Vertical Integration Strategy

Vertical integration expands the scope of the company’s activities in this industry. Companies can expand their activities towards suppliers (“back”) and / or to the end user of the goods (“forward”).

Choosing the path of vertical integration, companies strive for full integration (participation in all links of the industry value chain) or partial integration (taking positions in key links of the industry value chain). Vertical integration occurs in two ways: the company creates divisions in other parts of the industry value chain or absorbs companies operating in these links.

The only real reason to invest in vertical integration is to strengthen the company’s competitive position. If vertical integration does not lead to a significant reduction in the company’s costs or obtaining an additional competitive advantage, it is not justified strategically and financially.

Vertical integration has its advantages and disadvantages. The predominance of one or the other is due to the specific situation.

Vertical integration is useful when:

First, it creates a competitive advantage; secondly, it increases the efficiency of strategically important activities by reducing costs, creating new competencies, increasing the degree of product differentiation; thirdly, it increases the return on investment, flexibility and adaptive capabilities of the company to changes in consumer demand; Fourth, the company has a real opportunity to effectively manage general and administrative costs even with an increase in the number of links in the value chain.

Vertical integration has a number of significant drawbacks:

First, it increases capital investment in the industry where the company operates, thereby increasing entrepreneurial risk and preventing the company from directing financial resources to other, possibly more profitable areas; Secondly, the big disadvantage of vertical integration, both “forward” and “backward”, is that it forces the company to focus only on its own capabilities and sources of supply (which are more expensive than external supplies), and reduces the company’s susceptibility to changes in consumer demand in the direction of expanding the range of goods; Third, vertical integration makes it difficult to balance capacity at each link in the value chain. The most efficient volume of production in one link in the value chain may not correspond to the needs of the other link associated with it. Full capacity matching in the value chain is rare. If domestic supplies are not sufficient for production, the necessary components have to be purchased on the side; Fourth, integration “forward” and “backward” require different skills and capabilities. Production of spare parts and components, assembly operations, wholesale and retail trade, direct sales via the Internet – these are all different areas of business with different key success factors; Fifth, vertical integration with component manufacturers can reduce a company’s manufacturing flexibility and increase time to develop and market new models.

The main thing in vertical integration is to determine which activities from the company’s industry value chain are more profitable to perform independently, and which ones are transferred to external performers. In the absence of obvious and meaningful benefits, integration “forward” or “backward” is strategically impractical. Moreover, it is often more economically and strategically advantageous for a company to disintegrate production and focus on a narrow segment of the industry value chain.