As your business evolves, there may come a point where you feel you have outgrown the capabilities of your current supply chain partners – both up and downstream.
This is where vertical integration can come into play, helping your organisation achieve its goals without relying on others. But what is vertical integration, and what does it look like?
What is vertical integration?
Vertical integration is the acquisition of two or more stages of the supply chain, with the goal of streamlining or enhancing business efforts by controlling more of the process.
As a business seeking to vertically integrate, you might acquire your own distributors or suppliers, such as growers, component manufacturers or freight partners. You may also acquire companies downstream, gaining wholesalers or retail outlets.
Should a company gain total control of its sector through vertical integration, it is known as a vertical monopoly.
Why do companies vertically integrate?
Vertical integration has many advantages (which we discuss in greater detail below). For some organisations it is a matter of cost control – for example by controlling more of the manufacturing process, you get a bigger say in how things are priced.
For other organisations, it’s a matter of quality control, risk mitigation or market influence.
Vertical integration statistics
Vertical integration typically requires a hefty investment, particularly for organisations entering a new market for the first time (like a manufacturer buying out its own growers). But does that effort pay off?
A literature review by the Harvard Business Review (HBR) found a V-shaped relationship between ROI and intensity of vertical integration investment. The review sought to determine whether vertical integration was actually profitable, finding that companies were more likely to be more profitable with either very low rates of vertical integration or very high - but not in between. More investment in vertical integration also increased costs, sinking ROI, until the investment became high enough to flip it back around.
The review found there is a “winning combination” between intensity of investment and profit, but that this combination was quite uncommon.
Other interesting results include:
- Larger organisations (defined by % of market share) were more likely to achieve ROI than smaller organisations.
- Backwards integration enhanced ROI in both consumer and industrial products sectors, but forwards integration was more effective for consumer goods only. See below to learn more about these two terms.
- Vertically integrated businesses were more likely to be innovative than less-integrated peers.
So what’s the takeaway here?
Vertical integration is not right for every organisation.
However if your company is already able to operate efficiently at scale, you control a reasonably large market share and you see an opportunity to be more innovative, it may be a savvy investment.
For organisations that don’t fit that definition, you might want to consider either a limited investment in vertical integration, or alternatives to ownership. For example, long-term contracts with suppliers can often yield similar benefits to vertical integration as new business ownership, without the same risks.
Vertical integration vs horizontal integration
Vertical and horizontal integration both relate to the acquisition of new business units.
Where vertical integration is about taking control of new business units up and down the supply chain, horizontal integration is about taking control of new business units across the same level of the supply chain.
When horizontally integrating, an organisation looks to acquire companies with a similar function (such as a brewery taking over another brewery). This has a few advantages:
- It allows one organisation to share its people, processes and technology, potentially cutting costs and improving innovation (both companies will have learned different lessons, and can now learn from one another).
- It’s often a faster way to expand into new markets (if a brewery wishes to expand into a new city and integrates horizontally, it doesn’t have to build new facilities).
- It can eliminate competition.
Advantages of vertical integration
- Cost control: Controlling more of the supply chain can help you control costs. For example, decreasing lead times, improving coordination between supply chain stages or creating greater economies of scale.
- Quality control: With greater product control comes the potential for greater quality control. You’ll have oversight of not just the manufacturing process, but the production of raw materials and perhaps all the way through to retail, too.
- Less reliance on third parties: Gaining control of suppliers or other partners ensures your organisation relies less on third parties. It removes the risk that your business will be left in the lurch by someone else going into hardship, and means you can more seamlessly integrate different stages of your supply chain – creating greater cost efficiencies. In some cases, it may allow you to circumvent another company’s monopoly.
- Greater innovation: Vertically integrated business units can share better data with each other. For example, acquiring a retail arm will give you direct access to new customer insights, perhaps changing how you manufacture in future. All of this extra data can lead to greater levels of innovation across the business – one of the key advantages of vertical integration highlighted by the Harvard Business Review.
Challenges of vertical integration
- It’s expensive: Integrating vertically is a significant investment, usually requiring a lot of up-front capital – not to mention the extra costs of integrating IT systems, writing new processes and training staff. Looking back at HBR’s findings, this investment does not always achieve ROI.
- It can take a long time: On top of the cost is the time. Vertical integration is a long-term process, especially when you’re building new facilities. It’s a lot of money going into something which may not yield profit for many years – your organisation must be able to handle that risk.
- It can reduce flexibility: There is an advantage to being able to walk away from supply chain partners: it enables you to stay flexible if things don’t go as you expect, or the market changes due to external factors. When you control your own supply chain, you may not be able to pivot quite as quickly, leading to agility problems.
- It can muddy strategic goals: Some organisations lose sight of their strategic goals when attempting to vertically integrate, forgetting their core competencies in the race to access new markets. It can spread a company very thin, the classic ‘trying to do too much at once’ problem.
- Regulators may take notice: Any organisation which grows too large, or gains too much control, may attract the attention of regulators (i.e. antitrust bodies). This could pose a new legal risk to the business.
The three types of vertical integration
1. Backwards vertical integration
Backwards vertical integration (aka backwards integration) is the building or acquiring of new business units higher up the supply chain.
For example, a beer brewery could acquire hops growers and other related raw materials producers, as well as the logistics functions necessary to get those products to the brewery.
It’s up to each individual manufacturer how much of the supply chain to integrate. Some companies have found that more is better, whereas others find it’s more cost-effective to integrate the most important functions (i.e. raw materials), but continue to outsource functions which would be too expensive to start up – like bottle manufacturing and label printing.
