What is Vertical Integration?
Vertical Integration refers to a strategy adopted by a company or firm wherein it goes on to control over its supply chain by acquiring its suppliers or maybe even its distribution and adding up value.
There are times when a company desires that it will tend to gain efficiency by acquiring other businesses in the supply chain and it happens to go ahead with such a move. It refers to having to purchase the part of the production or the sales process an thus have it done in-house rather than having to outsource it, unlike how it was done pre-acquisition. Such a strategic move by the company helps it to control supplies, reduce costs and thereby bring about more efficiency in all of its operations that it plans to undertake.
Types of Vertical Integration
Given below are the 3 broad types –
#1 – Backward Integration
This takes place when a company goes on to acquire its subsidiaries that would use some of the inputs which are used in the product production process. A good example would be an automobile company that would acquire another company that produces tires.
#2 – Forward Integration
When a company goes on to acquire or take control of its distribution centers or even the retail outlets, such acquisition is known as forward integration. A good example would be a brewing company that goes on to acquire outlets or pubs
#3 – Balanced Integration
Firms that would generally use a combination of both forward and also backward integration is known as a balanced integration strategy.
Example of Vertical Integration
A good example would be of content streaming company-Netflix. What began as a DVD rental company that would continue to supply film and TV content has now gone on to use a distribution model that would also manufacture and promote its own content alongside other studio companies.
Problems and Benefits
- There is scope for better profit margins or also lower prices owing to significant cost cuts by the company.
- There will be control over the supply as well as the distribution process.
- There can be competitive prices as the company would now have the capacity to do the same.
- There will be economies of scale owing to lower costs.
- The company can seek to gain a larger market share due to its competitive practices.
- There are possibilities that the company may lose focus on its core competencies.
- The culture of the new company may not be compatible and there may be problems in operations.
- Competitive Advantage: The company will now have a competitive advantage because consumers can choose their products because costs are lower and the product quality will certainly be better, due to the company’s direct control.
- Avoidance of Supply Disruption: Since the supply is under its control it can have autonomy in the way the vendor runs the scheme as opposed to poorly run supply, should there have been one. It also needs to bother about strikes and worker disputes if it were present in a socialist country.
- Avoidance of Supplier Market Power: If the suppliers have total autonomy they would be in a position to dictate the various terms. However, if the company adopts the route of vertical integration, it can certainly lower the various internal costs and security for better delivery.
- Economies of Scale: The company will be able to cut costs as it will be able to buy in bulk and thus lower the cost per unit. Thus the large scale of operations would go a long way in having to lower the cost of the product owing to the advantage of economies of scale.
- Capital Expense: Company may have to incur a huge amount of capital expenditure in order to purchase or acquire a certain company and then also ensure that the plant runs in an effective way to improve on the profit margins.
- Loss of Focus: It is often considered that vertical integration may make a company lose focus on its core competency and will now have to find suitable management to run both the companies efficiently so there exists no drop in the quality of products and services.
Difference between Horizontal and Vertical Integration
- Horizontal integration involves the purchase of another similar company in the same line of business. A good example would be Anheuser-Busch InBev’s purchase of Sab Miller ion the year 2016.
- It is the purchase of another company in the supply chain which usually a supplier.
Alternatives to Vertical Integration
Instead of preferring a vertical integration, companies may at times also engage in various routes such as franchise agreements, joint ventures, co-location, long term explicit contracts, etc.
It is an infamous strategy adopted by companies to bring about efficiency in their operations to have control over its supply chain and add value by being a low-cost producer. And owing to economies of scale the same can no doubt be achieved. However, it becomes important to bear in mind that there are significant costs associated with this and hence the company may lose focus and miss out on its core competency undertaking while having to achieve synergies through vertical integration. Hence it becomes all the more important for companies to undertake a thorough and careful, analysis and study to ensure there is success in the long run before having to adopt the system of vertical integration.
This has been a guide to what is Vertical Integration. Here we discuss an example and 3 types of vertical integration (Backward, Forward and Balanced) along with their differences, benefits. You may learn more about financing from the following articles –