Back to the Future – The Revival of Vertical Integration

Is vertical integration as a business strategy back in vogue?  Perhaps if you see some recent corporate moves as the beginning of a trend. A number of bellwether firms have reversed outsourcing mandates and begun to  take key operations in house.  Two recent examples are Oracle’s purchase of hardware vendor Sun Microsystems  and PepSico’s acquisition of two of its bottling operations. PepSico and Oracle join other industry leaders such as ExxonMobil, Apple, Reliance Industries, American Apparel and Google who leverage vertical integration to drive competitive advantage. 

Obviously, a small number of corporate decisions do not portend a global trend.  And, there are still many firms that will continue to focus on core competencies and outsource non-core activities.  Yet, there are sound reasons to reconsider vertical integration as a core business strategy, especially when the firm has strong cash flows and ready access to capital.  Some of these reasons include:

Drive cost reduction

A difficult climate is forcing companies to challenge conventional wisdom around outsourcing and creatively think about how to cut costs and reduce complexity.  In many cases, outsourcing has not delivered target cost objectives and has too often led to significantly higher  indirect costs in areas like relationship management and travel.  Properly executed, vertical integration enables firms to deliver significant cost reduction by achieving higher scale economies and recapturing economic rent (i.e. the outsourcer’s profit).  Where some operations are outsourced as well as provided internally, vertical integration helps ensure suppliers deliver services at the lowest possible cost and highest quality. 

Improve supply chain responsiveness

Working with outsourcing partners has many benefits but high speed, flexibility and control do not rank near the top.  Redesigning outsourced operations, particularly fragmented and global ones, is nigh impossible in the short to medium term, especially under conditions of rapidly changing client tastes and fluctuating demand. Furthermore, once long term, fixed cost outsourcing deals are signed, the outsourcer often has little inclination or incentive to pass along efficiency improvements or innovation to their client.  

Enhance the customer experience

Improving your customer experience is one of the few areas that firms can generate sustainable differentiation.  To build a winning experience, companies need a high degree of control over their delivery model including a common vision, stable operating processes plus feedback mechanisms. Unfortunately, this is very tough to achieve when disparate firms are involved in the value chain.  As well, troubleshooting is often a challenge due to outsourcer process complexity and hidden employee turnover.

Reduce business risk

In dynamic markets, there usually is no problem in securing access to raw materials and specialized labour.  However, when economic or political turmoil occurs or markets become less competitive, companies run the risk of losing access to key inputs or operations.  Vertical integration can reduce business risk by ensuring these critical ingredients are available to the organization as needed.

It remains to be seen whether the actions of a few firms reverses 30 years of corporate orthodoxy around outsourcing’s superiority.  However, a number of trends may be creating a ripe environment for vertical integration including ever-shortening product lead times, continued economic turmoil and insecurity around access to specialized materials or skills. Should current economic conditions continue, we will likely witness  more firms seeking to control their value chain through vertical integration.

For more information on our services and work, please visit us at Quanta Consulting Inc.


3 comments so far

  1. […] vertically integrating some key cost centers like production and logistics in order to capture greater operating […]

  2. […] cost reduction strategies such as complexity reduction, supply chain re-engineering or in-sourcing expensive outsourced functions.  Not only can these methods produce compelling cost savings, but they also can help accelerate […]

  3. […] cost reduction strategies such as complexity reduction, supply chain re-engineering or in-sourcing expensive outsourced functions.  Not only can these methods produce compelling cost savings, but they also can help accelerate […]

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