The active growth of house construction and the number of sales deals in the residential real estate market usually leads to an increase in the demand for furniture. The purchase of new housing always involves the need to buy furniture. It is possible to notice these trends by comparing the dynamics of home construction and the volume of the furniture market. By tracking the performance of the construction market, one can predict the situation in the furniture industry. Nevertheless, the furniture market is one of the least consolidated retail segments.
The furniture market is changing rapidly, and the operating principles that have been in place before are currently not effective. To successfully develop, furniture enterprises need to adapt to these changes. The furniture market is transforming, including changing consumption patterns and new sales formats. The main changes are happening because of technologies and their extensive use. Now the potential customer is first looking for an item of interest on the Internet. Moreover, Internet sales are becoming more popular every day thanks to their easiness and time-saving.
In the British furniture market, the following main sales segments can be identified:
- Retail sales. According to the Home furnishing retailers market performance report (2020), this segment is dominated by companies such as IKEA, JYSK, Dunelm, DFS, and Habitat. Retail sales take place in shopping malls outside the city, where buyers can pick up the goods themselves or use the transportation service. The retail network consists of specialty stores located in towns and major cities.
- Online sales. This segment partially overlaps with the previous one, because retail stores use a combination of supply channels, such as IKEA. However, such companies as WayFair and Made.com work exclusively via the Internet.
- Part of the market is custom furniture, mainly in the HoReCa segment.
- The last segment is office furniture. The dominant company in this segment is Senator International. There are also a large number of niche suppliers of office partitions, built-in furniture and office chairs.
This work focuses on an imaginary company that has been operating for about five years. Consumers are offered furniture for living rooms, bedrooms, kitchens, and children’s rooms. The furniture of the brand “Cosiness” is distinguished by modern design, affordable price, and high quality of manufacture. All developments of the company are carried out by its own highly qualified designers, which allows implementing all modern trends in the furniture industry. The company also takes into account the specific production, achieving maximum quality in combination with the technological efficiency of the created products. The target audience is middle-income families who update furniture every three years and prefer unique, high-quality furniture made of natural materials, the medium-price segment.
The process of opening a retail store while managing manufacturing implies vertical integration. Integration refers to the pooling of production resources in a uniform system (Reefke and Gardiner, 2019). Vertical integration combines the manufacturing processes that follow each other. Wu (2017) argues that this concept also includes a merger of two or more companies that produce the components needed to create a single product. According to Dyer et al. (2017) theory distinguishes different types of vertical integration:
- product integration, or forward integration – involves the process of a firm acquiring enterprises belonging to subsequent stages of product sales
- resource integration, or backward integration – consisting of a firm acquiring enterprises that supply resources.
The present case involves opening a retail store – the next step after furniture production, which means that forward integration is necessary. Such actions bring the product closer to the final buyer. The main reasons for the forward integration for the firm are to guarantee the presence on market for their products, and cost savings. Vertical forward integration has several advantages and disadvantages that will be discussed further.
When to consider owning a retail shop?
Vertical integration is desirable in large enterprises with economies of scale. This method of expansion is least common in small businesses, the production of unique goods for a narrow market niche. Lee (2018) highlights a few reasons for vertical integration. The main of them are:
- Specialized investments result in high transaction costs (the cost of finding a supplier willing to sell the resources, high negotiation costs, etc.).
- The significant distance of production capacity from the place of consumption of goods. Vertical integration is distinguished by the fuel and energy complex, in which one enterprise is engaged in the extraction of raw materials, it’s processing, delivery and sale. This approach accelerates business processes, reduces the cost of intermediaries.
- The high competition combined with knowledge-intensive production. The high costs of research and design in the production of furniture are combined with the abundance of manufacturers. In such a case, combining research laboratories with a production complex will reduce costs, eliminate “leaks” of intellectual property through intermediaries.
It should be noted that an important role is played by a product’s market competitiveness because if it is not high enough opening the shop will be a waste of resources. It is also connected with the competitive environment because an objective analysis of competitive positions is a guarantee of market success. Market strategies, goods in comparison with products of competing companies are evaluated. The most effective methods of competitive analysis will be in relation to the market leader, as this will reveal the factors by which the enterprise is inferior to the leading position. Finally, the company must have sufficient financial resources for vertical integration. They are essential to the costs for production extension, to meet financial obligations and to economically stimulate workers.
Moreover, it can be noted that when the political and economic situation in the country remains uncertain for a long time, obtaining the necessary resources through contracts becomes a very expensive or impossible way at all (Cardinale, 2018). The only option that remains in such conditions for the company is to create its own structural units engaged in the production of these resources. The main advantage of this way of supporting the enterprise is the elimination of intermediaries. If previously independent firms become a single company, they have severely reduced opportunities for opportunistic actions towards each other.
Taking into account these reasons and “Cosiness” specialization, one can determine at what point it is best to open a retail store. Such actions will be necessary when production reaches a high level of competitiveness, thanks to high-quality design. Thus, the main motive should be not only cost reduction but also the readiness of the company to move to a new level. While considering the decision to implement vertical integration, one must bear in mind the various factors that affect the process’s success.
Factors to take into account
An analysis of the potential effectiveness of vertical integration in the relevant industry should be based on a comprehensive assessment of incentives that can be implemented by a vertically integrated structure (Kleineberg, 2019). According to Coughlan et al. (2006), it is important to consider such factors:
- Vertical market failure is a combination of opportunism, limited rationality, and uncertainty on the market. In such a case, transactions for the company pose a risk rather, and the prevention of such risks with cooperation with other organizations is not beneficial or even impossible.
- Defending against market power. Sometimes one stage of production brings more benefits than the other and has more power in the market. In such a case, it is necessary to consider the option of connecting the weak process with the strong one.
