Analysis of IT news

Saturday, June 10, 2006

General Theory: Vertical Integration vs. Horizontal Integration

Potentially any market is affected by this: the switch from a vertical integration (where each vendor build most of the components of their products) to a horizontal integration (where vendors specialize in one component and one vendor merely assemble and market them).

When a market is new, vertical integration is paramount. Products at that stage generally need all the performance they can get, so vendors have an incentive to come up with their own components specially tuned for these products. This happens not only in the IT world, but in every market. The Wright brothers, when designing the first plane, built their own engine because no engine on the market was light enough for their need.

But as time goes, performance gets better, and there comes a point where flexibility prevails as complexity rises. When IBM realized it needed to get a foot on the microcomputing market in the early 80's, it didn't have the time to design everything from scratch. So it quickly assembled a computer with existing off-the-shelf components (the operating system from Microsoft, the microprocessor from Intel, the hard disk by Seagate, etc.). The result wasn't particularly performing but it was good enough, and delivered in a record time.

But by doing so, IBM undercut its added value. If they could assemble a PC in no time, so could anybody else by buying from the same suppliers. That's how the people who reaped all the benefits of the PC were those who provided a real added value: Microsoft and Intel. Once a market has shifted to a horizontal model, it's very difficult to fight it. Compaq for example spent millions in research and developpement in the early 90's to come up with motherboards that would provide them with a competitive advantage. Unfortunately for them, Intel began selling their own motherboards. As a result, any PC vendor could buy a motherboard as good (if not better) than Compaq's without having to spend a cent on R&D, and probably at a cheaper price. Compaq just couldn't compete with Intel's huge economies of scale.

And we can observe the same behavior today. Google for example tries to provide a complete suite of online services on its own instead of leveraging existing third party services, which can backfire. It might indeed be because Google started competing with eBay with Google Base that the auction giant struck a partnership with Yahoo! And several people have questioned whether Microsoft capture of the Web browser market and obsession to tie it to the desktop was a good move. It didn't indeed bring any revenue for the company, and created a lot of security problem for Windows (not counting problems with the Department of Justice).

But switching from a vertical logic to a horizontal logic is more difficult than it seems. Relying on suppliers instead of coming up with your own components is a tough choice to make, because it erodes your competitive advantage (just like IBM experienced the hard way). Only a few companies like Dell who excel at operational excellence succeed.

Specializing is even harder, because it means changing your core target customers, which is a thing companies never do. Ford might now rely on thousands of suppliers, it still sells cars. Selling only engines would mean selling to car companies instead of selling to individuals, which would be too huge a cultural shift. Sometimes, a company makes more money with side products. American Airlines with its Sabre reservation system it licenced to all the other airline companies. And car manufacturers make a lot of their margins with car leases. But they still see themselves respectively as an airline company and car manufacturers. Second, companies integrate the vertical logic into their corporate cultures. Google was successful by reinventing the wheel. Web search existed years before Google, yet they succeeded by providing a better and faster service. Why would they want to stop reinventing the wheel?

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