Vertical Integration, Its Pros and Cons with Examples

Five Reasons Companies Go Vertical

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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. 

Types of Vertical Integration

There are two types of vertical integration. Both combine at least two of the four phases of the supply chain. The difference depends on where the company originated.

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 retailer, 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 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.

© The Balance 2018

Five Advantages

Any of the five benefits of vertical integration gives the company a competitive advantage over non-integrated companies. Consumers are more likely to choose the integrated firm's goods or services. Either the costs are lower, the quality is better, or the product is tailored directly to them. These are the three types of competitive advantage.

The first benefit is that the company can avoid supply disruption. By controlling its own supply, it can avoid the problems of poorly-run suppliers. It also misses the frequent strikes and labor disputes from companies that are in socialist countries. 

Second, a company benefits by avoiding suppliers with a lot of market power. Those suppliers are able to 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 better 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. Vertically integrated companies eliminate 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. Its brand-name manufacturers can't afford to sue for copyright infringement. They are unwilling to risk losing distribution through a major 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. It can transfer those savings to the consumer as lower prices. Examples include Best Buy, Walmart, and most national grocery store brands. 

Four 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 plant running to maintain efficiency and profit margins

That reduces flexibility. Vertically integrated companies become chained to the profitability of its operations. Retailers can't follow consumer trends that take them away from their factories. They also can't change factories to countries with lower exchange rates. On the other end, vertically integrated suppliers must keep products in their stores.

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. A non-integrated company can even use cultural diversity in the workplace to compete against the vertically integrated one.

Key Takeaways

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. The advantages of vertically integrating a supply chain are:

·        Significant cost cuts, resulting in better profit margins or lower prices.

·        Control over distribution and supply.

·        Capacity to offer very competitive prices.

·        Greater market share.

·       Economies of scale.

But, there are downsides. Vertically integrated companies must face the following:

·        Huge capital investments from establishing new companies.

·       Inflexibility and slow responses to market trends.

·        Lost focus on its core competencies.

·        The culture doesn't support all aspects of a vertically integrated company.

Apple, Ford, Disney, AT&T, and Chevron are few examples of successful vertically integrated companies.