What is the Actual Definition of Vertical Integration?

Executive Summary

• Vertical integration is an industry structure that is employed to control sequential supply.
• We cover both backward and forward integration.

Introduction

Those who have a familiarity with business have heard of the term vertical integration — where one company performs all of the activities that lead to the output product. Some of the best-known examples of vertical integration are Carnegie and his steel supply chain that went all the way from the mining of iron ore to steel production. Ford’s River Rouge Complex, still the largest manufacturing facility ever created  – although no longer in operation – is another example.

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Can There be Too Much Vertical Integration?

Too much vertical integration is the product of a bygone era. The new concept is to leverage competitive advantage and to outsource non-essential activities, so-called vertical dis-integration. Therefore, imagine how surprising it was for me to find the following information while performing research for a book interested in the relationships between locations in a supply network called Superplant.

Upon reviewing the Wikipedia definition of vertical integration, I thought vertical integration is not its official definition and was my misunderstanding. Wikipedia lists Apple Computer as a vertically integrated firm because of them.

…control the processor, the hardware and software. Hardware itself is not typically manufactured by Apple, but is outsourced to contract manufacturers such as Foxconn or Pegatron who manufacture Apple’s branded products to their specification.

Therefore according to Wikipedia’s definition, the primary definition of “vertical integration” is whether the company controls the process, not – as I think it is more generally thought to be the case, whether the company performs all of the tasks.

Control is, of course, synonymous with coordination and oversight, two things that planning systems provide. Concerning manufacturing, subcontracting and contract manufacturing’s twin trends are often considered to be movements away from vertical integration. However, in both instances, the OEM/contractor is still in firm control of the process. According to the Wikipedia definition, the main factor is whether the central entity “controls” the process — not whether they perform the process. I will propose an extension of the definition here – in a way I think that is accurate, that a simple dividing line is when a product is procured versus externally manufactured. By that definition, vertical integration is still alive and well.  There are several implications to this. However, the one I want to explore in this article is the implication for production planning.

Backward Integration

Backward integration is a type of vertical integration where the company purchases a company that is a supplier to its primary business. Backward integration is often done to increase control and to reduce the price. When an entity becomes large enough to purchase significant quantities from suppliers, it can be more economical to actually perform backward integration to be one’s own “supplier.” Backward integration can also be done to reduce dissatisfaction with the supplier. One of the best examples of backward integration was Ford Motor Company. No longer has much in the way of backward integration, but at one time, Ford’s River Rouge plant was famous for having so much backward integration that “steel went in one side the plant and cars came out the other.” One of Ford’s entries into backward integration also famously failed when Ford attempted to grow rubber trees for car tires in Brazil.

Forward Integration

Forward integration is when a company purchases or merges with a business that it normally buys services from. A great example of forwarding integration has been what Amazon is doing in transportation. Amazon is one of the largest shippers in the US. By selectively purchasing transportation assets under the Amazon Transportation Services division, Amazon is performing forward integration. Amazon is doing this because it can guarantee large amounts of freight along many routes. In particular, it plans to use its forward integration to move freight between its large distribution centers and its fulfillment centers closer to population centers. Amazon wants to obtain lower costs and more control through this forward integration.

Increasing the Scope of the Conversation Beyond Collaboration

Vertically integrated companies increasingly face scenarios where they perform planning and require manufacturing operations feedback, even though they often do not do the work within their enterprises. Many analysts distill these requirements down to collaboration, but this is an oversimplification – bordering on misrepresentation and what is needed. The planning, integration, and execution components must be made works for these processes to work smoothly and be leveraged effectively. In fact, the collaboration aspect may be the easiest part of the problem to solve, as collaboration can — at the most basic level be enabled with emails as to subcontractor capacities and the status of various subcontract activities. However, having a specialized application that does “collaboration” also seems flawed. Why aren’t all planning applications only designed to be collaborative in themselves? In the future, it is easy to imagine where subcontractors and contract manufacturers enter their information into web pages, which are simply one view of the planning application.

How to Best Accomplishing Increased Oversight

One critical component to external plant oversight is accomplished by leveraging the subcontract and contract manufacturer planning (in some applications), and it is significantly enabled if the application can mix and match and compare various competing alternate routings, routings which sometimes cross between internal locations and partner locations. Most companies now have some requirements which blur the line between what is “inside” and “outside” of the company, and most planning and ERP software are not keeping up. Vendors are often more than happy to tinker with old designs rather than to incur the expense of altering their applications from the ground up. When it comes down to changing the marketing literature, or changing the software, changing the marketing literature will win on most occasions. However, at least one vendor does have this functionality, and it can explain how these requirements can be met. This is Superplant functionality, the title of this book, and whose definition can be found at this link.