Backward Integration

What Is Backward Integration?

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. In other words, backward integration is when a company buys another company that supplies the products or services needed for production. For example, a company might buy their supplier of inventory or raw materials. Companies often complete backward integration by acquiring or merging with these other businesses, but they can also establish their own subsidiary to accomplish the task.

Backward integration is a method of vertical integration that extends to the previous levels of the supply chain, aiming to protect the quality of a product or a service by gaining control over the raw materials. In other words, it’s when a company purchases a supplier in or a supplier’s rights to materials in an effort to control its supply chain.

Backward integration is a type of vertical integration in which a consumer of raw materials acquires its suppliers, or sets up its own facilities to ensure a more reliable or cost-effective supply of inputs.

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 the group of individuals, organizations, resources, activities, and technologies involved in the manufacturing and sale of a product. The supply chain starts with the delivery of raw materials from a supplier to a manufacturer and ends with the sale of a final product to an end-consumer.

Backward integration is a strategy that uses vertical integration to boost efficiency. Vertical integration is when a company encompasses multiple segments of the supply chain with the goal of controlling a portion, or all, of their production process. Vertical integration might lead a company to control its distributors that ship their product, the retail locations that sell their product, or in the case of backward integration, their suppliers of inventory and raw materials. In short, backward integration occurs when a company initiates a vertical integration by moving backward in its industry’s supply chain.

An example of backward integration might be a bakery that purchases a wheat processor or a wheat farm. In this scenario, a retail supplier is purchasing one of its manufacturers, therefore cutting out the middleman, and hindering competition.

Example

Company ABC is a manufacturer of frozen food and seeks to acquire one of their suppliers who owns a poultry processing plant. By acquiring the poultry processing plant, the company will be able to control the cost of production, the quality of raw materials, and the quality of the produced food.

Furthermore, the company will be able to differentiate its products from its competitors as by assuming control over the supplier it will hinder competitive companies from buying supplies from the poultry processing plant. In doing so, the company will control the scarce resources and the raw materials, but also its costs due to the economies of scale.

Therefore, with backward integration, a firm controls its supply chain, lowers its costs and controls the raw materials, while hindering the access of competitors to these raw materials.

Advantages of Backward Integration

  1. Increased control. By integrating backward and merging with suppliers, Companies can control their supply chain in an efficient manner. 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 to be 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. In a supply chain, there is always a markup when goods are sold from one party to another. The supply chain involves various suppliers, distributors, middlemen. By integrating the business with the producer of the material, the Company can remove these middlemen from the supply chain and cut the markup 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, to keep the competition out of the market can acquire the supplier. Consider a scenario where a major supplier supplies materials to two Companies but one of them purchases the supplier so it can stop the supplies of goods to the competitor. By this way, the Company is trying that the existing competitor exits from business or look for another supplier and creating entry barriers for new Competitors. 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 can market itself differently from its competitors. Integrating backward will enhance the Company’s ability to meet the customer’s demand and may also help it to provide customized products since now it holds the production capacity internally than sourcing it from the market.

Disadvantages of Backward Integration

  1. Huge Investments. Integration, merging, or acquiring the manufacturer will require huge investments. It will be an extra burden on the Company’s balance sheet may be in the form of debt or reduction cash and cash equivalents.
  2. Costs. It is not always that the costs will be reduced in backward integration. 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 could not 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 low quality of products. If there is no or less competition in the market, the Company will become less efficient/less motivated in terms of 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 significant cost for in-house development or it may 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 within the Company.
  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.

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.

What Is The Importance of Backward Integration?

Many people might still doubt the importance of the backward integration strategy, and this part of the article is going to clear out all the doubt that they have.

We can say that it is one of the most important business strategies that people can use these days because it helps the company in addressing the bottom line of it.

There are certain costs which can be significantly reduced with the help of this particular strategy that we are talking about. Also, the production and distribution costs can be cut down. So, who wouldn’t want to use this strategy in the first place, right?

Apart from that, the businesses will be able to gain more and more control over the company when it comes to the value chain. This process also helps in increasing the efficiency of the company and provides some direct access to the raw materials which are required for the production.

Summary

  • Backward integration is when a company expands its role to fulfill tasks formerly completed by businesses up the supply chain.
  • Backward integration often involves is buying or merging with another company that supplies its products.
  • Companies pursue backward integration when it is expected to result in improved efficiency and cost savings.
  • Backward integration can be capital intensive, meaning it often requires large sums of money to purchase part of the supply chain.

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