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When people think of Amazon, chances are they think mostly of the online store from which they buy all sorts of products. However, that is only one part of a much larger company. Amazon doesn’t just sell items online to people all over the world—the company comprises all sorts of departments and areas rarely seen by customers. Some of those areas include cloud computing systems, vast warehouses, delivery services, and even banking services in certain parts of the world. Amazon is an excellent example of a business that has embraced a vertical integration strategy, and it’s a crucial reason why they’ve become a multibillion-dollar company.
Amazon wasn’t always like this. When Jeff Bezos started the company, he was working out of his garage. As he grew the company, scaling up at every opportunity, he eventually made the firm decision to stop outsourcing. Instead, he kept everything in-house, which allowed him to maximize revenue and limit costs. In other words, he was quick to pursue vertical integration, and it has paid dividends ever since.
As your business grows, you need to take time to think about what kind of growth strategy will lead to long-term profitability. Vertical integration is one way to do that. With a vertically integrated company, business leaders can cut costs by essentially eliminating the middleman.
Find out more below to learn if vertical integration is the right choice for you and your growing business.
What Is Vertical Integration?
A vertically integrated company is one that owns and controls every facet of the supply chain and production, all the way down to the customer-facing aspect of the business. A company that pursues vertical integration is one that does not have to depend on outside businesses, contracts, or suppliers. The company controls it all, meaning they don’t have to worry about additional costs or unexpected downturns. In a sense, the organization has a vertical monopoly on every area of the business.
Types of Vertical Integration
Vertical integration can come in different forms. Unlike horizontal integration, which is a strategy where a business acquires other companies at the same level, vertical integration focuses on controlling every level. The following are the key different types to consider when implementing a new vertical integration strategy.
Full Vertical Integration
When people talk about a vertically integrated company, this is likely what they mean. Full vertical integration embraces the definition listed above—it acquires every aspect of a company’s operations from the raw materials to customer service departments. A fully integrated company features no reliance on outside sources. They control it all.
When a company wants to vertically integrate, it may start out with a strategy called quasi-vertical integration. This type is where the company’s leaders acquire a percentage of another company either higher or lower on the supply chain. It doesn’t mean having outright control, but it does mean having some ownership in them. This can be the first step towards full integration and benefiting from economies of scale.
Backward Vertical Integration
This strategy involves a company that owns the materials and inputs used in its products. In other words, the company gains firm ownership over each process that comes earlier in the supply chain. So, a home construction company that owns the lumber, windows, plumbing fixtures, and more would feature backward vertical integration.
Forward Vertical Integration
This strategy is much like backward integration only in the other direction. It involves a business that gains ownership over every process that is later in the production line. An example of this would be a sports apparel company that expands to own its own line of stores to sell to customers.
Much like quasi-vertical integration, a company that uses long-term contracts is doing so as a form of integration without permanence. It’s a way for them to ensure the costs they experience don’t have dramatic fluctuations. Any company aiming for this strategy is likely only a few steps away from becoming fully vertically integrated. They may use long-term contracts as a sort of testing ground before expanding and acquiring more entities.
The Pros and Cons of Vertical Integration
While vertical integration has many advantages, that doesn’t mean it will work for just any company. For some businesses, vertical integration makes all the sense in the world. For others, it might not make as much sense and they’ll want to look further into horizontal integration. To make a decision on if it’s best for you and your company, check out the following pros and cons.
Benefits of Vertical Integration
- Less chance of disruptions affecting your production
- Enhanced coordination and distribution across all aspects of the business
- Decreased input costs thanks to economies of scale
- Improved lead times within the supply chain
- Decreased risks when the market is unstable
- Raises the market barrier for competitors
- Allows for more development of new markets
- More profitability overall in most situations
Disadvantages of Vertical Integration
- Can be even more costly than first anticipated
- Increased operational complexity
- More need for expertise across a wide range of fields
- Less flexibility to changes within the market
- Initial integration capital can be immense
- There may be a need to go into debt to finance the strategy
- The company’s vision may get swallowed up by the integration
How Does Vertical Integration Work in Action?
Most businesses start at one point in the supply chain. Perhaps a company is a retail outlet selling products to the customer. Or maybe the company is in the distribution or supplier industry. While horizontal integration would mean expanding along the same level in that supply chain (such as acquiring more retail outlets if you are one yourself), vertical integration means expanding to different levels of the supply chain.
