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Disadvantages of Vertical Integration

Vertical integration is a business approach wherein companies exert more control over their supply chains by taking ownership of more stages in the supply, production, distribution, and sale of their products and services. Once, a company can control all aspects of its business operations without third parties involved, it gives room for greater efficiencies and cost control. There are several other benefits of vertical integration but in this article, we will be discussing the disadvantages of vertical integration and what the strategy entails.

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Vertical integration meaning

A business strategy whereby a company takes control of more than one stage of its supply chain is known as vertical integration. The supply chain is the network of all the activities, organizations, individuals, resources, and technology involved in the creation and sale of a product. It involves the procurement of raw materials and the production, distribution, and sale of finished goods or services. This supply chain, therefore, comprises suppliers, producers, distributors, vendors, and retailers.

Disadvantages of vertical integration
Disadvantages of vertical integration

In order to understand how vertical integration works with the stages in a supply chain, let’s take Company A as an illustration. For this company, the processes in the supply chain begin with the procurement of raw materials, which proceeds through various stages of production, then, the finished product is distributed and, eventually, sold to the end customer.

Company A as a nonvertically integrated company might implement only one stage in the chain of processes (let’s say the production stage). Now, assuming Company A decides to vertically integrate, this means it would have to expand its operations to include the stages before (known as backward vertical integration) and/or after (known as forward vertical integration) the production stage that it already performs.

That is, in order to vertically integrate, the company may choose to acquire one or more of its suppliers in order to gain more control over production or reduce manufacturing costs. Another alternative would be the company investing in the retail end of the process, such as opening physical stores or introducing e-commerce capabilities in order to get closer to the customer and increase its profit margins. The company might also choose to take more control over distribution and logistics by investing in warehouses and vehicle fleets.

In the illustration, we can see that Company A as a manufacturer vertically integrates to act as its own supplier and distributor. Amazon is a typical example of a vertically integrated company. This company has vertically integrated much of its business; it acts as a marketplace for buyers and sellers, offers its own products and services, and has its own distribution channel. This means, Amazon has control of about three stages of its supply chain. It is in charge of sourcing its products, marketing and selling them on its website, and distributing them. This strategy has given Amazon an edge over its competitors by improving the company’s efficiencies while reducing costs.

This business strategy improves efficiencies and reduces costs which makes vertically integrated companies significantly competitive. It also gives the company power over suppliers and buyers and lowers the prices of products for consumers. However, despite the advantages of this strategy, there are several disadvantages of vertical integration that companies must also consider very carefully before getting vertically integrated. One of the major disadvantages of vertical integration is that it requires sizable capital investments and in some situations, the strategy can limit the flexibility that comes from partnering with a federation of suppliers. Let’s look at other negative effects of vertical integration.

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Disadvantages of vertical integration

  1. Vertical integration requires sizable up-front capital expenditures
  2. It increases organizational complexity
  3. This strategy can reduce the flexibility of an organization
  4. Vertically integrated companies can lose focus and specialization on their original core competencies
  5. There is a risk of failure
  6. The company has to operate within a larger economy
  7. There can be unforeseen barriers when a vertically integrated company enters a new market
  8. Vertical integration can result in management difficulties
  9. This strategy can create higher levels of internal confusion
  10. Lack of familiarity
  11. Vertical integration can result in an unbalanced throughput

Vertical integration is a strategy that has to be carefully thought through before implementing. It is a long-term process that needs widespread buy-in, thus, businesses can’t just vertically integrate overnight. The whole process requires heavy upfront capital expenditure in order to acquire or merge with the proper company. It also involves integrating new and existing systems, and ensuring employees are trained across the entire process. Hence, this whole process will come with some benefits and disadvantages. Here are some of the disadvantages of vertical integration:

Vertical integration requires sizable up-front capital expenditures

One of the disadvantages of vertical integration is that it requires sizable up-front capital expenditures and may take a really long time before the return on this investment is realized. Vertical integration is not a cheap investment; once a company chooses to vertically integrate, it has to make either a build or buy decision.

The company can buy some part of the supply chain by acquiring or merging with suppliers, manufacturers, distributors, or retailers; or, the company can choose to build some part of its supply chain from scratch by recreating one or more parts of the supply chain process that it had been outsourcing before.

The fact is, whether a company chooses to build or buy, the huge investment comes as a major disadvantage of vertical integration. It requires substantial upfront capital regardless of whether the company is establishing its own capabilities or attaining them through mergers and acquisitions.

