This blog is written by Mr. Agha Mudassar Khan, Manager Taxation and Accounting Services. Please read this technically explained Blog and provide us your useful comments
The objective behind writing this blog is to elucidate famous business strategy called Vertical Integration which involves getting engaged directly and taking control of some or all aspects of a business value/ supply chain.
Why & How and to Integrate Vertically?
Vertical integration, famed among business masses to benefit from every iota spent at several stages of value chain in such a way as to pulling the strings of one’s entire business supply chain, yet preserving striking equilibrium between Make vs. Buy or Use vs. Sell cognizance. More plainly speaking a vertically integrated business refers to a manoeuvre that can stretch both upstream and downstream into different steps along production, manufacturing, supply and after sale support within ones business value chain. Hence, a vertically integrated business secures ownership of some or all aspects of the supply chain, which means that it not only produces distributes and provides after sale support of the products and services it deals in, but can influence the creation and development of the product and markets.
Vertical integration either forward or backward, can both be achieved either by acquiring/ merging with the existing suppliers and customers within the supply chain (not to be confused with horizontal integration which involves acquiring/ merging with direct competitor at the same stage of value chain) or do the same organically by indulging oneself into the sowing the inputs or marketing/ distributing the harvests.
Is Vertical Integration Thing of the Past?
It is widely believed that vertical integration lost much of its gloss amongst business world in later part of the last century, when conglomeration became fashionable and outsourcing/ vertical dis-integration to concentrate and preserve one’s core competence looked better proposition going forward. But, is vertical integration a thing of the past and has fallen apart gradually and utterly? Answer is, Not exactly, as some of the major corporations around the globe are taking a page from the past and actively pursuing vertical integration to optimize all-out leverage within the value chain.
Apple the first Company to reach a trillion dollar evaluation in history around the business globe is a prime example in recent years to integrate vertically literally every phase amongst its value chain. Apple not only manufactures computers, iPhones and iPads and their accessories, but itself designs the software also that powers these products, hence relies on its own designers to invent software that is perfectly compatible with the company’s brand. Apple also has its own stores to ensure that its products are displayed, sold, and supported on the shop floor in a manner that is consistent with its brand values.
Amazon’s purchase of Whole Foods is yet, another highest-profile example of forward integration in recent years. Even before this, Amazon was already a vertically integrated company in many ways, since it publishes books itself and provides a publishing platform for independent writers also. It also owns its own transportation and distribution, which is both backward integration toward suppliers and forward integration, because Amazon delivers directly to end users. However, the Whole Foods acquisition counts as forward integration because it gives Amazon the 460 brick-and-mortar Whole Foods outlets as places to sell its products or have customers pick them up. Shares of traditional food retailers plunged, taking a $22 billion bite out of the industry in a day, because of the potential for Amazon to shake up the industry.
Other notable examples of major businesses integrating vertically in various sectors are:
- Netflix moving upstream from being a platform to distribute films and TV shows created by other content creators to a developer of original content, itself;
- The Nutriva Group moving forward from being a British Columbian simple daily farmer to Nutriva Group only a decade ago by having its own food brand and grocery store which also distributes to end consumers.
- Ferrero, the chocolate company, moving upstream back in 2014 by buying a Turkish company that processes hazelnuts, the precious ingredient in Nutella, its world-famous chocolate spread;
- Google, frustrated with the lack of innovation at incumbent telecom companies, is pushing itself downstream by setting up its own mobile network, in a hope to demonstrate that far better internet service is achievable;
- Delta Air Lines going downstream by buying a refinery near Philadelphia from ConocoPhillips to have its very own source of aviation fuel back in 2012;
- Exxon Mobil, Shell and BP, oil market giants, owns nearly the whole supply chain, which includes everything from the oil drilling, the transportation of crude oil, and the refining and distribution process to company-owned oil stations in the local communities.
