Vertical Integration Explained: How It Works, With Types and Examples

Definition

Vertical integration is a business strategy where a company takes control over multiple stages of its production or distribution process, including upstream suppliers and downstream distributors. This strategy is either backward (the manufacturer takes over supplier or input resources company) or forward (the manufacturer takes over the distribution part). Examples include a car manufacturer acquiring a tire company (backward integration) or a dairy farmer opening their own ice cream shop (forward integration).

Phonetic

“ˈvɝːtɪkəl ˌɪntɪˈgreɪʃən ɪkˈspleɪnd: haʊ ɪt wɝːks, wɪð taɪps ænd ɪɡˈzæmpəlz”

Key Takeaways

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1. Understanding Vertical Integration: Vertical integration is a business strategy where a company controls its supply chain, from manufacturing to end sales. By owning or controlling its distributors, suppliers and retail locations, a company can control its value chain and reduce costs, increase efficiencies and synchronize supply and demand.
2. Types of Vertical Integration: There are two primary types of vertical integration: forward and backward. In forward integration, a company controls or owns its distributors, retailers or end sales. This is seen in manufacturers who own their retail stores. In backward integration, a company controls or owns its raw material suppliers. This allows the reduction of production costs and increases control over product quality.
3. Examples of Vertical Integration: There’s a plethora of examples of companies using vertical integration. A prominent one includes Apple, who uses a mix of both forward and backward vertical integration. They design, manufacture (to an extent), market and sell their products in their own retail stores. Another example is Starbucks. They bought farms to control the quality of their coffee beans, which is an example of backward integration.

“`Please note, the nature and benefits of vertical integration vary based on industry context, companies’ capabilities, and market conditions.

Importance

Vertical Integration is a significant concept in business and finance, as it is a strategy used by companies to gain control over their supply chain, thereby improving efficiency and reducing costs. In essence, vertical integration involves a company expanding its operations into different stages of production or distribution within the same industry, either forward (towards the customer) or backward (towards raw materials). Different types can include companies integrating with suppliers, manufacturers, distributors, or retail outlets. For example, a clothing brand may own the cotton farms, textile mills, manufacturing units and the stores where its clothes are sold, making its operations vertically integrated. The importance of vertical integration lies in its potential to offer companies a competitive advantage; this strategy can allow companies to control the quality of their products or services, and respond more quickly to market changes, among other benefits. It is, however, not without its challenges and risks, thus understanding vertical integration is crucial for businesses to weigh its potential advantages against these.

Explanation

Vertical integration is a strategy whereby a company expands its business operations into different stages of production or distribution within the same industry to gain greater control over its supply chain. The primary purpose of vertical integration is to increase the company’s efficiency, secure supply of crucial raw materials, lower transaction costs, and gain an advantage over competitors. By merging the different stages of production and distribution all under one umbrella, the company has a better ability to control or influence the different parts of supply, production, marketing, and distribution. For example, a car manufacturer might own a tire company, a glass company, and a metal factory, allowing them to control the production of the parts necessary to manufacture their cars, leading to cost power, quality control and efficiency. Another type is backward integration, when a company controls products post-manufacturing, like a bakery choosing to own a retail shop to control the selling of their bread. Both types allow the company to streamline production, cut intermediary costs and secure supplies, creating a competitive edge in the market.

Examples

1. Amazon: Amazon started its operations as an online bookstore, later moving on to sell various consumer goods, digital media and local services, even cloud computing services. This is an example of vertical integration as they expanded and absorbed different processes in their supply chain to eliminate intermediaries and increase their profitability. Forward integration is seen as they started their own delivery network – Amazon Prime and backward integration when they acquired Whole Foods to control parts of their grocery supply chain.2. Netflix: Netflix has also used vertical integration for business growth. What started as a DVD mailing and movie streaming service, now produces its own content. By doing so, Netflix is involved in all stages of the supply chain, from content production (Netflix Originals) to distribution (through its streaming platform). This is a clear example of vertical integration to reduce production costs and control over their offerings.3. Apple: Apple Inc. is another company that’s known for its application of vertical integration. Apple designs and manufactures hardware (iPhone, MacBook, iPad, etc.), they also create software (iOS, MacOS) that runs on those devices, and they have their own retail stores (Apple stores). The integration helps them improve margins, having full control over the entire supply line and delivering a seamless experience for its customers. This is an example of both forward and backward integration, forward as they established their own distribution channels and backward as they make their own hardware and software.These are examples of ‘End to End’ vertical integration where businesses control their products from the inception to the point it reaches the consumer. But there are also numerous businesses who only control a part of this supply chain.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Supply Chain Management
• Mergers and Acquisitions
• Backward Integration
• Forward Integration
• Cost Efficiency

Sources for More Information

• Investopedia
• Corporate Finance Institute
• MBASkool
• Harvard Business Publishing