Vertical integration is one of the strategies used by companies to develop their business.
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What is vertical integration?
Vertical integration is a strategy allowing a company to control its value chain by integrating new activities into its production activity. This plan can be realized through the acquisition or creation of suppliers, distributors or retail outlets.
Vertical integration is a strategy that operates on the principle of ownership and control. It means that a company owns or controls its suppliers, distributors or outlets to manage its value creation or supply chain. This strategic decision involves the purchase or creation of a part of the production, distribution or retail process that was previously outsourced. In general, the supply chain of a company goes from the purchase of raw materials to the final sale of the product. Vertical integration therefore designates a process consisting of bringing together all the stages of production and distribution of a product under a single authority in order to integrate them into the company’s value chain. In most cases, the development of products or services is carried out by all the actors in this hierarchy. All these products are then grouped together to meet the same final need.
There are several ways to achieve vertical integration. The two most common types of vertical integration are backward integration and forward integration.
- We speak of upstream vertical integration when a company decides to expand by producing itself what it previously bought from a supplier, distributor or point of sale. Examples of backward integration include a carpentry company taking over a lumber business or a sawmill.
- Downstream vertical integration is characterized by a strategy where a company purchases and controls the direct distribution or supply of its products. This is, for example, the case of a company specializing in the creation of furniture that buys a company selling/distributing furniture.
One of the best examples of vertical integration is that of Netflix. Initially specializing in DVD rental, the company later launched into the online distribution of films and series under license from the studios. Netflix executives then found a way to increase their margins: the production of their own original programs such as “Grace & Frankie”, “Stranger things” or “The get down”. Today, Netflix uses its distribution model to promote its original content over studio-licensed programs.
What are the advantages of vertical integration?
Implementing vertical integration can prove beneficial for business growth. The main advantages of this strategy are:
- lower costs;
- security of supply;
- better management of production capacities;
- inventory optimization;
- a reduction in charges;
- business development;
- improved sales and profitability;
- an increase in competitiveness.
Vertical integration drastically reduces costs throughout the production process. By selling the final product directly to their customers, companies have the option of eliminating one or more intermediate steps that generate additional costs. Costs are reduced through more integrated processes. The organization is more efficient and controlled physical flows save money. The distribution process is managed by a single entity which can avoid unnecessary costs. Vertical integration also enables costs to be reduced through economies of scale, for example by purchasing raw materials in large quantities or by rationalizing the production process. Vertical integration therefore also induces a reduction in costs thanks to a more integrated value chain.
Achieving vertical integration is also a means of securing supplies, particularly of raw materials. This solution is to be preferred in the case of a contractual relationship that is too risky, and in particular in a situation of oligopoly, that is to say when there are few suppliers for many customers.
Vertical integration helps companies better manage their production capacities. It allows them to optimize investments, but also to limit overcapacity or bottlenecks at certain stages of the production process.
Through vertical integration, companies can optimize inventory by reducing their total volume. This is an advantage to be taken into account when the unit cost of the product and/or the cost of its storage are high.
Collaboration and negotiations between the different participants at the different stages of production can sometimes be an obstacle to the development of a company. Thanks to vertical integration, collaboration happens internally and is facilitated.
With vertical integration, companies benefit from a lever for increasing profitability by integrating a field of activity that generates higher margins.
By achieving vertical integration, companies can develop their competitiveness by selling their products directly and quickly to customers.
Vertical integration has many other benefits since it also allows companies to:
- improve their efficiency;
- ensure the distribution of their products;
- reduce execution and delivery times;
- reduce supply disruptions and quality issues from suppliers;
- to develop new markets;
- to have a better knowledge of outlets downstream;
- create a different value proposition;
- to increase their bargaining power.
What is the difference between vertical and horizontal integration?
To strengthen their position in their market, companies use competitive strategies such as vertical integration and horizontal integration. Although being means of growth for companies, these two strategies are totally different, even opposite. While vertical integration is based on the acquisition of existing business activities within the same production sector, horizontal integration is characterized by the acquisition of a related company. This means that a company grows by buying another company that manufactures similar or even competing products.
Horizontal integration has different advantages than vertical integration. It helps companies to:
- diversify their core business or product offering;
- conquer new markets;
- reduce competition in their industry;
- increase their overall sales;
- achieve economies of scale;
- develop a balance of power with the upstream structures and the downstream structures.
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