Vertical integration has been used as a business strategy for centuries, with examples dating back to the 18th and 19th centuries.
In the 19th century, the American industrialist Andrew Carnegie used vertical integration to control the entire process of steel production, from mining iron ore to producing finished steel products.
Similarly, the American industrialist John D. Rockefeller used vertical integration to control the entire process of oil production, from drilling for oil to refining it into finished products.
The use of vertical integration as a business strategy peaked in the early 20th century, with many large companies using it to gain a competitive advantage.
However, in the latter part of the 20th century, the trend shifted towards horizontal integration, where companies sought to diversify their operations by acquiring other companies in the same industry.
In recent years, there has been a resurgence of interest in vertical integration as a business strategy.
Now while we’re not out here purchasing oil rigs and mining ore, ecommerce and online businesses can definitely take advantage of the philosophy behind vertical integration, especially organizations with complex supply chains.
Curious if vertical integration is right for you? You’re in the right place. In this post, we’ll tackle:
- What vertical integration is (and the benefits of implementing it)
- Specific ways online and ecommerce businesses use vertical integration
- Why vertical and horizontal integration are not actually at odds but can complement each other
- The risks and obstacles associated with vertical integration
Let’s get into it!
What is vertical supply chain integration?
Vertical supply chain integration is a strategy that allows a company to take direct ownership of various stages of its production process, rather than relying on external suppliers or contractors.
This type of integration, also known as “vertical integration strategy,” can have a significant impact on the overall efficiency and effectiveness of a company’s supply chain. With vertical integration, a company can gain greater control over its entire supply chain, from the acquisition of raw materials to the manufacturing and distribution of finished products.
This type of integration can take the form of both forward integration, in which a company takes ownership of the stages that after before its current operations, and backward integration, in which it takes ownership of the stages that come before.
Example: a vertically-integrated restaurant
Consider the example of a business-savvy restaurant owner.
A horizontally-integrated restaurant would have to rely on different suppliers to provide it with all essential ingredients. Everything would need to be either imported or store-bought.
If that restaurant owner wanted to have ownership and control over the entire production cycle of his business, he could do things like: Invest in farmland to raise animals or grow vegetables, subsequently eliminating his dependence upon outside suppliers. But it doesn’t need to be so extreme as a land purchase.
Vertical integration can simply mean the head chef makes his own cheese as opposed to buying it from the store. Or cooks down his own sauce as opposed to getting it from a jar. Even small steps like these reduce a business’s dependence on outside suppliers and help them maintain more control over its product and customer experience.
Example: a vertically-integrated ecommerce clothing store
Let’s bring it back to something a little closer to home: an ecommerce business.
Consider an online store that specializes in custom-made clothing. The store currently relies on external suppliers to provide them with fabric and other raw materials, and they outsource the manufacturing of their clothing to external contractors. In order to streamline its operations and reduce costs, the store decides to implement a vertical integration strategy. They begin by acquiring a textile company that specializes in producing high-quality fabrics. This is an example of backward vertical integration.
By owning the textile company, the store can now have greater control over the quality and cost of its raw materials. They can also reduce the lead time for obtaining materials and eliminate the risk of supply chain disruptions from external suppliers.
The store then decides to ditch brick-and-mortar retailers and take control of all distribution via their website. This is an example of forward vertical integration, as it’s now taking ownership of the stages after its current operations.
By having its own manufacturing facility, the store can now have greater control over the quality of its finished products and reduce costs by eliminating the need to pay external contractors. In addition, by controlling the entire supply chain, from raw materials to finished products, the store can now gain core competencies in textile production and clothing manufacturing.
This can give them a competitive advantage in the market and allow them to differentiate their products from those of their competitors. However, there are certainly some risks and downsides to vertical integration (which we’ll discuss in detail later in this post).
The importance of understanding supply chain verticals and vertical integration for ecommerce businesses
Unless you’re a handmade ecommerce business that manufacturers and sells all your products in-house, it’s likely you rely on third-party suppliers and distributors to keep your business running.
Understanding the concept of supply chain verticals and vertical integration can help you make more informed decisions about how to structure your operations and gain a competitive edge in the ecommerce space.
