Vertical Integration Is Making a Comeback at U.S. Companies
(Bloomberg Opinion) -- As a corporate strategy, vertical integration is seriously old school. It requires a firm to take direct control of stages of the production process formerly handled by independent companies. A product of the Gilded Age, vertical integration fell out of favor as firms focused on their core business and outsourced everything else.
But big business is rethinking that approach and channeling the ghosts of long-gone vertically integrated enterprises. Cutting-edge firms such as Amazon.com Inc. and Tesla Inc. openly pursue a strategy of vertical integration. In recent weeks, more traditional enterprises such as General Motors Co and Ikea of Sweden AB have followed suit.
That this is happening is understandable. The conditions that gave rise to vertical integration in the 19th century have returned. Once again, large-scale enterprises confronted with uncertainty and inefficiency are responding by expanding backward and forward in the supply chain.
A handful of American entrepreneurs pioneered the practice in the late 1800s. Andrew Carnegie, who began building a steel empire in the 1870s, was one of these innovators. His mills employed state-of-the-art technology that churned out growing quantities of rails, rolled steel and other building blocks of the new industrial order.
As Carnegie’s empire grew, he began producing so much steel that he could no longer acquire enough lime, coal and iron ore from the open market. His “supply chain issues,” as we might call them today, cost him money because his massive plants could not sit idle without incurring significant costs.
In response, Carnegie and his deputies acquired the Henry C. Frick Coke Company, which manufactured the fuel derived from coal used to fuel steel furnaces. Carnegie subsequently acquired mines in the Mesabi Iron Range in Minnesota as well as sources of lime and raw coal.
Carnegie eventually eliminated remaining weak points in the production chain that made him dependent on outsiders. For example, what good was it if he could mine iron ore from Minnesota but have to depend on unreliable shippers to get it to Pittsburgh? He therefore bought a fleet of cargo ships to bring the ore across the Great Lakes, and purchased railroads to get raw materials to his furnaces.
A handful of other large corporations also went vertical at this time, for similar reasons. As the business historian Alfred Chandler Jr. observed, firms rarely integrated backward in the supply chain out of a desire to squelch the competition. Rather, he wrote, the “primary motive for vertical integration was to assure a steady supply of materials into the enterprise’s production processes.” It was a way of imposing order and predictability on the chaos of economic forces around them.
Backward integration insured that large, expensive-to-operate factories never went offline or that inventories of raw materials never became too high or too low. This form of corporate organization also guaranteed that suppliers of raw materials honored their commitments. After all, if they failed to do so, they would have to answer to the larger corporation.
Forward integration — when a company acquires businesses that handle the sale and delivery of goods to consumers — also came into vogue at the same time. Companies pursued this strategy when they found that existing distribution and sales networks were unable to handle the volume, diversity, or complexity of a given product line.
The giant meatpacking concern founded by Gustavus Swift typified this impulse. Swift’s slaughterhouses processed staggering amounts of meat via disassembly lines that took live animals and turned them into everything from steak to glue. But this production explosion meant nothing if he couldn’t get his goods to market.
This dilemma led Swift to develop his own fleet of refrigerated cars that could deliver meat throughout the country. He also built his own canning factories as well as a sales force to handle the choice cuts beloved by consumers and byproducts like fertilizer.
The soap giant Unilever purchased a coconut plantation in the Solomon Islands to secure a steady supply of oils used in its products. United Fruit Company did the same, acquiring plantations that provided a steady supply of bananas.
Firms manufacturing sewing machines, typewriters, mechanical reapers and other technologically complex goods also moved forward into marketing and retail. They did so because the existing infrastructure was ill-prepared to demonstrate products, finance their purchase, or service and repair them.
Henry Ford took vertical integration to noteworthy extremes in the 1920s. Eager to free himself from dependence on suppliers of all kinds, he bought mines, a rubber plantation in Brazil known as Fordlandia, forests and a sawmill, cargo ships and a railroad.
The upshot? Ford-owned freighters brought raw materials to one end of his River Rouge plant outside of Detroit; finished cars rolled out the other side. One of Ford’s slogans — “From Mine to Finished Car; One Organization” — said it all.
Ford’s factory may have been the high-water mark for vertical integration. Over the rest of the 20th century, corporations increasingly divested themselves of critical parts of the production and distribution chain, focusing instead on core competencies. This process intensified in the 1980s, inaugurating a wave of vertical disintegration that continued unabated until recently.
This made sense at the time. As firms outsourced much of their original business to third parties scattered around the world, they reaped significant savings.
A few tech giants, notably Amazon and Tesla, eschewed this approach. Much like their 19th-century forebears, they operated at a scale and scope that made dependency on third parties untenable.
Most others, though, made themselves exquisitely vulnerable to the slightest disruptions in supply chains. Those disruptions have now arrived. A trade war, a global pandemic and growing geopolitical tensions call into question the wisdom of stripping corporations down to a core dangerously dependent on the fortunes of widely dispersed suppliers and distributors. A company that can’t secure key components — or get truck drivers to deliver finished products — is in a tight spot.
The remedy is a blast from the past. Integrate backward, as today’s Ford Motor Co and other companies hope to do to guarantee a reliable supply of computer chips. Or move forward, as Amazon has done via a significant expansion of its fleet of delivery vans, enabling it to break free of its dependence on delivery services.
Such solutions, though, aren’t available to most enterprises. Only very large firms have the ability to pursue vertical integration. In other words, some of the biggest corporate behemoths are likely to get bigger.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stephen Mihm, a professor of history at the University of Georgia, is a contributor to Bloomberg Opinion.
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