Backward integration definition
/What is Backward Integration?
Backward integration occurs when a business acquires suppliers, so that its operations extend into its supply chain. This typically occurs when a company buys a key supplier, such as one that controls an essential raw material. By acquiring such a business, it eliminates the risk of running out of that raw material. It is also possible for a business to construct an in-house operation that takes on the same function as a supplier, though this is less common.
For example, a computer manufacturer is sometimes allocated microprocessors by its supplier when there is great demand for these items, so it decides to acquire the supplier. Doing so ensures that it will have a risk-free source of microprocessors in the future. A side benefit is that by securing its own control of this business, it is denying microprocessor capacity to its competitors.
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Advantages of Backward Integration
The key advantage of backward integration is that it reduces risk. Acquiring a supplier eliminates the possibility of being denied key goods or services. Another advantage is that the acquirer can take over the profits that had previously been generated by the acquiree. This is an especially important advantage when the supplier was in a monopoly or oligopoly situation, and so was able to charge unusually high prices for its goods or services. A third advantage is that the acquirer can enhance its purchase discount volumes by combining its own purchases with those of the acquiree. However, this advantage only applies if the acquiree purchases items similar to those purchased by the acquirer. It also requires a centralized purchasing function. A final advantage is that the acquirer can deny the output of the newly-purchased acquiree from its competitors - which can be a substantial advantage when supplies are constrained. This is an especially important advantage when the acquiree owns important patents, and so can block other suppliers from using the protected processes.
Disadvantages of Backward Integration
A key disadvantage of backward integration is that the acquiree may become less competitive over time. This situation arises because the sales of the acquiree are now assured, with its new owner buying all of its output. There is no longer any competitive pressure on the business, so there will be a tendency for it to become less efficient over time. It may also become less innovative, producing fewer new products. Another disadvantage is that the acquiree will require some management time by the senior management team, which can distract it from fulfilling the strategic plan of the acquirer. In effect, its management focus becomes watered down.
Another concern is that it requires cash to buy a supplier. This may be in the form of debt (which increases the debt burden of the acquirer) or equity (which waters down its ownership). When debt is used, this reduces the amount of additional cash that lenders may be willing to lend to the business in the future, and so reduces its options for making other acquisitions. This issue should lead management to only engage in backward integration when there are serious advantages to doing so.
Backward Integration vs. Forward Integration
Backward integration involves the purchase of suppliers, while forward integration involves the purchase of a firm’s distributors. For example, a seller of golf carts might purchase a major distributor of its products, which is a form of forward integration. Doing so gives it greater insights into the nature of its final customers, allows it to absorb the profits formerly generated by its distributor, and gives it the option to block competitors from selling to that distributor.