Specifically, vertical integration occurs when a company assumes control over several production or distribution steps involved in the creation of its product or service. Vertical integration can be carried out in two ways: backward integration and forward integration. A company that expands backward on the production path into manufacturing is assuming backward integration, while a company that expands forward on the production path into distribution is conducting forward integration.
Types of vertical integration strategies
As we have seen, vertical integration integrates a company with the units supplying raw materials to it (backward integration), or with the distribution channels that carry its products to the end-consumers (forward integration).
For example, a supermarket may acquire control of farms to ensure supply of fresh vegetables (backward integration) or may buy vehicles to smoothen the distribution of its products (forward integration).
A car manufacturer may acquire tyre and electrical-component factories (backward integration) or open its own showrooms to sell its vehicle models or provide after-sales service (forward integration).
There is a third type of vertical integration, called balanced integration, which is a judicious mix of backward and forward integration strategies.
When is vertical integration attractive for a business?
Several factors affect the decision-making that goes into backward and forward integration. A company may go in for these strategies in the following scenarios:
- The current suppliers of the company’s raw materials or components, or the distributors of its end products, are unreliable
- The prices of raw materials are unstable or the distributors charge high fees
- The suppliers or distributors earn big margins
- The company has the resources to manage the new business that is currently being taken care of by the suppliers or distributors
- The industry is expected to grow significantly
Advantages of vertical integration
What are the benefits of vertical integration? Let us take the example of a car manufacturer implementing this strategy. This company can
- smoothen its supply chain (by ensuring ready supply of tyres and electrical components in the exact specifications that it requires)
- make its distribution and after-sales service more efficient (by opening its own showrooms)
- absorb for itself upstream and downstream profits (profits that would have gone to the tyre and electrical companies and showrooms owned by others)
- increase entry barriers for new entrants (by being able to reduce costs through its own suppliers and distributors)
- invest in specific functions such as tyre-making and develop its core competencies
Disadvantages of vertical integration
But what is the downside? What are the drawbacks of vertical integration? Let us see the main disadvantages.
- The quality of goods supplied earlier by external sources may fall because of a lack of competition.
- Flexibility to increase or decrease production of raw materials or components may be lost as the company may need to sustain a level of production in pursuit of economies of scale.
- It may be difficult for the company to sustain core competencies as it focuses on the integration of the new units.
However, there are alternatives to vertical integration, such as purchases from the market (of tyres, for example) and short- and long-term contracts (for showrooms and with service stations, for example).