What Is Vertical Integration and What Are The Benefits?

You could probably recognize a vertically-integrated company from a mile away -- like Ticketmaster and Live Nation (LYV) or Target (TGT) , for instance. But what actually is vertical integration? And how is it used as a business strategy to create some of the most powerful conglomerates in the world? 

What is Vertical Integration?

Put simply, vertical integration is a strategic structure where a company owns the supply chain for its product -- so it is usually composed of one or two companies involved in different stages of production. The supply chain incorporates all the steps from taking a raw material to turning it into a product and selling that product -- in that sense, companies that are vertically integrated own multiple (or all) parts of their supply chain. For example, a company may buy out a producer of cotton as well as a t-shirt manufacturing company, and then might market and sell the products themselves. So, the original company (now a conglomerate of several companies along the same vertical, or the same kind product) is now in control of the four parts of the supply chain: commodities, manufacturing, distribution and retail. 

There are plenty of benefits for companies to vertically integrate, including being more in control of their supply chain, being able to offer lower prices, and having increased market control. However, there are two different ways a company can practice vertical integration, depending on what type of company it is: backward integration and forward integration. 

Forward Integration

When a company expands forward in its supply chain (for example, a manufacturer bought out a retailer), it would be performing forward integration. This is typically done by companies close to the start of the supply chain, like mining companies controlling factories further "downstream," as it is sometimes called. In this case, a manufacturer could take control of its distribution channels to offer products directly to consumers instead of going through a middleman. So, it's pretty simple -- since the company is expanding forward to getting the products out to the consumers, it is integrating forward. Basic stuff.

Backward Integration

On the contrary, when a company expands backward (or "upstream") to take control of parts of production further back in its supply chain (if, for instance, a retail company bought out a manufacturer or producer of its goods), it would be exercising backward integration. When the firm merges with the suppliers of raw materials, many costs are typically cut as the company gets everything it needs within itself, rather than having to use outside sources for parts of the process. In this sense, major retail or distribution companies will buy out producers or manufacturers of their goods to save on transportation costs and to keep their suppliers in check. 

Benefits of Vertical Integration

Companies pursue vertical integration for the obvious advantages it offers -- namely having greater control over the supply chain and the ability to offer lower prices while increasing market control. But there are plenty of other benefits to vertical integration (whether forward or backward). 

Regardless of what the product actually is, most vertically integrated companies have a leg up on the competition, because they can often offer lower-cost or higher-quality products to consumers. 

Independence From Suppliers

One of the principle advantages of vertical integration (whether forward or backward) no longer being dependent on suppliers -- and the costs and unpredictability that may come with them. This helps the company or firm increase efficiency by streamlining the process of obtaining supplies for its product, manufacturing it and selling it. In this manner, companies that vertically integrate often are more time efficient -- with shorter turnaround times. 

Additionally, since the companies are now independent of external suppliers, they may be immune to supply disruptions -- such as labor strikes or bad management of a supplier. This can help the process go more smoothly and eliminate the possibility of a supply hiccup. 

Cost Control

With vertical integration, the ability for manufacturers or retailers to control prices is a huge asset to conglomerates, who would ordinarily have to set some prices to match up with their supply chain. But when companies vertically integrate, they are able to control costs more closely, and often are able to offer lower prices (which translates to increased consumer demand and therefore an increased bottom line). Additionally, companies further downstream in the supply chain will be able to more closely manage how their products are marketed or presented. 

Creates Economies of Scale

One of the biggest benefits of vertical integration is that it helps companies create economies of scale. As defined by the Merriam-Webster dictionary, an economy of scale is "a reduction in the cost of producing something (such as a car or a unit of electricity) brought about especially by increased size of production facilities" -- basically, the larger the company gets, the more cost effective it is to produce its goods. And, by keeping management consolidated, overhead and other costs are often reduced. 

Having reduced production costs is obviously a huge incentive for companies to vertically integrate. 

Increased Product Knowledge and Marketability 

Although perhaps one of the less-obvious advantages to vertical integration, being able to understand the market for a product and create their own version (a knock-off, so to speak) is a huge benefit that typically only large companies can enjoy. When a manufacturer is partnered with a retail company along the supply chain, they are able to produce look-alike products (with similar processes or aspects as competitor's products) to those of competitors and distribute them through their retail channels -- and, due to the usual size and grandeur of vertically integrated companies, competitors are often unable or hesitant to sue for copyright infringement.  

Thus, a large vertically-integrated company can more readily meet market demands by eyeing products that are selling well and creating their own versions for less. 

Increased Market Control

Another major asset of vertical integration (and arguably one of the most important) is the increased market control a company assumes when vertically integrating. It's fairly obvious that when a company higher in the supply chain (like a retailer) merges with a producer or manufacturer, they are going to have more control over that producer's materials and products. In industries where one or two large producers control much of the goods used to make that product, this can translate into a huge amount of control over competitors. By buying a producer or the like, a company could also inherit things like permits, copyrights, resources, and emerging technologies that give it an advantage on its competitors. 

Lower Prices

A key advantage for consumers is certainly the lower prices that come with vertical integration. By reducing costs on overhead, transportation and other operational expenses, companies are often able to offer lower prices that attract customers. Companies that have done this include many grocery store brands, Walmart (WMT) , and even Best Buy (BBY) . 

