Essay on the Effect of Vertical Integration Strategy on Firm Performance

Introduction

Inventory management, and more critically, inventory turnover, is a major operations management concern for manufacturing and distribution firms. A myriad of models have been developed to address inventory-oriented challenges in the scientific literature, including the renowned models like Economic Order Quantity, stochastic inventory, MRPP, and the JIT frameworks ((Li & Tang, 2010; Legros & Newman, 2013; Mahoney 2017; Reed & Fronmueller, 2019; Harrigan, 2015; Bhuyan, 2012; Rothaermel et al., 2016). These concerns have also been explored from the supply perspective of chain management, with a focus on proper coordination of flow of information, resources, and finance.

To address supply chain challenges, managers and academic researchers have examined the implications of a vertical integration organizational structure. Vertical integration encompasses the in-house leverage of a company’s resources as well as the delivery of services, products, or intermediate outputs of the system (Li & Tang, 2010). Taking a management standpoint, the exploration of vertical integration strategy has occurred by significant corporations, primarily engaged in oil-based exploration and extraction and have felt compelled to procure downstream refineries and supply networks.

The fascinating question of whether or not the vertically integrated control frameworks have a distinct edge in finding a finesse to sophisticated coordination of corresponding challenges, such as supply chain issues, has been the subject of endless debate. Conclusively, vertical integration, or its absence, can have a substantial implication on company performance. While some analysts argue that sufficient vertical integration is critical for organizational survival, others lambast inordinate integration for business failures. There are numerous examples of the motivations for integration efforts, as well as their achievements or setbacks.

Vertical integration

Vertical integration is discussed in the theoretical literature concerning organizations’ decisions to provide products, or intermediary outputs and inputs internally or procure them from third parties. Vertical financial stewardship and total control over resources can be obtained through mergers, purchases, or internal development that extends corporate boundary lines or vertical contracting that includes exclusive dealings and resale value maintenance. The term “vertical quasi-integration” was coined by Blois (1972), to describe the strong economic ties between enterprises in adjacent levels. These relationships do not have to include additional control over production and marketing policy choices, such as loans, equity investment, capital leases, or inventory credits. Most vertical financial ownership theories, on the other hand, are more aptly explained as vertical integration approach theories.

Vertical fragmentation in production sector has been on the rise in many countries since the 1990s. as put by the prevalent management paradigm of emphasizing on fundamental competences, c ompanies ought to have vertically disintegrated control strategy to achieve cost savings, gain competitive edge, and boost company performance. as per the theory of management, most empirical investigations postulated a negative linear correlation between the extent of vertical integration and company performance, anticipating arise in performace as vertical integration diminishes.

According to Lafontaine and Slade (2007), vertical integration recognizes the strategy of a company to exercise control in the useable inputs production along the chain thus going beyond the contractual integration of supply chains. Another definition of vertical integration may be “consolidating various business operations in a production process under a single business’s management (Li & Tang, 2010; Legros & Newman, 2013; Mahoney 2017; Reed & Fronmueller, 2019; and Harrigan, 2015). It differs from supply chain integration, which is the assimilation of all value-added operations as well as supply chain from the extraction of raw materials to end-user consumption.

According to Klein (2018), a vertically integrated firm combines multiple single-output processes of production in which either (i) the entire “upstream” process output is used as a component, or the whole of the bulk of a single intermediate “downstream” processes output or (ii) the quantity of a single intermediate output entirely into the “downstream” process is achieved from a portion or the whole of the output (Kaiser & Obermaier, 2020). On the same assumption, Harrigan (2015) describes vertical integration in terms of a business unit’s requirements for a certain resource that it acquires from upstream related business units or the output that it sells to downstream related units.

According to Harrigan (2015), ‘partial’ vertical integration exists when most (but not all) of the upstream process’s output is used as the majority of the downstream process’s input. According to the document, vertical integration is defined as the complete control of ‘a firm’s resources.’ It claims that the nature of a company’s labour connection has no bearing on whether or not it is vertically integrated (Klein, 2018). This description of vertical integration implies a complete removal of market or contractual exchanges between businesses that are vertically integrated in favour of internal interactions within the firm’s borders.

Types of Vertical Integration

Vertical integration acts as an alternative for investors who continuously look for innovative methods of growing their companies. When a corporation controls multiple levels of the supply chain, it can be described as being vertically integrated. And may entail ownership or acquisition of upstream suppliers, ownership or acquisition of downstream distributors, or a hybrid of both.

Forward Vertical Integration

Forward integration arises in a situation in which a corporation advances forward in the supply chain (like, when a manufacturer buys out the retailer). Corporations usually do this near the beginning of the supply chain, such as mining firms that control enterprises further “downstream,” as it is frequently referred to (Broedner et al., 2009). Instead of engaging a go-between, a producer might take control of its distribution networks and sell products directly to consumers. So, it’s fairly straightforward: the corporation is integrating ahead in order to get the items out to the consumers.

