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Vertical Integration

Guide to Understanding Vertical Integration

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Vertical Integration

Vertical Integration – Merger Strategy

Vertical integration consists of a company taking control over at least two steps in a given value chain, such as the production, distribution, or selling of the finished good or service, as opposed to outsourcing certain tasks.

The vertical integration of a supply chain implies that each step of the process is owned and closely controlled by a combined entity.

If a company publicly announces its plans to control and own aspects of its supply chain rather than relying on external suppliers as it did in the past, the shift is called “vertical integration”.

Furthermore, the merged company possesses a greater proportion of the total market share, which directly causes its buyer power to increase and gives it more negotiating leverage over its suppliers and distributors.

The end goal for pursuing vertical integration is to streamline the operational process from start to finish, i.e. having more ownership over all of the various stages in a production process.

Companies often opt to outsource or rely on external 3rd parties in an effort to reduce spending, yet sub-par production and quality issues can cause real damage to the branding of the company and diminish the trust of their customer base.

Therefore, vertical integration consists of a company possessing ownership over most, if not all, stages of the production cycle, including the suppliers and distributors.

Pros/Cons of Vertical Integration

Normally, the supply chain process starts with purchasing raw materials from suppliers – followed by a wide range of potential steps depending on the context – until the final product reaches the customer.

The strategy of vertical integration implies the company controls multiple stages in its supply chain, thereby reducing or even eliminating the need for reliance on any third parties.

Vertical integration can result in the production process becoming more efficient with reduced costs (and higher profit margins).

The drawback, however, is that there is a great number of initial costs that are required to build the infrastructure and purchase the necessary equipment. Until the company recoups the initial cost, the integration would remain unprofitable.

Ownership of the supply chain from start to finish might initially sound appealing, but more control over the process does not necessarily result in higher quality.

While factors such as communication may be improved, the management team must have a thorough plan in order to be capable of managing every step of the production process.

Having an inept management team responsible for overseeing the complex supply chain can be very risky.

Example Vertical Integration

Suppose an electronics company decided to purchase a supplier that they have worked closely alongside in the past, and those suppliers’ parts (and components) are crucial inputs to the device.

If the electronics company decides to purchase the supplier to reduce manufacturing costs and streamline its operations, the acquisition would be an example of vertical integration.

Additionally, another example of vertical integration includes purchasing trucks and fleets of vehicles to transport the parts, i.e. the company is now in control of the entire distribution process.

Types of Vertical Integration: Forward vs. Backward Integration

There are two types of vertical integration:

  • Forward Integration → When an acquirer moves downstream; i.e. the company’s acquisition target moves them closer to the end customer, e.g. distributor or technical support.
  • Backward Integration → When an acquirer moves upstream, the company is purchasing suppliers or product manufacturers (that are further away from the end customer).

A company undergoing backward integration is shifting its ownership and control of the process to an earlier point in the supply chain, whereas a company pursuing forward integration is moving forward to own and control the production stages that interact more closely with the end customers, such as the distribution process.

Vertical Integration vs. Horizontal Integration

Horizontal integration refers to a merger where competitors are combining their operations (and asset base) to benefit from economies of scale, increased buyer power over suppliers and vendors, and expanding their reach into new geographical locations (and end markets).

The differentiating factor between horizontal integration and vertical integration is that horizontal integration is the merger of close competitors operating in the same market.

On the other hand, vertical integration is between companies operating at different stages in the value chain and with distinct responsibilities in the production cycle.

In contrast to horizontal integration, vertical integration consists of a merger involving companies functioning at various levels of the value chain, such as either upstream or downstream activities.

Each company engaged in vertical integration has its own unique role at a specific stage of the production process.

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