Vertical Integration Explained: How It Works, With Types and Examples

What Is Vertical Integration?

Vertical integration is a strategy that allows a company to streamline its operations by taking direct ownership of various stages of its production process rather than relying on external contractors or suppliers. Companies can achieve vertical integration by acquiring or establishing their own suppliers, manufacturers, distributors, or retail locations rather than outsourcing them. Vertical integration can be risky due to the significant initial capital investment required.

Key Takeaways

Vertical integration requires a company's direct ownership of suppliers, distributors, or retail locations to obtain greater control of its supply chain.
The advantages can include greater efficiencies, reduced costs, and more control along the manufacturing or distribution process.
Vertical integration often require heavy upfront capital that may reduce a company's long-term flexibility.
Forward integration occurs when a vendor attempts to acquire a company further along the supply chain (i.e. acquire a retailer).
Backward integration occurs when a vendor attempts to acquire a company prior to it along the supply chain (i.e. a raw material provider).

How Vertical Integration Works

Vertical integration occurs when a company attempts to broaden its footprint across the supply chain or manufacturing process. Instead of sticking to a single point along the process, a company engages in vertical integration to become more self-reliant on other aspects of the process. For example, a manufacturer may want to directly source its own raw materials or sell directly to consumers.

The supply chain or sales process typically begins with the purchase of raw materials from a supplier and ends with the sale of the final product to the customer. Vertical integration requires a company to take control of two or more of the steps involved in the creation and sale of a product or service. The company must buy or recreate a part of the production, distribution, or retail sales process that was previously outsourced.

Companies can vertically integrate by purchasing their suppliers to reduce manufacturing costs. They can invest in the retail end of the process by opening websites and physical stores. They can invest in warehouses and fleets of vans to control the distribution process.

All of these steps involve a substantial investment of money to set up facilities and hire additional talent and management. Vertical integration also ends up increasing the size and complexity of the company's operations.

As a company engages in more activities along a single supply chain, it may result in a market monopoly. A monopoly that occurs due to vertical integration is also called a vertical monopoly.

Types of Vertical Integration

There are a number of ways that a company can achieve vertical integration. Two of the most common are backward and forward integration.

Backward Integration

A company that chooses backward integration moves the ownership control of its products to a point earlier in the supply chain or the production process.

This form of vertical integration is aptly named as a company often strives to acquire a raw material distributor or provider towards the beginning of a supply chain. The companies towards the start of the supply chain are often specialized in their distinct step in the process (i.e. a wood distributor to a furniture manufacturer). In an attempt to streamline processes, the furniture manufacturer would try to bring the wood sourcing in-house.

Amazon (AMZN) started as an online retailer of books that it purchased from established publishers. Although it continues to do so, it also became a publisher. The company eventually branched out into thousands of branded products. Then, it introduced its own private label, Amazon Basics, to sell many of them directly to consumers.

Forward Integration

A company that decides on forward integration expands by gaining control of the distribution process and sale of its finished products.

A clothing manufacturer can sell its finished products to a middleman, who then sells them in smaller batches to individual retailers. If the clothing manufacturer were to experience forward vertical integration, the manufacturer would join a retailer and be able to open its own stores. The company would aim to bring in more money per product, assuming it can operate its retail arm efficiently.

Forward integration is a less common form of vertical integration because it is often more difficult for companies to acquire others that are further along the supply chain. For example, the largest retailers at the end of the supply chain often have the greatest cash flow and purchasing power. Instead of these retailers being acquired, they often have the capital on hand to be the acquirer, which is an example of backward integration.

Balanced Integration

A balanced integration is an approach to vertical integration where a company aims to merge with companies both before it and after it along the supply chain. A company must be the middleman and manufacture a product to engage in balanced integration. That's because it must both source raw materials as well as work with retailers to deliver the final product.

Consider the supply chain process for Coca-Cola (KO) where raw materials are sourced, the beverage is concocted, and bottled drinks are distributed for sale. Should Coca-Cola choose to merge with both its raw material providers as well as retailers who will sell the product, the company is then engaging in balanced integration.

Though most costly and risky due to the diversified nature of business operations, balanced integration also poses the greatest upside as a company is more likely to have greater (if not full) control over the entire supply chain process.

Although vertical integration can reduce costs and create a more efficient supply chain, the capital expenditures involved can be significant.

Advantages and Disadvantages of Vertical Integration

Vertical integration can help a company reduce costs and improve efficiency. However, when executed poorly, vertical integration may have negative consequences on the company.

Advantages

The primary goal of vertical integration is to gain greater control over the supply chain and manufacturing process. When performed well, vertical integration may lead to lower costs, economies of scale, and a lower reliance on external parties.

Vertical integration may lead to lower transportation costs, smaller turnaround times, or simpler logistics if the entire process is managed in-house. This may also result in higher quality products as the company has direct control over the raw materials used through the manufacturing line.

Companies may sometimes find themselves at the whim of suppliers who have market power. Through vertical integration, companies can circumnavigate external monopolies. In addition, a company may gain insights from a retailer on what goods are selling best; this information may be very useful in making manufacturing and product decisions.

