Discover Pricing Power Hidden in Vertical Integration

Inspired by recent AlixPartners' Research - 2024 Global Automotive Outlook

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Where my thoughts get started

AlixPartners, a renowned Consulting Firm in the Automotive Industry, recently has published 2024 Global Automotive Outlook, revealing quite a few key insights into ever strengthening disruptive forces from Chinese EV brands. Compared to western ones, Chinese brands have possessed 35% cost advantage, halved the product development time, and achieved 75% vertical integration. By winning in the most competitive and biggest automotive market, Chinese EV brands are increasingly setting the standard for an industry historically steered by the West, Japan, and South Korea. By 2030, AlixPartners foresees that Chinese brands will be a dominant force around the world, selling 9 million units outside China, contributing to a 33% market share globally.

Given enormous political headwinds, the only way to get there is for Chinese EV brands to set up their global production footprints in key overseas markets, marking a new era of China Enterprise’s globalization. This time around, this globalization drive by private Chinese brands is different from the previous one, an ill-fated $100 billion shopping spree spearheaded by HNA Group, Anbang Insurance Group etc.

What intrigues me most in AlixPartners study is this figure, 75% vertical integration. Why 75%? Is it still efficient for Chinese EV OEMs? It is well understood that the high level of vertical integration can help firms secure long term supplies of its strategic parts, gain the cost advantage, and better control product quality of finished products etc.

Meanwhile, we can hardly find any literature about pricing power in vertical integration. Being a pricing professional, in this article I’d like to take a stab at this, discovering the true pricing power hidden in vertical integration.

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How my thoughts unfold

My conclusion is that vertically integrated firms do gain pricing power, compared to independent firms, because independent firms incrementalize both fixed costs and profits from their 3rd-party suppliers. Put it another way, vertically integrated firms can amplify their operating leverage by avoiding the incrementalization of supplier’s fixed costs and profits.

First thing first, transfer pricing within a vertically integrated firm is out of scope here and is subject to local tax laws and regulations. In this article I squarely focus on commercial pricing strategy.

To illustrate this point, let’s look at some simple examples. In EV market let’s assume that we have 2 companies, X for independent Manufacturing Inc. and Y for vertically integrated Manufacturing Inc. Firm X procures its parts from independent supplier A and B. Firm Y procures its parts from fully owned supplier C and D. Let’s also assume that supplier A has the same cost structure as supplier C, and it is same for supplier B and D.

In both cases we also assume that 10% price cut leads to 30% sales increase in volume. Given this increase in volume, we assume that fixed costs don’t change. The goal here is to evaluate if this pricing strategy leads to increased operating profits.

Case 1:

The calculation itself is quite straightforward. Firm X incurs a loss of operating profits $80,000 from 10% price cut even with 30% more volume. However, both supplier A and B make a lot of money given their increased volume.?

Case 2:

The same calculation is applied here, but what a difference! All else equal, this pricing strategy turns out to be a great success for integrated firm Y with positive $160,000 profit, the sum of X’s loss and A’s & B’s profits.

So, what is the trick between firm X and Y? Here is the explanation:

In case 1, independent firm X incurs huge amount of variable input costs, the selling prices from supplier A and B. Since they are independent from each other, supplier A and B selling prices become the variable input costs. Both supplier A and B have fixed costs as well as profits, so such fixed costs and profits get incrementalized within this buy-and-sell relationship.

In case 2, integrated firm Y, given its nature of 100% ownership of supplier C and D, can execute this same pricing strategy to maximize the whole group’s operating profits without incrementalizing its suppliers’ fixed costs and profits. Put it plain and simple, firm Y really amplifies its operating leverage by leveraging all of suppliers’ fixed costs.

Given this analysis based on this simple example, I hope that the pricing power hidden in vertical integration has revealed itself. With such a structure if all else equal, firm X can hardly compete against firm Y especially in industries like Automotive with huge, fixed costs.

Obviously, in the real world, things are not so simple. Even for vertically integrated firms they may not have one ERP system wherein its subsidiaries are running their operations, and the number of suppliers could amount to hundreds not just as simple as 2. Furthermore, eventually not all costs are 100% fixed. Although it is complicated, there lies the true pricing power integrated firms could harness.

Where my thoughts end

Having done some hard work and invested huge amount of capital, Chinese EV firms have achieved such a high level of vertical integration. If they are aware of such a hidden pricing power and are skillful enough to wield such a pricing power, I do believe that they’ve got some extra tailwinds in their tough roads ahead to disrupt the global Automotive industry.

For independent firms with huge, fixed costs, what other options do they have to compete against vertically integrated ones? Here I recommend 2 alternatives:

1.??? One alternative is for independent firms to pay its suppliers’ fixed costs in a lump-sum payment, perhaps even retaining ownership of the assets in exchange for low supply prices that cover only incremental costs and reasonable returns.

2.?? Another alternative is to negotiate a high price for initial purchases that cover the fixed costs, with a lower price for all additional volume that cover only incremental costs and reasonable profits.

Both solutions are meant to avoid incrementalizing fixed costs and profits. Unfortunately, in both solutions we can’t eliminate the incrementalization of supplier’s profits completely. In the private world, maximizing profits is the best incentive for owners to provide customers with the best quality of product and service. If we take away this incentive completely, both customers and suppliers will suffer in the long run.

To conclude, vertically integrated firms are squarely sitting on this huge pricing power. If this hidden pricing power hasn’t been discovered yet, given the tough market we are in today, why not give it a run your money you already spent on your subsidiaries?

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