Vertical Integration Works for Apple — But It Won’t for Everyone

Google recently acquired mobile device maker Motorola Mobility and will soon manufacture smartphones and television set-top boxes. Amazon’s Kindle Fire tablet represents its bridge between hardware and e-commerce. Oracle bought Sun Microsystems and now champions engineered systems (integrated hardware and software devices). And even long-standing software giant Microsoft now makes hardware for its Xbox gaming system. Technology titans are increasingly looking like vertically integrated conglomerates largely in an attempt to emulate the success of Apple.

Vertical integration dictates that one company controls the end product as well as its component parts. In technology, Apple for 35 years has championed a vertical model, which features an integrated hardware and software approach. For instance, the iPhone and iPad have hardware and software designed by Apple, which also designed its own processors for the devices. This integration has allowed Apple to set the pace for mobile computing. “Despite the benefits of specialization, it can make sense to have everything under one roof,” says Wharton management professor David Hsu.

The tech industry’s success in this type of integration is mixed. Samsung, a large technology conglomerate, has thrived by making everything from LCD panels to processors, televisions and smartphones. But Sony, which has attempted to meld content, TVs and game systems like the PlayStation, has yet to find a way to make the disparate parts gel.

“Companies can emulate the Apple model, but it will not happen overnight,” notes Lawrence Hrebiniak, a Wharton management professor. Although tech companies for now are focusing on entering areas closely aligned with their core businesses, Hrebiniak notes that hardware and software require different competencies and skill-sets in areas such as manufacturing, procurement and supply chains. In that respect, the challenges these firms face will be similar to what many diversified multinationals deal with when managing disparate business units.

The technology industry’s rush to vertical integration may be misplaced, Hrebiniak says. After all, there is a reason that large conglomerates tend to trade at a discount on Wall Street — they are harder to manage. “Conglomerates can work if you have one line of business, go into another and then leave that unit alone,” Hrebiniak notes. “If you try to integrate disparate businesses, you become so unfocused that you lose the ability to coordinate.”

Yet, with technology companies under increasing pressure to keep growth rates up, expanding into new areas is an attractive proposition for many firms, according to Wharton new media director Kendall Whitehouse. Google may be getting into hardware today, but it could be Facebook tomorrow. “Haven’t we seen this movie before?” asks Whitehouse, pointing to the rise of multinational conglomerates in the mid-20th century. For example, Vivendi transformed itself from a water company to one focused on media, while GE started as an electric company but later expanded into such disparate businesses as microwave ovens and the NBC television network (which it recently sold to Comcast.) “Conglomerates are now refocusing after spreading themselves too thin,” says Whitehouse. “Can expanding tech companies learn the lessons of an earlier wave of conglomerates?”

There are also examples of tech firms that have switched gears and tried to return to a more specialized model. For instance, IBM divested its PC and printer operations to become a more service-focused company. “The fundamental question about efforts to expand is whether there are synergies between these parts,” notes Whitehouse. “If a new product or service dovetails nicely with your core business, then there is something to leverage. If not, focus is better.”

According to experts at Wharton, markets that are not commoditized, such as mobile computing, smartphones and tablets, benefit most from vertical integration. However, once markets become less differentiated, a specialized approach — where each member of a supply chain has a role — makes sense. Hsu notes that the PC and semiconductor markets were once vertically integrated. Eventually, however, the supply chains reverted to being more specialized. In the case of PCs, a group of companies now makes different parts of the machine that are then put together to create the final product: Microsoft builds operating systems, Intel makes processors, Nvidia provides graphic chips and a series of companies manufactures hard drives.

Looking Beyond ‘Apple Envy’

Google’s plan is to operate Motorola Mobility as a separate business, which is tightly coupled to the Android mobile operating system for smartphones and home set-top boxes. The trick for Google is making the key hardware and software connections to replicate Apple’s success. “Apple does well, but has had top-down integration of hardware and software for more than 30 years,” Hrebiniak states. That integration, which requires centralization foreign to Google and many other companies, is hard to deliver.

