Horizontal Integration as Business Strategy
How the times have changed. It seems like everyone is talking about vertical integration these days, as the newest and smartest way to run a business. Vertical integration is basically the internalizing of key activities of a business to make it more within the firm’s control.
A manufacturing company, for example, may want to bring in certain special processes such as heat treating, which is the process of altering the strength of a metal through extreme temperature changes and exposure. The process requires special ovens and equipment, but this equipment will certainly have a favorable payback period of a firm’s shipping costs are high.
Outsourcing the Future
It was in 1996 when I started working for a large manufacturer of industrial equipment. Although I had previously worked at another industrial manufacturing plant, my new position as a field service representative required that I spend a great deal of time on the production line learning the products. In 1996 when I started, the main production line was flanked by massive machines and equipment for making piece parts – brackets, fittings, braces, frames – from raw metal. These piece parts would later be installed on the industrial equipment assemblies making their way out the door. The dimly lit machining and fabrication areas were recognizable by its oil stained wooden floors and low ceilings.
As I spent more and more time down there, though, I began to notice improved lighting and giant holes in the floor emerging. “We’re outsourcing everything. It’s all about outsourcing. Making small parts ourselves is too expensive” the foreman said. The massive holes in the floor where mills, lathes and compound drill presses stood were sometimes 3 meters long by 4 meters wide, and half a meter deep.
One by one, the gaping holes in the floors were filled with cement. Over time, as the oily wooden floor was removed and replaced with cement, a bright white highly durable paint made the floor reminiscent of a brand new factory. New lighting was installed. And one by one, shelves as high as 10 meters tall were installed. The foreman explained “These shelves are for all the incoming parts. What used to be made here will simply be stored here.”
By 2004, when I left the firm to move on to new things, the once loud, dark machine and fabrication area was more like a grocery store, full of aisles and aisles of blue bins on racks from which personnel could pick out the necessary parts for the heavy machinery on the main assembly line.
The push, at that time, was to outsource everything. “Overheads are too high and our specialty is really not making small parts, but incorporating them into the large machines that leave the factory. All this equipment and labor makes us uncompetitive.” I was told. In many industries, work was sent to small businesses nearby, who fed the massive plant the piece parts it needed for its larger operation. There was (and still is) abundant outsourcing of IT jobs to places like India, Israel and China. “Cheaper labor, and the 24 hour work day thanks to time zones.” Anything that was not capitally prohibitive, did not require unique skill or simply didn’t fit with the core competency was outsourced.
Vertical Integration, the Anti-Outsourcing
And then it happened. Just last week, while I was vesting a large factory I was told by the line supervisor that they were having production issues because a supplier was falling behind. “We really need to be vertically integrated and bring that outside process in,” he said. “We spend way too much on premium freight only to have them get behind and we end up losing time.” Walking around the factory that day, I think I heard the lack of vertical integration identified as the source of problems about five times. “I thought outsourcing was the way to go?” I wondered.
Perhaps the pendulum has swung back a bit, as nearly 20 years later, businesses are realizing that while outsourcing has a place, vertical integration also has its merits. As the name implies, vertical integration suggestions that everything remains under one roof – all activities, operations and special processes – required to add value to customers. Vertical integration is like a sky scraper, with each floor offering a key step or operation in the vertical structure.
Vertical integration certainly does have its value. When things remain under one roof, it allows a business to be more nimble and push and pull levers to get things done. Said simply, while outsourcing may offer cost reduction, vertical integration provides a business with flexibility.
Horizontal Integration as Business Strategy
So with all the talk today of vertical integration, what about horizontal integration? Is it the red-headed step child of business? Far from it, in fact. If vertical integration is like a modern day sky scraper, horizontal integration is reminiscent of a shopping mall. Horizontal integration as a business strategy is the process in which companies package and add related products and services to round out their portfolio.
Speaking with another strategist the other day, we got into a discussion about a company that fabricated heat exchangers for small air conditioning units. The firm was considering several changes to help grow their business. The firm was convinced, though, that vertical integration was the key to their success, and was determined to bring everything ‘back in house’ to better control its operation.
My colleague and I then threw out the idea of horizontal integration. “If fabricating sheet metal is your real competency, what if you began to produce other sheet metal parts for air conditioning units?” he asked. I agreed, suggesting that the firm’s equipment was already geared to producing other piece part components of air conditioning units, and that while heat exchangers may have been their legacy bread and butter, their real skills surrounded metal fabrication. Further, given it was an industry they knew well, the firm was well positioned to quickly begin to develop new, but related, product lines. After about half an hour, the company’s leadership vowed to go off and discuss their options related to horizontal integrations.
Horizontal integration is by no means easy and one should not assume it’s as easy as just producing other products. Business leaders need to sit down and evaluate their true strength and weaknesses to identify their true strengths. Perhaps a SWOT analysis could help with this. A car manufacturer, for example, should probably not take on producing large trucks because they’re just a bigger version of a car. In contrast, a car company that specializes in sports cars may want to delve into more economical versions to leverage its expertise in design and production of smaller engine products.
Horizontal integration can also be a strategy used for mergers and acquisitions (M&A). When firms look at M&A activities, the objective is usually to gain market share. The aforementioned heat exchanger company, for example, could choose to horizontally integrate and produce adjacent product lines in their industry that use existing equipment. Alternatively, through some M&A activity, they could acquire a small company that makes electronic switches that are also used on air conditioning units. While the products are very different, the industry remains the same. And provided the proper skill sets for switch technology come with the acquisition, the firm would stand to gain some overall market share in the air conditioning unit space. Such a move would also help diversify the company a bit and bring in some new expertise.
It comes down to this: outsourcing and vertical integration certainly have their merits and decisions relating to both deserve careful thought. But many businesses overlook the benefits of horizontal integration and the impact it can have on overall market share.
Do you have a good example of a horizontal integration success story?
Is Organizational Friction Killing Your Business (White Paper)
Strategies for Effectively Managing People (Blog Post)
Preparing for an International Business Trip (Blog Post)
Doing Business in China 101 (Blog Post)