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From the analysis above we learn the way an integrated firm perceives activities depends on the location of its organizational center of gravity. The early lessons learned influence path-dependency and what activities the integrated firm finds important for continued success – its priority investments along the value chain. It also influences the diversity of resources and capabilities along the value chain and for what purpose they are deployed. An upstream center of gravity will prioritize value adding activities departing inside the manufacturing; one that is usually capital heavy and use the distribution to achieve upstream goals. A downstream center of gravity is receptive to changes in final user market and will use information to influence manufacturing flexibility and product development. This also influence who has the authority to define governance systems, and for what purpose interdependency is coordinated. The ability for integrated firms to balance its center of gravity in response to exogenous changes in the product markets for end-users is important to stay competitive.
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obvious solution. Yet, real business managers must deal with reality and try to manage this problem. While some have a hard time, others have found viable solutions despite the wanting prescriptive advice from academia. To understand the underlying governance challenges associated with forward integration from manufacturing into downstream distribution, the preceding sections have analyzed these challenges in the context of two different distribution types – directional and complex distribution.
We note that part of the disorientation may relate to often overlooked, but important, differences between backward and forward integration, along with their impact on the ability to manage interdependencies along the value chain. When manufacturing integrates backward, or suppliers integrate forward, the manufacturing center retains status and power as the last revenue collecting profit center in the value chain. However, when manufacturing integrates forward, the final revenue and profits are (now) recorded in the distribution business outside of the acquiring manufacturing center, which can dilute its status and power but also amplify moral hazard. Since manufacturing typically is the economic turning point in long-linked value-chains, this can have profound effects on the dynamics that coordinate interdependencies. It also influences how important resources and capabilities are incentivized and engaged to create a competitive advantage from integrating forward. When product markets are complex and dynamic, there is a need to engage specific distribution capabilities and knowledge in entrepreneurial efforts that generate new viable market offerings (Bustinza et al., 2015; Oliva and Kallenberg, 2003). However, this might be at odds with a governance structure that has power tilted toward manufacturing because it is not straightforward to resolve the reward structure between adjacent business entities to avoid the potential for incentive misalignment.
Double marginalization is a root to such incentive misalignment. For a manufacturing firm this requires a redistribution of profits to the distribution to reduce the difference in downstream profit maximizing volume between two sequential monopolies (Brickley et al., 2014; Riordan, 2008). This redistribution of profits can serve to engage entrepreneurial effort in distribution that otherwise would receive no incentive. By the same token, if engagement of entrepreneurial resources and capabilities is needed, but difficult to measure, the forward allocation of profits can give rise to moral hazard issues (e.g., Anderson, 1985; Anderson and Schmittlein, 1984;
Baker and Hubbard, 2004; Brickely and Dark, 1987; Shepard, 1993; Slade, 1996; Woodruff, 2002; Lafontiane and Slade, 2007). Disentangling the incentive misalignment from double
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marginalization of two sequential monopolies (Eccles, 1985; Klein, 1995; Riordan, 2008; Tirole, 1988) and related moral hazard (Lafontaine and Slade, 2007) can still entail important challenges. When manufacturing integrates forward into distribution and services, the direct contact to end-users in the final product markets is held with the acquired downstream distribution centers. The manufacturer’s dependency (Thompson, 1967) on distribution and its ability to exploit the proximity to end-user markets is exponential when complexity increases, herby amplifying the need to adapt to the changing needs of different end-users (Baines and Lightfoot, 2013; Woodruff, 2002).
Under directional distribution, the handling of product complexity originates from resources and capabilities inside the upstream manufacturing center (Galbraith, 1983; Nooteboom, 2004).
