Vertical Integration

Complete vertical integration is the operation of the organization across an entire spectrum of activities ranging from the source of raw materials at one end of the spectrum, through operations, to retailing to the end-use consumer at the other end of the spectrum. Thus, there are two opposite ends of the vertical integration spectrum. The term backward vertical or upstream integration refers to operation near the stage of raw materials in the industry. The term forward vertical or downstream integration refers to operation near to retailing the product or service.

Some organizations seek upstream activities to protect a source of supply or to insulate the parent firm from price fluctuations in the raw material. A good example of backward or upstream vertical integration to protect a source of supply was the practice of many hospitals in the mid 1990s of buying the practices of physicians. By buying those practices, the hospitals were acquiring a necessary input in the health care process, namely physicians, and protecting the referral of patients.

Other organizations seek forward vertical integration so that the consumer will identify with the parent organization and demand its product by name. A good example of forward or downstream vertical integration was the practice of many pharmaceutical companies to advertise prescription drugs by name directly to consumers (patients) in the media with the identity of the pharmaceutical companies. The objective was to cause patients to demand prescriptions from their physicians for the drugs.

Increasing vertical integration is a form of diversification. Becoming more integrated in addition to one's current position spreads risk and leads to areas wherein management has limited competence. Highly vertically integrated organizations report lower profitability than others. Apparently, the diversification activities required of increased vertical integration detract attention and resources from the firm's core of distinctive competence. This yields lower profitability, just as unrelated horizontal diversification does.