Transparent Horizontal Integration Equals Bad Customer Experience
"Vertical integration doesn't work" is a relatively recent management insight. Recent enough that there's still a lot of people debating the question (especially those clinging to failed vertical integration strategies). But the most successful industries of the past few decades--personal computing, networking, and anything Internet-based--are all aggressively horizontal. I expect the debate to die down within a few years as it becomes "obvious" that with only a few exceptions, horizontal is the way to go.
Mostly this is good. Horizontal integration allows maximal innovation and competition in every piece of a product or service. This drives down costs, advances technology, and generally makes the world a happier place (except for middle management, which is more likely to get fired as part of a lean-and-mean strategy).
But there are some significant risks to horizontal integration, and the biggest one is also the most painful one: if not handled carefully, horizontal integration leads to a really bad customer experience. It is no coincidence that some of the most infamous examples of bad products and services today--personal computing and mobile phones, for example--and also industries which are either the most aggressively horizontal, or industries which are moving from being vertical to horizontal
Vertical vs. Horizontal Integration
Imagine a diagram showing how raw materials get transformed into products or service consumers buy. At the top are the rawest of the raw materials: energy, ores, silica (sand), oil (for both energy and making plastics), and so forth.
As you move down the diagram, the raw materials are transformed into more and more refined products: sand is refined into silicon wafers; which are combined with numerous chemicals to become Pentium processors; which are incorporated into personal computers along with memory chips, hard drives, DVD recorders, and Microsoft software to make the product you buy at Circuit City.
On this diagram, no one company makes everything. Intel, for example, buys silicon and chemicals, and sells Pentium chips and motherboards. Dell buys plastic (or metal) cases, LCD displays, chips, motherboards, disk drives, and Microsoft Windows to make a Dell PC. If you were to draw a box around the products which a given company makes, vertically integrated companies would have tall boxes (spanning many steps in the process from raw material to consumer product), and horizontally integrated companies would have short boxes (with only one or two steps).
The classic example of a vertically integrated company is the old AT&T (before it broke up). It was not too much of an exaggeration to say that AT&T bought sand as its raw material and sold dial-tone as its service. In its heyday, AT&T manufactured its own chips, built its switches and telephones, strung the wires, and managed the network operations. AT&T is not the only example, though: way back when Ford Motors built a factory in St. Paul, one reason that location was chosen was because it sat on top of a high-quality sandstone deposit. The sandstone was important because Ford mined the sand, refined it, and made it into windshield glass, all on site.
Why Vertical Integration Doesn't Work
It has been a long time since Ford made its own windshields from sand mined at the St. Paul factory, and the reason why is the same reason vertical integration generally doesn't work as a business strategy: it is cheaper to buy glass made elsewhere by factories which specialize in making windshield glass.
Vertical integration, as a rule, short-circuits the competitive process which leads to better and cheaper products. Ford's in-house windshield factory had no incentive to become more efficient or produce better windshields, because it would be guaranteed to "sell" its production to Ford's car factory. No doubt when the factory was built it was state-of-the-art, but third-party glass factories had a continuous incentive to keep getting better. At some point, it became cheaper to buy the glass elsewhere than to make it in-house, even allowing for the profit margin a third party would demand.
Horizontal integration, by contrast, gives each company up and down the product cycle the chance to buy its raw materials competitively (at least in theory), which gives everyone from the ore miner to the retailer an incentive to improve their products and reduce the costs. If someone comes up with a better way to carry out any step in the production chain, that improvement can quickly benefit the entire industry.
There are some circumstances where vertical integration makes sense: for example, if no outside suppliers exist for some part or raw material, if the transaction cost of working with an outside supplier are too high (excessive transportation costs are a common reason this might happen), or if the shortcomings of a supplier negatively impact the end product (i.e. a company's step in the manufacturing chain is transparent--I'm getting to that). Monopolies--like the old AT&T and the current Microsoft--also often try to expand vertically, since they don't have room to expand within the confines of their primary market.
Horizontal Opacity
The key to making horizontal integration work well is that each step in the chain from raw material to consumer purchase has to be as opaque as possible. By "opaque" I mean that the customers of Company X should not need to know or care who the suppliers of Company X are.
Chip manufacturing is an excellent example of an opaque process. The buyers of memory chips or Pentium-class processors don't need to know or care where the fabrication plant purchased its silicon wafers or etching chemicals. All the buyer needs to know is what's the price? and does it perform up to specifications? The chip manufacturer is free to change suppliers, innovate, and otherwise improve.
Opacity also means that there's no finger-pointing. If a computer manufacturer gets a bad batch of memory chips, the chip manufacturer doesn't tell the computer manufacturer to talk to the company that supplied the silicon ingots. Rather, the chip manufacturer takes responsibility (after all, it should have caught the defects) and remedies the problems. Similarly, when you buy a car, it doesn't come with separate warranties from separate companies for each component (body, timing belt, upholstery, heater) even if the car manufacturer bought those components from other companies.
