Vertical integration is considered as a business strategy through which a firm is able to own or control its different key channels of vertical business operations such as distributors, retail locations, or suppliers in order to control its supply chain. This business strategy is used for a firm’s expansion by acquiring ownership of the previous distributor or supplier of the firm.
In simple terms, a firm’s control over single or more levels or stages of its production process or supply chain is termed as vertical integration.
Businesses or organizations look for the techniques for the purpose of quality control and reducing the costs of the products or services provided by them. A business can gain a competitive advantage by vertical integration at different levels of its supply chain or production process.
Vertical integration can be viewed as a strategic structure in which a firm holds the ownership of the supply chain and it comprises one or more than one firm that is involved in different levels or stages of production. The supply chain includes all the process i.e. from buying raw material, converting into a finished product, and further sale of the product. So, from this point of view, vertically integrated firms hold ownership of multiple or all the parts of the supply chain.
The working mechanism of Vertical integration
To understand the working process of vertical integration, it is required to look at the process of the supply chain or production stages first.
A process that is involved in the production of goods or services of businesses is termed as supply chain or production process. This process includes converting raw material into finished goods that are available for sale to customers. So, the process of supply chain generally starts with the purchasing of raw material and ends with the delivery of finished goods or final products or services to end-users or customers.
The 4 main stages of the supply chain or production process are as under:
- Procurement of raw materials or commodities
- Production or manufacturing
Vertical integration happens when a firm occupies control over several of the above stages of supply chain or production. It means that other than distributing the goods it sells; a firm is also into product creation and development.
This generally includes the purchase of a firm by another firm like key channels that are part of the supply chain of the same industry or market segment such as a distributor, retailer, or supplier. Mostly, vertically integrated companies look to acquire control over the stage of the supply chain that comes either just before or just after their place in the supply chain process.
Degrees that are involved in vertical integration are:
- Complete vertical integration: This includes all the expertise, assets, and resources required to imitate the supply chain member i.e. downstream or upstream.
- Partly vertical integration: This involves acquiring a supplier’s few stakes in the way of specialized investments or in the form of an equity stake in order to gain agency benefits through a rising ownership interest in the end result.
Purpose of Vertical Integration
A few of the reasons for adopting a vertical integration strategy by firms are as below:
- To approach new channels related to the distribution
- To lower down the manufacturing cost
- To enhance profits and production efficiency
- To decrease delays in distribution.
Merits of Vertical Integration
1. Freedom from suppliers
One of the major benefits of vertical integration strategy is that a firm needs not to depend on suppliers and also, different costs and uncertainty that may be associated with them. Due to a chain of the supply chain, firms may experience a delay between passing on the information or supplies among the different parties of the supply chain.
Through vertical integration, companies experience much-enhanced control over their production process. This helps in improving the flexibility of supply.
Vertical integration facilitates a firm or company to enhance efficiency by smoothing the process of attaining supplies for its goods, manufacturing it, and its sales at the end. So, in this way, vertically integrated companies generally have comparatively lesser turnaround times.
Also, firms become independent using vertical integration strategy as they are able to have the own control of their supply chain; so, they may not suffer due to supply-related disruptions like bad management on part of suppliers or labor strikes, etc. This helps in the smooth running of the process and removes any possibility of supply interruption.
2. Cost Control
The trading of goods and services is at costs in a perfectly competitive market. Some sort of imperfection exists too in most markets that result in higher profits due to market power, branding, or other market factors. This ultimately results in increase input costs i.e. the price of acquiring the company’s resources includes cost as well as margin.
Vertical integration allows companies to lower down these costs by reducing margin. Vertically integrated companies can control costs in a closer way and generally can offer reduced prices. Also, they are able to reduce transportation costs, overhead costs, and other operational costs and by doing so, companies offer lesser prices that attract customers. Best buy and Walmart grocery stores have done this using a vertical integration strategy.
3. Better economies of scale
One of the lucrative advantages of vertical integration is that it supports firms in gaining improved economies of scale. An economy of scale can be defined as depletion in the cost while producing or manufacturing something like an electricity unit or a car and doing so, they are able to take benefit of their increased size.
For example, the per-unit cost of a firm can be reduced by bulk purchasing. Through consolidated streamlining and management process, vertically integrated firms are able to remove overhead costs. So, by achieving greater economies of scale i.e. more production at lower costs enhances supply and reduces per unit variable and fixed costs. This ultimately helps in making products customer-friendly and more attractive.
