How Does Vertical Integration Work? (2024)

Disruptions in distributed supply chains have made news in recent years because they haveprevented customers from getting the products they want, when they want them, hurtingcompanies’ finances and damaging their reputations. One way companies can exert morecontrolover their supply chains is through vertical integration, whereby they take ownership ofmore steps in the manufacture and sale of their products and services.

In theory, vertical integration helps a company secure more aspects of the supply,production and distribution functions and, ultimately, the sale of its goods and services,improving efficiencies and reducing costs along the way. While some companies achievesignificant competitive advantage through vertical integration, the approach requiressizable capital investments and, in some cases, can limit the flexibility that comes frompartnering with a federation of suppliers. Companies must consider the business case forvertical integration — the costs, benefits and challenges — very carefully.

What Is Vertical Integration?

Most companies rely on a number of suppliers and partners to produce and distribute theirproducts, from raw material suppliers and manufacturing partners to distributors andretailers. Vertical integration refers to any effort by a company to take ownership of twoor more steps in this supply chain, thereby “integrating” them into its ownbusiness. Ratherthan focusing solely on a single aspect of the process — say, ecommerce sales orfinishedmanufacturing — the company opts to extend its reach and market power either forwardorbackward along the supply chain. Sometimes, a company will integrate in both directions.Some do this by building their own capabilities from the ground up, and others do it viamerger and acquisition.

However it’s done, the idea is to gain more control over supply chain processes bybringingmore of them in-house. Vertical integration requires sizable up-front financial outlays.But, in the right circ*mstances, the strategy can serve to streamline a company’sjourneyfrom raw materials to the delivery of a product into a customer’s hands, reducingcosts andraising customer value — which can yield competitive and financial advantages over thelongterm.

A manufacturing company, for example, may decide to backward-integrate by sourcing its ownraw materials — giving it greater visibility for managing its inventoryof those materials — or forward-integrate by selling directly to end customers,eliminatingdistributors and/or retailers. Many companies have embraced vertical integration, from oiland gas leaders to high-tech firms. In some cases, vertical integration has been elementalto corporate survival and success. In others, vertical integration has proven costly andeven led to corporate failure.

Key Takeaways

• Vertical integration involves a company taking ownership of two or more steps in itssupply chain.
• It’s often categorized directionally: Companies can integrate upstream processes(backward integration), downstream stages (forward integration) or both (balancedintegration).
• As vertical integration expands a company’s market footprint, it usually requiresheftyup-front investment and can be operationally challenging.
• When done well, benefits include lower costs, greater control, improved visibility andmore.
• Weighing the pros, cons, costs and return on investment for a vertical integrationinitiative requires access to high-quality supply chain data and analytics.

Vertical Integration Explained

To illustrate how vertical integration might proceed, consider the steps in a supply chain.Typically, the process begins with the purchase of raw materials, then proceeds throughvarious stages of production, from which a finished product emerges, is distributed and,ultimately, sold to the end customer. A nonvertically integrated company might implementjust one piece in that chain of processes. If the company wants to vertically integrate, itmust expand its operations to include steps before and/or after the step it alreadyperforms. The company may choose to acquire one or more of its suppliers in hopes ofreducing manufacturing costs or gaining more control over production. Or it might invest inthe retail end of the process, opening physical stores or introducing ecommercecapabilities to get closer to the customer and increase profit margins. It mightinvest in warehouses and vehicle fleets to take more control over distribution andlogistics.

When a company decides to vertically integrate, it always faces a build-or-buy decision. Thecompany may choose to build some part of the production, distribution or retail salesprocess from scratch, re-creating one or more aspects of the supply chain that it hadpreviously outsourced. Alternatively, they may buy their way into vertical integration,acquiring or merging with suppliers, manufacturers, distributors or retailers.

