Vertical integration is a business growth strategy in which a company takes control of its production processes (moving them in-house) and, in some cases, takes ownership of its supply chain rather than relying on external suppliers or distributors.
This strategy allows businesses to streamline operations, reduce costs, enhance quality control and increase customer satisfaction.
What is vertical integration?
Vertical integration is when a business brings previously outsourced operations in-house through a merger, acquisition or contract. So, rather than focusing solely on a single aspect of production, distribution or sales, the company extends its reach and market power forward (downstream) or backward (upstream) along the supply chain.
The company is ‘integrating’ them into the business by taking ownership of two or more steps in its supply chain. You can apply this strategy to any industry.
What are the different types of vertical integration?
There are three types of vertical integration — backward (upstream), forward (downstream) and balanced (both upstream and downstream). Examples of each include:
Forward integration
This type occurs when a company expands control over the distribution and sales of its finished products. For example, a clothing manufacturer may integrate a retailer to sell directly to consumers, instead of selling through other businesses.
Backward integration
A strategy in which a company moves processes in-house to take control of upstream steps in its supply chain. An example could be an ice cream manufacturer buying a dairy farm.
Balanced integration
Balanced integration is when a company uses backward and forward integration. For example, a beverage manufacturer could acquire their raw materials supplier and start selling directly to consumers. Balanced vertical integration helps a company control the whole supply chain process.
How does vertical integration work?
A company can achieve vertical integration in several ways, sometimes simultaneously, as shown below:
Acquire suppliers
Buying suppliers of raw materials or components reduces manufacturing costs and ensures a consistent supply. For example, a clothing manufacturer might vertically integrate by acquiring a textile mill (backward or upstream integration).
Invest in retail
The company acquires or opens physical or online stores to reach customers directly and control sales. Instead of only selling wholesale, the same clothing company will begin opening its retail stores (forward or downstream integration).
Controlling distribution
The clothing company takes over the warehouse management and adds transportation to manage product delivery logistics. By moving its products to and from its own retail stores, the company controls its own supply chain to achieve a balanced integration (both upstream and downstream).
Degrees of vertical integration
The degree of vertical integration measures the extent to which a company controls its supply chain.
Full vertical integration
Complete vertical integration is when a company acquires all the assets, resources and expertise to control production or distribution processes upstream and downstream.
Quasi-vertical integration
Quasi-vertical integration is when a business takes a partial stake in a supplier company by investing or taking equity.
Long-term contracts
Long-term contracts create a less intense form of vertical integration. This approach helps reduce product or service delivery inconsistencies while maintaining relatively stable costs over time.
Spot contracts
Spot contracts for vertical integration are when a company relies on immediate, short-term contracts to obtain what it needs for production. This option doesn’t involve long-term commitments or ownership.
Pros of vertical integration
The pros of vertical integration include addressing supply and demand risks. When implemented successfully, this supply chain strategy can reduce costs, boost efficiency and enhance control.
Better control over costs
Businesses can control costs by eliminating intermediaries within the supply chain. Redundant operations can be consolidated or streamlined.
Competitive advantages
Vertical integration can offer a significant competitive advantage. Companies can secure their supply of raw materials and reduce production delays. Increased control over inputs and processes and an optimised supply chain can lead to superior product quality and market differentiation.
Cost reduction
Cost reduction in vertical integration occurs when you internalise production, eliminating supplier management, supplier margins and transaction costs.
When you centralise operations, you can also cut overheads. Additionally, taking control of distribution will help you minimise disruptions. It can also boost your production efficiency as you may be able to produce more at lower cost.
Better customer experience
A better customer experience is often a positive side effect of vertical integration. If you control more of the supply chain, you can respond to changing customer demands faster. If you can keep costs down, you can also pass those savings on to customers through lower prices or improved product features.
Economies of scale
Economies of scale will emerge with vertical integration – lean production will reduce waste throughout the supply chain. It also lets you implement agile and just-in-time production methods, which can significantly lower inventory carrying costs.
Quality control
Increased quality control is a primary benefit of vertical integration. Taking control of multiple stages of production or distribution gives you better oversight and quality assurance.
Cons of vertical integration
The cons of vertical integration are essential to consider, from increased complexity to greater financial risk:
Increased management requirements
The increased management requirements of vertical integration can make running a business more complex. Managers need new skills to handle different parts of the supply chain, inventory management and more complex payroll and cash flow management.
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Large upfront investment
You’ll need a large upfront capital investment to buy other businesses, combine systems, and train workers. The scale of this investment can strain your finances and take a long time to return any value.
Increased financial risk
When you control more of your supply chain, you can expect increased financial risk. If demand planning is incorrect, and orders suddenly drop, it hurts the whole chain — and can create cash flow problems.
Example of vertical integration
An example of vertical integration could be a fast-food company. It owns the restaurant buildings, farms and manufacturing plants that produce burger patties, buns and fries. These ingredients are stored in company-owned warehouses and shipped around the country by an in-house freight division.
Vertical integration FAQs
What is the difference between horizontal and vertical integration?
Vertical and horizontal integration are different types of business growth strategies. Vertical integration focuses on buying companies at different stages of the supply chain. For example, a major furniture maker buys a timber supplier. Horizontal integration is when a company buys a competitor in the same industry.
Is vertical integration more effective than horizontal integration?
Vertical and horizontal integration can both be effective business growth strategies. Each has its own benefits.
Horizontal integration can help a company increase its market share, expand into new areas and reduce competition.
Vertical integration gives a company more control over its supply chain. This can help it save money and improve product quality.
Can horizontal and vertical integration work together?
Horizontal and vertical integration can work together to create a powerful competitive advantage. Companies often use both vertical and horizontal integration strategies because they give different benefits.
Horizontal integration helps increase market share and offer different products. Vertical integration helps streamline operations and control the supply chain.
Vertical Integration: the top-to-bottom line
Vertical integration is a powerful strategy that can help businesses reduce costs, improve efficiency and have greater control over the supply chain.
However, it takes careful planning, significant investment and effective management. By understanding all types of vertical integration and assessing the pros and cons, you can make informed decisions about your business and whether this approach supports your long-term goals. But having the right information on hand is essential.
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