Netflix was first a video streaming service, then became a TV show creator. Apple Initially produced hardware, and later started making software. Tesla, a car producer, began designing chips in the midst of the chip crisis. What do these companies have in common? They all went against the current.
Let’s have a look at the automotive industry. Typically, to increase its share in the market, car suppliers buy their competitors (Volkswagen case). It’s categorized as horizontal integration. At the same time, Elon Musk calls Tesla an absurdly vertically integrated company compared to its competitors. But what does vertical integration really mean and what makes it so profitable?
Horizontal integration is a strategy of developing a company by buying its competitors. It is believed that it works best under two conditions. First, the technology that the business develops should be mature, that is, no dramatic changes are expected to occur within the market. Second, the competitor should undergo some kind of issues, like financial instability, supply chain distractions or poor management.
Vertical integration, on the other hand, is a process of incorporating companies existing in the same supply chain (ahead or behind the spoken company). In layman’s terms, if a publishing house buys a bookstore, it’s forward vertical integration and if the bookstore owner buys a publishing house, it’s backward vertical integration.
Every business has its inefficiencies that the market is going to eventually verify. Recent pandemic and war crises brought our attention to vulnerabilities of the supply chains worldwide. We also experience high transport rates which you can read more about here: But even before that complicated supply chains whose parts belonged to different parties posed risk of miscalculations and inefficiencies.
If the supply chain’s members on the way belong to different parties, there’s always margins, overestimation of supply and worse flow of information between supply chain stages.
Bullwhip effect is a demand distortion communicated up the supply chain. What causes it? The longer the supply chain, the bigger the distortion. If increased demand, be it due to objective reasons like weather or subjective like seasonal trends, is communicated upwards, it may be already exaggerated in the first place. Why?We want to be prepared for an even bigger demand increase than the one we observed even if it may not be economically reasonable. We are driven by the psychological factor- loss aversion. The increased demand data is taken into consideration when creating forecasts at all stages of the process.
Quantitative discounts: not always a good deal
Although receiving a discount may be a pleasant experience, it may not always be a good idea to buy more in order to get it.. They are incentive to buy more so the initial concept was to buy less. That means you overstock. Keeping stock in the warehouse produces cost (may as a result decrease margin) and may cause cash flow issues.
What’s more, depending on the forecast model, your supplier may mistakenly include the increased amount of commodities (stemming from the quantitative discount) in their predictions. It translates into either lower margin for them or higher price for you in the future. Possibly both.
Vertical integration – what it may be a good idea
There are different extents to which you can vertically integrate your supply chain. Full integration occurs when you buy your supplier. Quasi, if you buy shares in your supplier, take part in profits and have a vote, you may also simply operate on long term contracts with fixed prices and other variables. The least integrated model is spot pricing in which there’s no established relationship between the supplier and purchaser. So it’s the choice of one of the options on the spectrum, rather than a binary choice of whether your company is or isn’t integrated vertically. You don’t have to actually buy the supplier in order to tighten ties with them. The more you’re integrated with your supplier, the less the chance of the bullwhip effect and other communication issues that may lead to lower margins, possible supply chain disruptions and higher warehousing costs for you.
Automotive industry has over the last two years been impacted by microchip shortage. Not so much Tesla whose business model is a lot more flexible than its competitors’. Other, traditional car suppliers rely on external parties when it comes to producing and programming chips. Tesla designs and programmes its chips and holds close ties with their producers. It has a model that is very far from standard catalog engineering– they don’t use ready parts you can order from suppliers but they create their own solutions that are dictated by the design needs. Thanks to that, their part suppliers have machinery that is curated only for their parts, especially, so their supply is safer. Another advantage of not using catalog engineering but rather designing their own machines is that Tesla doesn’t have to worry about being copied from. That ensures keeping their technological advantage.
While other companies struggled through the pandemic, Tesla increased its sales. It doesn’t mean that it is free from chip supply issues, though. They also had to take measures like eliminating unnecessary chips from their vehicles. However, it appears that they were more immune to the shortage. Should now everyone start vertically integrating their production companies? It of course should be dictated by a thorough analysis of the current supply chain and business strategy. Given the current war crisis and high inflation, producer companies are likely to look for ways of optimization and ensuring supply chain stability. Vertical integration may be one of them. Especially for companies that want to protect their technological advantage.