When companies become large enough and have enough capital, they often decide to acquire other businesses. This is known as "integration strategy." There are two basic forms of integration: horizontal and vertical.
Horizontal integration involves minimizing competition and increasing market share by purchasing competing businesses, while vertical integration involves purchasing suppliers or distributors to streamline the process and reduce the costs of bringing a product to market.
TL;DR (Too Long; Didn't Read)
Horizontal integration occurs when a company buys a company of the same type to increase market share or reach new customers, whereas vertical integration involves purchasing a supplier or distributor to streamline production.
Horizontal Integration Definition
Companies that grow through horizontal integration seek to purchase companies in the same industry, which can offer many benefits, including:
- Increasing their size
- Growing their product offerings
- Reducing competition
- Scaling up production
- Accessing new customers.
Horizontal integration can easily lead to monopolies and oligopolies if one company purchases all or most competitors in a market, which often raises antitrust issues. Many mergers of this type must be approved by the government before they occur in order to protect consumers from the reduced competition. For example, if Verizon purchased AT&T, consumers would have few mobile service options available to them.
Aside from reduced competition, one of the more common reasons a company will perform horizontal integration is to increase the number of products and services they are able to offer to consumers. In some cases, the company may even wish to combine its existing services with those of the company it wishes to acquire. This can also allow the company to scale up production with new factories and employees.
Horizontal Integration Examples
For example, if AriZona Beverages (the company behind AriZona iced tea) wanted to start selling flavored sparkling waters and teas but didn't want to invest in new equipment, factories and employees to make it, it could purchase a company that makes sparking waters, like La Croix, and start selling these beverages immediately. This would also give it instant access to La Croix's consumers rather than having to build up its own consumer base.
Real-life examples of horizontal integration include Marriott's 2016 purchase of Sheraton, Facebook's 2012 acquisition of Instagram and Disney's 2006 acquisition of Pixar.
Vertical Integration Definition
Vertical integration occurs when a company purchases entities engaged in different stages of the value chain. Essentially, this means that one firm purchases another involved in the production of the same product but at a different level of the supply chain, making the process of creating a product and getting it to market cheaper and faster. Vertically integrated companies may find doing so has helped them:
- Strengthened their supply chains
- Reduce production costs
- Capture more profits
- Access new distribution channels.
While it is more difficult to create a vertical monopoly than a horizontal one, when it is accomplished, it can leave a company in control of an entire industry rather than just a segment of it.
Vertical Integration Examples
For example, Andrew Carnegie is famous for pioneering the concept of vertical integration in order to corner the steel market by taking control of all aspects of the production process. He did not just own steel mills but also iron-ore barges, coal and iron fields and the railroads. He would sell directly to users, bypassing middlemen and their fees. As a result of his vertical integration across the industry, no competitors could afford to compete with Carnegie Steel's prices, and he held a monopoly over the industry for years.
More modern and less monopolistic examples of vertical integration include Google's 2001 acquisition of Motorola to produce smartphones and Ikea's 2015 purchase of Romanian forest land to produce its own raw furniture materials.
Backward and Forward Integration
Vertical integration can occur in one of two ways, depending on where the purchaser and its new acquisition sit on the supply chain. There are three types of vertical integration:
- forward (or downstream) integration
- backward (or upstream) integration
- balanced integration
Here is the difference between the three:
- Forward integration involves purchasing a company further down the supply chain, such as distributor. An example would be if a flower grower acquired a chain of florists.
- Backward integration occurs when a company purchases an entity above them on the supply chain, for example, if a cereal producer purchased the farms that grow the grains used in its cereal.
- Balanced integration involves taking over all parts of the production process and is also called a vertical monopoly. Andrew Carnegie's previously mentioned steel company was involved in balanced integration. This form of vertical integration is less common than forward or backward integration, as it is largely illegal in the United States due to antitrust legislation.
Benefits of Horizontal Integration
Both vertical and horizontal integration have their benefits, and a company needs to consider its own needs before deciding which form of integration strategy to pursue. Horizontal integration can be most advantageous when a company is:
- part of a rapidly growing industry, and it needs to maintain a large portion of the market share
- not thriving in head-on competition
- hoping to access a new market or client base
- seeking to scale up the business.
Of course, horizontal integration does not allow a company to become self-sufficient, so companies seeking to reduce distribution or supply costs may find vertical integration to be more beneficial.
Benefits of Vertical Integration
Vertical integration, on the other hand, may not immediately help a company increase its market share, but it can help reduce the costs associated with getting a product or service on the market and it can help a company absorb profits from both sides of the supply chain. Reduced profits may help a company pass savings on to the consumer in order to eventually obtain a larger market share or help it compete more efficiently with other products and services in the industry.
Vertical integration is most beneficial for firms that notice its distributors or suppliers are either unreliable or charging too much or if there are too many middlemen between the company and its consumer, adding unnecessary fees to the final cost of the product.
A company trying to produce products to exact specifications that are outside the norm for the industry may also look into vertical integration. For example, if a car company wishes to make tires a particular size that no existing tire companies sell, it may be more financially sound to purchase a tire company and start producing tires in that size rather than ordering specialty tires from an existing company.
Success With Vertical Integration
In order to perform a successful vertical integration, the company must have enough resources to manage the new business and be prepared to take over an entity involved in work with which it may not be familiar. For example, if a brewing company takes over an orchard to start selling apple cider, it needs to ensure it has the capital to survive a flood year and that the higher-ups are prepared to start making sound decisions about agriculture, an area in which they may have no prior experience.