Businesses are always looking for ways to increase profit and expand market share. However, there are countless challenges that impede them from achieving this goal — pandemics, supply chain disruptions, delays from the suppliers, cutthroat competition, and more.
One of the best strategies to overcome these issues and increase profitability is to become more self-reliant. In order to control more aspects of production, Henry Ford, the famous founder of Ford Motor Company, purchased railroads, acquired coal mines, built a sawmill, and bought over 700,000 acres of timberland!
When businesses reduce dependency on intermediaries on distributors and suppliers, they can better control their supply chain and avoid disruptions. Vertical integration is a strategy utilized by famous companies like Amazon, Netflix, and Apple. After reading this article, you’ll understand how these companies use vertical integration. You’ll also see whether it’s suitable for your business or not. Let’s get started!
There are many stages in the supply chain that facilitate a product’s journey to a consumer. First, the manufacturer gets raw materials from a supplier. After finishing production, the goods are sent to a distributor. The distributor then transfers goods to retailers, who finally sell goods to consumers.
Vertical integration is the process in which a business expands in order to gain ownership and control of more than one stage of their supply chain. In simpler terms, vertical integration is when a business attempts to perform production and distribution in-house instead of outsourcing it.
Vertical integration has been common since the industrial revolution. Andrew Carnegie was one of the pioneers — he owned iron mines that were utilized to mine steel resources for his company, Carnegie Steel. He also owned coal mines to get fuel for creating steel, and he owned railroads for transporting his materials. With this level of vertical integration, Carnegie created an entire ecosystem that helped him control his supply chain from production to transportation.
There are three types of vertical integration: Backward integration, forward integration, and balanced integration. Let’s look at these concepts in more detail.
In forward integration, businesses expand, acquire, or merge with another business that’s “farther up” in the supply chain. For example, EA sports – a video game development company – relies on distributors to sell their games to customers. EA sports decided to acquire a retailer (Gamestop), which is an example of forward or “upstream” integration. Generally, forward integration aims to seek control over distribution.Backward integration
In backward integration, businesses expand, acquire, or merge with a firm “below” them in the supply chain. For example, IKEA – a DIY furniture company – needs wood to manufacture furniture. IKEA decided to acquire a wood supplier, which is an example of backward or “downstream” integration.
Generally, backward integration aims to seek control over supply or manufacturing of a product. That way, they’re able to source everything themselves. This cuts costs and makes businesses more self-reliant.
Balanced integration is the combination of forward and backward integration. Through balanced integration, the company attempts to take control of both upstream and downstream activities in their supply chain.
Like vertical integration, horizontal integration helps businesses expand and gain more control over the supply chain. Many people get confused between horizontal and vertical integration. After finishing this section, you won’t be one of them!
|Horizontal Integration||Vertical Integration|
|The expansion in the same level of the supply chain (usually within the same industry)||The expansion into different stages of the supply chain (forward and backward)|
|Aims to increase market share and product differentiation, leading to a monopoly or oligopoly.||Aims to make a business self-reliant and get greater control over various stages of the value chain — from manufacturing to distribution.|
|Example: Facebook acquiring Instagram (a competing social media platform)||Example: Netflix is a video streaming platform (distributor) that also creates movies and web series (producer).|
To better clarify vertical integration, here are some real-life examples.
Apple is a premium consumer electronics company that leverages vertical integration to scale its business. Apple performs backwards integration by owning manufacturing plants in San Jose, Taiwan, and more. They also perform forward integration by owning retail outlets (The Apple Store) that help them connect with their customers.
We all know that Elon Musk wants to colonize Mars and explore space. Like Tesla, SpaceX is one of Musk’s companies that manufactures rockets and spacecraft. SpaceX uses vertical integration to reduce the cost of space exploration.
At first, Musk wasn’t able to source rockets at an affordable price. After some research, he realized that it only cost 3% of the sales price to manufacture a rocket! This incentivized him to produce rockets in-house (backward integration). One of his competitors, United Launch Appliance, was charging $460 million for each satellite launch into orbit, SpaceX was able to achieve the same for just $90 million. This is how vertical integration helps SpaceX offer their services for 5x less than their competitors.
Zara is a famous fast-fashion brand that has over 1,000 stores worldwide, and they are vertically integrated with their manufacturers and designers. While their competitors are at the mercy of independent designers, Zara designs in-house. This way, they can rapidly adapt to market trends. Because they own both retail and distribution, Zara is able to more efficiently manage their stock.
Ikea is a do-it-yourself (DIY) furniture brand that offers ready-to-assemble furniture and fittings. Customers can choose furniture from Ikea stores and assemble it at home. Ikea primarily sells wooden furniture, so they purchased a Romanian forest and integrated vertically. By doing this, they gained more leverage on raw material production (backward integration), which in turn gives them more control over manufacturing and distribution processes.
Most companies have realized how advantageous vertical integration is. Here’s why.
Economies of scale have an inverse relationship between cost and quantity. For example, if you increase production, the cost of producing each unit goes down. Whenever a business doubles its production output, the manufacturing costs fall from 70% to 90%.
So, how does an increase in production lead to a decrease in cost? When you manufacture goods in larger quantities, you place a larger order with your supplier. When you purchase items in bulk, you can get them at a discounted rate — which helps bring down production cost.
