Allied Academies International Internet Conference page 258

A REVIEW OF THE ADVANTAGES AND

DISADVANTAGES OF VERTICAL INTEGRATION
FROM A STRATEGIC MANAGEMENT AND FINANCE
PERSPECTIVE
Bevalee B. Pray, Christian Brothers University
bpray@cbu.edu
Sarah T. Pitts, Christian Brothers University
spitts@cbu.edu
Rob H. Kamery, Nova Southeastern University
robhkamery@yahoo.com
ABSTRACT

The purpose of this paper is to provide a summary of past research conducted on the topic
of vertical integration in both the strategic management and finance disciplines, providing a
theoretical foundation for further study. Second, and more important, this paper is designed to
illustrate the incomplete research on vertical integration.
INTRODUCTION

As with every strategy a firm may choose to follow, vertical integration has both advantages
and disadvantages associated with it. In the following paragraphs, three advantages of vertical
integration will be discussed, followed by a summary of three disadvantages.
TECHNOLOGICAL INSEPARABILITY

Bain (1968) pointed out that the technological process in the value-added chain might
necessitate vertical integration. For example, in the production of rolled steel, if all steps of the
process, from the making of pig iron to the rolling of flats and bars, are performed under the same
roof, neither the pig iron nor the steel ingots would need to be cooled and then reheated. Using such
an example, Bain illustrates how technological inseparabilities may make vertical integration
logistically efficient. This can also be viewed as an example of how two consecutive stages in the
vertical integration can be related enough procedurally as to be performed under the same roof.
TECHNICAL ECONOMIES

Vertical mergers may produce technical economies through several sources. First, cost
reductions may arise through more efficient utilization of managerial skill (Levitt, 1975). Secondly,
shipping costs may certainly be reduced because the inputs of one stage are the outputs of another
process located under the same roof. Finally, it has been argued by several researchers (Buzzell,
1983; Mansfield & Wagner, 1975) that firms which integrate backwards innovate better than other
firms, perhaps due to possible similarities or relatedness between steps in the vertical chain.
BARRIERS TO ENTRY

If a firm must be vertically integrated to compete successfully in an industry, established

companies may combine operations as a means of discouraging potential entrants (Buzzell, 1983).

Proceedings of the Allied Academies Internet Conference, Volume 6 2004

Allied Academies International Internet Conference page 259

Because the vertically integrated firm will have invested many resources (both financial and
managerial) to its business structure, it becomes harder for new entrants to compete (Balakrishnan
& Wernerfelt, 1986; Buzzell, 1983). This precludes many competitors from replicating any product
differentiation advantages the firm holds (Caves & Porter, 1977; Comanor, 1967) creating an entry
barrier and an advantage to the established firm.
DISADVANTAGES OF VERTICAL INTEGRATION

The preceding discussion illustrates how vertical integration can provide many benefits to
the firm. The advantages must be weighed against any disadvantages discussed in the following
paragraphs.
CAPITAL REQUIREMENTS

The process of integrating either through internal growth or acquisition often requires heavy
investment (Buzzell, 1983). Because of the negative association researchers have found between
investment intensity and profitability (Gale, 1980), vertical integration requiring massive capital
investment may be an unprofitable strategic move for firms.
UNBALANCED THROUGHPUT

Unless economies of scale are established at equal levels of production in every stage in the
production process, a firm may find itself having to operate at inefficient levels of production
(Buzzell, 1983). In order to maximize economies of scale at one stage, for example, the firm may
have storage costs at another.
REDUCED FLEXIBILITY

Although vertical integration can create barriers to entry as mentioned above, massive capital
requirements can also reduce a firm’s flexibility. For example, if one stage of the production
process becomes obsolete, a company may be committed to continue in that stage because of its
alignment with other stages of production (Buzzell, 1983). Furthermore, when a firm chooses to
transfer in-house, it loses its exposure to outside innovations occurring in the supplier’s industry.
Balakrishnan and Wernerfelt (1986) empirically showed how integration can be negatively affected
by the frequency of technological change, especially if competition is high.
CONTINGENCY THEORY

Probably the most work dealing with vertical integration can be attributed to Harrigan (1980,
1983a, 1983b, 1985a, 1985b, 1985c, 1985d, 1986). Harrigan’s studies concluded that vertical
integration differs not only among industries but within them as well. Her work provided substantial
evidence that vertical integration should be viewed from a contingency viewpoint. In other words,
vertical integration is a more viable option in some situations than in others.
Drawing on this extensive background of information, in 1986 Harrigan again extended the
literature on vertical integration by comparing successful and unsuccessful firms in terms of their
vertical integration decisions. Unsuccessful firms were defined as organizations “identified by a
consensus of managers as firms suffering significant losses in the target industries. (Significant
losses were those exceeding 5 percent ROS (Return on Sales) over 5-year averages.)” (p. 543). She
came to the following conclusions outlined in the next two section.

Proceedings of the Allied Academies Internet Conference, Volume 6 2004