Vertical integration in the grocery industry

Date : 11 December 2019

In response to intense competition, where consumers are demanding more for less, several retailers have decided to streamline operations and reduce operating costs. One approach to support these objectives is to vertically integrate aspects of the supply chain.

What’s vertical integration?

Vertical integration is a strategic decision that sees a business take ownership of part, or the entirety of the supply chain, for a given product. In other words, a vertically integrated organisation controls various aspects of the supply chain, meaning it not only sells/delivers a product, but also manufactures the product, and in some cases, further down the chain, sources the raw material that’s used to create the product.

It’s important to distinguish between three types of vertical integration:

  • Backward integration: Applies to an organisation that acquires a part (or parts) of the “upstream” supply chain. For example, a grocer that takes control of the sourcing and/or production processes of its private brand milk.
  • Forward integration: Involves an organisation that’s situated in the “upstream” part of the supply chain, and looks to acquire “downstream” activities. For instance, an online retailer that expands in bricks and mortar.
  • Balanced integration: It is simply a combination of backward and forward integration strategies. Businesses that adopt this approach tend to have a foothold in most of the supply chain stages.

Who’s adopted this model?

The type of integration most common among grocery players is backward integration. This model enables grocers to gain maximum control over key stages of the chain.

Walmart, the world’s largest retailer, has created its own milk supply chain by opening a dairy processing plant in Fort Wayne, Indiana, to supply its stores with private-label milk. Moreover, it has recently forayed into the beef industry, by developing an end-to-end supply chain for Angus beef. The retailer would directly source the beef from select farms, before being fed at a feed yard, slaughtered in Kansas, then packaged in Georgia. The Angus beef cuts are ultimately supplied to 500 stores across a number of states in the southeast. According to the retailer, the move ensures the supply of quality Angus beef and meets consumers’ demand for a more transparent supply chain.

Still in the U.S., Costco, the largest membership-only warehouse club in the country, decided a few years ago to fully control the production process of its rotisserie chickens from farm to store. To that end, it opened a poultry complex in Nebraska, which includes a processing facility, hatchery and feed mill.

Similarly, Morrisons, the fourth-largest grocer in the UK, operates a vertically integrated supply chain, where it owns multiple sites that produce a wide array of products, from baked bread to seafood, chilled foods and animal proteins.

Source: Strategy&, part of the PWC network

Benefits and drawbacks

Being vertically integrated has some clear benefits. Grocery retailers that implement this strategy can potentially gain complete control over costs since fewer intermediaries exist along the supply chain. The approach also boosts the transparency credentials of supply chains, thus providing end-to-end supply chain visibility to the end-consumer. Furthermore, vertical supply chains can mitigate, if not eliminate, the risks of costly disruption of supply.

In effect, vertical integration can also fuel grocers’ capacity to focus on particular categories that are of strategically valuable (one example is Costco’s staple rotisserie chickens), which not only renders the process of converting consumer preferences into the end product more efficient, but also informs future product development, since the retailer has full control over the value chain.

On the flip side, vertical integration can introduce risk. Considerable capital expenditure is needed to set up and maintain a vertical supply chain.

In addition to being expensive up front, this type of integration can reduce businesses’ flexibility, making them less resilient to changes in market trends. Essentially, the deeper a company is vertically integrated, the more it’s likely to struggle in adapting to a given situation, for example, the need to increase or decrease the number of units produced, or alter some features of the end-product since it needs to sustain a certain level of production to achieve economies of scale.

What does this suggest?

The decision to vertically integrate the supply chain shouldn’t be taken lightly. Grocers eying a move to a vertical integration should be able to answer the following questions:

  • Are your suppliers consistently unreliable?
  • Do you have the resources to manage a new part, or coordinate newly integrated parts of the supply chain?
  • Do you hold enough Capex to get the ball rolling?
  • Are you expecting the category to grow rapidly?
  • Are you expecting a continuous, fast shift in market trends?

The corresponding answers should help direct businesses but should be seen as the start point for a more detailed decision-making process.

Let’s take a look at a particular scenario where a yes answer applies to the first four questions, while a no answer applies to the last one. One’s first thought may well be that the prerequisites and conditions for a vertical integration strategy are met. This doesn’t necessarily mean it’s the right thing to do.

Even if, in theory, several companies are capable of implementing a vertically integrated supply chain, there is a chance that they might be tempted to look at different models that are not necessarily as costly or risky. For example, blockchain technology enhances transparency across the food chain and provides consumers with clear traceable information about certain a product. This, in a way, could replicate the transparency provided by a vertical integration model.

Companies can also build strategic alliances with key suppliers, whereby the relationship is mutually productive and valuable. All parties involved in the alliance are compelled not only to share the same vision and values but also share risks, investments and rewards, as well as maintain open communication channels. This approach offers some of the benefits of a vertically-integrated supply chain, but without the associated risks and costs.

Ideally, a balance should be struck between owning parts of the supply chain and applying alternative approaches that hand a level of control over resources, without ownership.

There is no one-size-fits-all model, since the circumstances that dictate the strategy to follow will vary from one business to another. Of course, regular reviews of strategy prompt businesses to ask fundamental questions about their supply chain relative to current and potential future market conditions. Take a look at how we see supply chain evolving.

Wassim El Attar

Supply Chain Analyst

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