Vertical Integration Strategies: Types and Stages

A lot of companies depend on suppliers of raw materials, manufacturing partners, distributors, and retailers for their business operations and tend to face disruptions in their supply chain; on the other hand, some companies have adopted different types of vertical integration strategies wherein they take ownership of two or more stages of their supply chain and integrate them into their own business.

Instead of focusing solely on a single aspect of the supply chain, such companies choose to extend their reach and market power either forward or backward along the supply chain by building their own capabilities from scratch or through mergers and acquisitions; some even integrate both backward and forward along the supply chain. In this article, we will discuss how the various types of vertical integration strategies work, the stages, examples, and effects.

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An example of a vertical integration strategy is a manufacturing company that chooses to source its own raw materials (backward integration) rather than depending on a raw material supplier. Also, this company can choose to sell directly to end customers (forward integration) eliminating its need for distributors and/or retailers. A vertically integrated automaker, like Tesla, for instance, integrates backward by producing the automobile components used for the manufacture of its vehicles and also integrates forward by selling directly to customers instead of depending on external contractors for these processes.

Utilizing any of the vertical integration strategies, in the right circumstances, can help to streamline a company’s journey from raw materials sourcing to the delivery of a product to the end user which in turn reduces costs and raises customer value. Hence, several companies have embraced this strategy, which has been a huge part of their corporate survival and success. Nonetheless, this strategy has proven costly and has also led to corporate failure.

One of the disadvantages of the vertical integration strategy is that it requires sizable up-front capital expenditures. Therefore, in order to own and control multiple stages of a supply chain, a company has to invest a substantial amount of money to set up facilities and hire additional talent and management. This can also cause an increase in the size and complexity of the company’s operations. However, if properly managed, any of the vertical integration strategies can yield long-term competitive and financial advantages.

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Stages of vertical integration strategies

1. Stage of raw materials sourcing or extraction
2. Stage of manufacturing or refining materials into basic parts
3. Stage of assembling basic parts into finished products
4. Stage of delivering finished products to consumers
5. Stage of selling finished products to consumers

A supply chain is a network of resources, individuals, and companies that are involved in the production, distribution, and sale of a product to a consumer. The stages that are relative to vertical integration are the procurement of raw materials, production, distribution, and sale of finished goods or services. That is, for a company to vertically integrate, it has to take control of two or more of these stages by buying or recreating these processes of raw materials sourcing, production, distribution, or retail sales that were previously outsourced.

The stages of vertical integration strategies, therefore, begin with the purchase of raw materials from a supplier, moving them to production, transporting the finished products to a retail store or distribution center to be delivered to end users, and then ends with the sale of the final product to the end users. Hence, companies achieve the stages of vertical integration strategies by establishing or acquiring their own suppliers, manufacturers, distributors, or retail stores instead of outsourcing them.

Companies can bring the sourcing or extraction of raw materials in-house in order to reduce manufacturing costs. They can invest in the retail end of the supply chain by opening physical stores and websites where they can sell directly to customers. Also, they can invest in warehouses and fleets of vehicles to control and own the process of distribution.

Let’s look at Tesla as an example of a vertical integration strategy to explain the various stages of vertical integration strategies. The stages of vertical integration strategies that are relative to Tesla involve sourcing raw materials, manufacturing materials into basic parts, assembling basic parts into complete vehicles, and selling directly to consumers. This strategy has given Tesla good control over the cost, quality, and timeliness of its production processes, over the years.

Instead of using external contractors, tesla manufactures the car batteries, electric motors, power electronics, and the software and firmware used in its cars. It also owns and takes charge of its vehicle assembly, solar power generation, and supercharger network. This automaker is also vertically integrated by taking charge of its sales and distribution through the establishment of its own stores and websites which gives it a chance to have more control over customer experience.

Furthermore, so many auto manufacturers have faced disruptions in their supply chains due to the global shortage of semiconductor chips which has resulted in a halt in their production. According to Elon Musk, Tesla was able to rewrite its software and found alternatives to the chips. Therefore, the company was not affected by the chip shortage and could continue production due to its multiple stages of vertical integration strategies.

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Types of vertical integration strategies

1. Backward vertical integration
2. Forward vertical integration
3. Balanced vertical integration

There are basically three types of vertical integration strategies. All three types involve an acquisition or merger with another company in at least one of the basic stages of the supply chain. The major difference between the three types of vertical integration strategies is where exactly the company falls in the order of the supply chain. Does the company expand and move further upstream in the supply chain, or does it move downstream, or probably in both directions? The direction in which the company moves along the supply chain determines the type of vertical integration strategy that is said to be implemented.

Backward vertical integration strategy

Backward integration strategy is a type of vertical integration whereby a company at the end of the supply chain moves a process in-house so as to have control over business activities that are earlier, or upstream in the supply chain. That is, the company expands its operational activities to take charge of tasks that were formerly completed by businesses up the supply chain. This happens when a company merges with or acquires another company that supplies the inventory or raw material needed for production.

