If a company is expanding their business operations into different steps, but remain on the same production path, then this would be vertical integration. An example of this would be a manufacturer that acts as its own supplier and distributor. It can be carried out in two ways: forward or backward integration.
Forward vertical integration occurs when the company goes “forward” into their production cycle when assuming control. Distribution would be a form of forward integration.
Backward vertical integration goes in the opposite direction. A manufacturer assuming control of the supplies needed for their goods or services would be focused on backward integration.
The primary advantage of vertical integration is that it improves efficiencies while reducing costs. When one organization can control all aspects of their business operations without third parties involved, then there are greater efficiencies that can be built into the system.
The disadvantage of vertical integration is that it reduces the amount of diversification that an organization can access. If disruptions within the supply chain occur, then the entire operation is put at-risk until the supply chain can be restored.
There are additional advantages and disadvantages to consider with vertical integration as well.
What Are the Advantages of Vertical Integration?
1. Positive differentiation can be created.
Vertical integration creates predictability because more information is available to the organization. There is more access to production inputs. Retail channels produce real-time information that isn’t filtered by third parties. Distribution requirements can be adjusted to promote specific items to unique demographics. By being in more control, from start to finish, an organization can adapt quickly to changes so that the most effective result can be achieved.
2. Asset investments can focus on specialization.
Instead of seeking our vendors and contractors with specific skill sets, vertical integration allows an organization to invest into internal assets that can specialize in the skill set that is required. This allows a company to differentiate itself from others within its industry, creating a specific brand message and value proposition that resonates consistently with its customer base.
3. It can increase a brand’s local market share.
Because an organization controls more of its supply chain, it can leverage specific benefits that a local demographic may need. This allows the organization to obtain a larger market share because they can create a value proposition that is better than what the competition offers.
4. Transaction costs are lower throughout the supply chain.
With a high level of vertical integration, brands can reduce the transaction costs that occur throughout their supply chain. This is done through the power to leverage the size and scope of the supply chain when dealing with suppliers and vendors that are not part of the integrated process.
5. Quality assurance can be built into the system.
When vertical integration is successful, it allows an organization to put more eyes on the quality of what is being produced. From the initial supply to the final sale, a better Q/A process within the system creates a value proposition that is more reliable. In return, greater customer satisfaction occurs, which builds brand loyalty and return revenues.
6. It opens new markets.
Whether an organization moves forward or backward with their vertical integration, the process can open new markets to the business. By partnering with or purchasing other vendors, proprietary information, property, or technologies can create local access that may have been unavailable to a brand and business before the acquisition or partnership. When this occurs, more profits can be achieved because there is a bigger base of leads to pursue.
7. Stability is created.
Companies that have vertically integrated can withstand economic changes than companies that have not. The stability that is created with supply chain control eliminates unpredictability.
What Are the Disadvantages of Vertical Integration?
1. It forces a business to operate within an economy of scale.
Economies of scale can provide businesses with numerous advantages, but only if they’re ready to adapt to the changes in their supply chain that occur. Here’s an example: when Haggen purchased grocery stores from Albertsons, 146 new locations in competitive, but unfamiliar locations expanded the brand’s footprint. More than $400 million was put into the conversion, which lasted less than 24 months before Albertsons purchased the stores back for about $100 million out of bankruptcy court.
2. It reduces flexibility.
Brands that work with several vendors or contractors have a certain flexibility that vertical integration normally does not provide. Businesses that have integrated vertically may have a few choices with their supply chain, but a business that uses third parties can make changes whenever they wish without maintenance costs within their infrastructure.
3. There may be unforeseen barriers when entering a new market.
Vertical integration does limit competition, but only when the corporation focused on this process has access to the materials necessary to be competitive in the first place. If raw materials are scarce or a brand’s information access to a local demographic is limited, then even with vertical integration firmly in place, market entry may not be possible.
4. Confusion is created easily and often.
Vertical integration falls under one specific brand, but the entities within the supply chain may operate as a distinct business. This creates confusion because customers think they are working with one company, only to realize that they are working with a different company. Google is an example of this. It operates as a subsidiary of Alphabet Incorporated, along with companies like Waymo and Verily.
5. It isn’t a cheap investment.
Capital is required to make a vertical integration effort possible. Even if the integration occurs through partnerships, an investment into specific patents, processes, or proprietary data is often required as part of the deal. New forward or backward vertical integration efforts may require building new facilities, hiring new staff, and understanding new processes that are unfamiliar to the corporation.
6. It isn’t simple.
Vertical integration requires companies to get involved in new aspects of the supply chain where they are usually unfamiliar. If you are in the retail sector and sell shirts, you know how to present that product to the customer in the most effective way. If you were asked to create that shirt from scratch, you would struggle to produce it. You would even need to source the raw fabrics. When fully integrated, vertical integration saves time and money, but it isn’t a simple process to get there.
The advantages and disadvantages of vertical integration show it is a useful investment to make if the capital exists to make it. There are challenges that must be met to take full advantage of the benefits that vertical integration can provide. For those that can meet those challenges, the potential for long-term benefits in any size of market can be quite profound.