What Is Backward Integration?

Backward integration is a form of vertical integration in which a company expands its role to fulfill tasks formerly completed by businesses up the supply chain. In other words, backward integration is when a company buys another company that supplies the products or services needed for production. For example, a company might buy their supplier of inventory or raw materials. Companies often complete backward integration by acquiring or merging with these other businesses, but they can also establish their own subsidiary to accomplish the task. Complete vertical integration occurs when a company owns every stage of the production process, from raw materials to finished goods/services.

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What is Backward Integration?

Key Takeaways

  • Backward integration is when a company expands its role to fulfill tasks formerly completed by businesses up the supply chain.
  • Backward integration often involves is buying or merging with another company that supplies its products.
  • Companies pursue backward integration when it is expected to result in improved efficiency and cost savings.
  • Backward integration can be capital intensive, meaning it often requires large sums of money to purchase part of the supply chain.

Understanding Backward Integration

Companies often use integration as a means to take over a portion of the company's supply chain. A supply chain is the group of individuals, organizations, resources, activities, and technologies involved in the manufacturing and sale of a product. The supply chain starts with the delivery of raw materials from a supplier to a manufacturer and ends with the sale of a final product to an end-consumer.

Backward integration is a strategy that uses vertical integration to boost efficiency. Vertical integration is when a company encompasses multiple segments of the supply chain with the goal of controlling a portion, or all, of their production process. Vertical integration might lead a company to control its distributors that ship their product, the retail locations that sell their product, or in the case of backward integration, their suppliers of inventory and raw materials. In short, backward integration occurs when a company initiates a vertical integration by moving backward in its industry's supply chain.

An example of backward integration might be a bakery that purchases a wheat processor or a wheat farm. In this scenario, a retail supplier is purchasing one of its manufacturers, therefore cutting out the middleman, and hindering competition. 

Backward Integration vs. Forward Integration

Forward integration is also a type of vertical integration, which involves the purchase or control of a company's distributors. An example of forward integration might be a clothing manufacturer that typically sells its clothes to retail department stores; instead, opens its own retail locations. Conversely, backward integration might involve the clothing manufacturer buying a textile company that produces the material for their clothing.

In short, backward integration involves buying part of the supply chain that occurs prior to the company's manufacturing process, while forward integration involves buying part of the process that occurs after the company's manufacturing process.

Netflix Inc., which started out as a DVD rental company supplying TV and film content, used backward integration to expand its business model by creating original content. 

Advantages of Backward Integration

Companies pursue backward integration when it is expected to result in improved efficiency and cost savings. For example, backward integration might cut transportation costs, improve profit margins, and make the firm more competitive. Costs can be controlled significantly from production through to the distribution process. Businesses can also gain more control over their value chain, increasing efficiency, and gaining direct access to the materials that they need. In addition, they can keep competitors at bay by gaining access to certain markets and resources, including technology or patents.

Disadvantages of Backward Integration

Backward integration can be capital intensive, meaning it often requires large sums of money to purchase part of the supply chain. If a company needs to purchase a supplier or production facility, it may need to take on large amounts of debt to accomplish backward integration. Although the company might realize cost savings, the cost of the additional debt might reduce any of the cost savings. Also, the added debt to the company's balance sheet might prevent them from getting approved for additional credit facilities from their bank in the future.

In some cases, it can be more efficient and cost-effective for companies to rely on independent distributors and suppliers. Backward integration would be undesirable if a supplier could achieve greater economies of scale–meaning lower costs as the number of units produced increases. Sometimes, the supplier might be able to provide input goods at a lower cost versus the manufacturer had it became the supplier as well as the producer.

Companies that engage in backward integration might become too large and difficult to manage. As a result, companies might stray away from their core strengths or what made the company so profitable. 

A Real-World Example of Backward Integration

Many large companies and conglomerates conduct backward integration, including Amazon.com Inc. Amazon began as an online book retailer in 1995, procuring books from publishers. In 2009, it opened its own dedicated publishing division, acquiring the rights to both older and new titles. It now has several imprints.

Although it still sells books produced by others, its own publishing efforts have boosted profits by attracting consumers to its own products, helped control distribution on its Kindle platform, and given it leverage over other publishing houses. In short, Amazon used backward integration to expand its business and become both a book retailer and a book publisher.