For the first in an ongoing series of business-related posts I intend on doing on Mondays, I thought I’d explain what vertical integration is (as well as horizontal integration), why you hear it so often, and what the relevance is in business. I hope you enjoy the MBA Monday concept as I intend to deliver at least an article a week on this type of content.
What is Vertically Integrated vs. Horizontal Integration?
Often times if you’re listening to the pundits on CNBC talking about a corporate acquisition, they’ll say something like “This deal totally makes sense; they’re vertically integrated…”. In the past, I didn’t know what this meant and I’d just ignore the statement. However, after finally completing an MBA, and having this issue resurface again in another professional certification I just completed, I figured I’d delve into vertical and horizontal integration.
If you think about a company’s supply chain, envision various flows left and right. With the raw material supplier starting at the left and working its way through various stages of production to the right, eventually, product flows to the manufacturer, the distributor, the retailer, and then finally, the customer at the far right. Meanwhile, orders, forecasts and cash flow back from the right to the left. This is a simplified generic supply chain, but you get the picture. When things progress as I described, and the various entities are different companies, like the following, the supply chain would be classified as horizontally integrated:
- Contract Manufacturer buys raw materials and chemicals from various outfits in India and China.
- Contract Manufacturer converts these materials to Active Pharmaceutical Ingredient (API) and sells that material to a large pharma.
- Large Pharma company then formulates the material into drug product and sends it to another contract manufacturer for packaging.
- Packaging contract manufacturer then sends material to distribution outlets, PBMs and various country-specific warehouses.
- These various outlets sell to thousands of retail pharmacies and hospitals.
- The patient/customers purchase final drug product at a multitude of outlets.
The supply chain described is very flat, or horizontal, with the pharma company (IP holder) only touching the actual product once at the formulation step.
Vertical Integration Example
To envision a vertical integration example in business, think of the old Ford model. As used to outsourcing as we are now, back in the day, Ford owned everything. Every step of the supply chain – they even paid their own workers a premium to get them to buy their vehicles, so they practically owned the employees. In the early 20th century, Ford went so far as to purchase the producer of pressed steel that went into their vehicles, timberyards, railroads, glassworks, sawmills and more so they could have full control of the supply chain. Control is often the primary reason for vertical integration. Other examples include the integrated oils. If you think about a BP for instance, they’re in exploration, drilling, refining all the way through owning/franchising gas stations to the end consumer.
Which is Better? Vertical or Horizontal Integration?
The world is moving toward horizontal integration. As firms become more and more specialized and focus on core competencies, they tend to outsource or form alliances with other parts of the supply chain as opposed to being a master of all domains. The “virtual organization” is become more the norm than the exception. In the example above, could you see Apple (AAPL) trying to make transistors, microchips, iPhone case assembly and peripherals? No. They’re a design and marketing machine. Their core competency is not in large-scale manufacturing. They outsource all their components, manufacturing and distribution to the likes of FoxConn and Taiwanese companies. Even large pharmas and biotechs are starting to divest their chemical operations, their API plants and even up through formulation/packaging. These days, since in-house R&D is no longer as productive, pharmas and biotechs are simply in-licensing new compounds, outsourcing the development and launch batches and then the full life-cycle manufacturing if it makes it to market (see why drugs are so damn expensive).
So, when an oil major buys a smaller firm that’s perhaps in exploration or refining, the pundits will tout the “vertical integration” benefit. Sometimes, it’s good, sometimes, it’s not efficient. It depends on the business, but what we’re seeing more of is companies moving AWAY from vertical integration and into horizontal integration.
That’s a bit on vertical integration vs horizontal integration. I have about 50 other topics I want to share with you, so make sure to subscribe to my RSS.
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