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 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 acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion. is known as forward integrationForward IntegrationForward integration is a strategic approach where the companies move ahead in the supply chain and take over the distribution and retail activities. The purpose of this vertical integration is to achieve cost efficiency.. 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 integrationBackward IntegrationBackward Integration is a vertical integration type in which a Company buys or integrates with its supplier firms to improve efficacy, save costs, & gain more control over the production process. 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 content alongside other studio companies.
Problems and Benefits
- There is scope for better profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. 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 undoubtedly 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 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 expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. 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. Hence, there exists no drop in the quality of products and services.
Difference between Horizontal and Vertical Integration
- Horizontal integrationHorizontal IntegrationHorizontal Integration is a merger that takes place between two companies operating in the same industry. These companies are usually competitors and merge to gain higher market power and economies of scale, an extensive customer base, higher pricing power, and lower employment cost. 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 venturesJoint VenturesA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture., 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 essential to bear in mind that there are significant costs associated with this. Hence, the company may lose focus and miss out on its core competency undertaking while having to achieve synergies through vertical integration. Thus it becomes all the more critical 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 article 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 –