Vertical Consolidation: Definition & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll discuss what it means when a company or an industry vertically consolidates. We'll also give reasons why a company or an industry will do this and we'll give an example of vertical consolidation for a pizza parlor.

'We Need To Do Something'

'We need to do something,' explained your business partner. This was true, you thought to yourself. For the past five years, you and your business partner had grown your business into the most popular pizza parlor in the area, but it seemed like you had reached an inflection point. For the past 12 months, sales had been flat. You needed to do something to grow sales. The million dollar question, however, is what exactly do you need to do? Your business partner went on to explain that the whole pizza food industry is going through vertical consolidation. This was gibberish to you when she said it initially, but since then you have researched what this means.

Vertical Consolidation

Vertical consolidation is when a company buys another company that performs a service or produces a good on a different part of the supply chain, and the supply chain describes the series of steps necessary to produce a good or service. For example, the supply chain for the widget industry is: 1) companies source the raw materials needed for the widget, 2) they send the raw material to assemblers who turn the raw material into finished goods, and 3) the finished goods are sold either directly to the customers or through wholesalers. If a 'widget assembler' decided to vertically consolidate they would either go backwards, and buy companies responsible for sourcing the raw materials, or they would vertically consolidate forwards by buying a company that specializes in selling the finished goods.

Reasons For Vertical Consolidation

There are several reasons why a company may decide to vertically consolidate:

  • For quality control purposes. If the goods the company provides the customer are of high quality, they may want to keep an eye on the raw material supplier, with the logic being that quality products come from quality ingredients. We've also recently seen increasingly vocal customers who demand ethical and environmentally-friendly suppliers. Companies have met the challenge by vertically consolidating backwards and raising the standards on the recently purchased supplier.
  • For just-in-time production purposes. Some companies dislike holding finished good inventory, but this requires a high degree of precision between the suppliers and the assembler (picture a complicated dance routine). Companies vertically consolidate to ensure better communication. Communication with yourself is much more accurate than communication with another entity.
  • For cost control. As each company in the supply chain performs their role, they extract a profit for the role they performed. A company cannot operate for very long without making a profit. They would have no cash to reinvest back into their business. Companies will then vertically consolidate to 'capture' the profits they would have had to pay out to others in the supply chain. Companies that do this also hope to gain scale and efficiency benefits that will further boost their profits or decrease their costs.
  • For better awareness of the customer's needs. An assembling company may pass along the finished good to a distributor. This can be trouble because the assembler is dependent on the distributor to understand what the end customer needs now and needs in the future. If the communication is poor the assembler may waste a lot of time and money producing goods that the customers will not buy.

Reasons Against Vertical Consolidation

There are also some reasons why a company may decide to not vertically consolidate:

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