Vertical Integration

vertical integration

Definition
Merger of firms at different stages of production and/or distribution in the same industry. When a firm acquires
its input supplier it is called backward integration, when it acquires firms in its output distribution chain it is
called forward integration. For example, a vertically integrated oil firm may end up owning oilfields,
refineries, tankers, trucks, and gas (petrol) filling stations.
In microeconomics and strategic management, the term vertical integration is a type of related
diversification that describes a style of nearly total ownership and control. The degree to which a
firm owns its upstream suppliers and its downstream buyers determines how vertically integrated
it is. Note, however, that there is no ratio or quantifiable measure to denote this.
Vertically integrated companies are united through a hierarchy and share a common owner.
Usually each member of the hierarchy produces a different product or service, and the products
are combined to satisfy a common need. It is contrasted with horizontal integration, in which one
part of the production process is expanded across several different market segments. A common
successful horizontal integration example is how Intel (INTC) has dominated the computer
processor market, supplying such chips to several different manufacturers, such as Dell (DELL) ,
Toshiba (TOSBF) , and the Hewlett-Packard Company (HPQ) .
Types of Vertical Integration

Vertical Integration comes in three flavors: backward (upstream) vertical integration, forward
(downstream) vertical integration, and balanced (equal) vertical integration.
Backward Vertical Integration
The company sets up subsidiaries that manufacture some of the inputs used in the production of
its goods. For example, an automobile company may own a tire company, a glass company, and
a metal company. Control of these three subsidiaries is intended to create a stable supply of
inputs and ensure a consistent quality in their final product. It was the main business approach of
Ford and other car companies in the 1920s, who sought to minimize costs by centralizing the
production of cars and car parts.
Backward Integration Mean?

A form of vertical integration that involves the purchase of suppliers in order to reduce
dependency.
Example
Backward Integration
A good example would be if a bakery business bought a wheat farm in order to reduce the risk
associated with the dependency on flour.
Forward Vertical Integration
The company sets up subsidiaries that distribute or market products to the end market or use the
products themselves. An example of this is a movie studio that also owns a chain of theaters.
Forward Integration Mean?

A business strategy that involves a form of vertical integration whereby activities are expanded
to include control of the direct distribution of its products.
Example Forward Integration

A good example of forward integration is when a farmer sells his/her crops at the local market
rather than to a distribution center.
Balanced Vertical Integration
The company sets up subsidiaries that both supply them with inputs and distribute their outputs.
If you view McDonald's (MCD), for example, as primarily a food manufacturer, backwards
vertical integration would mean that they would own the farms where they raise the cows,
chickens, potatoes and wheat as well as the factories that processes everything and turns it all
into food. vertical integration would mean that they own all of the mentioned components.
Examples
Carnegie Steel
Among the most popular examples of vertical integration is the Carnegie Steel Company.
Owning the process from beginning to end, the Company controlled the iron ore mines, the coal
mines, the transport methods (shipsr iron ore and trains for coal), the factories that processed the
raw materials, etc...
Oil Companies
From Rockefeller to Exxon Mobil (XOM) oil companies have favored vertically integrating.
They start from the very beginning, locating oil deposits, drilling and extracting it, transporting it
to refineries, and distributing to its own gas stations (and others).
Drawbacks of Vertical Integration
While some of the benefits of vertical integration can be quite attractive to the firm, the
drawbacks may negate any potential gains. Vertical integration potentially has the
following disadvantages:
 Capacity balancing issues
For example, the firm may need to build excess upstream capacity to ensure
that its downstream operations have sufficient supply under all demand
conditions.
 Potentially higher costs
 Due to low efficiencies resulting from lack of supplier competition.

 Increased Fixed cost
 Increase Business risk
 Increased overhead cost
 Higher Capital Investment requirements
 Decreased flexibility
 Due to previous upstream or downstream investments.

 Decreased ability to increase product variety if significant in-house
development is required.
 Developing new core competencies may compromise existing
competencies.
 Greater difficulties in getting rid of obsolete processes.
 Hard to compete when the environment takes a negative turns.
 Additional burden in the organizational structure
 Internal incentives v/s market incentives

 Information distortion – surplus ,boom and bust cycle
Factors against Vertical Integration
The following situational factors tend to make vertical integration less attractive:
 The quantity required from a supplier is much less than the minimum efficient
scale for producing the product.
 The product is a widely available commodity and its production cost decreases
significantly as cumulative quantity increases.
*quantity discounts
The core competencies between the activities are very different.

*focus must be on core competencies example Aga Khan Hospital
 The vertically adjacent activities are in very different types of industries. For
example, manufacturing is very different from retailing.
 The addition of the new activity places the firm in competition with another player
with which it needs to cooperate. The firm then may be viewed as a competitor
rather than a partner
*Car-tyres

Vertical Integration

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vertical integration

Types of Vertical Integration

Backward Vertical Integration

Backward Integration Mean?

Forward Vertical Integration

Forward Integration Mean?

Example Forward Integration

Balanced Vertical Integration

 Capacity balancing issues

 Potentially higher costs

 Due to low efficiencies resulting from lack of supplier competition.

 Due to previous upstream or downstream investments.

 Internal incentives v/s market incentives

Factors against Vertical Integration

The core competencies between the activities are very different.

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