Transparent Horizontal Integration
The opposite extreme is where problems happen. If opacity is good in horizontally integrated companies, transparency is bad. Transparency means that the customers of Company X know and care who Company X's suppliers are. In the extreme, Company X's products aren't really its own products, they are a hybrid of Company X and Company Y.
Mobile phones are a great example of this. Are you buying a Nokia mobile phone with Verizon service? Or Verizon wireless service with a Nokia mobile phone? Since the customer (often) cares about both the service provider and the phone manufacturer, neither company is completely free to change its product or service (since that might require changing or severing the relationship), and neither company is completely responsible when things don't work properly.
Another great (and wonderfully convoluted) example is the personal computer industry. You buy a Dell PC with Microsoft software and an Intel processor. Which of these three companies is responsible when the computer doesn't work? (answer: they'll each point fingers at the others) Is Dell free to substitute Apple or Linux software if it works better and is cheaper? (answer: no) Is Microsoft free to come out with a new version of Windows which works better but doesn't work on Dells? (answer: no) Which company has the ability to improve the overall customer experience? (answer: none of them, at least not individually) [Aside: strictly speaking, the choice of an Intel vs. a competitive CPU doesn't make much difference in the overall customer experience, so the processor choice is opaque. But customers do care about it, and it does impact the market dynamics.]
The end result is a mess. No one company is responsible for the complete product, and as a result, nobody has complete freedom to innovate or improve. Consumers are never sure which company is at fault for the state of affairs (good or bad) so they have a hard time making informed buying decisions (classic example: I have a Samsung mobile phone with SprintPCS service. Lately I've been having a hard time placing or receiving calls in areas which used to work well like my office. I don't know if this is because the SprintPCS service has gotten worse, or because the phone is getting old. The net result is that when my contract expires, I plan to get a new phone with a new carrier, and will not use either SprintPCS or Samsung).
Getting Out of the Transparency Trap
So far, everything I've said can be boiled down to: "hybrid products like mobile phones and PCs will always suck because no company is completely responsible for the customer experience." Maybe I should have just written that and skipped the first thousand words of this essay....
The problem is that this state of affairs is a trap for the companies involved because no company wants to give up the relationship with the end customer. Intel loves the fact that (some) customers care that its processors are at the core of most Windows PCs. That gives Intel a competitive advantage over other processor manufacturers, even though it reduces Intel's need to be the fastest or cheapest processor company. Intel spent a lot of money on branding to get that market position.
Similarly, Microsoft will do anything in its power to keep the operating system from becoming generic, even though compatible (if obscure and somewhat rough) alternatives exist. Microsoft makes a ton of money off the fact that 95% of PC buyers won't buy a PC that doesn't come loaded with the latest version of Windows.
And of course Dell--which is the natural candidate to own the customer relationship, since it sells the computer to the consumer--might want to find alternatives to Intel and Microsoft, but its ability to do so is limited by what the customers want.
Even though the inevitable result of this state of affairs is that the customer experience sucks, nobody has the ability to change things.
How to change things?
The most obvious way is for a company to vertically integrate just enough to make its product opaque to the customer. In other words, seize responsibility for everything which impacts the customer experience. This is what Apple has done in the personal computer market: when you buy a Mac, everything about the Mac experience out of the box is controlled by Apple, both hardware and software. This gives Apple the ability to integrate the operating system and basic software with its own hardware in a way Microsoft and Dell can only dream about. And you can't argue with the result: current versions of Mac hardware and software are light-years ahead of anything in the Wintel world in terms of the quality of the overall customer experience (the fact that some earlier versions of Mac hardware and software sucked also proves that merely controlling the customer experience isn't enough to make it good). The downside is that Apple's market is limited to the 5% or so of buyers who don't care if their computer doesn't run Windows on an Intel processor.
Another way out of the trap is to disconnect the parts of the hybrid product or service, and make them separate buying decisions. In Europe, for example, GSM mobile phones aren't tied to a particular carrier's network they way mobile phones are in the U.S. The customer makes two decisions instead of one: buying a phone and buying service, as opposed to buying a phone+service package. Each company can concentrate on making its product or service the best possible, and consumers can switch either the phone or the service when something better comes along. I suspect that it is no coincidence that Europe has long led the U.S. in mobile phone usage.
Conclusion
Industries changing from vertical integration to horizontal integration is probably one of the best things to happen in the business world for many decades. The benefits in terms of efficiency and innovation are immense.
But this has also led to some industries where the customer experience is spectacularly bad, usually when no one company controls the entire end product. The result is that no company is responsible or has the freedom to improve.
Unfortunately, when these situations arise it is usually the case that none of the companies wants to give up its relationship with the consumer for the sake of a better overall product.