Vertical Boundaries of the Firm
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The process that begins with the acquisition of raw materials and ends with distribution and sales of finished goods and services is known as the vertical chain. However, the key is to organize the vertical chain to achieve optimized results upon integration.
For example: Arrow Electronics is a global provider of products, services and solutions to industrial and commercial users of electronic components and enterprise computing solutions, with 2013 sales of $21.4 billion. Arrow serves as a supply channel partner for over 100,000 original equipment manufacturers, contract manufacturers and commercial customers through a global network of more than 460 locations in 58 countries with over 16,500 employees worldwide.
The company has two business segments, the Global Components (GC) business and the Global Enterprise Computing Solutions (ECS) business. For 2013, approximately 63% of the company's sales were from the GC business segment, and approximately 37% of the company's sales were from the global ECS business segment. Over the past three years, the GC and ECS business segments have completed 15 and 5 strategic acquisitions respectively to broaden its product and service offerings and to further expand its geographic reach.
The company's financial objectives are to grow sales faster than the market, increase the markets served, grow profits faster than sales, and increase return on invested capital. To achieve its objectives, the company seeks to capture significant opportunities to grow across products, markets, and geographies. To supplement its organic growth strategy, the company continually evaluates strategic acquisitions to broaden its product and value-added service offerings, increase its market penetration, and/or expand its geographic reach.
It can be said that Arrow Electronics has been both horizontally and vertically integrating itself. They have acquired 29 companies since the appointment of Michael J. Long who was appointed as CEO in 2009 and then as Chairman in 2010.
To further illustrate vertical integration, let us discuss the Make-or-Buy Dilemma.
Make or Buy Dilemma
A firm’s decision to perform an activity itself or to purchase it from an independent firm is called a Make-or-Buy Decision. Make and buy are two extremes along a continuum of possibilities for vertical integration.
Arrow Electronics launched ArrowSphere on 5th July 2012, a cloud services aggregation and brokerage platform for the European solution provider community, system integrators, independent software vendors and service providers. This was a “make” initiative for Arrow Electronics. They were already into buying products from vendors and distributing to end users via resellers. For them, it was also crucial to have a product of their own so as to maximize gross margin.
At the same time, Arrow Electronics wanted to expand their geographical reach to capture new markets. Following this strategy, in 2010 they acquired UK based security distributor Sphinx. Then in 2012, it was Altimate, a pan-European storage and server distributor along with the wireless and infrastructure business unit of Waching Company Ltd, a Chinese distributor. From 2010 to 2012, Arrow Electronics has acquired half a dozen distributors to increase its weight and keep growing in a bid to appease investors.
Computerlinks AG was one of the leading next generation value-added distributors for international manufacturers in IT Industry. Headquartered in Munich, Germany, Computerlinks AG had operations in Europe, North America, the Middle East and Asia. The company had over 660 employees operating across 25 countries worldwide in 2012 with a revenue of $1.2 billion. They were heavily competing with Arrow Electronics in America’s, UK and other major regions which was the reason of Arrow’s interest in acquiring Computerlinks AG. Venture capitalist Equistone bought Computerlinks AG off the Frankfurt Stock Exchange 5 years ago for $1.39 million.
In April 2013, Computerlinks AG was fined $2.8 million by the USA Bureau of Industry and Security for exporting devices designed to monitor and control internet traffic to Syria, an USA embargoed country. Following this news, Equistone took a decision of selling the company to Arrow Electronics. This proved to be a smart move since this was the best time to get attached to a bigger and better name so that the very existence of Computerlinks AG disappears and the business can continue and grow with minimum impact on sales.
On 28th October 2013, Arrow Electronics acquired Computerlinks AG for a purchase price of approximately $313,209. Computerlinks AG had forecasted sales of approximately $950 million in 2013 in accordance with Generally Accepted Accounting Principles in the USA.
Although Arrowsphere was a new concept, it did not attract much sales for the company. The company grew about 4.46% over 2012-2013. They have been benefitting more from the acquisitions than the internal product launch.
Hence, the “buy” decisions of Arrow Electronics have been helping them to benefit from economies of scale and are more profitable than their decision to “make” new products.
Manager and workers make many decisions that contribute to the profitability of a firm. Manger and workers who knowingly do not act in the best interests of their firm are shirking. Agency costs are the costs associated with shirking and the administrative controls to deter it.
Arrow Electronics makes the bulk of its sales to industrial and commercial users of electronic components alongside ECS unit. However, sales dropped 5% in 2012 and profitability was relatively low. Through its ECS unit, Arrow Electronics has a modest cloud business, although this is relatively under developed. Although acquiring new companies is boosting the sales, this may not necessarily be in the interest of shareholders. The shareholders may want them to focus more on large turnkey projects in order to increase revenue instead of acquiring new companies. Hence, the shareholders must keep monitoring their moves thus increasing the agency costs. On the other hand, the management of Arrow Electronics should also keep an eye on their managers to make sure that operating expenses are kept to the minimum. To effectively manage and reduce the agency costs, all decisions should be mutually agreed between Arrow Electronics and shareholders. At the same time, Arrow Electronics should release some guidelines for all the managers on how to minimize the operation costs.
A relationship-specific asset supports a given transaction and cannot be redeployed to another transaction without some sacrifice in productivity or some additional cost.
For example: Arrow Electronics gets a new vendor on board and invests on setting up a new sales and technical team based on the commitment from vendor that they will be diverting most of the business through them. Currently, this vendor is doing business with another distributor who has been there in the market for long. Now, the vendor cannot simply snatch the business from one working distributor to another new distributor since it may end up upsetting either or both of them. It is quite possible that the vendor is unable to comply with its commitments then Arrow Electronics will be at loss since it has already poured in money for hiring these employees and train them to the vendor’s expectations. They will be left with few choices as follows: Either they fire these new employees and hire some less experienced staff or train them on new products which may be coming on board soon or shift them to different department if possible but all of these options are going to cost them in one way or another. Thus, the investment done by Arrow Electronics for this vendor could back-fire them instead of generating more revenue which was the goal set by both parties prior to getting into this contract.
This may also result in a Hold-up problem. Arrow Electronics may go back to this vendor and renegotiate the terms in the contract. They may agree to hire less experienced staff thereby reducing their investments in exchange of expecting less revenues compared to the previous agreement.
Arrow Electronics may also choose to sue this vendor by exploiting the incompleteness of the contract. Virtually all real-world contracts are incomplete: they do not fully specify the "mapping" from every possible contingency to enforceable rights, responsibilities, and actions. Incomplete contracts involve some degree of open-endedness or ambiguity; there are circumstances where neither party's rights and responsibilities are clearly spelled out.
Thus, we can conclude that Arrow Electronics has integrated themselves both horizontally and vertically. Their “make” and “buy” decisions have been wise so far resulting in profitability and overall growth of the company. They have also been successful in keeping their agency costs to minimum as well as managing their relation-specific assets to avoid the hold-up problem.
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Bureau of Industry and Security. (2014) Bureau of Industry and Security Announces $2.8 Million Civil Settlement with Computerlinks FZCO for Charges Related to Unlawful Exporting of Technology to Syria. Available at: http://www.bis.doc.gov/index.php/about-bis/newsroom/102-about-bis/newsroom/press-releases/press-releases-2013/524-bureau-of-industry-and-security-announces-2-8-million-civil-settlement-with-computerlinks-fzco-for-charges-related-to-unlawful-exporting-of-technology-to-syria (Accessed: 12 August 2014)
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