Question

One company may desire a specific material output for input into its own production. Is it a good economic decision to vertically integrate in this fashion? What are the advantages and disadvantages?

Answer 1

Simply, vertical integration is a strategic structure where a company owns the supply chain for its product -- so it is usually composed of one or two companies involved in different stages of production. The supply chain incorporates all the steps from taking a raw material to turning it into a product and selling that product -- in that sense, companies that are vertically integrated own multiple (or all) parts of their supply chain. For example, a company may buy out a producer of cotton as well as a t-shirt manufacturing company, and then might market and sell the products themselves. So, the original company (now a conglomerate of several companies along the same vertical, or the same kind product) is now in control of the four parts of the supply chain: commodities, manufacturing, distribution and retail.

There are plenty of benefits for companies to vertically integrate, including being more in control of their supply chain, being able to offer lower prices, and having increased market control. However, there are two different ways a company can practice vertical integration, depending on what type of company it is: backward integration and forward integration.

Vertical integration potentially offers the following advantages:

• Reduce transportation costs if common ownership results in closer geographic proximity.
• Improve supply chain coordination.
• Provide more opportunities to differentiate by means of increased control over inputs

The disadvantage of vertical integration is that it reduces the amount of diversification that an organization can access. If disruptions within the supply chain occur, then the entire operation is put at-risk until the supply chain can be restored.