What Is Vertical Integration?

Table of Contents

1. What Is Vertical Integration

2. What Is the Difference Between Vertical Integration and Horizontal Integration?

3. The 3 Types of Vertical Integration

4. How Does Vertical Integration Work?

5. Cost-Effective Vertical Integration

6. Why Do Companies Use Vertical Integration?

7. Pros and Cons of Vertical Integration

8. The Benefits of Vertical Integration

9. The Disadvantages of Vertical Integration

10. Is Vertical Integration a Good Idea?

One of the ways that companies seek to gain control of their supply chain is through vertical integration. It provides many benefits, such as more control over quality and production and delivery timelines. In some cases, after the initial investment, it may even lower the costs of providing their products and services. Let’s take a look at vertical integration, why companies do it, and the pros and cons of vertically integrating.

What Is Vertical Integration

Vertical integration is an investment strategy that companies use to improve the quality or long-term health of their supply chain or just to expand their business. There are many reasons why a company may decide to vertically integrate:

Companies that rely on a large number of suppliers are at risk of disruption to their business if their suppliers experience issues. This is especially true if there are limited supplier options for aspects of their product or service. They may pursue vertical integration to improve the health of their supply chain.
Companies want more control over the quality of their products or services.
Suppliers may not be able to offer the customization that the company wants, or the company wants to move production in-house to keep planned innovation under wraps.
Companies may want to expand into new markets to increase profitability.

Whatever the reason, vertical integration involves companies either acquiring existing suppliers or starting their own business in that space. This involves significant upfront costs, so companies will often carefully weigh their options between whether vertical integration would be more efficient than expanding business in other ways, like opening a new location.

To ensure a smooth transition and legal compliance during their move towards vertical integration, the company consulted a business formation attorney for expert guidance on restructuring and acquisition processes.

What Is the Difference Between Vertical Integration and Horizontal Integration?

Vertical integration and horizontal integration are two different types of acquisitions. In both, a company expands its business by acquiring another business.

In vertical integration, the company acquires a business that is not in its market but is a part of its supply chain. In horizontal integration, the company acquires a competitor.

The goal of horizontal integration is to increase market share or acquire the tools, processes, technology, or even customer base of a competitor. The goal of vertical integration is to gain more control over the supply chain.

Aspect	Vertical Integration	Horizontal Integration
Definition	Vertical integration occurs when a company expands its operations into different stages of production within the same industry, often involving the supply chain process.	Horizontal integration happens when a company acquires or merges with other companies at the same level in the industry, usually competitors.
Objective	To control or own the supply chain, from raw materials to distribution, to increase efficiency and reduce costs.	To increase market share, reduce competition, and achieve economies of scale.
Example	A car manufacturer acquiring a tire company or a steel production plant to produce its own materials.	A large fast-food chain buying out smaller fast-food chains to expand its market presence.
Impact on Competition	May reduce dependence on suppliers or distributors, but does not necessarily change market competition dynamics significantly.	Directly reduces the number of competitors in the market, potentially increasing market power.
Regulatory Concerns	Less likely to face antitrust issues unless the integration leads to market dominance at one stage of the supply chain.	More likely to face regulatory scrutiny for antitrust or monopoly concerns, especially if it leads to significant market consolidation.
Benefits	Can lead to greater control over quality, cost reduction, and improved supply chain coordination.	Offers increased market share, reduced costs through economies of scale, and potential for greater market dominance.
Risks	Can involve significant capital investment and may lead to inefficiencies if the company lacks expertise in the new areas of operation.	Risk of regulatory pushback, potential for cultural clashes in mergers, and the dilution of brand identity.
Industry Examples	Common in manufacturing industries like automobiles and electronics.	Prevalent in sectors like retail, media, and banking.

Whether horizontal integration or vertical integration is the best expansion option will depend on a company’s market, business objectives, and frustrations. Considering both the long-term and short-term goals can be helpful in making that decision.

The 3 Types of Vertical Integration

There are 3 types of vertical integration: backward integration, forward integration, and balanced integration.

Backward Integration

Backward integration is where a company expands its control into an earlier step of the production process. Usually, this will be one step backward. Retailers will often do this to gain higher profit margins or to achieve more customizability of the products they sell.

