Maximizing profit is the main objective of every business. They use various techniques and methods to increase the sale and revenue. One of the main techniques companies uses is to achieve a cost advantage. Vertical integration is one such method. Today, we’ll discuss vertical integration, its types, and pros and cons.
Table of Contents
What is Vertical Integration?
Vertical integration is a business strategy when it acquires control over its supply chain system, retail location, distributors, or suppliers. The control process in the vertical integration allows the company to achieve cost efficiency. However, it’s a very costly strategy and it requires a plethora of investment.
Vertical integration is a process when a business acquires control over various production steps. The production steps that the company used to outsource from other businesses. Now, the business would build it in-house. Usually, businesses buy the supply chain process like producing in-house raw material and then selling the finished good at the company’s retail store.
Businesses can decrease manufacturing costs by buying the supplier and building the in-house raw material. They can further reduce cost by investing in the establishment of retail stores and selling the products directly to the customers. They all are common techniques in vertical integration.
Types of Vertical Integration Strategies
Different types of vertical integration strategies control various parts of the supply chain process. Its main types are as follows;
Forward integration is when a business expands forward and acquires control over the distribution channel. The goal is to kick out the middleman that was selling products on the company’s behalf. When you get rid of the middleman, it amplifies the overall company’s profitability.
For instance, a cotton manufacturer starts a retail shop and sells its products directly to the end consumer.
An iron mining company expands forward and purchases the steel factory.
Backward integration is when a retail business expands backward towards the manufacturing of the final products. It’s like a retailer buys the production unit.
For instance, Amazon used to be the retail book store, and then the company expanded backward and became a publisher. Amazon has control over the distribution channel and warehouses.
Balanced integration is when a company owns both forward and backward parts of the supply chain system.
For instance, a fashion retail brand or a smartphone company manufactures the products in-house and sells the finished good at the company’s retail stores. They achieve cost efficiency by producing the products in-house and sell them without the middlemen to the end customer.
Advantages of Vertical Integration
Some of the main advantages of vertical integration are as follows;
Protecting the Recipes
Vertical integration helps you protect your trade secret. For instance, if you outsource the production process, then it would jeopardize the very foundation of your enterprise. The production secret of Coca-Cola is very important to the company.
It helps businesses and companies to differentiate their product and service from the competitors. For instance, when an electronic manufacturing company opens up a retail shop, it could provide a better customer experience.
If your company is producing salad oil and olive groves, the distributor may mislabel your product, and put your business at risk. Or your business is about cakes manufacturing, and you know how much quantity of eggs and other ingredients you should use. However, the point is if businesses have control over the production processes, they can deliver better quality.
Vertical integration provides you the opportunity to build partnerships with various distributors in the new geographic areas. Most importantly, it helps you to expand your business in various segments like supply chain and distribution network.
Vertical integration allowed online e-commerce platforms like Alibaba and Amazon to produce and sell their products directly to the end customers anywhere and anytime. This new model of business has increased the company’s profitability exponentially.
Economies of Scale
There are two ways to achieve economies of scale and lower per-unit production costs. First, you should buy supplies and raw materials in a bulk quantity. Secondly, you could kick out the middlemen and other factors that are increasing your expense level.
The reason Walmart has an efficient distribution is that the company has its controlled distribution network. The retail brand experiments with the latest technology and new processes to find new ways to deliver the products to the customers.
Disadvantages of Vertical Integration
Some of the main disadvantages of vertical integration are as follows;
A company has specialization in one category like retailing and sales, and it’s giving a very tough time to the competitors. However, when it goes for vertical integration, it loses its focus from its main expertise. Resultantly, it changes the workplace environment permanently.
When a labor union or non-labor union combines with the opposite types, then it results in the form of many unexpected circumstances. Like the parent company starts outsourcing the production processes in order to decrease the cost. Sometimes it shuts down the supplies.
There’s no match for bulky production and economies of scale, and your competitors have this cost advantage in your business. For instance, when an automobile company acquires the tire production firm, then the sale of tire manufacturing firm would be limited to the parent company. On the other hand, a sole tire manufacturer company could sell tires to many automobiles company.
The obsolescence of technology is a common issue in the tech industry. For instance, your business integrates with the tech manufacturing company. New technology comes up at the same time, and you have to work all over again on the reinvention process to develop something new.
Vertical integration doesn’t always result in the form of cost reduction. Sometimes, you have to invest a lot of capital to acquire the supply chain. Even after purchasing the supply chain network, your company still can’t compete with the competitors that are outsourcing it with cheap labor. In the end, you would lose capital and won’t achieve the cost-competitive advantage.
Badly Impact Current
You have a handbag manufacturing business, and it’s generating sales through the independent distribution channel. Now, you plan to approach the customers directly by using the online store. When you shift your distribution network, your business would run into losses because the new channel would take a lot of time to establish the customer base.
Examples of Vertical Integration
When Apple started its brick-and-mortar retail shop back in 2001, it handled the customers much better than Microsoft had been doing it. Now, Apple manufactures smartphones and sells them directly to the end customers at its online stores and physical brick-and-mortar stores.
Netflix falls under the category of those businesses that successfully implement vertical integration. The online video streaming platform used to be the rental DVD brand, and then it became an online platform. However, the management realized that it could make more profit by producing in-house content. Now, Netflix produces its content and sells it on its platform.
Target has a worldwide network of retail stores and the brand also owns some manufacturing units. They help the retail company to manufacture, distribute, transport, and manage the in-house logistics.
Google and Motorola
When Motorola launched its first mobile phone and the company realized the significance of Android technology of Google, and the brand invested in Google’s project. However, Google bought Motorola back in 2012.
Ikea and Forests in Romania
IKEA is the world’s leading furniture company, and the brand purchased woodland of 83,000 acres in Romania in 2015. The purposes of buying the forest were that the company would have a consistent supply of wood for the production of furniture.
Vertical Integration [FAQS]
When did your acquisition consider vertically integrated?
Whenever a business or a company buys a customer retail shop, a manufacturing firm, or both at the same, then it falls under the category of vertical integration. The combinations of various businesses expand the company’s operations at various levels.
How does vertical integration affect costs?
Vertical integration affects costs in both ways through the parent company and customers. When the parent company internalizes various processes like distribution channel and supply chain, and it reduces the cost. The company doesn’t have to pay additional costs to the middlemen and others.
However, when a customer buys the product from a vertically integrated firm, then he has to pay the discounted price because of the cost-effectiveness of the manufacturer.
How Vertical integration is beneficial for your company?
Vertical integration internalizes various production processes and decreases the overall production cost. However, outsourcing and contracting third-party manufacturers turn out to be more cost-effective than in house production process. Therefore, the management should carefully evaluate both options, and then decide whatever is more cost-effective.
Four Reasons for Vertical Integration
Vertical integration fails because of the following four reasons;
- Unreliable and risky market
- Competitors in a similar niche have more market power over the chain
- Price discrimination and a barrier to entry
- Either market is too young or it’s at the declining stage