In order to vertically integrate, an organization has to build or purchase physical facilities, invest in new business processes and technologies, hire new employees and management, and understand new processes that are unfamiliar to the organization. And all these, in turn, increase the size and complexity of the overall organization.

Also, even if the organization is vertically integrated through partnerships, it would still have to invest in specific patents, processes, proprietary data, or research processes that can require significant assets, as part of the deal. This means that for vertical integration to be possible, a sizable capital is definitely required.

The high capital requirements for vertical integration can be a huge challenge for small businesses because they need to have a lot of capital available before they can invest in the processes of vertical integration.

Some companies after starting the processes of vertical integration often discover that they need more employees, better training facilities, and more real estate; if not properly prepared for such expenditures, they end up putting themselves at risk of bankruptcy and insolvency. Hence, it may be a better decision for a company to avoid any investment in vertical integration until it is certain it can manage the expenses that come with it.

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It increases organizational complexity

Another disadvantage of the vertical integration strategy is that it increases organizational complexity. Once this strategy is implemented, the organization must add to its existing operations, and must strategically integrate those operations with existing processes and systems in order to realize the potential benefits of the strategy.

The fact is vertical integration would cause a drastic increase in the size of an organization and larger organizations are usually much harder to manage effectively. This can be alleviated somewhat by creating subsidiaries, even though this too can result in increased complexity in the organization’s corporate structure. As a result of the complexity that comes with this strategy, the organization is put at higher risk of waste and mismanagement of resources.

This strategy can reduce the flexibility of an organization

Vertical integration can reduce an organization’s flexibility due to the sunk investment in infrastructure. This is one of the major disadvantages of vertical integration. An organization that works with several contractors or vendors tends to have a certain flexibility that vertically integrated organizations normally do not have.

By using a vertical integration strategy, businesses may have a few choices with their supply chain whereas businesses that use third parties can make changes whenever they deem fit without maintenance costs within their infrastructure. That is, when a business makes use of third-party providers, it has the option to make changes according to their contracts without any infrastructure maintenance costs.

However, when vertical integration is implemented, the supply chain sees fewer choices instead of more and this can make it challenging for a company to adapt to quickly changing economic conditions. A company that doesn’t work with several different contractors and vendors, would have less flexibility in the final outcome compared to when every other thing was outsourced.

Furthermore, vertical integration can be less flexible and extremely risky because it requires a commitment to a particular technology or way of operating. That is, if there is any change in technology or the market, the products or methods of one stage in a vertically integrated system become obsolete, and the vertically integrated company may find it very difficult to adjust.

For example, Jonathan Logan (Video on a women’s apparel producer), in the 1960s vertically integrated itself to double-knit fabrics by investing in a textile mill. As time went by, double-knits went out of fashion but the company continued to manufacture them, mainly to accommodate the mill’s production. However, when Jonathan Logan finally closed the mill in 1981, it reported a $40 million write-off.

Therefore, the fact remains that, companies sacrifice a little bit of flexibility once vertically integrated because they are committing capital to a particular process or product. That is, instead of having the option of declining purchasing from an external vendor, the company has already committed money to an integrated vendor that can not be easily recovered.

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Vertically integrated companies can lose focus and specialization on their original core competencies

Vertical integration can also have serious social impacts on the company. A company, by getting vertically integrated may end up trying to do too much and end up losing focus of its ultimate goal. Vertical integration can be disadvantageous when a company losses its focus and specialization.

Integrating a new company at a different stage in the supply chain is a lot of work and can be very difficult for the parent company due to the lack of experience in that field. The parent company may struggle to focus on its core competencies and would rather focus on the integration and management of the new company.

That is, one of the disadvantages of vertical integration is that it creates a loss of focus and specialization. Some companies are so good at what they do and due to their specialization, they almost remove themselves from the competition in the market. For instance, a company may be exceptional at retailing its products, but ill-equipped to manage the manufacturing process.

A vertical merger for such a company could have an adverse effect on the success and growth of the company and may permanently change the company’s culture.

There is a risk of failure

One of the major disadvantages of vertical integration is that it is an irreversible decision and this puts a company at risk if things go wrong. Due to the huge size of investment required in vertical integration, failure can have severe consequences for businesses. Large mergers and acquisitions cannot be reversed easily; unless the vertical merger or acquisition is doing very well, the company may eventually have to sell at a loss, if at all a sale is possible. Therefore, losses can be huge in a situation whereby the management of the vertical merger or vertical integration processes fails.

