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Vertical Integration

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6 views

Vertical Integration

Uploaded by

Mandhlaenkosi Mugara
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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QuickMBA / Strategy / Vertical Integration

Vertical Integration

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 Forward Integration

Raw Materials Raw Materials Raw Materials

Intermediate Intermediate Intermediate


Manufacturing Manufacturing Manufacturing
Assembly Assembly

Assembly

Distribution
Distribution

Distribution

End Customer
End Customer

End Customer

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.

Benefits of Vertical Integration

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.

 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.

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
QuickMBA / Strategy / Vertical Integration

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