Supply Chain Integration Strategies – Vertical and Horizontal Integration

Supply Chain Management (SCM) is defined as the integration strategies aimed at coordinating functions across suppliers, manufacturers, distributors and retailers to ensure that products and services are produced and distributed at the right volume, location and time with the aim of reducing operational costs, maximizing profits and ensuring satisfaction across the supply chain. Supply chain integration strategies are network-based business models used by organizations to align strategic decisions and processes across the network from supplier/manufacturer end to the customer end in order to achieve competitive advantages, synergy and efficiency in their operations as well as to gain more control in the input and output of their operations. Network-based business models are organizational structures that allow companies to operate as interconnected configurations across its value chain usually consisting of partnerships, collaborations and optimized cross-organizational activities.

Vertical Integration

Vertical integration is a coordination strategy in which a company owns its supply chain by incorporating supplier and/or distributor supply chains in its operations strategy or by expanding its operations to perform activities traditionally performed by suppliers and distributors. This strategy helps organizations to ensure high levels of control and to avoid the “hold up” problem, a situation in which an organization’s contract with another party in its supply chain results in delays and loss of profit due to delays, non-performance of contract or imbalance of bargaining power between the 2 parties. The Ford River Rouge Complex, an automobile factory built by Henry Ford in 1927 is a good example of a vertically integrated supply chain providing economies of scale and ensuring high levels of control in the supply and production process – Iron ore and coal from Ford owned mines arrived on Ford freighters to produce Ford steel. Ford also owned its timberlands, glass plants, rail lines and rubber plantation, which helped to ensure efficiency, availability of necessary components as well as control over inputs and outputs.

A vertical integrated supply chain can be implemented to varying degrees, broadly classified into 3 categories:

  1. Backward vertical integration, in which a company owns subsidiaries that produce the inputs/components used in production. For example, the Ford River Rouge Factory with its own timberland and glass making companies.
  2. Forward vertical Integration in which a company owns or controls its distribution center’s and/or retailers, thereby having direct contact with customers at the bottom of the value chain. For example, airlines performing the traditional roles of travel agents.
  3. Balanced vertical Integration in which a company implements both backward and forward integration by owning/controlling its supply, production, marketing and/or retail centers. Apple is a good example of a company implementing balanced vertical integration by owning their own data centers, manufacturing equipment to produce their own chips and other proprietary components, as well as their own marketing and retail stores, content platforms and support centers.

As a strategic tool, a vertically integrated supply chain can provide companies with solutions to mitigate or remove the threat of powerful suppliers, decrease bargaining powers of suppliers, distributors and customers as well as reduce transaction costs. When properly implemented, a vertically integrated supply chain can help companies achieve competitive advantage and higher profits through economies of scale and scope.

Horizontal Integration

Horizontal Integration is a single industry SCM strategy whereby companies seek to achieve competitive advantage and profitable growth through value creation activities that are focused on a single business or industry, for example, McDonald’s with its focus on global fast-food business and Walmart, with its focus on global discount retailing. A horizontally integrated supply chain is a business model whereby companies acquire or merge with industry competitors to achieve competitive advantage through economies of scale and scope. For example, Boeing merged with McDonnell Douglas to create the world’s largest aerospace company, Pfizer acquired Warner-Lambert to become the largest pharmaceutical company.

This SCM structure provides the advantage of focus and scope, particularly in fast growing, dynamic industries where companies are required to focus substantial resources and capabilities on competing in one area in order to achieve long term competitive advantage. Technological advancements, changing customer needs, fierce competition and low levels of entry barriers are common features of horizontally integrated supply chains. Due to changing customer needs, new competition and the pace of change in such industries, companies often find it difficult to sustain competitive advantage without changing/adapting their business model. For example, with the advent of wireless telephone service and the likes of SKYPE, companies like AT&T had to quickly adapt their business model and join forces wireless companies that provided them with the capability to start offering broadband and wireless services. Its merger with Time Warner and Comcast enabled AT&T’s competitive positioning and its relevance in the changing world of telecommunications.

