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Backward Integration Explained: How it Works (+ Examples)

Kison Patel
CEO and Founder of DealRoom
Kison Patel

Kison Patel is the Founder and CEO of DealRoom, a Chicago-based diligence management software that uses Agile principles to innovate and modernize the finance industry. As a former M&A advisor with over a decade of experience, Kison developed DealRoom after seeing first hand a number of deep-seated, industry-wide structural issues and inefficiencies.

CEO and Founder of DealRoom

If there’s one thing that almost all large companies, whatever their industry, have in common, it’s some degree of integration.

In this article, DealRoom looks at backward integration and why companies want more control over their supply chain.

What is Backward Integration?

Backward integration is the process by which companies acquire a segment (or segments) of their downstream supply chain - i.e. it acquires the companies behind it in the supply chain, hence the term ‘backward integration’. For a manufacturing firm, this could mean acquiring a raw materials provider, for a retail chain, it could mean acquiring a distributor or manufacturer.

What is Backward Integration?

How Does Backward Integration Work?

Companies rarely start out as fully integrated, instead typically focusing on one part of the supply chain. A retail chain rarely owns cotton fields or even manufacturing units.

Most large companies in the retail space outsource these segments of the supply chain to other companies that specialize in them. But when they decide to acquire them to take control of their supply chain, the process is known as backward integration.

Backward integration is likely to become a bigger theme in M&A in the years ahead as companies aim for fully sustainable supply chains. The suppliers who have direct contact with companies are known as Tier 1 suppliers.

These suppliers’ own suppliers are known as Tier 2 suppliers, and they in turn may have several Tier 3 suppliers. It’s easy to see how a company can quickly lose track of the sustainability of its supply network. The solution may be to bring more suppliers in-house through backward integration.

Hypothetically, bringing different segments of the supply chain under the same roof should bring benefits, right? (see next section for more on this question). This isn’t always the case, however. The reality is that moving away from specialization is never an easy path for companies. A clothes retailer may know how to sell clothes, but it probably doesn’t know as much about making them or the materials that go into them. The process, therefore, needs to be very carefully managed.

Advantages and Disadvantages of Backward Integrations

Advantages

  • Control: Backward integration provides more control over the supply chain, in theory enabling it to ensure it has constant access to the best raw materials.
  • Pricing: Controlling a raw materials seller ensures the company isn’t open to unfavorable price swings in the commodity, as its raw materials are not acquired on the open market.
  • Competitive advantage: Mainly in the case of rare raw materials (e.g.access to the rare metals used in mobile phones), backward integration could provide a competitive advantage for the company.

Disadvantages

  • Lack of flexibility: Maintaining several suppliers enables a company to create competition between them. By owning one, it is practically obliged to source goods from that company.
  • Lack of focus: As the previous section alluded to, companies are always better positioned to maintain focus on their core strengths - usually this doesn’t include other segments of their supply chain.
  • Lack of innovation: With the supply chain company now virtually guaranteed sales of its output, there is less incentive for it to innovate and continue to maintain a competitive culture within the company.

Forward vs. Backward Integration

forward vs backward integration

If backward integration is the acquisition of downstream companies in the supply chain, forward integration is the polar opposite: The acquisition of upstream companies in a company’s supply chain. This could mean a bottling plant acquiring a soft drinks brand, a cotton producer acquiring an apparel manufacturer, or even a mid-chain distribution company acquiring a chain of retail stores.

Backward Integration Example

Inditex, the parent company of clothes retailer Zara, is an example of a company in the apparel industry that has excelled at vertical integration.

In 2017, it acquired its largest supplier, IndiPunt, in which it already controlled a majority stake. The acquisition meant that Inditex’s brands were able to more quickly respond to changes in fashion trends, as well as benefitting from lower costs of distribution and increased transparency for customers.

Backward integration is also common among food giants. Take Walmart as an example. In 2018, it purchased land to build its own milk processing plant, enabling it to ship milk it produced to over 500 Walmart retailers and reducing several of the overheads involved in bringing milk to its refrigerators.

This was a particularly adept move by Walmart, as milk is the ultimate commodity product -often used in economics textbooks to illustrate perfect competition. By making its own milk, Walmart was undercutting several suppliers of the same commodity.

