When a firm integrates backward it becomes its own distributor?

A company acquires or merges with other businesses that supply raw materials for the finished product

Table of Contents Show

How It Works
Example of Backward Integration
Advantages of Backward Integration
Disadvantages of Backward Integration
Backward Integration vs. Forward Integration
Related Readings
Backward Integration Examples
Advantages of Backward Integration
Disadvantages of Backward Integration
Backward Integration Video
Recommended Articles

Backward integration is a process in which a company acquires or merges with other businesses that supply raw materials needed in the production of its finished product. Businesses pursue backward integration with the expectation that the process will result in cost savings, increased revenues, and improved efficiency in the production process. Companies also use backward integration as a way of gaining competitive advantage and creating barriers to entry to new industry entrants.

How It Works

A business that implements backward integration attempts to move backward in the supply chain to the control of raw materials. The supply chain process starts with the sourcing and delivery of raw materials to the manufacturer’s warehouse and ends when the final product gets to the end consumer.

Raw materials are scarce resources that every business attempts to control, and lacking access to such resources may cripple the operations of the business. In industries with high competition, manufacturers often make attempts to buy suppliers as a way of cutting out the middlemen and managing the increasing competition for scarce resources.

Example of Backward Integration

An example is a wine manufacturer that seeks to acquire a wine bottle manufacturing company that owns the rights and technologies of manufacturing glass. By acquiring the wine glass manufacturing company, the wine manufacturer will be in a position to control the quality of the manufactured glass, cost of production, as well as the quality of raw materials used in the manufacturing process.

This will limit other wine manufacturers from buying wine bottles from that supplier. Also, it will allow the acquirer to differentiate its wine bottles from those of the other competitors. Since the raw materials for the manufacture of glass are scarce in nature, the wine manufacturer will be in a position to manage the resource to make sure they are effectively used to produce high-quality bottles.

Advantages of Backward Integration

The following are some of the benefits that companies enjoy when they implement backward integration:

1. Better control

By acquiring the manufacturers of raw material, a company exercises greater control over the supply chain process from the production of raw materials to the production of the end product. First, the company will gain control over the quality of raw materials that are used in the production of the end product. Also, by acquiring the supplier of raw materials, the manufacturer will achieve greater control over the quantity and delivery of the raw materials to its warehouse.

2. Cost control

The supply chain process comprises many middlemen, which means that each phase in the supply chain includes a mark-up to allow the middleman to earn a profit. Thus, by the time the product gets to the company’s warehouse, the price will have doubled or tripled. This will make the finished product more expensive for the consumer.

By acquiring the supplier of the raw materials used in the production process, the company will do away with the middlemen involved in the process and reduce the cost of purchasing the raw materials. Controlling the entire supply chain will also reduce wastages, transport costs, and other costs incurred before the raw materials are delivered to the company’s warehouse.

3. Competitive advantage

Companies also use backward integration as a way to gain a competitive advantage over their competitors. For example, in the technology industry, companies integrate backward as a way of gaining access to patents, trademarks, and proprietary technology owned by other companies in the industry.

Acquiring such companies prevents competitors from using the same resources, and other firms are forced to look for alternatives in the market. Acquiring suppliers also create barriers to entry. New competitors will face difficulties getting suppliers for the raw materials required in the production process.

Disadvantages of Backward Integration

1. Inefficiencies

Implementing backward integration can result in inefficiencies. By acquiring the supplier of raw materials required in the production process, the company will limit competition, resulting in sluggishness and lack of innovation. The company will be less motivated to spend money on research and development. As a result, the quality of the company’s end product(s) may decline, and the costs of managing customer complaints will increase.

2. Substantial investment

Another disadvantage of backward integration is the substantial investment that will be needed to finance the acquisition. The company may be forced to utilize all its cash reserves and even take up more debts to finance the acquisition. If the company is unable to repay the debts or enjoy the benefits of the acquisition, it will face the risk of default and even liquidation.

Backward Integration vs. Forward Integration

While backward integration is the merging and acquisition of companies in the upper side of the supply chain, forward integration is the acquisition of companies on the lower part of the supply chain. In forward integration, the company is interested in acquiring distributors of its products or the retail stores that sell the final products to the end consumer.

For example, a wine manufacturer may decide to acquire businesses with wine distributorship rights or the retail chain stores that sell wine produced by the company. This will give the manufacturer better control in getting the finished product to the consumer and in obtaining first-hand information on the consumer’s experience with the company’s products.

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Economies of Scale
Strategic Management
Value Chain
Vertical Integration

Backward integration is a form of vertical integrationVertical integration is a corporate approach to take charge of its value chain or supply chain functions. It is the process of holding and managing the distributors, suppliers and retail locations at the company's discretion.read more by which the Company integrates its operations with the suppliers or the supply side of the business. The Company gains control over the raw material suppliers by integrating them with their ongoing business.

