What is Backward Integration?
Backward integration is a form of vertical integrationVertical IntegrationVertical integration is a corporate approach to take charge of its value chain or supply chain functions. It is the process of holding and managing the distributors, suppliers and retail locations at the company's discretion. 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
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, engine, etc. from various suppliers. If this car Company merges/ acquires the supplier of iron and steel, it will be called backward integration.
Another example would be a tomato ketchup manufacturer purchasing a tomato farm rather than buying tomatoes from the farmers.
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 until the production of the end product. By this, they will have a larger control on the 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 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 the material, the Company can remove these middlemen from the supply chain and cut the markupMarkupThe percentage of profits derived over the cost price of the product sold is known as markup. It is determined by dividing the company's total profit by the cost price of the product and multiplying the result by 100. 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 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 can market itself differently from its competitors. Integrating backward will enhance the Company’s ability to meet the customer’s 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
#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, which may be in the form of debt or reduction cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. .
#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 a 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 refers to the company’s strategy of vertical integration 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 also if the company decides to set up its own internal supply unit.
The Company needs to perform due diligence before integrating backward. Should it look at various factors such as – will the investment cost and finance costFinance CostFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains. 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.
Backward Integration Video
This article has been a guide to what is Backward Integrations and its definition. Here we discuss its examples along with the advantages and disadvantages of backward integration. You may also learn more about Mergers and Acquisitions from the following articles –