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What is 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 in the business and increase entry barriers. The Company can cut its costs by merging with its suppliers and maintain quality standards.
Backward Integration Examples
Backward Integration Example #1
Suppose there is a Car Company, XYZ which gets a lot of raw material like iron and steel for making cars, rubber for seats, pistons, engine etc. from various suppliers. If this car Company merges/ acquires the supplier of iron and steel it will be called backward integration.
Backward Integration Example #2
Another backward integration example would be a tomato ketchup manufacturer purchasing a tomato farm rather than buying tomatoes from the farmers.
Advantages of Backward Integration
Let us look at some of the advantages of backward integration:
#1 – Increased control
By integrating backward and merging with suppliers, Companies can control their supply chain in an efficient manner. They will control the production of raw materials till the production of the end product. By this, they will have a larger control on quality of raw material to be 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 the costs. In a supply chain, there is always a markup when goods are sold from one party to another. The supply chain involves various suppliers, distributors, middlemen. By integrating the business with the producer of material, 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, to keep the competition out of the market can acquire the supplier. Consider a scenario where a major supplier supplies materials to two Companies but one of them purchases the supplier so it can stop the supplies of goods to the competitor. By this way, the Company is trying that the existing competitor exits from business or look 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 which were only held by the supplying firm.
#5 – Differentiation
Companies integrate backward to maintain differentiation of its product from its competitors. It will gain access to the production units and distribution chain and thus can market itself differently from its competitors. Integrating backward will enhance the Company’s ability to meet the customers demand and may also help it to provide customized products since now it holds the production capacity internally than sourcing it from the market.
Disadvantages of Backward Integration
Above we have seen the advantages of backward integration, however backward integration is not always good. Let us look into potential issues with backward integration:
#1 – Huge Investments
Integration, merging or acquiring the manufacturer will require huge investments. It will be an extra burden on the Company’s balance sheet 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. 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 could not achieve the economies of scale that the supplier can achieve individually and produce goods at lower cost.
#3 – Quality
Lack of competition can lead to less innovation and thus low quality of products. If there is no or less competition in the market, the Company will become less efficient/less motivated in terms of 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 significant cost for in-house development or it may 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 within the Company.
#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 – Conclusion
Backward integration strategy is a business strategy whereby the Company acquires or merges itself with the suppliers and manufacturers of raw materials to control the supplies and the production costs in the process. As we have discussed above, integrating backward has its fair share of advantages and disadvantages. The Company needs to perform a due diligence before integrating backward. It should look at various factors such as – will the investment cost and finance cost will be lower than the long-term benefits it will have by acquiring the suppliers? The Company should diligently check the equipment, processes, workforce, patents etc. of the supplier/manufacturer to be acquired and if such an acquisition will help it to have a better and efficient supply chain.
This has been a guide to what is Backward Integrations. Here we discuss the backward integration examples along with advantages and disadvantages of backward integration. You may also learn more about Mergers and Acquisitions from the following articles –