The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.

Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.

The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution, as illustrated below:

Example of Backward and Forward Integration

No Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Backward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Forward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Two issues that should be considered when deciding whether to vertically integrate is cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.

The following benefits and drawbacks consider these issues.

Benefits of Vertical Integration

Vertical integration potentially offers the following advantages:

• Reduce transportation costs if common ownership results in closer geographic proximity.

• Improve supply chain coordination.

• Provide more opportunities to differentiate by means of increased control over inputs.

• Capture upstream or downstream profit margins.

• Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource.

• Gain access to downstream distribution channels that otherwise would be inaccessible.

• Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest.

• Lead to expansion of core competencies.

Drawbacks of Vertical Integration

While some of the benefits of vertical integration can be quite attractive to the firm, the drawbacks may negate any potential gains. Vertical integration potentially has the following disadvantages:

• Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions.

• Potentially higher costs due to low efficiencies resulting from lack of supplier competition.

• Decreased flexibility due to previous upstream or downstream investments. (Note however, that flexibility to coordinate vertically-related activities may increase.)

• Decreased ability to increase product variety if significant in-house development is required.

• Developing new core competencies may compromise existing competencies.

• Increased bureaucratic costs.

Factors Favoring Vertical Integration

The following situational factors tend to favor vertical integration:

• Taxes and regulations on market transactions

• Obstacles to the formulation and monitoring of contracts.

• Strategic similarity between the vertically-related activities.

• Sufficiently large production quantities so that the firm can benefit from economies of scale.

• Reluctance of other firms to make investments specific to the transaction.

Factors Against Vertical Integration

The following situational factors tend to make vertical integration less attractive:

• The quantity required from a supplier is much less than the minimum efficient scale for producing the product.

• The product is a widely available commodity and its production cost decreases significantly as cumulative quantity increases.

• The core competencies between the activities are very different.

• The vertically adjacent activities are in very different types of industries. For example, manufacturing is very different from retailing.

• The addition of the new activity places the firm in competition with another player with which it needs to cooperate. The firm then may be viewed as a competitor rather than a partner

Alternatives to Vertical Integration

There are alternatives to vertical integration that may provide some of the same benefits with fewer drawbacks. The following are a few of these alternatives for relationships between vertically-related organizations:

• long-term explicit contracts
• franchise agreements
• joint ventures
• co-location of facilities
• implicit contracts (relying on firms' reputation)

Recommended Reading

Greaver, Maurice F., Strategic Outsourcing : A Structured Approach to Outsourcing Decisions and Initiatives