When Does it Make Sense for a Company to Pursue Vertical Integration?

Vertical integration makes sense as a strategy, as it allows a company to reduce costs across various parts of production, ensures tighter quality control, and ensures a better flow and control of information across the supply chain. The goal of vertical integration is typically to increase sales, eliminate costs, and improve profits through better control over its business operations.

Key Takeaways

  • Vertical integration helps a company to manage and control various aspects of the production, distribution, and sales processes. 
  • The goal of vertical integration is typically to increase sales, eliminate costs, and improve profits by improving business operations.
  • Backward vertical integration can reduce or eliminate the leverage that suppliers have over the firm, and by doing so, reduce costs.
  • Forward integration is when a company owns its distribution channels and retail stores providing control of delivery, pricing, and sales.

A vertical integration business strategy helps a company to manage and control various aspects of the production, distribution, and sales processes. A company's supply chain is a network of companies that include suppliers who provide the raw materials and inventory, producers who may assist in the production process, warehouses, transportation and distribution centers, as well as retailers who sell the finished product to the customer. A vertical integration helps a company own or control some or all of the players within their supply chain.

However, the organization can also choose to expand without necessarily consolidating an operation, as would be the case when a company builds out its own retail network. The oil and gas industry has been particularly active in vertical integration, as firms in the sector tend to have control over their exploration, production, marketing, and refining operations.

There are different types of vertical integration strategies, depending on whether the goal is to reduce costs, improve efficiencies, or increase sales.

Backward Integration

Backward integration is when a company purchases one of its suppliers who provides their inventory or raw materials. Typically, backward integration results in the supplier becoming a subsidiary of the purchasing company. The acquisition is called a backward integration because the company is buying an entity up the supply chain. 

Backward integration helps companies to control the quantity of inventory produced by the supplier. For example, a supplier might be unable to keep up with the volume of sales that the company is generating. A backward integration helps the company better control its production volume, which prevents lost sales due to the supplier being unable to keep up with customer demand. 

An organization may also feel that its existing suppliers are exhibiting too much power over them. Through backward vertical integration, the organization can reduce or eliminate the leverage that suppliers have over the firm and by doing so, reduce costs. For example, if the supplier was charging too much for the needed raw materials, the company can buy out the supplier and eliminate the markup in price that the supplier was charging the company. In short, backward vertical integration allows a company to improve profitability by stripping out the middleman.

Forward Integration

Forward integration is a vertical integration strategy that involves a company expanding by purchasing companies that are distributors or retail stores. A forward integration allows a company to improve their process by advancing their control of the supply chain, bringing them closer to the end-user or customer. If a company buys one of its distributors, the company can better control its distribution channels, such as shipping to retail stores, or they can ship to their customers directly. 

Vertical integration can also be done to purchase the retail stores where the company's finished product is sold. By owning the retail stores, the company has direct control on how the product is marketed, priced, and sold to its customers.

The types of costs that can be reduced or removed in a forward vertical integration include transportation costs, transaction costs, and business-to-business marketing costs. A forward vertical integration strategy also eliminates the markup that the distributors and retail stores were charging for providing their services. These cost savings provide a company with flexibility to reduce their prices to their customers, which can lead to increased sales and improved market share. The cost savings could also be reinvested back into the company to help pay for the acquisition costs of the vertical integration strategy.

Companies can also engage in balanced integration, which is a combination of forward and backward integration.

By controlling the supply chain, vertical integration can provide companies with much-needed flexibility during challenging market conditions, when profits are under pressure.

Special Considerations

One of the drawbacks to vertical integration is that the strategy concentrates all the resources and prospects on the one approach. The “all the eggs in one basket” strategy can be risky in an uncertain market environment. In addition, the organizational and coordination costs may also be high.

Companies should be aware that the strategy could involve a significant amount of capital or money to finance the acquisitions. If the company needs to take on debt, it must be able to pay for that debt through the savings and increased profits from the integration. Also, a highly successful company that specializes in a specific product might dilute their core competencies by spreading themselves too thin. The company would need to be able to effectively manage the multiple companies or subsidiaries within the larger organization.

Vertical Integration vs. Horizontal Integration

Horizontal integration differs from vertical integration. A horizontal merger takes place between two organizations within the same industry. Companies might choose a horizontal integration when they want to increase and diversify their products and services, expand into new markets, and grow the size of their company.

Horizontal integration helps companies realize cost synergies by eliminating redundant operations, improving production capacity, and sharing technology. Examples of horizontal integration include the mergers of household products names Procter & Gamble and Gillette in 2006, and oil companies Exxon and Mobil in 1999.

Vertical integration is the purchase of companies within a company's existing supply chain as opposed to horizontal integration, which is the purchase of a competitor.

Examples of Vertical Integration

The acquisition of media and content provider Time Warner by America Online in 2000 is an example of backward integration. High-profile backward integrations within the technology sector include Google’s acquisition of Motorola Mobility Holdings and eBay’s purchase of PayPal. The 2003 purchase of OfficeMax, an office products manufacturer, by paper company Boise Cascade, is illustrative of forward integration.

Beauty products firm Avon is another company that pursued backward integration. The organization did this by venturing into the production of some of its cosmetics, rather than just focusing on the sales and marketing of the product. Meanwhile, clothes manufacturer Levi Strauss & Co. has become more forward integrated by opening retail stores to market its products.