Vertical integration is a business strategy where a firm owns and operates multiple levels of the supply chain.
Vertical integration can involve a firm expanding into any level of the supply chain: acquisition of raw materials, production, distribution, etc. This strategy can help a firm gain better control over its business, improving efficiency. But it can also pose problems both to the firm and to society.
A vertical integration example is a retail clothing stores that acquires a factory manufacturing clothes. The firm now controls both production and distribution in their supply chain.
Definition of Vertical Integration
Reed defines vertical integration as:
“a firm’s control over multiple levels of the production and distribution of a product”. (2004).
The strategy allows a firm to streamline its operations as it no longer has to depend on outsiders. A firm can adopt vertical integration by acquiring or creating its own suppliers, manufacturers, retailers, etc.
There are three types of vertical integrations:
- Backward integration: This occurs when a firm takes control of a level that comes earlier in the supply chain. For example, a furniture manufacturer acquiring a wood distributor, or a steel manufacturer having its own iron mines. This allows a firm to streamline its production operations.
- Forward Integration: Forward integration occurs when a firm expands into the later stages of the supply chain, say a manufacturer opening a retail store. Forward integration is less common because it is difficult for firms to acquire others further along the chain—the largest retailers at the end of the supply chain are usually the wealthiest.
- Balanced Integration: This occurs when a firm takes control over both earlier and later stages. Such a firm must be a “middleman”, which until now took raw materials from someone and also worked with retailers. If a mobile company decides to manufacture its microchips and retail its products, it would be a balanced integration.
Vertical integration is a type of related diversification, where a company diversifies into another product or service that is related to their core competency.
By contrast, if a firm expands outside of their supply chain to achieve diversification, we would call it horizontal diversification through horizontal integration.
Vertical Integration Examples
- Apple: Through control over the production and distribution of its products, Apple has become one of the leading tech companies in the world. They develop their own hardware, software, and services; it gives them more control over the supply chain and allows them to shape the products according to the company’s vision. Apple also owns retail stores through which they control product distribution & customer experience.
- Netflix: Netflix originally began as a DVD rental company but has now expanded through vertical integration. After DVDs, they moved to online streaming of films and shows licensed from other studios. But slowly, they started creating their own content (Stranger Things, Narcos, etc.), controlling both production & distribution. They also invest heavily in technology to develop codecs, maintain CDN networks etc.
- Ford River Rouge Complex: The Ford River Rouge Complex was an industrial complex that performed all the processes of automobile production. It had a power plant, steel mills, and even a deep-water port to ship raw materials/finished products. With this self-sufficient facility, Ford was no longer dependent on outside suppliers. It increased efficiency, reduced costs, and gave them a competitive advantage.
- Birds Eye: Birds Eye uses the vertical integration model to sell frozen foods. It owns and operates farms where vegetables are grown according to the company’s standards. They also own factories that process the vegetables for freezing along with distribution networks. In the agriculture industry, 90% of poultry, 69% of hogs, and 29% of cattle are raised through vertical integration models (Stokstad, 2008).
- ExxonMobil: Most oil companies, such as ExxonMobil, adopt a vertically integrated model and own the entire supply chain. The company’s Upstream unit explores, develops, and produces oil; the Downstream unit refines, markets, and transports it. By owning different levels of the supply chain, ExxonMobil benefits from economies of scale, is less dependent on outsiders, and has more control over prices.
- Alibaba: Alibaba, a China-based company, has used vertical integration to significantly expand its e-commerce platform. Besides its e-commerce store, Alibaba also runs supermarkets; by controlling both online and offline selling, the company gains more data on consumers, which helps its business decisions. The company has also acquired companies in the delivery and payment industries.
- Carnegie Steel: Carnegie Steel, a company founded in the late 19th century, is one of the earliest examples of vertical integration. It not only had steel mills but also controlled several other stages: it had its own coal and iron mines, coke ovens to coke the coal, and even controlled transportation through ships & railroad. The company relied on developing talent internally and also ran an educational institution.
