In a setting of economic and financial crisis, most companies experienced a reduction in their profitability. Thus, our study allows us to identify vertical integration strategies developed by companies to overcome the crisis. This paper is aimed at unveiling the determining factors of the profitability of Spanish agrifood firms, depending on whether they are backwards vertically integrated or not. In order to attain our objective, we implemented a first difference regression model. The main contributions of the article lie in the incorporation of a variable that distinguishes integrated firms from the rest and the separate analysis of the two groups of firms. The results suggest that firms that seek to differentiate themselves, either through offering a specific product or through providing higher quality with a view to maintaining their reputation, are more likely to adopt vertical integration due to the higher transaction costs of relations with suppliers. The grouping carried out in this study is shown to be highly relevant as asset structure implies different strategies for actions aimed at increasing profitability.
This work has one supplementary figure published online alongside the electronic version of the article.
In the strict sense of the term, vertical integration means carrying out more than one activity within the value creation chain. The value chain includes all the stages in the process that transform raw materials into the finished product that is fit for consumption, and it thus includes activities related to supply, production and distribution.
Here, we focus on the vertical integration of manufacturing firms. If such firms are only devoted to the second link in the chain, they purchase raw materials from third parties and sell the products to distributors. On occasions, the manufacturing firm may be interested in diversifying its primary exploitation and/or distribution activities. If the manufacturing firm undertakes the activity of supplying raw materials, this results in a backwards vertical integration, whereby the firm becomes its own supplier. By the same token, if the manufacturing firm takes over the distribution of its products, this constitutes a forward vertical integration, where the firm becomes its own customer
According to transaction cost theory (
This study allows us to uncover some of the reasons behind the decision to integrate vertically. In this sense, the literature points to the desire to maintain or reach a certain level of distinction or differentiation in the sector as a determining factor, either with a view to increasing reputation, or to offering specific or higher quality products. Several studies identify the adoption of vertical integration to this end, arguing that, if the objective of the manufacturer is to obtain a differentiated product in terms of quality and brand reputation, then the firm must engage in greater specific investment (see, among others,
This paper studies the agrifood industry. Several studies, such as those of
Among the more notable studies that analyze the determinants of the profitability of this sector are those of
Thus, our study allows us to identify vertical integration strategies developed by companies to overcome the crisis. This paper is aimed at identifying the determining factors of the profitability of Spanish agrifood firms, depending on whether they are backwards vertically integrated or not.
Our results suggest that firms that seek to differentiate themselves, either through offering a specific product or through providing higher quality with a view to maintaining their reputation, are more likely to adopt vertical integration due to the higher transaction costs of relations with suppliers. The grouping carried out in this study is shown to be highly relevant as asset structure implies different strategies for actions aimed at increasing profitability.
Vertical integration involves carrying out more than one activity within the value “creation chain”. When a firm is vertically integrated, it diversifies its activity, which affects the composition of its assets, along with the firm’s return on assets. The aim of this study is to analyze the factors that determine the profitability of firms in the agrifood industry based upon whether they are vertically integrated or not.
This research examines these notions from the perspective of transaction cost theory, which states that economic activity is organized according to the costs implied in contractual relations within which business activity develops. Organizations adopt vertical integration if the costs involved in carrying out the activity themselves are less than the transaction costs, including the agency costs derived from the relationships between firm and supplier when purchasing the raw materials, or between firm and customer when distributing the finished product.
Given the varying nature of the relationship with different stakeholders (suppliers and customers), we focused on the firm’s relationships with suppliers, leaving the analysis of the firm’s relationship with customers and distributors for subsequent research.
In the other hand, given that the decision to integrate vertically depends upon transaction costs and these depend, to a large extent, on the link in the value creation chain of the sector in which the firm operates, we isolated the effect of this factor by focusing our research on a single sector: the agrifood industry. The agrifood industry only includes manufacturing firms from the food sector which transform raw agricultural, livestock and fishing materials. This research thus focuses on a key, highly strategic sector for the Spanish economy. As shown in the report 2012 from the Spanish Federation of Food and Drink Industries (FIAB) (
A part of transaction costs are the agency costs (
With regard to asset specificity, an investment is specific if its best alternative usage implies a sizeable loss in value. We can talk about the specificity of fixed assets, of specialized employees or dedicated assets (
Another important factor related to transactions is uncertainty; a fundamental factor in the agrifood sector. Uncertainty refers to the ability of the parties in a transaction to ascertain and specify any possible contingencies that might arise. This concept includes environmental uncertainty (climate, insect plagues, demand elasticity, price variation for raw materials, etc.) and behavioral uncertainty (difficulty in anticipating the behavior of the other party in the relationship and of verifying the extent to which they comply with the contractual conditions).
