What is meant by Vertical Integration?

Merger of companies at different stages of production and/or distribution in the same industry.

When a company acquires its input supplier it is called backward integration. When it acquires companies in its distribution chain it is called forward integration. For example, a vertically integrated oil company may end up owning oilfields, refineries, tankers, trucks, and gas (petrol) filling stations. Also called vertical merger. See also horizontal integration.

expanding a company's operations either backward into an industry that produces inputs for its products or forward into an industry that uses, distributes, or sells its products.

Vertical Integration - Is a company's strategy, to which a company owns its upstream suppliers and its downstream buyers. Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.

Vertical integration potentially offers the following advantages:

- Reduce transportation costs if common ownership results in closer geographic proximity.

- Improve supply chain coordination.

- Provide more opportunities to differentiate by means of increased control over inputs.

- Capture upstream or downstream profit margins.

- Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource.

- Gain access to downstream distribution channels that otherwise would be inaccessible.

- Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest.

Vertical integration potentially has the following disadvantages:

- Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions.

- Potentially higher costs due to low efficiencies resulting from lack of supplier competition.

- Decreased flexibility due to previous upstream or downstream investments.

- Decreased ability to increase product variety if significant in-house development is required.

- Developing new core competencies may compromise existing competencies.

- Increased bureaucratic costs.

The following situational factors tend to favor vertical integration:

- Taxes and regulations on market transactions

- Obstacles to the formulation and monitoring of contracts.

- Strategic similarity between the vertically-related activities.

- Sufficiently large production quantities so that the firm can benefit from economies of scale.

- Reluctance of other firms to make investments specific to the transaction.

The following situational factors tend to make vertical integration less attractive:

- The quantity required from a supplier is much less than the minimum efficient scale for producing the product.

- The product is a widely available commodity and its production cost decreases significantly as cumulative quantity increases.

- The core competencies between the activities are very different.

- The vertically adjacent activities are in very different types of industries. For example, manufacturing is very different from retailing.

- The addition of the new activity places the firm in competition with another player with which it needs to cooperate. The firm then may be viewed as a competitor rather than a partner.

There are alternatives to vertical integration that may provide some of the same benefits with fewer drawbacks. The following are a few of these alternatives for relationships between vertically-related organizations:

- long-term explicit contracts

- franchise agreements

- joint ventures

- co-location of facilities

- implicit contracts (relying on firms' reputation)