What is Vertical Integration?

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Definition:

Vertical integration is when a business serves as part of its own supply chain — the path that raw materials and goods take when flowing from the supplier to the retailer to the end consumer.

🤔 Understanding vertical integration

Vertical integration is a business arrangement in which a company controls its own suppliers, distributors, retail locations, or other parts of its supply chain. This sometimes can make a company more efficient, but it also requires intensive capital investment and carries other risks. Vertical integration happens when a company controls part of its own supply chain, producing some of the inputs that it needs for its business to run or consuming some of the outputs of its production. Backward vertical integration means supplying the inputs your business needs; forward vertical integration means consuming your business’s outputs.

Example

Say a national coffee chain wanted to bring down the cost of its product and increase efficiency. One way of doing that might be to buy a coffee-growing operation so that the coffee chain could provide its own beans. This would be vertical integration.

Takeaway

Vertical integration is like a ladder...

Each business in the supply chain is a rung on the ladder. Goods move from rung to rung up and down the ladder until a final product is created. When one company owns two or more businesses that are next to each other on the ladder, it is vertically integrated.

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What is vertical integration?

Vertical integration is when a company becomes one of its own suppliers or customers.

Businesses produce goods and services. Some companies provide products that other companies refine before selling to yet other firms that make more changes to the goods before selling them to customers. So, most companies have to work with other businesses to ensure they have the raw materials they need to produce their products.

In some situations, it makes sense for a company to start producing its inputs instead of buying them from suppliers. In other situations, it makes sense for the company to add steps to its manufacturing processes and cut out the middlemen standing between it and the end consumer.

When a company expands operations — so that it is producing more of its inputs or consuming its outputs — it has vertically integrated.

What are some examples of vertically integrated companies?

One well-known, vertically integrated company is Netflix. When Netflix began, it provided DVDs and streaming services of TV shows and movies that were produced by other companies.

Eventually, Netflix expanded into producing original content and offering it alongside the content generated by other businesses. These Netflix-produced shows are the inputs in Netflix’s business. Because Netflix is making the shows, it is vertically integrated, even though it still offers content from other studios.

Many car manufacturers are another example of vertical integration. If you want to buy a Ford, there’s a good chance you have to visit the local Ford dealership. Tesla sells its cars through Tesla stores. These companies are responsible for both making the cars and selling them directly to consumers, placing it at two separate stages of the supply chain.

The merger of Ticketmaster and Live Nation is another example of vertical integration. Live Nation schedules and produces concerts and shows. Ticketmaster sells the tickets to those shows. Live Nation served as the supplier for Ticketmaster, so the companies vertically integrated when they merged in 2010.

What is the difference between vertical and horizontal integration?

Vertical integration occurs when two companies at different steps of the supply chain merge or when a company expands operations to occupy another stage of the supply chain.

Horizontal integration is when a business acquires or merges with another company at the same level of the supply chain. For example, an independent coffee shop that buys a struggling coffee shop at the other end of town is integrating horizontally.

What are the types of vertical integration?

There are two types of vertical integration: forward vertical integration and backward vertical integration.

Backward vertical integration is when a company becomes its own supplier. A restaurant that moves from buying its produce and spices from farmers to growing its own food is backward integrating because it is supplying its own raw materials.

Forward vertical integration occurs when a company starts to consume its outputs. A business that produces toys and sells them to retailers forward integrates when it opens its own retail locations and starts selling its toys directly to consumers.

What are the advantages of vertical integration?

Reduce supply chain disruption

Almost every business faces supply chain risk, and vertical integration can help reduce that risk. Suppliers may fail, produce fewer goods than expected, or decide not to sell products to individual companies. If a business is providing its inputs, then it won’t have to worry about suppliers going under to refusing to sell. Therefore, it will be able to forecast its production of inputs more accurately.

Similarly, companies that forward integrate will have fewer worries when it comes to finding buyers for their goods. Buyers can also fail or refuse to buy certain products, so if a vertically integrated company uses its outputs, the risk of losing buyers is reduced.

Reduce the market power of suppliers

A company that is entirely reliant on other businesses to supply required inputs gives those suppliers a lot of leverage. Suppliers might be able to raise prices, knowing that the company has to buy from them or stop producing goods.

If a company can produce its inputs, it becomes less reliant on outside vendors to supply its raw materials. This independence gives the business more negotiating power over suppliers when it comes to setting prices and other contract terms.

Leverage economies of scale

As businesses grow, they may be able to take advantage of economies of scale by buying large quantities of raw materials. It’s like buying a 20 lb bag of rice compared to a 5 lb bag of rice. Buying more significant amounts of a good usually means paying less on a per-unit basis.

What are the disadvantages?

Reduced flexibility

When companies vertically integrate, they increase their commitment to producing specific goods or services.

Consider a toymaker that produces plastic action figures. If that company integrates by building or purchasing a plant that produces raw plastic, the business is committed to providing plastic toys. Making a change in the product it sells — to, say, wooden toys — would become more difficult. If an integrated company wanted to make such a change, it would have to sell or shut down the plastic plant or start finding buyers for the plastic it is producing but not using.

Higher expenses

Every expansion a company makes brings additional costs. When a business vertically integrates, it has to pay all of the costs related to the strategy, including increased wages, rent, and taxes. If the company doesn’t have sufficient cash reserves or cash flow to handle these expenses, it may not be able to get the integration strategy off the ground and to the point where it realizes enough cost savings to fund the additional ongoing expenses.

Reduced focus on the core of the business

Almost every business has a core focus. That focus is what lets a company effectively serve its consumers. A restaurant doesn’t need to know how to catch a fish or grow a vegetable to know how to create a good meal and produce a relaxing atmosphere.

When a company vertically integrates, it needs to gain new knowledge and focus on accomplishing new business tasks. This learning curve can reduce the focus the company has on its original core business. A restaurant that expands into growing its food might lose sight of what made the restaurant appealing in the first place: good food and atmosphere.

Company culture conflicts

Conflict between company cultures can occur when a business integrates by merging with or purchasing another business. If the cultures of the two companies are wildly different, there can be a long period of resolving the conflicts before the companies are able to work together efficiently and realize the benefits of integration.

When should a business vertically integrate or avoid vertically integrating?

Businesses should consider vertically integrating when their suppliers have too much power over them, as vertical integration significantly reduces supplier power during negotiations. The same is true when the company’s customers have too much power.

Another reason for a company to vertically integrate is when the market for its product is young, and it needs a way to get its product to consumers. Selling directly to consumers can help businesses bypass the need to convince retailers to carry their products.

It may be best to avoid integrating when there is little benefit to doing so. In a market where a business’ suppliers and customers have little power, much of the benefit of integrating is reduced, so the expense of time and cash is unlikely to be worth it.

Businesses that are highly effective at a very specific process may also want to avoid using a vertical integration strategy because it can cause a loss of focus on that process.

Before vertically integrating, companies should run a make vs. buy analysis to figure out whether backward integration makes sense. This analysis involves factors such as the cost of creating and purchasing the product and whether the company has the capacity and expertise to manufacture the goods. It is also important to consider if the company has the cash required to start manufacturing, and whether there are any ways the company can work with suppliers to reduce costs or make their processes more efficient.

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