Horizontal Integration as Business Strategy

August 4, 2014 Business Strategy, Marketing, Product Development, Project Management, Technology, The Manager's Resource Handbook

Why Consider a Horizontal Integration Strategy?

Just about every firm continuously tweaks and looks for new ways to optimize their operation in the pursuit of growth and profits. In the early 2000s, made even more possible by a rapidly expanding internet, just about every industry seemed to jump on the outsourcing bandwagon. The thought was simple: why expend internal resources on something when it costs you less to pay someone else to do it? In doing so, it enabled organizations to concentrate their efforts on their core strengths.

Nowadays, the pendulum has swung back. It seems like everyone is talking about vertical integration, as the newest and smartest way to run a business. Vertical integration, after all, is essentially the internalizing of key activities of a business to make it more within the firm’s control.

But there is another operational strategy you can employ to grow your firm, known as horizontal integration. Let’s take a closer look each approach.

Outsourcing the Future

It was in 1999 when I started working for a large manufacturer of industrial equipment. At that time, the main assembly 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 where these small pieces produced were recognizable by their oil stained wooden floors and low ceilings.

As time went by, though, I noticed massive 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 were where the mills, lathes and compound drill presses once stood.

Outsourcing is a production strategy that helps reduce cost by paying outside suppliers or partners to do work at a lower cost than you can do it yourself.

One by one, the gaping holes in the floors were filled with cement. Section by section, as the oily wooden floor was removed and replaced with cement, a bright, highly durable paint was applied making the floor reminiscent of a brand new factory. New lighting was installed. 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 once we purchase them from another company.”

By 2004, 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 rather incorporating them into the large machines that leave the factory. All this equipment and labor makes us uncompetitive.” I was told.

Outsourcing part of your operation offers a great deal of value to many companies. As was the case with many industries, we sent work to small businesses nearby, who fed the massive plant the piece parts it needed for its larger operation. Outsourcing exists in many other forms as well. There was (and still is) abundant outsourcing of IT work to places like India, Israel and China. “Cheaper labor, and the 24 hour work day thanks to time zones.” Anything that is not capitally prohibitive, does not require your unique skill or simply does not fit with your company’s core competency is grounds for outsourcing.

Vertical Integration, the Anti-Outsourcing

And then it happened. While visiting a large factory last week, 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-house,” 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, the lack of vertical integration was cited as the source of many operation problems multiple times. “Isn’t outsourcing was the way to go?” I wondered.

To illustrate the idea of vertical integration, consider a manufacturing company that produces bicycles. This company assembles the bikes, but send them outside to be painted. While painting may not be a core competency of the bicycle manufacturing company, sending bikes outside for someone else to do the work adds time to the production schedule. Further outsourcing this work adds freight costs and increases the risk that some bikes may be damaged in transit. To vertically integrate, the manufacturing company would need to build its own paint booth and paint the bicycles internally. Vertically integrating the painting process, or bringing it back internally, gives the firm more control of its overall operation.

Vertical integration internalizes processes and operations such that you “add value” to products yourself instead of paying someone else to do it. Doing so ultimately provides you with flexibility.

Perhaps the pendulum has swung back a bit, as nearly 15 years later, businesses are realizing that while outsourcing has a place, vertical integration also has its merits because you are less dependent on outside organizations. As the name implies, vertical integration suggests that everything remains under one roof – all activities, operations and special processes.

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

With all the talk today of vertical integration and having everything under one roof, what do we mean by horizontal integration? What is the difference between vertical and horizontal integration? To offer an analogy, if vertical integration is like a modern-day sky scraper headquarters with everything under one roof, 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 existing portfolio – a one-stop-shop.

A colleague and I recently got into a discussion with 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 and grow their company.

Horizontal integration is a product strategy that adds related and adjacent product lines that complement your existing product lines.

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.

Horizontal integration is by no means easy and one should not assume it is 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 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. By doing so, the firm would stand to gain some overall market share in the air conditioning unit industry. Such a move would also help diversify the company a bit and bring in some new expertise.

Final Words on Outsourcing, Vertical and Horizontal Integration

When looking at these strategies, it comes down to this: outsourcing is a cost reduction strategy. Vertical integration is a production strategy that offers a firm flexibility. Horizontal integration is a product strategy that grows a business by diversifying the product offering.

Do you have a good example of a horizontal integration success story?