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What is 'Vertical Integration'

Vertical integration is a strategy where a company expands its business operations into different steps on the same production path, such as when a manufacturer owns its supplier and/or distributor. Vertical integration can help companies reduce costs and improve efficiencies by decreasing transportation expenses and reducing turnaround time, among other advantages. However, sometimes it is more effective for a company to rely on the established expertise and economies of scale of other vendors rather than trying to become vertically integrated.

BREAKING DOWN 'Vertical Integration'

Specifically, vertical integration occurs when a company assumes control over several production or distribution steps involved in the creation of its product or service. Vertical integration can be carried out in two ways: backward integration and forward integration. A company that expands backward on the production path into manufacturing is assuming backward integration, while a company that expands forward on the production path into distribution is conducting forward integration.

General Examples of Vertical Integration

Companies from many different industries and sectors choose to vertically integrate. A mortgage company that originates and services mortgages is a vertically integrated loan-servicing firm. The company lends money to homebuyers and collects their monthly payments, rather than specializing in one service or the other.

A solar power company that produces photovoltaic products and also manufactures the cells used to create those products is another example of a vertically integrated business. In this case, the company moved along the supply chain to assume the manufacturing duties, conducting a backward integration.

The merger of Live Nation and Ticketmaster created a vertically integrated entertainment company that manages and represents artists, produces shows and sells event tickets. This type of integration is forward from the perspective of Ticketmaster and backward from the perspective of Live Nation.

Apple as the Stalwart of Vertical Integration

Apple Inc. is one of the best-known companies for perfecting the art of vertical integration. The company 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 allow Apple to move along the supply chain in a backward integration, giving it flexibility and freedom in its manufacturing capabilities.

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.

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  3. What are the major costs to a firm when pursuing vertical integration?

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