4. Increases marketability
Through vertical integration, a manufacturer of the firm gets into the partnership with a retail firm through the supply chain and they can make a similar type of product that competitors are producing (similar aspects or processes that of products of competitors). The firm is able to distribute those products through its retail channels.
So, the big firms that use vertical integration strategy are able to meet market demands more quickly by keeping track of products having a great sale in the market.
5. Increased Market Control
Vertically integrated companies presume extended market control. It’s a natural phenomenon that once a firm carrying a higher supply chain such as a retailer gets merged with a manufacturing firm then they experience more control over the products and materials of that manufacturer or producer.
6. Quality assurance
Through vertical integration, quality assurance can be obtained into the system. On successful vertical integration, a company can keep track of the quality of its products more precisely. A better quality assurance process i.e. from the initial stage of raw material supply to sale of the final product within the production process generates a more reliable value proposition. This results in better customer satisfaction that ultimately improves brand loyalty and better ROI.
7. Creates synergies
Vertical integration also creates different synergies through which companies are able to reduce costs and increase the efficiency of internal workflow. Below are the largest synergies that are developed by vertical integration:
- Financial synergy: Through vertical integration, financial constraints of a company get reduced as funds are used to support the expansion, cost reduction, credit increase, and debit capacity growth of the merging company.
- Synergy related to operations: Vertical integration facilitates superior operation and administration of the supply chain through clubbing the merits or success factors of each organization and by the replacement of any trouble segments.
- Managerial synergy: Elimination of the team members of poor management is also possible through vertical integration by replacement with an efficient management team.
Demerits of vertical integration
1. Costly strategy
One of the most noticeable disadvantages of vertical integration is the cost associated with implementing this strategy. A huge capital amount is required by firms in order to purchase or set up factories. Also, maintaining these factories and keeping the manufacturer profitable demand heavy investment too. In the case of a forward merger of the producer itself, the bulk expense may occur to maintain retail and marketing.
2. Firm becomes more rigid to market trends
Firms become less flexible or more rigid to changes occur in market trends as it depends upon the set-up of the supply chain. Due to this, firms that are vertically integrated in a deep way i.e. have combined multiple areas of the supply chain; generally find it difficult in shifting the production to products of different types. Also, often such vertically integrated firms are unable to switch to foreign manufacturers or factories carrying lesser exchange rates or operating expenses.
3. Corporate Culture issue
One drawback of vertically integrated companies is related to the conflict that arises among the culture of retailers and manufacturers. Also, communication issues may arise due to poor management and a wide chain of command as multiple firms combine under a single head.
In other words, a firm may not have a supporting culture for factories and retail stores. A good retailer has a culture to attract sales and marketing areas. This culture isn’t suitable as per the needs of manufacturers and clashes may turn into conflict and productivity loss.
4. Clashes with entry barriers of the market
Despite a success factor associated with a vertically-integrate firm, other concerns may still arise due to the dominant position of the firm in its industry or market. Although production and market control is indeed an advantage of vertical integration, it may also create entry barriers in the market for emerging firms to gain access to the product space. It’s quite possible that antitrust issues may arise due to these entry barriers.
5. The flexibility of the firm is reduced
The flexibility of firms reduces under vertical integration as they are forced to go along with trends in the segments that are created due to vertical integration. For example, a firm that acquired the product of a retailer opened an outlet store including old merchandise too. The competitor of the retailer adopted new technology to boost sales. So, the new firm is required to adopt that new technology in order to survive in that competitive market.
Ever-evolving technology at various steps of the supply chain may result in more costly and difficult integration.
6. Less focus on core areas
Different skill sets are required to run a successful business of retail than a profitable manufacturing unit. So, finding a management team that is carrying expertise in handling both is a difficult task. Due to vertical integration, management may not be able to focus completely on their main competencies or domain and their main focus can be shifted to assets that are newly acquired.
Types of Vertical Integration strategy
Two main types of vertical integration are there i.e. Forward integration and Backward integration.
A) Forward integration
A form of vertical integration that includes forward movement of a firm in the direction to control the distribution of its goods or services is termed as a forward integration strategy. In other words, a firm’s forward expansion in its supply chain such as the acquisition of a retailer by a manufacturer in order to have control over distribution channels is referred to forward integration.
Forward integration is undertaken by a firm through acquisition or merger with other business enterprises that were previously its customers, though the firm maintains its control over its current business. If a manufacturing firm engages in sales or after-sales channels, it is involved in a forward integration strategy. Firms use this strategy to have a larger market share and economies of scale.
