The first main advantage is that by vertically integrating a company can reduce its production and distribution costs by linking together successive activities. This means that if a company can vertically integrate, say for example, with assembly and distribution then the cost will be cut, as the company won’t have to pay someone else to distribute the finished product. This can be beneficial in all stages of a products production. If a firm or company can secure reliable supplies of inputs or distribution outlets through vertical integration then it is able to remain competitive within the market sector. This is because the company is able to avoid transactions costs from outside suppliers/distributors as they are already integrated into that part of that process.
Not only does vertical integration promote greater efficiency in resource use but also typically forward integration can help secure a market. The greater efficiency comes from the company being able to lower operating costs by making savings from the production process by linking together technically related processes, for example, the casting and rolling operations in a steel mill. The closer matching of inventory and production requirements can also reduce Stockholding costs. Average costs will tend to fall thus lowering market price and increasing output of production to meet the demand for the lower market price.
The company can secure the market with forward integration because if a company has its own supplies of raw materials or distribution outlets it doesn’t have to rely on outsiders for help in the supplies or distribution for a product. The company will only have to pay for the cost price of these, for example, raw materials need mining and distributors need petrol, lorries etc. The company therefore can remain competitive by applying pressure on non-integrated rivals by depriving them of supplies or outlets. This is known as Price Squeezing. This is to effectively squeeze the profit margins of its competitors by raising their costs by charging them a higher price for raw materials than the price charged for there own company to use them. This can act as a barrier to entry to any potential new competitors as they are put off from entering the market because the cost of the supplies/distribution is too high and so would put them out of business before they had even started trading.
By vertically integrating a company can eliminate some or all of the purchasing and selling expenses in negotiating outside supply and advertising/selling contracts by internalising within the company. Financial economies may begin to accumulate through having more advantageous bulk-buying discounts; because once a company is vertically integrated it might need some of the same supplies it needed before it was integrated, in both parts of the production and not just in the single stage it once was. Also the financial economies may begin to grow as a company becomes vertically integrated because it is able to lower the cost of raising capital.
By vertically integrating a firm can increase the range of work that it carries out. For example a company that is supplying the raw materials needed and also manufacturing them is gaining valuable experience at both stage of a products production. This means that a company can become competent in both stages and so therefore cut costs by not using outside companies and suppliers. Once the company is satisfactorily supplying and manufacturing the raw material the reputation and core competencies will increase greatly.
Main disadvantages of Vertical Integration
There are quite a number of disadvantages too, why a company wouldn’t want to vertically integrate and so would rather stay as it is, at one operating stage in a products’ production or distribution.
The company may start to experience an increase in costs because of locked transfers of inputs, which cannot be unlocked, within the company this puts pressure on divisions that hold the costs in check while these transfers many make the company prejudiced to outside buying/selling opportunities.
As a growth strategy for a company vertical integration is a limited one. Vertical integration changes a variable cost, for example buying into a market, into a fixed investment cost, for instance self-supply, this in turn increases the company’s exposure to the risk of cyclical and secular downturns in demand. This means that if the demand for a product goes down then the whole firm will suffer because not only will the distribution be affected, as there isn’t as many finished products needed to meet the demand and so there isn’t, as many to transport, but assembly will suffer too as there is as many products to finish building. And so the company will see a big downturn in any profits gained for vertically integrating.
If a company becomes involved with the actual suppliers and decides to vertically integrate into this stage instead of getting the supplies from an outside supplier. Then this becomes a potentially a higher cost due to low efficiencies because there is a lack of competition for the supplies, for the production of this product.
A company, which has been used to producing the same products year in and year out without getting involved at any other stage in the products development will be very able and competent at doing so. If the company does decide to vertically integrate then this can lead to new core competencies being introduced, which can go against what people have been used to in the past. This means that if a company was making a product satisfactorily before the new integration of another stage of production, it may not be making a product satisfactorily once it has been integrated which could jeopardise the company’s reputation at what it used to do best.
If a company does decide to become vertically integrated then it has to weigh up the pros and cons of doing so. A disadvantage of being vertically integrated is that the company has a lot less flexibility to be able to branch out into other sectors of the market because of the investments made in making the company vertically integrated. For example, if a company wanted to produce a new variety of a product it would find it very hard because of all the investments in the other stages of production and distribution. This is even worse if significant in-house development is required.
Conclusions
There are quite a number of both advantages and disadvantages to why a company would and wouldn’t want to vertically integrate. These all have to be taken in to account and consideration, the pros and cons have to be weighed up against each other, before a company finally decides what to do about whether or not to vertically integrate either backwards or forwards. But there are other alternatives to vertical integration that the company can also be consider before a final decision is made, these include:
- Long-term explicit contracts
- Franchise agreements
- Joint ventures
- Co-ordination of facilities
- Implicit contracts (relying on firms’ reputation)
Bibliography
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Lowes, Pass and Sanderson, Companies and Markets, Chapter 3
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Besanko, Dranove and Shanley, Economies of Strategy (2nd Edition) Chapters 3,4
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Strategic Management, Vertical Integration,
- Economics of Industry course Manual Part 3, Vertical Integration
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