If a company wanted to streamline its operations without any middleman then it would need vertical integration. But what is vertical integration? This type of integration allows companies to directly take ownership of various stages of their production process rather than rely on external contractors or suppliers.
So, how can a company achieve this?
Companies have achieved “vertical integration” by establishing or acquiring their suppliers, manufacturers, distributors or retail locations instead of outsourcing them. Vertical integration can be risky due to the significant initial capital investment required.
Four Degrees of Vertical Integration
To understand It, let’s see its four degrees.
- Full Vertical Integration
Obtaining all assets, resources and expertise needed to replicate the upstream or downstream member of the supply chain.
- Quasi Vertical Integration
This entails obtaining some stake in a supplier in the form of specialised investments or an equity stake to obtain agency benefits by increasing the ownership interest in the outcome.
- Long-Term Contracts
This is a diluted form of vertical integration in which some elements of procurement remain constant. This reduces inconsistencies in product delivery while holding costs constant to a certain extent.
- Spot Contracts
The point at which a firm is not vertically integrated is when the firm relies on spigot contacts to receive the immediate input necessary for its production.
So, vertical integration is necessary. But what is vertical integration’s working and procedure? To understand that, let’s see how it works in detail.
What is Vertical Integration Working Process?
Vertical integration occurs when a company tries to broaden its footprint across the supply chain or manufacturing process. Instead of sticking to a single point along the process, a company engages in vertical integration to become more self-reliant on other aspects of the process. For instance, a manufacturer may want to directly source its raw materials or sell them to consumers.
Steps to Vertical Integration
The supply chain or the sales process generally begins with the purchase of raw materials from a supplier. It ends with the sale of the final product to the customers. These steps for vertical integration
- It requires a company to take control of two or more of the steps involved in the creation and sale of a product or service the company must buy or recreate a part of the production, distribution or retail sales process that was previously outsourced.
- Companies can avail of “what is vertical integration” by purchasing their suppliers to reduce manufacturing costs.
- They can invest in the retail end of the process by opening websites and physical stores.
- They can invest in warehouses and fleets of vans to control the distribution process.
All these steps involve a substantial investment of money to set up facilities and hire additional talent and management. Vertical integration also ends up increasing the size and complexity of the company’s operations. So now that we know the “What” and the “How,” let’s talk about the “Why.” So, what are the benefits of having a vertically integrated company?
What are the Advantages of Vertical Integration
Let’s see “what is vertical integration” strategy and its benefits for a supply chain system:
1. Supplier Stability
One of the perks of vertical integration is supplier stability. There is better communication and unified systems. A company that has both integrated into its supplier can:
- Monitor quality more closely
- Manage disruptions more efficiently
- Increase turnaround times
Companies can also increase turnaround times. It helps to reduce transportation costs by placing factories in optimal locations, depending on raw materials and consumer locations. This also mitigates supply chain shortages.
Companies can count on suppliers to ensure that their customers can rely on them. There are supply chain disruptions- but you always do not know what form they’ll take. Supply chain experts will have plans in place to deal with all kinds of supply chain disruptions.
2. Eliminating Hold-Ups
Sometimes (only sometimes- this is not universal) there is a conflict between suppliers and buyers who do not have vertical integration. Neither wants to relinquish a possible competitive advantage or bargaining power, but each is also aware that the other could just take its business elsewhere. This contributes to something known as the “hold-up problem”.
This problem stems from ambiguity in contracts between companies and their suppliers can undergo exploitation if the supplied products fail to meet expectations or specifications.
Let’s assess this with an example.
Company A agrees upon the price and quantity of items that the supplier will provide.
However, Company A claims that the items manufactured do not match up to what they requested.
So, Company A comes in with a lower price than the originally agreed-upon amount, holding up the Supplier.
But if the Supplier gets a better offer from Company B, then they can sell it or Company B.
So, companies and supply chains can eliminate this hold-up by learning “what is vertical integration” and collaborating with both parties.
3. Cost Reduction: Inputs Costs and Transfer Pricing
Combining two companies in a supply chain can significantly reduce the input costs, incurred to provide a product or service,
They include things like the cost of materials, labour and transportation. If a company is purchasing from supplies on the open market, those suppliers want to make a profit. So they add a little onto the price- like a margin- usually dictated by quality, branding and other market factors.
However, with an integrated supplier, this margin is greatly reduced, lowering their overall cost. Additionally, vertical integration can also help companies to benefit from careful transfer pricing. Transfer pricing depends on two divisions of the same parent company for exchanging goods or services.
Tax regulations do not appreciate manipulating transfer pricing to avoid taxes, but there are legal ways companies can use it to boost revenue and allocate profits for different regions throughout the world.
4. Economies of Scale
The term refers to how large businesses can reduce costs by producing more units of products. This happens due to an inverse relationship between cost and quantity, meaning the more you make, the lower your cost per item.
This can happen due to:
- Bulk pricing- this allows you to buy more raw materials at a lower price per unit, reducing your overall production cost.
- Managerial structures and organisational behaviour that make production more efficient
- Technological advances allow you to be more productive and eliminate waste.
A company needs to be large enough for economies of scale to work. Therefore, understanding “what is vertical integration” can help these companies to get the scale they need for such mechanisms to pay off.
5. Lower Consumer Prices
Efficiency gained through well-executed vertical integration translates into substantial cost savings. Passing on these savings to consumers by lowering prices not only enhances your brand’s competitiveness but also fosters greater customer loyalty. Striking the right balance between enticing customers and maximising profits is crucial, and effective pricing tools play a pivotal role in achieving this equilibrium.
6. Expansion of Capabilities and Assets
Strategic acquisitions can enrich your portfolio by incorporating specialised skills and resources, enhancing the quality of your offerings. For instance, acquiring a proficient tire supplier can elevate the quality of your products, enabling more effective marketing strategies focused on highlighting your value proposition to consumers.
7. Expansion into New Markets
Vertical integration opens doors to new markets, expanding your consumer base and revenue opportunities. Establishing a presence in previously untapped regions broadens your reach, presenting mоre avenues for profit generation.
8. Better Overall Control and Visibility of Your Supply Chain
Knowing “what is vertical integration”, you would know that successful vertical integration affords greater control and transparency across your supply chain. Complete ownership from raw materials to retail outlets enables faster access to consumer behaviour data, facilitating agile adjustments in production and distribution to meet market demands effectively.
FAQs: What is Vertical Integration: Understanding Strategies, Process, Benefits
How does vertical integration reduce costs?
This type of integration reduces costs by streamlining processes, eliminating middlemen and optimising resource utilisation, leading to economies of scale and greater control over production, distribution and supply chain management.
What are the main strategies of vertical integration?
Main strategies include backward integration like acquiring suppliers, forward integration, i.e. acquiring distributors or retailers and balanced integration like acquiring both suppliers and distributors.
What is the effect of vertical integration on demand?
It can influence demand by controlling prices, ensuring product availability, and enhancing customer experience through direct engagement, potentially leading to increased market share and customer loyalty.
Conclusion
Understanding what is vertical integration as a process in supply chains, helps companies to streamline their operations. This in turn has benefits like reducing costs and gaining greater control over the supply chain.
Through implementing strategies like backward and forward integration, companies can navigate the complexities and reap benefits lіke cost reduction, enhanced demand management, and increase market share. To have guidance on this, contact Qodenext.