As transaction cost theory states, environmental uncertainty is notable if specificity is high, as it is more important to maintain the relationship between the parties. Several authors (
Lastly, another factor underlined by
As we know, transaction costs will be higher in the firm-supplier relationship in accordance with the divergence of interests and the asymmetry of information between the parties, along with environmental uncertainty, specificity and the frequency of transactions.
We used economic-financial data for firms in this sector for the years 2008 and 2011; 2008 was a year of financial uncertainty, but the effects of the crisis had not yet reached all industries. Sectors that are less volatile and depend to a lesser extent on economic evolution, such as the food sector, tend not to be among the first to suffer the effects of any economic crisis
The sample is made up of firms from the Spanish agrifood industry. We obtained the data from the
The main activity of these firms consists of manufacturing agrifood products whose 4-digit code of activity begins with 10, 11 or 12 (food, drink and tobacco production, respectively). From these classifications, on the one hand, we selected only manufacturing firms that do not carry out secondary activities, in other words, those that are not vertically integrated, and on the other, those that were backwards vertically integrated throughout the chosen period;
We used economic-financial firm-level data for the years 2008 and 2011 for the following reasons: 2008 is a year in which the effects of the crisis had still not shown up in the agrifood industry; and 2011 was a year in which there was notable recession within the period of the crisis, producing devastating economic data for the Spanish economy (
From the chosen sample, we firstly eliminated the firms whose data were unavailable for some of the figures. We secondly excluded any firms whose figures indicated extreme accounting data (net sales figures or total asset value) which could skew the results. We eliminated the observations that exceeded 95% or fell below 5% of the sample distribution. This dual filtering process implied the loss of 9.26% of the original sample, ending up with a final total of 5,402 firms.
The decision to integrate vertically implies carrying out new activities, which involves investment in assets with the hope that the costs of this investment will be lower than the profit it generates. For this reason, the variable we want to explain is return on assets, which relates the benefits of exploitation with total assets, depending upon whether the firm is vertically integrated or not.
These initial results lead us to reflect on and analyze the possible effects of vertical integration more deeply, and also to examine the characteristics that affect the profitability of these firms, along with the reasons that lead them to integrate. We questioned whether integrated firms are more secure and less volatile due to the fact that they incorporate the supply of agrifood raw materials into their activity, and thus better withstand the conditions of the economic-financial crisis that is the framework for this research. For the period studied here, vertically integrated firms showed statistically significant stable averages of profitability throughout the crisis, while firms that are not vertically integrated went from a positive average profitability to a negative one.
This section presents the variables that we believe explain the return on assets of firms in the agrifood sector.
We went on to show the descriptive statistics of all of these explanatory variables (see
We firstly analyzed the variables cost efficiency (COSTEFFY) and asset turnover (TURNOV). The former indicates the proportion represented by operating costs over income so that the greater the value of this variable, the less efficient the firm is in term of costs and thus a negative relation can be expected between the variable COSTEFFY and profitability. The results in
TURNOV indicates the relation between the net sales and the total assets. The profitability of assets is the outcome of the product of two factors: turnover and margin
We went on to analyze the size of the firms using the following variables: the logarithm of the total asset (LOGASS), the market share (MARSHA) and the quotient between the net sales of each firm and the net sales for the whole sector, as well as the variables of growth for the year, both in asset size (GROASS) and in market share (GROMARSHA).