There are also some Technological benefits to economies of scale. As a company produces more of a product, they discover better ways to make the product. This leads to specialization and reduction of wastage.
Finally, there are also Governmental benefits, which is an example of external economies of scale. For example, there may be a shortage of oxygen cylinders at a time of medical emergency – like COVID – and the government may want to incentivize businesses to produce more oxygen cylinders. To achieve this, government can give tax benefits to the manufacturers to incentivize them to increase production. This would reduce the manufacturing cost.
When an organization adopts vertical integration, they achieve economies of scale by eradicating intermediaries and streamlining operations.
When a business is not vertically integrated, it depends on other parties in the supply chain. When and if there are supply chain disruptions, this can stop or slow down your operation. Through vertical integration, your business enjoys more control of the supply chain. You are able to maintain stability by solving problems external distributors can cause.
When you are not dependent on external suppliers and distributors, you’re better positioned to negotiate and do less business with suppliers who attempt to dictate the market. Protection of trade secrets is also easier when you’re not outsourcing manufacturing. Plus, by manufacturing on your own, you can shorten turnaround time and ensure that production quality matches your standards.
Walmart is an excellent example of this. Since they own their distribution centers, they have a massive amount of leverage. Walmart constantly experiments with emerging technologies such as augmented reality, drones, and hyperlocal distribution centers.
When retailers maintain direct contact with customers, they are better positioned to understand customer’s preferences. If you’re only a manufacturer, you focus solely on producing goods. Through forward integration, manufacturers are able to better understand customer behavior and calibrate their process to make products that are in higher demand. They can also create “knock-off” products of competitors’ best sellers to meet market demand.
By catering to customers’ needs and offering a better value proposition than other players in the market, fully integrated companies are able to win more market share.
Profit margin shrinks as more players enter your product’s supply chain. Successful vertical integration eliminates intermediaries and saves you money. By producing on your own, you’re able to leverage economies of scale and reduce your overall transaction cost. You can leverage these savings and even transfer them directly to your consumer by offering better deals. This strategy is commonly used by platforms like Best Buy and Walmart.
Vertical integration allows you to beat your competitors. By opening your own distribution centers, you’re able to offer a superior customer experience. This is exactly what Apple did in 2001 when they opened their first retail store, and it helped them out-compete Microsoft.
For geographical expansion, companies can either acquire other brands or launch their own distribution centers. Louis Vuitton, a luxury fashion brand, became a worldwide destination for leather goods after opening stores in fashion capitals across the globe.
Even though vertical integration is a great strategy for some of the most successful companies, there are some downsides. Let’s take a look.
This is by far the biggest drawback of implementing a vertical integration strategy. As a distributor, integration requires extensive capital. You need to invest in land, labor, and machinery if you want a factory. Building and maintaining production plants is expensive, too. And when a manufacturer decides to integrate forward to acquire distribution channels, they’ll need to invest in developing both their distribution centers and necessary personnel.
When a business is not vertically integrated, they have the flexibility to choose and replace vendors and distributors when a better alternative is found. When you attempt to do these tasks in-house, it’s a lot more tricky.
Since technology keeps on evolving, it can be expensive to adapt to trends and upgrade processes. Retraining employees on new technology requires a lot of time and money. If you’re not vertically integrated, you can simply source products from a different, more technologically up-to-date vendor. And you don’t have to worry about maintenance costs, either. Vertically integrated businesses may also find it difficult to outsource production to foreign factories with cheaper labor and operating costs.
Running a distribution or retail business is a lot different than running a factory. Retail stores require sales and marketing personnel, whereas a factory requires people with engineering backgrounds. In an attempt to become a “jack of all trades,” businesses may lose focus and put valuable time and energy into places where they aren’t as skilled or experienced. This has the potential to lead to a worse product, declining profits, and worse.
If you are the dominant player in a market and attempt to further control the supply chain process by controlling production, it can lead to antitrust issues. By trying to consolidate via vertical integration, you can face conflicts from both government and competitors. Vertical integration can also lead to labor issues, especially when a union company integrates with a non-union company.
Doing everything on your own can increase profit margins,However, it often takes a long time to reach that stage. When you first set up your new production unit, you will make mistakes that can lead to manufacturing inefficiency and higher production costs.
You might also find it challenging to compete with existing players who outsource their production to companies that are both more experienced and cheaper. Vertical integration makes your business less flexible, too. Thus, vertical integration has the potential to backfire — resulting in the loss of your competitive edge.
Warren Buffet sums it up best: “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”
Vertical integration can help businesses increase profitability and provide better experiences for their customers, but it doesn’t come without its risks. When done right, however, the results can be amazing. All we have to do is look at Amazon, which has complete control over distribution. This allows them to offer quick delivery and lower transportation costs. By analyzing sales data, they’re also able to track best-selling products and create their own branded variants (AmazonBasics) — which is an example of perfectly executed backward integration. Amazon also offers a video streaming service called Amazon Prime, which improves customer experience and ensures recurring revenue.
Vertical integration can be a great expansion strategy, provided that the company has deep pockets and the ability to take risks and overcome challenges. Unfortunately, not every company can do what Amazon does. It’s best to find the balance that works for you. Should you focus on what you’re best at, and outsource everything else? Or is vertical integration the best way forward? Contact us for a Cin7 demo and gain advice, tips, and more information about your options.
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