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All Geared Up

Will your business benefit from the many uses of vertical integration?
  • Ron Emery
September/October 2014
In order to simplify their supply chains and reduce risk, many organizations are choosing the path of vertical integration. This strategy can enable better and more constant control of supply, lower transaction expense, improved efficiency, shortened turnaround times, and increased distribution channels. However, the trade-offs sometimes are substantial. Thus, there are many key points to consider when assessing the viability of a vertically integrated supply chain.

 

The APICS Dictionary defines vertical integration as “the degree to which a firm has decided to directly produce multiple value-adding stages from raw material to the sale of the product to the ultimate consumer. The more steps there are in the sequence, the greater the vertical integration.” A basic illustration of a vertically integrated business would be a steel fabricator that increases customer value by augmenting its services with in-house machining or painting. As the fabricator vertically integrates its facility with these new functions, it also is assuming more responsibility.

Financial education firm Investopedia further explains that vertical integration describes a company that “expands its business into areas that are at different points on the same production path, such as when a manufacturer owns its supplier [or] distributor.” However, the firm also notes that it may be more effective for businesses to rely on the expertise and economies of scale of a vendor rather than being vertically integrated. And this is precisely why it’s so important to carefully consider your vertical integration strategy’s return on investment.

A look back

Vertical integration philosophies have changed significantly over the years. For instance, consider Standard Oil Company and Trust, part of the industrial empire of John D. Rockefeller and associates. For years, the business controlled almost all the production, processing, marketing, transport, and sales of gasoline in the United States. Owning the entire supply chain created a huge opportunity for the business—however, because others simply could not compete, a number of antitrust actions ensued. The government eventually dismantled Standard Oil, ruling that it had basically developed into a monopoly.

Henry Ford’s vertical integration strategy is another interesting example. His complex surrounding the Highland Park plant in Michigan included a power plant, machine shop, and foundry, thus bringing together the various stages in the manufacture of automobiles. By the 1920s, Ford had purchased a rubber plantation in Brazil, coal mines in Kentucky, acres of timberland and iron-ore mines in Michigan and Minnesota, a fleet of ships, and a railroad. These additional efforts to vertically integrate helped Ford make sure his company would have raw materials and parts when they were needed, guaranteeing a continuously operating assembly line. Such endeavors also enabled the company to profit from more of the processes involved in producing the automobile.

Now remember, the supply chain back then was not as robust as it is today. It was a tremendous challenge for Ford to ramp up schedules and time various components to come together when manufacturing his automobiles. Ships were not as fast, and containers could not be transported the way they are today on ultra-large vessels. Because the ability to build a global supply chain was more difficult in Ford’s time, much of this was new ground to explore.

Ford had to carry inventory to protect his production, and he carried a lot. In a modern-day business, however, the investment in capital would be astronomical, and the integration likely would not provide the necessary long-term advantages. This is why so many automotive companies have pared back or eliminated their vertical integration strategies altogether.

Indeed, backward vertical integration in the Ford sense—an organization acquiring suppliers or setting up its own facilities to ensure a more reliable or cost-effective supply of raw materials—is for the most part dead. Forward vertical integration as a business strategy, on the other hand, is alive and well. The APICS Dictionary defines forward integration as the process of buying or owning elements of the production cycle and the channel of distribution forward to the final customer. A forward strategy looks outward to the extended supply chain and takes a more narrow focus—for example, on distributors and retailers.

For many companies, such initiatives are intended to enhance Customer Relations by more accurately meet demand and get products to consumers quickly. Forward vertical integration is in vogue today particularly for high-tech manufacturers. In the Time magazine article “How Apple Made ‘Vertical Integration’ Hot Again—Too Hot, Maybe,” the author writes, “Technology titans are increasingly looking like vertically integrated conglomerates,” pointing to three specific industry examples: Google’s acquisition of mobile-device maker Motorola Mobility in order to manufacture smartphones and television set-top boxes; Amazon’s Kindle Fire tablet (and more recently, its Fire phone), which represents a bridge between hardware and e-commerce; and Oracle buying Sun Microsystems and championing engineered systems—specifically, integrated hardware-and-software devices.

Considering core capabilities

These days, no organization wants to absorb the risks Henry Ford faced in the 1920s. Thus, it’s critical first and foremost to be an expert at your principal business competence—the basic theory being to focus on what you are good at and outsource the balance. This idea stems from the business process outsourcing trend, which also contributed to the offshoring wave we have seen over the last 20 years.

Offshoring began with the outsourcing of mundane, repeatable, or predictable functions, such as information technology help desks, call centers, accounting, payroll, and human resources. The move to outsource is based on a reasonable return on investment, and higher value-added knowledge continues to fuel that move. This type of strategy helps an organization concentrate on services that are most likely to help it prosper and protect key roles and jobs. The intent is to transform it into a leaner, more agile entity that can compete successfully in today’s marketplace.

Performing your core business functions well is vital. However, as any good supply chain management professional will tell you, a number of strategies to meet customer needs should be in your tool kit. This is where vertical integration may be valuable and a smart business decision. If that is the route you choose, be sure to stay aware of the purpose behind the integration so that you can measure your actions through proven standards implemented at all levels of your business. This requires a supply chain that is aligned with both demand and operational ability, visibility into all the areas of your business, and a clear understanding of which actions are driving bottom-line benefits.

The vertical verdict

As more organizations move back toward their core business focuses, the days of the vertically integrated industrial giants are coming to an end. Still, you shouldn’t close the door on vertical integration just yet. There still remains a need for the strategy in some form—as long as you keep in mind that successful integration of disparate business entities is tricky at best, there must be a compelling reason for integrating, and proper return on investment is imperative. 

Ron Emery is an entrepreneur, teacher, mentor, and consultant. He runs two consulting businesses: Alchemy Associates and Empowering Healthcare Solutions. Emery also has served two terms as president of the APICS Youngstown chapter. He has just completed his first book, The Dysfunctional Organization: Why We Will Never Be Competitive in America Again. Emery may be contacted at ronemery@gmail.com or through his website at pb2au.biz.

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