Factors Determining Level/ Extent of Vertical Integration
Although, there are several aspects that may affect the choice of extent to which integrate vertically, such as phase of industry development, business strategy, volatility of competition, supply and demand uncertainty, the level/ extent of research and development facility available, access to resources bother monetary and intellectual and use of IT/ technological development. However, traditionally, what sits at heart of the level of vertical integration is whether one prefers being a cost leader or opts for differentiation strategy and by what levels net marginal wealth would propagate, by fencing around the various other stages of the supply chain.
Broadly speaking, if market transaction costs are higher, it may be more efficient for businesses to integrate and perform that same activity in house. However, on the contrary a decrease in vertical integration levels can result in a decline in cost, especially when the new information technologies dramatically lower transaction costs and economies of scale are far from their reach than what their suppliers or customers can afford to bid.
On the other hand, companies pursuing differentiation strategy, may not get bogged down by the transaction cost itself, instead what matters to them is whether their suppliers and customers can deliver the worth, which endmost consumers are perceived to be relishing, by paying paramount sums at the expenses of businesses making fortune out of them.
What Makes Vertical Integration Tick?
Vertical integration is predominantly chased due to various factors, as set out underneath:
- Reduction in dependence on others, staged at other phases in the value chain, thus effectively breaks the monopoly of ones suppliers and customers. Hence, ensures supplies are available, when needed and getting yield afloat as soon the demand is created;
- Reduction in transaction cost, not only because business can itself control and manipulate the prices of different variables of inputs and means of distribution of ultimate outcome, but through enhanced and timely coordination as well, hence making its supplies and services less burdensome for customers to afford. Optimum stock reorder level, economic order quantity and Just in Time (JIT) stock management also fits well by steering much of the supply chain within;
- Offloading, tied up working capital commitment, imposed by suppliers of inputs and extended to customers, since business itself is a provider and recipient, while all this can be rationalized internally;
- The more vertically integrated a business sector is, the greater the financial and managerial resources one would entail to enter and compete in it. Established businesses in an industry may combine their operations as a way of raising the stakes and discouraging potential new entrants. Of course, this gambit is effective only if vertical integration becomes indispensable for competing;
- Plenty of opportunity to safeguard excellence, especially in brand conscious/ niche industry, for business, which pledges differentiation or in extreme but rare cases, focus differentiation, as a business strategy. This can further be linked as it provides liberty for a business to invest into internal assets that can specialize in the skill set that is required to attain such brilliance. This allows a company to differentiate itself from others within its industry, creating a specific brand message and value proposition that resonates consistently with its customer base.
But, What Might Go Wrong?
While vertical integration tends to shower blessings for some, yet it may act as a mirage for others, if any of these go wrong:
- Economies of scale may not flow towards the benefit of vertically integrated business as expected, which its suppliers and distributors tend to benefit from operating on much grander stage. Hence, transaction cost, which vertically integrated business first thought would plummet, may not exist in realism, but would remorsefully amplify.
- Capital investment in abundance may make vertical integration an extremely uphill task. Even if the integration occurs through partnerships/ mergers, an investment into specific patents, processes, or proprietary data is often required as part of the deal. New forward or backward vertical integration efforts may require building new facilities, engaging new staff, and understanding new processes that the business is unacquainted, at least for now;
- By stretching itself across either or both ends of the value chain, a business may acquire new skills, but may risk impairing its core competence and values, for which it has expended many years to accomplish, as focus may gradually be drifting towards less familiar arenas of the value chain.
- Potential Corporate failure as damages suffered at one stage of the value chain, may lead to a domino effect throughout the realm.
Key Take Away from this Blog
Vertical integration, since turn of the century, despite dropping its footing couple of decades ago, is thriving again under many leading corporations around our sphere. Nevertheless, the payoff of strategy of increased integration, may tend to differ according to the market and prevalent competitive forces, no matter how prudently and diligently it is conceived and executed.
Nonetheless, vertical integration certainly is a pretty tempting venture, to shun by the business community at large.
Agha Mudassar Khan
Associate Chartered Certified Accountant