Disadvantages

Companies can't vertically integrate overnight. In fact, it is a long-term process that requires widespread buy-in. This also includes heavy upfront capital expenditure requirements to acquire the proper company, integrate new and existing systems, and ensure that staff is trained across the entire manufacturing process.

By vertically integrating, companies do sacrifice some degree of flexibility. This is because they commit capital to a specific process or product. Instead of being able to decline purchasing from an external vendor, a company will likely have committed money that can not be easily recovered. In addition, a company may lose the opportunity to gain unique knowledge through different external vendors.

Vertical integration may also have several social impacts. Companies may end up trying to do too much and lose focus on their ultimate goal. In addition, customers may not support the culture of a large manufacturer also interfacing directly with customers.

Pros

Long-term cost saving due to favorable pricing and minimal supply chain disruptions
Economies of scale, which increase efficiency
Reduces or eliminates the need to rely on external parties/suppliers
Greater control over the product, inputs, and process, which may lead to superior products

Cons

Requires large upfront capital requirements to implement
Reduce a company's long-term flexibility
Loss of focus on a company's primary objective or customer
Displeased customer base that would prefer to work with smaller retailer

Vertical Integration vs. Horizontal Integration

Vertical integration involves the acquisition of a key component of the supply chain that the company has previously contracted for. It may reduce the company's costs and give it greater control of its products. Ultimately, it can increase the company's profits.

Horizontal integration, on the other hand, involves the acquisition of a competitor or related business. A company may do this to accomplish any or all of the following:

Eliminate a rival and cut out its competition
Improve or diversify its core business
Expand into new markets
Increase its overall sales

While a vertical integration strategy stretches a company along a single process, horizontal integration is a more pointed approach that causes a company to become more specific or niche within a certain market. For example, instead of engaging in all aspects of a supply chain ranging from materials sourcing, manufacturing, or retail, a company can choose to master only one of those facets by acquiring similar companies to engage in horizontal integration.

Much analysis has gone into reviewing when it is more optimal to simply contract with another company as oppose to acquire them. Published modern economic theory on the matter dates back decades.

Examples of Vertical Integration

Netflix

Netflix (NFLX) is a prime example of vertical integration. The company started as a DVD rental business before moving into online streaming of films and movies licensed from major studios. Executives then realized they could improve their margins by producing some of their own original content like the hit shows "Grace & Frankie" and "Stranger Things." It also produced some bombs, like 2016's The "Get Down," which reportedly cost the company $120 million.

The company now uses its distribution model to promote its original content alongside programming licensed by studios. Instead of simply relying on the content of others, Netflix performed vertical integration to become more engaged in the entertainment development process earlier.

Fossil Fuel Industry

The fossil fuel industry is a case study in vertical integration. British Petroleum (BP), ExxonMobil (XOM), and Shell (SHEL) all have exploration divisions that seek new sources of oil and subsidiaries that are devoted to extracting and refining it. Their transportation divisions transport the finished product. Their retail divisions operate the gas stations that deliver their product.

Live Nation & Ticketmaster

The merger of Live Nation and Ticketmaster in 2010 created a vertically integrated entertainment company that manages and represents artists, produces shows, and sells event tickets. The combined entity manages and owns concert venues, while also selling tickets to the events at those venues.

When Is an Acquisition Considered Vertical Integration?

An acquisition is an example of vertical integration if it results in the company's direct control over a key piece of its production or distribution process that had previously been outsourced.

A company's acquisition of a supplier is known as backward integration. Its acquisition of a distributor or retailer is called forward integration. In the latter case, the company is often buying a customer, whether it was a wholesaler or a retailer.

Is Vertical Integration Good for a Company?

Whether vertical integration makes sense for a company depends on what's good for it in the long run. If a company makes clothing with buttons, it can buy the buttons or make them. Making them eliminates the markup charged by the button-maker. It may give the company greater flexibility to change styles or colors while eliminating the frustrations that come with dealing with a supplier.

Then again, the company would have to set up or buy a whole separate manufacturing process for buttons, buy the raw materials that go into making and attaching buttons, and hire people to make the buttons along with a management team to manage the button division.

What Is the Difference Between Vertical Integration and Horizontal Integration?

Vertical integration is the practice of acquiring different pieces along a supply chain that a company does not currently manage. Horizontal integration is the practice of acquiring similar companies to further master what it already does. Vertical integration makes a company broader while horizontal integration may help it penetrate a specific market further.

Why Do Companies Use Vertical Integration?

Companies use vertical integration to have more control over the supply chain of a manufacturing process. By taking certain steps in-house, the manufacturer can control the timing, process, and aspects of additional stages of development. Owning more of the process may also result in long-term cost savings (as opposed to buying outsourced goods at marked-up costs).

The Bottom Line

Vertical integration is the business arrangement in which a company controls different stages along the supply chain. Instead of relying on external suppliers, the company strives to bring processes in-house to have better control over the production process. Though vertical integration may result in increased upfront capital outlays, the goal of vertical integration is to streamline processes for more efficient and controlled operations in the long-term.