Which of the following is a drawback of vertical integration?

Over the last years, due to the development and complexity of technologies regarding supply chain management, many Companies are continuing to gain closer relationship with other parties operating at different levels of this sector, on the purpose of improving profitability and competitiveness of their business through cutting off costs.

This phenomenon, which is defined as "vertical integration", i.e. the combination, under a single ownership, of two or more stages of production or distribution (or both) that are usually separated, entails one Company exercising control over several or all integrated levels of supply chain, such as research and development, production, pricing policy, packaging, marketing and distribution, hence over all the levels from the factory through to retail outlets.

Before applying this business strategy to your organisation, however, it is important you are aware of the advantages and disadvantages connected with it, as whilst some authors allege that adequate vertical integration can be crucial for a Company to survival, others blame excessive integration for causing corporate failure.

Advantages

Besides the vertical integration can be used to obtain bigger control over the operations, to enhance the profits, to improve marketing and to envisage costs, it surely affords the following advantages.

• Advantages over other competitors

The Company will be able to attain important advantages over their competitors by blocking them from gaining access to relevant markets and sources and by being able to purchase specialised assets. By following this way, the Company will be able to have the only access to a limited resource, so distinguish itself from its competitors.

• Cost saving

By getting into a vertical integration, Companies are able to eliminate the duplicate sources of overheads by bypassing various steps in production and distribution and by consolidating management. A company that is vertically integrated has lower costs. As a consequence, the consumers will benefit from it by purchasing the products at a lower price.

• Quality of products

By getting into a vertical integration, the company is able to offer products of hight standard, as the other party operating at the level of the production will own a high quality control system.

Disadvantages

Lack of expertise and knowledge at a specific level in the supply chain associated with the need to eliminate the overheads with the control of different levels in the integrated chain may mean that the disadvantages of a vertical integration might surpass the benefits thereof. For this reason it is important to analyse thoroughly the disadvantages which might arise out.

• Capital requirement

The Companies interested in applying a vertical integration strategy to they business need to have a huge amount of capital to invest, i.e. the amount of capital that the newly integrated operations require.

• Risks and outlays

By getting into a vertical integration, the Company will not be able to share risks and outlays with a third party.

• Flexibility decreased

Vertically integrated companies are not able to follow the consumers trends, as they need to focus on their established strategy regardless of other factors. Moreover, those companies have been previously involved in upstream or downstream investments, so that their flexibility will likely result as decreased.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.

Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.

The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution, as illustrated below:

Example of Backward and Forward Integration

No Integration

Backward Integration

Assembly

Forward Integration

Distribution

Two issues that should be considered when deciding whether to vertically integrate is cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.

The following benefits and drawbacks consider these issues.

Benefits of Vertical 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.

• Lead to expansion of core competencies.

Drawbacks of Vertical Integration

While some of the benefits of vertical integration can be quite attractive to the firm, the drawbacks may negate any potential gains. 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. (Note however, that flexibility to coordinate vertically-related activities may increase.)

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

• Developing new core competencies may compromise existing competencies.

• Increased bureaucratic costs.

Factors Favoring Vertical Integration

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.

Factors Against Vertical Integration

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

Alternatives to Vertical Integration

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)

Recommended Reading

Greaver, Maurice F., Strategic Outsourcing : A Structured Approach to Outsourcing Decisions and Initiatives

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