Backward IntegrationDefined with Examples & More

Written By:
Lisa Borga

What is Backward Integration?

Backward integration is a strategy in which a company acquires or merges with companies further up its supply chain that supply it with raw materials which are needed in its production process.

Another form of backward integration may be performed by creating a subsidiary that can perform the same role.

This is a type of vertical integration companies may choose to perform in order to reduce costs, increase efficiency, and improve revenues.

It can also serve to create a barrier to entry for others considering entering the company’s industry.

Backward Integration Explained

A business that chooses to perform backward integration is attempting to proceed upward on its supply chain in order to gain control of the inventory and raw materials required in its own production process.

Supply chains include all of the activities, resources, and technologies required in order to create a finished product.

The supply chain begins with the delivery of raw materials to a manufacturer and ends once the finished product reaches the end customer.

With backward integration, a company attempts to boost its efficiency, cost savings, or revenue by integrating with multiple parts of the supply chain.

This may be only part of the supply chain, or a company may choose to fully vertically integrate and control the entire production process.

This may also be used as a way to deny others who may wish to enter the market from gaining access to suppliers of given inventory or raw materials or to cut off competitors from these resources.

Controlling access to scarce resources potentially cripples existing competitors and creates a high barrier to entry for any future entrants in an industry.

Backward vs. Forward Integration

With backward integration, a business attempts to gain control of activities that occur before it in the supply chain, but in contrast, a business practicing forward integration attempts to gain control of the business activities that occur after it in the supply chain.

This often takes the form of a manufacturer attempting to gain control of the distribution of its own products.

As an example, a TV manufacturer may practice backward integration by purchasing a manufacturer of LCD screens that it requires in its production process.

This same TV manufacturer could also choose to practice forward integration by selling its finished product directly to consumers instead of selling them to retailers, who would then markup the price.

The practice of forwarding integration can result in a competitive advantage by reducing costs from middlemen and additional transportation.

It can also result in gaining control over channels of distribution which could be planned more strategically and potentially be denied to rivals.

However, similarly to backward integration, it can result in bureaucratic inefficiency if it is not managed well and can be highly capital intensive.

Pros and Cons of Backward Integration

These are some of the pros and cons backward integration can offer a company:

Pros

• Greater Control: By gaining control of its supply of raw materials or inventory, a company can exercise more control over its entire supply chain from start to finish. This can allow a business to practice greater quality control and manage the flow of material to its own warehouse.
• Reduced Costs: For many companies, the supply chain involves several middlemen who will markup the price to earn a profit and potentially involve additional transportation costs as well. This means a higher cost of goods sold and, in turn, higher prices for the end customer. Through backward integration, a company can eliminate middlemen from the process, reducing its costs.
• Competitive Advantage: A company can gain a competitive advantage from performing backward integration. By purchasing or merging with other companies, a business can gain access to their technology and patents and deny this same advantage to competitors. Other companies will be forced to find alternatives to these technologies as well as other suppliers, which will create higher barriers to entry for new entrants to the market.

Cons

• Loss of Efficiency: By acquiring the supplier of a resource required in its production, a business will reduce competition. As a result, there is less need to spend on research to innovate and adapt in order to compete for profits. This reduces the opportunity to reduce costs and improve processes and quality for both the new acquisition and the parent company and can potentially lead to a loss of quality in the parent company’s own products.
• Capital Intensive: In many cases, backward integration can require a considerable capital investment to fund an acquisition or to create a subsidiary. This may require the use of all of a company’s cash reserve or force it to take on new debt in order to achieve this. This places a company at a greater risk of default.
• Different Competencies: Due to different business focuses, a company may lack the competencies to handle its new acquisition. A company that is focused on creating and selling a finished product may not have the same expertise as a company a business focused on producing raw materials. As a result, both businesses may suffer as they lose focus on their core competencies.

Example of Backward Integration

As an example of backward integration, consider Company X, a snack cake manufacturer that is considering whether or not to acquire a flour producer which supplies it with the flour needed in its own production process.

By taking control of the flour producer, it will eliminate the markup that this company charges in order to make a profit for itself and be able to control the quality of the flour and, as a result, better manage the quality of its own finished product.

Additionally, Company X will now be able to deny its competitors access to this supplier, which will force them to look elsewhere for a source of flour, potentially forcing them to accept a higher cost or even go out of business.

It will also allow the company to better differentiate its own products from those of competitors and potentially benefit from the economies of scale.

As a result, Company X chooses to proceed with the acquisition and attempt to negotiate a purchase of the flour producer.

Key Takeaways

• Backward Integration occurs when a business chooses to perform the role of companies further upward on its supply chain.
• The most common way or companies to perform backward integration is by purchasing or merging with companies that provide raw materials required in their production process.
• Backward integration can provide significant advantages, but the process often requires significant access to capital in order to purchase suppliers.