If there’s one thing that almost all large companies, whatever their industry, have in common, it’s some degree of integration.

In this article, DealRoom looks at backward integration and why companies want more control over their supply chain.

What is Backward Integration?

Backward integration is the process by which companies acquire a segment (or segments) of their downstream supply chain - i.e. it acquires the companies behind it in the supply chain, hence the term ‘backward integration’. For a manufacturing firm, this could mean acquiring a raw materials provider, for a retail chain, it could mean acquiring a distributor or manufacturer.

What is Backward Integration?

How Does Backward Integration Work?

Companies rarely start out as fully integrated, instead typically focusing on one part of the supply chain. A retail chain rarely owns cotton fields or even manufacturing units.

Most large companies in the retail space outsource these segments of the supply chain to other companies that specialize in them. But when they decide to acquire them to take control of their supply chain, the process is known as backward integration.

Backward integration is likely to become a bigger theme in M&A in the years ahead as companies aim for fully sustainable supply chains. The suppliers who have direct contact with companies are known as Tier 1 suppliers.

These suppliers’ own suppliers are known as Tier 2 suppliers, and they in turn may have several Tier 3 suppliers. It’s easy to see how a company can quickly lose track of the sustainability of its supply network. The solution may be to bring more suppliers in-house through backward integration.

Hypothetically, bringing different segments of the supply chain under the same roof should bring benefits, right? (see next section for more on this question). This isn’t always the case, however. The reality is that moving away from specialization is never an easy path for companies. A clothes retailer may know how to sell clothes, but it probably doesn’t know as much about making them or the materials that go into them. The process, therefore, needs to be very carefully managed.

Advantages and Disadvantages of Backward Integrations

Advantages

  • Control: Backward integration provides more control over the supply chain, in theory enabling it to ensure it has constant access to the best raw materials.
  • Pricing: Controlling a raw materials seller ensures the company isn’t open to unfavorable price swings in the commodity, as its raw materials are not acquired on the open market.
  • Competitive advantage: Mainly in the case of rare raw materials (e.g.access to the rare metals used in mobile phones), backward integration could provide a competitive advantage for the company.

Disadvantages

  • Lack of flexibility: Maintaining several suppliers enables a company to create competition between them. By owning one, it is practically obliged to source goods from that company.
  • Lack of focus: As the previous section alluded to, companies are always better positioned to maintain focus on their core strengths - usually this doesn’t include other segments of their supply chain.
  • Lack of innovation: With the supply chain company now virtually guaranteed sales of its output, there is less incentive for it to innovate and continue to maintain a competitive culture within the company.

Forward vs. Backward Integration

forward vs backward integration

If backward integration is the acquisition of downstream companies in the supply chain, forward integration is the polar opposite: The acquisition of upstream companies in a company’s supply chain. This could mean a bottling plant acquiring a soft drinks brand, a cotton producer acquiring an apparel manufacturer, or even a mid-chain distribution company acquiring a chain of retail stores.

Backward Integration Example

Inditex, the parent company of clothes retailer Zara, is an example of a company in the apparel industry that has excelled at vertical integration.

In 2017, it acquired its largest supplier, IndiPunt, in which it already controlled a majority stake. The acquisition meant that Inditex’s brands were able to more quickly respond to changes in fashion trends, as well as benefitting from lower costs of distribution and increased transparency for customers.

Backward integration is also common among food giants. Take Walmart as an example. In 2018, it purchased land to build its own milk processing plant, enabling it to ship milk it produced to over 500 Walmart retailers and reducing several of the overheads involved in bringing milk to its refrigerators.

This was a particularly adept move by Walmart, as milk is the ultimate commodity product -often used in economics textbooks to illustrate perfect competition. By making its own milk, Walmart was undercutting several suppliers of the same commodity.

Wrap up

As with many parts of mergers and acquisitions, backward integration is more complex than they first appear. While it’s a nice idea to control the entire supply chain, the laws of unintended consequences often appear after an acquisition: Less corporate focus and operational slack, for example.

The solution? Well, good due diligence of course.

Talk to DealRoom about how our M&A project management tool can help you avoid the pitfalls of backward integration.

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