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CHAPTER II LITERATURE REVIEW This chapter will be the basis of the study because of its significance to lay out the theories and literatures needed in order to gives out thorough analysis of the subject. To fully understand the study, it is important to analyze the industry and its structure, including the flow of the industry’s supply and demand. After the industry can be described, then it is important to explain vertical expansion, or commonly termed as vertical integration, especially upstream integration, financial projection, and Supply Chain Management before finally gives a description about the product. 2.1 Structural Analysis of Industry Industry is defined as the group of firms producing goods or services that are close substitutes or identical in consumption to each other (amosweb.com). Another definition of industry is a market in which similar or closely related products are sold to buyers (Porter, 1980). Overall, industry can be defined as a group of firms that participate in a market with similar or closely related products. The industry structure gives out strong influences in forming the rules of the competition and the strategies needed to overcome the industry. Competition in an industry is formed to intensively drive down the rate of return on invested capital. In economics, markets are divided into four classifications which are differentiated base on the structure of the industry that serve the market. The classifications are: A. Perfect Competition Perfect competition represents a market with lots of participants who sell the same goods. Usually this applies for commodity goods such as vegetables or meat. B. Monopolistic Competition Monopolistic competition is a market with many seller which sell differentiated items of the same purpose. For example, knifes in one store was made of steel while others were made of stainless steel or ceramics but all of them are knifes. 5 C. Oligopoly Oligopoly is a market where there are few sellers in the industry. This applies for Indonesian’s gas station industry where there are only five participants who involved in the market. D. Monopoly Monopoly means that the industry is being controlled by one participant only. Attempts of eliminating monopoly have been done by many countries to prevent unfairness to other party. In Indonesia, this practice is regulated, owned and monitored by the government due to its importance to the people of Indonesia. (Porter, 1980) Superficially, this company is participating in perfect competition due to the indifference of one company’s product to another. To fully understand the industry structure, further analysis needed by using tools such as Porter’s five forces model, SWOT analysis and PESTL analysis. 2.1.1 Five Forces Model by Porter Figure 2.1 ‐ Porter's Five Forces Model (Porter, 1980) POTENTIAL ENTRANTS Threats of New Entrants Bargaining Power of Suppliers INDUSTRY COMPETITIORS SUPPLIER Bargaining Power of Buyers BUYERS Rivalry among Existing Firms Threats of Substitute Products SUBSTITUTES Source: Competitive Strategy, Michael Porter (1980) The five forces model was developed by Michael E. Porter in 1979. This model identifies the competitive intensity and its attractiveness in the industry. The five competitive forces, new entry, threat of substitution, bargaining power of buyers and suppliers, and rivalry among current players, gives a description 6 that competition in the industry is beyond the competition described by other people. Altogether, the five forces determine the intensity of the industry competition and profitability. Therefore, the goal of the model is to identify and overcome the collective strength of these five forces and gain the ultimate profit potential in the industry. The model comprised of 5 forces that describe the industry’s situation A. The Threat of the Entry of New Competitors Threat of entry into an industry depends on the barrier of entry along with the reaction from existing competitors. a. Barriers of Entry There are six major barriers of entry Economies of Scale Economies of scale refer to declines in unit cost of a product as the absolute volume per period increases. In other words, as the number of production increase, total cost per unit decreases. In a vertical integration, there’s an additional economies of scale barrier, which is operating in successive stages of production or distribution. The company must enter integrated or face foreclosure. Product Differentiation Product differentiation means that established firms have brand identification and customer loyalties which created from previous build up brand equity. Capital Requirement Capital requirements refer to the need to invest large financial resources in order to compete, especially if the capital’s required for risky advertisement or research and development. Switching Cost Switching cost is the one time cost facing the buyer of switching from one supplier’s product to another. 