, grandparents often contribute a significant amount to the purchase of a crib, according to the firm's research. 

Will the strategy work?  It could work, provided that Stanley delivers on its high quality promise.  Beyond that, though, the firm ought to think about the potential advantages that vertical integration may offer.  For instance, producing the cribs in-house here in the USA gives the company the opportunity to do more than offer many different colors and designs.  It also can change its designs much more frequently than an off-shore manufacturer can.  Moreover, it may even be able to offer some level of customization to the consumer.   Mass customization might help support a hefty price premium.    In all these cases, the company relying on outsourcing has a disadvantage, as they will be counting on large production runs of standardized products to take advantage of economies of scale.  Stanley could sacrifice those economies in return for providing the customer some benefits for which they would pay enough of a premium to offset the higher manufacturing costs.   Such a strategy comes with some risk, but given that Stanley cannot compete on cost with Asian manufacturers, it may be the only way to go. 

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Will Delta really save money by acquiring an oil refinery?

The Wall Street Journal reports today that Delta Airlines is considering the acquisition of an oil refinery as a means of dealing with volatile oil prices. The article reports that Delta could save between $20 and $25 per barrel on fuel costs due to this backward integration strategy. Seriously? This claim represents one of the common myths about vertical integration. I find it hard to believe that the paper published such a claim. People often assume that you can save money by bringing an activity in-house and eliminating the markup/profit margin that the outside party was taking. This "savings" is completely false. You only get that "savings" by investing a ton of money in new assets you did not own previously! There is no free lunch! Later, in the "Heard on the Street" section of the paper, we see much more thoughtful analysis. There, the writers point out that Delta could achieve a similar result with a long term contract securing a certain fuel supply at a particular price; why vertically integrate, with all that capital investment, when contracts could achieve much the same result?  Whenever firms horizontally or vertically integrate, they should always ask whether they could achieve a similar outcome through a contract or long-term partnership.

In the segment below, which aired on CNBC, we hear a discussion of Delta's latest strategic move:

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