Vertical Integration Versus Outsourcing: A Knowledge-Based Reconciliation

Transcription

1 Vertical Integration Versus Outsourcing: A Knowledge-Based Reconciliation Jun Lin Department of Management Southern Illinois University at Carbondale Carbondale, IL Abstract In vertical integration literature, controversy remains over how organizational cost changes after vertical integration and how technological uncertainty influences vertical integration decisions. To reach a reconciliation, I draw on knowledge-based view of the firm (Grant, 1996, 1998; Spender, 1996, 1998), and propose a contingency model that examines moderating effects of knowledge absorptive capacity. In the new competitive landscape featured by hypercompetition and knowledge-based competitive advantage (Bettis & Hitt, 1995; D Aveni, 1994), a firm with high absorptive capacity (Cohen & Levinthal, 1990) can assimilate, utilize, and develop new knowledge to establish new cross-functional capabilities via vertical integration strategy. Consequently, the firm has high potential to realize synergic benefits of vertical integration and to cope with technological uncertainty.

2 Vertical Integration Versus Outsourcing: A Knowledge-Based Reconciliation Multiple theories have examined the motivations and antecedents of vertical integration. Structural contingency theory (Thompson, 1967) and resource dependence theory (Pfeffer & Salancik, 1978) assert that the firm adopts vertical integration strategy to control the contingencies in environments and eliminate interdependencies of its inputoutput connections. Transaction cost theory (Williamson,1985) argues that by vertical integration, the transaction costs incurred by bilateral monopoly could be avoided. But two issues remain unsolved. First, it is not clear how organizational cost will change after vertical integration. It might increase due to diseconomies of scale (Williamson, 1985), inflexibility, and blurred incentives (Perrow, 1986), or decrease due to synergic effects. Second, although vertical integration reduces environmental contingencies for the firm, technological uncertainty poses higher threats because the firm is locked in the inputoutput chain. Strategic management theorists respond to these two issues in two opposite directions. On one hand, scholars advocate outsourcing strategy to reduce organizational costs and keep the firm flexible in coping with environmental uncertainty (e.g., Harrigan, 1985). On the other hand, theorists (e.g., Masten, Meehan & Snyder, 1991) argue that vertical integration is a response to decreased organizational cost due to knowledge-based capability. Knowledge-based capabilities generate shared routines, technical skills, frames of reference, and common language, which enhance coordination within the firm. Moreover, knowledge-based capabilities often tend to be more flexible and help a firm respond to a variety of contingencies. Thus, vertical integration, rather than outsource, provides an efficient context to coordinate activities and handle uncertainty. Unfortunately, the knowledge-based view of the firm has not yet yielded decisive conclusions on the roles of organizational cost and technological uncertainty in vertical integration strategy (Poppo & Zenger, 1998). By extending the knowledge-based view of the firm, this paper attempts to establish a contingency model to reconcile these controversies (Figure 1). The central idea is that the firm s knowledge absorptive capacity, as a moderator, influences cost reduction effects and the firm s capability to cope with technological uncertainty. This paper has two theoretical contributions. First, my contingency model of vertical integration reconciles the inconclusive arguments on the roles of organizational cost and technological uncertainty. Second, my approach is an extension to the previous accounts on the relationship between static knowledge and vertical integration (e.g., Williamson, 1985). In the new competitive landscape, firms try to build competitive advantage on dynamic knowledge development such as knowledge assimilation, utilization, and reconfiguration. This conceptual study fills a gap by examining how dynamic knowledge development influences vertical integration strategy. 2

