Vertical integration definition
/What is Vertical Integration?
Vertical integration involves the merger of organizations within different stages of the production process within an industry, extending into the distribution of goods. The intent behind this action is to become more self-reliant in all aspects of the firm’s operations.
Reasons for Vertical Integration
There are several reasons for following this strategy. For example, the acquirer can secure essential raw materials that may be in short supply. Or, the acquirer can reduce the total turnaround time of the supply chain, since it now has accurate customer demand information. In addition, the acquirer can gather more information about the ultimate customer by acquiring distributors. Another possibility is that the acquirer can obtain all of the profits being generated along the supply chain. Finally, the acquirer can keep its acquired businesses away from competitors, thereby creating a limited form of monopoly.
Backward Integration and Forward Integration
When a company acquires one of its suppliers, the transaction is called backward integration, while the acquisition of a customer is called forward integration.
Examples of Vertical Integration
As an example of vertical integration, a backcountry skiing operation that buys a helicopter rental organization to give lifts to its skiers is an example of backward integration. By doing so, the skiing operation gains access to the helicopters needed for its operations. Alternatively, a clothing manufacturer that buys a women's clothing retail chain is an example of forward integration. By doing so, the manufacturer gains an assured customer and learns more about the retail chain's customers.
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Problems with Vertical Integration
A potential problem with vertical integration is that acquired suppliers now have an assured customer, and so have less incentive to engage in cost cutting and product development, which can eventually reduce the overall competitiveness of the combined company. This issue can be mitigated by allowing company divisions to buy from outside suppliers, rather than from other subsidiaries, which increases the level of competition to which the subsidiaries are exposed.
A further problem with vertical integration is that a business is spending substantial amounts of cash on these acquisitions, which might have been better spent on other investments that generate a better return on investment. In addition, the firm’s cash reserves are being used up, leaving fewer reserves in case the business is faced with problems in other areas.
Yet another problem is that these acquisitions make a business more complex. This makes it more difficult for the management team to do a creditable job of overseeing operations throughout the enterprise. The result could be a reduced level of competitiveness for the business as a whole, unless the senior management team drives responsibility for decision-making well down into the organizational structure, where local managers can more promptly respond to local conditions.