We expect the relationship between all these variables and profitability to be positive, except for LOGASS. Asset size does not necessarily imply greater profitability if it does not involve efficiency and productivity, which will depend on, among other things, the characteristics and structure of the sector in which firms operate. As
Some studies argue that smaller firms adapt to changes to product demand more easily and at lower cost while being able to reach higher levels of quality by vertically integrating (
We expect the relationship between all these variables and profitability to be positive. Asset size generated a notable number of contradictions in terms of its capacity to explain profitability, as a larger asset does not imply greater profitability if it does not involve efficiency and productivity, which depends, among other things, on the characteristics and structure of the sector in which the firms operate. However,
The following group of variables deals with liquidity and debt: liquidity (LIQUID) as the quotient between the current assets and the liquid liabilities, and the level of debt (INDEB) as a quotient between the total liabilities and the total financial resources We can expect a positive relationship between liquidity and profitability and a negative one between debt and profitability due to the negative leverage effect as a consequence of the crisis.
If we examine the statistical results (see
We went on to introduce trade credit granted to customers as an explanatory variable of profitability (CREGRANT). We measured it as the quotient between receivable accounts and net sales (
As previously deduced theoretically, firms that manufacture specific products, that is to say, differentiated, higher quality products and those that want to maintain a good reputation are more likely to vertically integrate, and we can therefore expect them to offer greater trade credit. As shown in
With regard to the relationship between CREGRANT and return on assets, we can expect a positive relation,
However, if the context is a period of crisis, certain studies (
Lastly, we introduced a dummy variable into our study (DUMACT) with a view to examining the potential effects of backwards vertical integration. The variable has a value of 1 when the firm is in the “integrated” group in
This section contains the econometric analysis that will enable us to examine the relationship between the profitability of Spanish manufacturing firms from the agrifood sector and vertical integration among these firms. The proposed methodology allows us to obtain robust results, not only due to the characteristics of the regression model itself and the method of estimation and contrast, but also due to the implementation of the variance inflation factor as a means of identifying potential problems of multicollinearity.
In order to attain our objective, we chose a multivariate regression model that studies the explanatory capacity of the variables proposed in the previous section on the evolution of return on assets. By using cross-sectional data, we can verify the effects of the final crisis from 2008 to 2011 on the behavior and evolution of the profitability of Spanish manufacturing firms in the agrifood sector.
To analyze the consequences of a group of firms carrying out activities linked with the primary sector within the agrifood industry, we propose different regression models. A first model that only includes firms that are not vertically integrated and are devoted exclusively to manufacturing (Model 1); a second regression where we only analyze firms that adopt backwards vertical integration or who, in other words, carry out first and second step activities in the value chain together (Model 2); and a third regression (Model 0) in which all firms are included from the two previous models and where a dummy activity variable is introduced (DUMACT). We can thus verify whether vertical integration is a determinant of profitability or not.
We aim to measure the behavior of economic profitability using two key periods as a points of reference: the beginning of the crisis (2008) and a later date when the crisis was at its height (2011). To this end, we implement a first difference regression model (please see the complete model in Fig. S1 [online supplement]), with the following structure:
where “∆” represents the change from the year 2008 to the year 2011. More precisely, shows the change in the firm’s economic profitability
We selected a first difference regression model for several reasons: (i) it eliminates problems of unobserved heterogeneity; as it is defined in terms of differences, this component is completely removed (see eq. [S1.4] in Fig. S1). This term encompasses all the unobserved factors that do not change over time and (ii) it ensures that the idiosyncratic error ∀
The regression model proposed in the
After the regression procedure, we calculated the estimator of the
The use of explanatory variables in the regression process could lead to multicollinearity problems, given the high degree of interrelation that could be established between them. Therefore, implementing techniques that allow us to identify and correct these problems is fundamental for obtaining statistics that allow for an objective argument. We can observe in
When analyzing the first results from the regression shown in
Our result indicates that the majority of the firms whose profitability has not gone down during the period considered are backwards vertically integrated. Indeed, agrifood firms that have to acquire raw materials from third parties are more exposed to the economic situation, and have experienced a reduction in their economic profitability to a greater extent during the crisis. However, backwards vertically integrated firms have scarcely seen a change in the profitability obtained before and after the crisis; demonstrating greater stability and less dependency on the economic climate.
From the results obtained with the other variables, we can see that the firms that are least vulnerable to the economic situation,
The results are consistent with the forecast and discussion made previously when presenting the explanatory variables. With regard to asset turnover (TURNOV), in line with the results obtained by
Firms that have been able to make investments in production and create growth (LOGASS and GROASS) by investing their own resources have also demonstrated better performance, as shown by the previous variable.
