Vertical Integration: backwards and forwards

Vertical integrated companies eliminate price markups for every production step, achieving cost efficiency by controlling quality step by step. If you have any doubts that markups inflate prices in our society beyond reason, check airplane ticket prices online and then try at the nearest airport, where the airlines are incentivized to fill their planes. The same seat on the same flight can cost thousands of dollars due to the retail markup alone. Vertical integration effectively cuts out the middlemen.

Vertically Integrate in two ways: forward and backward.

Luxottica, the eyewear manufacturer that owns Ray-Ban, forward integrate to increase their market share and gain higher economies of scale. E-commerce and the internet inspired a boom in forward vertical integration--modern manufacturers often forward vertically invest in their own online stores.

Inversely, backward vertical integration--when a firm annexes its supplier--secures a reliable, efficient flow of resources. In Hawaii, Hilo’s famous seafood restaurant has backwards integrated since 1921 by raising all their own fish.

Forward vertical integration works best when:

  • The distributors are making a killing, few and far between, or unreliable.
  • The industry as a whole is projected to grow.
  • The company has the financial reserves to expand drastically.

Backward vertical integration works best when:

  • Suppliers are making a killing.
  • An unfavorable competitor to supplier ratio exists.
  • The prices and quality of the supply are unstable.

Vertical integration is not black and white. Apple, the company that kicked off the integration craze thirty years ago, has thrived with their balanced integration strategy--Apple owns their hardware and software manufacturers, but they do rely on contractors in assembly, for example. Balanced vertical integration allowed Apple to make gains on their competitors by upgrading battery life and screen resolutions without creating an unwieldy bureaucratic chain.

Indeed, a lack in expertise and a convoluted supply chain can plague vertically integrated companies. Due to the difficulties of integrated delegation, vertically integrated conglomerates often trade for less on Wall Street. Perhaps the worst downside of vertical integration is that vertical integration can lead to monopolies that bar potential competitors, hampering innovation in the industry.

But firms operating on a one-dimensional level risk putting themselves at the mercy of economic conditions.