The company has to operate within a larger economy

Vertical integration forces a company to operate within a larger economy. If a company decides that vertical integration is necessary for its future, it must force itself into a growth period. There are several advantages to this if the company can use its size as leverage. However, the offside to this, is that the company has to have stable finances before this attempt is made.

When a company tries to grow big too quickly, the instability in its finances can create disastrous consequences. This is one of the disadvantages of vertical integration. It is just as common for companies to declare bankruptcy after getting vertically integrated as it is for a successful outcome to occur. Therefore, since there is so much money at stake with getting vertically integrated, it is very important that the C-Suite takes a complete look at the overall picture before proceeding.

There can be unforeseen barriers when a vertically integrated company enters a new market

Vertical integration can limit the effectiveness of a business’s competitors, but it doesn’t always account for the unforeseen barriers that are present in every new market. One of the advantages of vertical integration is that it limits competition, but this is only possible when the vertically integrated company has access to the materials necessary to be competitive in the first place.

This means that even with vertical integration firmly in place, market entry may be difficult, if raw materials are scarce or a company’s information access to a local demographic is limited. That is, vertically integrated companies must keep their focus on the processes that are necessary to access a new market in order to remain successful.

Entering a new market without having enough raw materials for the supply chain can result in an unnecessary barrier to the company’s production process. Hence, one of the disadvantages of vertical integration is that it may not create enough opportunities to make every effort put into the strategy profitable when the local access to markets is under restriction. This is why it is important to have a viability evaluation during the decision-making process in order to ensure that investment in vertical integration makes sense at that point.

Vertical integration can result in management difficulties

Another disadvantage of vertical integration is that it can result in management difficulties. When another company is vertically integrated into the parent company, there may be some management challenges.

For instance, a manufacturing business acquires a retailer; both companies are likely to have very different cultures. These two businesses are very different and as a result, some of the existing management may be retained to help.

Nonetheless, the retained employees may find it very difficult to work in a new environment where they have to answer to the parent company. Conflicts can arise from the retailer company as it goes from being independent to being told what to do. The conflict tends to be more, especially when the parent company has little experience in the industry.

This strategy can create higher levels of internal confusion

One of the disadvantages of vertical integration strategy is that it can create higher levels of internal confusion. Vertical integration results in different entities within the supply chain falling under one specific brand, even though these entities may operate as distinct businesses. This can create confusion among customers whereby they think they are working with one company, only to discover that they are working with a different company.

Confusion is easily created among customers when there is a realization that duplication occurs. Customers tend to see each product as its own company and when confused, they choose not to make a purchase. Also, customers may not like the concept of a large manufacturer also interfacing directly with customers.

Lack of familiarity

Vertical integration can be disadvantageous when there is a lack of familiarity. The process of vertical integration requires a company to get involved in new aspects of the supply chain that it is usually not familiar with.

For instance, a business that sells shirts is in the retail sector and knows how to present its product to customers in the most effective way. However, if this business is asked to create the shirts from scratch, it would struggle to produce them and would even need to source the raw fabrics. This means that getting vertically integrated would entail getting your business involved in sectors that may be unfamiliar or alien to your sector. This can be a huge challenge because succeeding in new fields can be hard, due to a lack of prior experience.

Familiarity is essential for the whole integration process to be successful. Any business without internal authority struggles with vertical integration because there isn’t internal knowledge. For instance, companies that are knowledgeable and familiar with retail would struggle when they venture into manufacturing because they do not fully understand all of the strategies and requirements needed for a successful outcome. The same would happen for producers that try to venture into retail. Hence, a lack of familiarity is one of the major challenges and disadvantages of vertical integration.

Vertical integration can result in an unbalanced throughput

One of the disadvantages of vertical integration is that it can result in an unbalanced throughput. In business, throughput is the amount of a product or service that a business can produce and deliver to a customer within a specified period of time. In order words, it is a company’s rate of production or the speed at which a company processes a product.

In business, a high throughput level is important because it generally indicates that a company can produce a product or service more efficiently than its competitors. Therefore, it is businesses with high throughput levels that take market share away from their lower throughput peers. Vertically integrated companies tend to have unbalanced throughput because when a company combines the various production or distribution stages, the different scales of operations that each requires can result in inefficiencies.

A vertically integrated company might discover that in order to match the cost competitiveness that an independent supplier offers, it needs to produce goods at a very high volume. There can be times when the minimum efficiency scale of an operation is greater than the volume of supplies required to produce goods for the marketplace. This can be a disadvantage because it means that it would be cheaper to maintain third-party relationships rather than trying to bring everything under one parent company.

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