Vertical integration can be a great way to reduce costs, improve product quality, and gain competitive advantages.
However, it’s important to understand the different stages of your supply chain and the possible implications of taking ownership of them. It’s also essential to consider the risks and downsides that come with vertical integration before making any major changes to your business.
Before we move forward, let’s get our definitions straight.
When we say “supply chain vertical” and “vertical supply chain integration,” we’re actually talking about two different, but highly interconnected concepts. A supply chain vertical refers to the different levels of a supply chain, such as raw material suppliers, manufacturers, wholesalers, and retailers. Each of these levels plays a crucial role in the flow of goods from the producer to the consumer.
An example of a supply chain vertical in an ecommerce business might be:
Raw material suppliers => Manufacturers => Wholesalers => Retailers (ecommerce stores) => Consumers.
Vertical integration, on the other hand, refers to a company owning and controlling multiple levels of the supply chain.
For example, an ecommerce business that is vertically integrated may own its own manufacturing facilities, distribution centers, or even retail outlets. This allows the company to have more control over the supply chain, resulting in cost savings, improved efficiency, and better control over quality. Understanding the different verticals and the relationships between them can help ecommerce businesses identify opportunities for improvement and optimize their supply chain.
The difference between horizontal and vertical integration, and how they can be used in conjunction to create a more effective supply chain
It is important to note that horizontal and vertical integration are not mutually exclusive and a balanced integration of both can be a more effective supply chain strategy.
A company can choose to integrate horizontally, vertically, or both depending on its goals, resources, and capabilities. A single supply chain can have multiple types of vertical integration and various stages of forward and backward integration. An example of a real-life company that uses both horizontal and vertical integration is Walmart.
Walmart owns and operates stores, warehouse clubs, distribution centers, and a trucking fleet to meet the needs of their customers. This integrated system allows them to supply their stores with a wide range of products quickly and cost-effectively.
Another example of a smaller company that uses both forms of supply chain integration is the online retailer Zara. Zara owns and operates its own factories, allowing it to have more control over production and respond quickly to changes in customer demand. It also uses a network of third-party suppliers for sourcing raw materials and components, allowing for greater flexibility and cost savings. By using both types of integration to manage their supply chain, Zara is able to produce the latest fashion trends in a cost-effective and timely manner.
By understanding the different types of integration and their implications for your business, you can create a more effective and efficient supply chain. This will ultimately lead to increased customer satisfaction and improved profitability in the long run.
We’ll talk more about how you can implement the best combination of horizontal and vertical integration later in this post.
The benefits of vertical integration for streamlining operations
Vertical integration is not for the faint of heart. It requires an extremely organized infrastructure as well as significant capital to get running (plus reliable employees to keep it running). Let’s look at some more specific ways vertical supply chain integration benefits organizations.
Forward and backward vertical integration can improve supply chain management
Think of a car assembly line. The car manufacturer may have a forward integration strategy by acquiring a dealership network to control the distribution of its cars, much like a manufacturer acquiring a distributor in forward vertical integration. This helps the manufacturer have direct control over the distribution of its cars and improve the customer experience.
On the other hand, the car manufacturer may also have a backward integration strategy by acquiring a tire manufacturer, much like a retailer acquiring a supplier in backward vertical integration. This helps the car manufacturer secure a reliable supply of tires, reduce the risk of supply chain disruptions, and improve its bargaining power with suppliers.
All of these “top-line” changes result in trickle-down increases in the company’s bottom line. Fewer supply chain disruptions mean more reliable sales figures. Better customer experiences mean repeat buyers and more referrals.
The impact of vertical integration on a company’s ability to reduce costs and increase market share
When a company vertically integrates, it can reduce costs and increase its market share.
Let’s use an online store as an example: when an online store integrates backward, they can source products directly from certain manufacturers. This eliminates the middle man and reduces costs for the retailer. The increased bargaining power of the retailer also allows them to secure discounts, which is another way vertical integration leads to cost savings. By having access to suppliers’ latest product lines before competitors, the online store is also able to increase their market share and gain an edge over competitors.
