A vintage toy manufacturer evaluating vertical integration opportunities

A $20MM+ US-based, but global, specialty vintage toys and games manufacturer had generated stable results over the past decade. With a history in manufacturing durable, cost efficient toys that were considered to large extent as collectibles, the company had built a differentiation-leadership position in its niche and a highly positive reputation. The C-suite team led by the CEO, with a mandate from the board, were however keen on finding ways how to improve the company’s profit margin, cost-structure and the existing overall competitive positioning in the marketplace.

HKH Management Consulting (HKH) was tasked by the company to evaluate various strategic choices that the company had in front of them for improving the cost-structure further. The HKH team of two partners approached the case deploying, classical but effective, realized strategy management framework. Over a period of six weeks HKH team evaluated, in detail, based on the company’s mission and objectives both the internal and external environment the client operated in drawing many insightful conclusions. Based on this landscape analysis the team investigated different strategic choices that the client could pursue, focusing on backward integration opportunities as these would have the opportunity to significantly impact the cost-structure. The team defined a hypothesis – “would it be better for the business to make or buy some of its critical components and parts?”

That is, should the firm make a certain, of the many, components that goes into its final products by itself or should it buy the component(s) from another firm in the marketplace. A starting point for the hypothesis was defined as – the make or buy question is equivalent to the question of when does a firm have an advantage over the market and vice versa. Hence, the “make” or “buy” decision depended upon whether transaction costs – the costs of organizing a transaction in the market- were higher or lower than the administrative costs of organizing the same within the company. The team then further hypothesized that the costs of searching for an appropriate supplier, the costs of negotiating a contract, and the costs of monitoring and enforcing the contracts constituted the transaction costs. The basic logic was then a straightforward formula, that is, if transaction costs in the market were higher than the administrative costs within the firm then then the client should make and if the transaction costs in the market were lower than administrative costs for the client then the client should buy. The team then evaluated in detail all the drivers of transaction and administrative costs.

It was important for the team to understand in full detail when does “make” perform better than “buy” for this particular client? Typically “make” outperforms “buy” when there are significant transaction-specific investments, hence vertical integration is likely to perform better than outsourcing or buying from an external supplier when transaction-specific investments are required. Where these required in this case? Further analysis of all the suppliers revealed that one of the critical component suppliers of the client would be forced to make a substantial investment in its machinery in the near future, potentially leading to a “holdup” position (a position in which HKH’s client would demand a considerably lower price knowing that the supplier cannot sell that particular component anywhere else). HKH team reasoned that the component supplier would not in practice accept such a contract (leading to “holdup”) even if HKH’s client would try to pursue a such route, they (component supplier) would, hence, be very reluctant to make the necessary investments to the new machinery.

While vertical integration (in the client’s case, backward vertical integration) in the presence of transaction-specific investment would minimize transaction costs, there were other issues to be kept in mind as well. First, there would be differences in the competencies required for running a specified component manufacturing versus manufacturing/assembling the end-product. The manufacturing processes and capabilities were also very different between the two businesses. Because of such differences, integration between these two businesses could potentially lead to problems of management and leadership. Second, there would be significant upfront investments for building up the capability for the component manufacturing. Third, backward integrating could potentially make HKH’s client less flexible to changes in market conditions and technologies.

Case outcomes

The HKH team provided clear and concise conclusions to the client with both pros and cons for vertically integrating backwards along the value-chain. Upon taking time to evaluate the options on the table, the client’s C-suite and board decided not to pursue with backward integration opportunity as the upfront investment for the needed machinery coupled with the recruitment of needed core-competencies were seen too high, and based on risk analysis too risky, to move forward at the given point in time.

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