Also referred to as upstream integration, this form of vertical integration is less prevalent. In general, influential retailers and business entities always have the most purchasing power towards the end of the supply chain. This earns them the position of ‘predator’ instead of the position of the ‘prey, which means that businesses lower levels of the supply chain usually have the financial muscles to buy enterprises above them in the chain, whereas the reverse is true for companies up the supply chain (Li & Tang, 2010; Legros & Newman, 2013; Mahoney 2017; Reed & Fronmueller, 2019; and Harrigan, 2015). Because the enterprises at the end of the supply chain are usually highly concentrated, forward vertical integration is not prevalent. Thousands of more suppliers, on the other hand, could only aspire to integrate upwards. Thousands of cocoa bean producers, for example, provide Mondelez. However, a tiny farming company in Columbia would never be able to afford to buy or combine with Mondelez.

Backward Vertical Integration

Backward vertical integration occurs when one company joins forces with another that is further along in the supply chain than it is. To put it another way, it merges with one of its suppliers. Backward vertical integration may also occur when the firm merger with the manufacturer. Because the firm is behind in the supply chain, it is referred to as backward vertical integration. As such, in a basic supply chain consisting of extraction of raw materials, processing, and distribution, it is possible for the distributor to merge with the extractor of raw materials or the manufacturer, resulting in backward vertical integration. This is due to the fact that they are at a later stage in the supply chain (Vickery et al., 2013). This type of vertical integration, also known as downstream integration, is quite common. This is due to the fact that large businesses at the base of the supply chain typically have higher purchasing power to absorb their suppliers.

Balanced Integration

Balanced integration is the third type of integration. Simply put, this is a combination of forward and backward integration. For example, balanced integration occurs when a company merges with both a company that comes before it in the supply chain and one that comes after it. As a result, balanced integration requires two transactions: one downstream and the other upstream. Indeed, this is a very uncommon type of integration that occurs only infrequently – not primarily due to the cost but also to the potential legal conflicts that may arise as a result of the vertical supply chain’s monopoly control.

Firm Performance

Firm performance is an economic metric that measures a company’s ability to fulfil its goals by combining people and material resources. The efficiency of utilizing business means during the manufacturing and consuming process is also taken into account when evaluating firm performance. The firm performance depicts the relationship between output results and input resources used in the process of conducting business activities. A measure of a company’s success is influenced not only by the company’s efficiency but also by the market in which it operates (Davis & Duhaime, 2012). It’s also known as financial sustainability or financial wellbeing in the financial sector. There are a variety of financial measurements that may be used to assess the performance of a particular firm. Revenue, return on assets, return on equity, profit margin, capital sufficiency, growth of sales, stock prices, and liquidity ratio, are examples of common financial measures.

Some financial ratios are more relevant than others, depending on the industry in which the organization operates. For example, return on assets, and inventory turnover, total unit sales may be significant ratios to monitor in a manufacturing organization. In contrast, stock prices, operating income, and ash flow, revenue may be critical ratios to monitor in a financial institution (Legros & Newman, 2013). Since consulting is not an asset-intensive enterprise, inventory turnover and return on assets may be meaningless for consulting firms.

Another factor worth considering when evaluating the performance of a firm is the relative value of the company’s financial measures when juxtaposed against its competitors in the same industry, since each sector is unique, and making comparisons across industries may result in a biased interpretation of a company’s performance. A comparison of return on assets between a consulting firm and a manufacturing firm, for example, may be useless because one is asset-intensive while the other is not.

Vertical Integration’s Impact on Firm Performance

Vertical integration, according to the literature, can impact a business’s performance directly. Vertical integration, for example, can boost profitability by erecting obstacles to entry, permitting price discrimination, decreasing service and promotional externalities, or giving a company control over buyers and suppliers (Li & Tang, 2010; Legros & Newman, 2013; Mahoney 2017; Reed & Fronmueller, 2019; and Harrigan, 2015). Costs can also be cut by minimizing market costs, lowering transaction costs, eliminating ambiguity or asymmetric knowledge, resulting in more effective input utilization, and safeguarding proprietary technologies.

Theoretical data based on transaction cost economics suggests that the willingness to adopt vertical integration is influenced by relative cost evaluation arising from constrained uncertainty and rationality caused by opportunism and self-interest of partners. However, the empirical literature is yet to establish the relationship between vertical integration and performance in absolute terms despite the existing empirical data.