Negatives of Vertical Integration

Still, despite the many benefits of vertical integration, it is not always advisable to take that route, as there are several potential negative aspects to consider. While most things in business are trade-offs, it is important to take note of the disadvantages to the vertical integration strategy. 

It's Expensive

One of the most obvious downsides to merging parts of the supply chain is the enormous expense. Companies require a huge amount of capital to set up, maintain, and keep factories or manufacturers profitable. And, if the producer itself merges forward, maintaining retail and marketing can be a hefty expense, as well. 

More Rigid to Trends

In addition to the expense, vertical integration can make companies less resilient to changes in market trends, given how the supply chain is set up. In this sense, companies that are deeply vertically integrated (have multiple parts of the supply chain combined) often struggle to shift their production to different kinds of products -- or anything that would break ties with their factories. Additionally, vertically-integrated companies are often not able to switch to foreign producers or factories who may have lower operating costs or exchange rates. 

Harder to Manage Well

Because vertical integration largely erodes specialization, it can be hard to manage as well due to the different kinds of companies or moving parts within the overarching organization. For example, if a CEO once managed a retail company before deciding to vertically integrate with a manufacturer, they now have to learn how to manage both businesses -- which, as has been seen, is no simple feat (and can often be an enormous challenge). 

Corporate Culture Tension

While perhaps not as critical a factor as some of the others, the conflict between retail and manufacturing cultures is still something to consider as a negative to vertical integration. And, it only makes sense that combining well-established cultures that are dichotomous -- like a marketing and sales-driven organization with a production and manufacturing-driven outfit -- can instigate some problems. Additionally, poor management may contribute to communication issues down the long chain of command that inherently comes with combining multiple companies under one head.

Conflicts with Market Entry Barriers

Regardless of how successful a vertically-integrated company is, there are still other concerns that can arise when said company has a dominant position in its market. While controlling production and the market is certainly a plus for vertical integration, it can also lead to the creation of market entry barriers for new companies to access the product space -- which could possibly lead to antitrust issues. By hoarding consumers, large, vertically-integrated companies could potentially face conflict or even retribution for crowding the market. 

Vertical vs. Horizontal Integration

While vertical integration is the combining of multiple companies along the same supply chain (as in a raw goods producer with a retailer who will sell the finished product), horizontal integration entails a company acquiring other companies similar to it (often competition) to increase customer base, market size, or diversify its products in the same industry. 

Horizontal integration often occurs within the same industry, but may also occur in different or related industries. 

Additionally, horizontal integration may occur to increase product differentiation or expand market control. So, while its intention is not necessarily to reduce costs by controlling more of its own supply chain, companies that horizontally integrate often do so in the hopes of increasing consumer base, assets and resources, or increasing revenue. 

Still, much as vertical integration is in danger of creating antitrust issues, horizontal integration can spiral into oligopolies, or clusters of companies that comprise the most market share of a certain industry. So, horizontal integration is typically closely watched by the Federal Trade Commission in order to prevent too little competition in an industry. 

Some examples of horizontal integration include Facebook's (FB) 2012 acquisition of Instagram (a fellow social media company), or Marriott International's (MAR) 2016 acquisition of Sheraton (both hospitality companies). This is different from the vertical integration that companies do --like Live Nation's (LYV) acquisition of Ticketmaster, which is an example of a company that specializes in the creation and promotion of concerts with a company specializing in selling tickets. 

Vertical Integration Examples

While there are countless examples of companies that are vertically integrated, there are several that stand out for their success in harnessing the strategy to their advantage.

Apple

Apple Inc. (APPL) has been very successful in vertically integrating multiple stages of its supply chain to dominate a huge part of the electronic and media product markets. In fact, Apple has been able to produce much of its own LCD screens, custom A-series chips for its iPhones and iPods and ID-fingerprint sensors to use in its products. And, when Apple opened up a 70,000-square-foot, $18.2 billion manufacturing facility in North San Jose in 2015, it kept its supply chain steady and flexible, producing its own products.

Still, Apple has also utilized a forward integration structure as well, keeping a tight hold on its distribution channels -- which, apart from some exceptions like vendor-partner Best Buy, mostly are owned and operated by the company itself. This selective distribution strategy has allowed Apple to achieve enormous margins -- and the company has recently been evaluated as the first $1 trillion company

Zara

Another strong example of successful vertical integration is mega "fast-fashion" giant Zara. While competitors like H&M and The Gap (GPS) have resorted to purchasing clothing from outside suppliers, Zara has been able to combine the design, manufacturing and retail parts of its supply chain to create an ultra-quick production and distribution channel that has allowed them to make and sell many more collections a year than its competitors. In fact, the flexibility that Zara's vertical integration has provided the brand has given it a step up on competitors due to how fast it can turn out new product and go with the flow of consumer trends. 

Live Nation and Ticketmaster

Live Nation wisely merged with Ticketmaster in 2010 to create a vertically-integrated company Live Nation Entertainment (LYV) that has combined the media promotion of concerts with the sale of tickets to customers. On the Live Nation side, the company manages artists and helps produce and promote shows, while the Ticketmaster side sells tickets to customers. Combined, the vertically-integrated company takes care of both the production and retail sides of the industry -- and has done so successfully. According to Billboard, Live Nation is the biggest promoter in the world. 

Still, like many vertically-integrated companies, as it has dominated the ticketing world, the Live Nation-Ticketmaster duo has faced some scrutiny -- notably at the hands of The New York Times.

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