Vertical integration is the combination of two or more production stages in one company that normally operate out of separate organizations. This strategy makes it possible for an agency to control or own its distributors, suppliers, and retail locations to control the supply chain or its overall value.
The benefits that are possible from an effort to vertically integrate include better control over the creation process, reduced costs, and an improvement in efficiency. These advantages are possible only when significant amounts of capital are available, which is why smaller firms typically outsource those needs instead of internalizing them.
This process can move forward or backward. Forward integration occurs when companies control the direct supply or distribution of their products. Backward integration happens when the organization expands in reverse along its production path into the manufacturing sector.
Several advantages and disadvantages of vertical integration are necessary to review before determining if this investment is worth making.
List of the Advantages of Vertical Integration
1. Vertical integration creates more information to review.
The processes of vertical integration create more predictability for organizations from a data-gathering standpoint. This advantage is possible because there is more information that is available to the company due to the increased availability of production inputs. Retail channels can create real-time data that doesn’t go through a third-party filtering process.
Distribution requirements in vertical integration can be adjusted to promote individualized products to specific demographics. By being in more control, from start to finish, companies can quickly adapt to changes so that the most efficient result is achievable.
2. Investments can focus on specialization for a company’s assets.
Vertical integration shifts the perspective of the organization from seeking third-party providers with specific skill sets to internal development processes. When there is recognition of a specific need within the supply chain, then this approach allows an agency to create what they need with their investments instead of spending money trying to find someone else. It is a process that creates more opportunities for differentiation within an industry.
When a company can stand apart from its competition, then consumers are typically more willing to listen to specific brand messages. That means the value proposition offered to each consumer can resonate better over time.
3. Vertical integration works to improve a company’s share of the market.
Companies that invest in their vertical integration processes will control more of their supply chain. This work gives the firm more leverage with specific benefits that their “perfect customers” might want to solve unique pain points. Since the messages shared with each consumer come from internal sources, it becomes easier to identify specific areas of the market where the organization can dominate.
The comparison factor between brands increases when vertical integration investments occur. If a product or service becomes better because of this effort, then it is more likely to secure a sale.
4. It lowers transaction costs for the organization.
Companies that can complete their vertical integration journey will have more control over their supply chain from start to finish. That means they can use this leverage to begin reducing transaction costs along that entire journey. Suppliers and vendors can take advantage of the size and scope of the organization to create positive impacts for their own efforts while reducing costs for the agency in question.
This advantage is the reason why Walmart is often successful at offering lower prices than their competition for in-store purchases. With thousands of stores and millions of customers, they are one of the world’s largest companies. This structure makes people want to do business there, which is how costs ultimately stay lower.
5. Companies can improve quality assurance measures with vertical integration.
A successful effort at vertical integration makes it possible for organizations to produce higher quality items at a lower cost point. The review process can begin at the earliest stages of product development when obtaining raw materials. Then it continues on until the item is in the hands of a consumer. Some companies would even include their approach to customer service in this advantage to encourage repetitive transactions.
Implementing a quality assurance approach with vertical integration allows for more consistency to enter the supply chain. That means the value proposition becomes reliable for the consumer, allowing for better satisfaction to develop across all channels. This process often results in higher brand loyalty and better revenue streams.
6. Vertical integration can unlock new markets for an organization.
The processes of vertical integration allow for an organization to open new markets for itself. This advantage is possible whether the effort is forward or backward with the effort. When companies begin to develop new assets that include IP, technology improvements, real estate acquisition, and other items that improve access to the consumer, then the reduction of obstacles creates more opportunities to complete transactions.
Not only does this work to reduce the costs of each transaction, but it also improves the amount of money that trades hands. When there are fewer hands in the cookie jar that need a percentage of the profits, then more of that goes to the organization.
7. It creates more stability within the company and its industry.
It is easier for organizations to withstand economic changes after going through a vertical integration process. There is an extra level of stability available in the company’s finances because there is more predictability available in the overall process. When there are elements of the supply chain that fall outside of a firm’s control, then a recession can be devastating to the agency’s bottom line.
It might take some capital to reach this stage, but most organizations feel like it is a worthwhile investment to make because of this advantage.
8. Vertical integration creates higher entry barriers.
When a company has high levels of vertical integration, then competitors must have greater financial and managerial resources available to become competitive. An established company can naturally limit disruption by combining their operations in ways that make it too expensive to pursue a new idea. This advantage can be a gamble since new technologies come out frequently that allow for smaller companies to remain competitive. It can also be one of the most effective ways to establish a consistent revenue stream.
9. It improves coordination throughout the entire supply chain.
Although supplies of materials may be certain, vertical integration can generate cost reductions by improving production and scheduling coordination between each stage. In-house suppliers can be more efficient with this advantage because there are firm internal commitments. That same level of stability isn’t as common when working with third-party providers or independent customers.
10. Vertical integration offers a higher level of supply assurance.
If an organization must have a supply of critical materials, then an effort at vertical integration is almost necessary to complete. This advantage has been a significant attraction for the oil industry strategy since the 1980s. When the fuel crisis hit in the early 1970s, some organizations found sharply reduced supplies waiting for them. Material shortages caused prices to double or triple.
Material shortages in industries with higher fixed costs create damaging conditions because it leads to low usage of expensive facilities. In this situation, vertical integration makes sense because there is more reliability in the availability of raw materials and other needed supplies.
