“Owning the value chain” was a favorite strategy in the early part of last century. Companies sought advantage by moving “upstream” to control the means of production that supplied their main business or “downstream” to ensure their path to market. For example, 100 years ago Ford owned rubber plantations, coal and iron ore mines, and even railways.
But vertical integration largely fell out of favor when conglomeration became fashionable during the late 1960s and early ’70s. In fact, many industries underwent vertical dis-integration. Today, for example, computer companies once made the memory and processing chips and wrote the operating and applications software for the computers they manufactured and sold, specialists in chip making, software development, and hardware assembly now dominate the industry. And although some energy companies still find oil in the deep sea, process it in their refineries, and sell it to us at our corner gas station, the oil industry now has “pure play” companies in each stage of its value chain.
Is vertical integration a thing of the past? On the contrary, it seems to be making a comeback, particularly in Silicon Valley, where it’s been given a new label (just to remind us that everything that emanates from there is innovative!): the “full stack” business model. Some companies are migrating upstream: Take Netflix and Amazon getting into the original programming business and Harry’s (a U.S. startup that sells men’s razors and shaving cream by monthly subscription) acquiring a factory in Germany to make its own razor blades. Others are integrating downstream. Consider Apple owning and operating a retail chain to sell its own products and Google launching a wireless telecom network in the United States. Some companies are even doing both. Tesla, for instance, is bypassing traditional dealerships to sell its cars directly to the consumer while also building the world’s largest battery plant.
Are all these modern forms of vertical integration good strategies? Yes, if two special conditions are met. The first is a “market failure” that is hurting your business; the most common are supply risk, demand risk, and profit gouging. The second is that you have the power or capabilities to fix and even exploit that market failure. Without market failure, vertical integration is just plain ole diversification. And without the power or capabilities to exploit a market failure, it’s a very risky strategy.
As a matter of fact, companies might be entering a new business in direct competition with those for whom that business is their focus. If they are right about their supply risk, their vertical integration will indeed be a critical ingredient to their continued success. But if they fail, they will learn that companies have to pay up for things that are not so easy to replicate on their own.
In the end, vertical integration is a strategy driven by lack of trust that upstream and downstream players will come through for your business, and not overcharge you. If that lack of trust is well founded, there’s a failure in the market. And if you have the market power or essential capabilities to enter your suppliers’ or customers’ business, vertical integration makes sense for your strategy. But those are two very big ifs.
Adapted from an article in S+B by Ken Favaro. To read the full article: