Vertical Integration: Definition, Examples, and Advantages
Companies can choose many business strategies to meet their supply chain and logistics needs. Each approach has advantages and disadvantages. The best method depends on a company’s specific needs, goals, and circumstances.
Vertically integrated corporations, like those in the booming field of vertical aerospace, are giants with a grip on multiple stages of their production process. This “vertical integration” can involve owning everything from raw material extraction to final product distribution, achieved through either backward integration (acquiring suppliers) or forward integration (taking over distributors).
Businesses may focus on efficiency and cost-cutting by opting for a lean, streamlined supply chain with minimal inventory and waste. Other companies may focus on flexibility and responsiveness and implement a more agile and adaptive supply chain that can quickly respond to changes in demand or supply.
Many companies opt for vertical integration as one of the best business strategies to ensure cost savings, increased efficiency, and improved supply chain coordination. In this post, we will define vertical integration, discuss the pros and cons of vertical integration, explore the differences between horizontal and vertical integration, share an example of vertical integration, explain what differentiates vertically integrated companies, show why vertical integration makes sense, and help readers understand the importance of horizontal and vertical agreements.
What Is Vertical Integration?
What’s vertical integration you might wonder? Who is vertical integration used by? Vertical integration is the strategic practice of controlling all operations within a supply chain or logistics organization. The vertical integration meaning involves organizing a company’s operations to include control over the production and distribution of its products or services. The vertical integration simple definition is companies take control of several links in the production chain, including raw materials, manufacturing, marketing, and distribution.
How Vertical Integration Works?
Vertical integration necessitates complete oversight of suppliers, distributors, or retail spaces for a corporation to have more control over its supply chain. The process starts when a company identifies critical areas of the supply chain that it wants to control, such as a specific raw material, a manufacturing process, or a distribution channel.
Companies then achieve vertical integration by acquiring or merging with other companies that are involved in different stages of the production process. Creating internal divisions to handle various aspects of production and distribution, including goods or services procurement and other procurement processes, also helps companies achieve vertical integration by allowing them to coordinate and control their operations.
The companies also develop new capabilities internally, including purchasing new equipment or hiring a team of experts to manage the unique aspects of the supply chain, and in some cases using specific supply chain management software. This brings new expertise and knowledge to the company and increases the efficiency and coordination of the supply chain.
Types of Vertical Integration
In order to fully understand what does vertical integration mean, it’s crucial to become familiar with the different types of vertical integration. This also answers the question of whats vertical integration. Companies can choose different types of vertical integration strategies for their supply chain management and logistical operations. Here are three types of vertical integration to help you understand what the term vertical integration refers to.
Backward Integration
Backward integration is a vertical integration that runs upstream of the supply chain. Companies expand their business operations back to the earlier stages of the supply chain. They take control of the raw material and intermediate products involved in producing the end product that the company makes.
This integration consists of purchasing the supplier outright or entering into a joint venture or partnership with the supplier. A company can also integrate the supplier’s operations into its own. Alternatively, a company may backward integrate by establishing its production facilities for raw materials or intermediate products.
Backward integration gives a company greater control over its operations and supply chain. It can lower costs by eliminating the need to purchase raw materials or intermediate products from other companies.
Forward Integration
Forward integration is a business strategy in which a company controls the downstream supply chain operations. It expands its operations by taking control of the distribution and sales of its products.
A company might acquire a company involved in distributing or selling its products, either through a purchase of the company’s assets or through a merger. Alternatively, a company might build its distribution or production facilities by constructing new buildings or acquiring existing ones.
Forward integration can give a company control over the quality of its products and the costs associated with producing them. This integration can help a company to increase its efficiency, improve its profitability, and strengthen its competitive edge in its market by eliminating the downstream intermediaries. It also helps with procurement process and procurement strategy.
Balanced Integration
Balanced integration is a vertical integration strategy that controls a supply chain’s upstream and downstream operations. It allows a company to have more control over the entire value chain of its products, from the production of raw materials, assembly, and distribution to sales.
A company can achieve balanced integration by purchasing or merging with smaller companies that provide the raw materials needed to produce its end product. It also connects existing distribution operations as a platform for offering its products to customers. The company gets to acquire suppliers and retailers as the middleman.
Balanced integration allows a company to better control the quality of its products, as it provides more direct control over the production process. It also helps reduce costs by eliminating intermediaries in the production and distribution process. Cost reduction can lead to customer attraction and increase the company’s market share.
Advantages of Vertical Integration
The application of vertical integration has numerous advantages for the supply chain and logistical organizations. To come to a full understanding of the vertical integration def, here are some benefits companies can accrue from using vertical integration.
Control of the Supply Chain
Vertical integration gives a company control over the production of raw materials, assembly, distribution, and sales of its products. It allows a company to implement its supply chain, logistics, and operations through centralized management.
A company can reduce its reliance on external suppliers by owning and controlling these operations. Companies that gain control of their supply chain will be able to meet the changing demands of their customers and put more effort into managing their costs. It also gives companies a competitive edge over their competitors.
Lower Operation Costs
Vertical integration helps companies enjoy economies of scale. It can control the quality of raw materials or intermediate products in manufacturing products. This control allows the company to adopt a lean production strategy that reduces waste in the supply chain. It also enables agile and just-in-time production reducing inventory holding costs.
Companies also can lower costs by eliminating redundant supply chain operations and consolidating or streamlining them. Vertical integration allows a company to pass on its savings to the end product that it produces. It also allows a company to reduce costs by eliminating intermediaries within the supply chain.
Better Coordination
Through vertical integration, companies can monitor, manage, and control the various operations within their supply chain. This coordination and fluent flow of information through the supply chain allow an efficient process from raw material production to product distribution to customers saving time.
For example, a company that owns its raw material suppliers can ensure that the materials it needs are available when needed, which helps prevent production delays. It can also closely coordinate the distribution and sale of its products, which can help to improve customer satisfaction.
Better Feedback
Through vertical integration, companies can get immediate feedback on the performance of their supply chain operations. The information companies receive from their raw materials suppliers and distribution partners is also accurate as they receive it themselves.
Coordination achieved by vertical integration helps a company to improve its response time by reducing the problems arising from delays in communication. Vertical integration also allows companies to increase their responsiveness to and flexibility concerning changes in their customer’s requirements or needs.
Disadvantages of Vertical Integration
While it can boost efficiency, control, and profitability, increased vertical integration isn’t without its challenges. High upfront costs and reduced flexibility can be daunting hurdles. Ultimately, the success of vertical integration depends on careful consideration of industry dynamics, company size, and the competitive landscape. For some, like Apple and Tesla, it’s been a recipe for dominance. For others, the complexities can outweigh the potential rewards.
A vertical integration strategy does not assure your company’s success. Let’s look at some disadvantages of vertical integration in supply chain and logistics organizations as we continue to define vertical integration.
Long-Term Process
The process involved in vertical integration causes the supply chain and logistics organizations to be longer-term. A company must maintain its operations for an extended period which provides its competitors a longer time than they need to adjust and make their strategy in response.
The slow process is particularly true if a company acquires or establishes new facilities or business units to house its supply chain operations. This integration would also include training employees who take time to learn and understand the newly integrated processes and procedures.
Heavy Initial Investment
The vertical integration process calls for significant initial capital. For a company to be fully vertically integrated, it may need to invest in new facilities and equipment, such as building a new manufacturing plant or acquiring a supplier. It also needs to integrate new operations into an existing business, such as training employees and incorporating new systems.
Similarly, suppose a company wants to vertically integrate by acquiring a supplier. In that case, it will need to pay for the acquisition and may also need to invest in upgrading or improving the supplier’s operations.
Less Flexibility
The integration of vertical operations into a single business unit can create rigidity in the supply chain. It can also prevent a company from taking advantage of cost savings and efficiency improvements when its supply chain operations run independently.
A company that owns its distribution channels may need more time to pivot to new tracks. In contrast, a company that relies on external suppliers and distributors may have more flexibility to respond to changes in the market because it is less committed to a particular production and distribution process.
Balancing Issues
Integrating supply chain operations into a single business unit can make it difficult for companies to balance the tradeoffs between cost and quality. Companies can also experience difficulty dealing with issues like supply shortages or fluctuations in demand.
A company that vertically integrates its production may need help to capture most of the cost savings from using better materials or finding new suppliers. It may also fail to take advantage of other benefits, such as obtaining better feedback on operations or learning to manage issues that arise in the production process.
Business Examples that Use Vertical Integration
Netflix is an example of a company that has successfully implemented a vertical integration strategy. The company offered a subscription-based streaming service but has expanded to produce its content. This approach allows Netflix to control the entire process of creating and distributing its range, from the initial idea to the final product.
Ford Motor Company has incorporated a vertical integration strategy in its operations. The company vertically integrates by producing its components, such as engines and transmissions, and assembling its vehicles. It also operates research and development facilities to design and test new products. Ford can save on costs and improve the quality of its products.
Dell also operates its distribution channels, including its website and a network of retail stores. It originally started as a direct-to-consumer computer manufacturer, selling PCs through its website and phone sales. It is vertically integrated by producing its components, such as motherboards and processors, and assembling its PCs.
Vertical Integration vs. Horizontal Integration
Vertical and horizontal integration are strategies involving expanding a company’s operations. Vertical integration broadens its operations by taking control of the production and distribution of goods or services. Horizontal integration consists of acquiring other companies engaged in the same core competencies.
A key difference between vertical and horizontal integration are the resources involved. A vertically integrated company expands its operations by acquiring or developing its resources, such as raw materials and distribution channels. In horizontal integration, companies acquire other companies with resources in their specific niche in the market.
Vertical integration also allows a company to better coordinate the production and distribution of its products, giving it a competitive advantage. On the other hand, horizontal integration allows a company to expand its market presence and potentially increase its bargaining power with suppliers and distributors.
One challenge of vertical integration is that it can be costly, requiring a company to invest in new facilities and equipment. It also affects the flexibility of a company. In contrast, horizontal integration can be challenging because it requires a company to integrate the operations of the acquired company, which can be complex and time-consuming.
When Should a Company Opt For Vertical Integration?
A company that relies on external suppliers or distributors may need help obtaining the resources it needs timely and cost-effectively. For example, suppose a company cannot secure reliable suppliers, or there are disruptions in the supply chain it may. In that case, it is beneficial to vertically integrate to have more control over the resources it needs.
Businesses can benefit from vertical integration if they operate in an industry subject to taxes or regulations that create trade barriers. A company can more easily navigate these challenges and reduce costs by using vertical integration.
By vertically integrating, a company can easily coordinate the production and distribution of its products and may have more control over the terms of its contracts. This integration will stop a company from having contract challenges, such as difficulties in negotiating favorable terms or problems with enforcing contracts.
When Should a Company Disregard Vertical Integration?
A company may disregard vertical integration in certain situations, such as when the company deals with widely available commodities. In such industries, it may not make sense for a company to invest in its production facilities, as many suppliers can provide the same product at similar or even prices.
Wrapping Up
Companies can fully or partially incorporate vertical integration or not at all. Depending on their specific needs and goals, they can choose which aspects of their operations to integrate.
Before integration, companies must consider various factors, such as the availability of materials, labor, resources, costs, and risks. This approach will allow the company to enjoy the benefits of vertical integration while maintaining flexibility.