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collected data with qualitative rigor (Gioia, et al., 2012) going back and forth between observations and theory to ‘abductively’ improve our understanding of both (Dubois and Gadde, 2002). The case study of a major European manufacturing firm provides insights into the challenges of forward integration into distribution, sales, services, and the logic assumed to justify the use of certain governance instruments.
In this industry, both upstream manufacturing capabilities and downstream distribution, sales, and service activities are considered important to create value and competitive advantage.
This market context is comprised by complex technical products sold to very demanding customers operating in dynamic markets representing what is referred to as complex distribution (Bering, 2020a). The economic rationales for forward integration in this industry argue for value creation from differentiated products that satisfy specific customer needs and relationships (e.g., Baines et al., 2007; Lightfoot et al., 2013; Mathieu, 2001; Oliva and Kallenberg; 2003). The case study explores how this representative manufacturing organization governs its forward integration platform and product distribution efforts towards the final users in the market. The generated insights offer a contextualized explanation for the choices made to govern forward integration in a large incumbent firm, and the differential performance outcomes across peers in the industry that derive from this.
The remainder of the article is structured as follows. First, we present the key theoretical rationales that inform the case study of forward integration, introduce the applicable complex distribution context, and discuss contractual arrangements between manufacturing and distribution. Then we outline the empirical study on governance of forward integration in the identified manufacturing firm presenting the qualitative study and its findings. Finally, we summarize the results and discuss the implications of the acquired insights.
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Conversely, when the manufactured products are for sale to fulfill specific needs of downstream end-users, there is a need to coordinate investments and efforts with the distributors that fulfill important sale and service activities. The manufacturer and distributors invest in specific assets and resources that hold a higher productive capacity in the specific trading relationship, compared to the second best alternative use. The implied asset specificity is said to generate incremental income, or quasi rents (Klein, Crawford and Alchian, 1978; Williamson, 1979, 1985). In other words, when the demand for the manufacturer’s products depend on value adding features in the adjacent downstream market, the relationship to the distributors become increasingly important.
In a long-linked technology, one activity in the value chain depends on successful completion of adjacent activities to produce, add value, and distribute the final output (Thompson, 1967). When long-linked value chains develop asset specific interdependency, we can distinguish between two representative types of manufacturer-distributor conditions referred to as directional and complex distribution contexts respectively (Bering, 2020a). These two distribution contexts contains differences in the needs of end-users’ aspects that are to varying degrees unknown to the value chains driving force, the manufacturer, and where codification of adjacent business units activities and product features are difficult (Bering; 2020a; Gereffi et al., 2005, 2018).
Under directional distribution, the business model’s value creation (Teece, 2010) predominantly derives from the manufacturer’s resources and capabilities embedded in the tangible product. The product alterations made by the downstream distribution are relatively simple and designed to support the manufactured tangible product (Mathieu, 2001; Tukker, 2004), and are often comprised in traditional franchise arrangements (Lafontaine and Raynaud, 2000; Lafontaine and Slade, 2007). Under complex distribution, the cooperation between manufacturer and distributors is more demanding because the intermediary product of the manufacturer requires additional engagement of resources and capabilities from the distributors (Mathieu, 2001; Neu and Brown, 2005; Spring and Araujo, 2013; Story et al., 2017; Tukker, 2004). The distributors now engage in extending the long-linked technology, where special customer requirements linked to the product complexity, are satisfied using the distributors’
idiosyncratic resources (Nooteboom, 2004; Thompson, 1967).
