Most products travel a long and winding road from raw material to a customers cart, and those materials pass through a lot of hands along the way. At each stage of this process, theres a company needing to make a profit. If you run one of those companies, theres a very real possibility that you could strengthen your operation and fatten your profits by expanding into more sections of that supply chain.
The strategy of controlling more of your products supply chain is called vertical integration. You can choose either to travel back or “upstream” on the supply chain, toward raw materials, or forward or “downstream” toward the end user. When your local business page speaks of a company spreading its wings with forward integration that means its following the second of those strategies.
Forward Integration Vs. Backward Integration || Strategic Management Series
Phases in the production process
To understand forward integration, its beneficial to know the phases in the production process. There are five stages of monetization to generate profits from production, and between one and five companies manage each stage:
Any company within the production process can practice forward integration by assuming control of steps lower on the list. For example, a retail company that offers after-sale services or a material producer that begins manufacturing with their raw materials are practicing forward integration.
What is forward integration?
Forward integration is a method for a company to gain more control over the distribution of its goods. It serves as a type of downstream vertical integration. In vertical integration, a company takes over new phases in the production process by purchasing an existing company or expanding its operations to cover a new phase. When applied to early steps in the production process, its called upstream integration, while absorbing later steps is downstream integration.
A company may apply forward integration to several steps in the production process, such as a production company assuming control of both sales and distribution of their product. Taking control of additional stages increases both the risk and reward for a company. The company assumes more responsibility for costs in production but also reduces the number of companies sharing the benefits of successful production.
Why do businesses use forward integration?
Owning more phases allows businesses to have additional control over the production process. Besides reducing the number of partners required to move through the entire production process, forward integration offers a way for companies to lower costs and raise overall profit.
For example, a production facility may acquire a distribution network of trucking operations. The production facility can now expand operations more easily as it can increase funding to their distribution arm without needing to rely on increased availability from a distribution partner. Because the facility owns distribution, it doesnt need to pay a premium to account for the distribution companys profit margin. This results in higher overall profit margins.
Differences between upstream and downstream integration
Both upstream and downstream integration are ways for companies to assume control over parts of the production process. With downstream integration, a company takes responsibility for later steps, such as distribution or sales. Upstream integration occurs when a company assumes control of earlier steps, such as material production. These integrations can allow a company to improve its performance and raise profitability. By assuming new steps in the production process, a company reduces the number of partners who might benefit from profit sharing. Integration also leads to increased autonomy so that companies can make improvements as needed when identifying opportunities.
A company may engage in both upstream and downstream integration. A retail company, for example, may seek to expand its operation through either upstream or downstream options. Offering after-sale benefits, such as installation or repair service, is a form of downstream integration. Acquiring a distribution company to manage distribution from manufacturers to the companys retail locations is an upstream integration.
Benefits and drawbacks of forward integration
When deciding if forward integration is the right decision for a company, its important to understand both the benefits and potential drawbacks.
Benefits of forward integration
The most important reasons to consider forward integration include:
Drawbacks of forward integration
Although there are many reasons to opt for a forward integration plan, its important to consider the downsides to determine if it is the right choice. Some of the most consequential considerations include:
Examples of forward integration
These examples show ways a company may use forward integration to make its operations more effective and increase profits:
Example 1: Sportswear manufacturer
A sports manufacturer creates athletic gear for a variety of sports. Under the current business model, it sells its products to sports retailers who sell them to consumers at a markup. After internal discussions, the company offers its products directly to consumers through online retail. The company invests in its web development team to create a digital marketplace on its website.
The company also decides to slowly expand its integration opportunities. While assuming retail responsibilities, the company continues to contract with a shipping company to manage distribution after sales. Despite keeping distribution under outside control, the company is still practicing forward integration by entering retail.
Example 2: Farmer
A farmer maintains and sells their crops to local grocers. The farm already practices upstream integration by using the current crops seeds to grow the next years crop. The farmer decides to further control their production by selling their yield to customers directly.
The farmer advertises fresh produce with signs designed to attract drivers passing the property. The farmer also begins attending farmers markets where they sell fresh produce to customers. By making direct sales, the farmer maintains full profit and sells at a higher profit margin on sales through the market. This increases the farms overall profitability each year.
Example 3: Technology retailer
A technology retailer specializes in selling electronics, including home computers, entertainment systems and mobile devices, directly to consumers. It identifies an opportunity to implement forward integration by providing after-sale services, such as installation and technical support on purchased devices.
The company establishes a new department that provides technical support. When selling devices to customers, the company offers the opportunity to take advantage of the technology professionals after-sale services. This new area of monetization increases the average profit per sale.