In microeconomics and management, the term vertical integration describes a style of management control. Vertically integrated companies in a supply chain are united through a common owner. Usually each member of the supply chain produces a different product or (market-specific) service, and the products combine to satisfy a common need.
It is contrasted with horizontal integration. Vertical integration has also described management styles that bring large portions of the supply chain not only under a common ownership, but also into one corporation. It is is an approach for increasing or decreasing the level of control which a firm has over its inputs and distribution of outputs.
Vertical integration is the extent to which an organization controls its inputs and the distribution of its products and services. There are two sorts of vertical integration:
- backward integration; and
- forward integration.
A firm’s control of its inputs or supplies is known as: backward integration. A firm’s control of its distribution is known as: forward integration.
Vertical integration is best understood by applying Michael Porter’s Value Chain model. Vertical integration refers to the degree of integration between a firm’s value chain and the value chains of its suppliers and distributors. Full vertical integration occurs when a firm incorporates the Value Chain of a supplier and/or that of a distribution channel into its own value chain. This generally happens either by a firm’s acquiring a supplier and/or a distributor or by a firm’s expanding its operations. Expanding operations means to perform activities traditionally undertaken by suppliers or distributors. A lower degree of vertical integration is commonly known as Supply Chain Optimization or also as Supply Chain Planning. This occurs when logistical information is exchanged between a firm and its suppliers and customers.
An illustration of vertical integration may be found in the airline industry. By performing the traditional role of travel agents, Airlines have achieved forward integration. Likewise, by performing the role of suppliers such as aircraft maintenance and in-flight catering, airlines have backwards integrated. Similarly, oil refining companies have traditionally owned their oil distribution channels such as gas stations. Sometimes they moved into oil exploration and exploitation.
A monopoly produced through vertical integration is called a vertical monopoly. Steel tycoon Andrew Carnegie’s example in the use of vertical integration led others to use the system to promote financial growth and efficiency in their businesses.
Origin of Vertical Integration
The strategic reasons for opting for a vertical integration strategy have changed over the years. During the 19th century, firms used vertical integration to achieve economies of scale. During the middle of the 20th century, vertical integration was used to assure a steady supply of vital inputs. In some cases, the theory of transaction cost economics was applied to backward integration or forward integration, as a means to total cost reduction. That is, it was cheaper for a firm to perform the role of suppliers and distributors than to spend time and money to interact with such parties. Subsequently, in the late 20th century, competition intensified in most industries. Corporate restructuring resulted in vertical disintegration by reducing the levels of vertical integration in large corporations. Vertical disintegration is facilitated by the widespread use of information and telecommunications technologies, which support lower transaction costs between market participants. As lower transaction costs can be achieved using information and communication technologies, rather than by vertically integrating, firms start to vertically disintegrate. This effect is commonly known as “Coase’s Law” (in recognition of Ronald Coase’s Nobel price) or the “Law of Diminishing Firms”. This law states that when the transaction costs are decreasing, the size of the firm will also decrease.
Usage of Vertical Integration
Decisions on vertical integration are usually made in the following contexts:
- In the strategy development process, vertical integration may be considered as a strategic choice. For example if suppliers are very powerful, a solution to that threat is to buy a number of them up.
- When you are analyzing industry dynamics, using Porter’s Five Forces model, vertical integration is an action to decrease the bargaining power of suppliers and customers. Compare: Kraljic Model.
- Vertical integration may be a path for reducing transaction costs.
Steps in Vertical Integration
When you are deciding whether to vertically integrate, and to what extent, you should consider the following issues:
- Are there economies of scope, which would make it cheaper for a firm to control inputs and outputs?
- Are there any market external factors, which would make it more efficient for a firm to control inputs and outputs?
- Is there a need to pursue monopoly power?
Strengths of Vertical Integration
- Economies of scale.
- Economies of scope.
- Cost reduction.
- Reduce threat from powerful suppliers and/or customers.
- Higher degree of control over the entire value chain.
Limitations of Vertical Integration
- There is no such thing as a completely integrated or a completely non-integrated firm. Thus the issue is not a choice between these two polar alternatives. Rather, it is a matter of selecting the optimal degree of vertical integration.
- The degree of vertical integration can hardly be determined via quantitative means.
- Whilst Vertical Integration may solve one headache, the firm may well be acquiring a bunch of others. Compare Core Competence.
- Load and capacity balancing between the old and the new activities may be hard to achieve.
Assumptions of Vertical Integration
- A firm has to have the competences to undertake an expanded role in the supply chain.
Source: Kathryn Rudie Harrigan – Vertical Integration, Outsourcing, and Corporate Strategy
Source: Roger Blair and David Kaserman – Law and Economics of Vertical Integration and ControlBusiness frameworks like Vertical Integration are invaluable to evaluating and analyzing various business problems. You can download business frameworks developed by management consultants and other business professionals at Flevy here.