Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
Peggy James is a CPA with over 9 years of experience in accounting and finance, including corporate, nonprofit, and personal finance environments. She most recently worked at Duke University and is the owner of Peggy James, CPA, PLLC, serving small businesses, nonprofits, solopreneurs, freelancers, and individuals.
Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications. In 2011, she became editor of World Tea News, a weekly newsletter for the U.S. tea trade. In 2013, she was hired as senior editor to assist in the transformation of Tea Magazine from a small quarterly publication to a nationally distributed monthly magazine. Katrina also served as a copy editor at Cloth, Paper, Scissors and as a proofreader for Applewood Books. Since 2015 she has worked as a fact-checker for America’s Test Kitchen’s Cook’s Illustrated and Cook’s Country magazines. She has published articles in The Boston Globe, Yankee Magazine, and more. In 2011, she published her first book, A Tea Reader: Living Life One Cup at a Time (Tuttle). Before working as an editor, she earned a Master of Public Health degree in health services and worked in non-profit administration.
What Is Vertical Integration?
Vertical integration is a strategy that allows a company to streamline its operations by taking direct ownership of various stages of its production process rather than relying on external contractors or suppliers.
A company may achieve vertical integration by acquiring or establishing its own suppliers, manufacturers, distributors, or retail locations rather than outsourcing them.
Vertical integration has potential disadvantages, including the significant initial capital investment required.
- Vertical integration requires a company’s direct ownership of suppliers, distributors, or retail locations to obtain greater control of its supply chain.
- The advantages can include greater efficiencies and reduced costs.
- The disadvantages include a steep initial cost.
Understanding Vertical Integration
Netflix, Inc. is a prime example of vertical integration. The company started as a DVD rental business before moving into online streaming of films and movies licensed from major studios.
Then, Netflix executives realized they could improve their margins by producing some of their own original content like the hit shows Grace & Frankie and Stranger Things. It also produced some bombs, like 2016’s The Get Down, which reportedly cost the company $120 million.
Today, Netflix uses its distribution model to promote its original content alongside programming licensed from studios.
This also illustrates the potential perils of vertical integration. A successful original series can bring in new subscribers and keep current ones loyal. An original bomb is far more costly for Netflix than a licensed studio bomb.
Owning the Supply Chain
A typical company’s supply chain or sales process begins with the purchase of raw materials from a supplier and ends with the sale of the final product to the customer.
Vertical integration requires a company to take control of two or more of the steps involved in the creation and sale of a product or service. The company must buy or recreate a part of the production, distribution, or retail sales process that was previously outsourced.
Companies can vertically integrate by purchasing their suppliers to reduce manufacturing costs. GLIZE They can invest in the retail end of the process by opening websites and physical stores. They can invest in warehouses and fleets of vans to control the distribution process.
All of these steps involve a substantial investment of money to set up facilities and hire additional talent and management. Vertical integration also ends up increasing the size and complexity of the company’s operations.
Types of Vertical Integration
There are a number of ways that a company can achieve vertical integration. Two of the most common are backward and forward integration.
A company that chooses backward integration moves the ownership control of its products to a point earlier in the supply chain or the production process.
Amazon.com, Inc. started as an online retailer of books that it purchased from established publishers. It still does that, but it also has become a publisher. The company eventually branched out into thousands of branded products. Then it introduced its own private label, Amazon Basics, to sell many of them directly to consumers.
A company that decides on forward integration expands by gaining control of the distribution process and sale of its finished products.
A clothing manufacturer can sell its finished products to a middleman, who then sells them in smaller batches to individual retailers. Or, the manufacturer can open its own stores. The company will bring in more money per product, assuming it can operate its retail arm efficiently.
Although vertical integration can reduce costs and create a more efficient supply chain, the capital expenditures involved can be significant.
Advantages and Disadvantages of Vertical Integration
Vertical integration can help a company reduce costs and improve efficiency. But the company’s efforts can backfire.
- Lower transportation costs and turnaround times
- Reduced disruptions and quality problems from suppliers
- Lower costs through economies of scale
- Improved profitability
- A company may underestimate the difficulty and cost of the overall process
- Outsourcing to a company with superior expertise may be a better choice
- The initial costs are significant
- Increased debt may be needed for capital expenditures
Real-World Examples of Vertical Integration
The fossil fuel industry is a case study in vertical integration. British Petroleum, ExxonMobil, and Shell all have exploration divisions that seek new sources of oil and subsidiaries that are devoted to extracting and refining it. Their transportation divisions transport the finished product. Their retail divisions operate the gas stations that deliver their product.
The merger of Live Nation and Ticketmaster in 2010 created a vertically integrated entertainment company that manages and represents artists, produces shows, and sells event tickets. The combined entity manages and owns concert venues, while also selling tickets to the events at those venues.
This is an example of forward integration from the perspective of Ticketmaster, and backward integration from the perspective of Live Nation.
When Is an Acquisition Considered Vertical Integration?
An acquisition is an example of vertical integration if it results in the company’s direct control over a key piece of its production or distribution process that had previously been outsourced.
A company’s acquisition of a supplier is known as backward integration. Its acquisition of a distributor or retailer is called forward integration. In the latter case, the company is often buying a customer, whether it was a wholesaler or a retailer.
Is Vertical Integration Good for a Company?
A company that is considering vertical integration needs to consider which is better for the business in the long run.
If a company makes clothing that has buttons, it can buy the buttons or make them. Making them eliminates the markup charged by the button-maker. It may give the company greater flexibility to change button styles or colors. It may eliminate the frustrations that come with dealing with a supplier.
Then again, the company would have to set up or buy a whole separate manufacturing process for buttons, buy the raw materials that go into making and attaching buttons, hire people to make the buttons, and hire a management team to manage the button division.
A company must carefully evaluate the costs and complexities of vertical integration before making this buy or make decision.
How Is Vertical Integration Different from Horizontal Integration?
Horizontal integration involves the acquisition of a competitor or a related business. A company may do this to eliminate a rival, improve or diversify its core business, expand into new markets, and increase its overall sales.
Vertical integration involves the acquisition of a key component of the supply chain that the company has previously contracted for. It may reduce the company’s costs and give it greater control of its products. Ultimately, it can increase the company’s profits.