What Is Vertical Integration?
Vertical integration is a strategy whereby a company owns or controls its suppliers, distributors, or retail locations to control its value or supply chain. Vertical integration benefits companies by allowing them to control the process, reduce costs, and improve efficiencies. However, vertical integration has its disadvantages, including the significant amounts of capital investment required.
Netflix is a prime example of vertical integration whereby the company started as a DVD rental company supplying film and TV content. The company's executive management realized they could generate more revenue by shifting to original content creation. Today, Netflix uses its distribution model to promote their original content alongside films from major studios.
Understanding Vertical Integration
Vertical integration occurs when a company assumes control over several of the production steps involved in the creation of its product or service in a particular market. In other words, vertical integration involves purchasing a part of the production or sales process that was previously outsourced to have it done in-house. Typically, a company's supply chain or sales process begins with the purchase of raw materials from a supplier and ends with selling the final product to the customer.
Companies can integrate by purchasing their suppliers to reduce the costs of manufacturing. Companies can also invest in the retail or sales end of the process by opening physical locations as well as service centers for the after-sales process. Controlling the distribution process is another common vertical integration strategy, meaning companies control the warehousing and delivery of their products.
- Vertical integration is when a company owns or controls its suppliers, distributors, or retail locations to control its value or supply chain.
- Vertical integration benefits companies by allowing them to control the process, reduce costs, and improve efficiencies.
- Backward integration is when a company expands backward on the production path into manufacturing.
- Forward integration is when companies control the direct distribution or supply of their products.
Types of Vertical Integration
There are various strategies that companies use to control multiple segments of the supply chain. Two of the most common methods of vertical integration include backward and forward integration.
Backward integration is when a company expands backward on the production path into manufacturing, meaning a retailer buys the manufacturer of their product. An example of backward integration might be Amazon.com Inc. (AMZN), which expanded from an online retailer that sold books to becoming a book publisher. Amazon also owns warehouses and parts of its distribution channel.
Forward integration is a strategy that companies use to expand by purchasing and controlling the direct distribution or supply of a company's products. A clothing manufacturer that opens its own retail locations to sell its product is an example of forward integration. Forward integration helps companies cut out the middleman by removing distributors that would typically be paid to sell a company's products—reducing their overall profitability.
An example of vertical integration is a mortgage company that originates and services mortgages. The company lends money to homebuyers and collects their monthly payments, rather than specializing in one of the services.
Another example of vertical integration is a solar power company that produces photovoltaic products and also manufactures the cells used to create those products. In doing so, the company moved along the supply chain to assume the manufacturing duties, conducting backward integration.
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 can help companies reduce costs and improve efficiencies. However, there are some disadvantages to implementing a vertical integration strategy.
Below are the benefits of vertical integration.
- Decrease transportation costs and reduce delivery turnaround times
- Reducing supply disruptions from suppliers that might fall into financial hardship
- Increase competitiveness by getting products to consumers directly and quickly
- Lower costs through economies of scale, which is lowering the per-unit cost by buying large quantities of raw materials or streamlining the manufacturing process
- Improve sales and profitability by creating and selling its own brand
Below are some of the disadvantages to vertical integration.
- Companies might get too big and mismanage the overall process
- Outsourcing to suppliers and vendors might be more efficient if their expertise is superior
- Costs of vertical integration such as purchasing a supplier can be quite significant
- Increased amounts of debt if borrowing is needed for capital expenditures
Real-World Examples of Vertical Integration
An example of vertical integration is the technology giant, Apple Inc. (AAPL), which has retail locations to sell its products as well as manufacturing facilities around the globe. Apple manufactures its custom A-series chips for its iPhones and iPads. It also manufactures its custom touch ID fingerprint sensor. Apple opened up a laboratory in Taiwan for developing LCD and OLED screen technologies in 2015. It also paid $18.2 million for a 70,000-square-foot manufacturing facility in North San Jose in 2015. These investments, among others, allow Apple to move along the supply chain in backward integration, giving it flexibility and freedom in its manufacturing capabilities.
However, the company still has suppliers that include Analog Devices, which provides the touchscreen controllers for iPhones. Also, Jabil Circuit supplies phone casings for Apple from its manufacturing facilities in China.
The company has also integrated forward as much as backward. The Apple retail model, one where the company's products are almost exclusively sold at company-owned locations, excluding Best Buy and other carefully selected retailers, allows the business to control its distribution and sale to the end consumer.
Live Nation and Ticketmaster
The merger of Live Nation and Ticketmaster in 2010, created a vertically integrated entertainment company that manages and represents artists, produces shows, and sells event tickets. The combined entity manages and owns concert venues while also selling tickets to the events at those venues. The integration was a forward integration from the perspective of Ticketmaster and a backward integration from the perspective of Live Nation.