Vertical N Horizontal Integration

Vertical Integration
The degree to which a firm owns its upstream suppliers and its downstream buyers is
referred to as vertical integration. Because it can have a significant impact on a
business unit's position in its industry with respect to cost, differentiation, and other
strategic issues, the vertical scope of the firm is an important consideration in corporate
strategy.
Expansion of activities downstream is referred to as forward integration, and expansion

upstream is referred to as backward integration.
The concept of vertical integration can be visualized using the value chain. Consider a
firm whose products are made via an assembly process. Such a firm may consider
backward integrating into intermediate manufacturing or forward integrating into
distribution, as illustrated below:
Example of Backward and Forward Integration
No Integration Backward Integration Forward Integration
Raw Materials Raw Materials Raw Materials
Intermediate Intermediate Intermediate

Manufacturing Manufacturing Manufacturing
Assembly
Assembly Assembly
Distribution Distribution Distribution
End Customer End Customer End Customer
Two issues that should be considered when deciding whether to vertically integrate is
cost and control. The cost aspect depends on the cost of market transactions between
firms versus the cost of administering the same activities internally within a single firm.
The second issue is the impact of asset control, which can impact barriers to entry and
which can assure cooperation of key value-adding players.
The following benefits and drawbacks consider these issues.
Benefits of Vertical Integration
Vertical integration potentially offers the following advantages:
 Reduce transportation costs if common ownership results in closer geographic

proximity.
 Improve supply chain coordination.
 Provide more opportunities to differentiate by means of increased control over
inputs.
 Capture upstream or downstream profit margins.
 Increase entry barriers to potential competitors, for example, if the firm can gain
sole access to a scarce resource.
 Gain access to downstream distribution channels that otherwise would be
inaccessible.
 Facilitate investment in highly specialized assets in which upstream or
downstream players may be reluctant to invest.
 Lead to expansion of core competencies.
Drawbacks of Vertical Integration

While some of the benefits of vertical integration can be quite attractive to the firm, the
drawbacks may negate any potential gains. Vertical integration potentially has the
following disadvantages:
 Capacity balancing issues. For example, the firm may need to build excess
upstream capacity to ensure that its downstream operations have sufficient
supply under all demand conditions.
 Potentially higher costs due to low efficiencies resulting from lack of supplier
competition.
 Decreased flexibility due to previous upstream or downstream investments. (Note
however, that flexibility to coordinate vertically-related activities may increase.)
 Decreased ability to increase product variety if significant in-house development
is required.
 Developing new core competencies may compromise existing competencies.
 Increased bureaucratic costs.
Factors Favoring Vertical Integration
The following situational factors tend to favor vertical integration:
 Taxes and regulations on market transactions

 Obstacles to the formulation and monitoring of contracts.
 Strategic similarity between the vertically-related activities.
 Sufficiently large production quantities so that the firm can benefit from
economies of scale.
 Reluctance of other firms to make investments specific to the transaction.
Factors Against Vertical Integration
The following situational factors tend to make vertical integration less attractive:
 The quantity required from a supplier is much less than the minimum efficient
scale for producing the product.
 The product is a widely available commodity and its production cost decreases
significantly as cumulative quantity increases.
 The core competencies between the activities are very different.
 The vertically adjacent activities are in very different types of industries. For
example, manufacturing is very different from retailing.
 The addition of the new activity places the firm in competition with another player
with which it needs to cooperate. The firm then may be viewed as a competitor
rather than a partner
Alternatives to Vertical Integration
There are alternatives to vertical integration that may provide some of the same benefits
with fewer drawbacks. The following are a few of these alternatives for relationships
between vertically-related organizations:
 long-term explicit contracts

 franchise agreements
 joint ventures
 co-location of facilities
 implicit contracts (relying on firms' reputation)
Horizontal Integration
The acquisition of additional business activities at the same level of the value chain is
referred to as horizontal integration. This form of expansion contrasts with vertical
integration by which the firm expands into upstream or downstream activities. Horizontal
growth can be achieved by internal expansion or by external expansion
through mergers and acquisitions of firms offering similar products and services. A firm
may diversify by growing horizontally into unrelated businesses.
Some examples of horizontal integration include:
 The Standard Oil Company's acquisition of 40 refineries.

 An automobile manufacturer's acquisition of a sport utility vehicle manufacturer.
 A media company's ownership of radio, television, newspapers, books, and
magazines.
Advantages of Horizontal Integration
The following are some benefits sought by firms that horizontally integrate:
 Economies of scale - acheived by selling more of the same product, for example,
by geographic expansion.
 Economies of scope - achieved by sharing resources common to different
products. Commonly referred to as "synergies."
 Increased market power (over suppliers and downstream channel members)
 Reduction in the cost of international trade by operating factories in foreign
markets.
Sometimes benefits can be gained through customer perceptions of linkages between

products. For example, in some cases synergy can be achieved by using the same
brand name to promote multiple products. However, such extensions can have
drawbacks, as pointed out by Al Ries and Jack Trout in their marketing
classic,Positioning.
Pitfalls of Horizontal Integration
Horizontal integration by acquisition of a competitor will increase a firm's market share.

However, if the industry concentration increases significantly then anti-trust issues may
arise.
Aside from legal issues, another concern is whether the anticipated economic gains will
materialize. Before expanding the scope of the firm through horizontal integration,
management should be sure that the imagined benefits are real. Many blunders have
been made by firms that broadened their horizontal scope to achieve synergies that did
not exist, for example, computer hardware manufacturers who entered the software
business on the premise that there were synergies between hardware and software.
However, a connection between two products does not necessarily imply realizable
economies of scope.
Finally, even when the potential benefits of horizontal integration exist, they do not
materialize spontaneously. There must be an explicit horizontal strategy in place. Such
strategies generally do not arise from the bottom-up, but rather, must be formulated by
corporate management.

Vertical N Horizontal Integration

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What are some benefits of vertical integration?

What are some benefits of vertical integration?

What are some drawbacks of vertical integration?

What are some drawbacks of vertical integration?

Vertical Integration

Expansion of activities downstream is referred to as forward integration, and expansion

Example of Backward and Forward Integration

No Integration Backward Integration Forward Integration

Raw Materials Raw Materials Raw Materials

Intermediate Intermediate Intermediate

End Customer End Customer End Customer

The following benefits and drawbacks consider these issues.

Benefits of Vertical Integration

Vertical integration potentially offers the following advantages:

 Reduce transportation costs if common ownership results in closer geographic

Drawbacks of Vertical Integration

Factors Favoring Vertical Integration

The following situational factors tend to favor vertical integration:

 Taxes and regulations on market transactions

Factors Against Vertical Integration

 long-term explicit contracts

Some examples of horizontal integration include:

 The Standard Oil Company's acquisition of 40 refineries.

Advantages of Horizontal Integration

Sometimes benefits can be gained through customer perceptions of linkages between

Pitfalls of Horizontal Integration

Horizontal integration by acquisition of a competitor will increase a firm's market share.

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