What is Vertical Integration?

Vertical Integration is a Strategy that consists in Expanding the Field of Action of a Company.

  • Expanding the Activities carried out by the Company.

 

It is called Vertical when these New Activities developed by the Company were carried out by:

  • Its Suppliers.
  • Its Clients.

 

This Strategy Cannibalizes Suppliers and / or Clients.

  • Assuming these Clients are not final Customers, of course.

 

Therefore there are two types of Vertical Integration:

  • Forward.
  • Backward.

Types of Vertical Integration

Forward: When a Company decides to do What its Clients do.

  • Clients of the Company; Distributors, Assemblers… Not final Customers.

 

Backward: When a Company decides to do What its Suppliers do.

  • Companies that provide it with Components, Products or Materials.

Of course, a Company can decide to carry out both Strategies.

  • Forward and Backward.

 

However, it would take a lot of time and effort.

  • Expanding the Activities of a Company is Difficult and Expensive.

 

That is why few Companies can successfully implement a Vertical Integration Strategy.

  • If it is very difficult to be Good at one thing… Being good at two or three, is almost impossible.

 

Let’s analyze the Pros and Cons of this Strategy:

Pros and Cons of Vertical Integration

Advantages of Vertical Integration

 

It can Increase Profitability.

  • The Company won’t have to pay the Profit Margin of Suppliers or Clients.

 

It offers more Control over Supply and Demand.

  • Companies can Design Optimal Stocks and Process cycles for themselves.

 

It Diversifies the Company’s Product Portfolio.

  • The Company can sell New Components or Products to third parties.

 

Disadvantages of Vertical Integration

 

It Disperses the Goals of a Company.

  • Generating much more Problems to solve and Variables to Focus on.

 

It can be Expensive and Difficult (Backward Integration especially).

  • Entering a New Market and obtaining Competitive Prices can require large Investments.

 

Overall Profitability can Decrease Significantly.

  • The Profitable Original Business generally ends up subsidizing the New Division.

These are the reasons Why Companies think twice before developing a Vertical Integration strategy.

  • Because it is a Risky movement that can create more Problems than Opportunities.

 

Now, before we see some examples we want to clarify one thing:

  • The difference between Vertical and Horizontal Integration.

 

We are sure that you have also heard of Horizontal Integration and may not know the difference.

Vertical Integration vs Horizontal Integration

 

As you can imagine, Horizontal Integration is Different than Vertical Integration.

  • We cannot say that it is the opposite, just different.

 

Horizontal Integration Focuses on other Market Players with Similar Products.

  • While Vertical Integration Focuses on the Suppliers and Clients of the Company,

 

Horizontal Integration usually consists on:

  • Partnering with a Competitor.
  • Acquiring or Merging with other Company.

 

Its Objective is to increase the company’s global Market Share.

The best way to understand the Vertical Integration Strategy and How to design it correctly is by sharing some examples with you:

Vertical Integration examples

We have chosen 4 Examples of Companies that have developed a Vertical Integration Successfully.

 

As you’ll see, not even these Big and Powerful companies have developed a Full Vertical Integration.

  • They use it to some extent.

 

Let’s see what we can learn:

Netflix - Vertical Integration example

 

Initially, Netflix only offered Content Produced by other Companies.

  • Dreamworks.
  • MGM.
  • LucasFilm.
  • etc.

 

But now, it is Investing Heavily in Producing its own Movies.

 

Why?

Because this Way, Netflix will earn the Margins of the Film Producers.

 

Who you think has better Margins in this Industry: Cinemas or Film Producers?

  • The answer: Film Producers… By far.

 

We can say that Netflix is developing a Backward Vertical Integration strategy.

  • With some of the movies it offers, not all of them, of course.

 

Netflix example – Backward Integration.

McDonald's - Vertical Integration example

 

The Case of McDonald’s is very curious.

  • It is curious because they are not Really the Retailers.

 

They Provide with their famous food to Franchises.

  • As well as everything necessary to comply with their standards.

 

McDonald’s owns just 7% of the total McDonald’s Restaurants.

  • Which is a lot, by the way, considering there are 38,000 McDonald’s in the World.

 

Therefore, we could say that McDonald’s has a limited Forward Vertical Integration Strategy.

  • With those 7% Restaurants.
    • In those Restaurants, they are the actual Retailers.

 

McDonald’s example – Forward Integration.

Apple - Vertical Integration example

As you may probably know, Apple products are assembled by Foxconn in China.

  • A huge company with thousands of employees.

 

In addition, Apple has dozens of Suppliers that provide it with reliable cutting-edge technology:

  • Qualcomm.
  • Intel.
  • Texas Instruments.
  • etc.

 

Then… How does Apple use Vertical Integration?

  • Apple Stores.

 

The first Apple Store opened in 2001.

  • 20 years after Apple was born.

 

Apple sells its products through many commercial channels:

  • Malls.
  • Technology shops.
  • etc.

 

But, they created Exclusive shops where they could be the Retailers and Improve:

  • Profit Margins.
  • Brand Image.

 

They employed a limited Forward Vertical Integration Strategy.

 

Apple example – Forward Integration.

Nike - Vertical Integration example

 

 

Nike Designs, and its Suppliers Create and Assemble its Products.

  • Very similar to what Apple does.

 

You won’t find a “Nike Factory”.

  • They have everything Outsourced (as far as we know).

 

They have the Brand and the Design, and the Suppliers the Workforce.

 

Then, How do they use the Vertical Integration Strategy?

  • They have Nike Stores.

 

It is the same of what Apple does with its Apple Stores.

  • A limited Forward Vertical Integration.

 

Nike example – Forward Integration.

As you can see, not even Nike, Apple or McDonald’s dare to develop a Backward Vertical Integration.

  • And their Forward Strategy is limited.

Vertical Integration is Difficult, Expensive and rarely works as expected.

Summarizing

Vertical Integration is a Strategy that consists on Expanding the Field of Action of a Company.

  • It is called Vertical when these New Activities were carried out by:
    • Its Suppliers.
    • Its Clients.

 

Therefore there are two types of Vertical Integration:

  • Forward: When a Company decides to do What its Clients do.
  • Backward: When a Company decides to do What its Suppliers do.

 

Advantages of Vertical Integration:

  • It can Increase Profitability.
  • It offers more Control over Supply and Demand.
  • It Diversifies the Company’s Product Portfolio.

 

Disadvantages of Vertical Integration:

  • It Disperses the Goals of a Company.
  • It can be very Expensive.
  • Overall Profitability can Decrease Significantly.

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