8 Interesting Observations About Vertical Integration

An entrepreneur hoping to grow a new business will be concerned with sourcing materials and ensuring that products are distributed and marketed effectively. In some cases, it may make sense — in order to take a business to the next level — to consider vertical integration.

Simply put, vertical integration refers to the expansion of a business to encompass multiple points along the production chain, such as when Amazon, seeking to emulate the success of Apple by organizing vertically, developed the Kindle Fire device as a bridge in the path from online commerce to hardware. Here are a few observations about vertical integration:

1. Integration along a supply chain

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A supply chain includes the suppliers of raw materials, manufacturers and producers, wholesalers, distributors, and consumer retail outlets. Integration along a supply chain enables participants to streamline the collection and usage of customer and inventory data, and to respond more quickly to challenges at any given point. There is also the advantage of greater control over the use and organization of the production materials. When a company organizes its supply chain into a vertically integrated system, it enjoys these benefits to an even greater degree.

2. Level of vertical integration

The degree to which a company owns its upstream producers and suppliers, as well as its downstream consumer-facing operations, indicates its level of vertical integration. Experts describe a business’ upstream acquisitions as backward integration — facing away from the consumer — and its expansion downstream as forward integration, meaning closer to the consumer. In balanced, or complete integration, a business owns all the components, ranging from the raw materials to the finished product, as well as its distribution points.

3. Horizontal integration

In contrast, horizontal integration refers to a situation in which a company merges with another in a comparable line of business, as when Standard Oil under John D. Rockefeller acquired dozens of petroleum refineries. The recently scrapped deal for American pharmaceutical giant Pfizer, Inc., to acquire Ireland-based Allergan Plc would have been another instance of horizontal integration. Disney’s purchase of Pixar is yet another example. Such a merger unites companies at the same or very similar levels of the production chain, in the same or closely related industries.

4. A look at Dell

In the 1990s, Michael Dell used “virtual integration” to describe his highly successful model for producing and distributing the Dell computer. The product was assembled from components sourced from a variety of suppliers and vendors that were part of a loose association based on shared information and needs.
A strategic partner of DocuSign, Dell is now part of the DocuSign Global Trust Network. Dell is a strategic investor, reseller, and customer.

5. Other examples of vertical integration

Apple has long been known for its tight focus on vertical integration. The company maintains control over multiple hardware and software components that go into the creation of its sophisticated finished products.

Other examples of vertical integration include supermarket chains that own food production companies and farms, as well as giant oil companies such as Shell that traditionally bought up both exploration interests and networks of filling stations. Richard Branson’s extension of his Virgin Records into talent management and music production is another one of the most successful and well-known instances of vertical integration.

6. Control over materials and resources

Historically, companies have used vertical integration as a means of maintaining control over limited quantities of physical materials and resources. In today’s world, companies tend toward a much greater degree of disaggregation, with individual units operating in outside joint ventures.

7. Cost reductions

Companies that opt to develop their capacity through vertical integration can achieve cost reductions in categories such as turnaround time and transportation. But under some circumstances, it makes more sense to rely on outside suppliers who have achieved economies of scale, rather than attempt to meet every supply need on one’s own.

Vertically integrated companies also enjoy those advantages associated with controlling access to inputs, as well as greater control over coordination along the supply chain. They enhance their ability to communicate among a variety of units on the path to production and distribution. In addition, they can develop revenue streams at multiple points upstream or downstream, and expand to additional distribution points downstream. They can also increase the barriers to competitors’ entry into key markets by dominating vital resources. These benefits can ultimately lead to the expansion of a company’s core competencies, which represent a competitive advantage.

Once a company has chosen vertical integration as an organizational strategy, it can be difficult to implement and to reverse course.

8. Economies of scale

A company that opts to expand through horizontal integration can achieve economies of scale and scope, including the ability to step up mass production at a lower cost. Horizontal integration, also known as lateral integration, can increase a corporation’s power in the marketplace and lower the price of doing business globally through a network of overseas offices. As a company expands horizontally, it can absorb or force its competitors out of businesses.

If all the companies engaged in a similar line of business were to merge, the resulting conglomerate would constitute a monopoly. Such a situation could cause a company to run up against antitrust regulations.