Vertical integration is where a company launches into one product market, but competes along multiple pieces of the supply chain. They can do this through backward integration and forward integration.
Backward integration is where a company chooses to make its own components. For example, Dell may choose to create their own hard drives or disk drives, taking control of the component manufacture.
Forward integration is where a company chooses to own its own distribution and store networks – Apple is an example of this.
Let’s look at Disney
Disney decided to forward integrate in the 1980’s and launch their own retail stores. Initially, these prospered. However, they started to struggle quite quickly, why? Because of external pressures from Walmart, Target and online shopping. By having their own stores, they were cannibalising their own market.
To get around this, they turned to Children’s Place, who were experts in the toy retail industry and asked them to operate the Disney stores on their behalf. They hoped that this would turn around the struggling retail chain. It didn’t work. Children’s place terminated the agreement after just a few years with little success.
Remember from our previous article when we spoke about Disney buying Pixar from Steve Jobs? Well, Jobs was still on the board at Disney. His input was that the stores needed to be an experience – a reason for customers to come directly to you, rather than buying their Disney toys from chain stores like Walmart. In other words, Disney needed to create synergy between the wider brand and their stores.
However, this caused a conundrum. If Disney let kids meet the characters in store and made the experience too great, then they would have less reason to visit the their theme parks – they didn’t want that.
So, what’s the solution? Many brands handle this issue by launching flagship stores, rather than being on every high street. This reduces overheads and makes visiting the store more of an ‘out of the ordinary’ experience. To drive customers to the store, companies generally offer some exclusivity – products which can’t be bought elsewhere.
Why vertically integrate?
You could consider vertical integration if you’re sure that you can create economies of scope and synergies between your different business units. That is, if the factories and stores work very closely with one another and you feel that greater cost and operational efficiency is achieved as a result, it may be worth vertically integrating.
There is also, of course, the ability to offset or mitigate some of the 5 forces, as discussed here. For example, the bargaining power of suppliers and the potential for hold-up can be mitigated if you’re able to backward integrate & produce the items yourself. Further, the bargaining power of buyers can be reduced by launching your own store fronts, through forward integration – so when negotiating with another retail chain to stock your products, they will have less price leverage over you.
Ultimately, by vertically integrating, you’re raising the barriers of entry for new players as it makes it very hard to imitate your strategy & for the new players to achieve the same economies of scale and scope that you’re business is able to achieve by operating at different points of the supply chain.
It also enhances your ability to differentiate your product & raise willingness to pay in an otherwise homogeneous marketplace.
Finally, it enables you to acquire information that you may otherwise not have access to. For example, by launching your own storefronts, you have direct discussions & feedback from your customers, rather than the feedback going through an intermediary, such as Walmart.
But, what are the costs?
Of course, these benefits are offset by some pretty hefty drawbacks.
Firstly, you have the dulled incentive. That is, if you were to buy from a supplier, they’d be looking to earn their money, they would need to sell to you and may make all kinds of concessions to make that happen. When you operate your own factory, you have a factory manager, who receives a salary and has a guaranteed end-customer in your other business unit. This may dull the incentive to work as hard as your external supplier otherwise might.
Also, you have the problem that it may cause conflict of interest. For example, if you were Dell, you may find that Best Buy is one of your top customers, buying thousands of units to sell to their large customer base. If you were to forward integrate and run your own retail stores, Best Buy would be both your best customer and your fiercest competitor. This can cause some issues.
It’s also harder to adapt to change when you own your own factories. If you’ve built up a factory using technology X and technology Y enters the market, you can’t swap without huge investment and lengthy time to market. If you had outsourced the process, you could switch suppliers, which would be much easier.
Next, you have the increased fixed costs. Running a factory obviously costs a lot of money and those costs (wages, lighting, heating) are unlikely to vary much from month to month. So, if there is a hard economic crash (like in 2008), both business units will take a hit. But then, you could just close the factory, right? Wrong! In some political climates you have to follow strict rules around downsizing. These rules, primarily in western Europe, were put in place to protect the workforce and can make leaving a market very difficult.
Finally, you have the integration issues. That is, getting all your business units working together in a cohesive manner.
What about partial ‘tapered’ integration?
This is become a much more popular business model, as adopted by Zara, which we will discuss shortly. The tapered integration approach is one whereby the business blends the use of external suppliers with their own factories or external retail outlets with their own stores.
The benefits of this mitigate a few of the drawbacks that we discussed above. For example, you can re-inject incentives into your staff by exposing the in-house business units to external competition. This can have the added benefit of knowledge transfer as in some partnerships (such as those prevalent in the Japanese auto industry) can result in staff cross-pollinating frequently working in one another’s factories, sharing best practice.
Zara make vertical integration work
Zara are a fashion retailer based in Spain. They’re one of the few fashion retailers that create their own products in their own factories.
The reason for this is that Zara has a fast follower strategy. That is, as soon as something hits the catwalk in Paris, Zara are already drawing up something similar, ready for production, to sell as soon as possible in their stores.
To do this, they own factories and produce small numbers of each design. This does two things. Firstly, if a fashion trend backfires, they haven’t created thousands of items, leaving themselves exposed to a huge amount of unsaleable stock and secondly, they create exclusivity around their products as something you see today, may not be there next week and with less availability, comes less chance someone else will be wearing the same thing as you.
Zara do, however, also use outsourced companies. They do this for the basic items, which don’t change frequently, such as t-shirts or socks – this enables them to buy large quantities & achieve good economies of scale. We refer to this use of both in-house factories and outsourced suppliers as ‘partial integration’.
The benefits of this model are: little excess inventory when they make a wrong decision; the ability to quickly change their product mix at a moments notice; no commitments to buy thousands of items and fewer product mark down’s – leading to a higher profit margin.
Of course, having factories in Western Europe incurs significantly higher wage bills than if they’d operated in the east. However, they offset those costs through marking less items down and retaining that higher profit margin.
Also, Zara do have to take on debt to fund new factories, which require large capital investment. This is not something their rivals are generally willing to do.
Zara have also adopted different business structures across the world. They have forward integration in Europe, franchising in Africa and joint ventures elsewhere. Depending on the market, Zara makes a calculated decision surrounding the business model that they need to adopt to achieve success.
We have seen a decline in vertical integration. This is because there are now much lower barriers to working with closely with partners in other countries, creating synergy between your two organisations. That is, improvements in video conferencing, lower costs flights and much more effective communications, which enable us to work with external, outsourced agencies, rather than building the products ourselves.
I wouldn’t go as far as to say that vertical integration does not make sense in the modern world, there are certainly times when it does make sense, as with Zara.
Ultimately, if you can create enough synergies through an integrated system of business units to justify the added investment and overheads, then it has to make sense for your business.
If you’re in an industry with slow development, like clothing, then owning your own supply chain could be a sensible thing to do. It enables you to be more agile and adapt to changes in the market.
However, in faster, more technological industries, it can insight ‘lock in’ and make exit or switching costs extremely high.
Certainly, adopting vertical integration with the view of capturing the profit margin currently enjoyed by retailers is not viable reasoning.
It all comes down to circumstance.