Definition
Vertical integration is when one company takes over several stages of the supply chain, from raw materials to final sale. It means bringing in-house the steps before and after yours that you used to hand off to others. A company can do this by buying a firm that runs that stage, or by building the facilities and doing it itself.
What if the bakery gets its own flour mill?
Say a neighborhood bakery buys flour from a wholesaler. When prices rise, the bakery takes the hit. When a delivery runs late, there's no bread that day. So some bakeries decide to buy a grinder and mill their own wheat.
But the two worries don't get solved equally. The price of wheat itself still goes up, even with a grinder. Bringing milling in-house can cut out the markup the miller and wholesaler used to add. But the bakery now pays the cost of milling directly. What it gains is control over when the flour arrives.
There are two paths here. One is to buy a mill that's already running and make it part of the family. The other is to put machines next to your storeroom and start from scratch. Both count as vertical integration. The name isn't only for buying another company.
There are two directions, too. One goes back toward the wheat, and one goes forward toward the customer. If the bakery delivers in its own van and opens its own shops, it has pulled the customer-facing, sales-side stages in-house. Moving toward raw materials is called backward integration. Moving toward customers is called forward integration.
What counts as a "stage" is the key
A supply chain is a series of stages. Take the rare earths used in magnets. The Congressional Research Service splits that supply chain into five stages. You mine the ore, separate out the seventeen elements one by one, turn the oxides into metals, make alloys, and then press them into magnets.
Each stage needs different equipment and know-how. Mining and separating happen in different plants, and sometimes in different countries. So when you say who makes most of an industry's output, you have to say which stage you mean for the answer to make sense.
There's one confusing neighbor. Vertical integration pulls the upstream and downstream stages of a supply chain into one company. A horizontal merger ties together competitors at the same stage. Two bakeries becoming one is a horizontal merger. A bakery taking on a mill is vertical integration.
It also runs opposite to outsourcing. Outsourcing hands work you did in-house to someone outside. Vertical integration brings work you used to hand outside back in.
A bit more precisely: it's not always a win
Bringing a stage in-house doesn't always pay off. Two conditions have to hold. The volumes at the neighboring stages need to match, and you need to be able to handle the skills and equipment that stage requires.
If the grinder sits idle half the day, the bakery eats that cost. On top of that, once you buy from yourself, you lose a price to compare against. When you buy outside, you can get quotes from several sellers. When you make it inside, it's hard to tell whether the price is cheap or expensive.
There are real cases of companies reversing course. An American auto plant completed in the 1920s took in iron ore and coal by ship, made its own glass and steel, and sent out finished cars. Yet in 1999 and 2000, two American carmakers spun off their parts divisions as independent companies.
Neither choice is simply right. What works better changes with the times. If milling costs swing wildly and supply often breaks down, bringing the mill in-house may be better. If prices are stable and there are plenty of sellers, buying may be better.
Common misconceptions
Vertical integration means buying other companies.
Acquisition is one way, but not the only one. Building that stage yourself and hiring people to run it is the same thing. The test is whether you brought a stage you used to outsource inside your own company.
Bringing several stages in-house removes the middleman's margin, so costs always go down.
The equipment and labor for the newly added stage become the company's burden. If volume at that stage is too low and the equipment sits idle, costs can actually rise. And when you buy from yourself, you have no one to compare prices against.
Where you meet it
Instead of buying flour, a bakery installs a grinder to mill its own wheat and sells through its own stores.
A solar company that only made panels (modules) builds a new cell factory for the stage right before it and links the two together.
In one sentence
Vertical integration means bringing the stages before and after yours in the supply chain in-house. It includes building them yourself, not just acquiring other companies.