This means that by integrating backward, a company controls subsidiaries that produce some of the inputs that it uses in the production of its products. The company can either acquire or merge with these subsidiaries or better still establish its own subsidiary to accomplish the task. For instance, an automobile company may own a glass company, a tire company, and a metal company. Owning and having control of these three companies can create a stable supply of inputs for the automobile company which can also ensure consistent quality in its finished product.

Backward vertical integration makes the barriers to entry into an industry more difficult. This is because the control of companies that produce the inventory or raw materials needed in a company’s production process gives the company the power to refuse access to resources for new entrants and competitors. Such a company has the ability to cut off the chain of supply for competing buyers and, in turn, strengthen its position in its respective industry.

There are several well-known companies that use the backward integration strategy. This strategy was the main business approach of Ford and other car companies in the 1920s. These automobile companies sought to minimize costs by integrating the production of car parts. Another backward integration example is the fast-food restaurant, McDonald’s. This fast-food restaurant is known to have taken ownership of certain processes, even all the way back to the agricultural production that supplies ingredients for its eateries. Netflix is also an example of a company with a backward vertical integration strategy; this video-streaming company is known to distribute and create its own content.

Such companies integrate backward as one of their vertical integration strategies because it is expected to improve efficiency and save costs. This strategy tends to cut down transportation costs, improve the company’s profit margins, and make it more competitive. By making use of this type of vertical integration strategy, costs can be significantly controlled from production to the distribution process. Backward-integrated companies can also have more control over their supply chain, which enables them to gain direct access to the materials that they need, thus, increasing efficiency.

However, this strategy has its disadvantages despite its benefits. For a company to integrate backward, it requires a huge amount of money. That is, backward integration can be capital intensive and in order to purchase a supplier or production facility, the company may end up taking on large amounts of debt. Even though the company might realize cost savings by using this strategy, the cost of the incurred debt might end up reducing any of the cost savings realized. Also, the incurred debt added to the company’s balance sheet might prevent it from getting approved for additional credit facilities from its bank in the future.

Forward vertical integration strategy

Forward vertical integration is another type of vertical integration strategy whereby a company owns and controls the business activities that are ahead in the supply chain of its industry, such as the direct distribution or sales of the company’s finished products and services. When using this strategy, a company at the beginning of the supply chain advances downstream or further along the supply chain to take control of the distribution or sales of its products.

Forward integration is usually referred to as ‘cutting out the middleman’ as the company gains ownership over other companies that were once customers. Hence, this type of integration strategy differs from the backward vertical integration strategy wherein a company tries to gain ownership over companies that were once its suppliers. Forward vertical integration is usually implemented by companies that want to increase control over their distributors or retailer in order to increase their market power.

Therefore, a company vertically integrates forward once it controls and owns the distribution and retail centers where its products are sold. Compared to backward vertical integration, which serves to reduce the costs of production, forward vertical integration serves to decrease a company’s costs of distribution. The decrease in the cost of distribution is achievable by integrating forward because the taxes paid for exchanges between stages in the chain of production is avoided, other price regulations are bypassed, and the need for intermediary markets is removed.

A typical example of forward integration is a brewing company that controls and owns a number of pubs or bars; or an iron mining company that owns a downstream activity like a steel factory. Real-life examples of forward vertical integration companies are Nike and Walt Disney. Nike, integrated forward by establishing its own retail stores; this brand reduced its dependence on wholesalers, distributors, and retailers, and prioritized direct-to-consumer sales. Likewise, the Walt Disney Company, as one of its vertical integration strategies, launched the Disney+ streaming service which allows it to deliver its entertainment library directly to consumers.

The forward integration strategy has been advantageous to these companies as it results in a more significant market share, low costs due to the elimination of market transaction costs, and also increases the barriers to entry for potential competitors. In addition, the forward vertical integration strategy causes strategic independence, a decline in transportation expenses, and proper coordination in the supply chain.

Balanced vertical integration strategy

This is a type of vertical integration strategy whereby a company vertically integrates both upstream and downstream of its supply chain. That is, the company aims to acquire or merge with companies along the supply chain that are before and after it. For a company to engage in balanced vertical integration, it must be a middleman and a manufacturer (i.e. the company sits in the middle of a supply chain and not at one end or the other).

Take, for instance, the supply chain process for a beverage company which involves the sourcing of raw materials, the concoction of the beverage, and the delivery of the packaged beverages for sale. A case whereby this company chooses to merge with both its raw material providers and the retailers who sell its products is considered as the company engaging in balanced vertical integration. This means that to vertically integrates both backward and forward, a company has to be in charge of sourcing its raw materials and work with or own the retailers that deliver its finished product.

