When and When Not to Vertically Integrate

A strategy as risky as integration can only succeed when it is chosen for the right reasons.

October 2015 | by David Delaney

Vertical integration is a risky strategy—complex, expensive, and hard to reverse. Yet some companies jump into it without an adequate analysis of the risks. This article develops a framework to help managers decide when it is useful to vertically integrate and when it is not. It examines four common reasons to integrate and warns managers against a number of other, spurious reasons. The primary message: don't vertically integrate unless it is absolutely necessary to create or protect value.

Vertical integration can be a highly important strategy, but it is notoriously difficult to implement successfully and—when it turns out to be the wrong strategy—costly to fix. Management's track record on vertical integration decisions is not good. This article is intended to help managers make better integration decisions. It discusses when to vertically integrate, when not to integrate, and when to use alternative, quasi-integration strategies. Finally, it presents a framework for making the decision.

When to Integrate

"Vertical integration" is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial. Consider hot-metal production and steel making, two stages in the traditional steel industry chain. Hot metal is produced in blast furnaces, tapped into insulated ladles, and transported in molten form at about 2,500 degrees perhaps 500 yards to the steel shop, where it is poured into steel-vessels. These two processes are almost always under common ownership, although occasionally hot metal is traded; for several months in 1991, Weirton Steel sold hot metal to Wheeling-Pittsburgh, almost ten miles away.

Such trading is rare, however. The fixed asset technologies and frequency of transactions would dictate a market structure of tightly bound pairs of buyers and sellers that would need to negotiate an almost continuous stream of transactions. Transaction costs and the risk of exploitation would be high. It is more effective, lower cost, and lower risk to combine these two stages under common ownership.

The tough part is that these criteria are often at odds with each other. Vertical integration typically reduces some risks and transaction costs, but it requires heavy setup costs, and its coordination effectiveness is often dubious.

When not to Integrate

Do not vertically integrate unless absolutely necessary. This strategy is too expensive, risky, and difficult to reverse. Sometimes vertical integration is necessary, but more often than not, companies err on the side of excessive integration. This occurs for two reasons: (1) decisions to integrate are often based on spurious reasons and (2) managers fail to consider the rich array of quasi-integration strategies that can be superior to full integration in both benefits and costs.

Companies should change their vertical integration strategies when market structures change. The structural factors most likely to change are the number of buyers and sellers and the importance of specialized assets. Of course, a company should also alter its strategy, even in the absence of change, when that strategy turns out to be wrong.

 

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Ms Anna Sullivan

Ms Anna Sullivan