The return of vertical integration.

Commentary about business and finance.
Aug. 17 2006 3:53 PM

Dis-Integration?

Why Michael Dell needs to act more like John D. Rockefeller.

On Monday, in a front-page article by Timothy Aeppel, the Wall Street Journal heralded the return of one of the great industrial developments of the late 19th century: vertical integration.

Responding to the recent rise in prices for crucial commodities like copper, rubber, nickel, and oil, manufacturers of all types have taken steps to ensure they have adequate supplies of raw materials and parts. The article cited several examples of companies that bought outright or took stakes in their suppliers. In July, Armor Holdings, which makes armored cars and other products for what it delicately calls the "survivability industry," acquired Integrated Textile Systems Inc., which makes a type of fiber used in Armor's products. To ensure a supply of titanium-based parts for its Dreamliner 787, Boeing last week created a joint venture with Russia's VSMPO-Avisma, the world's largest titanium producer.In 2005, Bridgestone, the Japanese tire maker, purchased a huge Indonesian rubber plantation from Goodyear.

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There's something larger going on. Vertical integration, pioneered by titans of industry like Andrew Carnegie, John D. Rockefeller, and Henry Ford, was the logical endpoint of the Industrial Revolution. As companies gained size and scope, they could realize huge efficiencies by controlling everything from the raw materials they used in the production process to the distribution of their finished products. So, Rockefeller, who started as an oil refiner, branched out into production (oil wells), distribution (pipelines and rail cars), and retail (gas stations).

Over time, this bureaucratic structure fell out of favor in the executive suite. It's difficult for companies to excel at and maintain competitive advantages in a range of disciplines. And a new set of mega-trends emerged that pushed companies away from vertical integration. The tenets of re-engineering and focusing on core competencies led firms to focus on performing only those functions they could carry out profitably and to outsource everything else. As strategists touted the power of intangible assets—like brands, business models, and patents—more companies adopted an asset-light strategy. Why tie up capital in factories that depreciate over time when you could invest in initiatives, like Web sites, that add value quickly?

The ability to outsource was abetted by another huge trend: the massive expansion of global trade and the emergence of armies of suppliers and workers in places like China, India, Eastern Europe, and Latin America. As a result, in the 1990s, the world was a huge discount shopping bazaar for purchasing managers. Whatever you needed—labor, finished textiles, oil, copper, electronic components—was suddenly available at low prices in markets that had, until recently, been closed. As a result, the transformation of the global economy from a comparatively closed system—in the 1980s, the United States didn't trade much with China or Russia or Vietnam or India—into a far more open one had a powerful anti-inflationary effect. What's more, in the 1990s, the global economy tended to grow in an asynchronous manner—at different times, some significant economy always seemed to be in crisis (Mexico in 1994, East Asia in 1997, Russia in 1998) or locked in a period of slow growth (Japan throughout the whole decade). This dynamic helped keep a lid on inflation by restraining global demand for commodities like oil and steel. It made sense to deintegrate as much as humanly possible. Indeed, the company whose stock performed the best in the 1990s was a poster child for this trend: Dell outsourced virtually everything—the production of components, assembly, installation, and help—much of it to Asia.

But in recent years, companies have increasingly come to realize the limits of deintegration. And today we're witnessing the flip side of the 1990s dynamic. Back then, the integration of China and India into the global economy was a huge factor in keeping inflation under control. Now, it's a huge factor in pushing inflation up. The prices of key raw materials like copper, steel, nickel, and oil have all risen dramatically in recent years, driven in large part by growing demand from emerging economies. In the 1990s, we had asynchronous growth. But for the last few years, all the world's major economies have been growing—at different rates, to be sure, but all growing. The rapid growth has raised concerns about the adequacy of supplies of key commodities, which has pushed prices up further. Put it all together, and in a relatively short time, some big purchasers have gone from being the masters of the global supply chain to helpless victims caught between world markets and their customers, who have grown accustomed to cheap goods.

Some companies were too successful at using deintegration as a cost-cutting tool. In the 1990s, the Big Three auto companies spun off their parts units as independent companies and then used their status as huge customers to bludgeon them into lowering prices year after year. This deintegration strategy allowed General Motors and DaimlerChrysler to escape the ravages of spiking raw-material costs as their former units, Delphi and Collins & Aikman, respectively, absorbed the costs and went bankrupt. GM hasn't folded Delphi's operations into the parent company, but it has been forced to take thousands of Delphi employees back onto its payroll and shell out for buyout offers to reduce Delphi's head count.

Then there's the issue of quality control and responsibility. This has proved to be something of a lost decade for Dell. And a chunk of its woes can be ascribed to its propensity to avoid integration. With prices of raw materials and transportation rising, Dell has had a difficult time maintaining profit margins. And there are ways in which outsourcing the down-and-dirty, low-margin production functions can harm the high-margin intangible assets, like your brand. Customers have complained about the decline in service. Most recently, Dell has had to contend with the burning laptop phenomenon. Dell has taken pains to note that the batteries that are being recalled were made by Sony. But customers and investors have poured out their wrath on Dell, not Sony. Letting somebody else do the hard work to guarantee the quality of your components used to be a great advantage of deintegration. But in this age of selective vertical reintegration, it can also be a liability.

Daniel Gross is a longtime Slate contributor. His most recent book is Better, Stronger, Faster. Follow him on Twitter.