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Vertical Integration and Diversification Strategies

Updated on June 2, 2017
Marc D Williams profile image

Marc is a business, marketing, & sales expert of TMTSI. He has an MSM in Project Management; currently seeking a DM in Executive Leadership

Vertical integration is anathema to firms building manageable and active departments internally to improve profits and increase market share. Investopedia calls vertical integration “…a strategy where a [firm] expands its business operations into different steps on the same production path, such as when a manufacturer owns its supplier and distributor.” (Investopedia, 2017) Vertical integration helps firms minimize expenses and advance proficiencies in several of their processes. Vertical integration also helps firms reduce the probability of having limited access to critical elements, possibly maintained by a monopoly-type supplier. Firms gain economies of scale by increasing their buying power and consolidation of possible management and other processes. With vertical integration, firms control access to rare physical resources or resources developed by other firms; plus, control the access to the inputs towards the firm. When a firm utilizes vertically integrates, they no longer have a dependence on their suppliers and avoid labor disputes that can cause supply chain disruptions. Vertical integration happens when firms, such as Ticketmaster and Live Nation, merge to form a vertically integrated entertainment company that produces shows and sells event tickets; plus, manage and represent the artists involved in the shows. Vertical integration also happens when Apple, Inc., the resolute of vertical integration, self-manufactures custom chips for its products. Before their vertical integration, Apple, Inc. implanted Samsung, an industry competitor, manufactured chips in their products. Another example of vertical integration, from another industry, is a mortgage firm that originates and services its mortgages. This type of mortgage firm vertically integrated into a loan-servicing mortgage firm.

These firms, along with many other firms in different industries, are vertically integrating to reduce costs and improve their efficiencies; such as transportation costs and reducing turnaround time. The vertical integration happening across industries is taking place in two forms of integration: forward and backward. When a firm performs forward integration, they are controlling from the beginning of the supply chain stages. The firm’s business activities expand to direct distribution and supply control of the firm’s products. Investopedia explains forward integration as a “…operational strategy implemented by a [firm] that wants to increase control over its suppliers, manufacturers, or distributors so that it can increase its market power.” (Investopedia, 2017) Ticketmaster and Live Nation vertical integration is forward integration for Ticketmaster and backward integration for Live Nation. Apple, Inc.’s vertical integration is also another example of forward integration because they have company-owned retail stores exclusively selling their products. Only very few select big-box retailers, like Best Buy and Walmart, sells Apple products, but Apple controls the distribution and costs to consumers. The realization of economies of scale and the desire for increase industry market share is viable reasons for firms to perform forward integration. Firms need to understand their costs and scope strategy before attempting forward integration and ensure no compromise of their core competencies. If firms want to have successful forward integration, the firms should perform acquisitions over firms that were previous customers.

In backward integration, a firm operating at the end of a supply chain begins to take on activities at the beginning of the supply chain. Another industry view of backward integration is when a firm moves backward in its supply chain. Firms pursue backward integration when they seek to improve cost savings and efficiency. An example of cost saving in backward integration is cutting transportation costs and improving efficiency is increasing the profit margins by making the firm more competitive. As with forward integration, backward integration is a difficult strategy to implement into the firm’s structure because it is difficult to reverse-engineer; making it very expensive to firms, expending large amounts of capital, when not integrated successfully. Firms will lose their flexibility of following consumer trends to remain competitive. Also, if the CEO, or executive leadership, lose focus on the firm’s mission, the backward integration can cause disruptions in the firm’s organizational culture. Netflix successfully enacted backward integration when they started manufacturing movie content in addition to being a movie distributor. As mentioned earlier, Apple, Inc. performed backward vertical integration when they manufactured their microchips for their iPhones and iPads. Amazon.com was another example of a firm performing backward vertical integration when they became a book retailer and a book publisher. Amazon.com’s vertical integration reduced its costs of producing and procuring books. Starbucks is another good example of backward vertical integration. Starbucks has multiple suppliers and vendors for their coffee beans and personalized items within their stores. After purchasing a Chinese coffee farm, Starbucks can eliminate their coffee bean supplier and control cost to the supply chain process and ensures there is always a supply of coffee beans to their firm. Each one of these firms performing backward integration was a consumer of raw materials that it acquired from a supplier or vendor. The firms determine there is an opportunity to integrate, set up its facility, or bought a competitor, to have more reliable, cost-effective, sustainability of its input supply.

