What is vertical integration and how can it make your business more profitable?

Mar 4, 2013

tips for buying a small business 2There’s something about the phrase “vertical integration” that sounds like more of a buzzword than a way to make money; but it has actually become a worthwhile endeavor for many entrepreneurs. In the online dictionary, vertical integration (ver•ti•cal in•te•gra•tion) is defined as “the combination in one company of two or more stages of production normally operated by separate companies.” In more practical terms, vertically integrated companies have a hand in more than one part of a given industry.

A good example of vertical integration is a food manufacturer who also owns a chain of supermarkets. Often contrasted with horizontal integration, which is the merging together of businesses at the same stage of production, vertical integration merges companies that might normally do business with one another, but under separate ownership.

What are the competitive advantages of vertical integration?

Businesses are upstream or downstream of each other when they are nearer or further away from the final consumer. The benefits of vertical integration come when organizations gain more control over cost, quality and delivery times. The benefits are particularly attractive when vertically integrated companies control access to scarce physical resources through participation in joint ventures and alliances.

What are some examples of vertical integration?

Some of the best known examples of big business and vertical integration are in the oil industry. In the 70s and 80s, many of the companies engaged in oil exploration and drilling for crude petroleum decided to acquire downstream distribution networks and refineries. In essence, companies like BP and Shell were in control of every step involved in bringing oil from its original access point to a vehicle’s fuel tank.

Dell Computer took the concept of vertical integration a step further by combining the traditional supply chain with the special characteristics of a virtual business to create something called a “virtual integration.” Dell may assemble its computers from parts made by outside companies, but it maintains relationships with these firms that are more binding than what is customary between buyer and supplier. Unlike a virtually integrated firm, Dell does not own these partner companies, but it achieves much the same goal through its close association and exchange of information with them. It’s what Michael Dell calls “a tightly coordinated supply chain.”

What are the risks with vertical integration?

While the rewards may be quite significant when done correctly, it can still be a difficult strategy to implement. Not only is it costly, it is hard to reverse. One of the safest ways to make it work is for upstream producers to integrate with downstream distributors, thereby securing a market for their product. This can work well when the economy is healthy but when demand falls away, many companies find themselves cutting prices sharply to their downstream distributors.
How does vertical integration apply to small business owners?

The best way to expand your business is one that helps you become more profitable and more flexible in the future. As an entrepreneur who owns a manufacturing or retail business, your next acquisition should be a strategic one. Rather than buying another business just like the one you already own, why not consider owning a distributor for your products or a manufacturer who is already one of your suppliers?

For example, if you own a few popular pizza shops, it could make sense to buy a company that supplies you with sauce, cheese, pizza boxes or other supplies. If you’re in the business of roasting coffee and selling beans to local coffee shops, maybe it’s time to open a few coffee shops of your own. Not only will this improve the “brand value” of your beans to potential customers, it will give you a place to sell them.

Not every business owner will be able to take advantage of vertical integration right away, but it doesn’t hurt to be prepared when the opportunity presents itself. Having a strategy in mind will make your online searches more effective when you seek out businesses for sale within your industry.

Photo Courtesy of Stuart Miles / FreeDigitalPhotos.net