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 processes, reduce costs and improve efficiencies. However, vertical integration has disadvantages, including the significant amounts of capital investment required.

Netflix is a prime example of vertical integration. The company started as a DVD rental business before moving into online streaming of films and movies licensed from major studios. Then, Netflix executives realized they could improve their margins by producing their own original content. Today, Netflix uses its distribution model to promote its original content alongside programming licensed from studios.

Key Takeaways

  • 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 processes, 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. 
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Vertical Integration

Understanding Vertical Integration

Vertical integration occurs when a company takes control over several of the production steps involved in the creation of a product or service. In other words, vertical integration involves purchasing and bringing in-house a part of the production or sales process that was previously outsourced. Typically, a company's supply chain or sales process begins with the purchase of raw materials from a supplier and ends with the sale of the final product to the customer.

Companies can integrate by purchasing their suppliers to reduce manufacturing costs. They can also invest in the retail or sales end of the process by opening physical stores and locations to provide after-sales service. Controlling the distribution process is another common vertical integration strategy, meaning companies control the warehousing and delivery of their products.

Types of Vertical Integration

There are various strategies companies use to control multiple segments of the supply chain. Two of the most common include backward and forward integration.

Backward 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 might be Amazon (AMZN), which expanded from an online retailer of books to become a publisher with its Kindle platform. Amazon also owns warehouses and parts of its distribution channel.

Forward Integration

Forward integration is when a company expands by purchasing and controlling the direct distribution or supply of its products. A clothing manufacturer that opens its own retail locations to sell its products is an example of forward integration. Forward integration helps companies cut out the middleperson. By removing distributors that would typically be paid to sell a company's products, overall profitability is improved.

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.

Advantages

Below are the benefits of vertical integration:

  • Decreased transportation costs and reduced delivery turnaround times
  • Reduced supply disruptions from suppliers that might fall into financial hardship
  • Increased competitiveness by getting products to consumers directly and quickly
  • Lower costs through economies of scale. By buying large quantities of raw materials or streamlining the manufacturing process, per-unit costs are lowered
  • Improved sales and profitability by creating and selling a company-owned brand

Disadvantages

Below are 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 significant
  • Increased amounts of debt if borrowing is needed for capital expenditures

Real-World Examples of Vertical Integration

An example of vertical integration is technology giant Apple (AAPL), which has retail locations to sell their branded products as well as manufacturing facilities around the globe. For example, in 2012 Apple acquired AuthenTec, which makes the touch ID fingerprint sensor that goes into its iPhones. In 2015, Apple opened a laboratory in Taiwan for developing LCD and OLED screen technologies. It also paid $18.2 million for a 70,000-square-foot manufacturing facility in North San Jose that same year. These investments, among others, allow Apple to move along the supply chain in backward integration, providing flexibility and freedom in its manufacturing.

However, the company still has suppliers that include Analog Devices (ADI), which provides 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. Apart from Best Buy and other carefully selected retailers, Apple products are almost exclusively sold at company-owned locations. This allows Apple to tightly control 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 is an example of forward integration from the perspective of Ticketmaster, and backward integration from the perspective of Live Nation.

Frequently Asked Questions

When is an acquisition considered vertical integration?

Vertical integration occurs when a company acquires a supplier (known as backward integration) or if it acquires a customer firm (forward integration). These business combinations will involve companies all involved at different levels of the same vertical or supply chain.

Is vertical integration good for a company?

This type of integration lowers the cost of doing business along a company's supply chain and internalizes the management of operations from start to finish. Sometimes, however, it is actually more cost-effective to outsource or contract out stages in the production process to nimbler firms or ones with particular skill or expertise in some facet of production. As a result, one must carefully evaluate whether or not vertical integration makes sense on a case-by-case basis.

How is vertical integration different from horizontal integration?

While vertical integration involves acquisitions up or down the supply chain, horizontal integration instead refers to the acquisition of a competitor or a related business. Horizontal integrations help companies expand in size, diversify product offerings, reduce competition, and expand into new markets, while vertical integrations can help boost profit and allow companies more immediate access to consumers.