Vertical integration, whether forward or backward is a risky strategy for any firm to undertake because it is difficult to re-engineer, very complex, and highly expensive operations. When firms vertically integrate, they should do so to protect, or create, value because the high are detrimental to the firm. Stuckey described four (4) valid reasons why a firm should vertically integrate into their market in his article to McKinsley Quarterly. The reasons are if: (1) the market is too risky and unreliable, (2) firms in adjacent stages of the industry chain have more market power than firms in the vertically integrating firm, (3) the vertical integration would create or exploit market power by raising entry barriers or allowing price discrimination across customer segments, or (4) the market is young, and the firm must forward integrate to develop a market, or the market is declining and independents are pulling out of adjacent stages. (Stuckey, 1993) While Stuckey’s reasons for vertically integrating are important reasons, firms also have internal motives for vertical integration without considering Stuckey’s reasons. Stuckey listed these reasons as a better risk management tool for firm’s management to perform to increase the probability of the firm’s success with the vertical integration. Firms are vertically integrating for more internal reasons as controlling cost and gaining more control over production or distribution processes; as mentioned earlier. Firms are gaining an advantage over their product presentation, but more importantly the prices to their consumer market. Firms are eliminating an extra cost step in the supply chain process to remove cost increases, to optimize resource utilization, and avoid cost wastes.

All firms have their reasons for vertically integrating, even though most have similar goals towards their vertical integration. Their vertical integration combines with a diversification strategy embedded in the vertical integration. A firm’s diversification strategy is implemented to minimize the risk of major losses to the firm. Some firm’s such as AT&T use a concentric diversification strategy to attempt their vertical integration with Time Warner. Concentric diversification is a strategy where a firm “…acquires or creates new products or services to reach more consumers. These new products and services are closely related to the company’s existing products and services.” (Lister, 2017) AT&T’s attempts to vertical integrate with Time Warner is best for them to achieve a competitive advantage in the telecommunications industry by achieving business synergy through the integration. Currently, the firm has telephone lines and cell phone towers, but the acquisition of a cable television firm will increase their product distribution and move the firm into new market areas. A concentric diversification strategy will not only increase product distribution but improve AT&T’s ability to improve in product development. Acquiring a cable television company, along with their other telecommunications products, will ensure the firm is fulfilling the needs, or demands of their given markets; plus, all new acquired Time Warne markets. AT&T is using the concentric diversification strategy in their vertical integration to increase their market share to give them a larger presence in the very competitive telecommunications industry. The acquisition of Time Warner gives AT&T a wider market presence in the telecommunications industry; which defines better health with their concentric diversification vertical integration. Sometimes a concentric diversification can cross into horizontal diversification to where the firm is simply developing, or acquire, new products unrelated to their core business, but appeal to their current consumer markets. If the firm’s focus on just a horizontal diversification strategy, it is considered less risky to undertake within vertical integration.

Firms not using the concentric diversification strategy in their vertical integration instead are using a conglomerate diversification strategy to gain a competitive advantage in their industries. These firms are logically adding non-related products into the firm’s current existing business operations. General Electric is a firm that successfully used the conglomerate diversification strategy by launching as a lighting firm but acquiring other firms that produced products, such as radios, refrigerators, wind turbines, and jet engines. What were the competitive advantage motives behind GE’s conglomerate diversification? GE was possibly suffering from declining annual sales and profits in a slow-moving market after saturation. GE was also possible seeking financial synergy with firms that had creditable capital and competent management team to have success in the new industries. GE capitalize on the conglomerate diversification strategy to remain a market leader in their relevant industries as well as remain the only firm to remain on the Dow Jones Industrial Average; from the original twelve (12).

Vertical integration and the diversification strategies used within are creating the competitive advantages the firms are desiring to increase market share over their competitors. There are firms operating in markets that have scarce resources, so the integration and diversification are key to simply survival. Firms are creating differentiation amongst the markets by developing access to more distribution resources, processes, and production inputs to increase the distinction. As Grant stated, vertical integration is “…beneficial because it allowed superior coordination and reduced risk…” (Grant, 2016) to firms seeking superiority, while reducing risk, in their markets.

REFERENCES

Grant, Robert M. (2016). Contemporary Strategy Analysis. Ninth Edition. Pearson. Retrieved from Colorado Technical University Virtual Campus, MGMT824-1702C-01: https://campus.ctuonline.edu

Investopedia (2017). Vertical Integration. Investopedia.com. Available at http://www.investopedia.com/terms/v/verticalintegration.asp

Kokemuller, N. (2017) The Advantages of a Vertical Integration Strategy. Heart Newspapers, LLC: Houston Chronicle. Available at http://smallbusiness.chron.com/advantages-vertical-integration-strategy-20987.html

Lister, J. (2017). What Are the Benefits of Concentric Diversification? Heart Newspapers, LLC: Houston Chronicle. Available at http://smallbusiness.chron.com/benefits-concentric-diversification-36784.html

Simonetti, B. (2017). Examples of Backward Vertical Integration Strategies. Heart Newspapers, LLC: Houston Chronicle. Available at http://smallbusiness.chron.com/examples-backward-vertical-integration-strategies-14703.html

Stuckey, J. & White, D. (1993) When and when not to vertically integrate. McKinsley Quarterly. Available at http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/when-and-when-not-to-vertically-integrate

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