3 FIGURE 1 Moderating Effects of Knowledge Absorptive Capacity on Vertical Integration Strategy Organizational Cost Knowledge Absorptive capacity Vertical Integration versus Outsourcing Strategies Technological Uncertainty Knowledge development and absorptive capacity Responding to the strategically significant role of knowledge in the new competition landscape (Bettis & Hitt, 1995), knowledge-based view envisions the firm as a learning entity that creates capabilities on the base of a bunch of knowledge (Grant, 1996, 1998; Spender, 1996, 1998) and makes its competitive advantage sustainable. Knowledge-based view takes knowledge creation and development as central to organizational activities. If we take the firm as a knowledge system, vertical integration and outsourcing strategies actually deals with decisions on what kind of knowledge should be included within the boundary of the firm. A firm s ability to develop knowledge depends largely on the nature of knowledge and the mechanism of knowledge development. Following Winter (1987), researchers have developed various dimensions of knowledge, such as individual versus collective knowledge, tacit versus explicit knowledge, component versus architectural knowledge, and private versus public knowledge. In order to create new capability, the task to assimilate, transform, and integrate knowledge is complex and difficult, especially for collective, tacit, private, or architectural knowledge. Grant (1996; 1998) argues that by direction and organizational routines, specialized knowledge is integrated into the architecture of organizational capabilities through a bottom-up hierarchy, from specialized tasks, to functional capabilities, and to cross-functional integration. On the other hand, Spender (1996, 1998) stresses that the outcomes of knowledge development are uncertain by nature. He argues that uncertainty exists first in the form of incommensurability -the difficulty in drawing different types of knowledge together into a single, rigorously structured and coherent knowledge system (Spender, 1998). 3

4 Second, knowledge is developed autonomously as self-organizing systems (Kauffman, 1995). This self-organizing process triggers the emergence of collective or architectural knowledge. However, such knowledge system cannot be designed by external designers in advance. These mechanisms of knowledge development reveal some inherent tensions. First, organizational communication constraints and personal cognitive limitations impede knowledge integration, especially between two knowledge bases without a common language (Cohen & Levinthal, 1990). Second, incommensurability, as well as the requirements for transformation between types of knowledge, place further constraints in the self-organizing process (Spender, 1998). Individual knowledge and component knowledge can only be extracted from their original source at the cost of contextual, systematic features. Third, assimilation of new knowledge may be difficult because of core rigidities that inhibit change (Leonard-Barton, 1992), as well as the path-dependence nature of knowledge development (Cohen & Levinthal, 1990). In addition, new knowledge assimilation is impeded because firms tend to react to environments without modifying their theory-in-use (Waldrop, 1992). Facing these tensions, firms manifest different abilities to develop knowledge. Drawing on Cohen and Levinthal (1990), I use the term knowledge absorptive capacity to describe the different abilities across firms in recognizing the existence of new knowledge, assimilating it with the existing knowledge body, and enhancing the development of new capabilities. In addition, I argue that a firm could improve its absorptive capacity in a dynamic manner by double-loop learning (Argyris & Schon, 1978). Knowledge development and vertical integration My conceptual model (Figure 1) proposes that a firm s knowledge absorptive capacity will help realize the benefits of vertical integration, such as reducing organizational cost, and coping with technological uncertainty. Therefore, absorptive capacity influences the firm s decisions on an appropriate firm boundary. The disputes on the role of organizational cost involve with how synergy can be realized after vertical integration. The potential of realizing synergy (Ansoff, 1965) depends on knowledge development after vertical integration, which is determined by the firm s absorptive capacity. After vertical integration, the firm develops its knowledge by transferring the best practices between the newly integrated part and the original components, and more importantly, by establishing new capabilities at cross-functional level. Knowledge may be transformed from individual to collective level and from tacit to explicit form to develop new capacities. Different knowledge may also be combined to create new capabilities, on the basis of relatively isolated capability areas. Moreover, the firm can potentially reconfigure knowledge combination by altering the knowledge linkages, or architectural knowledge, when new knowledge and insights of neighboring capability emerge (Henderson & Cockburn, 1994). Knowledge development depends first on the commonality of the knowledge between the vertically integrated firms. The commonality of language, conceptual 4