For example, let’s say a t-shirt design company has been purchasing plain t-shirts from a supplier and adding their design before selling them to retailers. When they are ready to expand, they may decide to start manufacturing their own t-shirts. This type of vertical integration will give them a multitude of benefits:

Lower production costs.
Higher potential profit margins or more competitive prices for retailers.
More control over product quality.
Increased opportunity to test and innovate.
Expansion of product line options.
Diversified income.
More reliable supply of t-shirts.

Backward integration offers the t-shirt design more stability and options. This is why it is a popular type of vertical integration, especially with companies whose product quality relies heavily on their suppliers.

Forward Integration

This type of vertical integration involves expanding into the next step in the supply chain. Depending on where the company sits in the supply chain, this may involve becoming distributors or even retailers.

If we return to the t-shirt designer company, they may decide to start selling their t-shirts online to add another stream of income to their business. This type of vertical integration will provide the following benefits:

Higher profit margin on the t-shirts they sell online.
Connection with the end-user (the people who wear their t-shirts) and ability to build a following around their t-shirts.
More control over the marketing and display of their products.
Create further opportunities for expansion.
Grow the demand for their products.
Market testing opportunities.

Forward integrations are not as common because retailers tend to have the most purchasing power in the supply chain.

Balanced Integration

Balanced integration is where a company expands in both directions. They will purchase or merge with companies ahead of it in the supply chain and behind it in the supply chain. This requires significant capital and can be risky, which is why it is an uncommon type of vertical integration. However, the benefit is that the company will have a high level of control over the supply chain. In the case where the supply chain is simple, they may even have full control of their supply chain after a balanced integration.

How Does Vertical Integration Work?

To understand how vertical integration works, you must first understand how the supply chain works.

A supply chain refers to the steps along the process of turning raw materials into a product and selling it to the end-user. There may be many steps along the way, for example:

Raw material sales
Manufacturing
Production
Distribution
Retail

Vertical integration happens when a company in one step of the supply chain expands its business by handling another step of the supply chain. As with the types of integration above, this is usually a step before or after. For example, a manufacturer may decide to produce its own products, or a production company may decide to sell directly to end-users.

A company may undertake vertical integration by starting its own business in that space or by purchasing or merging with an existing company in that space. Mergers and acquisitions are the most common vertical integration method because the business is already mostly set up. There is already infrastructure, tools, processes, and staff in place. Instead of building a business from the ground up, the company can focus on customizing this new step in the supply chain.

In some cases, vertical integration can create a monopoly. This usually happens when a company expands into significant portions of the supply chain or owns the end-to-end process entirely. This provides them with significant control and profitability, which often earns them greater market share.

The most well-known example of this is Amazon. They have used vertical integration to expand their business and now have ownership of retail stores, delivery services, warehouses, and their own products.

Cost-Effective Vertical Integration

It is possible to gain the benefits of vertical integration without the cost of buying a company outright. There are plenty of options like partnerships or buying a stake in another company. The options are often referred to as degrees of vertical integration.

The first option is vertical integration and buying the company outright. This is usually the option if a company wants complete control over an aspect of its supply chain. In buying the business, they are acquiring all assets, including tools, staff, processes, technology, and contacts. Depending on the company’s goals, their vertical integration plans may involve taking over one aspect of the supply chain or they may involve taking over the entire end-to-end process.

The second option is a quasi-vertical integration. There are many ways a company can have more control over its supply chain without purchasing another business. They tend to be more cost-effective and flexible. Some examples of a quasi-vertical integration include:

Buying a stake in a supplier (minority interest)
Franchising
Purchasing assets or technology
Joint ventures
Strategic alliances

These may be enough to overcome short-term frustrations or have greater input into that aspect of your supply chain.

The third option is to negotiate more favorable contracts with your suppliers. These may be long-term or short-term contracts to overcome a point of frustration in your relationship. The terms of the contract can be negotiated so that you both get a desirable outcome. Contracts such as these may pave the way for future contracts, quasi-vertical integration, or full vertical integration in the future. Short-term contracts or spot contracts are valuable to overcome immediate issues in the supplier relationship. They can tide you over while you find a better solution or help you overcome short-term supply chain disruption.

Why Do Companies Use Vertical Integration?

A company will decide to pursue vertical integration for a wide range of reasons. They may want more control of their supply chain. This could be because they want more control over their customer experience, product quality, or frustrations with suppliers.

