Backward Integration

Backward integration is a form of vertical integration by which the Company integrates its operations with the suppliers or the supply side of the business. The Company gains control over the raw material suppliers by integrating them with their ongoing business.

The Company does so to maintain a competitive advantage and increase entry barriers. In addition, the Company can cut its costs by merging with its suppliers and maintaining quality standards.

• Backward integration refers to the practice of a company that integrates with its suppliers and aims at an effective procurement of goods and services to reduce the cost of goods sold and adopt better innovation.
• Backward integration is done to derive additional benefits for a company in the supply stage of the company, wherein they integrate with their suppliers to reduce the cost.
• Implementing backward integration can derive benefits such as increased control, cost reduction, efficiency, competitive advantage, barriers to entry, differentiation, etc.
• However, it can also cause certain disadvantages for the company, such as the incurring of a huge investment. The cost can also increase due to unstable competition. It compromises the quality of the products, the company's competencies can get affected, and lead to high bureaucracy.

Example #1

Suppose there is a Car Company, XYZ, which gets a lot of raw materials like iron and steel for making cars, rubber for seats, pistons, engines, etc., from various suppliers. If this car Company merges/ acquires the supplier of iron and steel, it will be called backward integration.

Example #2

Another example would be a tomato ketchup manufacturer purchasing a tomato farm rather than buying tomatoes from the farmers.

#1 - Increased control

By integrating backward and merging with suppliers, Companies can efficiently control their supply chain. They will control the production of raw materials until the production of the end product. By this, they will have a larger control on the quality of raw material used in production. Also, the Company secures itself with the supply of material. It will ensure that the Company receives adequate supplies as and when required without worrying about raw materials being sold to the competitor or not produced /manufactured by the suppliers.

#2 - Cost Cutting

Generally, backward integration is done to cut costs. There is always a markup in a supply chain when goods are sold from one party to another. The supply chain involves various suppliers, distributors, intermediaries. By integrating the business with the material producer, the Company can remove these middlemen from the supply chain and cut the markup costs, transportation, and other unnecessary costs involved in the whole process.

#3 - Efficiency

While the Company will cut costs, backward integration also provides better efficiency in the whole manufacturing process. With control over the supply side of the chain, the Company can control when and which material to produce and how much to produce. With improved efficiency, the Company can save its cost on the material, which gets unnecessarily wasted due to over purchase.

#4 - Competitive Advantage and Creating Barriers to Entry

Sometimes, companies can acquire suppliers to keep the competition out of the market. For example, consider a scenario where a major supplier supplies materials to two Companies but one of them purchases the supplier to stop the supplies of goods to the competitor. In this way, the Company is trying to prevent the existing competitor from leaving the business or looking for another supplier and creating entry barriers for new Competitors. Also, sometimes the Company may integrate backward to gain access and control of technology, patents, and other important resources that were only held by the supplying firm.

#5 - Differentiation

Companies integrate backward to maintain the differentiation of their product from their competitors. It will gain access to the production units and distribution chain and thus market itself differently from its competitors. Integrating backward will enhance the Company’s ability to meet the customer’s demand. It may also help it provide customized products since now it holds the production capacity internally rather than sourcing it from the market.

#1 - Huge Investments

Integration, merging, or acquiring the manufacturer will require huge investments. As a result, it will be an extra burden on the Company’s balance sheet, which may be in the form of debt or reduction cash and cash equivalents.

#2 - Costs

It is not always that the costs will be reduced in backward integration. For example, lack of supplier competition can reduce efficiency and thus result in higher costs. Further, it will be an extra burden on the Company if it cannot achieve the economies of scale that the supplier can achieve individually and produce goods at a lower cost.

#3 - Quality

Lack of competition can lead to less innovation and thus the low quality of products. Suppose there is no competition in the market. In that case, the Company will become less efficient/less motivated in innovation, research, and development as it knows it can sell whatever it produces. Hence, this could impact the quality of the products. Further, if the Company wants to develop a different variety of goods, it may have a high cost for in-house development or incur high costs for switching to other suppliers.

#4 - Competencies

The Company may have to adopt new competencies over the old ones, or there may be a clash between the old and new competencies, causing inefficiency.

#5 - High bureaucracy

Acquiring the supplier will mean acquiring the workforce of the supplier as well. This will increase the size of the Company, thus bringing in new policies for the employees and leading to a bureaucratic culture in the Company.

Backward integration refers to the company’s vertical integration strategy with its supply-side or supplier where the company either merges with the suppliers or acquires the supplier’s business who provides raw materials to the company and if the company decides to set up its internal supply unit.

The Company needs to perform due diligence before integrating backward. Should it look at various factors such as - will the investment and finance cost lower than the long-term benefits it will have by acquiring the suppliers? In addition, the Company should diligently check the equipment, processes, workforce, patents, etc., of the supplier/manufacturer to be acquired. Such an acquisition will help it have a better and more efficient supply chain.

Frequently Asked Questions (FAQs)

This article has been a guide to backward integrations and their definition. Here we discuss its examples and the advantages and disadvantages of backward integration. You may also learn more about Mergers and Acquisitions from the following articles –

• Horizontal vs. Vertical Integration
• What is Statutory Merger?