The contractual relations between manufacturing and distribution is based on self-enforcement (Klein, 1995; Lafontaine and Raynaud, 2000) where the distributors have access to a provision when specific asset investments are used as requested. The distributors’ effort and activities are linked to defined tangible investments, made so that the manufactured products are effectively sold and distributed. The basis for this governance structure is entirely based on the competitiveness of the manufacturer’s products with the related investments and standardized activities that create rents, and allow the provision to be created and shared with distribution (Klein, 1995). This provision also secures that the distributors’ investment in specific tangible assets with limited plasticity to accomplish the sales task. The planning and standardization of the distribution processes increases efficiency and reduces the element of moral hazard.
However, is not always easy for the manufacturer to detect incentive misalignment. This can amplify the double marginalization problem and thereby incentive misalignment. First, the distributors can cut back on effort to sell output to the point where the provision paid by the manufacturer equals that of the manufacturer’s opportunity costs. This means that the manufacturer pays a provision without receiving any benefit, a kind of opportunism often attributed to moral hazard. Other misalignments may relate to incremental or excessive costs incurred by the distributors by their own choice. These costs can reflect value-creating effort to accommodate customers while other costs might reflect value-reducing perks like expensing a luxury car or just high salaries. These costs inside distribution require adjustments to the contracted provisions so they effectively capture the effects on sales volume and profits (Klein, 1995; Lafontiane and Raynaud, 2000).
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To reap the economic benefits from integration, the sharing of rents comprised in the provision paid to the distributors must be reduced, or even eliminate the potential misalignment of incentives. The rationale for integration and improved monitoring is to reduce moral hazard and internal costs and thereby increase the sales volume of distribution (Anderson, 1985;
Anderson and Schmittlein, 1984; Brickley and Dark, 1987). Since directional distribution requires little to no entrepreneurial effort based on intangible downstream resources and specific assets, manufacturing aims to exploit and control distribution activities by contractual provisions. This requires the ability to efficiently measure process and target fulfillment, defined by assigned diagnostic control systems (Lazear and Gibbs, 2014; Simons, 1995). In this governance structure, the manufacturer can improve incentive alignment and reduce exposure to moral hazard.
This means that authority must be consolidated in the upstream manufacturing business center, taking on the formal role as a profit center consolidating formal property rights (Aghion and Tirole, 1997; Eccles, 1985; Grossman and Hart, 1986). Consolidating authority with manufacturing has the advantage that the manufacturing headquarters, or center of gravity, can coordinate interdependencies through planning and standardization without interventions from the distribution (Williamson, 1975; Thompson, 1967). Since directional distribution provides reasonable measuring of activities related to output and costs in the distribution, the need to incentivize entrepreneurial effort related to unobservable or non-contractible activities is limited (Holmström and Tirole, 1991). The manufacturer can therefore use instruments like transfer pricing policy to minimize the exposure to downstream moral hazard. This occurs by transferring profits from distribution revenues to the manufacturing profit center. A manufacturing firm operating under directional distribution in an environment where the demands of distribution is relatively stable does not challenge the conventional governance approach (Bustinza et al., 2015; Teece, 2010; Visnjic et al., 2016) or require authority be moved further downstream (Galbraith, 1983; Nooteboom, 2004; Thompson, 1967).
Under complex distribution the responsibility to configure the product complexity in dynamic competitive markets resides both with the manufacturing and distribution entities. This means that the sharing of rents does not rely only on the value created by the manufacturer as a downstream quality supply, but on a more refined final product complexity derived through combined expertise and effort along the long-linked value chain. This has governance
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implications for manufacturing firms that integrate forward. The alignment of incentives, innovation, and coordination of interdependencies in the long-linked value chain must fundamentally change.
