What is vertical integration?
When we consider the industry supply chain, there are activities done before your firm (your suppliers), and potentially activities performed after your firm (activities undertaken by the customers that you supply to). Vertical integration involves either moving back in the supply chain, undertaking activities that your suppliers previously did, or forward, undertaking activities that your customers currently do.
Backward vertical integration
Backward vertical integration relates to conducting activities that would traditionally be performed by suppliers, internally within your organization. For example, there may be components or raw materials that are typically produced by outside organizations. Deciding to backward vertically integrate means starting to undertake these activities within the firm.
Forward vertical integration
Forward vertical integration means moving forward in the value chain, and starting to undertake activities that would traditionally be done by your customers. This may involve selling your goods directly to customers or moving forward in the supply chain to more profitable downstream activities.
Considering if vertical integration makes sense
One of the key advantages that comes from vertical integration is gaining greater control over the downstream or upstream activities. When you are working with external companies you may be able to influence their decisions – working with suppliers or retailers selling goods on your behalf, but you don’t have direct control over their decisions. By vertically integrating you gain much greater control to determine how the upstream or downstream activities are conducted.
Greater integration of activities
Another advantage of vertical integration is that it can allow you to more closely integrate the activities than would otherwise be possible. There may for example be efficiency gains by combing together activities within the same production line, rather than have parts produced by an external company.
Move into a more value-generating part of the supply chain
Vertical integration may also make sense if it allows you to move into part of the value chain that captures a greater proportion of the overall value created. If, for example, your suppliers or customers are capturing a large part of the overall value crated, moving into their area may allow you to capture a greater proportion of the overall value created.
Limitations of vertical integration
Dedicated firms may be more efficient
First, it is important to recognize that dedicated firms may be more efficient that undertaking the activities that they focus on. Such firms may have greater build up capabilities in the part of the value chain that they concentrate on. Concentrated firms, may also be able to take advantage of larger production volumes to gain economies of scale – potentially able to supply the activity at a lower cost than could be achieved internally.
Spanning different areas may add coordination challenges within the firm.
Another reason that looking to internalize activities may not make sense is that it could add greater coordination challenges within the firm. While there are challenges coordinating with external firms, there are also challenges associated with managing a larger with multiple different divisions. Spanning multiple different areas may add additional complexities that may it more challenging to manage the company.