What Is Vertical Integration?
Vertical integration is a strategy whereby a company owns or controls its suppliers, distributors, or retail locations to control its value or supply chain. Vertical integration benefits companies by allowing them to control processes, reduce costs and improve efficiencies. However, vertical integration has disadvantages, including the significant amounts of capital investment required.
Netflix is a prime example of vertical integration. The company started as a DVD rental business before moving into online streaming of films and movies licensed from major studios. Then, Netflix executives realized they could improve their margins by producing their own original content. Today, Netflix uses its distribution model to promote its original content alongside programming licensed from studios.1
Understanding Vertical Integration
Vertical integration occurs when a company takes control over several of the production steps involved in the creation of a product or service. In other words, vertical integration involves purchasing and bringing in-house a part of the production or sales process that was previously outsourced. Typically, a company’s supply chain or sales process begins with the purchase of raw materials from a supplier and ends with the sale of the final product to the customer.
Companies can integrate by purchasing their suppliers to reduce manufacturing costs. They can also invest in the retail or sales end of the process by opening physical stores and locations to provide after-sales service. Controlling the distribution process is another common vertical integration strategy, meaning companies control the warehousing and delivery of their products.
Types of Vertical Integration
There are various strategies companies use to control multiple segments of the supply chain. Two of the most common include backward and forward integration.
Backward integration is when a company expands backward on the production path into manufacturing, meaning a retailer buys the manufacturer of their product. An example might be Amazon (AMZN), which expanded from an online retailer of books to become a publisher with its Kindle platform.2 Amazon also owns warehouses and parts of its distribution channel.
Forward integration is when a company expands by purchasing and controlling the direct distribution or supply of its products. A clothing manufacturer that opens its own retail locations to sell its products is an example of forward integration. Forward integration helps companies cut out the middleperson. By removing distributors that would typically be paid to sell a company’s products, overall profitability is improved.
An example of vertical integration is a mortgage company that originates and services mortgages. The company lends money to homebuyers and collects their monthly payments, rather than specializing in one of the services.
Although vertical integration can reduce costs and create a more efficient supply chain, the capital expenditures involved can be significant.