The result obtained with the variable CREGRANT is consistent with the school of thought that indicates that business credit can be interpreted as a sign of a good reputation (
We went on to analyze the differences in the results obtained with firms that are not vertically integrated (Model 1, Panel B) and those that are backwards vertically integrated (Model 2, Panel C), shown in
The determinant variables for profitability in Model 1 are exactly the same as those obtained in Model 0 (except for the DUMACT variable, which only appears in the latter model). In other words, firms in the agrifood sector that are not vertically integrated and that have not undergone a reduction in profitability during the crisis are those that have increased in the efficiency and turnover of their assets, have undergone greater growth, are less indebted and have increased the amount of commercial credit they can grant to their customers.
However, when applying the study exclusively for firms in the sample that are backwards vertically integrated, the results are notably different. The only variables that continue to show up as determinants of profitability are COSTEFFY, CREGRANT and INDEB, while market share MARSHA becomes a significant variable. The variables TURNOV and LOGASS cease to be significant and the variable GROASS loses a degree of significance.
The reason why the asset turnover (TURNOV) and size (LOGASS) are not significant variables in this model could lie in the fact that vertically integrated firms are generally larger and more intensive in terms of fixed assets. We have already discussed the fact that backwards integrated firms have less turnover because they generally make products with a longer manufacturing period. As a result, it is more difficult for them to act on turnover to increase profitability, and it can therefore be deduced that they act on their operating margin. The reason why market share (MARSHA) becomes significant can be found in the fact that sales in non-integrated firms have, to a lesser or greater extent, become smaller, while integrated firms have been able to maintain or increase sales and their market share, and have become more profitable.
Lastly, we highlight the fact that the results we obtained justify the separation carried out in this study between the two groups of firms, whereby we are able to detect different determining factors of profitability in accordance with the activities in which the firm engages. On the one hand, the firms from the agrifood sector that have increased profitability between the years 2008 and 2011 have in common the fact that they have increased cost efficiency, reduced the level of debt by putting the financial structure in order and have increased the amount of customers, granting greater business credit. However, if firms are not vertically integrated, they have had to make more of an effort and act upon asset turnover when faced with a reduction in margins during a period of financial crisis, while vertically integrated firms have acted on the margin, as TURNOV is not significant. However, if firms do not carry out additional activities, they are less vulnerable to the effects of the crisis if they have been able to increase investments or, alternatively, if they are backwards vertically integrated firms that have attempted to increase their market share.
The main conclusions obtained from the study are as follows. Firstly, one factor that has determined whether or not the firm has maintained, or even increased its profitability during the period of crisis is the adoption of backwards vertical integration itself. We have also demonstrated the existence of a direct relationship between integration and specificity, and can thus state that firms who manufacture more specific, differentiated products have a greater chance of diminishing the effects of an adverse economic situation. Secondly, another conclusion to highlight is the relevance of the grouping of firms carried out in this study. By analyzing the whole sample together, it can be observed that the heterogeneity of the group is not taken into account and obtaining conclusive results becomes more difficult. In fact, analyzing the two groups of firms separately reveals that the same set of variables does not determine their profitability.
In order to continue this research and examine the phenomenon in greater depth, we believe it would be appropriate to complement this study with an analysis of forwards vertical integration, which includes the third link in the value creation chain: distribution.
For a more in-depth description of the concept of vertical integration, see
The study by
The FIAB 2008 economic report (
The remaining activities with codes pertain to forest and timber-related activities).
The worsening of the sovereign debt crisis impeded the slight recovery of the Spanish economy, immersing it in a period of recession; internal demand dropped sharply (1.7%), countering the measures taken since 2008; supply in all sectors has become weaker while the employment shortage has intensified since the summer, taking the economic crisis to new depths; the high level of debt does not allow for reforms that might allow for the imbalances that hinder economic recovery to be corrected.
They are diversified and carry out both an activity that begins with the CNAE-2009 code 10, 11 or 12 and those that start with 01, 03 or 023.
See, among others,
EBIT/Asset (ROA) = EBIT/Sales (Margin) × Sales/Asset (Turnover).
For a more detailed analysis of the effects of reputation on profit, see
The variable DUMACT only appears in Model 0, which includes both vertically integrated and non-integrated firms.
Alternatively, see the manual of
It should be remembered that a higher value of this variable indicates less cost efficiency, which is why it is negative in