Building a successful company hinges on finding the best avenues to ensure quality, keep costs affordable, and make sure the supply chain works without a hitch.
For some companies (like Nike and Gap), that means outsourcing part of the supply chain to other organizations. Others (like Zara and Apple) are more successful when they own parts, or all, of the supply chain management.
In economic terms, companies that outsource the supply chain are not vertically integrated. And organizations that keep two or more parts of the supply chain in-house are vertically integrated.
This article will cover everything you need to know about vertical integration, including the three types of vertical integration, the pros and cons, and expert tips when making the transition.
What is vertical integration?
Vertical integration is a business strategy where a company owns two or more stages of its supply chain, such as manufacturing and distribution.
Integrating vertically minimizes reliance on external companies, reduces costs, and offers the flexibility to respond faster to customer demands and market trends.
How vertical integration works
Say a retail fashion brand handles the design and marketing of its clothing but is outsourcing the manufacturing of fabrics, the assembly of garments, and the distribution to retail stores.
If the fashion brand were working toward full vertical integration, it would stop outsourcing to other companies and take direct ownership of fabric manufacturing, assembly, and distribution.
To illustrate, here’s a step-by-step of how this fashion brand’s vertical integration might work:
- Identify integration points. The company would first conduct an analysis to determine how much they are spending by outsourcing manufacturing, assembly, and distribution. They’d need to consider other factors that affect business, such as sustainability and ethical business practices. Then, they’d determine how to cut costs and improve business by bringing operations internally.
- Evaluate acquisition or establishment. The fashion brand would decide whether it makes more sense to acquire a company they’re already working with (e.g., buying the logistics company they rely on now), or if they need to establish a new branch of their company (e.g., build logistics internally).
- Integrate and streamline operations. Once this retail brand controls the new stages of the supply chain, it must integrate it into its existing operations. This means aligning operational practices, IT systems, and more. It also includes streamlining operations to reduce inefficiencies or produce higher-quality products.
- Coordinate and adjust. Vertical integration done right will allow this brand full control of its supply chain. Now, they can manage inventory, synchronize supply with demand, and adjust production schedules to respond to market changes—all at a reduced price.
Types of vertical integration
There are three main types of vertical integration: backward, forward, and balanced integration. To learn the difference between the three, it’s essential to first review the basics of the supply chain and the river metaphor.
The "supply chain river" encompasses all elements involved in the production and delivery of a product. It starts with sourcing raw materials and the early stages of production (upstream) and progresses through tasks such as distribution, retail, and the final sale of the product to the consumer (downstream).
But, there are more than one type of vertical integration.
Backward integration
Backward integration is when a company expands its ownership of operations upstream in the supply chain. In other words, the company will either acquire businesses that were once its raw material suppliers, or move sourcing and production of its products in-house.
For example, say you own a clothing store, and you source materials and have clothing assembled in a factory in Vietnam. If you wanted to adopt backward integration, you’d halt operations in Vietnam and make sourcing materials and clothing assembly part of your company umbrella.
As you can imagine, backward integration is capital-intensive. But, in the long run, it may end up cutting costs. It also gives you control over your material quality, sustainability, and labor and manufacturing practices.
Forward integration
Forward integration is when a company moves further downstream of the supply chain (toward the final sale of a finished product to a customer). In forward integration, a company would own distribution and/or retail to gain greater control over how consumers acquire products.
Say you own a small jewelry store and typically sell your products on multiple channels like Etsy or Amazon. You’re leaving a portion of your profits on the table in exchange for access to the Etsy or Amazon marketplace.
Forward integration of your business would involve setting up your own ecommerce store on a platform like Shopify and taking ownership of the sales, distribution, and marketing of your products.
The advantages of forward vertical integration include control over the customer experience, smooth shipping, and higher profit margins.
Balanced integration
Balanced integration is when a company practices both forward and backward integration. In other words, the company owns the full supply chain, from sourcing materials and design to its retail stores and distribution.
Imagine you own a mid-sized coffee company, which you currently sell through third-party retailers and distributors. To adopt balanced vertical integration, you both source your coffee beans directly by owning or partnering with coffee farms (backward integration) and develop your own chain of coffee shops to sell your product directly to consumers (forward integration).
Balanced vertical integration is less common than forward and backward vertical integration and requires strategic planning and robust capital investment. The advantage is you control everything from your materials to sales processes.
Real examples of vertical integration
1. Backward vertical integration example: Zara
Zara is an example of backward vertical integration. The fashion brand owns a large portion of its production process and has its own manufacturing plants in Spain. With its own backward vertically integrated operation, Zara controls its quality and speed of production. This translates into higher quality products at lower prices for customers.
2. Forward vertical integration example: Amazon + Whole Foods
Amazon's acquisition of Whole Foods is a prime example of forward vertical integration. By purchasing the grocery chain, Amazon extended its reach into the physical retail space.
This move allowed Amazon to integrate its extensive e-commerce logistics with Whole Foods' brick-and-mortar stores, enhancing its distribution capabilities and providing a seamless online-to-offline shopping experience for customers.
3. Balanced vertical integration example: Apple
Apple is a famous example of balanced vertical integration. It designs its own hardware and software, manufactures key components, and sells its products through its own retail stores. This ensures a seamless customer experience and control over the entire supply chain.
Pros and cons of vertical integration
Is vertical integration the right next move for your business? The answer: it depends. Here are the pros and cons of adopting vertical integration to help you understand if you’re ready and if it’s a lucrative way to grow your company.
Pros of vertical integration
- Increased control. Greater oversight over your entire supply chain ensures quality and consistency.
- Cost savings. Eliminates the middleman, reducing costs associated with third-party suppliers.
- Improved coordination. Streamlines processes and reduces delays by integrating operations.
- Competitive advantage. Unique control over the supply chain can lead to a stronger market position.
- Better customer experience. Direct control over distribution channels can lead to improved service and satisfaction.
Cons of vertical integration
- High initial investment. Significant capital is required to acquire or develop new stages of the supply chain.
- Complex management. Increased complexity in managing a broader range of operations.
- Reduced flexibility. Tied to in-house processes and resources, making it harder to adapt to market changes.
- Potential for inefficiency. Lack of specialization can lead to inefficiencies in areas outside core competencies.
- Regulatory risks. Greater scrutiny from regulators concerned about anti-competitive practices.
Vertical vs. horizontal integration
Quick review: Vertical integration is when a company acquires or merges with other companies at different stages of its supply chain within a vertical market. The aim of vertical integration is to control more aspects of the production process, improve coordination, reduce costs, and ensure consistent quality.
So, what is horizontal integration?
Horizontal integration is where a company acquires or merges with other companies at the same stage of the supply chain. The aim of horizontal integration is to increase market share, reduce competition, and achieve economies of scale.
Meta’s journey is an example of horizontal integration. Facebook, Instagram, and WhatsApp all operate within the social media and communication sector. Facebook acquired Instagram and WhatsApp to grow Meta, offer more features, and become a dominant social media company.
Tips for implementing a vertical integration strategy
Who better to help you with successful vertical integration than supply chain experts writing about vertical integration? Here are the top tips for successful vertical integration.
1. Conduct a thorough cost-benefit analysis
In a 2023 NetSuite article, Abby Jenkins, a product marketing manager for supply chain products, explains a critical first step in successful vertical integration: cost-benefit analysis.
She says that a detailed cost-benefit analysis helps businesses determine the financial feasibility of vertical integration.
A cost-benefit analysis involves evaluating both direct and indirect costs, tangible and intangible benefits, and potential long-term impacts. When you understand all of these factors, you can make informed decisions about your investment.
2. Develop a clear strategic vision
Moving forward with vertical integration without a clear strategic vision is a recipe for disaster.
In a 2023 Retailisation article, founder, supply chain simplifier, and change agent Jasper Zeelenberg explains how a clear strategic vision is crucial for successful vertical integration.
Zeelenberg explains the vision for vertical integration should align with the company's long-term goals and provide a roadmap for integrating new supply chain stages. A clear vision helps with setting measurable objectives and guiding decision-making processes.
3. Build strong relationships with suppliers
Zeelenberg offers additional insight into the topic in the same Retailisation article. He provides the perfect example of how building strong relationships with suppliers is integral to success.
He says H&M is in a unique position because it doesn’t fully own its supply chain processes like Zara. Instead, H&M outsources its supply processes to around 850 independent suppliers.
As such, H&M maintains strong control and oversight through close, collaborative relationships with these suppliers (supported by real-time data exchange and digitization).
Positive relationships and close collaboration help H&M maintain flexibility, control quality, and respond quickly to market demands.
4. Invest in technology and infrastructure
Insight from McKinsey on successful vertical integration doesn’t disappoint. In the article, “The tech transformation imperative in retail,” McKinsey advises investing in modern tech and infrastructure to support vertical integration.
This includes adopting advanced IT systems for real-time data management, automating processes, and integrating e-commerce with retail operations.
5. Implement comprehensive risk management
In the same analysis, McKinsey offers another critical tip in guiding a smooth vertical integration transition—implementing a comprehensive risk management strategy.
Risk management starts with identifying and documenting potential risks across the entire supply chain—from suppliers to distribution nodes. It also includes planning for adverse scenarios, conducting stress tests, and establishing governance structures for continuous risk monitoring.
Use vertical integration to grow your ecommerce business
The most common examples of vertical integration come from huge companies with complex operations. But, the truth is, a company of any size can integrate vertically. For example, say you own a small, but growing, brick-and-mortar retail store.
You may rely on your local farmers market and foot traffic to your boutique for local sales and marketplaces like Amazon, Etsy, and Depop for ecommerce sales.
But, here’s the thing. Those marketplaces take a cut of every ecommerce sale you make. If you want to boost efficiency, reduce costs, and own your own ecommerce operations, you can vertically integrate and create your own ecommerce website with Shopify.
Vertical integration FAQ
What is vertical integration, and an example?
Vertical integration is a business strategy where a company takes control of multiple stages of the production and distribution process of its products. For example, Apple is vertically integrated, designing its hardware and software and selling products directly to consumers through its own retail stores. This allows Apple to control quality, costs, and the overall customer experience more effectively.
What is vertical integration vs. horizontal integration?
Horizontal and vertical integration are different. Vertical integration involves a company expanding control over different stages of production and distribution within the same industry, such as a manufacturer acquiring its supplier. Horizontal integration, on the other hand, occurs when a company acquires or merges with other companies at the same level in the industry, like a car manufacturer buying another car manufacturer.
What are the 4 stages of vertical integration?
The four stages of vertical integration are:
- Identification. Determining which parts of the supply chain to control, from raw materials to customer interactions.
- Acquisition or development. Purchasing existing businesses or building new facilities to control more of the supply chain.
- Integration. Merging acquired or newly developed operations with existing business processes for seamless functionality.
- Optimization. Streamlining integrated operations to enhance efficiency, reduce costs, and improve overall performance.
What is an example of the vertical integration of Disney?
Disney has full control over its entertainment production and distribution chain, making it the perfect example of a vertically integrated company. Disney produces its films and TV shows and also distributes them through its own networks like ABC and streaming platforms such as Disney+. What’s more, Disney also owns its theme parks and retail stores.
