Vertical integration occurs when a manufacturer merges with other members of its supply chain. The merger can cover suppliers of components or raw materials, or organisations that provide logistics or distribution services. The aim of vertical integration is to increase efficiency and reduce costs throughout the supply chain, improving competitiveness and profitability as a result. Vertical integration can also create barriers to market entry, improving competitiveness even further.
Vertical integration enables manufacturers to gain greater control over the inputs to the production process, according to "The Economist." Integration also enables the manufacturer to control the cost, quality and delivery times of components, raw materials and other supplies. That level of control can increase efficiency throughout the supply chain by coordinating ordering and production.
Although vertical integration gives manufacturers control over supplies, it can also create capacity problems, according to Quick MBA. If demand for a product falls, it can be difficult for a vertically integrated to scale down production or reduce order quantities with a supplier. In the same way, a steep rise in demand can highlight under capacity in the supply chain, with little flexibility to switch suppliers or use multiple sources.
Vertical integration in the supply chain can improve efficiency by coordinating production and eliminating the procurement costs of dealing with external suppliers. However, the lack of competition between suppliers in a vertically-integrated chain can also lead to inefficiency and an increase in cost of production, according to Quick MBA.
When a manufacturer merges with distributors or a retail chain, it aims to secure and control an outlet for its products. Vertical integration gives a manufacturer access to the distributors' existing customer base, reducing marketing and customer acquisition costs. However, if demand falls, the manufacturer may be forced to cut prices to maintain production output -- a move that could damage profitability throughout the supply chain.
Manufacturers that control access to critical components or scarce raw materials through vertical integration can create barriers to market entry. By limiting competition, they can build a strong market position and protect their customer base. However, the company may also face antitrust legislation if regulators believe that a merger distorts market concentration.