Balanced vertical integration is not easy to pull off as it is costly and risky due to the diversified nature of business operations. However, once executed well, any of the balanced vertical integration strategies used would offer greater benefits; a balanced integrated company is more likely to have greater (if not full) control over its entire supply chain process. Apple, for example, extended itself both backward and forward in its supply chain. This company vertically integrates forward by opening retail stores and vertically integrates backward by designing its own semiconductors.

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Examples of businesses using vertical integration strategy

1. Target
2. Walmart
3. Carnegie Steel Company
4. Nike
5. Mc Donald’s
6. Apple
7. U.S. Entertainment Studios (Allen Media Group)
8. Ford Motor Company
9. Tesla
10. CVS Health Corporation
11. Amazon
12. Alibaba
13. Netflix
14. EssilorLuxottica
15. Telstra

Listed above are just a few examples of businesses using vertical integration strategy; there are several other vertically integrated companies around the world.

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Pros of vertical integration strategies

1. One of the major pros of vertical integration strategies is that it results in long-term cost savings due to minimizing disruptions in the supply chain and favorable pricing.
2. Vertical integration strategy causes economies of scale, which in turn increases efficiency.
3. It establishes independence and reduces the need to depend on external parties or suppliers which comes with many issues such as Nike’s Supply Chain Issues and Management.
4. One of the pros of the vertical integration strategy is that it gives vertically integrated companies greater control over their inputs, products, and process, which may result in the production of superior products.
5. Using a vertical integration strategy helps in cost control and increases market control.
6. This strategy improves product knowledge and marketability.
7. A company that uses vertical integration strategies can offer its products at a much lower price compared to a nonintegrated company.

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Cons of vertical integration strategies

1. One of the prominent cons of vertical integration strategy is that it requires sizable up-front capital expenditures.
2. This strategy increases organizational complexity
3. Using vertical integration strategies can reduce the flexibility of a company
4. Vertically integrated companies can also lose focus and specialization on their original core objective or customer.
5. There is a risk of failure if vertical integration strategies are not properly implemented and thoroughly thought through.
6. One of the pros of vertical integration is that the company has to operate within a larger economy
7. A vertically integrated company can encounter unforeseen barriers when it enters a new market
8. Implementing vertical integration strategies can result in management difficulties and can create higher levels of internal confusion
9. There is a lack of familiarity that comes with vertical integration.

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When and when not to vertically integrate

Vertical integration strategies can be highly essential, but can be difficult to implement successfully; if it turns out to be the wrong strategy, it can be very costly to fix. Therefore, having known the pros and cons of vertical integration, it is important to know when and when not to use a vertical integration strategy. There are instances that make sense to vertically integrate as there are times that the strategy may not also be a good idea.

A company should not use any of the vertical integration strategies unless it is absolutely necessary because this strategy is too expensive, risky, and difficult to reverse. It is not advisable for a company to vertically integrate based on shallow reasons like reducing cyclicality, moving into the high value-added stage, assuring market access, or getting closer to customers. These reasons are sometimes valid but are often not strong enough reasons to vertically integrate.

There are better reasons to vertically integrate like when there is a risk of supply chain failure. It can be a good approach to make use of any vertical integration strategies during a supply chain failure. When there are very few buyers or sellers of a product or service, a supply chain failure can occur, which can result in high trading risk between adjacent stages in the supply chain. Such a situation can be a good time for the companies in these stages to vertically integrate.

It also makes sense to vertically integrate when companies in adjacent stages in the supply chain have more market power than the companies in your stage. That is, vertical integration can be beneficial when the adjacent supply chain members have an imbalance of market power; vertically integrating these adjacent supply chain members will definitely increase the profit that the weaker supply chain member yields.

This can also raise barriers to other businesses entering that segment of the market because when most competitors in the industry are vertically integrated, it makes it very difficult for nonintegrated players to enter the market. Hence, in order to compete with vertically integrated companies, potential entrants may have to enter all stages of the supply chain.

Another reason to vertically integrate would be when a market is emerging or declining. If a market is emerging, it can be beneficial for a company to vertically integrate supply chain members that are closer to the end customer (forward integration) in order to develop a market. Also, it makes more sense to vertically integrate when the market is declining and weaker independents are pulling out of adjacent stages.

As weaker independents pull out of the supply chain, the major players are left vulnerable to exploitation due to an increase in the number of concentrated suppliers or customers. Hence, companies can vertically integrate to fill the gaps left by the weaker independents that are pulling out, to avoid exploitation.

In conclusion, it is important for companies to consider the rich array of strategies available before opting for vertical integration as the supposing right strategy. Sometimes, using other strategies such as long-term contracts, strategic alliances, asset ownership, joint ventures, technology licenses, and franchising tends to give a company greater flexibility and also requires lower capital costs compared to using any of the vertical integration strategies.

Related:

• IKEA Supply Chain Problems and Issues
• McDonald’s Supply Chain Issues and Process