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When the long-linked interactions no longer are simple arm’s length transactions, but enhance asset specific investments capable of generating quasi rents, they become exposed to hold-up; this is where opportunistic behaviors from partners may seek to appropriate the quasi rents (Klein et al., 1978; Williamson, 1979). In the case of forward integration, opportunistic distributors can appropriate the manufacturer’s profits from the specific nature of investments with a high degree of plasticity, reflecting a wider range of investment options and information asymmetry (Alchian and Woodward, 1978; Gibbons, 2005, 2010). This entails two types of transaction costs. Asset specific investments can be vulnerable to hold-up where quasi rents are appropriated (Klein et al., 1978; Williamson, 1985) or to moral hazards (Alchian and Demsetz, 1972; Salanié, 2005) where quasi rents are diluted as distributors shirk on efforts that are difficult to monitor. When asset specific investments have low plasticity, they are vulnerable to hold-up but are immune to moral hazard if the associated monitoring is easy. In contrast, when the effects of efforts are difficult to detect, asset specific investment, or ‘plastic’ assets, can be vulnerable to hold-up as well as moral hazards (Alchian and Woodward, 1988). In short, proper integration of business activities can offset appropriation of quasi rents, whereas specific investments in plastic assets remain exposed to moral hazards (Alchian and Woodward, 1988;
Gibbons, 2005, 2010). These concerns are typically considered in the contractual arrangements between interacting entities.
In the context of directional distribution, the business model builds on the manufacturer’s product attractiveness in the market for the end-users. The distributors’ transformation of the manufactured product offering is simple. In combinations with services, the distributors aim to support the sale of the manufactured product, and therefore do not challenge the knowledge and capabilities residing inside the manufacturer. The codification of product specifications and related distributor investments is relatively easy for the manufacturer to accomplish (Bering, 2020a; Gereffi et al., 2005, 2018; Mathieu, 2001; Tukker, 2004). The efficiency of distribution therefore depends on contractually defined investments where asset specificity and human effort add to the generation of quasi rents. The business model offered by the manufacturer must give the downstream distributors incentives to invest in mutual asset specificity that exceeds the distributors’ opportunity costs (Klein, 1995). The provisions that the manufacturer provides to promote this are usually made by giving access to the product brand and offering a price sufficiently low to allow the distributors to profit from on-selling the products.
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Investment requirements in asset specificity under directional distribution can be considerable and represent an opportunity for the distributors to hold-up the manufacturer by haggling over the required investments. Empirical studies of forward integration identify the importance of asset specificity, but also the plasticity of investments related to moral hazard exposures (e.g. Andersen and Schmittlein, 1984; Baker and Hubbard, 2004; Brickley and Dark, 1987; Brickley et al., 2003; Lafontaine, 1992). Hence, the manufacturer will seek to protect the provisions used to incentivize distributor investments in asset specificity. This is accomplished through use of self-enforcing mechanisms that seek to internalize the opportunism of moral hazards (Klein, 1995; Kalnins and Lafontaine; 2013; Lafontaine and Raynaud, 2000). The contractual terms therefore seek to link the distribution of profits to outputs when there is an accurate measure of inputs (Anderson and Schmittlein, 1984; Anderson, 1985; Lazear and Gibbs, 2014) or impose a possibility of losing access to the share of the manufacturer’s quasi rents (Klein, 1995; Lafontaine and Raynaud, 2000). This leads to a governance regime where economies and interdependencies between manufacturing and distribution are coordinated under the manufacturer’s authority – using instruments like planning and standardization (Thompson, 1967).
When market conditions commensurate with complex distribution, distributors are required to assume a more entrepreneurial value-adding role (Baines and Lightfoot, 2014; Bering, 2020a;
Neu and Brown, 2005; Woodruff, 2004) that increase the complexity of interdependencies between the manufacturer and distributors (Thompson, 1967). The manufacturer’s intermediary product now appears more unfinished, and the bridging role of downstream distributors to satisfy final customer needs requires the engagement of different resources and capabilities (Nooteboom, 2004; Story et al., 2017; Teece, 2010). This reflects situations of complex business activities and transactions linked to specific resources and capabilities between interdependent parties (Bering, 2020a; Gereffi et al., 2005, 2018). Under complex distribution, the manufacturer must offer the downstream distributors a product input that holds potential for the distributors to earn quasi rents from the added value related to their own asset specific investments (Klein et al., 1978; Williamson, 1979). This includes investments in intangible assets like specific knowledge and processes, in addition to an entrepreneurial mindset that can extend the value of the manufactured product. These extended activities are based on specific resources and knowledge that are difficult to codify and transmit through the standardized coordination mechanisms and formal governance structures (Bering, 2020a; Gereffi et al., 2005, 2018; Jensen
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and Meckling, 1990). These conditions also reflect downstream distributors that operate in a demanding multitasking environment (Holmström and Milgrom, 1991; Shepard, 1993; Slade, 1996).
