Advanced Corporate Strategy

ST104x

How does vertical integration add value?

We have argued that vertical integration adds value by three ways:

1. increasing barriers to entry,

2. reducing dependence on suppliers and channel partners, and

3. providing firms with the ability to price their products right.

Do these value additions work the same way across all industries?

There are two scenarios,

I. one where the market for intermediate goods is mature, and

II. two where the market for intermediate goods is not established or mature.

The value addition due to vertical integration will be different across these two industry
contexts.

In an industry with mature market for intermediate goods, vertical integration only adds value
when pursued for exercising control over suppliers or vendors. It is pretty much difficult to
establish barriers to entry in such markets. However, in industries where the market for
intermediate goods is non-existent or where the intermediate goods are typically custom-
built for the specific users, vertical integration helps erect barriers to entry.

In addition, value creation also depends on the criticality of the products, and frequency of
transactions. When the products being produced are critical to quality of the primary product
or service, vertical integration adds value. It provides the firm with control over quality and

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 Advanced Corporate Strategy

ST104x

scheduling of supplies. On the other hand, if the firm buys the product or service too
infrequently, then the costs of vertical integration outweighs the benefits.

We need to consider two more conditions apart from these two – asset specificity and the
ease of governance. When the supplier has to make specific investments to serve the
customer, the supplier bargaining power increases, and the customer has all the incentives to
vertically integrate.

And another critical criterion for value addition through vertical integration is the ease of
governance – the more difficult it is to contract and govern, there is value addition due to
vertical integration. Otherwise, the firm should outsource these activities.

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