The goals of most businesses are to make money and grow.
Vertical integration is one way of achieving those objectives, but what is it and when it should be undertaken?
There are potential legal barriers to carry out vertical integration and a sound knowledge of what they are and how to avoid legal risk is important.
What is vertical integration?
Put simply, vertical integration is the arrangement in which a company owns its own supply chain. This is not strictly limited to suppliers – it can also include distributors and retail locations.
The key benefit of vertical integration is to achieve a higher degree of control over a company’s supply chain, as well as reducing the variable production costs incurred in production.
Vertical integration and the extension of a company’s supply chain can be an upstream integration (when it extends backwards) or an upstream integration when the supply chain extension is forward. The achievement of the integration may be handled internally by the company or it may involve the extension of a production line or acquiring a vertical extension.
It is a restructuring strategy that can give an organisation greater control over processes, costs and efficiencies, allowing them to become far more streamlined than would otherwise be possible.
By vertically integrating a supply chain there is extended control over the entire production process so that information and material can be extended more readily between the supply chain components or members, all of which creates more flexibility to adapt to production requirements and demand.
Examples of vertical integration include Google purchasing Motorola,Netflix producing its own content, SpaceX produces most componentry in-house and can undercut competitors like United Space Alliance, which is a joint partnership between Boeing and Lockheed Martin.
In the SpaceX’s case, the launch cost via vertical integration means it pays around $90 million per launch compared to $460 per launch for United with its dispersed supply chain using various suppliers.
Vertical integration is different to horizontal integration, which is when a company grows by acquiring a competitor.
When to implement vertical integration?
Vertical integration will be undertaken when a company needs to increase sales, reduce or eliminate costs, and improve profits. Depending on what the focus is, there are different vertical integration strategies.
Backward integration – this is when a company purchases a supplier to gain greater control over its inventory and reduce costs.
Forward integration – this is when a company purchases distributors or retail stores to get closer to the customer and take greater control over how their product is marketed and priced.
Balanced integration – this is simply a combination of backward and forward integration.
The pros and cons
The advantages of vertical integration include:
- Benefiting from upstream or downstream profit margins
- Increased opportunities to differentiate
- The ability to invest in specialised assets that purchased companies may have swerved
- Improved supply chain coordination
The drawbacks, meanwhile, include:
- Issues with capacity balancing
- The potential for higher costs due to lower efficiencies from a lack of supplier competition
- Bureaucratic costs going up
The legal barriers
If vertical integration is achieved through a merger, the deal will be able to go ahead unless it contravenes UK competition law.
Factors that may be taken into consideration when assessing the competitiveness of a merger include whether retail outlets will block certain suppliers, or if competitors find their access to resources blocked.
If the merger gives a company such control over the market that it dissuades others from entering, it may also be considered uncompetitive.
The importance of ensuring the legal compliance and issues arising from vertical compliance are achieved are obviously highly important, as are the benefits of correctly implementing the processes required.