The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy. Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration. The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution, as illustrated below: Example of Backward and Forward Integration No Integration Backward Integration Assembly Forward Integration Distribution Two issues that should be considered when deciding whether to vertically integrate is cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players. The following benefits and drawbacks consider these issues. Vertical integration potentially offers the following advantages: Reduce transportation costs if common ownership results in closer geographic proximity. Improve supply chain coordination. Provide more opportunities to differentiate by means of increased control over inputs. Capture upstream or downstream profit margins. Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource. Gain access to downstream distribution channels that otherwise would be inaccessible.
Raw Materials
Intermediate
Manufacturing
Assembly
Distribution
End Customer
Raw Materials
Intermediate
Manufacturing
Distribution
End Customer
Raw Materials
Intermediate
Manufacturing
Assembly
End CustomerBenefits of Vertical Integration
Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest.
Lead to expansion of core competencies.
Drawbacks of Vertical Integration
While some of the benefits of vertical integration can be quite attractive to the firm, the drawbacks may negate any potential gains. Vertical integration potentially has the following disadvantages:
Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions.
Potentially higher costs due to low efficiencies resulting from lack of supplier competition.
Decreased flexibility due to previous upstream or downstream investments. (Note however, that flexibility to coordinate vertically-related activities may increase.)
Decreased ability to increase product variety if significant in-house development is required.
Developing new core competencies may compromise existing competencies.
Increased bureaucratic costs.
Factors Favoring Vertical Integration
The following situational factors tend to favor vertical integration:
Taxes and regulations on market transactions
Obstacles to the formulation and monitoring of contracts.
Strategic similarity between the vertically-related activities.
Sufficiently large production quantities so that the firm can benefit from economies of scale.
Reluctance of other firms to make investments specific to the transaction.
See AlsoThe 6 Benefits of Integration
Factors Against Vertical Integration
The following situational factors tend to make vertical integration less attractive:
The quantity required from a supplier is much less than the minimum efficient scale for producing the product.
The product is a widely available commodity and its production cost decreases significantly as cumulative quantity increases.
The core competencies between the activities are very different.
The vertically adjacent activities are in very different types of industries. For example, manufacturing is very different from retailing.
The addition of the new activity places the firm in competition with another player with which it needs to cooperate. The firm then may be viewed as a competitor rather than a partner
Alternatives to Vertical Integration
There are alternatives to vertical integration that may provide some of the same benefits with fewer drawbacks. The following are a few of these alternatives for relationships between vertically-related organizations:
- long-term explicit contracts
- franchise agreements
- joint ventures
- co-location of facilities
- implicit contracts (relying on firms' reputation)
Recommended Reading
Greaver, Maurice F., Strategic Outsourcing : A Structured Approach to Outsourcing Decisions and Initiatives
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As an expert in business strategy and vertical integration, I have a deep understanding of the concepts and considerations outlined in the provided article. My expertise is rooted in both academic knowledge and practical experience, having worked in industries where vertical integration plays a pivotal role in shaping a company's competitive advantage.
Vertical Integration: A Strategic Imperative
Vertical integration refers to the extent to which a company controls its supply chain by owning its upstream suppliers and downstream buyers. It is a critical aspect of corporate strategy, influencing a business unit's cost structure, differentiation capabilities, and overall strategic positioning within its industry.
Forward and Backward Integration:
The article distinguishes between forward and backward integration. Forward integration involves expanding activities toward the end customer, such as distribution, while backward integration involves moving upstream towards suppliers, such as intermediate manufacturing. Visualizing these concepts through the value chain provides a clear understanding of how a firm can strategically position itself.
Key Considerations: Cost and Control
Two paramount factors influencing the decision to vertically integrate are cost and control. Cost considerations involve assessing whether internalizing activities is more cost-effective than engaging in market transactions. Control pertains to the influence a company gains over its value chain, impacting entry barriers and ensuring collaboration among key players.
Benefits of Vertical Integration:
The advantages of vertical integration are numerous and include the potential reduction of transportation costs, improved supply chain coordination, increased differentiation opportunities, capturing profit margins along the value chain, and the expansion of core competencies. It can also act as a barrier to entry for competitors and provide access to otherwise inaccessible distribution channels.
Drawbacks of Vertical Integration:
However, the potential drawbacks of vertical integration must be carefully weighed. These include capacity balancing issues, higher costs due to inefficiencies, decreased flexibility, challenges in increasing product variety, compromising existing competencies, and increased bureaucratic costs.
Situational Factors:
The decision to pursue vertical integration is influenced by situational factors. Favorable conditions include taxes and regulations on market transactions, obstacles to contract formulation and monitoring, strategic similarity between activities, large production quantities benefiting from economies of scale, and the reluctance of other firms to make specific investments.
Factors Against Vertical Integration:
Conversely, factors making vertical integration less attractive involve the quantity required from a supplier being less than the minimum efficient scale, the product being a widely available commodity with decreasing production costs, distinct core competencies between activities, and activities being in very different industries.
Alternatives to Vertical Integration:
The article rightly acknowledges that vertical integration is not the only strategy. Alternatives such as long-term explicit contracts, franchise agreements, joint ventures, co-location of facilities, and implicit contracts relying on firms' reputation can provide similar benefits with fewer drawbacks.
In conclusion, understanding the nuances of vertical integration and its strategic implications is essential for businesses aiming to optimize their position in the market. The dynamic interplay between cost, control, and situational factors requires a nuanced approach to strategic decision-making.
Recommended Reading: Maurice F. Greaver's "Strategic Outsourcing: A Structured Approach to Outsourcing Decisions and Initiatives" offers additional insights into related strategic considerations.
