Forward integration and backward integration are sometimes collectively referred to as vertical integration. Vertical integration strategies allow a firm to gain control over distributors and suppliers, whereas horizontal integration refers to gaining ownership and/or control over competitors. Vertical and horizontal actions by firms are broadly referred to as integration strategies.
1. Forward Integration
Forward integration involves gaining ownership or increased control over distributors or retailers. Increasing numbers of manufacturers (suppliers) are pursuing a forward integration strategy by establishing websites to sell their products directly to consumers.
In a forward integration move, Coca-Cola recently signed a 10-year partnership with Green Mountain Coffee Roasters, maker of the Keurig single-serve coffeemaker, to offer for the first time a Coca-Cola drink through a K-Cup. Coca-Cola thus plans to sell Coke through the at-home beverage system Keurig K-Cup. With the partnership, Coca-Cola also acquired 10 percent of the Green Mountain company for about $1.25 billion. Green Mountain now has a similar partnership with Campbell Soup to brew a cup of chicken broth in a K-Cup.
Based in Cincinnati and having more than 2,600 grocery stores, Kroger recently acquired Viatcost.com to expand its push into online groceries, partly so as not to concede the same-day food delivery market to Amazon.com. FedEx and UPS are both using forward integration, paying the United States Post Office (USPS) to ship their packages. Today, USPS delivers about 2.5 million packages daily for FedEx, or about one third of FedEx’s express-mail U.S.-bound mailings.
Amazon is forward integrating into the “installation business.” When you buy, for example, a ceiling fan or car stereo from Amazon, the company now wants to install it for you for a fee—at least in three cities (Los Angeles, New York, and Seattle). Amazon’s new program is called Amazon Local Services and is another step by the company to erode brick-and-mortar’s 90 percent market share of retail sales in the United States. In addition, Amazon is developing a new mobile application that recruits and pays ordinary people to be carriers of packages as they travel, doing away with the need for FedEx, UPS, and even the United States Postal Service. This new Amazon forward integration strategy is known as “On My Way” and is still being tested to resolve potential issues such as what happens if the package is damaged, or even stolen, by the transporter.
Taco Bell also wants to ring your doorbell and deliver you the goods. Fast food delivery is already a strategy at some rival firms, such as Jimmy John’s sandwich shop; Burger King has been offering delivery in select markets for a couple of years now; Starbucks is testing delivery.
An effective means of implementing forward integration is franchising. Approximately 2000 companies in about 50 different industries in the United States use franchising to distribute their products or services. Businesses can expand rapidly by franchising because costs and opportunities are spread among many individuals. Total sales by franchises in the United States are annually about $1 trillion. There are about 800,000 franchise businesses in the United States. However, a growing trend is for franchisees, who, for example, may operate 10 franchised restaurants, stores, or whatever, to buy out their part of the business from their franchiser (corporate owner). A growing rift between franchisees and franchisers is escalating as the offspring often outperforms the parent.
Restaurant chains are increasingly being pressured to own fewer of their locations. For example, TGI Fridays recently sold its 250 company-owned restaurants in the United States to franchisees as well as its 63 company-owned restaurants in the United Kingdom. Applebee’s also is becoming much more a franchisee-owned business. Burger King is converting virtually all of its company-owned outlets to franchised operations, with revenue from franchisees going from 30 percent of sales in 2011 to 90 percent in 2015. This change results in a drop in Burger King revenues, since franchisees show revenues on their own personal income statements. In contrast, rival Yum Brands owns virtually all of its outside-U.S. restaurants and says that policy gives greater control and benefits if things go well (or bad).
The following six guidelines indicate when forward integration may be an especially effective strategy:4
- An organization’s present distributors are especially expensive, unreliable, or incapable of meeting the firm’s distribution needs.
- The availability of quality distributors is so limited as to offer a competitive advantage to those firms that promote forward integration.
- An organization competes in an industry that is growing and is expected to continue to grow markedly; this is a factor because forward integration reduces an organization’s ability to diversify if its basic industry falters.
- An organization has both the capital and human resources needed to manage the new business of distributing its own products.
- The advantages of stable production are particularly high; this is a consideration because an organization can increase the predictability of the demand for its output through forward integration.
- Present distributors or retailers have high profit margins; this situation suggests that a company could profitably distribute its own products and price them more competitively by integrating forward.
2. Backward Integration
Backward integration is a strategy of seeking ownership or increased control of a firm’s suppliers. This strategy can be especially appropriate when a firm’s current suppliers are unreliable, too costly, or cannot meet the firm’s needs. Starbucks recently purchased its first coffee farm—a 600-acre property in Costa Rica. This backward integration strategy was utilized primarily to develop new coffee varieties and to test methods to combat a fungal disease known as coffee rust that plagues the industry. Manufacturers as well as retailers purchase needed materials from suppliers.