Let’s understand the forward integration through the below example
A company named X which is a computer technology company and has expertise in manufacturing PC microprocessors; supplies processors to another technology company Y. These processors are intermediate goods that need to be placed within the hardware of PCs of company Y. In the case, company X plans to move further in the supply chain then it may merge or acquire company Y to have its own manufacturing unit in the industry.
So, if company X chooses to do the above forward integration then in the future or long run, it can acquire a monopoly status and is able to dominate the industry by controlling both raw material and finished goods.
Forward integration strategy is effective in the following circumstances:
- There are lesser quality distributors in the market or industry.
- Retailers or distributors have high-profit margins.
- Unreliable or expensive distributors who are not able to provide quality service.
- Significant growth is there in the industry in the long run.
- Possibility of stable distribution and manufacturing.
- A firm carries a pool of resources and competencies to handle the new business.
Merits of the forward integration strategy
Usually, using a forward integration strategy, companies are able to sustain profits by reducing profit losses. Various advantages of the strategy include:
1. Hike in a firm’s market share
Through the implementation of a forward integration strategy, a firm may raise its market share. Usually, various transportation and transaction expenses are eliminated through the strategy. This ultimately results in deciding the low final cost of the product of the firm. So, in this way the firm is able to achieve increased market share through fewer product costs.
2. Command over distribution channels
Forward integration strategy is used by companies to have control over its distribution channels in its market. This ensures that the company is able to operate as an independent strategy company from 3rd parties.
3. Competitive benefit
If the implementation of a forward integration strategy is done successfully in a firm that it may lead to a competitive advantage or benefit to the company over its competitors. Key factors that support in gaining competitive advantage are reduced costs and greater control over distribution channels of the industry.
4. Barriers to potential rivals
Forward integration strengthens the position of the company in its industry and creates hurdles for its potential competitors. For example, if the integration happens between a company and retailer of the large industry then potential rivals may have a little access to distribution channels.
5. Increase in sales
Through forward integration, more sales can be achieved by bypassing wholesalers, dealers, or retailers who may not give their 100% in pushing sales of the products.
Real-life examples of Vertical integration using Forward integration
1. Purchase of PayPal by eBay
One of the perfect examples of the forward integration is the merger held between eBay and PayPal in the year 2002. eBay is a website for online shopping and auction whereas PayPal offers money transfer services and users can make payments online through it. Despite the great success of eBay, there was a concern for the company was the avoidance of eBay by many people because of the fear of online sell and purchase of goods with strangers. This issue was addressed by PayPal by serving as an intermediary among online sellers and buyers. This acquisition of PayPal by eBay was in the step forward to intimate customers that it is completely safe to make online transactions through them.
Though both companies were into different business operations; still the integration between the two, supported eBay by increasing its transactions.
2. The forward integration strategy of Apple
Apple implemented forward integration by exclusively selling its products at its own locations or stores. By this, the company is able to have tight control over distribution and sales. Having the sense of ownership of owning branded stores of its own, Apple sets itself apart from other computer technology companies like Acer, HP (Hewlett-Packard), Gateway that rely only on retailers such as Staples, Best Buy for distribution of their products. Moreover, the popularity of Apple stores is also due to the expertise of its store employees in the products of the company. These employees are able to provide correct and useful advice to customers regarding the use, after-sales-service, purchases of products. This is considered as an important benefit that is the result of the forward vertical integration.
3. Acquisition of Whole Foods by Amazon
One another popular example of the forward integration is when Amazon acquired the Whole Foods brand in 2017. This is also one of the examples of highest-profit based forward integration. This deal was meant for the purpose of owning the responsibility of the sale and distribution of products by Amazon to its customers rather than only wholesale distribution.
Amazon which has already implemented a vertical integration strategy in different ways such as it takes ownership to publish books on its own and a publishing platform is provided to independent writers. It also has its own distribution and product transportation facility, which is an example of the forward integration as Amazon delivers its products directly to customers or end-users.
The acquisition of Whole Foods is considered as the forward integration because Amazon is able to use the food outlets of Whole Foods as places for selling its products or to increase customer base. Though Amazon is into the grocery business already, still due to this acquisition, it raised as a major player in the industry.
B) Backward Integration
A merger or acquisition process through which a company acquires control over businesses that supply the raw material required for the production of finished goods to the company; is considered as Backward integration. In other words, an expansion of a company towards a backward direction or upstream in order to gain control of production parts by moving back in its supply chain is known as backward integration.