With segregated ownership and exchange in spot markets, the contracts between specialized firms are designed to reward the residual claimants for their entrepreneurial efforts. The purpose of this contracting is to reduce incentive misalignment between the manufacturer and distribution as individual firms (Lafontaine and Raynaud, 2000). With forward integration from a manufacturing firm into distribution, the incentives related to entrepreneurial effort and refined product configuration needs to be preserved (Bustinza et al., 2015; Baines and Lightfoot, 2014;
Gebauer et al, 2005). Several elements are noteworthy here. First, the contractually required investments by the distributors do not only favor manufacturing, but also the distributors’ ability to generate profit from their own effort. This is supposed to be reflected in the distributors’
investment incentives. Secondly, the distributors should remain the residual claimants to the use of their idiosyncratic investments and efforts so the generated quasi-rents are not appropriated by an opportunistic manufacturing center (Grossman and Hart, 1986; Gibbons, 2005; 2010;
Woodruff, 2002). This includes the use of specific market knowledge that often is tacit in nature and embedded in customer relationships that can ensure end-user satisfaction and loyalty for future business engagements. Effectively these product complexities and related elements are a tool to differentiate and tailor products to specific use with the aim to increase the customers’
willingness to pay more (Hoopes et al., 2003). They are considered value-adding distribution artifacts that are needed to reach profit optimizing sales quantities.
Forward integration under complex distribution therefore needs to reconfigure the governance structure of the integrated enterprise (Bustina et al., 2015; Gebauer et al., 2010;
Suarez et al., 2015; Teece, 2010; Visnjic et al., 2014). There is a need to impose incentives that preserve the positive effects of segregated asset ownership according to boundary theories (e.g., Anderson and Schmittlein, 1984; Brickley and Dark, 1987; Kosová et al., 2013; Lafontaine and Slade, 2007; Nickerson and Silverman, 2003; Shepard, 1993; Woodruff, 2002). Under complex distribution, the plasticity of the distribution resources is high, which exposes manufacturing to distributors’ opportunism (Alchian and Woodward, 1988; Gibbons, 2005, 2010). The distributors’ use of asymmetric market information allows them to haggle over quasi-rents inside manufacturing when verification is difficult and measurement costs are high. A higher
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level of asset plasticity makes it even more difficult for manufacturing to ascertain the structure of costs inside the distribution activities, and accurately meter the relations between input and output. The essential question here is whether the costs inside distribution are an accurate indicator for unproductive ‘laziness,’ or if they constitute incremental costs with future returns from entrepreneurial investments in warranted product complexity. The distributors will refrain from engaging in these investments and activities if the future profits from these interdependencies with manufacturing can be appropriated – often because they are difficult to observe, measure, and contract (Grossman and Hart, 1986; Hart and Moore, 1990). Separating these costs can often prove difficult when they are embedded in human factors and entrepreneurial initiatives (Lafontaine and Slade, 2007).
When manufacturing integrates forward, it leaves the governance question open to the difficulty of separating the nature of costs of interdependent activities along the value chain. The issues are obvious. Leaving integrated managers without incentives to contribute with their unique capabilities increases the risk of costs from moral hazard (Alchian and Demsetz, 1972).
Interpreting distributors’ unobservable and difficult to monitor effort as being unproductive and attributing this to moral hazard while other and more easy to meter, are being incentivized and rewarded, increases the risk wrong prioritizations. This essentially pinpoints the multitasking issue, which can be resolved and internalized if the distributors become residual claimants to these prioritized efforts (Baker and Hubbard, 2004; Brickley and Dark, 1987; Shepard, 1993;
Slade, 1996). This also illustrates the challenge to convert an ex post directional distribution model to a complex distribution. The transformation from a governance regime, where all value-adding activities are monitored and incentivized by the manufacturing center, to a more customer orientated operation exploring specialized knowledge and resources in the downstream market can prove difficult (Gebauer et al., 2005; Grossman and Hart, 1986; Oliva and Kallenberg, 2003; Woodruff, 2002). The governance structure of an integrated complex distribution setting therefore needs to consider the proper reward of interacting agents in the internal coordination mechanisms, control processes, and incentive systems.
