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Session 9: Vertical integration

OBJECTIVE: Growing your business could include getting into one or more additional operating levels that occur within your industry. Vertical integration is an option to explore. In this session you will cover the potential opportunities and risks associated with vertical integration.

      Vertical integration

What is vertical integration?

Example of vertical integration The definition
Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers with the goal of increasing the company's power in the marketplace. There are three varieties of vertical integration:

  • Backward, where a company controls products used in the production of its products such as a car company owning a tire company.
  • Forward, where the company owns the distribution and retailing of its products.
  • Complete, or balanced, meaning a firm that controls all components from raw materials to final delivery.

Examples of vertical integration

  • Oil companies such as Shell Oil own the entire supply chain starting with the oil wells, refines the oil and retails through their gasoline service stations.
  • Fashion retailer American Apparel even advertises itself as a vertically integrated. They own the designing, production and marketing which includes their own retail locations.
  • Design-build firm Majestic Realty Co. has built a portfolio of over 60 million square feet of buildings as a 100% vertically integrated firm:
  • Land > planning > construction > financing > leasing > management

  • A healthcare system that serves the entire range of services from out-patient to hospital and long-term care.

Potential opportunities to consider

Partial vertical integration
Growing your business could include getting into one or more additional operating levels that occur within your industry. For most students of this course, limited degrees of vertical integration are opportunities to consider. We will review the advantages and risks and then provide you with a guide to evaluate whether partial vertical integration is worth considering for your own business.

Regardless of your business, you are located somewhere in this vertical chain starting with a raw material and ending up with the consumer.

Sugar beet grower
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Sugar refiner
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Distributor
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Retailer
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End user

Your opportunities will lie not in owning all parts of the chain but in acquiring a company that either supplies you with goods or services (an upstream integration) or acquire a company that you sell to (a downstream integration).

Lincoln Watase President, Yum Yum Donut Shops, Inc. Lincoln Watase
President, Yum Yum Donut Shops, Inc.
Play Video
Has vertical integration worked well for Yum Yum - Winchell's?
Examples of partial vertical integrations you could consider
  • Some franchisors create profit centers by manufacturing their own products which are sold to their franchisees. But franchisors with widely dispersed markets will more often depend on local vendors who are required to meet rigid specifications.
  • In some businesses, vertical integration is inherent-most wine producers produce their own grapes. Big producers also make their own bottles.
  • Apple© has moved from a manufacturer (of its outsourced production) into the marketing side of their products including direct online sale of their products as well as their own chain of retail stores. Apple has also gone into retailing through their website.
  • Yum Yum/Winchell Donuts operates a manufacturing facility to produce the prepared mixes and fillings used in its stores. A major benefit is maintaining absolute control of the ingredients and quality of its finished products.
  • A home based costume jewelry entrepreneur is vertically integrated if she or he is also the designer and manufacture of the products.

Advantages of vertically integrating

Achieve economies of scale
When Walmart eliminated the traditional grocery wholesaler, manufacturers began making direct deliveries to their warehouses. A key part of their success was successfully incorporating state-of-the-art communications and computer tools in the distribution process.

Create new profit centers Create new profit centers
Internet based online stores now enable manufacturers to sell direct to customers anywhere, anytime, creating an entirely new center of earnings. Why lease and staff stores when people can buy your product from their homes?

Likewise, business-to-business sales (as contrasted to business between a producer and a consumer) have led to successful vertical integrations.

Expand geographically
Geographical expansion generally works best when expanding within a firm's own segment in the supply-distribution spectrum. For example Proctor and Gamble's acquisition of Iam's pet foods expanded Iam's reach into world-wide markets.

Louis Vuitton, the manufacturer of fine leather goods, became a world-wide destination for women after opening their own stores in the fashion capitals of the world.

Maintain quality control
If you're a cake maker and manufacture your own cake mixes, you're not at risk of a supplier cutting down or substituting the eggs. Or if you're a manufacturer of salad oil and own your own olive groves, you're not at risk of mislabeling (which according to a UC Davis study was found to be the case in over two-thirds of extra virgin olive oil sold in stores.)

Protecting proprietary processes or recipes
In some cases secret recipes are so valuable that they are maintained as true trade secrets and outsourcing their manufacture would be unthinkable. Think Coke©.

Risks in vertical integration

Phil Holland Founder, My Own Business Phil Holland
Founder, My Own Business
Play Video
How can I best create incentives for my store managers?
Established distribution channels may be adversely affected
Let's assume you manufacture ladies handbags and your established sales have been through independently owned gift shops. You are considering vertically integrating by selling direct to consumers on your website. Your plans for going into online sales must take into account potential loss of sales through your present avenues of distribution. Will you lose already established sales to gift shops?

Unprofitable outcome
Your new operation may not live up to your earnings forecast. And too often an acquisition mistake cannot be made profitable by working harder. As Warren Buffett has said, "Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

Obsolescence due to new technologies
Vertical integration could potentially hurt a company when new technologies evolve quickly and become available. The company is then forced to reinvest in the new technologies in order to stay competitive.

Higher cost due to lower volume
If you go into manufacturing you may not achieve the economies or scale or efficiencies of competing independent suppliers who may gain economies of scale by selling to many other customers. For example, when an auto manufacturer owns its own tire manufacturing, its production of tires is most likely limited to the needs of the parent firm, whereas a stand-alone tire company can sell to numerous auto manufacturers.