The dual (upstream and downstream) locations of (and investment in) relevant resources and competences change the nature of the interdependencies between the manufacturer and the distributors from being purely sequential, to also being reciprocal (Thompson, 1967). Hence, the upstream manufacturer and the downstream distributors are mutually affected by various externalities, but also depend on the specific competences and resources of each other as the means to enhance their joint competitiveness. This distributes the responsibility to resolve and coordinate interdependent entrepreneurial and instrumental challenges that are linked to changes in market conditions and product complexity more evenly between the manufacturer and the distributors (ibid). The more complex distribution conditions make the manufacturer dependent on updated market information from the downstream distributors. This relates to both the manufacturer’s own product innovation and the distributors’ investments in intangibles, like knowledge specific competencies and entrepreneurial efforts closer to the end-users. It also makes the contractual codification of product elements and processes very difficult and costly (Bering, 2020a; Gereffi et al., 2005, 2018). However, this complexity of interdependent relations also makes it challenging to obtain accurate price information in the markets for end-users; this makes the profit sharing arrangements vulnerable to manipulation and misuse of asymmetric information.
The mutual interdependencies between manufacturing and distribution – and higher reliance on downstream entrepreneurial activities – have been subject to empirical studies. One perspective is that the increasing plasticity of asset specificity makes it difficult for the manufacturer to tie the distributors’ measurable efforts to outputs, and as a consequence the self-enforcing contracts lose their corrective functionality (Raynaud and Lafontaine, 2000). This means, that the plasticity of asset specific investments becomes a threat to the sharing of quasi rents. This shifts the focus from monitoring moral hazards to incentivizing the different constituents as residual claimants of their own private efforts (e.g., Baker and Hubbard, 2004;
Brickley and Dark, 1987; Brickley et al., 2003; Kosová et al., 2013; Lafontaine and Bhattacharyya, 1995; Norton, 1988; Oliva and Kallenberg, 2003, Woodruff, 2002).
The increased importance ascribed to incentivize downstream entrepreneurial efforts in complex distribution uncovers a need to consider different contractual mechanisms. The
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asymmetric nature of information and knowledge between the manufacturer and the distributors makes it difficult to align the interdependencies in explicit coordination mechanisms, like planning and standardization. This ultimately leaves the contracts incomplete (Williamson, 1985); many elements in reality are difficult to meter and non-contractible when distributors are forced to prioritize between activities (Holmström and Milgrom, 1991). Hence, the manufacturer is no longer able to exercise control over the distributors’ investments, but must rely on mutual coordination of reciprocal interdependencies (Thompson, 1967). This relates to the distribution resources and competences like service oriented entrepreneurial capabilities (Brickley and Dark, 1987; Gebauer et al., 2005) that often represent non-contractual intangible investments (Grossman and Hart, 1986; Woodruff, 2002). Therefore, the contracts must incentivize the distributors as residual claimants to their own tangible and intangible assets, and future returns from their value creating entrepreneurial activities (Lafontaine and Raynaud, 2000).
This discussion of contrasting types of distribution, directional and complex, makes it clear that the decision of a manufacturing firm to integrate forward into distribution presents different governance challenges dependent on the prevailing market context. As manufacturing firms move towards conditions of complex distribution, the integration challenges become increasingly indeterminate without easy solutions. Empirical studies find that forward integration can provide competitive advantage but the success rates in achieving this remain rather low (e.g., Benedettini et al., 2015; Gebauer et al., 2005; Neely, 2008; Harrigan, 1986;
Visnjic et al., 2016). This illustrates that complex distribution contexts require different integration approaches, therefore presenting a new governance challenge (Bering, 2020a,b).
To better understand how contemporary manufacturing firms deal with this challenge, this article poses the research question of how manufacturing firms govern forward integration in an increasingly complex distribution environment where manufacturers seek to differentiate products to customer specific needs and gain competitive advantage. Given the sometimes conflicting economic integration rationales – and observing that different firms operating in the same manufacturing industry pursue different business models with different outcomes – we also seek to uncover why certain firms govern forward integration the way they do.
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