5 Important Reasons Why Businesses Should Leverage Backward Integration

5 Important Reasons Why Businesses Should Leverage Backward Integration | Strategy and Innovation | Emeritus

In a highly competitive market, business success depends on the effectiveness of strategies. It is, therefore, crucial to get them right. Several firms, for instance, resort to Mergers and Acquisitions (M&A) to achieve growth. This is evident by the fact that M&A accounted for $8.3 trillion of capital deployment in the last decade for the world’s 2,000 largest companies, according to McKinsey & Company. Among the several types of M&A methodologies used by firms are backward and forward integration. Between these two, the former is a strategic move that can benefit any organization by improving its competitive edge, supply chain, and bottom line. So let’s dive deep into the concept of backward integration and how it can change a company’s business outlook significantly.

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What is Backward Integration?

There are many types of M&A strategies, such as horizontal integration, vertical integration, and takeover. We need to briefly understand vertical integration before we elaborate on backward integration.

A firm merges with companies operating at different stages of the production/distribution cycle under vertical integration. The process typically involves two types of integrationbackward and forward integration.

A company joins hands with distributors or downstream entities in forward integration. On the other hand, backward integration is a type of vertical integration that includes the purchase of, or merger with, suppliers or upstream entities.

For example, an automobile manufacturer may acquire a company that builds engines instead of relying on suppliers. As a result, they can improve their efficiency, reduce costs, and standardize quality. In short, firms can exercise control over their overall supply chain using this strategy.

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How Can Organizations Implement Backward Integration Effectively?

1. Define Business Goals

First, figure out the final aim of opting for backward integration because it will decide the acquisition approach. For example, a firm must know if it wants to secure the supply of raw materials, improve control over quality, or reduce costs.

2. Undertake Analysis

There are different types of integration, so the second step is to conduct a thorough analysis to see if backward integration is beneficial. The analysis should reflect on factors like market, industry dynamics, and the supply chain.

3. Find Suitable Suppliers

A firm needs to identify suppliers that offer strategic value. They should have the capabilities to meet its requirements. It is useful to evaluate them on reliability, quality, cost, proximity, and technological capabilities.

4. Negotiate Favorable Terms

A company should be proactive in discussions and sign agreements with terms and conditions fruitful for both parties. It should pay close attention to factors such as pricing, supply agreements, quality standards, and impetus for innovation.

5. Build Infrastructure

A company’s infrastructure should be able to support backward integration. It may need to upgrade facilities, equipment, technology, and talent required for processes previously undertaken by suppliers.

6. Navigate Cultural Differences

A company must focus on cultural integration to align the workforce with the organization’s values, goals, and processes. Culture management is a vital aspect of any integration, as per McKinsey. In fact, it can improve M&A success.

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What are the Potential Risks Associated With Backward Integration?

1. Requires Excessive Capital

It is not cheap to acquire or set up new business units. The high investment can affect a company’s finances and limit its available resources.

2. Complicates Operational Flow

A company may end up biting more than it can chew because it is forced to deal with unfamiliar operations. A lack of expertise can also result in quality issues or production delays.

3. Reduces Flexibility

There are various types of mergers so it can be challenging to pick the right one. A misguided bet on backward integration might affect revenue or agility, affecting a firm’s ability to respond to changing winds.

4. Causes Cultural Clash

It is not easy to merge different company cultures and management styles. A company can face inefficiencies and repeated conflicts if it fails to integrate the acquired businesses accordingly.

5. Strains Supplier Relationships

An organization can alienate former suppliers, who may view backward integration as threatening their revenue. Consequently, it can provoke price wars or disruptions in the supply chain.

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How Does Backward Integration Impact a Company’s Supply Chain?

1. Greater Control

A firm exercises better control over its supply chain. This allows them to manage production schedules, quality standards, and inventory levels subsequently.

2. Resilience

A company can avoid supply chain disruptions caused by supplier failures, delivery delays, or fluctuations in raw material prices by integrating backward and acquiring key suppliers.

3. Cost Reduction

A firm does not have to pay markups levied by suppliers with backward integration. They also cut down transportation and logistics costs.

4. Quality Control

Companies can maintain strict quality standards at their production facilities with backward integration. As a result, they can be reliable and comply with regulatory requirements.

5. Competitive Advantage

An organization can facilitate innovation by integrating backward because it controls the production of raw inputs. This can differentiate it in the market and get it ahead of its competitors.

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What are Some Successful Examples of Companies Utilizing Backward Integration?

1. Netflix

Netflix was a DVD rental company that used the Internet to allow customers to select movies and receive them via mail. It later switched to offering content, with the help of licensing deals, on an online streaming platform. However, Netflix realized that it stood to gain more by producing original content. The move reduced the platform’s expenditure on licensed content considerably.

2. Apple

Apple not only designs its hardware but also the software. It sourced chips from other companies once but now makes these chips after acquiring firms like PA Semi (semiconductor design) and AuthenTec (biometric security technology). The company can control the entire user experience and quality throughout production.

3. Zara

Inditex, the parent company behind Zara, is famous for leveraging backward integration efficiently. They own or have significant stakes in many of their suppliers, allowing for a fast and responsive production cycle. It is crucial in the case of Zara—a fast fashion brand. It can adapt to trends quickly and deliver new clothing lines steadily.

4. Tesla

The company houses several aspects of its production process within its perimeter. They manufacture cars and produce their batteries. They have also invested in mining operations for key battery materials like lithium. Hence, they can secure a steady supply of critical components and reduce reliance on external suppliers.

Elevate Your Career With Emeritus

There is no doubt that companies will look to ramp up their M&A strategy in the coming days. Companies will look for professionals with expertise in all types of mergers to develop the right strategy. Emeritus offers a range of strategy and innovation courses curated to empower individuals with practical insights. These courses enable you to succeed in today’s business landscape, gain access to industry experts, and achieve new heights in your career.

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About the Author

Content Writer, Emeritus Blog
Mitaksh has an extensive background in journalism, focusing on various beats, including technology, education, and the environment, spanning over six years. He has previously actively monitored telecom, crypto, and online streaming developments for a notable news website. In his leisure time, you can often find Mitaksh at his local theatre, indulging in a multitude of movies.
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