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Vertical Integration and the Extended Supply Chain

By Dave Turbide, CFPIM, CIRM, CSCP, CMfgE |   2014 | 9 | 8

When a manufacturer owns or controls its suppliers—often with the aim of managing availability, quality, and cost—that’s called vertical integration. While common practice a century ago, vertical integration has fallen out of favor. More companies are selling off divisions outside of their central business focus and outsourcing anything beyond core competencies. Known in the industry as horizontal or lateral integration, this partnership approach to the supply chain is considered more flexible and agile—although there is arguably more risk than with wholly owned suppliers and distributors. As with most business approaches, the pendulum tends to swing back and forth between strategies.

As today’s industries have evolved and matured, many organizations have chosen to buy rather than make components in order to reduce time to market and eliminate the capital investment required to build plants and acquire equipment. The first checkpoint on that decision path is whether the business has, or is willing to develop, production capability. Once it is determined that internal production is even possible, the following questions will help you explore whether vertical integration makes sense:

  • Is the product or process strategically important? It may be risky to rely on outside suppliers for items that are vital to business success.
  • Is there intellectual property that would be at risk if outsourced?
  • Are there internal operational capabilities or efficiencies that an outside supplier is unlikely to be able to provide or surpass?

If your exploration gets to this point with “no” answers to all the qualifying questions, then consider outsourcing on an economic basis, keeping in mind quality, delivery reliability, ongoing improvement, and supply chain risk.

Reshoring

Over the past several decades, many products that formerly were made in-house were outsourced to suppliers in developing areas. This great manufacturing migration was driven by simple economics. But things change. Significantly higher labor rates, advances in automation, escalating transportation costs, and currency exchange rate fluctuations are just a few examples. Companies are revisiting their outsourcing decisions and also putting more emphasis on noneconomic factors such as delivery reliability, quality, lead time, supply risk, and flexibility.

The actual process of reshoring production is, however, very difficult. When a company changed from domestic production to offshore outsourced production, domestic production capabilities likely were closed down. Whether previously made in-house or domestically sourced, the tools and equipment, facilities, and skilled workers were all scrapped, sold off, or dispersed. If the business chooses to bring back that work decades later, there are no resources. Once more, a choice must be made—develop the wherewithal to make it in-house, encourage a supplier to gain the capability, or acquire a plant that can be converted to the needed capability. The first and third alternatives are effectively vertical integration.

Another way to resolve the challenges of off-shore production is to acquire the offshore factory in order to gain control over quality, delivery performance, and availability of products. Again, the strongest reason to vertically integrate your supply chain is to have that power. However, some problems may ensue. Subsidiaries aren’t always great suppliers, and parent companies can become insensitive to the stresses and restrictions of a captive supplier. For example, they may change requirements within lead times or be unwilling to pay what the subsidiary requires to remain a profitable division within the enterprise.

Vertical integration today

Vertically integrated organizations evolved in the early days of industrialization because they represented the best way—perhaps the only way—to secure needed materials. The very existence of these wholly owned suppliers was self-perpetuating. It discouraged the development of alternate sources, and the corporate owners simply couldn’t consider going outside if it would bankrupt their own supplier divisions.

But concern for the welfare of those existing facilities can threaten the very existence of the enterprise. With rapidly changing technologies and customer tastes, the existing investment in plant and technology can lead to a form of blindness to disruptive shifts that is far more likely to come from independent sources unburdened by “the way it’s always been done.” If a company is buying parts from an outside supplier and a new, better idea comes along, there is little to prevent that organization from switching. With a captive supplier, the new entrant might be seen as a threat to be resisted rather than an opportunity to move the market.

These are the forces that spelled doom for the vertically integrated giants of the last century. Many still exist, but they now are horizontal enterprises, relying on an army of suppliers. Some of these businesses actually do little more than design and market, while outsourcing everything else. Others manufacture someone else’s designs or distribute someone else’s products. Such businesses focus only on their core competency and find partners whose own core competencies offer the right complement.

Vertical integration is no longer considered the key to success that it once was, but it does have its place—especially where control becomes a driving factor due to the importance of quality, availability, or protection of intellectual property. As times change, there is no doubt that the pendulum will swing again. Keep an open mind and be ready.

Dave Turbide, CFPIM, CIRM, CSCP, CMfgE, is a New Hampshire-based independent consultant, freelance writer, and president of the APICS Granite State chapter, as well as the author of APICS magazine’s “Enterprise Insights” department. Turbide also is an APICS CPIM and CSCP instructor and Fresh Connection trainer. He may be contacted at dave@daveturbide.com.

 

For more on this topic, read the September/October 2014 APICS magazine article “All Geared Up: Will your business benefit from the many uses of vertical integration?” by Ron Emery.

For more from author Dave Turbide, read the September/October 2014 APICS magazine article “Build to Suit: Choose an ERP solution that best fits your business,” and attend his APICS 2014 educational session Reduce Work in Process, Reduce Lead Time. For more information and to register for the conference, visit apicsconference.org

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