In economics, the business layout that occupies several links along the industrial chain is called vertical integration. Vertical integration is a development strategy for enterprises to expand existing business operations in two possible directions, including forward integration and backward integration.
Advantages:
The advantages of vertical integration are:
1. Bringing economy. After adopting this strategy, the enterprise's internalization of external market activities has the following economics: the economy of internal control and coordination; the economy of information; (obtaining information is critical) the economy of saving transaction costs; the economy of stabilizing relationships .
2. Help develop technology. In some cases, vertical integration provides the opportunity to further become familiar with technologies relevant to upstream or downstream operations. This kind of technical information is very important for the exploration and development of basic management technology. For example, parts manufacturing companies in many fields have developed forward integration systems. You can learn technical information about how parts are assembled.
3. Ensure supply and demand. Vertical integration can ensure that companies receive sufficient supply when product supply is in short supply, or have a smooth product output channel when total demand is low. In other words, vertical integration can reduce the uncertainty of upstream and downstream companies from arbitrarily suspending transactions. Of course, during the transaction process, the internal transfer price must be in line with the market.
4. Weaken the price negotiation power of suppliers or customers. If a company does business with its suppliers or customers, the suppliers and customers have strong price negotiation power, and their investment returns exceed the opportunity cost of capital (opportunity cost: what must be given up in order to obtain something) thing), then, even if it does not bring other benefits, it is worth doing for the enterprise. Because integration weakens the opponent's price negotiation power, it will not only reduce procurement costs (backward integration) or increase prices (forward integration), but also improve efficiency by reducing negotiation input.
5. Improve differentiation capabilities. Vertical integration can improve the company's ability to differentiate itself from other companies by providing a range of additional value within management's control. (Maintenance of core competencies) For example, in order to ensure the production of high-quality cigarettes, the Yunnan Yuxi Tobacco Factory supports tobacco farmers in surrounding counties so that they can provide high-quality tobacco specifically for the factory; a winery has its own grape production area as well. An illustration of integration. Similarly, when some companies sell their own technically complex products (FAW), they also need to have their own sales outlets to provide standard after-sales services.
6. Increase entry barriers. When an enterprise implements an integration strategy, especially a vertical integration strategy, it can control key investment resources and sales channels in its own hands, thereby discouraging new entrants to the industry and preventing competitors from entering the company's business areas. By implementing the integration strategy, enterprises not only protect their original business scope, but also expand their business operations. At the same time, they also limit the degree of competition in their industry, allowing the enterprise to have greater autonomy in pricing, thereby gaining greater profits. profit. For example, IBM is a typical example of vertical integration. The company produces microprocessors and memory chips for microcomputers, designs and assembles microcomputers, produces the software required for microcomputers, and sells final products directly to users. The reason why IBM adopts vertical integration is that many of the microcomputer components and software produced by the company are patented. Only if they are produced within the company, competitors cannot obtain these patents, thus forming a barrier to entry.
7. Enter high-return industries. The suppliers or dealers that companies now use have higher profits, which means that the fields they operate in are industries worth entering. In this case, through vertical integration, a company can increase its return on total assets and can set more competitive prices.
8. Prevent being excluded. If competitors are vertically integrated enterprises, integration has defensive implications. Because competitors' extensive integration can capture many supply resources or have many desirable customers or retail opportunities. Therefore, for defensive purposes, companies should implement vertical integration strategies, otherwise they will face exclusion.
Disadvantages:
The disadvantages of vertical integration strategy are:
1. It brings risks.
Vertical integration will increase companies' investment in the industry, raise exit barriers, thereby increasing business risks (what to do when the industry downturns), and sometimes even prevent companies from allocating their resources to more valuable places. Vertically integrated firms tend to adopt new technologies more slowly than non-integrated firms because of the high cost of abandoning the invested facilities before they are exhausted.
2. It is expensive. Vertical integration forces a firm to rely on its own on-site activities rather than external sources of supply, which may become more expensive than external sourcing over time. There are many reasons for this. For example, vertical integration may cut off the flow of technology from suppliers and customers. If the enterprise does not implement integration, suppliers are often willing to actively support the enterprise in research, engineering, etc. For another example, vertical integration means buying and selling through fixed relationships, and the operating incentives of upstream units may weaken competition because they sell internally. Conversely, when purchasing products from a unit within the integrated enterprise, the company will not bargain as fiercely as when doing business with external suppliers. Therefore, internal transactions will weaken employees' motivation to reduce costs and improve technology.
3. It is not conducive to balance. Vertical integration has the problem of balancing production capabilities at various stages of the value chain. The most efficient scale of production operations for each activity in the value chain may be different, making complete integration difficult to achieve. For an activity, if its internal capacity is insufficient to supply the next stage, the difference needs to be purchased externally. If there is excess internal capacity, customers must be found for the excess, and if by-products are produced, they must be disposed of.
4. Different skills and management capabilities are required. Although there is a vertical relationship, different critical success factors may be required at different points in the supply chain, and firms may differ in structure, technology, and management. Familiarity with how to manage such a business with different characteristics is a major cost of vertical integration. For example, many manufacturing companies will find that investing significant time and capital in developing proprietary capabilities and franchise skills to forward-integrate into retail wholesale does not always add as much value to their core business as they imagined. And owning and operating a wholesale and retail network brings a lot of thorny issues.
5. The time is extended. Backward integration into the production of spare parts may reduce a company's production flexibility, prolong the time it takes to make changes to designs and models, and extend the time it takes a company to bring new products to market. If a company must frequently change the design and tooling of its products to accommodate buyer preferences, they often find backward integration, i.e., moving into the production of spare parts, to be burdensome because doing so must frequently be retooled and retooled. Design must take time to implement and coordinate the resulting changes. Purchasing spare parts from outside is usually cheaper and simpler than manufacturing them yourself, allowing companies to be more flexible and quickly adjust their products to meet the needs and preferences of buyers. Although most automobile manufacturers in the world have automated technology and production lines, they still believe that from the perspective of quality, cost and design flexibility, they will gain more by purchasing spare parts from professional manufacturers rather than producing them themselves. interests.