7 Access to Distribution Channel Distribution channel need to be persuaded in order to secure distribution for its products through price breaks or cooperative advertising allowances which reduce profits. Other way to gain access to distribution channel is to create one. Policy Government Government policy can become a barrier because government can limit or even foreclose entry into industries with such controls as licensing requirements and limits to raw materials. b. Expected Retaliation The potential entrants’ expectation when entering will also influence the threat of entry. Conditions that signals the strong likelihood of retaliation to entry are vary from blocking of access to resources by established firms to history of vigorous retaliation to entrants. B. The Intensity of Rivalry among Existing Competitors Rivalry happens because one or more competitor feels intimidated or sees the opportunities to improve their market position. Intensity of rivalry can be termed as “Jockeying for Position” by using tactics such as price competition, advertising battles, product introductions, and increased customer service or warranties. Price competition is highly unstable and could harm the company and industry for the worse. Different from price competition, Advertising could create a strong brand image, increase demands, and may become a firm brand reference to potential buyers. C. The Threat of Substitute Products Substitute product is a different product that can replace the existing product, not just a brand difference. This difference is like butter and margarine, similar function but different product. Such products limit the potential returns in the industry by placing a ceiling on the prices firms the industry can charge. Substitutes products that deserve the most attention are 8 one that subject to improving their price‐performance tradeoff with the 9 industry’s product and products that are produced by industries with high profits. D. The Bargaining Power of Buyers Buyers compete with the industry by forcing down prices, bargaining for more service or quality, and playing competitors against each other. A buyer group is powerful if; buyers are concentrated on large volumes, significance to the fraction of total cost, product is undifferentiated, faces few switching cost, poses threat of backward integration, and buyers have full information concerning the industry and the product. E. The Bargaining Power of Suppliers Suppliers also pose a bargaining power as the buyers. By increasing the prices and decrease their quality, a supplier can gain extra profit from their buyers. A supplier group is powerful if this scenario happens; products dominated by a few companies, not obligated to contend with other substitute products, the industry is not an important customers of the suppliers group, supplier’s product is an important input, has a switching cost involved, and suppliers group poses threat to forward integration. (Porter, 1980) 2.1.2 SWOT Analysis According to Thompson, SWOT analysis as tool for sizing up a company’s resource capabilities (strengths) and deficiencies (weaknesses), market opportunities, and the external threats to its future well being (Thompson, 2010). SWOT analysis is commonly used to identify the external possibilities and review to the internal capabilities. Strengths and Weaknesses used to analyze the internal capabilities and compare it with Opportunities and Threats as the externalities that are exposed to the company. Thompson argues that a good SWOT analysis could be the basis for crafting a strategy that capitalizes on the company’s resources, aims squarely at capturing the company’s best 10 opportunities, and defends against the threats to its well being. Components of SWOT analysis are: A. Strengths Strengths are something a company is good at doing or an attribute that enhances its competitiveness in the market place. This has to do with the company’s core competence (a competitively important activity that a company performs better than other internal activities) and distinctive competence (a competitively valuable activity that a company performs better than its rival). B. Weaknesses Weaknesses, or deficiencies, are the components that the company lacks or does poorly (when in comparison to others) or a condition that puts the company at a disadvantage in the marketplace. C. Opportunities Opportunities are the potential chances that the company should be able to attain by assessing the strengths and weaknesses that the company possesses to compose the strategy to reach it. The market opportunities most relevant to a company are those that match up well with the company’s financial and organizational resource capabilities, offer the best growth and profitability, and present the most potential for competitive advantage. D. Threats Threats are the certain factor in the company’s environment pose risks toward profitability, competitive well being, and growth prospects. External threats may pose no more than a moderate degree of adversity because all companies confront some threatening elements in the course of doing business, or they may be so imposing as to make a company’s situation and outlook quite tenuous. It is up to management to identify the threats to the company’s prospects and to evaluate what strategic action can be taken to neutralize or lessen the impact. (Compiled from Thompson, 2009) 11 2.1.3 PESTL Analysis Babette Bensoussan refers PESTL analysis as a tool to map the aspects of the environment, which are political, economic, social, technological, and