Wednesday, April 01, 2009

Vertical integration

Vertical integration

Mar 30th 2009

Vertical integration is the merging together of two businesses that are at different stages of production—for example, a food manufacturer and a chain of supermarkets. Merging in this way with something further on in the production process (and thus closer to the final consumer) is known as forward integration.

Vertical integration can be contrasted to horizontal integration, the merging together of businesses that are at the same stage of production, such as two supermarkets, or two food manufacturers. Merging with something further back in the process (if a food manufacturer were to merge with a farm, say) is known as backward integration. The integration of two organisations that are in completely different lines of business is sometimes referred to as conglomerate integration.

Businesses are downstream or upstream of each other depending on whether they are nearer to or further away from the final consumer (the “sea”, as it were, to which the river of production flows).

The benefits of vertical integration come from the greater capacity it gives organisations to control access to inputs (and to control the cost, quality and delivery times of those inputs). In line with the changing organisational structure of the late 20th century, however, this logic became less compelling. In the late 1990s, consultants McKinsey & Company wrote:

Whereas historically firms have vertically integrated in order to control access to scarce physical resources, modern firms are internally and externally disaggregated, participating in a variety of alliances and joint ventures and outsourcing even those activities normally regarded as core.

Some of the best known examples of vertical integration have been in the oil industry. In the 1970s and 1980s, many companies that were primarily engaged in exploration and the extraction of crude petroleum decided to acquire downstream refineries and distribution networks. Companies such as Shell and BP came to control every step involved in bringing a drop of oil from its North Sea or Alaskan origins to a vehicle’s fuel tank.

The idea of vertical integration was taken a step further by Dell Computer, one of the most successful companies of the 1990s. Michael Dell, its founder, said that he combined the traditional vertical integration of the supply chain with the special characteristics of the virtual organisation to create something that he called “virtual integration”. Dell assembles computers from other firms’ parts, but it has relationships with those firms that are more binding than the traditional links between buyer and supplier. It does not own them in the way of the vertically integrated firm, but through exchanges of information and a variety of loose associations it achieves much the same aim—what Michael Dell calls “a tightly co-ordinated supply chain”.

Vertical integration is a difficult strategy for companies to implement successfully. It is often expensive and hard to reverse. Upstream producers frequently integrate with downstream distributors to secure a market for their output. This is fine when times are good. But many firms have found themselves cutting prices sharply to their downstream distributors when demand has fallen just so they can maintain targeted levels of plant utilisation.

The vertically integrated giants of the computer industry, firms such as IBM, Digital and Burroughs, were felled like young saplings when at the end of the 1970s Apple formed a network of independent specialists that produced machines far more efficiently than the do-it-all giants.

Further reading

Dell, M., Magretta, J. and Rollins, K., “The power of virtual integration: an interview with Dell Computer’s Michael Dell”, Harvard Business Review, March–April 1998

Harrigan, K.R., “Vertical Integration, Outsourcing and Corporate Strategy”, Beard Books, 2003

Stuckey, J. and White, D., “When and When Not to Vertically Integrate”, McKinsey Quarterly, No. 3, 1993