Whether they build or buy, vertical integration is a big investment. Companies must devotesignificant up-front capital, whether they are establishing their own capabilities orattaining them through mergers and acquisitions. They have to build or purchase physicalfacilities, hire additional employees and management and invest in new business processesand technologies — all of which increases the size and complexity of the overallorganization.

Types of Vertical Integration

There are several types of vertical integration. A company may expand further“upstream” inthe supply chain (backward integration), further “downstream” (forwardintegration) or movein both directions (balanced integration). Any approach in which a company eliminates stepsin the journey from raw materials through production to the customer can be calleddisintermediation, but that term is usually reserved for when companies try to take over astep between themselves and the final customer.

Backward Integration

Backward integration happens when a company moves a process in-house so as to take controlof earlier, or upstream, steps in the supply chain process. Fast-food restaurantMcDonald’sis a good example of backward integration, having taken ownership of certain processes allthe way back to the agricultural production that supplies ingredients for its eateries.

Forward Integration

By contrast, forward integration is when a company takes ownership of processes furtheralong, or downstream, in the supply chain, perhaps by taking control of distribution orsales of finished goods and services.Nike, for example, took a forward integration approach in establishing its own retailstores. The Walt Disney Company’s launch of the Disney+ streaming service, whichallows itto deliver its entertainment library directly to consumers, is another example.

Balanced Integration

When a company vertically integrates processes both upstream and downstream, it’spursuingbalanced integration. Naturally, this can occur only when a company sits somewhere in themiddle of a supply chain (rather than at one end or the other). Balanced integration can betrickier to pull off but can also offer greater benefits when executed well. Apple, forexample, extended itself both forward in the supply chain with the opening of its retailstores and backward, when it designed its own semiconductors.

Disintermediation

Disintermediation refers to the process of removing intermediaries — aka“middlemen” — froma company’s supply chain, usually to get closer to the customer but always to reducecostsand increase efficiencies. Computer manufacturer Dell and electric-auto maker Tesla areexamples. Both opted to exclusively sell their products direct to consumers rather than relyon distributors, dealerships and retailers. Tesla also offers an example of balancedintegration, as it operates its own plants and designs its own batteries and chargingstations, in addition to its direct sales approach.

Benefits and Drawbacks of Vertical Integration

When companies can make a clear case for the value of vertical integration — forexample, toaddress supply or demand risks — and have the capabilities to pursue it, verticalintegration can help a company reduce costs, improve efficiency and have more control overits supply chain. When executed poorly or without a clear rationale, vertical integrationcan be a costly mistake. Vertical integration often involves trade-offs, requiring companiesto carefully evaluate the advantages and disadvantages relative to their specificcirc*mstances.

Benefits. Among the most notable potential benefits of vertical integrationare: greater economies of scale, as an organization’s fixed-cost base is spread acrossalarger range of operations; the migration of some fixed, external costs (e.g., logistics) tovariable costs, over which the organization has greater control; fewer supply chaindisruptions, or at least more visibility, which gives the company an earlierwarning when a possible disruption is coming; lower lead time; and faster time tomarket, because with more control over the supply chain, the company can prioritizenew-product activities when it is advantageous to do so. Thinking further, cases of forwardintegration could lead to improved customer or market insight; and that, together withgreater control over supply chain inputs and processes, can lead to higher quality productsand services. Taking ownership of more steps in a supply chain may even help a company deal with inflation.Together, all these benefits add up to an organization that is better able to synchronizesupply and demand and capture more of the available profit margin in a given market.

Drawbacks. But a successful vertical integration means a company mustmanage multiple challenges, any one or combination of which could derail those benefits andleave the organization worse off. Vertical integration is not a quick fix — it’sa long-termstrategy that requires significant up-front capital expenditures and yet may take arelatively long time before its returns are realized. So, it requires a long-term commitmentat all levels of the organization, especially the C-suite. By definition, verticalintegration increases organizational complexity — it means a company must add to itsexisting operations, and, if it is to realize the potential benefits, it must thoughtfullyintegrate those operations with existing processes and systems. In some ways, it candecrease an organization’s flexibility relative to partnering because of the sunkinvestmentin infrastructure. It can decrease an organization’s focus on its original corecompetencies. And, in extreme cases, a company that is very successful at verticalintegration can catch the eyes of antitrust regulators.

