Which of the following is a drawback of vertical integration?

Business owners are always thinking of new ways to expand their business, and one opportunity to consider is vertical integration. A company is vertically integrated when it controls more than one level of the supply chain. This can include owning or acquiring its upstream suppliers (backward vertical integration), owning or acquiring its downstream distributors (forward vertical integration) or a combination of both (complete vertical integration).

Advantages of Vertical Integration

There are many advantages of vertical integration that can help your company increase its competitiveness and profitability in the marketplace:

• Achieve economies of scale

When companies lower their per-unit fixed cost, they achieve what is called “economies of scale.” One way to do this is to buy supplies in bulk, spreading the cost over a larger quantity of products. Another way to achieve economies of scale is to cut costs by eliminating expensive markups from middlemen, consolidating management and staff, and optimizing operations.

For example, Walmart operates their own distribution centers, giving them more control over the distribution process. A key part of their success has been state-of-the-art technology and establishing more efficient processes for loading and delivering products. The company continues to experiment with technology, such as virtual reality, hyperlocal distribution centers, and drones, in order to increase efficiency and cut costs even further.

Cutting costs have the added benefit of offering lower prices to consumers, which is another key to Walmart’s success. 

• Create new profit centers

Online stores such as Amazon and Chinese e-commerce giant Alibaba, now enable manufacturers to sell directly to customers anywhere, anytime, creating an entirely new center of earnings. Why lease and staff stores when people can buy your product from their homes?

• Expand geographically

Vertical integration can allow your business to expand geographically by adding distribution centers in new areas or by acquiring a new brand. Generally, geographical expansion works best when expanding within a company’s own segment in the supply-distribution spectrum.

For example, Proctor and Gamble's acquisition of Iams pet foods expanded the company’s reach into worldwide markets. And Louis Vuitton, the manufacturer of fine leather goods, became a worldwide destination for women after opening their own stores in the fashion capitals of the world.

• Maintain quality control

If you're a cake maker and manufacture your own cake mixes, you're not at risk of a supplier cutting down or substituting the eggs. If you're a manufacturer of salad oil and own your own olive groves, you're not at risk of mislabeling (which according to a UC Davis study was found to be the case in over two-thirds of extra virgin olive oil sold in stores.) Companies that have more control over the production process are able maintain higher quality standards.

• Differentiate from competitors

Vertical integration may allow a company to set itself apart from its competitors. For example, a company that manufacturers electronics could establish itself as a retailer, providing an experience for its customers that its competitors cannot. For example, when Apple opened its first retail store in 2001, it was able to cater to customers in a way that Microsoft could not.

• Protecting proprietary processes or recipes

In some cases, secret recipes are so valuable that they are maintained as true trade secrets and outsourcing their manufacturing would be unthinkable, such as with Coca-Cola.

Disadvantages of Vertical Integration

While vertical integration can lead to many benefits, it also comes with risks, such as:

• Established distribution channels may be adversely affected

Let's assume you manufacture handbags and your established sales have been through independently owned gift shops. You are considering vertically integrating by selling direct to consumers on your website. Your plans for going into online sales must take into account potential loss of sales through your present avenues of distribution. Will you lose already established sales to gift shops?

• Unprofitable outcome

Vertical integration can be expensive, and growing the supply chain does not always lead to greater profits. It may require a large investment to set up and maintain manufacturing or distribution centers, and your company may find it difficult to compete with other companies that outsource to countries with cheap labor. Vertical integration also allows for less flexibility, so it is difficult to reverse.

In the end, you may end up losing money on your investment, and too often an acquisition mistake cannot be made profitable by working harder. As Warren Buffett has said, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

• Obsolescence due to new technologies

Vertical integration could potentially hurt a company when new technologies evolve quickly and become available. The company is then forced to reinvest in the new technologies in order to stay competitive, which is costly and may require retraining of employees.

• Higher cost due to lower volume

If you go into manufacturing, you may not be able to keep costs as low as independent suppliers who sell to many other customers. For example, when an auto manufacturer owns its own tire manufacturing, its production of tires is most likely limited to the needs of the parent firm, whereas a standalone tire company can sell to numerous auto manufacturers, achieving greater economies of scale. 

• Unforeseen labor issues

When a union company vertically integrates with a non-union company, labor issues can arise. For example, if a non-union company vertically integrates with a union supplier, there is a chance of the parent company shutting down the supplier and outsourcing the service to reduce costs. This, in fact, has been the trend in the airline industry where outsourcing maintenance to lower cost overseas shops has soared.

• Loss of continuing focus on the originating business

Through specialization, some companies are so good at what they do they almost remove themselves from the competition. Your company may be excellent at retailing its products, but ill-equipped to manage the manufacturing process. A vertical merger could put the success of the company in jeopardy and may change the culture permanently.

While there are many advantages of vertical integration, all risks must be considered before moving forward. You may find that other strategies, such as buying a business at your own level in the supply chain, are better opportunities with less risk.

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