What’s it: Vertical integration is the company’s action to expand business by entering other stages of the current supply chain under its ownership or control. In other words, the company enters the downstream or upstream business. This may be through mergers, acquisitions, or internal growth.
The company strives to control all stages in the supply chain, from raw material extraction to final product sales. An example of vertical integration is a manufacturing company acquiring its product distributor or supplier of raw materials.
Vertical integration aims to secure the supply chain and capture value creation and profit in each value chain. It allows the company to control the supply and sales, thereby reducing costs and increasing efficiency.
Nevertheless, this integration strategy also has weaknesses. Apart from requiring a large investment, failures also arise because companies become less focused on their core business or core competencies.
Vertical integration types
The supply chain involves a variety of companies and activities. For manufacturing companies, the stages start from natural resource extraction activities, raw material production to product sales to end customers.
Before integrated, a company focused on one activity, for example manufacturing consumer products. Meanwhile, raw material production and sales activities are under other companies. The company cannot control its raw material suppliers or distributors because it does not own their shares.
To increase control over raw material supply and sales, the company pursues a vertical integration strategy. Its main motive is to reduce production costs and ensure quality and on-time delivery of raw materials. Also, companies can better control distribution, including warehousing and shipping of products to end-users.
In general, vertical integration falls into two types based on the position of the company in the supply chain:
- Backward vertical integration
- Forward vertical integration
Backward vertical integration
Backward vertical integration is when a company expands its business by entering the upstream market. Or, in other words, the company enters the input market. Its primary purpose is to secure input supply (specifications and delivery times) to ensure consistent final output quality.
When a cooking oil company establishes a crude palm oil subsidiary, it is an example of backward vertical integration. Or, in another case, the carmaker takes over the tire company.
Forward vertical integration
Forward vertical integration is the opposite of backward integration. Here, the company expands the business into its downstream market (distribution or retail). For example, suppose a car manufacturer takes over a car distributor.
A forward vertical integration aims to ensure the product reaches the customer without damaging the company image. Also, the company can gather information and receive feedback from customers. It is useful for new product development and creating superior value in the future.
Difference between vertical integration and horizontal integration
Integration strategies fall into two types, vertical and horizontal integrations. Vertical integration consolidates multiple businesses at different supply chain stages (suppliers and distributors). Meanwhile, horizontal integration consolidates businesses in the same supply chain stage (competitors).
To carry out horizontal integration, companies acquire their competitors. Another option is through a merger. Also, the company can set up a subsidiary in another country with the same core business.
Under horizontal integration, the company’s size grows more extensive, allowing it to have more market power, both directly and through its subsidiaries. Profits should increase as the firm has more customers, supporting higher sales output and economies of scale.
Some of the horizontal integrations were successful, and some failed. Failure can come from cultural conflicts and failure to synergize core competencies. In the case of an acquisition, failure also occurs because the takeover’s cost is higher than the acquisition value.
Compared to horizontal integration, vertical integration is less prone to tighter scrutiny by the government. It does not make monopoly power as in horizontal integration.
In contrast, under a horizontal integration, acquisitions and mergers with competitors are subject to the anti-monopoly law. Both increase market power and are vulnerable to anti-competitive practices. For example, in duopoly markets, horizontal mergers result in monopolies, and they are illegal in some countries.
Three ways of business integration
Three alternatives to vertical integration are:
- Merger
- Acquisition
- Internal growth
Under internal growth, the company enters as a new player in the distribution or input markets. It establishes new subsidiaries, builds production facilities, and recruits workers on its own. It is usually slow and requires significant resources.
A faster alternative is to acquire a supplier or distributor. This strategy is also to avoid retaliation and competitive reactions from competitors in the target market. When a company enters as a new player, it adds new supply and depresses prices and profits. Hence, incumbents will prevent it.
Furthermore, a merger involves fusing two companies and leaving one surviving entity. Say, the manufacturer merges with the distributor and leaves the manufacturer as the surviving entity. In this case, management and employees are merged into the manufacturer and under one management.
In contrast to a merger, in an acquisition, the acquirer and the target company are still two entities and survive with independent management. After the acquisition, the target company becomes the acquirer’s subsidiary.
Advantages and disadvantages of vertical integration
Companies adopt a vertical integration strategy to gain tighter control over the supply or distribution networks. And the breakdown of advantages of vertical integration is as follows:
- Higher sales and profitability. Companies can capture more profit and value in each supply chain. Post-integration means consolidating revenue and profits, which their suppliers or distributors previously enjoyed.
- Lower production costs. Under one control, the company can save costs related to production, transportation, input quality inspection, and delivery time. Firms can transfer the cost savings in one supply chain to consumers (through lower prices).
- Reducing dependence on external parties. This is important when external parties experience financial difficulties or business failure. Thus, integration reduces disruption due to external parties’ unreliability.
- Stronger bargaining position. Through integration, supply, and distribution under company control. The company has a chance to negotiate specifications for quality, price, or credit terms, which it may not have had before integration.
- Get customer feedback. Companies get information about marketing and competition, which is valuable for developing new products and providing superior offers.
- Improve reliability. For example, companies ensure products arrive at customers in order and on time by increasing synergy and coordination between supply, production, and distribution.
- Build market powers and entry barriers. Firms can monopolize the market throughout the chain and provide competitors with less access.
On the other hand, vertical integration also contains the following disadvantages:
- Distracts business. Companies have some businesses outside of their core competencies, making the coordination process more complicated. They lose focus on the core business. Different businesses require different approaches to create value and profit.
- Adds risk. Getting into a new business means increasing business risk, not just increasing potential profits.
- More complicated management. Operations became fatter and bureaucracy more complex, making it more challenging to organize and coordinate business processes. It also reduces the company’s flexibility in responding to competitive and demand dynamics.
- Requires large capital. Companies must invest a lot of capital to take over another company or establish a subsidiary. Often, they finance it through debt, which increases financial leverage. When integration fails to create value higher than the cost of capital, it lowers firm value.
- Operating inefficiency. Buying from external parties is a better option than producing internally. It may be cheaper and more efficient. Being more focused, suppliers can achieve better economies of scale and competitive advantages, for example, because they can reach a broader range of sales and customers. Inefficiency also arises because management does not have a core business focus.
- Susceptible to internal failure. A failure in one supply chain disrupts operations as a whole. If forced to outsource to external parties, it will increase costs.
