Become a Financial Modeling & Valuation Analyst (FMVA)®. Enroll today to advance your career!
Login to your new FMVA dashboard today!

Backward Integration

A company acquires or merges with other businesses that supply raw materials for the finished product

What is Backward Integration?

Backward integration is a process in which a company acquires or merges with other businesses that supply raw materials needed in the production of the finished product. Businesses pursue backward integration with the expectation that the process will result in cost savings, increased revenues, and improved efficiency in the production process. Companies also use backward integration as a way of gaining competitive advantage and creating barriers to entry to new industry entrants.

 

Backward Integration

 

How It Works

A business that implements backward integration attempts to move backward in the industrial chain to the control of raw materials. The supply chain process starts with the sourcing and delivery of raw materials to the manufacturer’s warehouse and ends when the final product gets to the end consumer.

Raw materials are scarce resources that every business attempts to control, and lacking access to such resources may cripple the operations of the business. In industries with high competition, the manufacturers make attempts to buy the suppliers as a way of cutting out the middlemen and managing the increasing competition for the scarce resource.

 

Example of Backward Integration

An example is a wine manufacturer that seeks to acquire a wine glass manufacturing company that owns the rights and technologies of manufacturing glass. By acquiring the wine glass manufacturing company, the wine manufacturer will be in a position to control the quality of the manufactured glass, cost of production, as well as the quality of raw materials used in the manufacturing process.

It will limit other wine manufacturers from buying wine glasses from that supplier. Also, it will allow the acquirer to differentiate its wine glasses from those of the other competitors. Since the raw materials for the manufacture of glass are scarce in nature, the wine manufacturer will be in a position to manage the resource to make sure they are effectively used to produce high-quality glasses.

 

Advantages of Backward Integration

The following are some of the benefits that companies enjoy when they implement backward integration:

 

1. Better control

By acquiring the manufacturers of raw material, the company exercises greater control over the supply chain process from the production of raw materials to the production of the end product. First, the company will gain control over the quality of raw materials that are used in the production of the end product. Also, by acquiring the supplier of raw materials, the manufacturer will achieve greater control over the quantity and delivery of the raw materials to the warehouse.

 

2. Cost control

The supply chain process comprises many middlemen, which means that each phase in the supply chain includes a mark-up to allow the middleman to earn a profit. Thus, by the time the product gets to the company’s warehouse, the price will have doubled or tripled. It will make the finished product more expensive for the consumer.

By acquiring the supplier of the raw materials used in the production process, the company will do away with the middlemen involved in the process and reduce the cost of purchasing the raw materials. Controlling the entire supply chain will also reduce wastages, transport costs, and other costs incurred before the raw materials are delivered to the company’s warehouse.

 

3. Competitive advantage

Companies also use backward integration as a way to gain a competitive advantage over their competitors. For example, in the technology industry, companies integrate backward as a way of gaining access to patents, trademarks, and proprietary technology owned by other companies in the industry.

Acquiring such companies prevents competitors from using the same resources, and other firms are forced to look for alternatives in the market. Acquiring suppliers also create barriers to entry. New competitors will face difficulties getting suppliers for the raw materials required in the production process.

 

Disadvantages of Backward Integration

 

1. Inefficiencies

Implementing backward integration will result in inefficiencies. By acquiring the supplier of raw materials required in the production process, the company will limit competition, resulting in sluggishness and lack of innovation. The company will be less motivated to spend money on research and development. As a result, the quality of the company’s end product(s) will decline, and costs of managing the customer complaints will increase.

 

2. Substantial investment

Another disadvantage of backward integration is the substantial investments that will be needed to finance the acquisition. The company will be forced to utilize all its cash reserves and even take up more debts to finance the acquisition. If the company is unable to repay the debts or enjoy the benefits of the acquisition, it will face the risk of default and even liquidation.

 

Backward Integration vs. Forward Integration

While backward integration is the merging and acquisition of companies in the upper side of the supply chain, forward integration is the acquisition of companies on the lower part of the supply chain. In forward integration, the company is interested in acquiring distributors of its products or the retail stores that sell the final products to the end consumer.

For example, a wine manufacturer may decide to acquire businesses with wine distributorship rights or the retail chain stores that sell wine produced by the company. It will give the manufacturer better control in getting the finished product to the consumer and get first-hand information on the consumer’s experience with the company’s products.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Economies of Scale
  • Strategic Management
  • Value Chain
  • Vertical Integration

CFI's Corporate & Business Strategy Course

Learn to perform Strategic Analysis in CFI’s online Business Strategy Course! The comprehensive course covers all the most important topics in corporate strategy!