Vertical integration can also help a company make more informed decisions when it comes to pricing, inventory management, and product development as they have direct access to customer data and feedback.
This type of information is invaluable when making strategic business decisions.
The advantages of a vertically integrated supply chain for cost savings
The relationship between raw materials and forward integration in a vertically integrated supply chain
Forward integration has never been more possible thanks to the advent of ecommerce and online-exclusive sales.
Businesses can build a high-performing website using powerful tools like Magento, Shopify, or WooCommerce, drive traffic to that site, and manage every facet of distribution while significantly reducing overhead.
It’s safe that say that if you’re looking for a place to start, forward integration is your best bet. In general, it’s likely going to be more challenging to acquire or control the manufacturing/production side of the supply chain than the distribution side.
The relationship between finished goods and backward integration in a vertically integrated supply chain
Now, let’s think of it from the opposite perspective.
Remember, backwards vertical integration is when a company acquires a supplier or a company that is involved in an earlier stage of the production process to increase control over the supply chain and reduce dependency on external suppliers.
For example, a clothing retailer could acquire a fabric manufacturer to ensure delivery of quality fabrics in a timely manner. This would help them maximize the efficiency of their production process and reduce lead times while maintaining control over the quality of their finished goods. By decreasing the number of suppliers they are dependent on and having control over the supply chain, the retailer can reduce costs and increase their profit margins.
The importance of a balanced integration strategy for supply chain partners
The bottom line is that horizontal and vertical integration are nothing more than tools in your toolchest as an ecommerce business owner.
Your goal should be to find the best supply chain setup for your business goals, specific niche, and future growth plans. That said, everything begins with a supply chain vertical audit. This means mapping out the various stages of your supply chain, evaluating the current performance of each stage and identifying areas for improvement.
For example, if you find that costs in your supply chain are high due to too much dependence on external suppliers, then adding backward integration might be a good option for reducing reliance and improving efficiency. Or, if you find that there’s a particular distributor that hasn’t been impressing you lately, you might consider creating your own distribution channels, thus implementing forward vertical integration.
The process of vertically integrating a supply chain and the types of vertical integration
Let’s make this really practical.
Here’s a step-by-step guide on how to leverage vertical integration in your own ecommerce business:
Step 1: Assess the supply chain
Evaluate your current supply chain to identify areas that can be improved through vertical integration.
Step 2: Determine integration type
Decide if forward or backward integration would be the best fit for your business. Forward integration would be acquiring a company involved in the distribution or retail aspect, while backward integration involves acquiring a company involved in an earlier stage of production.
Step 3: Identify potential partners
Research and identify potential companies to acquire that complement your current supply chain.
Step 4: Negotiate and close the deal
Once a suitable partner has been found, negotiate and finalize the acquisition.
Step 5: Integrate the new partner
After acquiring the new partner, integrate them into your supply chain. This may require changes in processes, systems, and personnel.
Step 6: Monitor progress
Continuously monitor the integration process to ensure the new partner is contributing positively to your supply chain.
Step 7: Evaluate results
After some time, assess the results of the integration to determine if the investment was worth it. Consider factors such as cost savings, increased efficiency, and control over the supply chain.
Example: Handmade jewelry ecommerce store
Let’s look at how this framework might play out with a hypothetical handmade jewelry store.
Our hypothetical ecommerce business sells handmade jewelry and has a supply chain that includes:
- Sourcing raw materials from suppliers
- Producing the jewelry in-house
- Distributing the finished products to customers
The business assesses the supply chain and finds that their margins are being impacted by the cost of raw materials.
The business decides to pursue backward integration, as they believe that acquiring a company that specializes in sourcing raw materials would allow them to reduce the cost of raw materials and improve their margins.
The business researches and identifies several companies that specialize in sourcing raw materials for handmade jewelry.
They assess these companies based on factors such as cost, quality of materials, and compatibility with their existing supply chain.
The business selects a company that they believe will be the best fit and negotiate the terms of the acquisition. They successfully close the deal and acquire the company.
The newly acquired company is integrated into the existing supply chain, which involves changes to processes, systems, and personnel.
