Vertical and horizontal integration is a significant factor in a firm’s strategy, since it can influence its costs, differentiation, and overall positioning within an industry.
Vertical integration refers to the value chain in an industry. The graphic above shows a manufacturing example, with five simple steps (from raw materials, to component manufacturing, to assembly, to distribution, to the end user). If a firm is currently active in the assembly segment of the value chain, vertical integration could either go backward (or upstream) buying a component manufacturer. Or it could go forward (downstream), leading the firm to buy a distributor in the industry.
Vertical integration can have a number of benefits:
- Control over assets in various parts of the value chain can create barriers to entry.
- Improvement of supply chain coordination, transportation costs, etc.
- Increased opportunities to differentiate, given that better coordination and increase scale may allow a firm to make specialized investments.
- There is an argument that a firm can also capture upstream or downstream profit margins, although the capital markets theory will state that owners of the firm may be better off by owning shares of various independent firms.
- Vertical integration can also lead to the development of additional core competencies.
Vertical integration will make sense if there are strategic similarities between vertically related activities, if there are tax or regulatory issues that make contractual transactions difficult or expensive, or if joint ownership will allow for specific investments in capabilities and assets that may not happen in an independent set up.
Vertical integration can, however, also have significant drawbacks:
- The lack of supplier competition can lead to lower efficiencies and higher costs.
- Decreased flexibility if a firm is tied in to specific investments made in upstream operations.
- Capacity issues – an operation may be asked to build up sufficient capacity to ensure downstream operations don’t get interrupted.
- Increased overhead, management and coordination costs.
If the quantity required from a supplier is quite minimal (less than minimum efficient scale), if a product is a widely available commodity, if core competencies between firms are radically different, vertical integration probably doesn’t make sense. Vertical integration also can have the significant drawback that it may put a firm in competition with another company it needs to cooperate with. If you need various distributors for your product, and you then buy one of those distributors, the others will start to look at you as a competitor! In these circumstances, there are a number of alternatives that firms may want to consider: Long-term contractual arrangements, franchise agreement, or joint ventures may all be more advantageous.
Horizontal integration refers to the acquisition of an operation at the same level of the value chain (in the graphic above, a firm who owns one assembly plant buying another assembly plant). This can be achieved either through internal/organic growth or through an M&A deal. And a firm can expand horizontally into a related business (e.g. acquiring more radio stations if you already own a few) or other business (e.g. acquiring a few television stations).
The benefits of horizontal integration:
- Economies of scale, through e.g. geographic expansion.
- Economies of scope, e.g. by sharing resources and creating synergies in manufacturing.
- Increase negotiating power over suppliers or distributors
As always, there are drawbacks as well as benefits. The negative aspects of horizontal integration include:
- Potential management, complexity and coordination costs may outweigh the benefits.
- There could potentially be anti-trust and legal issues, if a firm’s market share becomes too large.