Vertical integration is when a firm extends its operations within its supply chain. It means that a vertically integrated company will bring in previously outsourced operations in-house. The direction of vertical integration can either be upstream (backward) or downstream (forward). It can be achieved either by internally developing an extended production line or by acquiring vertically.
The Four Degrees of Vertical Integration
1. Full Vertical Integration
Obtaining all the assets, resources, and expertise needed to replicate the upstream or downstream member of the supply chain.
2. Quasi Vertical Integration
Obtaining some stake in a supplier in the form of specialized investments or an equity stake to obtain agency benefits by increasing the ownership interest in the outcome.
3. Long-term Contracts
A diluted form of vertical integration in which some elements of procurement are held constant to reduce inconsistencies in product delivery while holding costs constant to a certain extent.
4. Spot Contracts
The point at which a firm is not vertically integrated is when the firm relies on spot contracts to receive the immediate input necessary for its production.
Advantages of Vertical Integration
The direct benefits of pursuing vertical integration are greater control over the supply chain and lower variable production costs.
Information and product delivery experience lead times within a supply chain. In other words, there is a delay in conveying the information or supplies between the different members of a supply chain. It creates an effect that is known as the Bullwhip Effect, where information relating to the quantity demanded by the customer is amplified along the supply chain such that the manufacturer overreacts to the actual information.
By vertically integrating, greater control over the production process is achieved in the sense that information flows more freely between the different supply chain members. As a result, this allows for greater flexibility in adapting to changes in demand, which improves the elasticity of supply.
In a perfectly competitive market, goods and services are traded at costs. However, most markets face some level of imperfection that allows for increased profits due to either branding, information asymmetry, market power, or other factors. As a result, the price at which a company acquires its resources is often at cost plus margin.
Through vertical integration, the company is able to reduce these input costs by the margin. In reality, the prices of input do not fall by an amount equal to the margin but within some range between the costs of production and market prices. Transfer pricing describes how two vertically integrated entities set a price for exchange while the overall entity internalizes the net benefits.
Disadvantages of Vertical Integration
One of the primary disadvantages of vertically integrating is the increase in managerial complexity. This is because entering a new line of work requires a new set of expertise to complement the existing business. A clear result of this is the increase in divestitures to return a company to its core competency.
One instance of increased managerial complexity being a disincentive for vertical integration was when Exxon Mobil (NYSE: XOM) contemplated operating convenience stores alongside its gas stations. This is because moving into the management of retail outlets would require a new set of expertise, acquiring new suppliers, and managing the new line of business. Eventually, they did take on this forward integration but not without considering the difficulties of the integration.
Applications of Vertical Integration
Some companies are able to gain a competitive advantage through vertical integration, whereas others instead opt to develop more efficient ways to manage their supply chain and input costs. It depends on the tradeoff of benefits and costs of integration.
SpaceX is the modern example of using vertical integration to lower the costs of its deliverable. By producing the majority of its components in-house, it is able to undercut the costs of its primary competitor, United Space Alliance. United is a joint partnership between Boeing (NYSE: BA) and Lockheed Martin (NYSE: LMT).
SpaceX enjoys several advantages over United, because of the latter’s dispersed supply chain where various suppliers were producing at cost plus a profit margin, resulting in an inflated cost of approximately $460 million per launch. In contrast, SpaceX’s cost is $90 million per launch, which is also falling due to its reusable design.
Alternatively, McDonald’s (NYSE: MCD) is known for its very dispersed supply chain due to its franchising business model. Instead of pursuing a vertical integration strategy, it uses a robust communication system between its managers and external suppliers. Part of this system is a crowdsourcing platform where various suppliers are able to share ideas and improve on individual processes and efficiency.
Synergies in Financial Modeling
A financial analyst performing financial modeling and valuation of a business should incorporate the potential synergies (cost savings) that could arise from vertical integration. If the integration happens as part of a merger or acquisition, the analyst will build an M&A model in Excel and factor in the cost savings that result.
Video Explanation of Vertical Integration
Watch this short video to quickly understand the main concepts covered in this guide, including what vertical integration is, the types of vertical integration, as well as the pros and cons of performing vertical integration.
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