What it is:
Vertical integration describes a company's control over several or all of the production and/or distribution steps involved in the creation of its product or service.
How it works (Example):
Let's assume XYZ Company, which manufactures frozen french fries, wants to vertically integrate. By purchasing a potato farm and a potato processing plant, XYZ could engage in upstream integration (also known as backward integration) and control the quantity, cost, and quality of the product's raw materials. Likewise, XYZ Company could engage in downstream integration (also known as forward integration) to control the distribution of the company's products by purchasing a packaging plant and a fleet of delivery trucks. Ultimately, XYZ could also use balanced integration, which incorporates both upstream and downstream integration, to control the cost and quality of the entire production and distribution process.
Why it Matters:
One of the biggest advantages of vertical integration is that it often creates economies of scale and lowers production costs because it eliminates many of the price markups in each production step. Vertically integrated companies also achieve cost efficiencies by controlling quality at each step, which reduces repair costs, returns, and downtime. In addition, vertically-integrated companies do not have to allocate resources to pricing, contracting, paying, and coordinating with third-party vendors.
Vertical integration can ultimately create barriers to entry for potential competitors, especially if the company controls access to some or all of a scare resource involved in production. This is why in some cases a company may control so much of the market or supply of raw materials that vertical integration can raise antitrust concerns.
A company must have expertise in each step of the production and distribution process in order to maximize the advantages of vertical integration. Using the example above, XYZ Company must know how to farm potatoes as well as it knows how to manufacture french fries. Another considerable risk is that XYZ will need to modify its infrastructure significantly to accommodate technological changes and other industry innovations. This investment in infrastructure can be very expensive and limit the company's flexibility. By controlling the value chain, the company also becomes responsible for innovation and product variety.
To simulate some aspects of vertical integration without explicitly doing so, companies may wish to sign long-term contracts with certain suppliers, co-locate facilities with suppliers or distributors, or engage in joint ventures with production partners.