Vertical Integration (Part I)

The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.

There are 3 different types of vertical integration:

1. Backward vertical integration (expansion of activities upstream)
   
2. Forward vertical integration (expansion of activities downstream)
   
3. Balanced vertical integration (the company sets up subsidiaries that both supply them with inputs and distribute their outputs.)
   

The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution, as illustrated below:

Example of Backward and Forward Integration

No Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Backward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Forward Integration Raw Materials Intermediate Manufacturing Assembly Distribution End Customer

Two issues that should be considered when deciding whether to vertically integrate is cost and control.

• The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm.
• The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.

For examples of vertical integration click here.