Vertical Integration: Pros, Cons and Examples

5 Reasons Companies Go Vertical

vertical integration
The auto industry in the U.S. is vertically integrated through a tight relationship with dealers. Photo: Glowimages/Getty Images

Definition: Vertical integration is when a company controls more than one stage of the supply chain. That's the process businesses use to turn raw material into a product and get it to the consumer. There are four phases of the supply chain: commodities, manufacturing, distribution and retail. A company vertically integrates when it controls two or more of these stages. 

There are two types of vertical integration.

Forward integration is when a company at the beginning of the supply chain controls stages farther along. Examples include iron mining companies that own "downstream" activities such as steel factories. Backward integration is when a business at the end of the supply chain takes on activities "upstream." An example is when a movie distributor, such as Netflix, also manufactures content.

Examples

An example of vertical integration is a store, like Target, which has its own store brands. It owns the manufacturing, controls the distribution, and is the retailer. Because it cuts out the middleman, it can offer a product like the brand name product, but at a much lower price.

Manufacturers can also integrate vertically. Many footwear and apparel companies have a flagship store that sells a wider range of products than you can get from a regular retailer. Many also have outlet stores that sell last season's products at a discount.

Five Advantages

Any the five advantages of vertical integration gives the company a competitive advantage over non-integrated companies. That means consumers are more likely to choose its good or service. That's because the costs are lower, the quality is better or the product is tailored directly to them.

The first advantage is that the company doesn't have to rely on suppliers. They are less likely to face disruptions from those that aren't well-run. They can avoid frequent strikes and labor disputes from companies that are in socialist countries. 

Second, companies benefit from vertical integration when its suppliers have a lot of market power, and can dictate terms. That is critical if one of the suppliers is a monopoly.  If the company can go around these providers, it reaps many benefits. It can lower internal costs and have better delivery of needed items. It's less likely to be short of critical elements.

Third, vertical integration gives a company economies of scale.  That's when the size of the business allows it to cut costs. For example, it can lower the per unit cost by buying in bulk. Another way is to make the manufacturing process itself more efficient. A third example is eliminating overhead by consolidating management.  

Fourth, a retailer with vertical integration knows what is selling well. It can then "knock off" the most popular brand-name products. That's when it copies the ingredients or manufacturing process. It creates similar, but store-branded, marketing messages and packaging.

Only powerful retailers can do this. That's because the brand-name manufacturers can't afford to sue for copyright infringement. They are unwilling to risk losing distribution through the retailer.

The fifth advantage is the one that's most obvious to consumers. That's low prices. A company that's vertically integrated can lower costs. That can be transferred to the consumer as lower prices. Examples include Best Buy, Walmart and most national grocery store brands. 

Disadvantages

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

That reduces flexibility. Vertically integrated companies can't follow consumer trends that take them away from their factories.

They also can't change factories to countries with lower exchange rates.

A third problem is a 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 CEO that's good at both.

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. That culture isn't responsive to the needs of factories. The clash of cultures can lead to misunderstandings, conflict and lost productivity. To find out how to manage this, see Cultural Diversity in the Workplace