The new partner provides the business with access to high-quality raw materials at a lower cost, which improves the business’s margins.
The business continuously monitors the integration process to ensure that the new partner is contributing positively to their supply chain.
They assess factors such as the cost of raw materials, the quality of materials, and the efficiency of the supply chain.
After several months, the business evaluates the results of the integration. They find that the acquisition has resulted in significant cost savings, improved efficiency, and increased control over the supply chain.
The business decides that the investment was worthwhile and continues to operate with the new partner integrated into their supply chain.
The challenges and risks of implementing a vertical integration strategy
Alright, so we’ve spent a lot of time singing the praises of vertical integration. But like any supply chain philosophy, it has its downsides, obstacles, and potential risks to the business.
We want you to go into vertical integration with both eyes open, so let’s review those potential pitfalls now.
Stifling competition and innovation
A main drawback of vertical integration is that it can limit competition and stifle innovation.
When a company vertically integrates, they are essentially creating a monopoly. By owning all aspects of the supply chain, they eliminate any potential for competition.
This lack of competition can lead to higher prices for consumers and reduced innovation as the company has no incentive to innovate if they are not competing with anyone.
Vertical integration can be a significant financial investment, requiring a large upfront cost for acquiring another company or establishing a new production line.
If your aim is to control significant portions of your supply chain, you could be looking at multi-six-figure acquisitions at the very least.
Even if you’re just doing some basic forward integration, setting up your own distribution channels (even just online) will often require a large upfront investment.
Integrating another company into your supply chain can be complex and time-consuming, requiring changes to processes, systems, and personnel.
There are significant risks associated with acquiring another company or absorbing the responsibilities of part of your supply chain.
These include the possibility that the company may not perform as expected, or that the integration may not go smoothly.
At its most fundamental level, business is really just one person looking at another person and saying: “Hey. You do [certain task] way better than I ever could, and I don’t have the time to develop your level of expertise or execute it myself. I’ll pay you to do it for me.”
This is the essence of outsourcing, delegation, and horizontal integration. And what vertical integration gains in profit, it loses it potential expertise.
ecommerce businesses may not have the expertise or experience to effectively integrate and manage a new partner or their responsibilities, hence why it’s important to do due diligence and research beforehand.
Loss of focus
Vertically integrating can be a time-consuming and distracting process, which can take time and resources away from core business activities.
Vertical integration can result in increased responsibility for the ecommerce business, including liability for any problems with the newly acquired company or phase of the supply chain.
The historical evolution of vertical integration and its impact on the economy
How vertical integration has been used by large companies throughout history to gain market power
Vertical integration is not a new concept by any means. It has been used throughout history in different forms as companies sought to gain market power, increase efficiency, and control their supply chain.
As mentioned in the introduction, large factories vertically integrated all aspects of production from raw materials to finished goods, creating massive monopolies during the Industrial Revolution.
In the 20th century, conglomerates such as Ford Motor Company and General Electric continued to use vertical integration to control all aspects of their business from production to distribution.
Today, many companies are using vertical integration, especially in the digital age where technology has made it more feasible.
Companies such as Amazon and Apple are heavily vertically integrated, controlling all aspects of their business from product design to delivery.
Vertical integration has had a profound impact on the economy as a whole. It has allowed companies to gain significant market power, leading to higher profits and increased efficiency.
In summary, vertical integration can be a powerful tool for ecommerce businesses that wish to gain control over their supply chain. However, it requires careful consideration due to the significant financial investment, added complexity, risk, and potential for loss of focus.
It can also result in increased responsibility and potential liability. As with any major business decision, it’s important to do your research and due diligence before making the jump into vertical integration.
For an ecommerce business that succeeds in their vertical integration efforts, the benefits can be considerable in terms of control, efficiency, profitability, and market power.
Finally, it is essential to remember that vertical integration is not the only option for businesses looking to gain control over their supply chain.
There are other strategies available such as outsourcing certain elements of production, relying on third-party providers or exploring alternative supply chain solutions. Ultimately, the best solution for any business depends on their particular needs and goals.