To ensure that the idiosyncratic specialized resources and capabilities of the integrated distribution continue to add value to manufacturing, it requires that these resources still can find their proper utility. Hence, responsibility and authority is delegated to the respective profit centers to ensure that value is ascribed to the use of the specialized resources and capabilities
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within the business unit. Having distribution take on the formal role as profit center can provide this advantage (Brickley, et al., 2014; Holmström and Tirole, 1991). It means that the resources of agents in the distribution functions are deployed to create value by responding to the prevailing market conditions as much as possible, despite mandatory internal transfers. With manufacturing also taking formal status as a profit center, this effectively consolidates profits inside both manufacturing and distribution (Eccles, 1985; Holmström and Tirole, 1991). For the profit centers to function effectively – that is to internalize the incentives – they must operate with an accounting system that records the profits and losses generated within each center from the use of their own deployed assets and liabilities, as resources available for sequential business activities (Baines and Lightfoot, 2014; Brickley, et al., 2014; Holmström and Tirole, 1991).
To establish credible profit and loss statements upon which managers in the profit centers can be fairly evaluated, and where the information revealed is not taking advantage of by headquarter controllers and owners, the valuation of intermediate product transfers must be based on true and fair value-creating incentives (Eccles, 1985; Bester and Krähmer, 2008). This means that the transfer prices on intermediate goods are not used to transfer profits away from the buying business center to avoid moral hazard; they are rather used to incentivize and reward both observable and non-observable effort of sequential business activities along the value chain (Holmström and Tirole, 1991). However, establishing credible incentives goes beyond proper transfer pricing policies. The coordination of interdependent activities must not be based on a manufacturing center of gravity using acquired property rights to appropriate internal profit opportunities (Alchian, 1989; Gibbons, 2010; Grossman and Hart, 1986) and seal off its technological core to satisfy its desire for efficiency (Thompson, 1967). This includes the use of standardized practices and planning with authoritative delegation of budget targets to coordinate interdependencies. The proper coordination mechanisms must be based on the principles of mutual adaptation (ibid). This also comprises of innovative efforts to enhance offerings to the final product markets, and efficiency improvements in the manufacturing processes (Nooteboom, 2004). Sequential profit centers with reciprocal interdependencies are more effective in dealing with product complexities than if one single center takes the formal role of profit center (Eccles, 1985). This will also balance a pure manufacturing center of gravity to incorporate the distinctive contributions from distribution to embrace dynamic variations in demand in the final product markets (Galbraith, 1983). The manufacturing headquarters, or center of gravity, must become detached from the legacy of its organizational technology to
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consider the value offering of the integrated enterprise as a new perspective of unbiased forbearance between the sequential business activities (Baines and Lightfoot; 2014; Gebauer et al., 2010; Williamson, 1985).
When an integrated firm operates in a complex distribution setting, this also creates asymmetric information between the sequential business centers. Just as contractual exchanges in markets can be imperfect and exposed to opportunities that create transaction costs, so can internal markets guided by hierarchy (Gibbons, 2010; Rosen, 1991). The delegation of responsibility and authority in a corporate decision structure can also be abused, and therefore activities need proper incentives and controls (Aghion and Tirole, 1997; Bester and Krähmer, 2008). The monitoring of performance under complex distribution must be able to take intangible inputs into account. While moral hazard still needs to be monitored in diagnostic control systems, other systems of control need to accompany this (Simons, 1995). Using purely diagnostic controls focused on elements that can be measured will force managers faced with multitasking to focus on tasks that can be measured, as opposed to those that cannot (Holmström and Milgom, 1991, 1994) – even if they are important. Complex distribution is particularly vulnerable to excessive diagnostic measuring since value often is created from difficult to observe idiosyncratic resource deployment. The incentives for managers in the profit centers must therefore take more aggregated measures that consider own (and joint) current (and future) performance into account. This also implies that headquarters establish softer guidance systems that force managers on the corporate mission, core values, organizational beliefs including encouragement to engage in interactive collaboration, and open dialogue (Simon, 1991; Simons, 1991, 1995).