Vertical integration

Vertical integration is integration along a supply chain. For example, if a retailer starts manufacturing the products it sells, it is increasing its level of vertical integration. Vertical integration may be backward or forward.

The advantages of vertical integration include the ability to secure supplies and future orders. This can also mean that the parts of the business sheltered from competition can become less efficient as they are no longer subject to the discipline of competing in an open market. Vertical integration is most often justifiable where it leads to either operational efficiencies or some other source of strategic advantage.

Businesses have increasingly moved to outsourcing many functions. This is often a significant move away from vertical integration: for example the separation of design and marketing from manufacturing that has occurred in electronics.

Vertical integration can affect profit and margins at all levels. Gross profit, in particular, tends to grow with vertical integration, simply because it excludes so many costs. Even without any cost saving synergies, the gross profit of a vertically integrated business should be the sum of the gross profits of each part.

To make a fair comparison of the margins of a vertically integrated business with peers that are not vertically integrated one needs to look at comparable parts of each business. In addition, remember that a vertically integrated business is larger than a non vertically integrated business with the same revenues, so it should be generating greater profits.

The same applies to almost all financial ratios, with the additional complication that a vertically integrated business may operate in industries that differ in what one would expect.

Businesses may also choose to integrate horizontally.

Copyright © 2005-2016