Vertical Intergration

Vertical integration is a corporate strategy employed by firms to gain competitive advantage by operating in several businesses at the same time. Of course firms could use several other kinds of corporate strategies such as strategic alliances, diversification, and mergers & acquisitions.

A value chain is the set of activities that must take place for a product or service to come to fruition and be sold to a customer (raw material to final sale). Michael Porter introduced the concept of the value chain in 1985. A good example of is the milk industry. A very simplified chain would be as follows:

Breading > Management of animals > Milk production > Short term storage > Transport to processing > Processing/Pasteurization > Packaging > Shipping distributor > Shipping to retailer > Selling to consumer

When a firm vertically integrates, they basically are involved in the individual steps within the industry’s value chain. Dean Foods, the United States largest processor and distributor of milk, is involved in four of the above activities, processing, packaging, and shipping (both to distributors and retailers). They also took steps to get closer to consumers by purchasing many small local dairy brands, including South Florida’s Macarthur. More likely than not, if you are drinking milk or eating ice cream bearing the brand name of what you think is a local dairy, your consuming a Dean Foods’ product. This is an example of forward vertical integration. In this case the firm took steps to get closer to the end of the value chain, in other words closer to their end consumer. If they wanted to go even further, they might consider opening ice cream/milk shake shops or stands. Although such a move would really bring them close to their ultimate customer, the operation of retail establishment is likely not within the firms capabilities. More on that subject later.

Dean had also become involved dairy production in the early 2000’s. In a series of mergers, they became involved with the Dairy Farmers of America, the entity which represents the majority of the nation’s dairy farmers. In essence, “the nation’s largest dairy processor is in bed with the nation’s largest dairy producer.” This strategy is one of backward vertical integration or the incorporation of steps on the value chain closer to gaining access to the raw materials. For Dean, this particular move caught the attention of the FTC. Federal anti-trust case was barely avoided when Dean arranged to spin off 11 plants in 8 states to a “nominal competitor.” That being said, their move proved to very successful.

“This means that Deans’ overwhelming dominance in the dairy sector has now become the federal benchmark for acceptable market share throughout the U.S. food industry at both the regional and national level. Deans now has a quasi-dairy monopoly in many parts of the U.S.: Massachusetts—80%; Northern Alabama and Tennessee— 80%; Michigan— 80% and Texas— over 66%. If Deans is allowed to absorb what is left of the crumbling Italian-based Parmalat dairy empire on the East Coast, it would also control 85-90% of the lucrative New York City milk market. In preparation for this scenario, Deans hired outgoing Parmalat executive, Frank Ferrante, in Dec. 2003.”

VRIO and Vertical Integration

For vertical integration to meet the VRIO criteria, we must determine if the strategy is valuable, rare, costly to imitate, and if the firm is organized to implement it. If so a firm may create a competitive advantage.

When referring to creating value for the firm, the three most significant reasons are threat of opportunism, control of capabilities, and flexibility. Opportunism is when a firm is unfairly exploited. Referring back to our Dean Food’s example, this would be a case when the processing plant is expecting grade a milk, and instead receives b grade or lower (or a party expects high quality and receives something of a lower quality than expected. Second, a firm should vertically integrate into business activities