- The Bell System: Most telephone companies in the 20th century were vertically integrated. The largest among these was the Bell System, which controlled all aspects of telecommunication. These included research and development, manufacturing, installation, and operation of telephone infrastructure. Besides equipment, it also provided telephone services to the customers.
- EssilorLuxottica: EssilorLuxottica controls multiple levels of the eyewear supply chain through vertical integration. Its production segment produces a wide range of lenses, which gives the company more control over costs & ensures a steady supply. The company operates a network of retail stores under different brands like Ray-Ban & Oakley, while also owning eye insurance groups like EyeMed (Goodman, 2014).
- AT&T: Many media conglomerates like AT&T and Comcast operate through vertical integration. Through wired and wireless networks, AT&T provides telephone and internet services to its customers. Plus, the company also owns entertainment services like HBO Max, DirectTV, and WarnerMedia. It is the first vertically integrated company to have mobile phone services and a film studio under it.
Advantages of Vertical Integration
Vertical integration can improve efficiency and increase profitability.
Vertical integration allows a firm to gain greater control over the various stages of the supply chain.
Reducing the dependence on outsiders leads to cost savings, which is especially crucial when dealing with raw materials that are in limited supply or subject to price fluctuations.
The strategy also improves the firm’s efficiency as it can more easily streamline and coordinate various operations (Naidu, 2018). It also leads to better quality control because the firm can shape the products as per its vision, which is exemplified by Apple.
Vertical integration also allows a company to learn from the later stages & incorporate them into earlier stages: say, gain insights from customer experience in retail stores and revise production accordingly. It gives better control over pricing and the ability to enter new markets.
It is also beneficial to society in some ways: for example, the reduction of intermediaries leads to lower consumer prices.
Disadvantages of Vertical Integration
Vertical integration can also pose risks to both the firm and to society.
It requires huge capital expenditure to acquire a company, develop facilities, and train the staff for different operations. Rapid technological developments further increase costs and make integration difficult.
Going into newer sections of the supply chain may prove to be too challenging for the firm as it requires diverse business skills. And, after so much capital gets committed to specific purposes, the flexibility of the firm reduces, and it may struggle to adapt to market changes.
A vertically integrated firm can no longer learn from external vendors. Plus, in trying to do everything on its own, it may lose sight of its ultimate aim.
Vertical integration can also be harmful to society. It leads to the monopolization of the market (vertical monopoly), as a large corporation owns & runs everything. This lack of competition can lead to reduced innovation and also give the firm the ability to manipulate prices.
Because of these reasons, the government often steps in to regulate vertical integration practices. For example, in 2011, the U.S. Department of Justice made AT&T divest some assets before its merger with T-Mobile; this was to ensure competition in the wireless market.
Vertical integration is a business strategy of owning multiple levels of the supply chain, which can help a firm improve efficiency but can also be risky.
By adopting it, a firm streamlines its operations as it is no longer dependent on outsiders. This also leads to cost savings, increased efficiency, and greater quality control.
However, vertical integration can also be risky as it requires huge upfront capital expenditure, which makes the firm less flexible. The wide variety of business activities can overwhelm the firm, making it lose sight of its primary goal.
It also leads to market monopolization. Therefore, government regulations are often necessary to keep vertical integrations in check.
Goodman, Andrew (2014). “There’s More to Ray-Ban and Oakley Than Meets the Eye”. Forbes.
Stokstad, Paul (2008). “Enforcing Environmental Law in an Unequal Market: The Case of Concentrated Animal Feeding Operations”. William & Mary Environmental Law and Policy Review. College of William and Mary.
Reed, R. (2004). “Vertical integration and the boundaries of the firm: the case of the motion picture industry”. Journal of Economic Behavior & Organization. Elsevier
Naidu, S. (2018). Vertical integration. The Concise Encyclopedia of Economics. Library of Economics and Liberty.