legal, that can affect the competitiveness of industries and companies (Bensoussan, 2008). Meanwhile, John William sees PESTL analysis as a business measurement tool for understanding market growth or decline (Williams, 2006). Overall, PESTL analysis can be defined as a tool that analyses the Political, Economic, Social, Technology, and legal aspect of the macro environment, hence the acronym PESTL. Each point is listed based on the importance to the evaluator in order to recognize the potential and threats that each point could deliver. A. Politic Political factors include government’s intervention toward the economy. This intervention can be in form of tax policy, labor law, environmental law, trade restriction, tariffs, and political stability. B. Economy Economy factors affect the purchasing power of potential customers and the firms cost of capital. C. Social The social factors include the demographic and cultural aspects of the external macro‐environment which affect customer needs and the size of potential markets. D. Technological Technological factors can lower barriers to entry, reduce minimum efficient production levels and influence outsourcing decisions. E. Legal The legal factor is the regulation and rulings for the company. (Compiled from Williams, 2006) 2.1.4 Supply and Demand Analysis Supply and Demand is the backbone of theory of economics. To put it simply, a potential buyer (demand) wants to purchase a product or service by 12 come to a market, a place where buyers and sellers communicate with one another for voluntary exchange (Png, 2009), where this potential buyer could meet and purchase this particular product from a seller (supplier). A. Demand Demand refers to the will to purchase a product or service at a given price (Berk, 2007). The graph that shows the individual demand, which is showing the quantity that the buyer will purchase at every possible price (Png, 2009) is: Figure 2.2 – Demand Curve Price Quantity Source: Hubbard,2008. This demand curve’s slope is downward because of the Law of Demand that states “When the price of a product falls, the quantity demanded of the product will increase and vice versa, ceteris paribus” (Hubbard, 2008). This demand curve could shift upward (higher prices for the same amount of quantity) and downward (lower price for the same amount of quantity) for several reasons such as: a. Income The income that consumers have available to spend affects their willingness and ability to buy a good. If the income rises, demand of a good will increase, which makes it Normal Goods. On the other hand, Inferior Goods is a type of good that increase the number of demand when the income decreases and vice versa. 13 b. Prices of related goods The price of other goods can also affect consumer’s demand for a product. Goods and services that can be used for the same purpose are Substitute. When two products or services are substitutes, the more a person buys of one, the less that person buys the other product or service. For example: CD player and MP3 player, LCD TV from different brands, etc. In comparison to substitute product or service, Complementary products and services are used together. When two goods are complements, the more consumers buy of one, the more they will buy of the other. Examples include compact discs and CD player, washing machine with water and detergent, and many more. c. Tastes Consumers can be affected by an advertising campaign for a product which affected the consumer’s taste and decision when trying to purchase a product. d. Population and demographics Population and demographic factors can affect the demand for a product. As the population increases, the demand is also increases. The demographics of a population, or the characteristics of a population based on age, race, and gender, can also take effect of the demand. For example, when a certain area’s population has started to be overtaken by a certain race, the demand of a product would start to change as a certain race has their own preferences of a product. e. Expected future price Consumers choose not only which products to buy, but also when to buy them. If enough consumers become convinced that a certain product will be selling for a lower price three months from now, the demand for that product will decrease. Alternatively, if enough consumers become convinced that the price of that product will be higher in near future, the demand will increase due to the consumers who want to avoid the price changes. 14 B. Supply The definition of supply is the amount of products or services available at the market for sale (Berk, 2007), or the amount of products or services a firm is willing and able to provide at a given price (Hubbard, 2008). The law of supply states “Increase in price case increases in the quantity supplied and vice versa, ceteris paribus” (Hubbard, 2008). This law of supply causes the graph sloped upward as follows: Figure 2.3 – Supply Curve Price Quantity Source: Hubbard,2008. Like the demand curve, the supply curve is also able to shift left to right for these reasons: a. Prices of Inputs The factor most likely to cause the supply curve for a product to shift is a change in the price of an input, or any material used in the production of a good or service. b. Technological Change Technological change is a positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs. Shift from this factor can happen from the increase of production without any, or minimal, changes from the input. c. Prices of Substitutes in Production Firms often choose which good or service they will produce. Alternative products that a firm could produce are called substitute in production. 