What is Backward Integration?
Backward integration is when a company takes control of an earlier stage of its production process or supply chain. This means the company starts doing things that used to be done by its suppliers. The goal is to have more control over the entire process of making and delivering products to customers.
Why Companies Do Backward Integration
There are a few key reasons why a company might decide to do backward integration:
To Cut Costs and Boost Profits
If a company can make the parts or materials it needs instead of buying them from suppliers, it can often save money. The price the suppliers charge includes their own costs plus a profit margin. By cutting out the middleman, the company keeps more of the money for itself.
To Ensure a Reliable Supply
When a company relies on outside suppliers, there’s always a risk the suppliers will have problems that disrupt the flow of parts and materials. If a supplier has to temporarily shut down or can’t make enough to meet the company’s needs, it can bring the company’s production to a halt. Owning the supply chain means the company controls its own destiny.
To Improve Quality Control
With outside suppliers, the company has limited ability to make sure the parts and materials meet its quality standards. There can be a lot of back-and-forth trying to fix issues. When the company is in charge of that production itself, it can build quality control into the process from the beginning and catch any problems early.
Vertical vs. Horizontal Integration
Backward integration is a type of vertical integration. This refers to a company expanding into different stages of the production process for its own industry. The stages go in a line from raw materials to finished product.
The other type is horizontal integration. This is when a company expands into other products or services at the same stage of the production process. For example, a company that makes cars might purchase a company that makes motorcycles. Both make vehicles, but they’re separate operations.
Advantages of Backward Integration
Efficiency and Cost Savings
As mentioned before, one of the biggest benefits of backward integration is cutting costs by eliminating the markup that suppliers charge. The company may also find ways to make the production process itself more efficient once it’s under the company’s control.
Improved Quality and Innovation
Controlling the earlier stages of production gives the company the ability to use higher-quality materials and implement better quality control measures. It can set its own standards. The company may also have more flexibility to innovate and develop new and improved materials and components.
More Reliable Supply Chain
Outside suppliers can be unreliable for many reasons – labor disputes, financial trouble, problems with their own suppliers, and so on. Bringing the supply chain in-house reduces these risks. The company is no longer at the mercy of outside factors it can’t control.
Capturing More Profit and Competitive Advantage
By bringing more of the production process in-house, the company captures profit that would otherwise go to suppliers. If the company is able to produce supplies more efficiently than competitors who still rely on outside suppliers, it can gain an important edge in the market.
Disadvantages of Backward Integration
High Upfront Costs
Setting up the ability to produce the materials and components in-house is expensive. The company has to invest in equipment, facilities, expertise, and personnel. If demand drops for the finished products, the company can be stuck with expensive production capacity it doesn’t need.
Loss of Flexibility
Owning the supply chain makes a company less nimble. If the requirements for materials or components change, the company has to retool its own production rather than simply switching to a different supplier. It’s committed to its own process.
Management Challenges
The company’s management now has to oversee more aspects of the business. Making components and materials requires different skills and knowledge than the production of the finished product. Executives may be faced with unfamiliar challenges and a lack of in-house expertise.
Reduced Focus on Core Competencies
There’s a risk the company will get distracted from what it does best. If it expends too much effort and attention on the backward integration side of things, its core products and services may suffer. It can be difficult to maintain a high level of performance in all aspects of an expanded production process.
Examples of Backward Integration
Many well-known companies have engaged in backward integration. Here are a few examples:
Apple
Apple has long used multiple outside suppliers to provide components for its devices. But it has been steadily expanding its own chip design capabilities and replacing third-party chips with Apple silicon. Designing its own chips gives Apple more control over both the performance and the supply of this critical component.
Amazon
Amazon has made aggressive moves into logistics and delivery, including acquiring truck trailers, cargo planes, and local delivery companies. This backward integration into its supply chain helps Amazon control costs and delivery speed and reliability to keep its customers satisfied.
Fast Food Industry
Several major fast-food brands have integrated backwards, taking ownership of a range of raw material and ingredient production. For example, McDonald’s in the US eventually owned a large portion of the lettuce, onions and fish used in its menu items, to ensure reliable supply during periods of financial crisis or general supply shortages. Burger King also increasingly owns or has integrated backwards into potato and chicken farms.
Backward Integration Isn’t Right For Everyone
Backward integration can offer compelling advantages in terms of cost, quality control, and supply chain reliability. But it’s a major undertaking that comes with significant risks and challenges. Companies have to carefully weigh the potential benefits against the drawbacks. They need to consider their capabilities and whether the backward integration would enhance or distract from their core business. What works well for one company could be a disaster for another.
Companies should ask themselves some key questions before taking the backward integration plunge:
- Do we have the financial resources to invest in this major expansion?
- Do we have the right expertise to manage the new aspects of the business?
- Will backward integration give us a meaningful competitive advantage?
- Are the problems with our current suppliers serious enough to justify this step?
- Will we be able to maintain focus on our core products and services?
The answers to these questions will help determine whether backward integration is the right strategic move. Even if a company decides to move forward, it has to plan carefully and execute well to reap the potential benefits. Backward integration is a powerful tool, but it must be wielded skillfully.