For example, Research in Motion also bought QNX, a company with an operating system, and is trying to assimilate it with the firm’s hardware offerings, such as the BlackBerry. But RIM’s QNX-based operating system has been delayed as the company struggled to sell the PlayBook tablet.

Apple’s integration efforts were on display when the company unveiled its third-generation iPad last week. The new version will come with 4G connectivity, a high definition display and a faster processor. Sterne Agee analyst Shaw Wu said in a research note that Apple has been able to advance features like power consumption precisely because it controls the parts that make up the iPad. “Our industry checks indicate Apple has made notable progress in improving battery life that has plagued competitors,” said Wu. “This is due to Apple’s ownership of core intellectual property including systems design, semiconductors, battery chemistry and software.”

According to Wharton management professor Dan Levinthal, what Apple’s competitors really envy is the company’s control of its ecosystem. “It is important to distinguish between a motivation to manage the interface between hardware and software and a desire to manage one’s ecosystem. I think many of these moves are really about the latter sort of motivation,” says Levinthal, who adds that Google’s purchase of Motorola Mobility was not only a way to gain control of various patents, but also to fend off Apple’s patent lawsuits.

Google also wants to create a more seamless user experience that will entice consumers to invest in its full line of products, rather than just using one or two, Levinthal notes. Analysts say Apple’s successes in this area led to increased market share. “We believe that Apple’s software ecosystem (including 3rd party apps, iOS and Apple’s own applications) is the key to driving sales long term,” Barclays Capital analyst Ben Reitzes said in a research note.”There is just too much you can do with an iPad versus other devices.”

The Risk to Innovation

As technology companies push to become more vertically integrated, a few unpleasant side effects could emerge. For instance, Hsu suggests that the advancement and growth of Google’s Android technology may slow if the company is juggling hardware and software efforts. Even though Android is technically open source, Google drives development. “Google integration with Motorola Mobility could make products better, but the risk is that Android may not evolve at the same pace it would under a specialization model.”

Andrea Matwyshyn, a legal studies and business ethics professor at Wharton, has similar concerns. “Vertical integration is desirable for some products, but you need multiple models in the technology industry,” she says. “If every tech company followed Apple, there would be a degree of novelty and innovation lost.” After all, Apple’s success may be largely a function of a command and control structure instituted under former CEO Steve Jobs. If others followed suit, large technology companies would dominate supply chains and innovation, which could make it harder for a start-up to develop a breakthrough product. “In some ways, you can make the case that more vertical integration could mean less innovation,” Matwyshyn adds.

Matwyshyn predicts that many technology companies currently trying to integrate software and hardware will back off in a few years. “In 10 years, these companies are going to look a lot different,” says Matwyshyn. “Every industry has periods where vertical integration looks better. A few years ago, everyone was outsourcing.”

Typically, companies back away from vertical integration as products become more commoditized. It is unclear when that will happen in the smartphone or tablet markets, but the advent of that period would likely mean trouble for vertically integrated firms. “What Apple has done well is stay ahead of commoditization,” Hsu notes. “Apple is more of a trailblazer and that opens up possibilities.” The catch is that a vertical approach does not provide a significant advantage if a firm is unable to stay ahead of the competition. Indeed, Apple’s integrated approach in the PC market did not work to the firm’s benefit when it was battling Microsoft in the 1980s and 1990s.

In its current form, Apple has found a way to balance vertical integration with an outsourcing model. For instance, Apple focuses on design and integration, but Foxconn, a Chinese contract equipment manufacturer, actually puts together iPads and iPhones. According to Hsu, Apple has deployed a hybrid model, where it has control over the product and supply chain, but uses contractors in many areas. In addition, Hsu says, Apple is so large that it can dictate terms to contractors — a leverage point that other technology companies cannot match.

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