DJ Stockbridge is currently pursuing a Masters degree in Accounting.
'We Need To Make A Change'
'We need to make a change,' explains your business partner. This is true, you think to yourself. For the past five years, you and your business partner have grown your business into the most popular pizza parlor in the area, but it seems your business has stalled, or hit a 'speed bump.' There are not as many new customers coming in the door. In fact, for the past 12 months, your sales have been flat. You need to do something to grow sales again. The 'million dollar' question, however, is what exactly do you need to do? Your business partner explains that you could 'horizontally integrate into other food.' This is gibberish to you when she says it initially, but you decide to do some research to learn what this means.
Horizontal integration is when a company increases the number of products or services it sells in one part of the supply chain. The supply chain is the series of steps it takes to produce a good or service. The supply chain for the widget industry, for example, is: 1) companies source the raw materials needed for the widget, 2) they send the raw material to assemblers who turn the raw materials into finished goods, and 3) the finished goods are sold either directly to the customers or through wholesalers. If a widget assembler decided to horizontally integrate, it would add more products to assemble in addition to the widget. It could expand, for example, into shoe buttons, or screws. There are several reasons why a company like a widget assembler or a pizza parlor would decide to horizontally integrate. Some of those reasons will be discussed in the next section.
Reasons For Horizontal Integration
- To gain even more purchasing power over the suppliers. If a company horizontally integrates and starts providing other products or services, the list of supplies it needs will get longer, and as it becomes a bigger 'shopper' it will be able to exert more pricing power over the suppliers. For example, if James goes to a local grocery store and asks for a 5% discount on his purchase of one candy bar, the owner would most likely not give it to him. If he goes to the same shop owner and says he would buy all the candy bars and if he likes the quality, keep buying them in high volume, but only if he gets a 5% discount, the owner will most likely give him the discount. In this case, the shop could still earn a profit off the sale, and the shop owner wants to please James in order to get his future business. The same logic applies here: If a company orders a larger number of products from a supplier, it will become a valuable customer and may be able to request a good rate.
- To gain even more power over the distributors. Like the increased power it can gain over the supplier, a horizontally integrated company can exert more pressure on its distributors if the new goods it produces can go through the same distributors. The company will be able to use its greater size to dictate better terms. Distributors are predominately low-margin, high-turnover businesses. They desperately need new volume, and would 'trip over themselves' to service a large, horizontally integrated company.
- To better serve the customers' needs. A company may decide to horizontally integrate because it realizes that its current customers are being underserved. Customers may want a certain product or service that no one else is providing. If customer demand is strong enough, a company might step in and fill that void if it can deliver that good or service at a low enough cost and still generate a profit.
Horizontal Integration for the Pizza Parlor
After you do some research about horizontal integration, you identify several ways the pizza parlor could horizontally integrate:
- You've noticed that your customers want a dessert option after their pizza, and a survey reveals that most people would like to have ice cream. You'll need to research the costs and storage requirements of ice cream to see if you can deliver it at a reasonable cost, but this seems like a 'doable' way to horizontally integrate. You are a little wary of this option, however, because you have no experience with the ice cream suppliers.
- Some customers have expressed that they would like to see more healthy options. They'd like to see salads in particular. This is another new product you should explore to see if the costs and storage are reasonable.
- Another product you could provide is sandwiches, for example, a meatball sandwich, meat lovers, ham and cheese, etc. You like this option because you could use the same suppliers you have been using for your pizzas. This way you'll have a larger order, and you may be able to exert lenient pricing terms on the supplier, for example, with favorable transportation costs, since the supplier is already driving to your location to deliver pizza ingredients. The additional cost to carry a few more supplies is minimal because the main cost for them is the truck and fuel. As long as they have the space, a bigger order will mean they can 'spread' the fixed costs of the truck over more goods, decreasing the cost per good and increasing the profit margin on each good sold. The suppliers will eagerly seek to fill up their truck, and may give lower average prices on the products to do that.
You are excited to see your business partner so you can explain to her the different ways the parlor could horizontally integrate. All this thinking has made you hungry. In fact, a slice of pizza would taste good right now…
In this lesson,
- You learned that horizontal integration is when a company increases the number of products or services sold in one part of the supply chain. The supply chain is the series of steps it takes to produce a good or service.
- You learned that a very basic widget supply chain is composed of 1) raw material suppliers, 2) assemblers, and 3) distributors.
- You learned that a company will decide to horizontally integrate for a few reasons including: to gain purchasing power over the supplier, to obtain more flexible terms from the suppliers and/or distributors, and to better serve their customers.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack