What is vertical integration and how does it work?

The term “vertical integration” sounds like a business buzzword that gets overused in meetings and emails but ultimately offers little value.

In fact, adopting a vertically integrated strategy can help your company take control of its supply chains and reduce the risk of disruption.

Here’s how.

Here’s what we’ll cover

What is vertical integration?

Vertical integration happens when your company takes ownership of two (or more) steps in the supply chain.

Consider an example: you’re a business that manufactures specialised components for the automotive industry.

Ensuring components are produced on schedule requires a steady supply of raw materials while making sure end products get to their destination requires reliable distribution.

If your material suppliers experience a sudden shortage, or distributors face a staffing crisis, you may not be able to produce or deliver your products, leading to both revenue loss and reputation damage.

Taking ownership of your material supply or product distribution creates vertical integration since the business now controls at least two steps in the supply chain.

How does vertical integration work?

Your business has 2 choices for vertical integration: build or buy.

In a build scenario, your company might create its own distribution centre or build a processing plant to handle raw materials.

In a buy approach, you purchase or merge with existing businesses to gain control of steps in the supply chain.

These businesses may already be part of your supply chain or may be new companies that offer advantages over your current supply chain partners.

Worth noting? There’s no “right” way to achieve vertical integration.

What works for one company may not work for another—the steps you choose to control and the build or buy choice you make depend on your current business targets, existing market demand, and future strategic goals.

Why vertical integration happens

Vertical integration helps your company take more control over supply chain challenges.

As costs related to labour, shipping, and compliance rise, materials suppliers must raise their prices to remain profitable.

Vertical integration offers a way for companies to take direct control of costly or time-consuming aspects of their supply chain.

In addition, vertical integration allows your business to more tightly integrate processes across multiple supply chain steps.

For example, if you own both materials suppliers and the means of production, you can know exactly how much material you have, when it will be processed, and when it will arrive on-site at your processing plant.

Common types of vertical integration

There are four common types of vertical integration: forward, backward, balanced, and disintermediation.

Here’s a look at each in more detail.

Forward

Forward integration refers to building or buying downstream assets in the supply chain process.

In other words, you’re taking control of businesses or providers that are closer to the customer.

If you’re a manufacturing firm, this could mean building your own distribution channel or partnering with retailers directly to sell your products.

One advantage of forward integration is agility—you have greater control over where your products are going, when they will arrive, and where they’re being sold.

Backward

Backward integration sees your business moving farther upstream in the supply chain.

In this case, your manufacturing firm either builds a new raw materials processing plant or acquires one that already exists.

One of the key benefits of backward integration is quality control—since you control the supply, you can ensure that parts and materials are up to your standards.

Balanced

Balanced integration has your company moving both upstream and downstream across the supply chain.

For example, you might purchase from both a materials company and a distribution provider, which, in turn, gives you full control right up until the retail sales phase.

Disintermediation

Disintermediation is simply the removal of “middlemen” from the supply chain process.

The most common form of disintermediation is a manufacturing company skipping both the distribution and retail steps of the supply chain to sell directly to customers.

This can help your business foster closer relationships with consumers and also comes with the benefits of reduced costs and improved efficiencies.

For example, removing the distribution means you no longer have to pay a company for this service—while you do have to take on the task itself, you gain visibility into the process.

Advantages of vertical integration

Choosing a vertical integration strategy offers multiple benefits for businesses, including:

Control

Buying or building an upstream or downstream supply chain component gives you complete control over that component.

You know exactly what things cost, and how long processes will take, and you can identify key areas for process improvements.

Visibility

Owning more steps in the supply chain provides increased visibility.

This helps reduce the risk of unexpected delays or issues with product quality.

If you take on the role of materials supplier, you decide where materials are obtained, how they’re evaluated, and which ones make the cut.

Efficiency

Inter-company communication naturally creates inefficiencies.

Teams need to wait for responses from their counterparts, which is especially problematic if businesses and suppliers are in different time zones.

Changes in organisational structure can also result in challenges if familiar points of contact are abruptly replaced or if supply communication processes change.

Taking ownership of suppliers or distributors means communication falls entirely under your company’s purview, giving you complete control over how, when, and where communication happens.

Potential pitfalls of vertical integration

Vertical integration also comes with potential pitfalls, such as:

Cost

It’s not cheap to build or buy new supply chain components.

This is especially true if you operate in a high-demand industry—suppliers may be able to charge a significant premium for selling, or take on multiple, competing offers.

The rising costs of materials and labour, meanwhile, can make building a new facility an expensive endeavour.

Time

There’s also a significant time investment required to take ownership of upstream or downstream supply chain components.

This can include the time required to purchase a company and transfer ownership, or the time needed to build a new facility from scratch.

Depending on the approach you take and current market conditions, this could take months.

Complexity

Complexity is another challenge.

While vertical integration brings multiple supply chain processes under your control, it also means you’re responsible for managing all these processes simultaneously.

From onboarding new staff to testing new processes, integration isn’t easy.

In many cases, these pitfalls can be mitigated with solid pre-integration planning.

By taking the time to sit down with company stakeholders, leaders, and staff before integration occurs, your company can pinpoint potential problem areas.

For example, speaking to your IT team might reveal that a potential materials supplier buyout could be problematic because they use legacy technology solutions that aren’t compatible with cloud-based or edge computing systems.

This knowledge helps prepare companies for greater cost investment and teams for more time and effort getting new company systems up to speed.

The different degrees of vertical integration

Vertical integration doesn’t have to be all-or-nothing.

Instead, it’s a matter of degrees.

Full integration

In a full integration scenario, your company buys or builds the assets necessary to control at least one other step in your supply chain.

This term can also refer to businesses that take complete control of their supply chain from start to finish.

Partial integration

Partial or quasi-integration happens when your business purchases a minority stake in a supply chain partner’s business or undertakes a joint venture with the supply chain partner to streamline operations.

While this option offers less control, it also lowers total risk and decreases overall complexity.

Long-term contracts

Another option is signing long-term contracts with suppliers to help increase predictability and ensure your materials or deliveries are prioritised.

Short-term contracts

Finally, you might choose short-term or “spot” contracts to meet specific supply chain needs.

For example, if your current materials supplier experiences a sudden shortage, you might draft a short-term contract with another company to bridge the gap.

Examples of vertical integration

So, what does vertical integration look like in practice?

E-commerce giant Amazon offers an illustration of integration in action.

When the company moved from selling books online to offering a wide range of consumer products, it used third-party logistics and delivery services.

While this helped limit overall costs, it also caused problems for consumers when packages didn’t arrive on time or were difficult to track.

Given the company’s focus on its Prime membership and the speedy shipping services it offers, this distribution disconnect was problematic.

To solve the problem, Amazon moved packaging, logistics, and delivery in-house, building massive warehouses for this purpose and purchasing fleets of Amazon-branded trucks.

While the initial cash outlay was significant, the control and consistency offered by vertical integration helped earn the company a reputation for fast and reliable delivery.

Horizontal vs. vertical integration

Moving up or down the supply chain isn’t the only option for integration.

Your business can also move sideways, which is known as horizontal integration.

In practice, moving sideways means acquiring or merging with another company that occupies the same level in the supply chain.

For example, if you run a retail business you might choose to partner with or buy out another retail brand that offers similar products.

Or, you might choose to acquire a retail brand that sells products in a similar but distinct market to help capture a larger market share.

Steps to get started with vertical integration

If you’re considering vertical integration, four steps can help you get started.

1. Take the temperature

Before taking on any vertical integration project, it’s important to take the temperature in the room.

This means talking to staff, stakeholders, and business leaders about overall interest in integration, along with what they see as potential benefits or pitfalls.

2. Plan, plan, plan

Planning is next. Given the complexity of integration efforts, more time spent planning can help reduce the amount of time spent navigating integration challenges.

3. Pinpoint potential challenges

Speaking of challenges, it’s also worth brainstorming about potential pitfalls before kicking off the integration process.

By identifying these issues ahead of time, you can take steps to proactively mediate problems rather than reacting as they occur.

4. Ensure your IT infrastructure is ready

Last but not least?

Make sure your IT infrastructure is ready for integration.

For example, if you’re still relying on legacy tools and technologies for primary business processes, it’s worth modernising systems first.

How ERP software helps manage vertical integration

The right ERP software tools can help streamline the process of vertical integration.

Let’s say your business decides on a balanced integration strategy.

You’re a manufacturer, so you acquire both a materials supplier and a distribution company, which, in theory, gives you significant control over your supply chain.

The challenge?

Your new supplier and distributor both have their own sets of technology infrastructure, which may not play nicely with your systems and solutions.

If your teams can’t quickly and effectively address this disconnect, the results can range from lost revenue to damaged reputation if goods aren’t produced, packaged, and shipped on time.

Cloud-based ERP solutions—such as Sage Intacct—help streamline the process of creating consistent operations across multiple business units.

By integrating a single ERP system across all levels of your owned supply chain, you gain the end-to-end visibility required to make decisions and take actions that boost your bottom line.

Consider the case of a materials supplier you own that encounters issues with changing local government regulations.

While materials will still be acquired and shipped, the process will take twice as long as normal.

Without end-to-end ERP visibility, this delay data isn’t immediately accessible, which in turn can lead to production performance problems as factories wait for goods that won’t arrive for days or weeks.

With on-demand, connected access to relevant materials data, however, your company can pivot to another product during the delay, and inform customers about what’s happening.

This keeps production lines running and lets your company keep distribution providers and customers in the loop.

Final thoughts on vertical integration

Vertical integration offers a way for your company to improve visibility by taking ownership of supply chain levels above or below your own.

There’s no single “right way” to vertically integrate your operations.

There are, however, common ways to avoid potential pitfalls.

By taking the time to understand stakeholder and staff perspectives, create a detailed plan, prepare for potential problems, and implement infrastructure capable of providing end-to-end visibility, you’re better prepared to make the most of vertical integration.