Vertical Expansion in Business: 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 vertically expands. We'll give reasons why companies do this and examples of the vertical expansion of a pizza parlor.

''We Need to Do Something''

''We need to do something,'' 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 that you have reached some sort of plateau. For the past twelve months, sales had been flat. You need to do something to grow sales. The million-dollar question, however, is, what exactly do you need to do? Your business partner goes on to explain that you could ''vertically expand across the pizza supply chain.'' This makes no sense to you when she says it initially, but since then you have been researching what this means.

In this lesson, we'll discuss what vertical expansion means in a business context. We'll give reasons why companies vertically expand and we'll give examples of vertical expansion that the pizza parlor can adopt.

Vertical Expansion

Vertical expansion is when a company moves to perform a service or produce a good on a few different parts of the supply chain. The supply chain is series of steps 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.
  3. The finished goods are sold either directly to the customers or through wholesalers.

If a widget assembler decides to vertically expand they can either go backward and start sourcing their own raw materials, or they can vertically expand forward into selling the finished goods. Let's look at some of the reasons why a company, like a pizza parlor, may decide to vertically integrate.

Reasons for Vertical Expansion

For quality control purposes

If the company provides high-quality goods to the customer, they may want to keep an eye on the raw material supplier. The logic behind this is 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 either vertically expanding backward or by creating better tools to survey their suppliers.

For just-in-time production purposes

Some companies dislike holding an inventory of finished product. This requires a high degree of precision between the suppliers and the assembler (picture a complicated dance routine). Companies vertically expand to ensure better communication.

For cost control

As each company in the supply chain performs their role, they extract a profit for the role they perform. A company cannot operate for very long without making a profit. They would have no cash to reinvest back into their business. Companies will vertically expand 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 assembly company may pass the finished good along to a distributor. This can be trouble because the assembler is dependent on the distributor to understand what the end customer needs now and in the future. If the communication is poor, the assembler may waste a lot of time and money producing goods that customers will not buy.

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