Vertical integration is typically the preferred strategy for long-term business growth and development. Vertical integration is a business strategy in which a company acquires or has control over the operations of its suppliers, distributors, or retail stores in order to control its supply chain, reduce costs, and improve efficiency. However, the process of implementing vertical integration is time-consuming and expensive in practice.

As a result, outsourcing is a more favorable option in some situations. Outsourcing is the business practice of hiring another company to be responsible for a business activity that could be done internally.

Key Takeaways

  • Companies use outsourcing to reduce labor costs, lower their business expenses, and to focus on the core aspects of the business.
  • While vertical integration offers many advantages, the process is time-consuming and expensive in practice, and outsourcing can also provide a competitive advantage for a business.
  • Outsourcing makes the most sense in industries where the cost of labor and capital resources are high and is usually the best choice for young businesses that cannot afford the high costs associated with implementing vertical integration.

Over time, most companies save money and increase quality by implementing vertical integration. The challenge for small and medium-sized companies is that the initial process of vertical integration requires a significant investment of resources.

The reason for adopting a vertical integration strategy or an outsourcing strategy is to make a business's operations more efficient. For some companies, vertical integration will give them a competitive edge. For others, outsourcing is the most viable approach. The decision to vertically integrate or outsource depends on the nature of the business activities and the industry the business is operating in.

Advantages of Vertical Integration

There are four stages of the supply chain:

A company has vertically integrated when it controls two or more of these stages.

The most significant advantage of vertical integration is avoiding any supply disruptions. Suppliers can be unreliable if they are poorly-run. Suppliers are also sometimes impacted by labor strikes or disputes. In addition, if a company is reliant on a supplier that has a monopoly in the industry, that supplier will be able to dictate the terms (which could mean setting higher rates). A company that is vertically integrated can avoid suppliers with a lot of market power.

Another advantage of vertical integration is lowering per-unit costs. A larger company can purchase items in bulk and also reduce their fixed costs by consolidating management. A retail company that is vertically-integrated can also identify popular brand-name items and make "knock-off," store-brand items with the same ingredients and manufacturing process, and offer them to consumers at a lower price. The most obvious advantage of vertically integrating is that the strategy saves a company money, and those savings can be passed onto the consumer in the form of lower prices.

Disadvantages of Vertical Integration

Vertical integration is a risky strategy because it is complex and expensive. The biggest disadvantage of vertical integration is the upfront costs. The capital required to set up or buy factories or acquire retail stores, plus the costs of maintaining those operations after the fact, can be prohibitive for many companies.

Also, the time and investment required to maintain these operations can reduce the nimbleness of a company. For example, they may lack the flexibility to follow consumer trends and introduce products to the market that would have to be produced outside of their factories.

Another problem companies that attempt vertical integration can encounter is the different skill sets required to run a company that ranges from retail to factory operations. Finding leadership that is well-versed in all of these industries can be challenging. Similarly, the type of employee that is attracted to working at a retail business can be very different than the type of employee that works at a factory. These cultural differences can lead to conflict and low productivity.

Advantages of Outsourcing

Outsourcing entails giving out different business operations to companies that specialize in providing these services. Some functions that companies may decide to outsource include payroll, information technology, research and development, and customer care services.

Companies decide to outsource to reduce the costs of their operations or to increase their efficiency. One advantage of outsourcing is that you can trust that the outsourcing company is an expert in the service that it is providing. If a company had to train its own staff to perform that same task, there would be a transitional period when the service was not being performed to the expected standard.

In addition, it can cost less to pay an outsourcing company to perform certain services than to employ several individuals to do the same job. A company can avoid paying the salaries, benefits, and payroll taxes of additional employees if they outsource the tasks. Similarly, if you are outsourcing certain aspects of production, you can avoid the investment of purchasing expensive equipment.

An additional benefit of outsourcing certain services is that you have a new partner in business. If the company is operating in a different time zone, it's possible that your business "partner" will be working while you are sleeping because your business hours are different. At the end of the day, this can increase efficiency.

Disadvantages of Outsourcing

Control

An obvious disadvantage of outsourcing is that you are turning over control of some of the management of your company to another company. The company you outsource to may not have the same standards as your company, and they will be driven primarily by making a profit. In addition, the outsourcing company will be the one to create a contract for their services.

Hidden Costs

There may be hidden costs that are not immediately apparent if you don't have an accurate understanding of the contract's terms. It's advised that companies that decide to outsource also hire a lawyer to review (and possibly amend) the terms of the contract.

Confidentiality

An additional disadvantage of outsourcing is that confidentiality can be compromised when you release certain documents to another company. If another company has access to your payroll documents, medical records, or any other documents with proprietary company data, you may be risking leaks of information. When making the decision to outsource, a company should always take extra steps to make sure that their data is protected.

Communication Barriers

Finally, if a company outsources to a business outside of the U.S., there is the potential for communication barriers or cultural conflicts. Plus, you will always be tied to the financial well-being of any company that you outsource to. If that company goes bankrupt, you will be left paying the price.

Is Outsourcing Right for Your Company?

In recent years, outsourcing has become controversial. Opponents of outsourcing claim that it results in a loss of domestic jobs. Proponents of outsourcing argue that it encourages businesses to allocate resources where they are the most cost-efficient.

Outsourcing allows companies to focus on streamlining their daily operations and encourages international business and trade.

When you outsource parts of your business, you can avoid the cost of expensive equipment and machinery. Plus, you have more flexibility and time to focus on the core aspects of your business and how to make them more efficient.

Outsourcing makes the most sense in industries where the cost of labor and capital resources is high. For example, the high cost of maintaining a workforce and the expensive machinery required in the manufacturing industry means that outsourcing is often applied by manufacturing companies.

Companies that outsource get to benefit from the differences in labor and production costs in other countries. For example, many companies in the U.S. have outsourced their customer service centers to lower-cost locations.

Vertical integration is hard to implement. In some cases, it's in the best interest of companies to outsource—and rely on the expertise of others—rather than make the decision to vertically integrate.