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Vertical Integration – Definition

Vertical Integration Definition

Vertical integration is basically when a company is able to control several levels of the supply chain. In the supply chain, we have a number of stages such as; raw material, manufacturing, distribution, and retail. A company may play a role of manufacturing, distributing and retailing. In this case, it converts raw material into a product and then gets it to consumers cutting out the middleman. When a firm is able to integrate and control two or more of these, then it is termed as vertical integration.

In other terms, Vertical Integration may refer to an arrangement where the supply chain of a firm is owned by that same firm. In most cases, each member of the supply chain produces a different specific product service. This is then combined to produce an end product that satisfies consumers’ needs. However, it is sometimes beneficial when a firm relies on the already established expertise and economies of scale of other dealers instead of being vertically integrated.

A Little More on What is Vertical Integration

A company may use vertical integration to gain control over its suppliers and to increase its power in the market. It can also use it to moderate transaction costs and also secure distribution networks. Forward and backward are the common types of vertical integration that companies use in their business’ operations.

Also,there is the  balance integration which is also used by firms in operating their businesses. However, this one is not common like the other two. The choice to use either of them depends on what the firm intends to achieve or gain.

Types of Vertical Integration

  • Forward integration

This is when a company is able to control the stages of the supply chain further. It is a state where a business gains back ownership of its distributors and retailers. It can be used by businesses when their intention is to focus on expanding their market shares. Many manufacturing companies who use forward integration own online stores. They sell their products directly to consumers thus cutting out retailers.

This happens when at the end of a supply chain a manufacturing company takes on activities. It may start making intermediate goods on its own and start supplying. In other terms, backward integration is simply taking over its previous ownership of suppliers. A good example is when a movie distributor decides to also manufacture content and distribute. A business may want to pursue backward integration for the following reasons: To become more efficient and To secure a stable input of resources.

  • Balance Integration

Balance integration is a strategy that has a combination of both forward and backward integration. This is implemented when both strategies are proving difficult to implement and may, in the end, cost the business. In this case, strategies from both sides are incorporated to ensure smooth and continued running of the business.

Advantages of Vertical Integration

  1. The consumers are able to buy products at a lower price. This is because when a company operates on a vertical integration basis, it is able to operate on reduced costs. This, therefore, enables it to translate the savings to the consumer as a lower price.
  2. It allows companies to cut costs. For instance, when a company buys a certain product in bulk, the seller may lower unit cost.
  3. The company does not rely on suppliers. This means there are minimal chances of experiencing disruption from suppliers who sometimes may not be reliable.
  4. It is easy to study market trends. In this case, the retailer can easily know what is selling well in the market. He can then use this opportunity to its advantage by manufacturing or creating a similar product that can beat the existing brand.
  5. It increases managerial complexity. This is because a new line of work requires a new set of expertise to match the existing business. At times it may prove difficult to get a good and reliable CEO who can run the factory and ensure that it operates on profits.

Disadvantages of Vertical Integration

  1. Vertical integration is expensive as the firms are required to come up with a considerably good amount of money (capital) to establish a functioning factory. Besides putting up the factory, there are also costs of maintaining the plant to ensure that it efficiently runs and makes profits.
  2. Vertical integration reduces versatility. It is difficult for a firm that operates on vertical integration to follow consumer trends. This is because it is not possible for them to change their factories to be able to play along with the consumer trend. In this case, there is a limitation on what the firm can produce and supply. It is easy for a non-integrated company to use diversified culture to compete against the vertically integrated one.

Examples of Vertical Integration

The following examples will give you a good understanding of what vertical integration is and how it works:

Example 1

If a mortgage company lends money to people who want to buy a home and the same company collects the monthly payments, it will be implementing vertical integration. In this case, it is implementing both the lending and the collection instead of focusing on one service.

Example 2

When firm A and B merge to form an entertainment company that represents artists, produce shows and sells event tickets, is also another good example of vertical integration. In this case, one company will be implementing forward integration while the other one backward integration depending on what each was engaged in before merging.

Example 3

A company like Apple manufactures its own products and manages its distribution and sales. For example, it manufactures custom A-series chips for its iPhones and iPads. The firm also owns laboratories and manufacturing facilities in Taiwan and in North San Jose where they create their own ID fingerprint sensor and develop LCD and OLE screen technologies.

Almost all of Apple’s products are sold at company-owned locations. This allows the firm to be in charge of its distribution and sales. They are the manufacturers, distributors, and retailers who sell their products to the end consumer.

References for Vertical Integration

Academic Research on Vertical integration

Vertical integration, appropriable rents, and the competitive contracting process, Klein, B., Crawford, R. G., & Alchian, A. A. (1978). The journal of Law and Economics, 21(2), 297-326.

Vertical integration and antitrust policy, Spengler, J. J. (1950). Journal of political economy, 58(4), 347-352.

The vertical integration of production: market failure considerations, Williamson, O. E. (1971). The American Economic Review, 61(2), 112-123.

Vertical integration: determinants and effects, Perry, M. K. (1989). Handbook of industrial organization, 1, 183-255.

Supplier switching costs and vertical integration in the automobile industry, Monteverde, K., & Teece, D. J. (1982). The Bell Journal of Economics, 206-213.

An industry equilibrium analysis of downstream vertical integration, McGuire, T. W., & Staelin, R. (1983). Marketing science, 2(2), 161-191.

Vertical integration and communication, Arrow, K. J. (1975). The Bell Journal of Economics, 173-183.

Vertical integration and market foreclosure, Hart, O., Tirole, J., Carlton, D. W., & Williamson, O. E. (1990). Microeconomics, 1990, 205-286.

Vertical integration and corporate strategy, Harrigan, K. R. (1985). Academy of Management journal, 28(2), 397-425.

Is vertical integration profitable, Buzzell, R. D. (1983). Harv. Bus. Rev.;(United States), 61(1).

Formulating vertical integration strategies, Harrigan, K. R. (1984). Academy of management review, 9(4), 638-652.

The choice of organizational form: vertical financial ownership versus other methods of vertical integration, Mahoney, J. T. (1992). Strategic Management Journal, 13(8), 559-584.

The empirical determinants of vertical integration, Caves, R. E., & Bradburd, R. M. (1988). Journal of Economic Behavior & Organization, 9(3), 265-279.

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