Growing ahead with the What & Why of Backward Integration

During the strict Covid lockdown, ensuring regular supply of fresh vegetables, that too without visiting the wet market, had been a challenging task. ‘Go organic’ mantra only sprayed fuel to the dormant demand of a kitchen garden. Most conversations at home gravitated to “Let’s grow our own vegetables… then, you do not have to go to market, you will save money and it will be fun (read Instagram worthy)!” I languorously gave in when the idea was successfully sold to me as a stress-buster.

Our kitchen garden in the balcony may provide few herbs in small quantity for in-house consumption. I knew well that this would seldom replace the regular supplies from the vegetable vendor. While the germ of the idea had potential of full-scale Backward Integration, any large-scale fruition was unlikely to happen. Hereon, we will learn why.

Simply put, a company’s supply chain process begins with buying from suppliers, manufacturing in own factories and delivering to distributor channels who in turn sell to retailers. Backward integration involves owning part of the production/sales process that was earlier done by your suppliers, to be now done in-house.

Different stages of the value chain require different competencies and strengths. Let’s understand with a foody example! In the ready-to-eat curry value chain, the tomato grower needs fertile land, low-cost labour, suitable weather condition and efficient post-harvest process/infrastructure. For the manufacturer, the requirement is a winning recipe assuasive to customers fastidious palate, efficient manufacturing, market reach, a trusted brand. Further down the value chain, the retailers need to have a winning proposition on location, pricing, product range, service.

Backward integration forays into a field far away from one’s core competence may end up being a stress-builder. One could fathom out the reason behind many short-lived kitchen garden experiments in metro cities.

Should one stick to the core competence and let go of this strategic option? I would say, “No”. Reliance, Ikea, Netflix, Zara are just a few names who made the decision to integrate backwards at the right time and attained unmatched competitive advantage.

During the 1970s, Reliance was one of the many companies involved in synthetic yarn and textiles. Reliance decided to go backwards into manufacturing of PTA that is used in making polyester fabric. Large scale production capacity made Reliance a virtual monopoly, supplying PTA also to its competitors as well. The next step was to go one step further backwards into the petroleum sector.

Ikea, world’s largest furniture retailer, is also one of the largest owners of forest. Yes, you read it right. Ikea owns forests in Romania and Bulgaria. Owning and operating forests has helped ensure long-term continuous supply of wood at affordable prices.

Netflix was in the business of renting DVDs. For many years now, they have reduced dependence on content from famous studios. Instead, Netflix has its own production house bringing us ‘Netflix Originals’ aplenty.

Almost all online and offline retailers offer private labels to their customers. While banking on such winning stories, one should not throw caution to the winds. So, what all should be considered to make a calculated decision of integrating backwards?

Reward-of-Backward I.

  • Greater control on the supply process, quality and timeliness of deliveries to core business’ manufacturing units. Enhanced control should be used to drive operational efficiency, process innovation and cost reduction.
  • Reduced costs, shorter delivery lead times, higher inventory turns, lower supply disruption risk, traceability (food safety) are benefits in the package.
  • Customization in supply production process, control of RM quality can aid innovation (product differentiation) in the core business.
  • Going backward is unavoidable when the core business ought to protect a proprietary technology, which one does not wish to share with external parties.
  • Further, this strategic option may be exercised to gain access to key raw materials. This would garner competitive advantage and create entry barrier for competition in many cases.
  • Leverage: Buyers would also be able to offset the negotiating power of suppliers with in-house supply capability.

Wayward-of-Backward I.

Hugely successful Spanish fast-fashion retailer Zara ventured backwards into on design, manufacturing and distribution operations.

Customer can choose what they want from a large variety. Zara makes lower quantities for each style. This also provides a feeling of exclusivity to customers. Zara is able to give the new designs to the customers faster than anybody in the market. Due to lower committed stock for each style Zara seldom does markdowns, and this is a hefty gain in bottom line.

All this comes at a significant fixed cost, a lower ROA and high exit barrier due to investments in manufacturing operations.

Drawback-of-Backward I.

  • Investments involved are high. If your only driver is ‘operating costs reduction’, I would urge you to consider ROA carefully. There would be better opportunities to allocate the finite funds.
  • Dilution of the focus: It would certainly require new skills and capabilities as a company. Be prepared to acquire and retain talent with skills very different from the existing talent pool. It is also important to devise governance mechanism to control disparate business types.
  • There could be reduced flexibility with more assets tied to the same chain. Planner would whine about capacity matching problems. One can expect to face a higher exit barrier from the key product line for which the integrated agency supplies RM.
  • Coordination challenge between firms: There could be dis-economies of scale if the bigger company of the two is less efficient.
  • Conflict of interest: There is reduced incentive to buy cheaper from other suppliers as there is a captive supply unit. The integrated supply unit has lesser incentive to outperform as it has a confirmed inhouse buyer (business), for which it had to compete earlier.
  • Some established suppliers may push-back by increasing their costs/ terms. This could be serious issue until suppliers have superior expertise.

Final word-of-Backward I.

It is advised not to integrate backwards only to capture operating margin, the decision must add significant value and bring competitive advantage.

In the initial phase of integrating backwards, it is prudent to choose the middle-path with tapered investments. While maintaining limited in-house capacity for priority requirements, one could continue to work with key suppliers, benefiting from both supply sources.

You may also evaluate alternative options to strengthen supply sustainability at lower costs. These include:

  • Long-term contracts: do conscientiously build-in agreement terms that provide flexibility to either party. Contract farming examples: Lays- potatoes, Punjab; Cadbury Cocoa, Kerala.
  • Joint venture: With a higher commitment from both parties, this could be a go-to option when sharing proprietary technology
  • Vendor partnerships: This option is less formal and more collaborative. Collaborate for growth, work together with mutual trust. Uphold the tenets of risk-sharing and other incentives to continue working together.

This article by Shammi Dua, Lead – Supply Chain CSL, Distribution at Unilever originally appeared in the SCM Spotlight segment for the November 2021 issue of Logistics Insider magazine. All views expressed in the article are his own and do not represent those of any entity he was, is or will be associated with.

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