5 knowledge framework, experience, shared behavioral norm and culture will facilitate the knowledge communication and integration processes (Grant, 1998). In addition, knowledge scopes between firms provide a certain form of redundancy of background knowledge (Spender, 1998). Relatively narrow spread of knowledge and high commonality of norms and culture will facilitate knowledge development. Diversity of knowledge is another factor. Admittedly, increase in the scope of knowledge will pose problems to communication and knowledge integration. But diversity of knowledge tends to increase the potential of knowledge development and capability establishment at cross-functional level as well. The complementarity between vertical stages makes it possible to develop cross-functional capabilities. This reconfiguration process will be more likely to generate new competitive advantages. According to the above arguments, a firm with high absorptive capacity has high potential to develop new knowledge after vertical integration. Such knowledge is the source of competitive advantage because the firm can reduce coordination and production costs and realize the synergic benefits of vertical integration. On the contrary, a firm with low absorptive capacity has difficulties in developing knowledge and realizing the potential benefits of vertical integration. It might increase its organizational cost because the original routines are disrupted while new routines are very costly to establish. Proposition 1: Knowledge absorptive capacity moderates the relationship between organizational cost and vertical integration strategy. The higher the absorptive capacity is, the more likely vertical integration will reduce organizational cost. Technological uncertainty is defined as changes in component specifications and industrial basic technology. Theorists argue that technological uncertainty leads to vertical integration (Williamson, 1985), because vertical integration avoids high bargaining costs over recontracting when design changes under technological uncertainty. Other theorists argue that technological uncertainty leads to outsourcing because firms will bear the risk of technological obsolescence when exit barrier is high (Harrigan, 1985). To reconcile, I argue that the role of technological uncertainty in vertical integration is moderated by knowledge absorptive capacity. The knowledge-based view of the firm argues that managing uncertainty is the central issue for a firm to develop knowledge (Spender, 1998). Facing uncertainty, firms usually respond by collecting more data. They may try to attain the strategic value of knowledge by use a combination of rules and procedures, information systems, special studies, and planning mechanisms to gather and process data about the future (Daft & Lengel, 1986). Vertical integration, accompanied with the process of knowledge assimilation, utilization and reconfiguration, is a channel for the firm to develop knowledge for strategic purpose. By vertical integration strategy, the firm achieves learning opportunities based on both knowledge sharing and knowledge diversity. Knowledge sharing usually exists between vertically, closely connected business lines that have a common language and an interface channel. The complementary functions with some redundancy in expertise may create opportunities for cross-functional knowledge absorption (Cohen & Levinthal, 5

6 1990). Meanwhile, such knowledge as good practices in different areas bring knowledge diversity, which stimulates the generation of new ideas (Pisano, 1994). Vertical integration enables the firm to develop and improve its architectural knowledge, which enable the firm to cope with technological uncertainty. Architectural knowledge is the outcome of knowledge integration across disciplinary and sub-unit boundaries within the firm (Henderson & Cockburn, 1994). By reconfiguring knowledge into architectural innovations, the firm can actually develop flexible capabilities that can continuously develop its knowledge and capabilities in the double-loop learning process (Argyris & Schon, 1978). When firms develop new capabilities by integrating broadscope knowledge, they tend to be able to cope with technological uncertainty. Even more important, firms adopting vertical integration strategy should be alert to radical technological change that alters the industry basis or technological discontinuities (Tushman & Anderson, 1986). To avoid self-reinforcing behavior that leads to the neglect of new technological developments, the firm with high absorptive capacity should evaluate new developments in fields in which it is not currently investing (Cohen & Levinthal, 1990). Lei, Hitt and Bettis (1996) argue that firms can reduce uncertainty by embedding the dynamic core competences and the learning practices, partially because of the capability to share problem solution insights across units and the ability to more rapidly transfer skills across those units. Firms thus may be in a better position to respond to sudden changes in the environments. Although outsourcing increases a firm s flexibility in managing its capabilities, this is only part of the story. What is missing is that when knowledge is tacit and embedded in the broad contextual system of the firm, capabilities related to such knowledge are either unrecognizable or inseparable from the firm. Considering uncertainties over appropriability and valuation, Grant (1998) believes that market contracts are typically inefficient means for knowledge transfer and utilization. This is consistent with Demsetz (1991) that market transactions of knowledge transfer are efficient only when knowledge is embodied within a product. In such cases, buyer does not need to assimilate the knowledge or access to the human capital to utilize the product (Klein, 1991). Proposition 2: Knowledge absorptive capacity moderates the relationship between technological uncertainty and vertical integration strategy. The higher the absorptive capacity, the more positive the effect for the firm adopting vertical integration to cope with technological uncertainty. Discussion and Conclusion In the new competition landscape (Bettis & Hitt, 1995), Corporate America witnesses both trends of vertical integration and outsourcing. This phenomenon elicits different and even contradicting theoretical opinions in academia. Meanwhile, researches on vertical integration exhibit two characteristics recently: (1) focusing on integration between business line, and (2) treating governance structure as a continuous spectrum. These two trends help to enhance the understanding of vertical integration in the new competition landscape. First, lowering the level of analysis make it possible to examine 6