The huge wine and beer producer, Constellation Brands, recently purchased several glass- bottle factories after experiencing problems with several suppliers of their bottles. Constellation acquired a controlling interest in a Mexican Anheuser-Busch glass-bottle factory, giving Constellation ownership now of more than 50 percent of the glass bottles it uses.
Some industries, such as automotive and aluminum producers, are reducing their historical pursuit of backward integration. Instead of owning their suppliers, companies negotiate with several outside suppliers. Ford and Chrysler buy more than half of their component parts from outside suppliers such as TRW, Eaton, General Electric (GE), and Johnson Controls. De-integration makes sense in industries that have global sources of supply. Companies today shop around, play one seller against another, and go with the best deal. Global competition is also spurring firms to reduce their number of suppliers and to demand higher levels of service and quality from those they keep. Although traditionally relying on many suppliers to ensure uninterrupted supplies and low prices, many U.S. firms now are following the lead of Japanese firms, which have far fewer suppliers and closer, long-term relationships with those few. “Keeping track of so many suppliers is onerous,” said Mark Shimelonis, formerly of Xerox.
Seven guidelines when backward integration may be an especially effective strategy are:5
- An organization’s present suppliers are especially expensive, unreliable, or incapable of meeting the firm’s needs for parts, components, assemblies, or raw materials.
- The number of suppliers is small and the number of competitors is large.
- An organization competes in an industry that is growing rapidly; this is a factor because integrative-type strategies (forward, backward, and horizontal) reduce an organization’s ability to diversify in a declining industry.
- An organization has both capital and human resources to manage the new business of supplying its own raw materials.
- The advantages of stable prices are particularly important; this is a factor because an organization can stabilize the cost of its raw materials and the associated price of its product(s) through backward integration.
- Present suppliers have high profit margins, which suggest that the business of supplying products or services in a given industry is a worthwhile venture.
- An organization needs to quickly acquire a needed resource.
3. Horizontal Integration
Seeking ownership of or control over a firm’s competitors, horizontal integration is arguably the most common growth strategy. Thousands of mergers, acquisitions, and takeovers among competitors are consummated annually. Nearly all these transactions aim for increased economies of scale and enhanced transfer of resources and competencies. Kenneth Davidson makes the following observation about horizontal integration:
The trend towards horizontal integration seems to reflect strategists’ misgivings about their ability to operate many unrelated businesses. Mergers between direct competitors are more likely to create efficiencies than mergers between unrelated businesses, both because there is a greater potential for eliminating duplicate facilities and because the management of the acquiring firm is more likely to understand the business of the target.6
In the cigarette industry, Reynolds American recently acquired Lorillard for $25 billion. The merger combined Reynolds’ Pall Mall and Camel brands (with 8.1 percent market share each in the United States) with Lorillard’s Newport brand (with 12.2 market share) to combat industry leader Altria’s Marlboro brand that commands 40.2 percent market share in the United States. As part of the transaction, to combat antitrust concerns, Reynolds CEO Susan Cameron said her company will divest Lorillard’s Blu e-cigarette to Imperial Tobacco (another rival firm), while keeping and growing Reynolds’ Vuse e-cigarette. Reynolds also divested its Kool, Winston, Salem, and Maverick brands to Imperial.
Both Dollar General and Dollar Tree recently competed for months to acquire Family Dollar. The winner, Dollar Tree, is reducing prices and converting Family Dollar stores into bright, clean, friendly places. Dollar Tree still sells more items for a dollar or less, whereas Family Dollar sells more branded merchandise. About 5,000 Dollar Tree stores and 8,300 Family Dollar stores now compete with industry leader Dollar General’s 11,500 stores.
Charter Communications (CHTR) recently acquired (1) Time Warner Cable (TWC) for $55.33 billion and (2) Bright House Networks for $10.4 billion, creating a giant U.S. TV and Internet firm. The new Charter has nearly 24 million customers, below the leader Comcast’s (CMCSK) 27.2 million customers. Comcast owns NBCUniversal. Charter also lags AT&T (T), whose recent merger with DirecTV (DTV) gave AT&T 26.4 million TV customers and 16.1 million fixed Internet customers, as well as tens of millions of wireless customers. Several major factors are spurring horizontal integration in the TV and Internet business, including that cable providers are rapidly losing TV subscribers, and pressure from online video services such as Netflix (NFLX), Hulu, and Amazon is increasing dramatically.
The following five guidelines indicate when horizontal integration may be an especially effective strategy:7
- An organization can gain monopolistic characteristics in a particular area or region without being challenged by the federal government for “tending substantially” to reduce competition.
- An organization competes in a growing industry.
- Increased economies of scale provide major competitive advantages.
- An organization has both the capital and human talent needed to successfully manage an expanded organization.
- Competitors are faltering as a result of a lack of managerial expertise or a need for particular resources that an organization possesses; note that horizontal integration would not be appropriate if competitors are doing poorly because in that case overall industry sales are declining.
Source: David Fred, David Forest (2016), Strategic Management: A Competitive Advantage Approach, Concepts and Cases, Pearson (16th Edition).