Vertical Integration

Vertical-integration is an expansion strategy where businesses acquire additional levels of the supply chain. The acquisition could be raw materials, production, distribution, retail, etc. It is a decision to have it done in-house instead of outsourcing.

By integrating various levels of the supply chain, companies can control supplies, reduce costs, ramp up production and increase efficiency. In addition, vertical integration facilitates economies of scale—eliminating supply disruption and supplier dominance. Vertical Integration is both expensive and irreversible—it takes time for the new members to function smoothly with the existing team.

• Vertical-integration is a strategy where a business undertakes control over various supply chain stages—raw material, production, distribution, sales, or customer support.
• Companies can implement forward integration to align their supply chain facilities towards the final consumers.
• Alternatively, backward integration is acquiring supply chain stages in reverse order. A retailing firm could start procuring stages all the way to raw materials.

Companies adopt a vertical-integration strategy to win over their competitors by strengthening their supply chain. The supply chain begins with the procurement of raw materials and the production of finished goods. Then, it extends all the way to distribution and sale. This system comprises suppliers, producers, distributors, vendors, retailers, and consumers.

Vertical-integration, therefore, ensures superior command over the supply chain. It facilitates economies of scale - increased production and lower costs. Such a business does not outsource raw materials, distribution, retail, or customer service. These companies try to own all the levels of the chain. They merge with or acquire supply chain partners. Sometimes they go all the way and develop new supply chain units. However, management should be conscious of the high cost of such expansions. Companies can lose focus and relinquish existing strengths in the pursuit of synergies.

Owning levels of the supply chain should not be confused with horizontal integration strategy. Horizontal integration emphasizes the merger or acquisition between the firms engaged in the same business line (often competitors). Moreover, horizontally integrated businesses function at the same supply chain level.

Tesla inc. is an efficient example of vertical-integration. On Jan 4, 2021, the company gained an edge over the competition by overcoming supply chain problems in the global automobile industry.

During the 2020 Covid pandemic, there was a shortage of chips used in cars. Tesla's competitors curtailed production, expecting a fall in demand. However, Tesla proceeded with an optimistic forecast of the rapid rise in automobile demand. The company directly connected with its chip suppliers to keep track of its orders.

It was possible because Tesla designs more hardware and software than its rivals—who rely on external suppliers. Compared to the competition, the company is more vertically-integrated. It ultimately increased its supply of cars and increased prices to fund newly developed levels of the supply chain.  

The direction in which the firm merges along its supply chain determines the type of vertical-integration it opts for:

#1 - Forward Integration

When a company has an in-house manufacturing unit, it can merge or acquire distribution centers or retail outlets. Thus, the company moves ahead in the supply chain, i.e., from raw material to retail.

#2 - Backward Integration

This strategy is undertaken by companies with in-house units built for the final stages of the supply chain—retail. Such firms can engage in the initial stages—production and procurement of raw material.

#3 - Balanced Integration

Such firms generally use a combination of Forward Integration and Backward Integration strategies. This is applicable to businesses engaged in the mid-supply chain function. They expand their operations upward and downward.

For example, Hershey relies on cocoa bean suppliers and distributors like Walmart and Target. Hershey can acquire both cocoa bean suppliers and distributors—balanced integration.

The benefits of owning various levels of the supply chain are as follows:

1. Competitive Advantage: Company will have an edge owing to low-priced products or services. And all this is achieved with improved product quality.
2. Eliminates Supply Disruption: When companies rely on the vendors for supplies, they can fail to deliver on time. Thus, developing an in-house supply chain level improves efficiency.
3. Discourages Supplier Dominance: If the suppliers have autonomy, they can dictate the terms as well. Therefore, vertical-integration can certainly lower costs and eliminate supplier dominance.
4. Economies of Scale: Vertically-integrated companies produce in bulk—cost per unit reduces.
5. Increases Profitability: There is a simultaneous increase in manufacturing capacity and decrease in production costs - profitability accelerates.
6. Expansion: A larger corporation owning more levels of the supply chain can develop a unique selling point (USP).

The disadvantages of expansion are as follows:

1. Capital Expenditure: Mergers and acquisitions incur a huge amount of capital. In addition, the upkeep of newly acquired assets also cost a lot.
2. Loss of Focus: In the pursuit of new levels, companies can lose core competency. It is unchartered territory for the management; decision-making becomes challenging.
3. Requires Efficient Management: The company has to hire a new team. There could be problems in hiring the right talent. Even if all goes well, a new group of individuals take time to function smoothly.
4. Cultural Difference: The new company culture may not be compatible with the old.
5. Risk of Failure: It is an irreversible decision. If management fails, the losses can be huge.

This article has been a guide to what is Vertical-Integration & its Definition. Here we explain vertical-integration along with examples, types, advantages, disadvantages, and supply chain integration. You may learn more about financing from the following articles –

• Vertical Merger
• Types of Acquisition
• Takeover Premium