Strategic Management: Formulation and Implementation

Vertical Integration Strategies

Vertical integration is a growth strategy that involves extending an organization's present business in two possible directions:

If a business integrates by moving into an area that serves as suppliers, the process is referred to as backward integration. In internal backward integration, the firm creates its own sources of supply, perhaps by establishing a subsidiary company. The external approach involves the purchase or acquisition of an existing supplier.

If a business integrates by mowing into an area that serves as a customer or user of its products or services, the process is referred to as forward integration. A firm can accomplish forward integration internally by establishing it own production facility (if it is a supplier of raw materials), sales force, wholesale system, or retail outlets. External forward integration can be accomplished by acquiring firms that presently perform the desired function.

The reasons for choosing a vertical integration strategy are more varied and sometimes less obvious. If a firm believes that it is paying more for materials than it would cost to produce its own, the temptation to integrate vertically is great. The attraction is still greater if getting materials from a supplier on time has been a problem or is expected to become problem.

Therefore, the main reason for backward integration is the desire to increase the dependability of supply or quality of raw materials or production inputs.

The rationale for forward vertical integration is similar: cost and effectiveness. Greater control over marketing and closer coordination between distribution channels and manufacturing may improve sales. Forward integration is a preferred strategy if the advantages of stable production are particularly high.

However, both backward and forward vertical integration require investment generate a commensurate return. Particularly, backward vertical integration into raw and commodity materials may require a huge investment. Operation may have to reach a level of output that affords economies of a scale or otherwise be uneconomical to operate.

Moreover, for vertically integrated firms, the risks result from expansion of the company into areas requiring strategic managers to broaden the base of their competencies and assume additional responsibilities . Therefore, organizations should adopt a vertical integration strategy with caution because integrated organizations have become associated with mature and less profitable industries. Escape from these industries is particularly difficult for a large, vertically integrated organization.

The main lessons to be learned with regard to vertical integration are that:

Critical complementary assets must be owned (mainly when they are specialized for the needs of the firm), unless their is a cash constraint. In this last case, the firm should try to form a partnership with at least a minority position.

When critical complementary assets are not owned, the firm should secure early access to them, mainly when its product is not protected by a thigh regime of appropriability (it is an easy matter to copy it), and when the capability of complementary assets is in short supply and may become a bottleneck.

Vertical integration involves a set of decisions that, by the nature of their scope, reside at the corporate level of the organization. Some of these decisions are discussed below.