The return of vertical integration

Once English entrepreneur Matthew Boulton took over his father’s toy factory in the 18th century and started rolling his own steel to produce products from candlesticks to steam engines, vertical integration became the business model for the industrialised world. The efficiencies of controlling all parts of the process – from rearing cows to delivering the milk, or mining ore to making cars – proved compelling.

Oil companies have possibly grasped vertical integration most tightly, owning the oil wells, refineries, pipelines and tankers, plus the gas stations that fill motorists’ tanks. But it is the model employed by brewers that grew their own hops and owned the pubs selling their ale, and by clothing groups that owned sweatshops making garments and high-street shops selling them. Henry Ford bought iron ore and coal mines in America and built foundries on both sides of the Atlantic to feed his car plants.

But in the late 20th century, the business structure changed:Vertical integration was replaced by a horizontal pattern in which specialist retailers bought from the garment makers – and spread sideways into selling shoes or jewellery made by other manufacturers who no longer wanted to run shops. Soon this horizontal expansion was seen as so virtuous, companies acquired completely unrelated businesses and the  conglomerate was born. Such groups offered diversification, unlike vertically-integrated operations that, despite the variety of processes and skills employed, still had all its eggs in one basket.

The big corporate beasts became companies such as Hanson, whose activities in America and Britain included coal mining, cigarettes and bricks. Corporations such as General Motorsadded finance to motor manufacture; Nabisco foods shared ownership with Reynolds tobacco; Smith & Weston guns belonged to the same group as a British baker.

Then fashion changed again and the buzzword became “focus”. Conglomerates were dismantled, divisions demerged and administration outsourced as companies retreated to a single core activity. Even Ford, a devotee of the vertical mode, sold its foundries.

But now the circle has turned 360 degrees: Vertical integration is back in favour. Australia’s Macarthur Coal, which supplies a third of the coal used by the world steel industry, has been bought up by milling companies eager to secure their own fuel source. ArcelorMittal, the world’s largest steel maker, has restructured into a vertical company, buying iron ore mines from Liberia to Mexico.

In the U.S., Boeing has bought some of its suppliers. In 2009 the Seattle-based plane maker acquired Vought Aircraft Industries in South Carolina for $580 million, having the previous year purchased Global Aeronautics in the same state. Both companies make or assemble fuselages for Boeing’s 787 Dreamliner plane and Boeing Commercial Airplanes’ Chief Executive, Scott Carson, says: “Integrating this facility and its talented employees will strengthen the 787 program by enabling us to accelerate productivity and efficiency improvements.”

Securing supplies is one benefit of vertical integration. Even if there is no price advantage from using in-house suppliers, control should ensure uninterrupted deliveries during shortages or when demand exceeds capacity. Many companies own sources of power to maintain production, irrespective of whether it is cheaper than external suppliers.

But there are other advantages. Owning distribution routes or outlets can ensure the product is sold in the way that the company wants. For complex products or those new to consumers, such as mobile telephones, owning the shop can ensure greater sales, and outlets selling only one brand can protect suppliers in intensely competitive markets.

And there are benefits, as Boeing is finding, in exploiting the skills of staff further back in the supply chain. Instead of duplicating Vought’s research and development, the new owner can now share technologies without fear of them going outside the group. When companies unravelled their vertical structures by selling subsidiaries or back-offices, they not only allowed talent to go outside the group, they allowed those skills to be sold to rivals.

Britain’s Co-operative retail group has always believed invertical integration, owning its own food suppliers. Its 70,000 acres may be small by American standards but that is the size of the Isle of Wight and the group has started expanding its estate. Fourscore Farm in Cambridgeshire, bought last summer, will supply broccoli, onions and potatoes directly to local Co-op shops. Now the larger rival supermarket group Morrisons, which took over Safeway in the UK, is buying its first farms, in Scotland and south-east England.

Anglian Building Products, one of the UK’s largest double-glazing companies, has adopted vertical integration as its model too, operating glass furnaces, blending its own PVC-u to extrude into sections, and employing its own van fleet and instalment staff.

Director Melanie Russell says: “One of the main competitive advantages is that we operate a vertically-integrated service enabling total control of all processes, from initial design, survey, manufacture, fabrication and glazing to final installation and after sales support.”

When vertical integration was out of fashion, companies outsourced customer service to call-centres, often overseas. However, losing control of this vital function proved unsatisfactory for many and the phones groups Orange and AT&T, plus Abbey bank, are among firms bringing it back in-house. BT, the UK phone company currently cutting 30,000 staff, justified axing its Indian call-centres to help its own workforce retain jobs.

As the biggest gainer from outsourcing, India has most to lose but its also converts to vertical integration. Its largest business, Reliance Industries, stretches from oil production through textiles, to retailing, and Chairman Mukesh Ambani says: “Backward vertical integration has been the cornerstone of the evolution and growth of Resolution.”

The Tata conglomerate has now adopted the same policy, following its purchase of Britain’s Corus steel company by buying vehicle makers Jaguar and Land Rover.

But the main brake on this trend may be governments that fearvertical integration is non-competitive. The EU blockedGeneral Electric’s $44 billion bid for Honeywell because a combined group would control too much of the jet engines market, while British regulators balked at Sky television owning Manchester United Football Club and in 2009 blocked a ticket agency from buying a concert organiser.

But while trends in organisational structure keep changing, the current wish to control supplies and outlets is making vertical integration popular again. Matthew Boulton would be proud.

Edited by Ian Armitage

Manufacturing Digital Magazine