Unforeseen labor issues
If a union firm vertically integrates with either a supplier or a distributor that is non-union, it could face a greater risk of the acquired firm also becoming a unionized unit. Or if a non-union firm vertically integrates with a union supplier or distributor, the chances of itself becoming unionized is increased.

In any case where a parent company is vertically integrated with a union suppler, there could be a strong cost-reduction incentive to close down the supplier and outsource the service. This in fact has been the trend in the airline industry where outsourcing maintenance to lower cost overseas shops has soared.

John Powers Attorney-at-Law John Powers
Attorney-at-Law
Play Video
Issues in buying a business
Loss of continuing focus on the originating business
Through specialization, some companies are so good at what they do they almost remove themselves from competition. A vertical merger could upset the chemistry of a special operating focus. Here are some overall risks to look out for from the Starting a Business course.

If you are acquiring a commodity type product, not having lowest costs
If you acquire a commodity business, you will need to be assured that you will have the lowest cost among all competitors. Otherwise you will be competing in a market where price is everything and you'll be "only as smart as your dumbest competitor."

Unsatisfactory return on invested capital
Remember that vertical integration is one of a number of investment possibilities. Any deployment of your retained earnings will require scrutiny as to the anticipated return of the money invested. Other options include:

  • Buying a company at your own level in the supply- demand chain, such as Albertson's acquiring American Stores.
  • Reinvest in your own business.
  • Build up retained earnings by not spending and save for future acquisitions.
  • Pay in dividends.
  • Buy back stock and make your shareholders happy. (Their remaining shares will be more valuable).

Evaluating the potential of vertical integration

Some businesses are more appropriately suited for vertical integration than others. You will need to objectively decide if the benefits you will gain from vertical integration will outweigh the costs and risks. Here are some tools to help:

Look for examples of success in your own industry
In most cases you industry has already determined the best potentials for vertical integration. This "me too" approach enjoys the benefit of following in the footsteps of what competitors have already proven. For example, it's already been proven in the shoe business that a manufacturer can successfully operate company stores.

Look for failures in your industry
If you are a manufacturer in the toy business, Disney has already demonstrated that it might not be a good idea to operate retail outlets.

Maureen Costello Wholesale Distributor Maureen Costello
Wholesale Distributor
Play Video
Is buying a business easier than starting one from scratch?
Look for possibilities both "up" and "down" the chain
Once you have outlined the vertical chain of functions in your industry, you can look for opportunities in both directions. If you're a retailer of furniture could you establish a manufacturing function (go upstream)? Or if you're a distributor could you get into retailing (downstream)?

Weigh advantages against the risks
Review the lists of advantages and risks listed in this session. For each entry assign a numeral value 1 - 10 as to the degree of benefit or risk. A + 10 would be for a benefit of the highest order. A - 10 would be a risk of the highest order. By summing up objectively both the benefits and risks you can gain an increased level of objectivity for making a decision.

Evaluate alternative strategies to vertical integration
Vertical integration was the primary tool used by the great industrialists of the 19th century who dominated entire industries and became very rich. Andrew Carnegie was a classic example. He not only owned the steel mills but controlled the coal and iron fields, the railroads and everywhere he bypassed middleman and their fees.

Under any instances of vertical integration growth, you will be gaining the benefit of acquiring an existing business rather than starting one from scratch. Here are some important benefits spelled out by experienced entrepreneur and CEO Maureen Costello.

But today you will need to closely scrutinize emerging threats which are increasing the risks of vertical integration, especially on the supply side. Vertical integration now competes with:

  • Outsourcing to low-cost suppliers in developing economies throughout the world.
  • World wide resources of highly skilled labor that is more and more accessible. Firms like Apple, Costco, Dell, Nike, HP don't own factories; instead they outsource.
  • The outsourcing alternative eliminates the investment in plant, equipment labor, etc.
  • World-wide inexpensive transportation is available including just-in-time shipping.
  • The lifespan of products and services have been greatly shortened, putting invested dollars in plants at greater risk.

Expanding into a vertically integrated operation The bottom line is this: Growing a business is not easy. Continue working on improving your business skills. Consult and hire people smarter than you. Be conservative when you invest your retained earnings. Don't over leverage. And never take a risk that will bet your company.

Test it first
Expanding into a vertically integrated operation will expose you to an uncommonly high business risk. First set up the operation on a small, pilot plant basis before committing major expansion and funding. Take on small steps before taking big ones and learn more as you proceed. Make careful financial comparisons of investment required, including the risks of obsolescence.

Top Ten Do's and Don'ts

THE TOP TEN DO'S
  1. Include vertical integration as a potential growth strategy.
  2. Determine where vertical integration is practiced in your industry.
  3. Study your competitor's vertical integration benefits.
  4. Achieve economies of scale.
  5. Investigate potential labor issues as a vertical integration risk.
  6. Evaluate vertical integration for geographical expansion.
  7. Evaluate vertical integration to maintain quality control.
  8. Evaluate vertical integration to protect your proprietary process or recipes.
  9. Weigh the risk carefully before proceeding into vertical integration.
  10. Compare potential return on investment with other growth alternatives.
THE TOP TEN DON'TS
  1. Disregard potentials of vertical integration.
  2. Overlook the possibility of higher cost due to lower volume.
  3. Disregard potential loss of existing income streams.
  4. Risk losing your original focus or specialization.
  5. Expand in a commodity pricing environment.
  6. Disregard an unsatisfactory return on invested capital.
  7. Compete with your customers.
  8. Overlook partial vertical integration possibilities.
  9. Ignore the best potentials on your vertical chain.
  10. Vertically integrate if the benefits don't outweigh the costs and risks.

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