What are the determinants of Vertical Integration in Business?
It goes without saying that integration policy if properly designed and adopted, can yield high profitability. But whether the company should opt for integration or not depends on a variety of factors. Some of these important factors have been discussed here.
1. Possible Savings Resulting from Coordination
If a firm produces goods or materials for its own use, it is easier to ensure promptness of delivery to customers and make adjustments in emergencies. If the firm is aware of its needs and the production process, and production schedule, optimum benefits can be achieved.
Vertical integration tends to limit flexibility in the production design to a considerable extent. The huge investment in plant or raw materials hampers the shift to a new design. But the firm that buys from outside can easily shift to a new product design.
In the short run, integrated firms cut down their purchases or shift to different suppliers. While doing so, they must recognize the effect of such action on unabsorbed overheads.
3. Elimination of Marketing Expenditure
If the firm manufactures parts or the raw material required for the production of goods, the expenditure incurred on procuring goods from outside is altogether eliminated.
4. Effects of Patents
The control of patents by other companies inflates the cost of production. But if the company obtains control over patents, a policy for large-scale production is desirable. If the company feels that raw materials cannot be procured easily, then, in order to keep up production, it will have to stock the raw materials.
5. Volume Required for Economic Production
Most of the small companies cannot undertake backward integration because the volume of their requirements for any part or material is too small to facilitate the utilization of the entire plant capacity. To optimize profit, the company, therefore, sells the balance of the production in the market.
6. Financial Status of the Company
One of the important factors governing vertical integration is the financial status of the company. It has been noted that financially weak firms are not in a position to procure capital from the market. On the other hand, financially strong companies can effectively undertake vertical expansion. Their financial strength facilitates improvements in the manufacturing operations.
Vertical integration decisions are of paramount importance to the success of business. These decisions, therefore, should be carefully examined in terms of the various key factors, such as probable sales, the ratio of savings to investments, and the rate of return. A detailed analysis of these will enable the company to design a broad policy.