What is vertical integration?
What is vertical integration, anyway? Vertical integration is where a company takes control of one or more parts of its supply or distribution chain. Instead of buying copper ore from a supplier, it buys the copper mine and takes over mining operations. Instead of subcontracting with a manufacturer, it opens a manufacturing plant in house and produces its own products.
There are four degrees of vertical integration:
- Full vertical integration: You buy out your supplier or you obtain all the resources, assets and knowledge to create an alternative supply source of your own, thus gaining full control over that part of your chain.
- Quasi vertical integration: You obtain a partial interest in a supplier via an equity stake or a specialized investment. In return, you get limited control of the venture.
- Long-term contracts: A slightly less permanent version of vertical integration in which long-term dedicated contracts ensure special relationships with suppliers.
- Spot contracts: The status quo, where companies arrange spot contracts to obtain supplies, products or retail representation.
Types of vertical integration
Several different types of vertical integration exist. The three most common are forward, backward and balanced vertical integration.
Forward
Forward vertical integration travels downstream. When companies engage in forward vertical integration, they control their distribution chains. They might buy retail stores, wholesale warehouses or a range of websites designed to ship products straight to consumers. Forward integration cuts out the middleman, increasing profits and retaining control over the user experience.
Example:
You’re a clothing manufacturer and you decide to purchase mall spots in all 50 states to sell your clothes directly to the general public.
Backward
Backward vertical integration travels upstream. When businesses activate backward vertical integration strategies, they control their supply chains. Businesses buy suppliers or create their own supply chains from scratch. Cheaper wholesale products and raw materials help to drive profits and ensure greater quality control.
Example:
You’re a shoe designer and instead of outsourcing the manufacturing process to a third party, you found your own footwear factory.
Balanced
Balanced vertical integration travels both upstream and downstream. In a balanced vertical integration model, companies own both their supply and their distribution chains. This type of vertical integration maximizes profits across the board, but it’s also the most expensive to implement.
Example:
You make oak furniture and source your own wood from a company-owned forest in North America. You own a furniture manufacturing facility, a wholesale warehouse, a retail chain and a comprehensive direct-to-consumer website.
Vertical integration in the wild
Many larger companies use vertical integration to drive profits and gain greater control over their supply chains. Here are five vertical integration examples.
Apple
Apple began its forward vertical integration journey with a foray into retail. The first two Apple stores opened in May 2001, and since then, the company has become a fixture in high streets all over the world. By October 2020, Apple had 510 retail stores spread across 25 countries and regions.
Apple’s vertical integration goes backward, too. The company owns or has a partial stake in many of its component manufacturers, including Dialog Semiconductor and Corning Inc. Apple’s integration extends as far as energy production: Apple Energy produces and sells solar energy, while its North Carolina landfill gas energy plant generates electricity for its nearby data center.
FedEx
A major international distribution company, FedEx is forward vertical integration royalty. Its huge air cargo fleet incorporates more than 650 planes, making it the world’s largest A300 operator. FedEx doesn’t manufacture its own aircraft, but it does run its own flight schedule. It also operates a well-known ground delivery service.
FedEx also operates its own ShipCenter stores, which offer customers free packaging materials and convenient shipping options. FedEx Office stores, FedEx-authorized retailers and local drop boxes expand the company’s logistics presence on Main Street.
IBM
Multinational tech company IBM began its vertical integration strategy way back in the 1930s. Early IBM acquisitions included Electromatic Typewriters Inc. in 1933 and Pierce Wire Recorder Corporation in 1959. IBM owned commercial hardware manufacturer ROLM corporation between 1984 and 1989, and bought software company Transarc in 1999. These mergers and purchases gave IBM a virtual monopoly in the computer industry for decades.
Many recent IBM acquisitions expand the company’s influence in the blockchain sector, the cybersecurity industry and automation. Between July 2019 and November 2020, IBM bought open source software company Red Hat, cloud cybersecurity venture Spanugo, WDG Automation and analytics company TruQua Enterprises.
McDonald’s
“I’m sorry ma’am, but we’ve run out of quarter pounders” isn’t a sentence you’ll hear spoken very often in a McDonald’s restaurant—and for good reason. One of the most famous vertically integrated companies, McDonald’s outright owns facilities that produce standard ingredients that go into its meals. A cost leader in the fast food universe, McDonalds uses a “broad differentiation generic strategy” to minimize costs and offer products at an extremely low price point.
McDonalds owns the fleet of trucks it uses to supply the majority of its restaurants. It also owns its own cattle and its own meat-processing plants. McDonald’s french fries are made from potatoes grown at the company’s agricultural facilities. The company also owns the land upon which most of its restaurants sit.
Netflix
Founded in 1997, Netflix began as a mail-order DVD distributor. As the physical rental sector faded, the company moved into online streaming in 2007. At about the same time, Netflix began to act as an independent film distributor via its Red Envelope Entertainment division. REE produced original content for Netflix until 2008. Subscription-based smartphone, smart TV and video game console streaming apps soon followed.
Netflix began to create its Netflix Original content in 2011 and House of Cards, the first of its original series, debuted in February 2013. In the same year, the company announced its own awards ceremony, which it named “The Flixies.”
Pros and cons of vertical integration
Like anything else, vertical integration has its pros and cons. Some companies don’t have the capital to cover the initial costs associated with vertical integration, while others borrow money and dive straight in.
Pros
Organizations that choose a vertical integration strategy usually do so because they believe the pros outweigh the cons. Here are five of the most obvious positives.
Reduced costs
Vertical integration reduces or eliminates costs associated with production, handling and distribution. Market research, promotion, staffing and advertising costs generally also decrease.
Reliable supply chain
Vertically integrated companies don’t have to deal with higher-than-expected wholesale spot contract prices, and they can plan well in advance to avoid running out of critical supplies.
Improved efficiency
Better communication between production, warehousing and distribution stages can improve efficiency and reduce costs even more.
Greater innovation
Backward vertical integration makes company-wide innovation easier because distribution teams understand the manufacturing process and vice versa.
Raised barriers to entry
Fully vertically integrated companies are very difficult to compete with because rivals have to invest significant sums of money to achieve the same level of integration.
Cons
Companies that choose not to integrate vertically are usually risk averse and prefer to form relationships with third-party manufacturers and distributors. Here are four important negatives.
Initial expense
All types of vertical integration require some investment—and that investment doesn’t always translate into profit in the short or medium term.
Uneven throughput
Scale requirements often differ between vertically linked activities, making balanced integration financially unfeasible for small-scale production companies.
Reduced flexibility
Vertical integration requires commitment, so it’s a pretty risky endeavour. If markets collapse or production methods change, business owners are left out of pocket.
Less specialization
By its very nature, vertical integration reduces specialization. Control systems and management styles that work for one part of an integrated business might not work for another. Entire operations can become less efficient as a result.
Vertical integration recapped
What is vertical integration? Vertical integration helps to reduce cost in the medium and long term by onboarding various stages of a company’s production and distribution network. It’s an expensive venture to begin with—you have to have the capital to buy other businesses, including potentially expensive ventures. Over time, you’ll recoup those costs via increased profits—and you’ll also gain greater control over your supply chain.