A typical supply chain vertical integration process will look like this:
- Acquiring raw materials
- Manufacturing different parts of a product
- Assembling the final product
- Shipping the product to retail stores
- Running the retail store itself, which deals directly with the customer
As your company starts vertically integrating, it will own more and more of that supply chain. You might do this by becoming a parent company to another company on a different level. Or you can achieve it by simply buying out other organizations and taking over their operations.
Vertical Integration Examples
SpaceX and Tesla
Elon Musk is known for being a firm proponent of vertical integration. His company SpaceX has made headlines for cutting down on the costs of constructing a rocket ship. That’s because SpaceX manufactures most of the components for the rockets themselves. Musk has extended this idea to his other famous company, Tesla. Thanks to strategies such as building the new Tesla Gigafactory, he can keep things in-house and save on rising costs. This is partly how Musk has been able to get more electric vehicles into the hands of consumers.
When Netflix started out, the company delivered DVDs to consumers via mail. They soon made waves by becoming a streaming service, but all the while they remained a customer-side business—they delivered the product to customers. This might be seen as embracing horizontal integration. By 2013, however, they decided to pursue a vertical integration strategy. Instead of paying other companies for the right to be a distribution service for their movies and television shows, they would make the entertainment themselves. The approach has been a huge success for the company. Now, Netflix can exert more control as a supplier, all while not having to worry about additional costs.
You don’t need to have instant name recognition to be successful with vertical integration. Glidewell Dental is a large company with more than 5,000 employees, and part of its strategy is to vertically integrate all aspects of the business. Jim Glidewell, the founder, has bought dental labs all over the world, including Germany and Latin America. The company now owns the most dental labs in the world. But the integration doesn’t stop there. Glidewell Dental has its own marketing team, AI department, software developers, gym and fitness centers, on-site medical clinic, dentists, cooks for office cafeterias, and more. The company outsources nothing, including its own R&D department that creates new developments in the dental industry.
Many oil companies are also examples of the vertical integration process in action. For instance, many people know Shell for the gas stations the company owns, but their involvement in the industry goes beyond simply providing gas to customers. Shell is involved in the extraction of oil through rigs located all over the world. The company also transports that oil to where it needs to go. Additionally, Shell owns refineries that prepare the fuel for customers. At every level, Shell controls what happens to the main product, meaning they have a better handle on costs.
We all know McDonald’s for its restaurants, and indeed, that’s how they got started. McDonald’s, however, has pursued a strategy of backward integration where they acquired companies further up the supply chain. To have more control over the quality of the supply, McDonald’s has farms where it produces its own materials needed to make the food. The company also has manufacturing plants to produce other materials such as paper for napkins and bags.
The South Korean company Samsung also shows how successful a company can be with vertical integration. Samsung manufactures numerous components for the wide variety of products they make, including semiconductors and LCD displays. What’s interesting is that Samsung has been so successful at this that even some competitors like Apple have to buy from them. The integration doesn’t stop there. Samsung also assembles its products and features its own branded stores to sell to customers.
Alternatives to Vertical Integration
Unless you’re already a large company with firm resources and a lot of market share, vertical integration might not be feasible for you. As discussed, one alternative to this strategy is horizontal integration. With horizontal integration, you can still expand as a company, but you don’t necessarily add on more complexity. Horizontal integration can also act as a stepping stone before becoming a vertically integrated company. Other alternatives have been discussed earlier in this article, but the following can act as a good summary.
- Long-term contracts
- Joint ventures
- Spot contracts
- Implicit contracts
- Co-location agreements
- Franchise opportunities
Vertical Integration: A Centuries-Old Way to Successfully Scale a Business
The concept behind vertical integration isn’t new—it’s been around for decades. It all started with Andrew Carnegie, who introduced the idea on a large scale thanks to Carnegie Steel. Other businessmen like John D. Rockefeller followed suit, forming huge companies that controlled all aspects of the supply chain.
It’s not different from what today’s billionaires like Jeff Bezos and Elon Musk have done. The technology has changed, but the core strategy remains consistent. It goes to show that effective strategies make business owners billionaires. To get to that next level, vertical integration is often necessary. Business owners who are doing it today are really just following in the footsteps of the big magnates of the past. In a way, this proves that it’s good for a business owner to look at what others have done to find massive success and keep that momentum going.
For more on what you can learn from John D. Rockefeller, check out the following article: