When pursuing a vertical integration strategy, a firm gets involved in new portions of the value chain. This approach can be very attractive when a firm’s suppliers or buyers have too much power over the firm and are becoming increasingly profitable at the firm’s expense. By entering the domain of a supplier or a buyer, executives can reduce or eliminate the leverage that the supplier or buyer has over the firm. Considering vertical integration alongside Porter’s five forces model highlights that such moves can create greater profit potential. Firms can pursue vertical integration on their own, such as when Apple opened stores bearing its brand, or through a merger or acquisition, such as when eBay purchased PayPal.
Example 7.5 Vertical Integration
In the late 1800s, Carnegie Steel Company was a pioneer in the use of vertical integration. The firm controlled the iron mines that provided the key ingredient in steel, the coal mines that provided the fuel for steelmaking, the railroads that transported raw material to steel mills, and the steel mills themselves. By having control over all elements of the production process, they ensured the stability and quality of key inputs. By using vertical integration, Carnegie Steel achieved levels of efficiency never before seen in the steel industry.
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Today, oil companies are among the most vertically integrated firms. Firms such as ExxonMobil and ConocoPhillips can be involved in all stages of the value chain including crude oil exploration, drilling for oil, shipping oil to refineries, refining crude oil into products such as gasoline, distributing fuel to gas stations, and operating gas stations.
Vertical integration also creates risks. Venturing into new portions of the value chain can take a firm into very different businesses. A lumberyard that started building houses, for example, would find that the skills it developed in the lumber business have very limited value to home construction. Such a firm would be better off selling just lumber to contractors.
Example 7.6 Safety through Vertical Integration
The risk of not being vertically integrated is illustrated by the 2010 Deepwater Horizon oil spill in the Gulf of Mexico. Although the US government held BP responsible for the disaster, BP cast at least some of the blame on drilling rig owner Transocean and two other suppliers: Halliburton Energy Services (which created the cement casing for the rig on the ocean floor) and Cameron International Corporation (which had sold Transocean blowout prevention equipment that failed to prevent the disaster). In April 2011, BP sued these three firms for what it viewed as their roles in the oil spill.
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Vertical integration can also create complacency. For example, a situation in which an aluminum company is purchased by a can company. People within the aluminum company may believe that they do not need to worry about doing a good job because the can company is guaranteed to use their products. Some companies try to avoid this problem by forcing their subsidiary to compete with outside suppliers, but this undermines the reason for purchasing the subsidiary in the first place.
A backward vertical integration strategy involves a firm moving back along the value chain and entering a supplier’s business. Some firms use this strategy when executives are concerned that a supplier has too much power over their firm. In the early days of the automobile business, Ford Motor Company created subsidiaries that provided key inputs to vehicles such as rubber, glass, and metal. This approach ensured that Ford would not be hurt by suppliers holding out for higher prices or providing materials of inferior quality.
A forward vertical integration strategy involves a firm moving further down the value chain to enter a buyer’s business. Disney has pursued forward vertical integration by operating more than three hundred retail stores that sell merchandise based on Disney’s characters and movies. This allows Disney to capture profits that would otherwise be enjoyed by another store. Each time a Hannah Montana book bag is sold through a Disney store, the firm makes more profit than it would if the same book bag were sold by a retailer such as Target.