7 the synergic effects and the importance of internal capabilities based on knowledge. Second, treating vertical integration as a continuous process reveals the dynamic synergic effects based on knowledge development over time. Consequently, we can examine how the blurred industrial boundaries (Hitt, Keats, & DeMarie, 1998) stimulate knowledge development after vertical integration. Under this background, this paper adopts a knowledge perspective to explain why some firms adopt vertical integration strategy, but others prefer outsourcing, even given the similar environmental contingencies. Meanwhile, this paper suggests several implications for practice. In the new competitive landscape, firms competitive advantages are eroded by imitation and technological innovation. To cope with such hypercompetitive conditions, firms adopting vertical integration strategies should seize opportunities to extend current capabilities by assimilating new knowledge and reconfiguring the existing knowledge. Firms should try to improve architectural knowledge that integrates knowledge across disciplinary and organizational boundaries within the firm and develop flexible capabilities. In the short run, knowledge reconfiguration may increase cost due to the change of routines as argued above. Nevertheless, the discontinuous change in industrial environment requires firms to create new capabilities constantly rather than merely extend current core capabilities. Firms are thus pushed to act proactively towards radical changes, for example, trying to improve absorptive capacity to cope with hypercompetition more effectively. Another implication is that managers should match their vertical integration/outsourcing strategies with the firm s knowledge absorptive capacity. Managers might exaggerate the ability of absorbing new knowledge by overextending organizational boundaries. This will lead to difficulties in realizing synergic benefits after vertical integration. The recent outsourcing trend is somewhat an adjustment of the overextending boundary that goes beyond its absorptive capacity. As a conceptual model, this paper has not addressed empirical study issues. One key issue could be how to measure the firm s knowledge absorptive capacity. As the above theoretical arguments suggest, knowledge absorptive capacity is a multiple dimensional construct. Prior researchers have made attempts to measure it from certain perspectives (e.g., Harrington & Guimaraes, 1999; Szulanski, 1996). Based on extant literature, I expect that knowledge absorptive capacity could be measured by a multiple-item composite scale, which includes items on knowledge bases, knowledge scope, communication channel, and learning experience, etc. Further researches are necessary to develop such a scale and test its construct validity and reliability. Conclusion. Based on knowledge-based theory (Grant, 1996, 1998; Spender, 1996, 1998), this study places vertical integration strategy in the context of new competitive landscape (Bettis & Hitt, 1995) that stresses on knowledge development. After vertical integration, the firm tries to integrate new knowledge and develops new capabilities to cope with hypercompetition (D Aveni, 1994). Knowledge absorptive capacity varies across firms. For firms with high knowledge absorptive capacity, the tremendous benefits of vertical integration could be realized by reducing organizational cost and developing new knowledge in double-loop learning (Argyris & Schon, 1978). They can further develop flexible capabilities to cope with technological uncertainty. For firms with low knowledge absorptive capacity, a proper outsourcing strategy may be a 7

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