What Is Vertical Integration (Explained: All You Need To Know)

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What Is Vertical Integration

In business, vertical integration refers to the process of directly handling or owning different stages of a company’s production process.

The idea is to handle as many steps in the production process as possible without having to rely on other companies.

The more a company is vertically integrated, the more it controls its production process.

Companies can achieve vertical integration by directly investing in business activities intended to streamline their production process or they could acquire companies that tend to be their supplier, manufacturer, distributor, or retailer.

The main reason why some companies will want to achieve vertical integration is that they will be able to control more steps in their production process, better control costs, achieve greater market dominance, and rely less on companies in their supply chain.

However, vertical integration does expose companies to potential risk and so this strategy should be used when the option has been carefully vetted.

Keep reading as I will further break down the meaning of vertical integration and tell you how it works.

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Vertical Integration Types

A company can vertically integrate its supply chain phases into its operations in different ways.

The most common types of vertical integration are backward integration, forward integration, and mixed integration.

Backward integration is when a company takes control over supply chain processes in upstream industries.

For example, a personal computer maker may acquire the computer chip maker.

Forward integration is when a company handles supply chain steps in downstream industries.

For example, a personal computer maker will acquire its distributor.

A mixed integration is a type of vertical integration where a company acquires both an upstream and a downstream step.

The idea is to cut the middleman in its supply chain.

For example, a manufacturer acquires its raw material supplier (upstream) and retailer (downstream).

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Benefits of Vertical Integration

There are many benefits that companies can achieve by vertically integrating.

The most notable advantage is that vertical integration allows a company to control more steps in its supply chain all the way to the sale to end customers.

In other words, a company will have a better ability to control what raw materials to buy, how to produce, and how to deliver to end customers.

Another important reason why companies consider vertical integration is to reduce their production costs and achieve greater economies of scale.

Every middle person within the supply chain is looking to earn a profit.

The idea is to eliminate the middle person, avoid paying the middle person and be able to reduce your production costs.

Also, by reducing costs and having greater control over the production process, a company can ultimately achieve economies of scale.

When large companies achieve significant vertical integration, they can wield significant market power and influence.

This can lead to monopolistic tendencies that may ultimately hurt the market as a whole.

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Drawbacks of Vertical Integration

Although vertical integration does have key benefits, it’s important to be mindful of its drawbacks as well.

One of the most important drawbacks to vertical integration is that you will need to invest a lot of capital to get it right.

Either you will need to invest directly in your production and distribution process or you will need to acquire companies that operate within your supply chain.

Also, when you acquire companies in your supply chain, you will need to ensure that you remain focused on your core business activity.

If the integration does not go well or the employees are not well-trained, you may end up spending time integrating and focusing less on your core business operations.

Another challenge companies face in vertical integrations is that the company is unable to streamline its operations and thus fails to reduce costs.

Without the cost savings, vertical integration investment may end up costing the company.

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Vertical Integration Examples

Let’s look at a few examples of vertical integration to better understand the concept.

Example 1:

Let’s look at the coffee business to see how vertical integration can work.

In the coffee business, you have coffee growers, processors, exporters, roasters, distributors, and retailers.

A coffee distributor may decide to start selling coffee directly to end customers by investing in coffee shops.

In addition, it could decide to acquire companies that grow coffee.

In this context, the company takes control of the growing, distribution, and retail sales of coffee.

Example 2:

Another example is a personal computer company investing in vertical integration by taking over its computer chip maker.

In addition, it starts selling its own computers by investing in an e-commerce platform and opening physical stores in key regions.

This way, the company relies less on different retailers to sell its products in the market.

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Vertical Integration vs Horizontal Integration

What is the difference between vertical integration and horizontal integration?

Vertical integration is when a company invests to own or control different steps in its supply chain either upstream or downstream.

In other words, the company is looking to internally handle more phases of its supply chain.

For example, a car manufacturer will want to purchase is raw materials supplier.

The idea of vertical integration is to achieve greater control over your production process and sale to end customers.

On the other hand, horizontal integration is when a company acquires other companies with similar business models.

The idea is for a company to expand its product line, get into new markets, provide complementary products or services, or even eliminate its competitors.

While vertical integration requires a company to handle more steps in its production process giving it more control, horizontal integration allows a company to remain focused on what it knows best.

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Vertical Integration FAQ

What does vertical integration mean?

Vertical integration is a business strategy where a company’s objective is to take control of its production process and find ways to reduce costs.

In general, there are six supply chain steps: planning the inventory and manufacturing process, the manufacturing and sourcing of materials, the assembling of parts and testing, packaging, transportation and delivery of finished goods, and customer support.

A company can invest in handling more of the supply chain steps instead of outsourcing it to other companies (this is called vertical integration).

What is backward vertical integration?

Backward vertical integration means a company invests in supply chain steps that are upstream to where it is situated.

For example, the retailer of the goods may acquire its distributor upstream.

In other words, you are going “backward” in the supply chain steps.

What is forward vertical integration?

Forward vertical integration is when a company invests in supply chain steps that are downstream to where it is situated.

For example, a manufacturer may acquire its distributor.

Forward vertical integration means that you are moving “forward” in your supply chain steps.

Is vertical integration a good strategy?

Vertical integration can be a good strategy for some companies and additional risk for others.

The most important benefits are that you control more supply chain steps, can streamline your operations, reduce costs, and have greater influence over your remaining suppliers or clients.

On the other hand, vertical integration is costly and will require significant investment.

In addition to the financial burden, companies engaging in vertical integration must recognize that they will need to direct their attention to other production processes that were not originally in their core area of expertise.

If the company does not remain focused, it may lose its competitive edge in its main area of expertise and in its supply chain steps.

It can be beneficial to vertically integrate but it must be done carefully.

What are the different degrees of vertical integration?

There are generally four degrees of vertical integration that companies can achieve: full vertical integration, quasi vertical integration, long-term contracts, and spot contracts.

Full vertical integration is when you can handle all upstream and downstream supply chain processes.

Quasi vertical integration is when you acquire an equity stake in key suppliers or make special investments in them to get certain benefits in return.

Long-term contracts are when you sign a long-term contract with companies in your supply chain where you keep certain elements of your procurement constant.

Spot contracts are when a company enters into contracts to get the necessary inputs on an as-needed basis.

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Takeaways 

So there you have it folks!

What does vertical integration mean?

In a nutshell, vertical integration refers to a company extending its operations within its supply chain.

In other words, the company starts handling supply chain phases that used to be previously outsourced.

A company can vertically integrate upstream or downstream in its supply chain.

Controlling more steps in your supply chain can lead to lowering your production costs, increasing your profits, improving your operational efficiency, and achieving economies of scale.

However, before engaging in vertical integration, it’s important that you assess the pros and cons and properly forecast your potential returns.

Now that you know what vertical integration means and how it works, good luck with your research!

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