What Are the Effects of Backward Integration?

A form of vertical integration, backward integration allows businesses to obtain control over suppliers and improve supply chain efficiency. Businesses merge with and acquire their suppliers to gain strategic advantages over competitors and lower costs.

In some markets, this may create monopolies and violate antitrust laws. This strategy has many advantages for most businesses, but companies should be aware of potential problems with backward integration.

Key Takeaways

  • Backward integration occurs when a company obtains complete control over its supply chain either through purchasing suppliers or starting its own subsidiary.
  • This move allows businesses to improve supply chain efficiency and reduce costs.
  • Backward integration comes with many challenges and risks, such as successfully merging two or more companies, understanding a new business, and maintaining adequate amounts of capital.
  • Companies can gain a competitive advantage through backward integration if they control a supplier that their competitor previously had access to.
  • For smaller and midsized companies, obtaining affordable products may become more expensive, and the merger may not be worthwhile if economies of scale cannot be created to reduce costs.


Backward Integration

Backward integration occurs when a business decides to fulfill the roles done by its suppliers. This occurs when a business acquires a company that supplies it with either raw materials, products, or services. For example, a company that makes sweaters and purchases its wool from a sheep farm would backward integrate if it purchased that sheep farm.

Businesses backward integrate to achieve complete control over supply chain areas with the goal of reducing inefficiencies and costs. In the business's opinion, it would lower costs, improve margins, distribute faster, and grow its customer base if it controlled certain aspects of its supply chain rather than relying on outsiders of which it has no control.

Advantages and Disadvantages of Backward Integration

Advantages

The primary advantage of backward integration is complete control. Depending on the suppliers purchased, a company will have complete control from the period of obtaining raw materials to selling the final good. In this aspect, a company has control over the quality of the raw materials, the speed at which they are converted into the final product, and how fast they are distributed to customers.

Another advantage is lower costs. If a company is paying suppliers then it is paying a markup. Suppliers need to cover their costs and make a profit. By owning its suppliers, a company no longer has to pay the markup fee but can operate at cost. This allows a company to either have higher profit margins or charge less to their consumers, which has the likelihood of increasing demand for its product and taking market share away from competitors.

A company needs to perform due diligence and a financial analysis before backwardly integrating to determine if the acquisition and integration costs will reduce overall costs in the long run.

Backward integration also provides a competitive advantage. If a supplier is supplying to more than one company, a company that purchases the supplier has now improved its advantage over its competitor as that competitor will now need to find a new supplier.

Disadvantages

Backward integration has several potential challenges and risks. Companies that are unable to effectively manage their supply chain after acquiring their suppliers may lose profits and produce lower-quality products. The costs of managing the suppliers may not be in the best interests of the business, or the company may not have the best expertise to manufacture products.

Furthermore, the competitive advantage gained by purchasing suppliers may lead to a lack of competition, which typically results in a lack of innovation. In addition, acquiring a supplier means integrating its workforce, which may prove difficult if there is a clash of cultures or unintended bureaucracy.

For smaller and midsized companies, obtaining affordable products may become more expensive, and the merger may not be worthwhile if economies of scale cannot be created to reduce costs. If a cheaper supplier enters the market, the company owning its own supply chain may no longer be able to take advantage of the new lower prices created in the market by supply and demand.

Many midsized companies do not have sufficient capital to invest in their own business and their suppliers. By acquiring suppliers, the business may be at risk of reduced cash flows and weaker operations.

Pros
  • Complete control

  • Improved efficiency

  • Lower costs

  • Increased competitive advantage

Cons
  • Large capital outlay

  • Increased bureaucracy

  • Challenges of merging companies

  • Possible lack of innovation

Real-World Example

One of the best and more recent examples of backward integration is Netflix. Netflix started out as a DVD rental company over the Internet, whereby customers would log into their accounts, select movies, and receive them via mail.

Netflix then switched to offering movies and shows via a streaming platform as the Internet grew and streaming video capabilities improved. To offer these movies and shows, Netflix struck licensing deals with the companies that owned the media.

Eventually, Netflix backward integrated by producing its own original content where it could make greater profits. This removed its reliance on other creators and catered to the demand of its customers that were interested in more original content. Over time, Netflix's original content has become the main draw for its subscribers rather than the licensed content.

What Is the Difference Between Forward Integration and Backward Integration?

Backward integration is when a company purchases or controls its suppliers or supply chain. Forward integration is when a company controls its distributors or distribution process. For example, Amazon relied on various delivery services, such as UPS or FedEx to deliver its good to its customers. By purchasing and creating its own vehicles to deliver goods, Amazon forward integrated.

What Types of Companies Benefit From Backward Integration?

Most types of companies can benefit from backward integration as long as the backward integration process is done correctly, both in terms of operationally and financially. Industrial, retail, and tech companies can all benefit from backward integration.

Does Amazon Use Forward Integration?

Amazon operates a variety of businesses and its purchase of grocery chain Whole Foods was a form of forward integration. Whole Foods is the final step in supplying food to consumers and by purchasing the food company, Amazon forward integrated.

Amazon also forward integrated by creating and using its own fleet of delivery vehicles rather than relying on traditional delivery services, such as UPS and FedEx.

What Integration Does Apple Use?

Apple is a vertically integrated company, controlling all aspects of its supply chain, hence having backward integration. Apple is a hardware company, a software company, a retail company, and a services company.

The Bottom Line

Businesses should carefully consider the risks and benefits of a backward integration strategy as part of their business plan. Midsized businesses may not be ready for the added risk of acquiring suppliers and should be cautious. If, however, controlling suppliers allows for better profit margins and secures the availability of supplies for production, backward integration may be beneficial.

Article Sources
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  1. Time. "Why Competing With Apple Is So Difficult." Accessed Jan. 2, 2022.

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