What is vertical integration?

By eliminating reliance on external contractors or suppliers and assuming direct ownership of multiple stages of the production process, vertical integration enables a business to streamline its operations. Instead of outsourcing, companies can accomplish vertical integration by acquiring or establishing their suppliers, manufacturers, distributors, or retail locations. Vertical integration carries inherent risk due to the substantial initial capital outlay necessary.

The Operation of Vertical Integration

Vertical integration occurs when an organization endeavors to expand its presence throughout the entirety of the supply chain or manufacturing procedure. Instead of concentrating on a single point, a business implements vertical integration to increase its independence in other process stages. For instance, a manufacturer might want to source raw materials in-house or sell them directly to consumers.

Typically, the sales process or supply chain commences with procuring primary materials from a supplier and concludes with the consumer receiving the finished product. Vertical integration necessitates that an organization regulate at least two processes connected to developing and distributing a given good or service. The organization must purchase or replicate a portion of the previously outsourced manufacturing, distribution, or retail sales process.

Businesses can achieve vertical integration by acquiring their suppliers to cut manufacturing costs. They may establish physical and online establishments and invest in the retail phase. Fleets of vans and warehouses can be purchased to exert control over the distribution process.

These procedures require a significant financial outlay for facility setup, additional personnel, and management recruitment. Additionally, vertical integration ultimately expands and intricates the organization’s activities.

Expanding a business’s operations along a singular supply chain may lead to establishing a market monopoly. A monopoly resulting from vertical integration is an alternative term to a “vertical monopoly.”

Varieties of vertical merger

Several methodologies exist through which an organization may attain vertical integration. Forward and reverse integration are two prevalent types.

Reverse Integration

When a business implements backward integration, ownership and control of its products are transferred to an earlier stage in the production process or supply chain.

Appropriately, this type of vertical integration is characterized by a firm’s pursuit of acquiring a provider or distributor of primary materials at the outset of the supply chain. Frequently, the initial companies in the supply chain specialize in a particular process stage (e.g., a timber distributor for a furniture manufacturer). The furniture manufacturer would endeavor to procure the timber internally to optimize operations.

Amazon.com, Inc. was initially an internet-based bookstore that sold books acquired from well-established publishers. In addition to continuing to operate in this capacity, it has expanded into publishing. Eventually, the business grew into thousands of branded products. Amazon then launched Amazon Basics, its private trademark, to sell a significant portion of these items directly to consumers.

In the Forward Direction

Forward integration enables a business to grow by assuming authority over distributing and selling its finished goods.

A textile manufacturer may sell its completed goods to an intermediary, who then distributes them to individual retailers in lesser quantities. In the event of forward vertical integration, the apparel manufacturer would become a subsidiary of a retailer and gain the ability to establish its retail locations. The company’s objective is to increase revenue per unit, assuming its retail division can function optimally.

Forward integration is a less prevalent form of vertical integration due to businesses’ difficulties when acquiring entities further along the supply chain. For instance, the purchasing power and cash flow of the largest retailers at the end of the supply chain are frequently the highest. Conversely, these retailers often possess the necessary capital to acquire others, an instance of backward integration.

Harmonious Integration

A balanced integration is a vertical integration strategy in which a company seeks to consolidate with firms preceding and succeeding in the supply chain. To perform balanced integration, a business must function as an intermediary and produce a product. This is because, besides sourcing primary materials, the company must collaborate with merchants to deliver the finished product.

The supply chain process of Coca-Cola (KO) encompasses the procurement of primary materials, the formulation of the beverage, and the distribution of bottled drinks for retail. If Coca-Cola decides to consolidate with retailers who will distribute the product in addition to its raw material suppliers, the organization would be implementing balanced integration.

Balanced integration, despite being the most expensive and hazardous due to the diversified nature of business operations, offers the most significant benefit: a company is more likely to have complete (if not total) control over the entire supply chain process.

While vertical integration may result in cost reductions and enhanced supply chain efficiency, it can also entail substantial capital expenditures.

Positives and Negatives Regarding Vertical Integration

Vertical integration can assist a business in decreasing expenses and increasing productivity. Nevertheless, its effective implementation could positively impact the organization.

The benefit

Vertical integration aims to increase management’s influence over the manufacturing process and supply chain. Vertical integration may reduce expenses, economies of scale, and dependence on external entities if executed effectively.

When executed internally, vertical integration can reduce transportation expenses, streamline logistics, and shorten production cycles. Additionally, it may lead to products of superior quality, given that the organization exercises direct authority over the primary materials utilized in the production process.

Occasionally, businesses may be subject to the whims of suppliers with market dominance. Vertical integration enables enterprises to bypass the constraints imposed by external monopolies. Furthermore, a retailer may provide a company with valuable information regarding which products sell the most, which can be applied to critical manufacturing and product decisions.

The disadvantages

Instantaneously, businesses cannot vertically integrate. Indeed, it is a protracted undertaking that necessitates broad support. Furthermore, this entails substantial initial capital outlays necessary for company acquisition, system integration of new and existing technologies, and comprehensive staff training throughout manufacturing.

Businesses that engage in vertical integration do relinquish a certain level of flexibility. Because they allocate capital to a particular process or product, this is the case. Rather than being able to refuse purchases from external vendors, a business will likely have made irretrievable financial commitments. Additionally, an organization may forego the chance to acquire distinctive expertise from various external vendors.

Additionally, vertical integration may have several social effects. Businesses risk becoming overly ambitious and losing sight of their ultimate objective. Additionally, customers might disagree with a major manufacturer’s ethos if it engages them directly.

Pros

• Long-term cost savings as a result of advantageous pricing and limited disruptions in the supply chain
• Scale economies that enhance efficiency
• Eliminates or reduces dependence on external suppliers or parties.
• More significant management of the process, inputs, and products may produce superior goods.

Cons

• Major upfront capital expenditures are necessary for implementation.
• Decrease the long-term flexibility of an organization.
• Inattention to the fundamental objective or customer of an organization
• A client base that is dissatisfied and prefers to do business with a smaller retailer

Horizontal Integration as opposed to Vertical Integration

Vertical integration pertains to procuring a critical supply chain element previously under contract with the organization. It may give the business greater control over its products and lead to cost savings. It may increase the profits of the business.

However, horizontal integration entails the procurement of a rival or affiliated company. A business may do this for any or all of the following purposes:

• Remove a competitor and eliminate its competition.
• Diversify or enhance its primary business.
• Develop additional markets
• Enhance its total sales

In contrast to the vertical integration approach, which involves a company’s expansion along a single process, horizontal integration entails a more targeted transformation of the organization into a niche entity within a particular market. As an illustration, a corporation may opt to specialize in a single facet of a supply chain—such as materials sourcing, manufacturing, or retail—by acquiring comparable firms to implement horizontal integration.

Considerable deliberation has been devoted to determining when it is more advantageous to enter into a contract with another company rather than acquire it. Decades-old modern economic theory has been published on the subject.

Instances of vertical consolidation

Netflix (year)

Netflix (NFLX) serves as an exemplary illustration of vertical integration. DVD rental was the company’s original business model before its expansion into online streaming of films and films licensed from major studios. Subsequently, executives realized they could increase their profit margins by creating original programming such as the critically acclaimed “Stranger Things” and “Grace & Frankie.” The corporation also produced several explosives, including the 2016 film “Get Down,” which reportedly cost $120 million.

Presently, the organization employs its distribution model to advertise its proprietary content and studio-licensed programming.

Before relying solely on others’ content, Netflix increased its involvement in the entertainment development process through vertical integration.

The Fossil Fuel Sector

Consider the fossil fuel sector as an illustration of vertical integration. British Petroleum’s (BP), ExxonMobil’s (XOM), and Shell’s (SHEL) exploration divisions pursue new oil sources, while subsidiaries are dedicated to oil extraction and refinement. Their respective transportation divisions transport the final product. Their retail divisions run gas stations, from which they deliver their products.

AMC and Ticketmaster Live

The 2010 merger of Live Nation and Ticketmaster created a vertically integrated entertainment corporation that manages and represents artists, stages performances, and sells event tickets. In addition to managing and owning concert venues, the merged organization distributes tickets for the performances at those venues.

When is vertical integration applied to an acquisition?

Vertical integration occurs when an organization acquires an outsourced component of a critical production or distribution process and subsequently gains direct control over it.

Procuring a supplier from a business is called “backward integration.” The process by which a company obtains a retailer or distributor is called forward integration. The organization frequently acquires a retailer or wholesaler client in the latter scenario.

Does vertical integration benefit an organization?

Whether or not vertical integration is prudent for a business is contingent on its long-term interests. A corporation may purchase or manufacture the buttons if it manufactures apparel with buttons. Making them effectively cancels out the markup that the button maker imposed. It could provide the company with increased adaptability to modify designs or hues while also mitigating the challenges associated with supplier relations.

Moreover, the organization would be required to establish or procure an entirely distinct manufacturing process dedicated to buttons, procure the necessary raw materials for button production and attachment, employ personnel to manufacture the controls, and assemble a management team to oversee the button division.

What is the distinction between horizontal and vertical integration?

Vertical integration involves a business acquiring various supply chain components that it does not currently control. The horizontal integration strategy entails procuring comparable firms to enhance one’s capabilities. Vertical integration expands the scope of a business, whereas horizontal integration can facilitate a deeper entry into a particular market.

Why do organizations implement vertical integration?

Businesses implement vertical integration to exert greater control over the supply chain of a manufacturing process. By performing specific procedures internally, the manufacturer can exert control over the timing, process, and various aspects of subsequent stages of development. Additionally, long-term cost reductions may result from owning a more significant portion of the process (as opposed to purchasing products from outside sources at a markup).

In summary

Vertical integration refers to a corporate structure wherein a single entity exercises control over multiple phases throughout the supply chain. The organization endeavors to internalize processes rather than depend on external suppliers to attain greater control over the manufacturing process. While vertical integration may initially lead to higher initial capital expenditures, its ultimate objective is to optimize processes to achieve more streamlined and regulated operations over an extended period.

Conclusion

• Vertical integration entails directly owning suppliers, distributors, or retail locations to increase supply chain control.
• Advantages may include increased control, decreased expenses, and enhanced efficiency throughout manufacturing or distribution.
• Vertical integration frequently necessitates substantial initial investment, which can curtail the long-term adaptability of a business.
• A vendor may decide to make a strategic acquisition of a business located at a higher level of the supply chain, such as a retailer.
• Backward integration occurs when a supplier endeavors to procure a company that is situated before it in the supply chain, such as a provider of basic materials.