One of the fundamental questions companies should ask before setting a growth strategy is whether they should pursue it through horizontal integration, vertical integration, or both.
Horizontal integration is when a business grows by acquiring a similar company in their industry at the same point of the supply chain. Vertical integration is when a business expands by acquiring another company that operates before or after them in the supply chain.
Deciding on which strategic direction a company should pursue is very important before starting any initiative. They need to decide if acquiring a company in an effort to achieve horizontal and vertical integration will provide the best growth leverage for the company.
Both horizontal and vertical integration can be successful. But before pursuing either strategy, a company should know which parts of its operation would produce the most leverage on its profit if drastically improved.
How Horizontal Integration Works
It is very common for companies to grow by taking customers from their competition. This is a form of horizontal integration.
Comparatively, a company can pursue vertical integration when it can increase its profits by obtaining better control of its operations.
Companies can also practice horizontal integration by buying or merging with their competitors. This works well when a company has a successful business model and needs to add more customers to increase their profit at higher economies of scale. Buying or merging is also done to diversify a company's products or services and reduce competitors in the marketplace. Examples of horizontal integration include when one large hotel chain buys another or when a major studio company purchases a small, independent film making company.
Unfortunately, horizontal integration is not always successful. This method of growth works best when the two companies have synergistic cultures and customers. Even when two companies sell a similar product to a similar product, the merger may fail if there are problems merging the two company cultures.
How Vertical Integration Works
Other businesses choose to expand by acquiring a company that occupies a critical place in their supply chain process. This includes raw materials sourcing, product manufacturing, transportation, distribution or retailing.
Vertical integration can also be the degree to which a firm owns its upstream suppliers (backward integration) and its downstream buyers (forward integration). Businesses do this to secure the supplies, distribution points or other parts of the transaction necessary to produce or market products or services at a lower or more predictable price. (For example, an auction site purchasing a payment company to capture the revenue stream that comes from the fee of paying online.)
The synergies involved in vertical integration are not always successful. Sometimes the two companies have uneven requirements of how much product or service needs to flow through their part of the supply chain. Vertical integration also means making a commitment to a particular company, technology, or process. This can result in a lack of flexibility when market trends change.
Pursuing Horizontal and Vertical Integration in Your Business
Deciding between horizontal and vertical integration? Here are some of the elements a company should consider.
A business can pursue horizontal integration when it operates in a growing industry and its competitors lack some of the competencies or financial resources it possesses.
It is typically successful when economies of scale of an existing process would have a significant effect on profit. Please remember that the acquiring or merging organizations need to have the financial resources to manage this process.
A company can pursue vertical integration when it can increase its profits by obtaining better control of its operations. Through this growth method, it can reduce its costs across different parts of its production cycle, ensure higher quality control and get more control of information across their supply chain.
Some companies pursue vertical integration when they want their existing suppliers or distributors to have less power over their business.
Both horizontal and vertical integration can be successful. But before pursuing either strategy, a company should know which parts of its operation would produce the most leverage on its profit if drastically improved.
How have you grown your company through horizontal and vertical integration?
Frequently Asked Questions
1. What is the difference between vertical and horizontal integration?
Vertical integration:
Vertical integration is when a company expands its business operations into different stages of production. This occurs when a company controls the supply chain from start to finish.
Horizontal Integration:
Horizontal integration is when a company expands its business operations by acquiring or merging with other companies at the same production stage. This occurs when a company expands its product offerings or services by working with other companies to produce similar products or services.
2. What are the pros and cons of vertical and horizontal integration?
Vertical integration:
Pros:
- Allows for greater control over the supply chain
- Can lead to cost savings
- Can create efficiencies
Cons:
- Can lead to higher overhead costs
- May result in less flexibility
Horizontal integration:
Pros:
- Brings together complementary products or services
- Can lead to market expansion
- May result in cost savings
Cons:
- Can lead to higher overhead costs
- May result in less flexibility
- Can result in conflicts of interest between the companies involved
A version of this article was originally published on January 03, 2019.
Photo: Getty Images
