Vertical Integration Strategy: Definition, Advantages, Disadvantages

Vertical Integration StrategyIntegration strategy consists of three types of strategies; Backward integration strategy, forward integration strategy, and horizontal integration strategy.

Backward integration and forward integration are often referred to as a vertical integration strategy. This section deals with vertical integration strategy.

Vertical integration strategy combines backward integration and forward integration. It means that the vertical integration strategy involves extending the present business of a firm, in two possible directions.

Backward Integration moves an organization into supplying some or all of the products used in producing its present products. Forward Integration moves the organization into distributing its own products. Vertical integration is popularly known as a vertical linkage in our country.

There may be backward linkage (backward integration) and/or forward linkage (forward integration). Vertical integration occurs within the same industry.

For a company, vertical integration involves engaging in producing raw “materials or components that it purchased from other firms and selling products to the end-users directly. When the company engages in producing the raw materials or components backward, integration (or linkage) takes place.

When it engages in direct selling of products to end-users, forward integration (or linkage) takes place. Thus, vertical integration takes the form of expanding . business backward into the sources of supply and. forward toward the users of the products.

Situations Suitable for Backwardlntegration

A firm can accomplish backward integration by starting its own operations in the production of raw materials or components, or by acquiring a firm already performing the same activities.

When the suppliers of a firm are unreliable, or when purchasing from suppliers is too costly, or when the suppliers cannot meet the needs of the firm, it is wise to go for backward integration. More specifically, backward integration for a firm may be suitable when.

  • The firm’s present suppliers are especially expensive, or unreliable or incapable of meeting the needs.
  • The number of suppliers is small.
  • The firm is competing in an industry that is growing rapidly.
  • The firm has the resources to manage the new business of supplying its own raw materials.
  • Advantages of stable prices are particularly important.
  • The firm needs to acquire a needed resource quickly.

Situations Suitable for Forward Integration

Forward integration in a firm occurs when the firm gains ownership in the distribution of its own products. A company may integrate forward into wholesaling or retailing via company-owned distributorships, own dealer networks, or a chain of retail stores.11 Bata Shoe Company, Pride textiles, Pizza Hut and Wimpy have forward integration. Forward integration for a firm may be suitable when;

  • The firm’s present distributors are especially expensive or unreliable, or incapable of meeting the firm’s distribution needs.
  • Availability of quality distributors is limited.
  • The firm is competing in an industry that is growing and is expected to grow markedly.
  • The firm has the required resources to manage the distribution function by itself.
  • The firm intends to maintain stability in production and demand.
  • It is possible to distribute own products more competitively than the independent distributors and retailers

Advantages of Vertical Integration

Companies involve themselves in vertical integration basically for gaining a competitive position in the market.

Vertical integration becomes attractive when it can strengthen a company’s competitive position.

Either profit-wise or strategy-wise, vertical integration is likely to be a flop if it fails to produce sufficient cost savings and /or substantially improve company’s technological and competitive strengths Let us discuss the strategic advantages of vertical integration first for backward integration and then for forward integration.

Advantages of Backward Integration

  • It can achieve greater competitiveness by generating cost-savings. This is possible if the volume of production can j result in the economics of scale better than the suppliers.
  • It can improve a company’s technological capabilities.
  • It can produce a differentiation-based competitive advantage. This comes true when the company is able to produce quality products better than those of the suppliers.
  • Competitive advantage may also be gained if vertical integration improves the quality of customer service and enhances the performance of final products.
  • It can add to a company’s differentiating capabilities by creating core competencies.
  • It reduces the dependence of a company on suppliers of crucial raw materials or components.
  • It minimizes/eliminates the risk of becoming vulnerable at the hand of suppliers who”raise prices of raw materials and components without valid reasons. Thus, a company may escape itself from the clutches of such opportunistic suppliers.

Advantages of Forward Integration

  1. The main spirit of forward integration is to enhance a company’s competitiveness.
  2. A company achieves greater control over the distribution of products. It may at least partially lose control over distribution when products are sold through intermediaries.
  3. A company can increase sales by avoiding dealers, wholesalers, and retailers who may not wholeheartedly push; the sales of the company’s products. These intermediaries may be more interested to sell the products of the competitors who offer better commissions.
  4. When a company integrates forward and directly sells products to end-users, it can reduce distribution costs and even lower selling prices.
  5. Because of lower distribution costs, the company can produce a relative cost advantage over certain competitors.

Disadvantages of Vertical Integration

  1. It increases business risk because of diversification and more investments in the other stages of business activities.
  2. It may block scarce financial resources in some value chain activities of the industry and thus prevents the firm from investing in otherwise profitable ventures.
  3. As the vertically integrated firms have the tendency to jealously protect their present investments in the backward and forward activities they slow down investing in research and development.
  4. Even if there is scope to procure materials at a cheaper cost from outside vendors, vertically- integrated firms cannot avail of this opportunity. Because they have already locked themselves into in-house activities.
  5. As the vertically integrated firms become less flexible due to reliance on in-house activities and own sources of supply, they may eventually face problems in responding to buyer demand for a variety of products.
  6. When a firm goes for forwarding or backward integration or both, they require different skills and capabilities to manage the integrated business activities, the fulfillment of this requirement is always costly and may not finally be worthwhile.
  7. Backward integration into the production of components and parts may reduce the flexibility of a firm in its manufacturing activity. In technologically sophisticated industries (such as computers) outsourcing component production is often cheaper than producing by a firm itself.