DEFINITION: The phrase “vertical integration” refers to a business tactic which enables a company to optimize its operations by directly controlling multiple phases of its production process.
Vertical integration makes it possible for a company to dispense with external contractors or suppliers.
ETYMOLOGY: The phrase “vertical integration” appears to have been coined sometime around the turn of the twentieth century by industrialist Andrew Carnegie.
The English adjective “vertical” is attested from the sixteenth century. It derives, via Middle French and Late Latin, from the classical Latin adjective verticalis, which is connected to the noun vertex, verticis, meaning “eddy,” “whirl,” “crown of the head,” “head,” or “pole star.”
The noun “integration” is attested from the early seventeenth century. The connected verb “to Integrate” is derived directly from the Latin past participle integratus, from the verb integro, integrare, meaning “to make whole.”
USAGE: Generally speaking, the supply chain usually begins by procuring raw materials and ends by selling the end product to the customer.
A company is said to be “vertically integrated” when it establishes control over two or more of the stages in the development and sale of a product or service. This may include either purchasing or creating its own suppliers, manufacturers, distributors, or retail outlets, as opposed to outsourcing these functions.
This may proceed in various ways. For example, companies may vertically integrate by purchasing their suppliers, by buying warehouses and fleets of vans to control the distribution process, or by investing in the retail end of the process by such means as opening brick-and-mortar stores or websites.
The reason for all these types of vertical integration is to streamline the production process so that the company may operate more efficiently.
On the other hand, all of these activities require a significant capital investment for such things as building facilities and recruiting additional skilled personnel and management. Moreover, vertical integration leads to the expansion of both the scale and the intricacy of the company’s operations.
For these reasons, vertical integration may carry considerable risk, as well as opportunity for savings through the greater efficiency of its operations.
There are two chief types of vertical integration: backward and forward.
Backward Integration
“Backward integration” refers to shifting ownership and control of its products to a previous point within the supply chain or the production process.
This type of vertical integration is appropriately termed “backward,” seeing that companies often aim to purchase companies situated at the origin of a supply chain, such as a raw material distributor or supplier.
For example, take the case of a furniture manufacturer. In a bid to optimize operations, the manufacturer might attempt to purchase the distributor from which it has been receiving its raw materials—in this case, wood.
Forward Integration
“Forward integration” refers to obtaining control over a later point within the supply chain or the production process.
For example, in the case of the furniture manufacturer, forward integration might involve taking over the distribution process or the sale of its finished products. This might occur in several ways.
For instance, the manufacturer might merge with a retailer to acquire the capability of launching its own stores. The purpose of such a merger would be to generate higher revenue per product.
Forward integration is less frequently employed in vertical integration than backward integration. This is mainly due to the fact that the farther along the supply chain a company is located, the more difficult it is for a company located earlier along the chain to acquire it.
For instance, major retailers situated at the end of a supply chain usually possess substantial cash flow and significant purchasing influence. Instead of these retailers being purchased, they frequently have the financial resources to initiate acquisitions themselves.