Should Your Supply Chain Join the Vertical Integration Revival?

Ever since the early 1970s supply chain organisations have taken on increasingly distributed structures, a shift from a long-standing tradition of vertical integration.

 

Vertical Integration quote by Peter Thiel

 

Horizontal integration has become the go-to value chain strategy over the last two or three decades, to the point where companies that insisted upon remaining vertical became the outliers in a global field of distributed organisations.

Now it seems the trend may be reversing once more, as a definite movement—sometimes referred to as Vertical Integration 2.0—gathers momentum, particularly in the apparel and digital technology industries.

 

Factors Driving the Shift to Vertical

So what’s driving an increasing number of companies to switch integration strategies, move away from intense specialisation and revive the conglomeration preferences so popular in the mid-twentieth century?

Each company will have its own reasons, but in the fashion industry we can look to one company as being the catalyst for change… Zara (If you’re wondering why the image here relates to Starbucks and not Zara, all will be explained a few paragraphs on).

 

2017 Coffee Shortage Statistic

 

Since the Inditex-owned fashion company, which set out with the intention to keep tight control over its value chain, pioneered what we know today as “fast fashion,” consumer demand has dictated the need for other retailers to drastically rethink their methods of meeting retail demand.

 

Vertical integration is one of the keys to a rapid and agile supply chain, without which it’s difficult for apparel retailers to compete with the likes of Zara, Forever 21, Uniqlo and other fast fashion giants.

 

While some fashion brands (like H&M) have managed to shorten their supply chains while maintaining a horizontally integrated structure, ownership of the value chain has become the preferred option for many new market entrants—and a transitional driver for a number of longer-established fashion retailers.

 

Speed, Trust, Growth, and Control

Supply chain speed is also making vertical integration (VI) attractive in other industries, but perhaps not to the same degree as in apparel retail. Other issues appearing to influence the new VI trend include:

  • Global expansion goals
  • Concerns over supply risks and disruptions
  • The belief that forward integration will strengthen demand for products or services
  • The desire for absolute control over manufacturing or raw material quality (a driver for backward integration)
  • The belief that upstream suppliers are engaging in profit-gouging (also driving backward integration)

To illustrate these drivers a bit more comprehensively, let’s look at a few examples of companies that have either started out with a vertically integrated structure, or have become more vertical via mergers or acquisitions.

 

Starbucks: Owning Quality from Bean to Cup

As Starbucks Executive Chairman would tell you himself, Starbucks is an enterprise that’s “vertically integrated to the extreme.” But to understand just how vertical, you need to look a little closer at the supply chain of probably the most famous name in coffee anywhere.

Starbucks boasts ownership of all the following value chain assets and activities:

  • Coffee bean farms
  • Coffee bean roasting plants
  • Warehouses and distribution assets
  • Retail outlets

Whilst the bean farms under Starbucks’ ownership are not able to meet the full raw material needs of the company, a sufficient supply is assured through solid purchase agreements with a wide range of growers. This is a good example of how vertical integration does not always have to be achieved by asset ownership… but more on that later.

 

Starbucks has essentially chosen VI because it doesn’t want to trust its exacting quality requirements in the hands of external agencies. For Starbucks, vertical integration is a risk mitigation strategy.

 

At the same time, ownership of the entire value chain means Starbucks doesn’t depend on external distribution channels, so quality is guaranteed all the way through the supply chain. Furthermore, the company can be price-competitive because it’s not reliant on the raw material market, or to put it another way, is not at the mercy of growers’ pricing strategies.

 

Ferrero: They Must be Nuts

Geopolitical and environmental concerns were the primary reasons why Ferrero broke its own long standing commitment to avoid mergers and acquisitions and purchase Turkey’s largest hazelnut producer, Oltan Gida.

Hazelnuts are the principal ingredient in Nutella, which is Ferrero’s most important product. The Oltan Gida purchase secured the chocolate giant’s ability to ensure continuous hazelnut supply, to the detriment of other hazelnut buyers if necessary, as Ferrero now controls a significant portion of the world’s hazelnut supply.

The company is now also moving into forward, as well as backward integration, having begun to open Nutella bars, where consumers can go to eat and drink everything Nutella.

 

Other Examples

Bridgestone decided a few years ago to backward integrate and diversify into rubber production. The multinational tyre giant chose this path because its leaders believe that at some point, the demand for rubber will become so great that it will be too hard to get quality materials for tyre manufacture.

Armor Holdings makes armoured cars and bullet-proof vests. In 2006, Armor purchased a company that produces super-strength fibres used in the manufacture of bullet-proof materials.

In 2012, Delta Airlines took ownership of an oil refinery that makes jet fuel.

 

The list goes on, but the examples above should serve to stress the point that vertical integration is falling back into favour as an enterprise strategy.

 

It’s interesting to note than in each of these examples, the main aim is to secure availability of materials presumed to be at risk of becoming more expensive or difficult to obtain. It doesn’t take too much imagination to see how these acquisitions also increase the market control exercised by the companies concerned.

