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What is Vertical Integration?

It probably sounds like a term from a physics classroom but it isn’t. “Vertical integration is a term in business that refers to a strategy used by firms and corporations to control vertical business operations”.

It can simply be defined as when a company controls more than one level of the supply chain. The supply chain is the process that businesses indulge in producing goods and services. The supply chain normally ranges from the acquisition of raw materials to the delivery to the customers.

Vertical Integration

There are four phases of a supply chain. These phases are;

  • Commodity
  • Manufacturing
  • Distribution
  • Retail

Every other good and service passes through these four phases. In order to understand how vertical integration works, you need to understand how the supply chain works. In a supply chain, a business will source raw materials commodities. Let’s take a bread processing business or a bakery as our example. A bakery needs wheat as the core raw materials to make bread. There are other raw materials involved such as sugar, butter, and the bakery needs to assemble all these before it starts making bread.

The second stage in a supply chain is the manufacturing stage whereby the business actually processes all the raw materials it has collected into finished goods. In this case, the finished product is bread.

The third stage involves the distribution of the product. The company has to get the bread to its customers. There are very many ways this can be achieved although I won’t get into it now.

Once the bread is distributed, it reaches the fourth stage of the supply chain which is the retail stage. In this stage, the bread basically is stocked by retail shops and sold to customers. This is the retail stage.

BREAKING DOWN Vertical Integration

Vertical Integration, therefore, can be defined as the involvement of business in activities that are under more than one stage of the supply chain. In our example, vertical integration would be used to refer to a circumstance whereby the bakery was directly involved in the creation of the raw material. In the bakery’s case, the raw material can be anything from butter, to sugar to any raw material that is required in the production of the bread.

If the bakery is involved in the growing of wheat, this can be referred to as vertical integration. This is because the business has involved itself in more than two stages of the supply chain and that is the commodity stage and the manufacturing stage.

Types of Vertical Integration

There are basically three types of vertical integration. They are;

  • Backward Integration.
  • Forward Integration.
  • Combined/ balanced Integration

1. Backward Integration

Simply involves the business taking ownership/ control over its suppliers. It involves itself in a backward stage of the supply chain. Using our bakery as an example, we can understand backward integration better. If the bakery doesn’t like dealing with the suppliers, they can go ahead and buy their suppliers’ business and hence control it. This is what is referred to as backward integration. It is used by businesses that feel the need for total control of their suppliers to reduce deficiencies in the supplier’s work.

2. Forward Integration

On the other hand, it refers to when a business gets involved/ takes control of later stages in the supply chain which is the distribution and the retail stage. In this case, the bakery can decide to control the retailers of its product or sets a retail store for itself. This is done by many businesses that feel the retailers of their good are taking advantage of the customers. It is also done by businesses that want to get rid of counterfeit goods by recommending that customers only buy from their retail stores.

Apple Inc. is a perfect example of forwarding integration whereby they have control over the distribution of its products i.e. iPhones, iPads and MacBook laptops.

Other examples of Vertical Integration

  • A brewery merging with a chain of pubs
  • Car firms merging with producers of steel
  • Textile companies merging with cotton farmers
  • Beer makers merging with corn farmers

Benefits of Vertical Integration in the Business World

As you can predict from the definitions and characteristics of vertical integration, there is a lot to earn from this module of operation. Companies have adopted vertical integration into their operations and they have gained massive benefits. A good example is Apple Inc. which has made advancements in mobile phone production by buying off its suppliers and setting up very efficient retail stores for its numerous products.

  • Lower Prices of Goods

When a company has total control of the supply of its raw materials, there is reliability and cost-effectiveness. The company can hire the best economists to bring the cost of getting supplies down considerably. This brings down the cost of production by a very great margin and therefore the overall cost of a good drop significantly.

  • Increases Barriers to Competitors

Gaining control of supply channels to your raw materials can mean that you block your competitors from accessing raw materials. This can be very important if the raw material in question is very rare. Thus, through vertical integration, you get to beat off your competitors by simply blocking them at the source.

  • Improves Supply Chain Coordination

The entire vertical integration process involves taking control over more levels of the supply chain. Thus, when a company does this, it gets to coordinate the entire supply chain effectively without any disruption as compared to when suppliers, distributors, and retailers were in place.

  • Captures Upstream and Downstream Profit Margins

Gaining control of the distribution, retail and commodity levels of the supply chain means that the company invests and reaps all the profits that accrue from all these levels. Vertical integration is just a simple way of making more profit without necessarily creating a new product or opening a newer business.

Drawbacks of Vertical Integration

Vertical integration has several notable drawbacks to a business. These are the most notable ones;

  • Steep Overhead Cost of Vertically Integrating

The entire process of buying off suppliers can be very costly to manage. Suppliers can ask for fortunes in order to sell their companies off. These require a company to have a lot of funds that other companies can lack or are unwilling to spend thus jeopardizing the entire process of vertical integration.

  • Lack of Competition

When vertical integration happens, there is virtually decreased competition among suppliers which can cause the whole supply of commodities to be less efficient. When there is a lack of competition among suppliers, the quality of commodities that is supplied will be much lower. This will eventually cause low quality in the final product.

  • Need to Balance Upstream and Downstream Activities

During integration, the company should ensure that it has the capacity to balance the dynamics of upstream and downstream activities. Vertical integration stretches the focus of a firm to another level and it requires a lot of funds and commitment to fully operate a vertically integrated module. Staffing and company management should be well equipped to manage a vertically integrated business.

See also  Porter's Five Forces for Understanding the Competitiveness of Your Business Environment

About Sonia Kukreja

I am a mother of a lovely kid, and an avid fan technology, computing and management related topics. I hold a degree in MBA from well known management college in India. After completing my post graduation I thought to start a website where I can share management related concepts with rest of the people.