Value Creation -- Vertical Integration

Dec. 11, 2000
Grabbing more links of the value chain can reduce risk and increase control.

Companies can raise their overall value as they increase ownership of processes related to their product. Usually this is considered when critical suppliers are late or raise prices. Vertical integration lessens the risk of cost increases, disruption of critical material supplies, and quality problems. It has to do with the control we exert over successive stages of the entire production process. As risk falls, corporate value increases.

Benefits of vertical integration: The most obvious reason many of us manufacture critical components is to control costs. Ford and General Motors are famous for threatening to self-manufacture key components. Some large clothing chains have integrated the manufacturing of certain popular styles themselves, leaving their former suppliers out of the loop entirely. Self-manufacturing removes power from the supplier by bringing critical information in-house. It also eliminates the need for shopping and reduces negotiating costs. Vertical integration also offers economies of combined operations such as sales, purchasing, and overhead allocations. By lowering manufacturing costs and ensuring a stable supply of critical components, vertical integrators remove some of the risk in their businesses.

Tapered integration: Tapered integration allows you to preserve the threat of manufacturing key items yourself without full commitment to the process. You only manufacture a part of the total components needed and outsource the rest. If your internal manufacturing operation can be easily expanded, you'll put more teeth in any threats made toward uncooperative suppliers.

Forward integration: We can integrate our customers into the downstream supply chain, too. PepsiCo did this when it began acquiring local bottlers. McDonald's practices the same with its extensive franchise network. Forward integration ensures a ready and willing outlet for our products. Forward integration also allows us to link already existing control over the production process with the way our customers sell our products. If creating a brand is an important differentiating strategy to your company, then forward integration may assist the process: Monfort Beef Co. of Greeley, Colo. (now a division of ConAgra) bought up meatpacking and distribution operations to complement their cattle feedlot operations. They were then able to successfully differentiate their own brand by promoting the quality control they had over the entire process. Differentiating your company from the competition -- especially if your products are commodities -- comes from integrating part of your customers' needs into your operation. For example, some metal distributors now have transitioned into metal service centers. This differentiation greatly enhances the value of dealing with those service-oriented companies versus the competition that fails to punch, cut, or process the material.

Backward integration: We can integrate the inputs into our manufacturing operation as well -- essentially looking upstream in our value chain. The major automotive manufacturers routinely practice this by producing their own engines and transmissions that go into their cars. Hewlett-Packard does the same thing by manufacturing its own specialized integrated circuits for use in their laser printers, shortening response time to changing market conditions. Backward integration improves control over proprietary knowledge critical to our final product. This avoids giving suppliers information and control over a component that increases their bargaining power. For years Polaroid internally produced many of its proprietary components for this very reason. Backward integration enables us to produce our own components with specific, unique features that distinguish our products from our competitors'. Zacky Farms of South El Monte, Calif., for example, grows its own poultry, enabling Bob Zacky to claim there's something special included in his chickens that no other distributor offers.

Chris Malburg is a venture capitalist with WAWMAC Partners LLP in Lake Forest, Calif. He is the author of The Controller's and Treasurer's Desk Reference (1994, McGraw-Hill Inc.)

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