I was arranging a shipment of stone from a quarry, and was surprised when they told me they use Yellow Freight, a trucking service, to deliver their material, rather than using their own trucks. Their business is selling big heavy rocks, and I cant imagine anyone driving their pickup trucks there to load tons of rocks, not even Mike Rowe in a Ford commercial. They said its more business efficient this way, because they have variable shipping needs. And that got me thinking about the pros and cons of vertical integration. Forward vertical integration is when a company integrates members of the supply chain from their core activity, towards getting the product to the consumer. Like if a bakery buys a fleet of bread trucks to deliver their goods to the supermarkets. Further forward integration is if the bakery also owns the supermarkets. Apple is an example of being forward integrated, as they own the brick-and-mortar retail stores, as compared to Samsung and HTC, who mostly rely on 3rd party retailers like Best Buy and AT&T to carry their products. Backward vertical integration is when a company integrates the subsidiaries that provides it with its raw material. Like if a computer manufacturing company acquires the factory that makes the PC frame, plastic covers, processors, chips, and other components, rather than buy them from independent companies. Further backward integration is if they owned the mines to obtain the metals used in the parts. Examples of backward integration are oil companies, who often own the refineries, the tankers, the drilling operations, and exploration. Typically, company managers prefer vertical integration, because they have more control. When they want something shipped, its theirs. Theres no Sorry, our trucks are out, and theyre scheduled to ship someone elses product tomorrow. Try back next week. They get service when they want it. However, vertical integration often hurts the bottom line, even when it appears to save money. Take the quarry for example. Say it costs $200 an hour to operate a truck (driver, gas, maintenance, insurance, etc). A 4 hour round-trip delivery would cost them $800, while an outside shipping service would charge $1000. They saved $200 with their own trucks, right? Not exactly. First, what if they dont use that truck 8 hours a day? A truck sitting in the yard still needs to be maintained. They still have to pay the driver a full days wage, even if hes sitting in the office waiting for a call. Also theres the financing or opportunity cost of buying the truck. These are sunk costs that have to be paid regardless if the truck is being used to capacity. Second, if a shipping company charges $1000, and it only costs them $800 to ship in-house, they didnt really save $200. Rather, their trucking division gave the manufacturing division a $200 discount. In essence, its be like the trucking company losing $200 by not operating at market rates, in order to subsidize the manufacturing company with $200 of savings. Many companies, especially large corporations with little oversight, have the problem of wanting to vertically integrate, for the sake of growing, justified by synergy. The CEO of a computer company would say we can get processors at 25% discount if we buy them out! But even if theyre saving 25% on the computer end, that comes out of the revenue from the processor division, which wouldve been able to sell for more on the open market. The net gain is $0. But still the CEO would push for this acquisition, because then hed be head of a $100m company, rather than a $75m computer company that buys parts from a $25m processor manufacturer. And surely his salary would increase to match. On the other hand, it makes more sense for small companies to integrate, because its easier to manage potential inefficiency. It wouldnt make sense for a pizza shop to rent a cab every time they make a delivery, so they do it with a delivery driver on staff. But if theres no deliveries...the driver can help in the shop, like folding pizza boxes or some other task. Something that a manager overseeing 5 employees can easily account for, but not in a large lumbering corporation. Bottom line, vertical integration has its pros and cons. Dont integrate for the sake of inflating company size, and when you hear about a companys PR department hyping their new acquisition, dont rush out to buy their stocks.
Posted on: Thu, 07 Aug 2014 19:01:07 +0000
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