Vertical Integration: Pros, Cons, and Examples

Vertical Integration Is a Restructuring Strategy

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Businesses are always looking for methods to reduce costs and control the quality of the products and services they provide. A company is able to create a competitive advantage by integrating different stages of its production process and supply chain into their business. This is called vertical integration.

Depending on the source of information, there are generally six accepted stages of a supply chain. The stages relative to vertical integration are materials, suppliers, manufacturing, and distribution.

There are three types of integration, each with several shared advantages and disadvantages when merging two businesses in different stages of production.

Types of Vertical Integration

There are more than a few types of vertical integration. All types involve a merger with another company in at least one of the four relevant stages of the supply chain. The difference depends on where the company falls in the order of the supply chain.

When a company at the beginning of the supply chain controls stages farther down the chain, it is referred to as being integrated forward. Examples include iron mining companies that own "downstream" activities such as steel factories.

Backward integration takes place when businesses at the end of the supply chain take on activities that are "upstream" of its products or services. Netflix, a video streaming company that distributes and creates content, is an example of a company with backward integration.

A balanced integration is one in which a company merges with other businesses to attempt to control both upstream and downstream activities.

Examples

An example of a company that is vertically integrated is Target, which has its own store brands and manufacturing plants. They create, distribute, and sell their products—eliminating the need for outside entities such as manufacturers, transportation, or other logistical necessities.

Manufacturers can also integrate vertically. Many footwear and apparel companies have a flagship store that sells a wider range of their products than are available from outside retailers. Many also have outlet stores that sell last season's products at a discount.

Pros and Cons
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Advantages

There are five noteworthy benefits of vertical integration that give a company a competitive advantage over non-integrated competitors.

A vertically integrated company can avoid supply disruption. By controlling its own supply chain, it is more able to control and deal with any supply problems itself.

A company benefits by avoiding suppliers with market power. These suppliers are able to dictate terms, pricing, and availability of materials and supplies. When a company can circumvent suppliers such as these, it is able to reduce costs and prevent production slow-downs caused by negotiations or other aspects external to the company.

Vertical integration gives a company better economies of scale. Large companies employ economies of scale when they are able to cut costs while ramping up productions—they take advantage of their size. For example, a company could lower the per-unit cost by buying in bulk or by reassigning employees from failing ventures. Vertically integrated companies eliminate overhead by consolidating management and streamlining processes. 

"Economies of scale" is the concept of producing more to lower prices. This increases supply, lowers fixed and variable costs per unit, and makes a product more attractive to consumers.

Companies keep themselves informed on their competition. Retailers know what is selling well. If a company was vertically integrated with a retail store, manufacturing plant, and supply chain, they would be able to create "knock-offs" of the most popular brand-name products. A knock-off is a copy of a product—a similar product but company-branded with company marketing messages and packaging. Only powerful retailers can do this. Brand-name manufacturers can't afford to sue for copyright infringement, as they would risk losing major distribution through a large retailer.

Lower pricing strategies can be used. A company that's vertically integrated can transfer the cost savings they create to the consumer. Examples include Best Buy, Walmart, and most national grocery store brands.

Disadvantages

The biggest disadvantage of vertical integration is the expense. Companies must invest a great deal of capital to set up or buy factories. They must then keep the plants running to maintain efficiency and profit margins

Vertical integration reduces a company's flexibility by forcing them to follow trends in the segments they integrated. Suppose a company acquired a retailer for their product and created an outlet store that carried the old merchandise as well. That retailer's competition began using a new technology which boosted their sales. The new parent company would now need to acquire that technology to stay relevant in that market.

Rapidly changing technology can have a major effect on integration. Different technologies across the various stages of supply can also make integration difficult and more expensive.

Another problem is the loss of focus. Running a successful retail business, for example, requires a different set of skills than a profitable factory. It's difficult to find a management team that's good at both. Integration can cause management to focus less on their core competencies, and more on the newly acquired assets.

Culture class is an issue. It's also not likely that any company will have a culture that supports both retail stores and factories. A successful retailer attracts marketing and sales types. This type of culture isn't responsive to the needs of factories and the clash can lead to misunderstandings, conflict, and lost productivity.

Vertical Integration of a Supply Chain

Many large businesses decide to control sourcing, manufacturing, distribution, and marketing of their products, instead of leaving it to other companies to handle one area or another.

Vertical integration, while advantageous to some large businesses that have positioned themselves correctly in their market and industry, is a step many businesses simply cannot afford to take. Any company considering this step should take care to thoroughly understand their ability to scale while absorbing the costs of acquisitions.

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Article Sources

  1. The National Bureau of Economic Research. "Do Prices Determine Vertical Integration?" Accessed Feb 13, 2020.