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Vertical and Horizontal Integration – Definition

Cite this article as: Jason Mance Gordon, "Vertical and Horizontal Integration – Definition," in The Business Professor, updated April 30, 2017, last accessed January 22, 2020, https://thebusinessprofessor.com/knowledge-base/vertical-and-horizontal-integration/.

Understanding Strategy

Strategy is a firm’s orientation, objectives, and tactics employed in pursuit of its objectives or goals. A strategic plan is how these attributes are organized or aligned. Strategies can be applied generally to the firm’s value proposition or to any objective or goal within the firm.

Porter’s Generic Strategies identify how strategy is applied to make a firm’s value proposition feasible in a competitive market through differentiation, cost structure, or niche markets. Structural strategies, such as vertical and horizontal integration, encompasses reorganizing the firm’s operational structure to create competencies at any point in the value chain. That is, the firm develops a business structure that allows it to grow by creating efficiencies (such as cutting costs or ensuring supply) at any stage of their value delivery process.

Vertical Integration as a Strategy

The value creation chain is commonly represented as a vertical series of stages. Each stage contains some step that is critical in creating and delivering value to the consumer. Vertical integration means that a firm assumes control over more stages in the value chain.

Let’s take the development of a plastic toy for example. The products value chain include a plastic production facility to develop the appropriate plastic material; the logistics carrier transporting the plastics to the manufacturer; the manufacturing facility that molds the plastic into the product; the box company that packages the product; the shipping line that exports the product; the distribution of products to retailers; and the retail store that provide the product to customers. A company may organize structurally to control each or any of these stages of the value chain – such as by purchasing or merging with any of these companies. Alternatively, the company would hire or outsource the steps with third-party service or product providers.

Types of Vertical Integration – Backward, Forward, and Balanced

Vertical integration is generally separated into “backward integration” and “forward integration”.

Backward integration involves restructuring to control the parts of the value chain supplying the business or moving backward toward the earliest stages of production or manufacturing. For example, a manufacturer might acquire the suppliers of raw material or parts for the company’s product.

Forward integration involves restructuring to control the downstream parts of the value chain. This includes any stage down to purchase of the product or service by the customer or end-user. For example, the manufacturer might develop or purchase a distributor or retailer of the product.

Balanced Integration is a mix between backward and forward integration efforts or strategy.

When to seek Vertical Integration

A vertical integration strategy is for a company seeking to secure all stages of a particular value chain. This is useful when failure to do so creates an identifiable risk for the company. For example, a material or parts supplier may be unreliable or the price may fluctuate wildly. Alternatively, it may also be useful when it allows the company to dramatically expand its margin by capturing the margins of these businesses (i.e. reducing their cost structure to increase their profit margin).

The ultimate effect of a vertical integration strategy should be linked to a distinct growth objective of the company. Growth objectives might include: secure resources, increase margin, increase profit, increase efficiency, acquire market share, new market penetration, expand core competencies, etc.

The negative aspect of verticle integration is that the company must diversify its attention. Splitting focus presents challenges in maintaining its core competencies. Assuming control of a part of the value chain in which the company does not have extensive knowledge or ability (a core competency) can result in poorer quality of materials, parts, or goods (particularly when competition does not force maintained quality). Finally, fluctuating markets may dramatically affect the profitability or efficiency of a given stage of the value chain. These fluctuations must now be born by the integrating firm.

Horizontal Integration as a Strategy

Horizontal integration strategy is when a business acquires a related business that occupies the same stage of the value chain and provides a similar type of value as the business. The acquired business does not have to be a direct competitor. It may produce a substitute product that serves a similar need for the customer or end-user. Acquiring the company allows the company to supply differing products that meet a similar value proposition.

Normally horizontal integration happens through merger with or acquisition of another company. For example, a retail store or chain may purchase another retail store or chain to expand in its existing market.

When to Seek Horizontal Integration

As with vertical integration, a horizontal integration strategy should align with the company’s strategic goals or objectives. This strategy may be appropriate when a company wishes to:

  • reduce competition,
  • expand product or service offerings,
  • cut costs by taking advantage of economies of scale,
  • increase market share or capacity, or
  • penetrate new markets.

This strategy can be difficult to execute, as operating a larger organization may be demanding and can dilute core competencies. The process of integrating two companies can also be very difficult. It requires a combination of physical, human, and technological resources. Finally, the ability to control a single stage of the value stage may be limited by antitrust law. Acquisition of or merger between major competitors may create a monopoly and result in a lack of competition in the market. See our lecture on antitrust law and monopolies for more information on this topic.

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