The Importance of Vertical Expansion For Small Businesses

The Importance of Vertical Expansion For Small Businesses

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Traditionally speaking, your supply chain flows as follows: manufacturer to wholesale distributor to retailer to customer. Pretty standard right? And while certainly tried and true, many companies are integrating vertical expansion into their business model. In this article, we'd like to explain a bit more about vertical expansion and why it might be important for you.

Understanding the Concept of Vertical Integration

In its simplest terms, vertical integration is the process by which a company takes on the responsibility of multiple processes in the supply chain noted above. Such a company might buy out another company, as in they might purchase the company which manufactures parts needed for its products/services. Vertical integration can be forward or backward. What this means is that in a forward integration a company will take control of one or more companies that enable it to move up in its current supply chain.

Whereas with backward vertical integration the company will look into buying those companies that fall behind them in the supply chain ranks, in a manner of speaking. The example of Apple is a good one, as they frequently purchase smaller businesses who manufacture the parts required in a number of their products.

Whichever way you opt to move within the supply chain, the benefits of vertical integration are definitely there. Most often, such benefits relate to the amount of control a company has overall. Below are a few of the key benefits explained.

Product Control

One of the foremost reasons for vertical integration is to have more control over the product itself. This is especially true in a backward move. For instance, a retailer might want to gain greater control from a manufacturing standpoint. They may thus acquire one of the companies that manufacture the product or parts of said product.

To this end, they gain ownership over their products, plus, they get to manufacture it in accordance with market demand. Again, if we look to Apple—they buy those firms that make the various parts associated with their products, and thus they can make sure that such parts are constructed according to their high standards.

In a forward-looking move, the manufacturer may look to purchase a retail outfit. Perhaps the retailer isn't selling and/or presenting a product in conjunction with the manufacturer's views. By buying the retailer and thus implementing forward vertical integration they can now offer their products as they deem best.

Better Control of Costs

Another reason for vertical integration may be to cut down on some of the costs as well as to finetune the overall process. Given the traditional supply chain scenario, each link in the chain relies upon the one previous in order for things to run smoothly. If there are any delays, hiccups or issues that arise, this can then subvert the entire chain and the process all but breaks down.

When the "host" company purchases the other components and thus absorbs all under one, there is much tighter control of the process and less chance for catastrophic glitches. From a cost standpoint, there are always going to be additional costs when dealing with multiple entities. Again, by vertically integrating all such links in the chain, costs become more manageable. The process of going through everything internally stands to be far less than working with multiple third-party organizations.

Greater Market Control

Think about it, if you have more control over production as well as a tighter rein on costs, then the market is also more controllable. A prime example of this is Netflix. Initially, they offered third-party content. Flash forward, and now they're creating their own content as well. This, in turn, forces customers to pay for a Netflix subscription in order to see their originals.

Currently, subscription prices aren't terribly high. However, they really do have the capacity to ultimately charge what they want, especially as they make the cable more and more obsolete.

Understanding the Challenges of Being a Vertically Integrated Business

So yes, there are major benefits to both backward and forward vertical integration. Keep in mind though, this could be a very time-consuming not to mention complex process. And before you do decide to make such a move, it's important to consider the issues/challenges with which you might be faced.

The Costs

Acquiring another company is not a cheap endeavor. In fact, it could be fairly expensive. There's the initial purchase cost, on top of that there is the transition cost. Not to mention, there are probably a hundred other "hidden" costs that you won't discover until you're in the midst of the deal.

Some other costs you should keep in mind as you contemplate whether or not to vertically integrate: new marketing efforts, product development, finetuning the fulfillment process. And these are ongoing costs—so do note that.

Ongoing Management

The responsibilities associated with vertical integration are definitely demanding. It could be a matter of just letting the company being absorbed continue running as normal, or it could be far more significant. There may need to be close management in the initial phases in order to ensure smooth operations. Then there is also the infusion of capital that you may need to put into it.

Also, a retail company is going to be quite different from a manufacturing company. Getting these two to sync up in a manner of speaking could be a tremendous (and costly/) task. Do you have the capacity to run this new company and the current company? Are the resources in place? If not, you may want to rethink vertical integration.

In Conclusion…

If you are frustrated with the way that things currently stand among your supply chain—then vertical integration may be the way to improve the situation. You gain more control over the product, the market and perhaps most importantly, your bottom line. That said, you want to make sure you're definitely prepared for some of the challenges that may be associated with such integration. Bringing everything together seamlessly is no small task. But if you do believe you're ready and are eager to maintain more control over the process, then do your homework and look forward to future growth!

If your business is in need of funding for this process, First Union offers many loan options from short term loans to lines of credit. Call today to find out how we can help you!

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