15 When this substitute in production happens, then the production of the good or services will decrease. d. Number of Firms in the Market A change in number of firms in the market will change the supply that enters the market. When new firms enter a market, the supply will increase and also applies when the opposite happens. e. Expected Future Price When a firm expects that the price of its product will be higher in the future, then it has the incentives to decrease supply for the moment and increase the production later. (Compiled from Hubbard, 2008) 2.2 Supply Chain Management 2.2.1 Definition Supply Chain has been defined by many that suggest different things. Mentzer (2001), for example, defined it as “a set of three or more entities directly involved in the upstream and downstream flows of products, services, finances, and information from the source to their customers.” Ayers (2001) defined supply chain as knowledge movement that includes all activities related to the back flow of product from customers back up to the chain in the form of product return, reuse and recycling. According to Harland (1996), Supply Chain Management is the management of a network of interconnected businesses involved in the ultimate provision of product and service packages required by end customer. From all of these definitions, we can conclude that Supply Chain Management is the knowledge and management of the flow (supply network) of products or services, along with information and money, from the source (raw material) to user end. 16 Figure 2.4 – Supply Chain Model Source: Webber State University 2.2.2 Significance of Supply Chain Management Most of the studies of Supply Chain Management stated these significances: A. Increase trust and bond between participants within the supply chain. By applying supply chain management, usually there is a signed agreement between parties along the supply chain, which include an agreement of more controlled price. That way, the supplier can be assured of an everlasting customer. B. Lower inventory cost. The application of supply chain management enables the downstream entity to apply the zero inventories and just in time inventory system. That way, the downstream entity can press the inventory cost to minimum and reduce the bullwhip effect. C. Keep the price competitive. Combining both points above, the downstream company can lower the cost down and increase the margin while maintaining the price to stay low. 17 2.2.3 Downside of Supply Chain Management Along with the positive, there will be a negative side of everything. Studies of Supply Chain Management have identified these downsides: A. Leak of company’s secret Since the supply chain management is coming from different entities from a single industry working together, a downstream company’s secret could be recognized by the upstream company. Especially if the upstream company supplied the most important component of the product or services. B. Fragmentation of ownership Once again, supply chain management is comprised of different companies from an industry working together as one. That being mention, different companies also have different goals and visions. This difference could create clash of interest between participants. (Compiled from Ayers, 2008; Petrovic‐ Lazarevic, 2007; Mentzer, 2001) 2.3 Vertical Integration 2.3.1 Definition Vertical expansion referred to as an act of expanding a company’s line of business by creating or acquiring the previous or next step on the product’s supply chain. In many literatures, vertical expansion is termed vertical integration since the term integration defined in the English Dictionary as an act of combining or organizing into a whole. In other word, integration is to organize different entities, either from a specific company group or not, so that they combined into one. According to a journal of vertical integration by Paul L. Joskow, there are many interpretation of vertical integration and there will be no unified definition of vertical integration due to the market imperfections (Joskow, 2006). One of the commonly used definitions of vertical integration is the combination of technologically distinct production, distribution, selling, and/or other economic processes within the confines of a single firm that 18 represent a decision by the firm to utilize internal or administrative transaction to accomplish its economic purposes (Porter, 1980). 2.3.2 Types of Vertical Integration According to Michael Porter (Porter, 1980), vertical integration can be achieved by: A. Full Integration Full integration refers to integration from within the company by one entity fully supplies the other. B. Tapered Integration Tapered integration, however, means that the company only produces most of their requirements and buys the rest. C. Quasi Integration Quasi Integration means that making use of debt or equity investments or other means in order to create alliances between vertically related firms without full ownership. This type of integration is considered cheaper than full acquisition. 