- Creating and exploiting market power can be the purpose of a company. In such a case, it is a factor for considering vertical integration.
- Responding to the industry life cycle is a factor relevant at the moment of the earliest development of the industry. In such a situation, vertical integration helps to develop the market.
Vertical integration would be appropriate if, as a result of an analysis of its potential efficiency, it was found that the integration of enterprises could bring additional economic benefits compared to disintegrated production. Based on the results obtained as objective sources of information, it is possible to make a reasonable decision to form a vertically integrated structure.
Potential benefits and risks
Vertical integration can be useful for the firm because it allows reducing production and sales costs by connecting successive production stages. Moreover, it may be vital for the firm to provide reliable sources of supply for production operations or distribution channels to maintain its competitiveness. The vertical integration benefits can be achieved through various effects. These include, in particular, technical savings from connecting continuous manufacturing processes. By improving the reliability of the products’ delivery, it is possible to reduce buffer stocks and thereby minimize storage spending (Brandon-Jones and Slack, 2018). Vertically integrated firms can avoid some trading costs when dealing with external resource providers and with advertising and trading agencies by carrying out transactions within firms.
Management savings can be achieved if the firm has a single administrative system to manage multiple production activities. The financial economy arises from the use of profitable wholesale discounts, as well as from the reduction of the cost of growing capital. When firms gain in all these types of efficiency through vertical integration, their average costs will decrease. It will reduce market prices and increase the output of the product.
However, vertical integration has its limitations and possible risks. They affect the decline in the productive efficiency and firms’ economic situation involved in this process, as well as the market as a whole. Vertical integration can result in loss of specialization, which can reduce production efficiency and increase unit costs (Loertscher and Riordan, 2019). Therefore, the independent production cost for the firm will be higher than the price at which the goods could be bought on the market. The second risk against vertical integration is the complication of the management process due to the increase in the scale of the firm and, as a result, the increase in management costs (Allain, Chambolle and Rey, 2016). Another disadvantage of vertical integration is that the merger or absorption involves a significant amount of the cost of carrying out such an association (Lajoux, 2019).
Moreover, vertical integration creates barriers to entering the market and the monopoly power of the seller firms. This type of integration between intermediate suppliers and final product producers at any stage of the process chain reduces actual and potential competition in both middle and final product markets (Akbar and Todorov, 2018). In intermediate markets, access to new buyers is limited due to the inability to contract with firms included in the vertically integrated structure. In end-product markets, a vertically integrated firm has a cost advantage that increases monopoly power.
Considering the number of potential competitors for the furniture store, such a problem as deterioration of quality due to monopoly should not arise. According to this, provided that the product is high-quality and competitive, the main risk for such actions as vertical integration is a bureaucratic and administrative complication of the company’s activities. The right management approach will solve this problem and increase the chances that vertical integration will only bring benefits.
Frameworks and models for vertical integration
A few main frameworks should be identified in the work of researchers studying vertical integration – transaction cost economics (TCE) and property right theory (PRT) (Dranove, et al., 2017). These approaches make it possible to take a very different look at both the process of integration of companies and their activities, the improvement of which can serve as one of the most powerful incentives for integration. Both approaches highlight the impact of contract imperfections and the opportunistic behavior of the parties.
Fazlelahi and Burgers (2018) describe TCE as a theory that considers vertical integration as a way to address opportunistic behavior and predicts the presence of vertical integration in cases where the costs of such action are too high. Opportunistic behavior characterizes a situation in which one party of a transaction acts in a deceptive manner, in order to achieve their selfish interests rather than fulfilling the essence of the contract. According to the approach, vertical integration reduces such a risk.
In the case of opening a furniture store, it is worth paying attention to the first approach – TCE. Among the key advantages of this strategy, according to Williamson (2017), is the possibility to minimize transaction costs caused by:
- Limited rationality – the inability of contract participants to predict all options for future events and to develop an appropriate action plan;
- Risk of opportunism – the possibility of losses due to breach of contractual obligations by the counterparty;
- The specificity of assets – certain inevitable losses of factors of production in their alternative use.
However, there are many other more specific frameworks for vertical integration that various authors propose. For example, Coughlan et al. (2006) describe a useful decision framework. According to this concept, the return on investment from vertical integration will be better than when outsourcing in two cases. First, if the company’s capabilities (intangible or tangible) become substantial. Second, if the organization’s activities are too ambiguous and there are no good results. This approach should be taken when the company is not sufficiently confident in deciding on vertical integration.
One of the critical points that affect the efficiency of companies in the decision to integrate. Companies desire to manage and reduce their risks, thereby making them more valuable, gaining stability, and ultimately increasing profitability. It is the desire to minimize the risks of interaction with counterparties that is one of the main goals of vertical integration. For the possibility of controlling supply chains and at the same time for the possibility of reducing the identified risk, the company is ready to pay significant costs directly related to the integration process itself.
Learning from the experience of creating and operating different vertically integrated companies suggests that a successful vertical integration strategy at the corporate level is possible only if particular prerequisites exist. These may include:
- Companies’ desire to control the markets of final products;
- The need to create a well-managed organization of production and sales;
- The possibility of economies of scale that reduce unit costs and increase profits;
- Provision of controlled sources of support within vertically integrated structures.
Moreover, it should be noted that while vertical integration leads to power and reduced competition in the market, it also leads to a more sophisticated management process within the integrated firm and, consequently, to higher management costs. Therefore, it may be accompanied by a deterioration in the manageability of the firm as a whole. It is necessary to take into account these negative consequences of vertical integration – the bureaucracy of the company, increase of expenses for legal support of the business. In the long term, full-cycle enterprises form a closed market with minimal competition, which reduces the quality of products.
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