The Company does so to maintain a competitive advantage and increase entry barriers. In addition, the Company can cut its costs by merging with its suppliers and maintaining quality standards.

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Source: Backward Integration (wallstreetmojo.com)

Backward Integration Examples

Example #1

Suppose there is a Car Company, XYZ, which gets a lot of raw materials like iron and steel for making cars, rubber for seats, pistons, engines, etc., from various suppliers. If this car Company merges/ acquires the supplier of iron and steel, it will be called backward integration.

Example #2

Another example would be a tomato ketchup manufacturer purchasing a tomato farm rather than buying tomatoes from the farmers.

Advantages of Backward Integration

#1 – Increased control

By integrating backward and merging with suppliers, Companies can efficiently control their supply chain. They will control the production of raw materials until the production of the end product. By this, they will have a larger control on the quality of raw material used in production. Also, the Company secures itself with the supply of material. It will ensure that the Company receives adequate supplies as and when required without worrying about raw materials being sold to the competitor or not produced /manufactured by the suppliers.

#2 – Cost Cutting

Generally, backward integration is done to cut costs. There is always a markup in a supply chain when goods are sold from one party to another. The supply chain involves various suppliers, distributors, intermediaries. By integrating the business with the material producer, the Company can remove these middlemen from the supply chain and cut the markupThe percentage of profits derived over the cost price of the product sold is known as markup. It is determined by dividing the company's total profit by the cost price of the product and multiplying the result by 100.read more costs, transportation, and other unnecessary costs involved in the whole process.

#3 – Efficiency

While the Company will cut costs, backward integration also provides better efficiency in the whole manufacturing process. With control over the supply side of the chain, the Company can control when and which material to produce and how much to produce. With improved efficiency, the Company can save its cost on the material, which gets unnecessarily wasted due to over purchase.

#4 – Competitive Advantage and Creating Barriers to Entry

Sometimes, companies can acquire suppliers to keep the competition out of the market. For example, consider a scenario where a major supplier supplies materials to two Companies but one of them purchases the supplier to stop the supplies of goods to the competitor. In this way, the Company is trying to prevent the existing competitor from leaving the business or looking for another supplier and creating entry barriers for new CompetitorsBarriers to entry are the economic hurdles that a new entrant must face in order to enter a market. For example, new entrants must pay fixed costs regardless of production or sales that would not have been incurred if the participant had not been a new entrant.read more. Also, sometimes the Company may integrate backward to gain access and control of technology, patents, and other important resources that were only held by the supplying firm.

#5 – Differentiation

Companies integrate backward to maintain the differentiation of their product from their competitors. It will gain access to the production units and distribution chain and thus market itself differently from its competitors. Integrating backward will enhance the Company’s ability to meet the customer’s demand. It may also help it provide customized products since now it holds the production capacity internally rather than sourcing it from the market.

Disadvantages of Backward Integration

#1 – Huge Investments

Integration, merging, or acquiring the manufacturer will require huge investments. As a result, it will be an extra burden on the Company’s balance sheet, which may be in the form of debt or reduction cash and cash equivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more.

#2 – Costs

It is not always that the costs will be reduced in backward integration. For example, lack of supplier competition can reduce efficiency and thus result in higher costs. Further, it will be an extra burden on the Company if it cannot achieve the economies of scale that the supplier can achieve individually and produce goods at a lower cost.

#3 – Quality

Lack of competition can lead to less innovation and thus the low quality of products. Suppose there is no competition in the market. In that case, the Company will become less efficient/less motivated in innovation, research, and development as it knows it can sell whatever it produces. Hence, this could impact the quality of the products. Further, if the Company wants to develop a different variety of goods, it may have a high cost for in-house development or incur high costs for switching to other suppliers.

#4 – Competencies

The Company may have to adopt new competencies over the old ones, or there may be a clash between the old and new competencies, causing inefficiency.

#5 – High bureaucracy

Acquiring the supplier will mean acquiring the workforce of the supplier as well. This will increase the size of the Company, thus bringing in new policies for the employees and leading to a bureaucratic culture in the Company.

Conclusion

Backward integration refers to the company’s vertical integration strategy with its supply-side or supplier where the company either merges with the suppliers or acquires the supplier’s business who provides raw materials to the company and if the company decides to set up its internal supply unit.

The Company needs to perform due diligence before integrating backward. Should it look at various factors such as – will the investment and finance costFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more lower than the long-term benefits it will have by acquiring the suppliers? In addition, the Company should diligently check the equipment, processes, workforce, patents, etc., of the supplier/manufacturer to be acquired. Such an acquisition will help it have a better and more efficient supply chain.