2.3.3 Strategic Benefits and Costs of Vertical Integration Vertical integration has its benefits and costs that are important and crucial. One of benefits of vertical integration, especially backward integration, most depended on the volume of products or services the firm purchases from or sells to the adjacent stage relative to the size of the efficient production facility in that stage. The volume of purchases of the firm who do backward integration must be large enough to support an in house supplying unit and reap all economies of scale in producing the input. Excess of production can be sold in an open market. Other benefits of integration are; increase efficiency from combining both operations, costs for internal control and coordination for Just‐In‐Time storage 19 strategy can be lowered, lowering cost of gaining information about the supply market and decreasing the cost from maintaining relationship. Along with benefit, there’s also cost that goes along with integration. Costs that involves in integration are; cost of overcoming mobility barrier, increase in fixed costs, reducing flexibility in switching partners, higher exit barriers, and many other cost that comes with integration. 2.3.4 Strategic issues in Upstream Integration Since this study discusses upstream integration or expansion in particular, then it is important to discuss strategic issues that come with upstream integration. Very often the specifications for component parts reveal the key characteristics of the final product’s design or manufacture to the suppliers. Therefore, the company need to protect their design and specification by produce the parts internally. If the firm cannot produce the component internally, then supplier will have a bigger bargaining power and will pose a threat of entry. Moreover, upstream integration can allow the firm to enhance differentiation. By gaining control of the production of certain products, the company can produce a product that’s distinguishable from others. (Compiled from Porter, 1980; Joskow, 2006) 2.4 Projected Financial Statements 2.4.1 Definition and Explanation Projected financial statements are tools to estimates the future financial performance of a business. Projected financial statement can be used for creating a benchmarking for the future, to estimate the effect of proposed operating changes, anticipate the firm’s future financial needs, and to estimate future cash flow. The financial planning process can be broken into these steps: A. Project financial statements and use the projections to analyze the effects of the operating plan on projected profits and financial ratios 20 B. Determine the funds needed to support the five‐year plan. C. Forecast funds availability over the next five years which includes estimating the funds to be generated internally as well as those to be obtained from external sources. Any constraints on operating plans imposed by financial restrictions must be incorporated into the plan. D. Establish a performance‐based management compensation system. In order to start creating a financial statement, it’s important to forecast the sales figures since it is the main source of funds that runs the company. Sales forecast generally starts with a review of sales during the past five to ten years. By using a present value equation of ݁ ܲ ݁݊݁ܲݑ݊݁ܲ݊݁ܲ݊݁ܲ ݐ݊݁ݏ ݁ݎൌ ி ௨௧௨ ௨ , ሺଵା௧௦௧ሻ ೌ After this, the percentage of growth can be derived from there. Once sales have been forecasted, we must forecast future balance sheets and income statements using the percent of sales method which comprised of 4 steps, which are analyzing the historical ratios, forecasting the income statement, forecasting the balance sheet, and raising the additional funds needed. Analyzing the historical ratios is needed to view the company’s performance data and compare it to the industry or rival as a comparison. In forecasting the income statement, the data inside the income statement will be forecasted using corporate goals and trends. The same set of rules is also applied for forecasting balance sheet. In this final step, raising the additional funds will be needed to replenish the shortage by taking short term loan. Alongside with present value, the projected financial statement can be used to find the Net Present Value and Internal Rate of Return of a project. Net Present Value (NPV), as defined by Jerry Weygandt in Accounting Principles book, is referred to a value taken from discounting net cash flow to their present value and comparing it to the capital outlay required by the investment (Weygandt, 21 2002). Berk and DeMarzo has defined NPV, in a simpler way, as the difference 22 between the present value of a project or investment’s benefits and the present value of the costs (Berk, 2007). Therefore, to find the NPV of a project, the formula is: ܲ݁݊ܲ݁݊ܲ݁݊ ൌ ܲ݁݊݁݊݁݊ ൌ Σ ܲ݁݊ܲ݁݊ ݄ܲ݊݁݊݁ܲ ܽݎ ݓൌ Σ ܲ݁݊ܲ݁݊ ܲ݁݊ݎܲ݁݊ܲ݁݊ܲ݁ ݁݊ܥ ݐݐݏ ܲ݊݁݊݁݊݁ܲܫ ݄ ܽݎݓ ൌ ሺ1 ݁ ݁ ௬ ܲ݁݊݁݊ݐ݊݁ݏݎݐሻ ܲ݊݁ܲ݊݁ܲݐݑ݊݁ܲ ݄ ܽݎݓ ݁ ݁ ௬ ሺ1 ܲ݁݊ܲ݁݊ݐ݊݁ݏݎݐሻ Weygandt also provide the definition of Internal Rate of Return (IRR), which is the rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflow (Weygandt, 2002). In other word, IRR is the interest rate that sets the net present value of the cash flow equal to zero (Berk, 2007). The formula for IRR is: ܲ ܽ ݄ ܲܫݓ ݎ ܲ ܽ ݄ ܲ݁݊݊݁݊݁ܲݐݑݓ ݎ ݁݊ܲ ݁݊݁݊ ൌ 0 ൌ ݁ ݁ ݁ ௬ ݁ ௬ ൌ ሺ1 ܲ݁݊݁݊ݐ݊݁ݏݎݐሻ ሺ1 ܲ݁݊݁݊ݐ݊݁ݏݎݐሻ 2.4.2 Downside of Projected Financial Statement Projected financial statement is developed using controlled parameters that previously defined. These parameters are defined using the historical trend and the company’s expectation, which contradict the fluctuating nature of the market. Therefore, due to the imbalance between expectation and reality, financial projection can’t be the source of information but can be the company’s benchmark that must be attained. (Compiled from Weygandt, 2002; Berk,2007) 2.5 Corrugated Carton Box 2.5.1 Definition Corrugated carton box, or corrugated carton board, is the product of Wirajaya. It consist of, at least, 3 layers of paper which formed by a piece of paper with a wavy contour (fluted paper or medium) glued inside two smooth surfaced papers (kraft liners or liners). Corrugated carton box normally used for packaging use because of its rigid properties and inexpensiveness. Nowadays, corrugated carton box are using recycled papers from used carton boxes. To 23 recycle a paper, it must be derived from similar product to preserve the quality of the paper. For example, paper used for corrugated carton box were taken from recycling old corrugated carton box while bleached papers used for daily office activity were recycled from another bleached papers. 2.5.2 History Since the invention of paper in China around 250 BC, paper has been used as a writing media. Some attempts to use paper as a packaging material has been done, from thickening the width of the paper to the creation of a corrugated paper by Edward C. Healey and Edward E. Allen which patent was approved in 1871. All of these attempts then perfected by Oliver Long in 1874 who joined the corrugated paper with two liners glued to the side which become the corrugated cardboard that we know today. In 1890, Robert Gair invented the precut paperboard boxes due to an accident. This invention eases up the creation of corrugated carton box that every factory uses. 2.5.3 Corrugated Carton Box Production Process The production cycle of corrugated carton box contains two different line of production, the paper making production line and corrugated carton box production line. 24 a. Paper Making Production Line Figure 2.5 – Paper Making Process Source: Compiled from Different Sources The paper making production, as described in the picture above, is processed through several major steps, pulp making process, fourdrainier process, and cutting and rewinding process. Firstly, in the pulp making process, used corrugated carton box is inserted into the pulper bin to be destroyed and transform it to pulp. After the process is finished, the pulp is pumped out of the bin to the fourdrainier process. Fourdrainier process is composed of four different processes that are described in the picture. Pulp is poured and filtered in the roller and then pressed and stretched in the wet press process. In the dryer process, heated air is used to draw water out of the paper while the paper is stretched further. Calender section is a process where further smoothing and stretching is applied. Different settings in this section can be applied to differentiate the paper’s surface and thickness, thus producing liner and medium paper that could have different weight, thickness, and quality. Before sent to the corrugated carton box producer, the paper is rewind and cut to be rolled into several uniformed and smaller, yet manageable, finished products which are rolls of liner and medium paper. 25 b. Corrugated Carton Box Production Line Figure 2.6 – Process of Making Corrugated Carton Box Source: Compiled from Different Sources After the paper making process is finished, the new paper, both liner and medium paper, then sent to the corrugated carton box producer. The corrugated carton box production line is starting with turning smooth medium paper into fluted or corrugated medium paper. After turning medium paper into fluted medium paper, then the medium paper is placed and glued in between two liner paper to form corrugated carton board. In this form, corrugated carton box maker could process customization for each of their customers. Customization could be in form of exterior printing, pre‐ cut dimension, or even the shape of the finished product. Figure 2.7 – Sample of Different Form and Sizes of Corrugated Carton Box 26 2.5.4 Significance in Today’s Application Corrugated carton box is being used to this day as a packaging material of all sizes. From big name companies to small scale companies uses corrugated carton box as packaging tools that help transporting goods locally and internationally. Following the growth of the world’s economics, demands of corrugated carton box are increasing of which signals an everlasting industry lifecycle. Even though it is sometimes considered as a tertiary object, but its usefulness has made corrugated carton box become a daily necessity to humankind. (Compiled from Wikipedia, 2010; Wirajaya, 2006; CIC, 2009; Boxboard Containers Magazine, 1998) 27