Definition: Vertical integration is a business strategy that allows a firm to control two interlinked stages of the value chain. It typically consists a sequence of alterations that are applied during the value chain until one or more raw materials are converted into a finished product. In other words, it’s when a company expands its operations to control more of the manufacturing or distribution of its product by either acquiring another company or building out existing segments.
What Does Vertical Integration Mean?
More specifically, vertical integration takes place when a company takes over control of different production or distribution stages of the value chain process until a product or a service is created. This process can be accomplished in two ways: backward integration when the company assumes control of the manufacturing processes or in forward integration when the company assumes control of the distribution processes.
Let’s look at an example.
A firm has a contract with a supplier for the purchase of a large quantity of a particular product. Yet, the content of the contract changes and the firm needs a larger quantity, yet with the same amount of money for a given period. In this case, the firm has to renegotiate the contract with the supplier to buy a larger quantity. The outcome depends on the willingness of supplier to deliver more than what has been originally agreed on the same amount of money. In other words, the firm depends on the willingness of suppliers to meet the increased consumer demand.
Rather than dealing with suppliers, the company can choose to integrate this step in the value chain into its own operations.
If the firm had assumed control over the manufacturing process (backward integration), it would simply increase production. Therefore, with VI, there is a higher degree of coordination in the supply chain.
In addition, by having increased control over the output, the firm can differentiate its product from its competitors, thus gaining a competitive advantage, increasing its market share and boosting its profits.
The firm can also implement a forward integration strategy and assume control over the distribution of its products. In doing so, it will gain access to distribution networks, thereby controlling to whom, when, and how to handle the distribution.
One example of backward integration might be a pizza restaurant buying a tomato farm to own the manufacturing of its tomato sauces. If the restaurant wanted to get into selling frozen pizzas and jarred sauces to customers, it might also look to forward integrate its business by purchasing grocery stores to control its distribution channels.