When companies want to expand their business operations in multiple ways, but still stay on the same path of production, then vertical integration is the process which they choose to pursue. The most common way to vertically integrate for organizations today is to become the supplier and distributor of goods or services simultaneously. It is possible to integrate forwards or backwards in this way.
If a company decides that forward integration is in their best interest, then they push the production cycle in a vertical direction. Distribution is one of the most common examples of this effort. A backwards integration takes the cycle in the opposite direction. In this circumstance, the manufacturer would need to assume control of their supply chain so that their processes receive internal support throughout the production effort.
There are several advantages and disadvantages to consider when looking at the concept of vertical integration in the modern business world. This effort can lead to improved efficiencies in multiple areas, but it can also reduce the amount of diversification that is available within the organizational portfolio.
Because of these issues, the pros and cons of vertical integration must have every critical point reviewed by an organization’s leadership before instituting an effort to achieve it.
List of the Pros of Vertical Integration
1. It allows a business to control more than one stage of the supply chain.
Vertical integration occurs when a company can control more than one stage of its supply chain, which is the process an organization uses to turn raw materials into a usable product that the consumer can purchase. There are four phases of every basic supply chain: commodities, manufacturing and production, distribution, and retail sales. An effort in this area allows for the company to control two or more of these areas.
2. Companies no longer need to rely on suppliers.
Many organizations look at vertical integration as a way to build independence within their supply chain. When this effort is successful, then the company no longer needs to rely on its suppliers to bring products or services to the market. That means there are fewer risks to assume if their partnerships create disruptions due to a lack of management skill. This advantage also makes it easier to avoid labor disputes and frequent employee strikes when the business operates in countries with mixed economies that trend closer to socialism than capitalism.
3. It allows the organization to dictate the terms of the relationship.
There are times when vertical integration is necessary because the suppliers in the market hold enough power to dictate terms to the company. This issue occurs frequently if one of the suppliers has a monopoly in an area where the organization in question does business. By working to vertically integrate on the supply chain, it becomes possible to go around the providers which control a majority of the market, reaping the benefits of being able to provide better pricing structures since internal costs have more control.
Better delivery methods are possible with this advantage as well because the organization is less likely to fall short of the critical elements that are necessary for a final delivery.
4. This process allows an organization to achieve an economy of scale.
When an organization begins pursuing vertical integration, then they are seeking to achieve an economy of scale. This benefit occurs when the size of the company allows it to cut costs because it can lower the per-unit cost of purchasing in bulk. It becomes possible to make the manufacturing processes more efficient with this effort or improve the delivery mechanisms that bring products or services to the consumer. Companies who are successful with vertical integration can eliminate overhead expenses because they are consolidating management in the middle.
5. It allows companies to know what is selling well.
When you walk into a Walmart pharmacy, then you will see shelves that are packed with numerous brand-name products. Things like Benadryl, Tums, and Advil are popular commodities that people purchase every day because they meet basic needs. Because of the processes that vertical integration supports, it is possible to see or know what sells well and then create a replica of the items in question underneath a store-based brand. If you purchase an Equate products from Walmart, then this is what you are doing.
Since the brand-name products require the distribution channels from Walmart to get their items in front of possible consumers, there is less of a risk of a lawsuit for copyright infringement. That means the company wins because they are more competitive on price, and then the consumers win because they pay less for what they need.
6. Prices are almost always lower because of vertical integration.
Consumers appreciate the effort a business takes to vertically integrate because it almost always results in a lower price during the checkout process. Companies which are successful in this effort can lower their costs, increase the quality of what they offer, and build higher levels of customer loyalty because of their ability to take control over their supply chain. Almost all grocery stores today that are part of a regional or national chain use vertical integration as a way to increase consumer choice and decrease costs.
7. Vertical integration can open new markets for an organization.
Weather an organization decides to move forward or backward in their effort to vertically integrate, this investment and the processes which follow can lead the company into new markets where consumers are already wanting to purchase the item at the retail level. This outcome makes it possible to establish additional revenue resources that can allow the business to continue expansion efforts, improve internal qualities, or even hire more people thanks to the increased interest in their products.
Even partnerships which allow for access to the different stages of the supply chain instead of complete ownership can bring about this advantage. Properties, technologies, and access to proprietary information can create local access that is unavailable to a business before their effort at vertical integration. Because there are more leads to pursue, it is possible that additional profits can make the organization scalable.
8. It is easier to build quality assurance into the system.
A successful vertical integration attempt allows an organization to review the overall quality of their products or services throughout the entire supply chain instead of only during one stage of it. This process makes it possible for a company to review the quality of each item from conception to its final sale. It allows for more value in the proposition offered to consumers because there is more reliability in the outcome at each stage.
When there is consistency throughout the supply chain, then there will be higher levels of consumer satisfaction. That makes it possible to retain more customers because the value proposition of the company inspires more loyalty, which then creates the potential for repetitive sales.
9. Vertical integration allows companies to focus on asset specialization.
Vertical integration makes it possible for companies to seek out specific skill sets as part of their recruiting efforts instead of trying to find them in contractors, freelancers, or vendors. By bringing in these people underneath the corporate umbrella, it is possible to focus on asset specialization from a team perspective instead of being forced into an outsourcing point of view. Not only does this outcome allow the business to differentiate itself from its competitors, but it also builds the foundation for a specific brand message that encourages a robust value proposition that will echo in the ears of its target consumers.
This advantage can eventually improve the local market share for a brand in multiple communities at once. It is possible because the company controls more of the supply chain after a successful vertical integration attempt. Their presence at multiple stages allows for better leveraging on micro levels because there is more data available about what customers are going to want or need.
