What Is Vertical Integration?

Table of Contents

What Is Vertical Integration?

Let me explain vertical integration directly to you: it's a strategy companies use to streamline their operations by taking ownership of various stages in their production process. You achieve this through mergers, acquisitions, or by establishing your own suppliers, manufacturers, distributors, or retail locations instead of outsourcing them. Keep in mind, this often requires a significant initial capital investment.

Key Takeaways

Vertical integration means a company takes ownership of suppliers, distributors, or retail locations to gain greater control over its supply chain. This approach increases efficiency, reduces costs, and boosts control throughout the manufacturing or distribution process. Remember, upfront capital investment is necessary for vertical integration.

How Companies Use Vertical Integration

A company can broaden its footprint across the supply chain or manufacturing process with vertical integration, which allows for more self-reliance on key aspects. As a manufacturer, you might directly source raw materials or sell products to consumers through this strategy. The supply chain or sales process typically starts with raw materials from a supplier and ends with the final product reaching the customer. To vertically integrate, you buy or recreate parts of the production, distribution, or retail sales that were previously outsourced. You could purchase suppliers to cut manufacturing costs, invest in websites and physical stores for the retail end, or even set up warehouses and fleets of vans to handle distribution.

Fast Fact

As a company engages in more activities along a single supply chain, it may result in a market monopoly. This kind of monopoly due to vertical integration is also called a vertical monopoly.

Types of Vertical Integration

Backward integration happens when a company acquires a raw material distributor or provider at the start of the supply chain, moving ownership control earlier in the process. For instance, a furniture retailer might buy a wood distributor or manufacturer. Forward integration expands control over the distribution and sale of finished products; a clothing manufacturer could acquire a retailer to open stores, though this is less common due to the difficulty in acquiring down the chain where larger capital is often held. Balanced integration involves merging with companies both before and after in the supply chain, requiring you to be a middleman manufacturing a product. Take Coca-Cola: if it merges with raw material providers and retailers, that's balanced integration, controlling the entire process from sourcing to sales.

Important Note

Although vertical integration can reduce costs and create a more efficient supply chain, the capital expenditures involved can be significant.

Advantages and Disadvantages of Vertical Integration

Vertical integration gives companies greater control over the supply chain and manufacturing, leading to lower costs, economies of scale, and less reliance on external parties. You can even circumnavigate external monopolies this way. However, it starts a long-term process needing widespread buy-in, with heavy upfront capital to acquire companies, integrate systems, and train staff. Since you're committing capital to specific processes instead of vendors, that money might not be easily recovered, and you could miss out on unique knowledge from external sources.

Pros

Long-term cost saving due to favorable pricing and minimal supply chain disruptions
Economies of scale, which increase efficiency
Reduces or eliminates the need to rely on external parties/suppliers
Greater control over the product, inputs, and process, which may lead to superior products

Cons

Requires large upfront capital requirements to implement
Reduces a company’s long-term flexibility
Loss of focus on a company’s primary objective or customer
Displeased customer base that would prefer to work with smaller retailer

Vertical Integration vs. Horizontal Integration

Vertical integration involves acquiring a key component of the supply chain that was previously contracted out, which may reduce costs and give greater control over products, ultimately increasing profits. In contrast, horizontal integration means acquiring a competitor or related business to eliminate rivals, diversify, expand into new markets, or boost sales. While vertical integration stretches a company along a single process, horizontal integration makes it more specific or niche within a market.

Examples of Vertical Integration

Netflix is a clear example: it started as a DVD rental business, then moved into online streaming with licensed content, and now promotes its original content through its own distribution model. The merger of Live Nation and Ticketmaster created a vertically integrated entertainment company that manages artists, produces shows, owns venues, and sells tickets. In the fossil fuel industry, companies like British Petroleum and Shell have exploration divisions, extraction and refining subsidiaries, transportation divisions, and retail gas stations, controlling the entire process from source to sale.

Explain Like I'm Five

Vertical integration is when a company buys up multiple businesses at different stages of its supply chain. For example, a restaurant might buy a farm for steady produce, or an oil company might buy a shipping company for transportation. This lets companies reduce costs and streamline operations by acting as their own suppliers and controlling the production process instead of buying on the open market.

When Is an Acquisition Considered Vertical Integration?

An acquisition counts as vertical integration if it gives the company direct control over a key piece of its production or distribution process that was previously outsourced.

Is Vertical Integration Good for a Company?

Whether vertical integration is good depends on what's best for the company long-term. For instance, if a clothing company uses buttons, it could buy them or make them in-house, eliminating supplier markups and frustrations, and gaining flexibility in styles or colors.

Why Do Companies Use Vertical Integration?

Companies use it to gain control over the supply chain in manufacturing or distribution. By taking steps in-house, you control timing, processes, and additional development stages, which may lead to long-term cost savings.

The Bottom Line

Vertical integration is a business arrangement where a company controls different stages along the supply chain, bringing production processes in-house instead of relying on external suppliers. Though it may require increased upfront capital, the goal is to streamline for more efficient and controlled operations in the long term.

What Is Vertical Integration?

Highlights