 

Vertical Integration as a Power-play

If the decision to integrate vertically proves to be the right one, the companies discussed above stand to gain plenty from providing coffee beans, high-strength fibres, raw rubber, hazelnuts, and petrochemicals at a price of their choosing, should these products really become scarce in the future.

 

Strategy Quote by Dr. Michael Porter

 

In effect, what these companies all have in common is that they have integrated vertically in anticipation of a failure in their respective vertical markets.

 

This is to some extent a speculative move, which is why it remains to be seen whether or not the decision to go vertical was correct. If not, these enterprises might have a very tough time in the future, because it’s not easy or cheap to reverse a vertical integration strategy once implemented.

 

Indeed, despite the apparent revival in the popularity of vertical integration, it’s not a decision to be taken lightly, especially for companies that have long been established as specialists.

 

Strangely enough though, there has been no shortage of companies taking the VI route for the wrong reasons, only to find that the results were not as positive as they might have expected. This is probably a good topic on which to focus next, so let’s explore some situations in which it might seem a good idea to vertically integrate, but to do so would probably be a very bad move.

 

Scenarios in Which Vertical Integration Could be Disastrous

Solution vs ProblemWe’ll begin with a simple guideline to help you know if vertical integration would be right for your company (assuming it’s not already vertically integrated)…

Unless there is a specific supply chain problem that vertical integration would solve, your company is probably better off as it is. 

Aside from this general rule of thumb, think very carefully about setting off on the VI path with any of the following as a singular aim:

  • To reduce risk for shareholders. It’s better to let shareholders take care of their own portfolio diversification.
  • To secure supply or distribution assets in situations where the markets for either are efficient and there are plenty of parties with which to trade.
  • To move closer to customers (unless doing so will deliver high levels of economic surplus).

Of course there’s little value in warning against vertical integration (even for spurious reasons) if that warning doesn’t come with some idea of the risks and possible pitfalls of a vertical supply chain restructure.

 

What Can Possibly Go Wrong?

It’s tempting to think that ownership of your entire value chain (or a significant part of it) is a state for your competitors to envy.

 

Profit and Loss Quote by Charles Duhigg

 

Of course it can be if it’s done for the right reasons—and done right. On the other hand though, there is plenty that can go wrong. To illustrate this, here are a few examples of traps that companies have fallen into after embarking on complex and expensive VI initiatives:

  • Loss of flexibility: All the while a company can contract with external service or product providers, strategic changes can be made with relative ease. Not so once that same company has invested in supply chain assets and infrastructure of its own.
  • Confusion for customers: Depending on how a vertically integrated brand is structured, there is a risk of customers becoming confused about who they are doing business with. This is especially true if your company comprises subsidiaries operating in different parts of the supply chain.
  • Underestimation of investment: Vertical integration can require truly massive investments in both financial and human capital. Plenty of companies have underestimated the enormity of a vertical merger and the requirements for facilities, labour, and knowledge acquisition.
  • Failure to adapt: The intellectual investment needed for vertical integration is considerable too. Your company may be entering into completely unfamiliar areas of supply chain operation. Some companies struggle to handle the increased operational scope, and hence fail to generate the potential supply chain control benefits.
  • Loss of focus: The addition of new supply chain operations can draw attention away from those which previously formed the core of a business. This loss of focus can be damaging to the chemistry of the company and may even lead to customer attrition.

Other risks abound in vertical integration, relating to economies of scale (or the lack of them), difficulties in entering new markets, and for larger companies, the possibility of intervention from anti-trust regulators.

Of course that’s not to say that vertical supply chain integration is always a bad idea. Indeed, judging by the recent revival, there are plenty of business scenarios in which it’s a winning solution. The important thing is to make sure the size of the prize really makes the abnormally high levels of risk and cost worthwhile.

 

The Costs Involved in Vertical Integration

We’ve mentioned vertical integration costs a couple of times in this article, so now would seem a good point at which to briefly elaborate on what kind of costs your company should expect to encounter.

 

Merger and Acquisition Deals Statistic

 

It goes without saying that if you’re integrating through a merger or acquisition, your company will need to raise purchase capital, but you should also prepare for some or all of the following additional expenses:

  • Administrative, legal, and transactional costs involved in affiliation of two companies
  • Possible costs of defending anti-trust challenges
  • An increase in the costs of operational management and administration (it’s common to suffer a loss of management and administrative efficiency after a merger
  • Costs involved in management and staff restructuring
  • Possible capacity-balancing costs

These are just some of the costs arising from a successful integration. If your company should get it wrong, you could easily find operational transaction costs increasing rather than decreasing and ultimately, be faced with the massive cost of disintegration.

 

Rewards for Getting it Right

Aside from being a way to mitigate existing or future risks in the supply chain, VI does offer some key advantages—provided it proves to be the right approach and that the business cultures, as well as the entities are successfully integrated.

 

Acquisition Quote by Baba Kalyani

 

Possible advantages are as follows:

  • Increased predictability and stability
  • Reduction in marketing costs
  • Certainty of supply of raw materials or components
  • Improved control of distribution
  • Inventory management can be easier and more effective
  • Improved access to information, especially when forward integrating into retail
  • It becomes easier to target marketing and promotions to specific demographic groups
  • It enables differentiation from competitors that continue to follow a specialisation strategy
  • Transaction costs can be reduced throughout the supply chain
  • New markets may become accessible, increasing the scope for profitability
  • Successful VI can create a company that is more resilient to market fluctuations
  • Solid quality assurance solutions can be built and controlled, resulting in improved customer satisfaction
  • Vertical integration can help to increase market share, by enabling additional product or service offerings

Remember though, these advantages are not inherently guaranteed, and depend upon the overall success of the VI venture. Furthermore, many of these advantages can be attained without taking a full integration approach. A number of quasi or “virtual” vertical integration options are available to companies today, thanks to technology that wasn’t around in the mid-twentieth century heyday of VI.

 

Alternatives to Full Vertical Integration

When vertical integration efforts fail to deliver, the companies concerned need only to look internally in many cases to find the root cause of the troubles. It’s not unusual to find that the management team has gone ahead without sufficiently analysing the risks.

 

Investments Quote by Donald Trump

 

It’s really very easy to over-integrate, but that’s a problem that can sometimes be avoided by choosing alternative paths to integration—paths which don’t necessarily involve mergers and acquisitions. Quasi integration for example, can be achieved in some cases by forming strategic alliances or even joint ventures with companies in upstream or downstream segments of the supply chain.

 

Asset Ownership as an Alternative to Vertical Integration

Another possibility, particularly for companies that require manufactured components, is to contract with external partners while maintaining ownership of manufacturing assets such as specialized tools, jigs, dies, moulds and patterns. This type of arrangement allows the asset owner to exercise considerable control over the contractor while also helping to guard against exploitative practices.

 

Forward integration can also be implemented through ownership of assets, although the arrangement works a little differently.

 

If you were to forward integrate using this approach, you would likely maintain control over your partners by ownership of intellectual property, namely your brand. You might recognise this integration method as franchising, a practice which many large brand owners (like McDonalds for example) have successfully utilised for years.

 

All in all, there are many more possibilities available today for companies wishing to vertically integrate without the massive capital requirements of acquisition.

 

The Internet has made it possible to build relationships and links between companies that simply weren’t possible in earlier eras. The use of long-term contractual agreements for example, can deliver many of the benefits of true vertical integration, and can be closely monitored and managed with help from online enterprise technology.

 

5 Questions to Ask Before Choosing Vertical Integration

 

Real Questions quote by Charles Earnes

 

If your company is planning to join the swelling ranks of 21st century vertical integrators, it will pay to be mindful of the points made in this article so far. However, to help you evaluate the pros and cons of vertical integration, be sure to ask (and answer) the following five questions with the help of your executive colleagues.

1) Will our company save money over the long term by controlling more of our supply chain?

2) Will controlling more of the value chain make our company’s operations more efficient?

3) Will we gain a greater advantage over our competitors if we vertically integrate?

4) Are any of our competitors vertically integrated? If so, what benefits do they appear to receive?

5) Will vertical integration help our enterprise to expand geographically?

 

Other Things to Consider Before Deciding

 

Antitrust Laws Quote by Isabel Paterson

 

If answering the questions above leaves you with the sense that vertical integration could be good for your organisation, move on to pursue the following areas of investigation:

  • Does vertical integration make sense as a growth strategy for your company?
  • Where else in your industry is vertical integration evident?
  • What labour issues might your company encounter if you decide to vertically integrate?
  • Is a potential merger or acquisition likely to threaten competition enough to create anti-trust issues?

Remember also to carefully compare the potential ROI from a VI strategy against alternative growth options. Ask yourself and your fellow decision-makers if diversification will jeopardise performance in your current core areas of competence. If you are planning to forward integrate into direct selling to consumers, you should also evaluate the risk of a sales decline in your existing channels.

 

Getting Help With the Decision Process

It’s understandable, with supply chains extending across the globe, why more companies are seeking the stability and security of VI through ownership, but it’s a decision often made more on the basis of gut feeling and survival instincts than diligent and objective thought processes.

That’s why it can help a great deal to engage external help in deciding whether a vertical restructure is the right strategy for your enterprise. Specialist supply chain consulting firms like Logistics Bureau have experts in place who specialise in helping companies rationalise and restructure their supply chains.

 

These experts bring the experience of many completed integration projects, and the tools and models to help you assess the risks and opportunities vertical integration presents to your company.

 

If you’d like to talk to a consultant about rationalising your supply chain operations, or need some help to prepare for a merger or acquisition, contact us online or by phone at one of our offices in Australia or Southeast Asia.

 

Contact Rob O'Byrne
Best Regards,
Rob O’Byrne
Email: [email protected]
Phone: +61 417 417 307