Degrees of Vertical Integration

Companies that pursue vertical integration should understand the risks and rewards of thestrategy. They should also consider the degree to which vertical integration makes sense forthe organization. Companies do not necessarily have to go “all in” with averticalintegration approach to achieve some significant benefits. There are varying degrees ofintegration to explore, from full integration to none at all.

Full vertical integration

For any given organization, full vertical integration can mean one of two things. Mostoften, it refers to an organization that seeks to acquire or build all the assets,resources, capabilities and skills necessary to take over one entire step in its supplychain, either upstream or downstream. But it can also refer to an organization that takesfull control over all the steps in its supply chain, from the raw materials to thecustomer’s doorstep.

Quasi vertical integration

There is a wide variety of strategies that stop short of total integration that companiescan employ to secure some of the benefits of vertical integration via a more contained—and, therefore, less risky — investment. Often, this means acquiring a minorityinterest inone or more upstream or downstream companies. It could also involve joint ventures,strategic alliances, asset acquisitions, technology licenses and franchising opportunities,all of which entail lower up-front costs and can offer greater flexibility than fullyintegrating a supply chain process.

Long-term contracts

Companies can exert more control upstream or downstream by signing long-term contracts witha partner, potentially increasingly predictability and/or decreasing costs.

Spot contracts

In contrast to long-term contracts, which offer some consistency and predictability, tradingin the so-called spot market occurs when companies purchase supplies as needed for the nextstep in the production process. Sitting at the opposite end of the spectrum from fullvertical integration, these are one-off transactions for satisfying immediate needs.

Vertical Integration Examples

Carnegie Steel was one of the first and most significant examples of balanced, full verticalintegration. By the 1890s, the industrial giant had acquired all sources of supply, as wellas logistics and shipping. The company wielded significant market power, owning andoperating iron ore and coal mines, steel mills and coal processing plants, and even theships and railroads that moved everything throughout the supply chain.

Historically, the telecommunications industry has been tightly integrated, initially toensure end-to-end control of the complex infrastructure required to deliver telephoneservices. Throughout the 20th century, most telephone companies made their own telephones,telephone cables and other supplies; they also sold and delivered their services directly tocustomers.

The oil and gas industry has been marked by extreme vertical integration (and, sometimes,disintegration). Exxon Mobil, for example, has integrated each stage of the industry valuechain within its business units. Its upstream division owns and manages global productionassets and processes. Its downstream division includes refineries and retail outlets. Andits chemical division produces synthetic petrochemical products. Similarly, BP has anupstream segment responsible for oil and gas exploration, development and production, aswell as a downstream segment that includes a logistics and retail network to ship and sellits fuels, lubricants and petrochemicals.

The merger of Live Nation and Ticketmaster in 2010 offers another case study in balancedvertical integration. For Ticketmaster, which sells tickets to events, the transactionrepresented forward integration, while for Live Nation (which produces events), it was abackward integration strategy.

SpaceX offers a more recent example of vertical integration. In contrast to competitorUnited Space Alliance (a joint venture between aerospace companies Boeing and LockheedMartin), SpaceX manufactures most components in-house, which lowers its costs to the tune of$370 million per launch.

Is It Time to Integrate? Your NetSuite Data Can Tell You

Companies with good supply chain visibility will be in the best position to assessopportunities for vertical integration within their own value chains. NetSuite’s Supply Chain Management capabilities makeit easier for companies to track spending and monitor supplier performance over time, withan eye toward the potential benefits of integration. And, for those organizations that domake the leap to greater vertical integration, robust supply chain management software iscritical to optimizing integrated operations and unlocking the full value of the investment.NetSuite software can empower vertically integrated companies to reduce the costs associatedwith planning and executing supply chain processes, improve inventory management,increase cash flow, and identify and mitigate risk with predictive analytics and scenarioplanning.

