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Virtual integration costs and the limits of supply chain scalability

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Some enterprises adopt highly vertically integrated structures to carry out essential value chain activities whilst others derive economic benefits from adopting extended structures using Internet-based technologies and through the effective integration of supplier relationships. Extended supply chain alliances can enable low operating/production costs as each partner firm specialises in defined core functions. Such benefits however have to be weighed against the necessary investments in financial and management information systems to enable activities undertaken by supply chain partners to be properly controlled and coordinated. As inter-enterprise activities grow in size and complexity, information system and electronic linkage costs also increase due to possible system incompatibilities with prospective suppliers, the need to meet regulatory compliance requisites, the increased probability of system breakdowns as connection points with suppliers increase and security assurance measures over cross-enterprise information networks. These virtual integration (VI) costs will be low when few suppliers are linked to the extending enterprise. Once a certain level of VI complexity is achieved, the further scalability of supply chain integration will no longer prove cost effective. When this “threshold” point is reached, it will be preferable for a firm to cease further VI. In fact VI costs can increase even without further supply chain extension due to changing technical risks, application difficulties or environmental turbulence and it may then be worthwhile for the firm to scale back to a higher degree of vertical integration. This paper develops a real options based model to demonstrate the VI linked cost/benefit dynamics of enterprise extension and provides a numerical illustration of the relationships captured by the model. The model extends our knowledge of factors which render extended structures stable rather than transient enterprise forms.

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