For example, a retail or distribution company acquires a manufacturer or raw material supplier of its products. The merger of a company with its raw material supplier may result in cost-cutting as the company has all the required parts within rather than to depend on outside sources for the same. So, the big distribution or retail companies purchase manufacturers or suppliers of their products that save transportation expenses by implementing a backward integration strategy.
Merits of Backward integration strategy
1. Control on expenses or costs
The process of the supply chain includes many middlemen and each step of the supply chain process gives a profit-earning opportunity to the middleman. So, the cost of the product becomes double or triple once it reaches a warehouse of the company. This results in more costly finished goods for the end-user or customer.
Through backward integration strategy, a company acquires the raw material suppliers and eliminates the middlemen indulged in the production process. This reduces the purchasing cost of raw materials. Taking control over the whole supply chain also results in less wastage, transportation cost, and other related costs which incurs before the delivery of raw material in the company’s warehouse.
2. Better control over the supply chain
A company has much better control over its supply chain’s process i.e. from raw material production to the production of finished goods by acquiring the raw material of manufacturers. Through the acquisition of raw material suppliers, the manufacturer can also gain greater control over the quality, delivery, and quantity of raw materials.
3. Edge over competitors
Backward integration strategy is also used by companies to have a competitive edge or advantages over competitors. For instance, technical companies adopt backward integration in order to gain access to trademarks, patents, etc.
By the acquisition of such companies, competitors are not able to use the same resources and other companies are bound to find alternatives in the industry. Entry barriers are created by acquiring suppliers. Hurdles may be faced by the new competitors to get the production process related to raw material suppliers.
Real-life examples of vertical integration using Backward integration
The example of technology brand Apple is the perfect example for vertical integration i.e. both forward and backward vertical integration. Apple sells its products through its retail locations and has its own manufacturing facilities across the world. Apple acquired the firm AuthenTec in 2012 which develops a touch-based ID fingerprint sensor that is used for its iPhones. A laboratory was opened in Taiwan by Apple in 2015 for making OLED and LCD screen technologies. It also purchased a manufacturing facility of 70,000 sq ft in North San Jose in the same year. Through these investments, Apple is able to move backward along with its supply chain through backward integration, and this provided independence and flexibility in its manufacturing.
The brand McDonald is also considered as a famous example of vertical integration strategy through backward integration. The worldwide popular fast-food chain McDonald has expertise in implementing a vertical integration successfully. The brand is operating 100 plus stores all over the world and serving food beverages has implemented a backward integration strategy for the whole supply chain. For preparing its eatables, McDonald’s developed its own manufacturing units for raw-material procurement.
Furthermore, the brand is into raising its own agriculture-based products for maintaining the quality of products and to ensure the offering of the same products to end-users or customers around the globe. Through this backward integration, the brand is recognized as a successful food chain at the global level, and also, it is able to deliver more value of money to its loyal customers.
Few more real-life examples of Vertical integration
1. Zara brand
A successful vertical integration strategy was implemented by fast-fashion giant Zara. The brand successfully combined the main parts of the supply chain i.e. design, retail, and manufacturing to develop a much faster production cum distribution channel that has facilitated the brand to produce and sell many more collections in a year as compared to its competitors. The vertical integration of Zara has provided flexibility to the brand which has given a competitive edge over its competitors due to comparatively faster access to new products to customers as per the trends of the market.
One example of vertical integration is India’s famous supermarket chain store DMART. The industry in which the brand operates is the Food and Merchandise that generally has to face the pressure of high margin due to the boom in e-commerce. In such a challenging environment, the brand is able to successfully implement both types of vertical integration i.e. backward and forward that ultimately results in consistent ROI (Return on investment) for both customers and shareholders.
A corporate strategy that was followed by the company Netflix is also an example of vertical integration. Initially, the company opened up as a simple DVD rental company that used to offer a vast collection of movies through the mail. After the physical rental market went down, Netflix took the opportunity of technological advancements and started offering TV shows and movies in digital form. Then it was decided by the management of the company to raise revenue by entering into the segment of creating original content. Today, Netflix controls all areas related to the production and distribution of its original content.
Alibaba is considered as a popular and one of the largest e-commerce platform company and its services are available almost all over the world. The continuous expansion of the company created the need for the company’s expansion in other areas in order to maintain its growth. Alibaba achieved this by taking over of product warehousing and sourcing or vertical backward integration of those operations that were near to the source. Also, the company has adopted forward integration by expanding into the payment and distribution systems, and operations that are nearer to the end-user or customers.