Backward integration is a form of vertical integration in which a company expands its role to fulfill tasks formerly completed by businesses up the supply chain. This strategy involves a company buying another company that supplies the products or services needed for production. For instance, a company might acquire their supplier of inventory or raw materials. Companies often achieve backward integration through acquiring or merging with other businesses, but they can also establish their own subsidiary to accomplish the task. Complete vertical integration occurs when a company owns every stage of the production process, from raw materials to finished goods/services.
Key Takeaways
- Enhanced Control: Backward integration happens when a company expands to fulfill tasks previously completed by businesses up the supply chain.
- Mergers and Acquisitions: This often involves buying or merging with another company that supplies its products.
- Efficiency and Savings: Companies pursue backward integration to improve efficiency and save costs.
- Cost Intensive: It can be capital intensive, as it may require large sums to purchase part of the supply chain.
Understanding Backward Integration
Companies often use integration as a means to take over a portion of the company’s supply chain. A supply chain is comprised of individuals, organizations, resources, activities, and technologies involved in the making and selling of a product. It starts with the delivery of raw materials from a supplier to a manufacturer and ends with the sale of a final product to the end-consumer.
Backward integration aims to boost efficiency by utilizing vertical integration, where a company controls multiple segments of the supply chain with the goal of managing a portion or all of the production process. Vertical integration might lead a company to control its distributors that ship their product, the retail locations that sell their product, or their suppliers of inventory and raw materials in the case of backward integration. Simply put, backward integration occurs when a company initiates vertical integration by moving backward in its cargo supply chain.
An illustrative example of backward integration could be a bakery purchasing a wheat processor or even a wheat farm, thereby cutting out intermediaries and decreasing competition.
Backward Integration vs. Forward Integration
Forward integration is another type of vertical integration which involves the purchase or control of a company’s distributors. An example of forward integration could be a clothing manufacturer that traditionally sells clothes to department stores but opens its own retail locations instead. Conversely, a clothing manufacturer practicing backward integration might buy a textile company that produces the material for their clothing.
In essence, backward integration involves acquiring parts of the supply chain before the company’s manufacturing process, while forward integration comprises parts of the process occurring after the manufacturing stage. For example, Netflix started as a DVD rental company but utilized backward integration by creating its original content.
Advantages of Backward Integration
Companies pursue backward integration when it is expected to result in boosted efficiency and cost savings. This strategy can lower transportation costs, improve profit margins, make the firm more competitive, and control costs from production through the distribution process. Businesses also gain more control over their value chain, enhancing efficiency and gaining direct access to essential materials. Moreover, backward integration keeps competitors at bay by securing access to specific markets and resources, including technology or patents.
Disadvantages of Backward Integration
However, backward integration can be very capital-intensive, requiring large financial investments to purchase part of the supply chain. If a company needs to buy a supplier or production facility, it might have to incur significant debt, diminishing any cost savings realized. The burden of debt also confines the company’s ability to procure additional credit facilities in the future.
In some scenarios, relying on independent suppliers and distributors might be more efficient and cost-effective. A supplier might acquire more economies of scale, resulting in lower costs per unit as production volume increases. Some suppliers can offer input goods at a cost lower than what a manufacturer could achieve itself.
Further, companies engaging in backward integration might become excessively large and unmanageable, causing them to stray away from their core strengths and profitability trails.
A Real-World Example of Backward Integration
Many large companies and conglomerates practice backward integration, and a significant example is Amazon.com Inc. Initially an online book retailer in 1995, Amazon started by procuring books from publishers. In 2009, it launched its own dedicated publishing division and acquired rights to both older and new titles, now running several imprints. Although Amazon still sells books produced by others, its own publishing efforts have increased profits, attracted consumers to its products, and controlled distribution on its Kindle platform, providing leverage over other publishing houses. Thus, Amazon successfully used backward integration to evolve into both a book retailer and book publisher.
Related Terms: vertical integration, supply chain, forward integration, profit margins, conglomerate, economies of scale.
