5.1.2 Why choose vertical integration? Benefits and drawbacks

To decide if vertical integration is a good strategy for your organisation, you must consider mainly two issues: the cost and the control.1

In your organisation you have costs due to the market transactions with suppliers and with clients. You have to consider which costs will occur for your organisation if what they supply is produced by you. What will be the investment for integration and when will you reach the breakeven point. Overall the organisation continues to create costs. The main difference is that instead of an external supplier it will have an internal supplier (when making backward integration) and so costs are expected to be reduced.2

How can you reach lower costs, then? You can lower costs by reducing the transportation costs. You no longer need to transport the product from your supplier or to your client, since you are both, and even if you produce / handle these products in separate facilities, they should be closer than without vertical integration. Another aspect that should reduce costs is that, you will capture the profit margins that your previous supplier or client were earning.

The main advantage of the vertical integration is the increased control. For instance, an enterprise has a contract with a supplier for buying a maximum amount of a product, but the context changes and that organisation needs more than the fixed amount for a certain period of time. It has to renegotiate with the supplier to buy a higher amount, but it is really up to the supplier to deliver more than agreed previously, and it is possible that he won´t do it. Now, if the organisation is handling that product by itself, it just has to increase production - it has the control to increase or reduce production, at will, so there is more supply chain coordination.

Another benefit of vertical integration, related to the previous one, is that you will be able to invest in highly specialized assets, which could represent an advantage over competitors, that your external supplier or client wouldn´t be interested in. This way you can invest, and improve your products.

Vertical integration offers you the opportunity to go even further. With specialized assets and having more control over inputs, it is possible that you can differentiate from your competitors, and gain competitive advantage. This is a way to increase your share in the market, which can lead to increased profits.

One other way to increase your market share, which can be a benefit from downstream vertical integration including distribution of the product, is the possibility to access distribution channels that otherwise would be inaccessible. The possible advantage is that your organisation distributes the product, and you decide to whom, how and in what way the distribution is handled.

If the vertical integration is done backwards, in a way that your organisation can gain sole access to a scarce resource (product or raw material), that would represent a strong barrier to potential competitors. This would definitely be a huge benefit of vertical integration to your organisation!

When you integrate in your organisation the work done by previous suppliers or costumers, you are also introducing or expanding the core competencies of your workers. That way you can be enriching some of your organisation jobs, leading to increasing satisfaction and motivation of your workers, which is an important benefit.

EXERCISE: Consider you are performing a vertical integration in your firm, either backwards or forwards. Just opt for one. What will be the benefits you envisage for your organisation?

However, vertical integration doesn´t only provide potential provide potential benefits, there may also be some possible drawbacks3. One must consider those when choosing to operate this particular strategy. For one, there are capacity balancing issues: your organisation might need to build excess backwards capacity in order to have the required amount of supplies for follow-on operations, which will lead, eventually, to excessive costs and maybe backwards integration could lead to retaliation from your previous suppliers, or from their own suppliers, which can endanger your main production.

When you operate vertical integration, you make significant investments in the organisation. These investments, either to backwards or forwards integration, may prevent reduce flexibility in your production, at least for a certain period of time (depending on the investment). These situations can have serious consequences especially if you work in a very unpredictable market environment. Lack of flexibility in production can decrease your market share, which is more visible in very competitive business sectors.

Related to the disadvantage of vertical integration highlighted above, there is a risk of reducing your organisation´s flexibility product variety due to the demands of internal development that results from integrating different tasks in your work process. The organisation now have more work, and that can lead to a lack of time for innovation which could be used to create more variety in other products.

When you integrate more work that is different in your organisation, you are developing new core competencies, which is, as seen before, a positive effect. Nevertheless, this can represent a drawback when these new competencies affect existing competencies in a negative way, making people uncomfortable in performing their functions, which can end in less satisfaction and motivation of the workers and in less productivity of the enterprise.

Although vertical integration should lead to lower costs, in fact in some cases you can obtain quite the opposite. It is possible that you increase your organisations bureaucratic costs by the fact that you are integrating different jobs in the same organisation. Another issue is that if you integrate backwards, you may reduce or eliminate competition amongst suppliers, which can result in low efficiencies and, consequently, higher costs.

EXERCISE: Consider the same vertical integration to your enterprise you used in the previous exercise. What could be the drawbacks of that action? Can you think of other disadvantages that are different from what is written above?

1 Rocha, 2002. "Integração vertical e incerteza".
2 Grossman & Hart, 1986, "The costs and benefits of ownership: a theory of vertical and lateral integration".
3 Rocha, 2002. "Integração vertical e incerteza". Romme, 1990, "Vertical integration as organizational strategy formation". Cacciatori & Jacobides, 2005, "The dynamic limits of specialization: vertical integration reconsidered".