2. Forwards vertical integration
Forwards vertical integration (aka forwards integration) is the building or acquiring of new business units further down the supply chain.
For example, a beer brewery might integrate a retail component to its organisation so that it can sell directly to consumers. It may also open its own taverns, selling its own products, to move into the hospitality space too.
Forwards integration is less common than backwards integration, because it’s typically much harder to make profitable. The further down the pipeline you get, often the tougher the competition (consider the difference in market power between a chain of bottle stores, and a farm that grows hops).
3. Balanced vertical integration
Balanced integration is the building or acquiring of new business units both up and down the supply chain.
For example, a brewery (which is a middleman company in its sector) might acquire its own growers as well as its own taverns or retail outlets in order to control the entire supply chain, perhaps with the exception of freight partners.
Balanced integration is a risky venture even by vertical integration standards, committing an organisation to its single supply pipeline. That said, the organisation gains enormous control over the quality of its products which may balance out the risk after a few years.
Bonus term: Disintermediation
Disintermediation is an extra term to know which, while not considered a ‘type’ of vertical integration, does have more or less the same purpose.
Disintermediation is the cutting out of the middleman in a process. It was originally a financial term (where investors trimmed out banks and brokers by buying financial products directly). Nowadays it is commonly known by its retail terms, Direct-to-Consumer (D2C) or Business-to-Consumer (B2C).
This practice has grown more common in the internet age, which enables manufacturers to sell D2C via an eCommerce function. That said, the internet has also brought about new, powerful intermediaries that almost everyone uses – such as Amazon, or the Apple App Store.
Vertical integration examples
Disney – forwards integration
Prior to its forwards integration, Disney could only sell its products (i.e. movies) to consumers via intermediaries such as movie theatres and DVD retailers.
However, when it created the streaming service Disney+, it built a new business unit further down the supply chain, allowing it to sell D2C in direct competition with those previous intermediaries (plus new competitors, like Netflix).
Amazon Kindle – backwards integration
Amazon brings us examples of both forwards and backwards vertical integration, but today we’re focusing on its original business – selling books.
In its early days, Amazon was a bookseller. It required distributors and publishers upstream in order to acquire products to sell. However, when it gave authors a direct platform upon which to sell their books D2C, it integrated backwards and cut out the need for both publishers and book distributors.
Estate wineries – balanced integration
Estate wineries are an example of an entire subsector of the winemaking industry which, by design, uses balanced integration to achieve greater product control.
Winemaking estates are those which grow their own grapes, produce their own wine and sell it directly to customers. While they may hire additional partners (such as bottle manufacturers and retail wholesalers), they function independently for the most part.
For a product as finicky as wine, this balanced integration gives the winemakers a high level of control over their product’s flavour profile. Additionally, it enables them to run a very tight ship from a cost point of view, cutting out the need to transport grapes over long distances.
Live Nation and Ticketmaster merger – both forwards and backwards
In 2010, companies Live Nation and Ticketmaster announced a merger. Previously, Live Nation was one of the USA’s leading concert producers, with Ticketmaster a leading event ticketer.
This merger is an example of one company integrating forwards, and the other backwards, to create a new, balanced organisation. As a single unit, Ticketmaster now owns its own event spaces, can create and promote live concerts, and then sell tickets to those concerts directly to consumers. This has made it a powerful vertical monopoly in its sector.
Vertical integration strategies and things to consider
Factors which influence whether you should vertically integrate
These factors come from a combined Harvard/Indian Institute of Management study which looked specifically into vertical integration in India.
Researchers identified these as the core decision making factors to consider when looking at vertical integration:
- Distance to your suppliers.
- Frequency of purchases from suppliers.
- Volume requirements from suppliers.
- R&D requirements.
- Scale of your firm.
- Product specificity, i.e. your niche.
- Competition both upstream and downstream.
You may find that, if too many of these factors are risky, costly, inconvenient or ripe for innovation, you might have an opportunity to vertically integrate. Of course, your existing scale and competition within your niche will affect that decision.
Vertical integration tips
1. Determine if it’s right for you
McKinsey & Co identified five reasons a company might vertically integrate:
- Your market is unreliable.
- Companies near yours in the supply chain have more market power than your company.
- Integration would allow you to better control pricing.
- You’re developing a new market, so forwards integration is a necessity.
- The market is declining, and your existing supply chain partners are retreating.
Remember, analysis has shown that vertical integration tends to work best at scale – otherwise specialised companies who already dominate their part of the supply chain may be too tough to beat.
2. Ensure your goals are clear
One of the common challenges of investing in vertical integration is losing sight of business goals.
Your business exists because it serves a function or solves a problem. If you’re in a position where M&A is a real business opportunity, chances are you’re extremely good at what you do. Expanding your horizons up or down the supply chain could muddy those waters by detracting from the core of your business.
3. Keep an eye on your costs
Vertical integration is expensive, and it’s easy to get carried away making investments in the excitement of opening up new markets or creating new business opportunities.
But, the ideal vertical integration strategy is one which increases the value of your business without adding significant new investment. At all times, when building or acquiring new units, consider how you can achieve your integration goals while minimising costs. This could take on a few forms, including:
- Buying out competitors instead of building whole new facilities.
- Determining how to get more out of your existing infrastructure.
- Expanding piece by piece, instead of all at once, to ensure business stability as you grow.