10. It can increase product knowledge and marketability for a brand.
One of the less obvious benefits to a successful vertical integration attempt is to understand the market for a product and the information known about it. Producing items that correct the errors of previous attempts will provide additional value to a consumer when there is a non-pain point that must be addressed. This process makes it possible for a vertically integrated organization to meet the demand of their market with greater consistency, whether they decide to sell products that they manufacture or represent items from a strategic partnership.
List of the Cons of Vertical Integration
1. The expense of vertical integration is enough for some organizations to avoid it.
Vertical integration requires a significant capital investment by an organization if this effort has a chance to be successful. A company must have enough resources available to set up or purchase factories that can produce items for sale. Then the business must continue to keep these assets running in specific ways because efficiency must be maintained for the profit margin to remain consistent.
If there is not enough money in the bank for an organization to make the initial purchases that are necessary for vertical integration, then there is no way for the business to be successful in its efforts.
2. There is less flexibility available with a vertically integrated company.
When Walmart decides that Advil is not selling as well as it should be on its shelves, then it can look at other ibuprofen manufacturers to see if a competitive product would perform better. The organization might decide to pursue Tylenol or Aleve as a featured brand-name item to sell to customers. There are choices available because there are multiple producers in the industry that offer a similar product.
When a company decides to pursue vertical integration, then there is less flexibility available because the business is already producing the competitive product. If Advil sells better than Equate does for Walmart, then the only choices available are to stop producing generic ibuprofen or stop carrying the brand-name product.
3. Vertical integration can cause companies to lose their focus.
Each step of the supply chain requires a different set of skills within the leadership and executive teams. What it takes to run a successful retail business is very different then the set of skills that are necessary to supervise an efficient and profitable factory. Unless there is an effort to find staffing before an organization attempts to achieve a stronger footprint in their supply chain, then it is challenging to create a successful outcome. It is exceptionally rare to find leaders for the C-Suite who are good at multiple stages.
4. The organizational culture may not support vertical integration.
Most companies do not have a culture that can support multiple simultaneous stages for the supply chain. Organizations are used to working with the manufacturing process or the retail process, but not both of them. That is why businesses will often encounter resistance when they start pursuing vertical integration. Their staff does not have the wherewithal to respond to corporate needs which are outside of their expertise or comfort zone.
Successful retailers attract people who are skilled in sales and marketing. That culture is not as responsive to the needs of a factory as someone who is familiar with industrial cycles. These cultural differences can lead to misunderstandings, lost productivity, and even conflict in the workplace. It is even possible for a non-integrated company with cultural diversity to compete against ones that have been successful with these efforts.
5. It requires infrastructure to be successful.
Because vertical integration relies on an economy of scale to be successful, there must be a strong foundation in place before this effort begins if the outcome is going to be as expected. When there isn’t enough strength at the bottom of the organization, then the entire effort to vertically integrate can topple over quickly.
We saw this happen in recent years when Haggen’s decided to purchase over 100 grocery stores from Albertson’s as a way to expand throughout the western United States in 2014. The company went from 18 stores with 16 pharmacies to 164 stores and 106 pharmacies, moving from 2,000 employees to 10,000 workers almost overnight. In less than a year, the grocery store chain filed for bankruptcy, and now Albertson’s owns the Haggen core stores as well.
6. Companies may not be able to see barriers to entry.
Even though a successful vertical integration attempt can help to limit competition for an organization, it is only possible to achieve results when a complete overview of any market barriers to entry are in place. If the wrong materials for production are scarce for an unknown reason or the market information is inaccurate, then the decisions that the business makes to take over more of their supply chain are not as accurate as they should be. This outcome can mean higher expenses, less market access, or even a complete failure of the effort.
7. Vertical integration can create confusion in the consumer base.
Because of the many benefits that occur with vertical integration, numerous corporations have taken over every step of their supply chain to maximize profits. This outcome means that many different brands all fall under the same corporate umbrella. We can even see this disadvantage in the tech sector since Alphabet operates Google, Verily, and Waymo as subsidiaries. Coca-Cola has over 1,000 different brands to its name, while PepsiCo produces several popular food products – some of which even compete with each other.
Customers who feel dissatisfied with a specific brand may choose a different product without realizing that they are still shopping with the same company. Vertical integration can help businesses save a lot of money, but it can also create enough confusion within the consumer base that some organizations may never reach their full potential.
Verdict on the Pros and Cons of Vertical Integration
Vertical integration is not an investment that every company can or should make. This process benefits consumers the most when an organization is already operating on more than a regional scale. When Walmart, Target, The Home Depot, Lowe’s, McDonald’s, and other national brands make the effort to internalize every possible stage of their supply chain, then the final cost to the consumer can be significantly lower. The benefit is not always possible when small enterprises at the regional level attempt to do the same thing.
There is always a risk that an organization will bite off more than it can chew when pursuing vertical integration because there’s not enough experience available to follow through with the necessary work.
The pros and cons of vertical integration show us that it is a useful investment when there is enough capital available and plenty of consumer interest in specific goods or services. There are plenty of challenges that must be considered before the first steps toward the takeover of another supply chain stage is initiated. When successful, the outcomes provide more choices at lowers costs. When it fails, then a company may put itself on the verge of bankruptcy.
Natalie Regoli is a child of God, devoted wife, and mother of two boys. She has a Masters Degree in Law from The University of Texas. Natalie has been published in several national journals and has been practicing law for 18 years.