Getting to grips with investor jargon: The ins and outs of vertical integration

Julie Brownlee, Fsp Invest, 13 Jan. 2015

Tags: vertical integration, what is vertical integration, how vertical integration works, investing in companies,

When you embark on your investing venture, you’ll come across a lot of terms that will be new to you.

The more you read and immerse yourself in financial and investment information, the clearer these will become.

One piece of investor jargon you may come across is ‘vertical integration’.

So what is vertical integration? And what does it mean?

Here’s what you need to know…

What is vertical integration?

Vertical integration is when two businesses, which are at different stages of production, merge to form one larger company.

To understand vertical integration, think about a river. All rivers start from a source and end up flowing into the sea.

There are two aspects to this:

  • Anything that takes a company towards the source (the initial part of a product) is ‘upstream’ or ‘backward’ integration.
  • Anything that takes a company towards its final customer (the sea) is ‘downstream’ or ‘forward’ integration.

An example of vertical integration

To see vertical integration in action, one of the best examples is the oil industry. An oil company will start off upstream looking for oil. Then getting the oil out of the ground.

Oil companies then become vertically integrated by moving downstream. They’ll buy refineries to turn oil into different products. And they’ll buy petrol stations and chemical businesses to sell the finished product to its customers.

The pros and cons of vertical integration

Vertical integration can be advantageous to companies as it gives them better control over costs and the quality of their products.

But when times are tough, it can result in companies having a lot of assets that aren’t profitable. You can see this at the moment in big oil companies, which are struggling as the oil price continues to drop.

More recently, there’s been a move away from vertical integration.

Instead companies opt for outsourcing – looking to other companies specialising in the supplies or expertise that they need. This leaves companies focusing on what they do best.

So there you have it, the ins and outs of vertical integration.

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