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What is Vertical Integration?

Redwood trees

Redwood trees

Redwood trees in a forest.

Successful businesses are always looking for ways to expand and increase their power in the marketplace, and one strategy that will help you get there is vertical integration. When a company is vertically integrated, it controls more than one level of the supply chain, such as owning its upstream suppliers and/or its downstream distributors.

Defining Vertical Integration

There are three types of vertical integration:

1. Backward, or Upstream: The company controls the production of its supplies, such as a car company owning a tire company. This can help lower costs and ensure quality standards.

2. Forward, or Downstream: The company owns the distribution and retailing of its products, such as a fashion designer opening up a boutique to sell his or her own clothes. This can lower transportation costs and give the company more control over the retail experience.

3. Complete, or Balanced: The company controls all components of the supply chain, from raw materials to final delivery. This includes Shell Oil, which owns the oil wells, refines the oil and owns the distribution through their gasoline service stations.

Majestic Realty Co. is another example of a complete vertically integrated company. They own the land and control the construction, financing, leasing, and management of over 60 million square feet of buildings.

A healthcare system that serves the entire range of services from outpatient to hospital and long-term care is also an example of a complete vertical integration.

Partial Vertical Integration

Regardless of what business you’re in, your company is located somewhere along this vertical chain:

Raw material

Manufacturer

Distributor

Retailer

Consumer

Growing your business could include getting into one or more additional operating levels that occur within your industry. Your opportunities lie not in owning all parts of the chain but in partial vertical integration, such as acquiring a company that supplies you with goods or services; or acquiring a company that you sell to.

Examples of Partial Vertical Integration:

  • Some franchisors create profit centers by manufacturing their own products, which are then sold to their franchisees. Keep in mind, however, that franchisors with widely dispersed markets will more often depend on local vendors who are required to meet rigid specifications.
  • Most wine producers grow their own grapes, and many big producers also manufacture their own bottles.
  • Apple, which always manufactured their own products, expanded by opening up their own retail stores and selling their products on their website.
  • Yum Yum/Winchell Donuts operates a manufacturing facility to produce the prepared mixes and fillings used in its stores, which gives them absolute control of the ingredients and quality of its finished products.

How To Decide If Vertical Integration Is Right For Your Business

Some businesses are more appropriately suited for vertical integration than others. You will need to objectively decide if the benefits you will gain from vertical integration will outweigh the costs and risks. Here are some tools to help:

  • Look for successful examples of vertical integration in your own industry. In most cases, your industry will have already determined the best ways to vertically integrate. Study your most successful competitors. How have they vertically integrated? Can you do the same?
  • Look for possibilities both "up" and "down" the chain . If you’re a retailer, could you start manufacturing some of your products? If you’re a distributor, could you get into retailing?
  • Weigh the advantages against the risks. For example, opening up a store to sell your jewelry may help you attract more customers, but it may leave you with less time and energy to focus on the core of your business, which is designing jewelry.
  • Consider the factors that may increase your risks. This is especially relevant for suppliers. For example, many large companies outsource to low-cost suppliers, making them difficult to compete with.

If you decide that vertical integration is right for your company, just be sure to test it first. Set up a pilot operation on a small scale before you commit to a major expansion. Every small step you take will allow you to learn more and refine your approach before you proceed.

Keep in mind that growing a business is not easy, and there’s no one-size-fits-all solution. While vertical integration may work well for some, you may be more suited to franchising or buying a business. No matter what strategy you choose, always weigh the pros and cons, be conservative when you invest your retained earnings and never take a risk that will bet your company.

For more help with vertical integration strategy, read Session 9 of MOBI’s Business Expansion Course. For more ideas on how to expand your business, register for the course here.

Oct 12, 2017