As stated by Harrigan (2015), the transaction cost framework argues that vertical financial control is apparently the most effective way to attain profit inventiveness because anticipatory claims on profits between independent enterprises are avoided. Davis and Duhaime (2012) discovered that vertical integration results in economies. They claim that vertically integrated business lines saved money on general and management expenses and selling, promotion, and Research and development. Due to greater production costs, they were only marginally more profitable than non-integrated areas of business. They also discovered that forward vertical integration is linked to minimize the costs of transaction. According to Reed & Fronmueller (2019), vertical integration has a more favourable impact on business performance. Internalizing value chain activities reduces transaction costs, which is likely to have a favourable impact on performance.

Companies attain “economies of scale” when they significantly minimize their fixed per-unit costs. Buying goods in large quantity and spreading the expense over a larger number of products is among the effectively applicable approaches. Cutting costs by minimizing exorbitant margins from intermediaries, assimilating management and employees, and optimizing operations is similarly a good strategy to attain economies of scale (Harrigan, 2015). Vertical integration can also help the company expand geographically by opening additional distribution facilities or acquiring a new brand.

The term “integration” refers to the connection between customers and suppliers. One of the most important goals of integration is to pursue data-sharing policie in order to reduce supply chain precariousness caused by fluctuating lead times. If a manufacturing company wants to provide higher value to its customers, the value/supply chain links are crucial (Mahoney, 2017). In today’s lean distribution networks, value is important in the manner of delivery reliability, on-time delivery, inventory service level, and lead time length, is especially, as poor service performance may have outcomes that, for instance, may spread to the end-customer due to reduced buffer stocks as well as make-to-order approaches (Harrigan, 2015). Vertical integration should, on this basis, contribute to enhanced coordination and integration in a company’s value chain, and thus to betterment in coordination mechanisms relating to its inbound and outbound operations, not to mention inventory levels and costs, along with financial performance.

While vertical integration has numerous advantages, it also has risks, some of which are explored in this article. For starters, traditional distribution routes may be harmed. Assuming you are a textile manufacturer who historically, sells to independently owned gift stores. You are interested in vertically integrating the business by doing direct sales to customers online (Forbes & Lederman, 2010). The strategy to expand into online sales must account for the potential loss of sales from your current distribution channels. You will not consider losing sales to your already established gift shops.

Another negative impact of vertical integration on the performance of a firm is unprofitable outcome. Vertical integration is expensive, and opening up the supply chain often does not equate to increased income. Installing and running a manufacturing or distribution enterprise can be costly, and a company may find it difficult to compete against its rivals who outsource to economies with low labor costs (Vickery et al., 2013). Vertical integration also hinders adaptability and makes reversal difficult. One may take a loss on an investment at some point, and even upon hard work, an acquisition error is rarely profitable. As clearly put by Warren Buffett, “Should one find themselves in a continuously leaking boat, the energy expended switching vessels is nearly more productive than effort invested patching the leaks”.

Finally, vertical integration may cause a shift in focus away from the original firm. Being an excellent performer in what you do due to specialization as an enterprise help reduce or completely eliminate competition in the market space. (Lu & Tao, 2008). a business may may perform excellently with regards to retailing its goods, but this would be woeful if it is not unprepared to oversee the manufacturing processes. A vertical merger could jeopardize the company’s prosperity and forever alter the culture.

Nonetheless, based on the facts mentioned above, we expect a favourable relationship between vertical integration and firm performance in the framework of our conceptual model. This hypothesis compares the direct impact of vertical integration on operating performance with the implication of vertical integration through enhanced inventory turnover as well as process support costs (Harrigan, 2015). As a result, compared to non-vertically integrated organizations, vertically integrated firms will have better overall financial performance.

Conclusion

This study looks into the influence of vertical integration on a wide range of accounts receivable in a company’s supply chain, as well as the impact on the company’s financial and operational performance. Management must understand the value of supply chain integration, especially vertical supply chain integration, in attaining operational and financial objectives. To enhance inventory levels and develop efficiency, a company may integrate with other companies internationally and internally across all operating units.

The study’s findings show that vertical integration has favourable and worthwhile implications on inventory levels, indicating that vertical integration may have positive benefits in upstream and downstream supplier and distributor, coordination, cooperation, and collaboration. Vertical integration’s good impacts could be attributed to the increased degrees of control, synchronization, and integration gained between formerly distinct supply chain nodes that are now under shared control (Reed & Fronmueller, 2019). Integrating a manufacturer’s relations and transactions with suppliers raises the bar for understanding retailers’, distributors, and wholesalers’ requirements. It is imperative that downstream marketing and logistics responsibilities are appropriately executed for the supply chain to run smoothly and the rewards of vertical integration to be comprehensively realized. As a result, the managers of a vertically integrated business will need to take on and play a more prominent role in the downstream supply chain partners’ influence, control, integration, and coordination (Lahiri & Narayanan, 2013). Administrators must also acknowledge that integration of the supply chain dramatically impacts operational performance, inventory levels, and the firm’s financial performance.

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