Alternatively, they may pursue vertical integration as a way to diversify their company or increase profits. In the short term, vertical integration is expensive, but it results in significant long-term savings.

Pros and Cons of Vertical Integration

Vertical integration is not right for all types of business. It is important to consider the pros and cons of vertical integration when considering if it is right for your company.

Aspect	Pros of Vertical Integration	Cons of Vertical Integration
Control Over Supply Chain	Allows greater control over the production process and supply chain, leading to more consistent quality and availability of inputs.	Requires significant investment and resources to manage different stages of production, which can be complex and inefficient.
Cost Reduction	Can lead to cost savings through the elimination of middlemen and reduced transaction costs.	The costs of setting up and maintaining operations at multiple stages can be high, and potential cost savings may not materialize.
Market Dependence	Reduces dependence on suppliers and distributors, providing more stability and less vulnerability to external market fluctuations.	Can lead to over-reliance on internal capabilities and reduce flexibility in responding to market changes.
Competitive Advantage	Provides a competitive edge by unique positioning in the market, potentially leading to a monopoly in certain areas.	Could potentially lead to antitrust issues and regulatory scrutiny if it results in market dominance.
Profit Margins	Higher profit margins may be achieved by owning more of the production process and reducing external costs.	Inefficiencies in new areas of operation can lead to unexpected costs, negating potential profit margin improvements.
Innovation and Coordination	Easier coordination across different stages of production can enhance innovation and responsiveness to customer needs.	Vertical integration can sometimes lead to complacency and a reduction in innovative efforts due to a lack of competitive pressure.
Business Focus	Provides the ability to focus on core competencies at various stages of the supply chain.	May divert attention and resources away from the core business, leading to a dilution of expertise.
Market Response	Quicker and more efficient response to market demands due to control over the supply chain.	Possible slow response to market shifts if the company becomes too large and unwieldy due to integration.

The Benefits of Vertical Integration

There are many reasons why a company may consider vertical integration, but there are numerous benefits. Here are some of the most common benefits of vertical integration:

Cost-effectiveness: One of the most common reasons for vertical integration is to lower costs so that the company can earn more profit, offer more competitive pricing, or both.
Streamlined logistics: Frustration over logistical problems is often the catalyst behind vertical integration. A company may struggle to find reliable suppliers or have faced issues with rising costs or timely supply and decide to eliminate these issues by doing it themselves.
Customizability: Companies are somewhat restricted by what their suppliers can offer. Vertical integration is a way for a company to gain more control over its product design.
Quality: Changes to a supplier’s product or service can have implications on the quality of the company’s offering. A company may choose vertical integration if suppliers are making it difficult for them to offer the same quality product or service.
Market insights: Buying a retailer may give a company insight into trends in consumer behavior. In that way, vertical integration can help companies make in-demand products.

The Disadvantages of Vertical Integration

At the same time, there are some disadvantages of vertical integration that may outweigh the benefits. Here are some of the most common disadvantages:

Cost: Vertical integration requires a large upfront investment. The costs involved include acquisition costs, new tools and equipment, system migration costs, possible downtime, staff training costs, and hiring costs.
Over-Diversification: Diversification can be either a positive or a negative aspect of vertical integration. The downside of diversification is that if it is not well-managed, it can result in a company losing focus on its business objectives. As in all cases, growth should be purposeful rather than growth for growth’s sake.
Loss of Expertise: Suppliers and Buyers often have a symbiotic relationship and regularly swap insights. This may be lost in vertical integration if a company does not take care to ensure they hire talent and expertise in their new venture.
Short-term losses: There are often teething problems involved in expansion and taking over companies. This can mean that the company will experience losses following vertical integration until those issues are straightened out.

Is Vertical Integration a Good Idea?

The answer to whether vertical integration is a good idea will vary from company to company. A company may work with multiple suppliers for different aspects of their product or service. Vertical integration should be reserved for aspects of the supply chain that are central to providing the products and services. Otherwise, it may be more beneficial to switch suppliers or negotiate a more favorable contract.

Vertical integration can also be a good idea when a company is experiencing significant supply frustrations, especially if they have limited alternatives. They have the ability to solve the issues they have been facing and not have to worry about any future issues that come from a supplier who has a monopoly on their market.

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