A successfully implemented horizontal integration strategy can increase a company’s profitability due to reduction in cost structures as a result of:

  • Economies of scale, particularly in industries with high fixed cost structures;
  • Increased product differentiation due to the combined product lines from merger or acquisition which enables the company to be able to offer product bundles and innovative new products to customers at different price points;
  • Replication of the business model due to the ability to leverage the increased product differentiation and lower cost structure achieved through horizontal integration to replicate the business model in new market segment, for example Walmart using its low-cost discount retail business model to enter into the warehouse and supermarket segments in the US as well replicating the model globally as by acquiring supermarket chains in several countries;
  • Reduced industry rivalry, as excess capacity is eliminated in the industry through acquisition or merging of competitors which results in more stable price environments and the elimination/reduction of price wars;
  • Increased bargaining power due to the consolidation of the industry resulting in companies that are a much larger buyer and hence wield a level of leverage or “buyer power” which can be used to drive down the price it pays to suppliers. Walmart is a good example of a horizontally integrated supply chain with bargaining power advantage.

Horizontal integration has limitations that are worth noting and guarding against. Similar to vertical integration, horizontal integration is a complex and difficult strategy to implement. For example, it is difficult to successfully merge companies with very different corporate cultures and where the merge/acquisition is a hostile takeover, it often results in high staff turnover and loss of much needed talent and expertise hence resulting suboptimal benefits or downright failure. There is also the risk of failure or penalty due to antitrust laws when companies attempt to use horizontal integration to become a dominant industry player as these laws exist to ensure fair trading and prevent companies from using their market powers to prevent competition.

Vertical and Horizontal Integration – Key Issues to Consider:

Similarities

Vertically and horizontally integrated supply chains are usually complex and capital intensive to implement. Both are also similar in the sense that they are business models that are aimed at optimizing value chain processes and performance in other to achieve competitive advantage through economies of scale and scope. However, organizations need to consider several factors to ascertain the right strategy and whether it will be a profitable investment, including:

  1. Are there economies of scope to make it cheaper for the company to own or control subsidiaries involved in the supply and production of its inputs and outputs?
  2. Is there need to establish entry barrier in the industry or obtain monopoly power by controlling the value chain in order to have competitive advantage?
  3. Is it cheaper overall for the company to perform the role of suppliers and distributors than to conduct business with arm’s length suppliers and distributors?

Differences

Companies pursuing vertical integration may also pursue horizontal integration and in fact many do. However, the underlying principles and the operational implications of implementing both strategies have very clear differentiators.

In a vertical integration, the company enters new industries to support the business model of its core industry, whereas in a horizontal integration, the company competes in a single industry but expands through mergers, acquisitions and strategic alliances/collaborations. Vertical integration is more closed/proprietary model compared to horizontal integration which is more open because of the involvement of partners and the need to cooperate/collaborate. The differences in the operational implications include:

Vertical integrationHorizontal integration
More control through ownership of the value-adding stages.Less control due to dependence on others cooperation.
The vertically integrated company reaps the higher benefit.Benefits are from the success of everyone in the value chain
Efficiency over flexibilityFlexibility over maximum efficiency
Intensive capital required to create, produce, and distribute all components of the end product.Lower capital requirements due to shared ownership.

Stakeholder Management

In vertical integration, the proprietary nature of the investment creates a more closed/not very trusting approach in the interaction with partners as the organization will seek to protect its trade secrets/intellectual property. In horizontal integration however, companies adopt a more open and trusting approach with partners, as this is integral to the success of their business model. For example, Microsoft and Google have adopted a more open approach to working with partners in their values chain as the success is achieved collaboratively and through open source platforms. Apple on the other hand operates a proprietary model, which tightly protects its intellectual property through its vertically integrated supply chain.

Conclusion

Vertically and horizontally integrated supply chains are supply chain management strategies adopted by companies to take advantage of synergies in their value chain to achieve more profits and competitive advantage. Effective supply chains are critical to the success of organizations operating in global multifaceted environments as well as organizations seeking to achieve optimal efficiency and customer satisfaction. An increasingly competitive and interconnected global environment means that successful performance depends on the collective decisions and actions of all members of a supply chain rather than that of a single member and competition is increasingly between supply chains rather than between individual firms. Hence, organizations are faced with the challenge of making decisions regarding appropriate supply chain strategies that will deliver their objectives based on their capabilities, needs and circumstances. Vertical and Horizontal supply chain integration are two such strategies that enable companies to manage their organizations and their relationships with other companies in the same supply chain/value chain.

From a supply chain management perspective, vertical and horizontal integration aim to achieve cost savings, higher profits, greater efficiency and customer satisfaction by improving supply chain processes and performance through value-adding investment and activities that benefit all supply chain member. For example, achieving cost reductions, improved performance and better target market access as a result of eliminating redundancies/duplications, lowering inventories, shorter lead times, greater control over supply and distribution, access to partner networks and lower fixed costs.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.