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What is vertical integration? – Vertical integration refers to the consolidation of two businesses that are at different levels in the production process, and it is a way to increase or decrease the company’s level of control over its input and output distribution i.e. the degree to which a firm controls its distribution of inputs, products, or services, Such as food factories and supermarket chains.
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It occurs when a product goes through many stages from raw material to finished product and finally into the hands of consumers. If a company is originally responsible for a certain stage, when the company starts to produce raw materials previously supplied by its suppliers, or when the company starts producing products made from the raw materials it produces in the past.
There are two types of vertical integration – the next step in the integration with the production process is called forward integration, and the previous step of the production process is called backward integration. The forward or backwardness of business activities depends on how close they are to the end consumer.
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A company’s control over its production inputs is organized and integrated i.e backward integration. Control over the distribution of its outputs is controlled for forward integration.
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Michael Porter‘s Value Chain model is the best understanding and application of vertical integration. Vertical integration means the level of integration between the company’s value chain and its supplier and dealer value chain. If a company integrates the value chain of its suppliers or distributors into its own value chain, it is called Full Vertical Integration.
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Vertical integration in the aviation industry is perhaps the most typical. Now, airlines are increasingly enforcing the role that used to be played by travel agents, a classic forward integration. Similarly, airlines are also pro-friendly to suppliers such as aircraft maintenance, flight catering, is typical of backward integration. A similar example is the typical vertical integration of refiners that own and operate oil distribution channels such as gas stations and sometimes enter the oil exploration industry.
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It is different from horizontal integration, which combines two businesses at the same level of the production process, like two supermarkets or two food manufacturing plants. Integration of two completely different business organizations is sometimes referred to as centralized integration.
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Development of vertical integration
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It has a long history, but its strategic motivations are not the same in each period. In the 19th century, the company used vertical integration to expand the scale of operations. In the middle of the 20th century, the use of vertical integration mainly reflected in stabilizing the supply of key production raw materials. The benefits of vertical integration come from the organization’s ability to control inputs, costs, quality, and the time they are transported. However, as the organizational structure of command and control types ceased to be popular at the end of the 20th century, this logic became less appealing.
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It is a difficult strategy for a company to succeed. It is often complex, expensive and difficult to reverse. Producers of the previous process often integrated distributors of the next process to ensure the market place for their products. When demand drops to a level where the plant is only able to maintain its utilization, many companies find themselves slashing prices on the distributors below. This often has the effect of driving out of the business of competitors who are not integrated, and making customers very reluctant to accept the resulting price increases.
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Application
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Vertical integration is commonly used in the following situations:
In the course of a company’s strategic development, it is often considered as a strategic choice. For example, where strong suppliers pose a threat to the company’s development, one strategy is to take a large number of suppliers with solutions.
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When using Porter’s five-force model industry for dynamic analysis, vertical integration is an inevitable choice to reduce the bargaining power of suppliers and customers.
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Vertical integration is also a way to reduce transaction costs.
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Considerations
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When considering whether to adopt a vertical integration strategy and to what extent, you need to consider the following:
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Is there a way for companies to control inputs and output cheaply?
Is there an external market factor that enables the firm to control inputs and output efficiently?
Is it necessary to pursue monopoly power?
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Why vertical integration is needed
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To increase the company’s control over product sales and suppliers, reduce uncertainty, get more complete information about markets and suppliers, get more profit
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With the rent cost, labour cost rising and profit falling sharply, more and more enterprises tend to bypass the layer stoic buyers directly with upstream origin (agricultural product base, manufacturing enterprises), the vertical integration of the supply chain has become a new topic for most enterprises. Compared with the previous two resource-integrated supply chain and the whole category supply chain, vertical category supply chain is more refined, according to the industry.
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Vertical integration strategy
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The vertical integration strategy pushes the enterprise to the product’s process (upstream or downstream), with the aim of reducing the fixed cost of the content, reducing the time cost, and can more effectively grasp the business and technical skills, and add the value of the product. The objectives of vertical integration include: the establishment of barriers, the protection of products, the improvement of scheduling, the improvement of investment.
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Why should it be implemented?
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To increase control of the company’s product sales and suppliers
Reducing uncertainty
Get more complete information about markets and suppliers
Get more profit
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Vertical integration case study
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Most visible examples occur in the oil industry. In the 1970s and 1980s, many companies that were originally engaged in the extraction and refining of crude oil decided to acquire the next tier of refining companies and distribution networks. Companies like Shell and BP control and own every drop of crude oil from the North Sea or Alaska into the car’s gasoline tank alone.
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The idea of vertical integration has taken the company one step further, and it was one of the most successful companies of the 1990s. Dell, which also has a closer relationship with these companies than traditional buyers and suppliers. It does not own these companies in a vertically integrated manner, but uses information and connections to achieve the same goal.
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Advantages and disadvantages
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Advantages
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- Forming barriers
- Invest in exclusive assets
- Mastering critical resources or resistance
- Maintain product quality
- Improved scheduling
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Disadvantages
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- Lack of adjustment flexibility
- Precious resources sluggish
- High cost of coordination
- Integration is not easy
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