Vertical integration can be difficult to capitalize on — it’s costly, complexand not easilyundone. However, when well executed, it can confer a number of advantages, including greatercontrol, reduced costs, increased profitability, better product or service quality,increased customer and market insights and more. Those companies with good visibility intotheir existing supply chain in either direction, along with access to integrated dataanalytics, will be best equipped to explore the opportunities of vertical integration.

Vertical Integration FAQs

When is an acquisition considered vertical integration?

Not all corporate acquisitions result in vertical integration. However, when a companyacquires a trading partner (either a supplier or a customer), it is an example of verticalintegration because it results in the company owning and operating more steps in its supplychain.

What’s the difference between vertical and horizontalintegration?

With horizontal integration, a company is expanding its reach in its existing area of corecompetency (say, a manufacturer acquiring another manufacturer or an accounting firmacquiring another accounting firm). With vertical integration, a company is reaching beyondits existing area of focus to take on additional roles in the product or service valuechain, whether that’s a technology company that takes over the sourcing and productionofits components or a luxury-goods maker that expands into retail sales.

What is vertical and horizontal integration?

Horizontal integration takes place when a company acquires a competitor or related business,expanding its footprint in its core competency. A grocery chain may buy a rival chain to,say, eliminate competition, expand into new geographic markets or increase its overallsales. Vertical integration involves the acquisition of a key component of a company’ssupply chain, either upstream or downstream from its own core competency. Companies pursuevertical integration for a number of reasons, including increased control, reduced costs orimproved margins. When a company takes over an upstream step, such as a manufacturingbusiness taking over sourcing of raw materials, it is called backward integration. When acompany brings a downstream step in-house, such as a manufacturer that opts to open retailor ecommerce direct sales channels, it is called forward integration. A company could alsopursue a balanced integration approach, expanding its reach in both directions.

Is vertical integration profitable?

In short, it depends. A number of variables can determine the profitability of a verticalintegration strategy. Examples of successful and failed vertical integration abound. Inaddition, there are different approaches and degrees of vertical integration possible. Avertical integration strategy can deliver advantages, including greater economies of scale,lower variable production costs, decreased logistics costs and quality concerns and —yes —increased profitability. However, full vertical integration takes time, requires significantcapital investment and can result in increased complexity and decreased flexibility.Companies must consider the advantages and costs of a specific vertical integration approachcarefully. Some companies are able to secure significant competitive advantage via verticalintegration, while others may determine that the costs of integration outweigh its benefits.

What is an example of vertical integration?

Carnegie Steel was one of the first examples of full vertical integration. By the 1890s,Carnegie owned mines for iron ore and coal, steel mills and coal processing plants, as wellas the ships and railroads that moved raw materials and finished products throughout thesupply chain. Similarly, some of the world’s largest oil and gas companies controlbothdownstream and upstream operations, from exploration and extraction to refining andlogistics to retail and business sales. Technology giants Amazon and Apple have pursuedbalanced integration opportunities over the years. (Balanced integration is when a companyacquires steps in the supply chain both preceding and following its own link in the chain.)Electric-auto maker Tesla embraced balanced integration from the start, running andoperating its own plants and opting to sell its products directly to consumers.

What is a vertical integration structure?

A vertical integration structure involves a company taking over multiple stages of itsproduction or sales processes rather than relying on external suppliers and trade partners.

What is vertical integration in economics?

In economics, vertical integration is the term used to describe a business strategy in whicha company takes ownership of two or more key stages of its supply chain. A verticallyintegrated automaker, for example, might produce automobile components and vehicles and alsosell directly to customers.