List of the Disadvantages of Vertical Integration
1. The capital requirements for vertical integration are high.
Companies must have a lot of capital available to invest in vertical integration processes. Forward and backward efforts are often costly, even when there is an emphasis on creating partnerships instead of outright ownership. Deals in this area often include proprietary data, specific patents, and research processes that can require significant assets. Organizations often find that they need more staff, better training facilities, and more real estate after starting this effort.
Some of this disadvantage can be offset by internal knowledge of the vertical integration update. If that data isn’t available, then it may be a better decision to avoid this investment until the organization can manage the expense.
2. The organization must operate within a larger economy.
Companies must force themselves into a growth period if they decide that vertical integration is necessary for their future. Numerous advantages are possible when the organization can use its size as leverage, but it needs to get there with stable finances before this attempt is made. When agencies try to grow big too quickly, then the instability in their finances can create devastating consequences.
It is just as common for companies to enter into bankruptcy after attempting vertical integration as it is for a successful outcome to happen. Since there are often hundreds of millions of dollars at stake in these transactions, it is imperative that a complete look at the overall picture is taken by the C-Suite before proceeding.
3. Vertical integration reduces a company’s flexibility.
When an organization works with several different contractors and vendors, then there is more flexibility in the final outcome than if everything becomes internalized. A supply chain sees fewer choices instead of more when forward or backward efforts engage, and that means it can be challenging to adapt to quickly changing economic conditions. When a firm uses third-party providers, they have the option to make changes according to their contracts without any infrastructure maintenance costs.
Jonathan Logan was a women’s apparel producer in the 1960s. The company committed to double-knit fabrics since they were in style at the time, integrating themselves in a textile mill to save costs. The brand continued to manufacture them after they were no longer profitable to accommodate the mill’s production. It ended up being a $40 million write-off.
4. It doesn’t account for the unexpected.
Vertical integration can limit the effectiveness of an organization’s competitors, but it doesn’t always account for the hidden obstacles that are present in every new market. Companies must keep their focus on the processes that are necessary to access a new market in the first place to remain successful. Entering a new demographic without having enough raw materials for the supply chain can create an unnecessary hindrance to the production process.
When local access to markets is under restriction, vertical integration may not create enough opportunities to make every effort profitable. That’s why a viability evaluation must occur during the decision-making process to ensure this investment makes sense.
5. Vertical integration can create higher levels of internal confusion.
Several entities under one umbrella organization can operate as different brands. The Coca-Cola Company has over 1,000 different beverages and food products that it represents in the marketplace. Now the company doesn’t need to vertically integrate each one into its own supply chain to save money, but many customers don’t realize that some of their favorite products come from the same company.
When there is a realization that duplication occurs, then consumer confusion usually results. Customers see each product as its own “company” of sorts. Purchasing Vitaminwater, Simply Orange, Minute Maid, Honest Tea, or Fuze means you’re staying within the same umbrella and its vertical integration. Confused customers don’t always choose to make purchases.
6. It can result in an unbalanced throughput.
When companies combine the various production or distribution stages, the varying scale of operations that each requires can lead to inefficiencies. An organization might find that they need to produce items at a very high volume to match the cost competitiveness that an independent supplier offers. There are times when the minimum efficiency scale of an operation is greater than the volume of supplies needed to produce goods for the marketplace. This disadvantage means that it could be cheaper to maintain third-party relationships instead of trying to bring everything under one banner.
7. Vertical integration creates a loss of specialization.
Although this disadvantage can be challenging to pinpoint at times, the danger of vertical integration is that there are distinct managerial approaches to each stage of production that become necessary. Manufacturers and processors have different needs than wholesalers or retailers. Oil companies in the 1930s thought it would be a good idea to own service stations, but the differences in need were so great that they phased out ownership in favor of franchising.
8. This investment can be overly complicated for some industries.
An effort at vertical integration requires organizations to become involved in new aspects of the supply chain. Familiarity is necessary for this process to be successful. Firms that are familiar with retail struggle when they move back to manufacturing because they don’t fully understand all of the requirements needed for a successful outcome. The same holds true for producers that try to move into retail.
It isn’t just the oil industry that discovered this disadvantage. Every business without internal authority struggles with vertical integration when there isn’t internal knowledge. Every company can get to where they need to be eventually, but the process can be extremely complex for some industries.
Observations about vertical integration that go as far back as the 1980s suggest that excessive investments can create adverse outcomes. When the U.S. automotive industry decided to integrate backward because of the short-term rewards that were present, managers were then restricted in their ability to create innovative pathways for the future.
The effort to vertically integrate can involve significant resource commitments. It is enough to make-or-break the fortunes of even the largest companies in the world. You’re caught in the decision of “do I make it” or “do I buy it” in this circumstance.
When reviewing the advantages and disadvantages of vertical integration, it is clear to see that there isn’t one answer to pursue. Each company must decide if this effort, either forward or backward, is worth the required investment. There are times when it may be the better choice to continue using suppliers.
Keith Miller has over 25 years experience as a CEO and serial entrepreneur. As an entreprenuer, he has founded several multi-million dollar companies. As a writer, Keith's work has been mentioned in CIO Magazine, Workable, BizTech, and The Charlotte Observer. If you have any questions about the content of this blog post, then please send our content editing team a message here.