Backward integration is the type of vertical integration in which companies acquire or merge with a supplier in their value chain for raw materials or services used to produce their final product or services.
This guide defines backward integration, describes the advantages and disadvantages of backward integration as a business strategy, and provides real examples of backward integration.
Table of Contents
- What is Backward Integration?
- How Backward Integration Works
- The Effects of Backward Integration
- Examples of Backward Integration
- Vertical Integration vs Horizontal Integration
- Backward vs Forward Integration
- Which Companies Should Use Backward Integration?
- Benefits of Backward Integration
- Pitfalls of Backward Integration
- Importance of Backward Integration
What is Backward Integration?
Backward integration is a type of vertical integration and M&A corporate finance strategy in which businesses acquire or merge with raw materials inventory or parts suppliers in their supply chain. The companies then own and produce these earlier-stage inputs vs. buy them from outside companies in the supply chain.
How Backward Integration Works
Backward integration works through this process: Companies evaluate opportunities to acquire or merge with a supplier used to produce their products or services. They complete due diligence and an M&A transaction when the benefits of backward integration are justified and financially feasible. Backward integration is a form of vertical integration.
When making backward integration decisions, evaluate the advantages and disadvantages (including riskiness).
Advantages of backward integration include:
- Better control
- Securing a supply of needed raw materials for a product
- Reducing costs through economies of scale
- Eliminating inefficiencies
- Gaining in-house technology skills for competitive advantage and differentiation
With backward integration, you’re an owner rather than a customer making company purchases from suppliers. Your company may gain market share in your industry by getting a limited supply of raw materials before your competitors. That’s particularly true in times of delays from supply chain disruption. Your business will be able to produce finished goods to deliver sooner and more consistently to customers that are end consumers of your product.
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The Effects of Backward Integration
Backward integration is an M&A strategy that can reduce cash, add debt, or dilute shareholders through new share issuance. But the buying company gains new revenue, greater control over its products, and ability to save costs later. Backward integration can be used to reduce product costs, increase quality, and improve availability of raw materials and work-in-process inventory for manufacturing.
Examples of Backward Integration
Two examples of companies using backward integration from the early part of the supply chain are Tesla and Intuitive Surgical.
Tesla Backward Integration Example
Tesla is a company using vertical backward integration to increase early-stage manufacturing needed to produce its electric vehicles. One application that Tesla has been pursuing in 2022 is refining the raw material lithium hydroxide for use in electric batteries on the Gulf Coast of Texas near Robstown. If this plan goes forward, lithium production is targeted to begin in 2024.
Seeking backward integration, during 2014 and 2015, Tesla tried to buy Simbol Materials, a lithium extraction startup company near the Salton Sea in California that has since ceased operations. The deal wasn’t completed by Tesla and Simbol, primarily due to valuation issues.
Tesla is considering in-house lithium refining rather than buying lithium through its supply chain because the cost of buying lithium is skyrocketing.
Besides using M&A to achieve backward integration, Tesla is using internal innovation. Reducing its supplier reliance, Tesla replaced supplier Nvidia’s chips for autonomous driving with internally designed chips and has also reduced the total number of chips needed in its electric vehicles.
Intuitive Surgical Backward Integration Example
Intuitive Surgical is a robotic-assisted surgery device company using a backward integration strategy. In July 2019, Intuitive Surgical bought the robotic endoscope business from its 20-year supplier, Schölly Fiberoptic, based in Germany. Besides the sale of its robotic endoscope business, the company will continue to act as an Intuitive Surgical supplier for its fiberoptic business products.
Vertical Integration vs Horizontal Integration
Vertical integration is an M&A strategy to acquire or merge with suppliers in the supply chain; horizontal integration is an M&A strategy to grow through acquisitions or mergers in the same industry to expand market share.
Horizontal vs vertical integration are not mutually exclusive. A vertically integrated company and a horizontally integrated company are both viable control, expansion, and cost and profitability improvement strategies to consider.
The third type of M&A strategy (besides vertical and horizontal) is a conglomerate merger, in which acquired or merged companies are in a variety of industries for diversification, with ownership through a corporate holding company.
Backward integration and forward integration are two types of vertical integration.
Backward vs Forward Integration
The main difference between backward vs forward integration is that backward integration involves acquiring raw material suppliers earlier in the supply chain to increase internal production processes, whereas forward integration relates to buying wholesale distributors, last-mile delivery companies, sales, and services operators in the supply chain to discontinue outsourcing these functions.
Which Companies Should Use Backward Integration?
Companies with difficulty obtaining raw materials on time for a reasonable cost should consider backward integration. If experiencing supplier quality or financial stability problems relating to essential parts, businesses should investigate using backward integration vs. switching suppliers. Companies may consider buying suppliers for technological expertise or efficiency enhancement.
Benefits of Backward Integration
Benefits of backward integration include:
- Added revenue stream from other customers for acquired products or services
- Expected deal synergies
- Lower costs by eliminating the mark-up of supplier profits
- Potential for higher volume discounts from other suppliers
- Increased certainty of raw materials supply
- Manufacturing process improvements for better quality, increased efficiency, and higher profit margins
You’ll use these parts to build your own products. Backward integration can help your company expand its revenues if you also ship to external companies.
With backward integration, you make vs. buy products from the acquired supplier. Your company will be able to reduce costs by eliminating the profits earned by middlemen or vendors at an earlier stage in the supply chain.
In M&A deals, you’ll expect cost savings synergies from staff reductions and expenses related to redundant functions.
Combined manufacturers buy some of the same parts from external suppliers. An example is computer chips. If your company can buy these common parts from the same vendor, the volume bought by your entity will increase. You can negotiate for higher volume discounts.
With increased financial strength, the acquired or merged entity may receive better payment terms from other suppliers and improve its global supplier management relationships.
A reason for buying a supplier is to increase the ability to get all the raw materials needed for manufacturing your finished product. An example is rare earth elements needed for electric battery or semiconductor production.
And it may be the case when supply chain disruption delays impact your manufacturing schedule.
Your company may choose backward integration not only to buy a supplier’s company or product lines. Perhaps you’re aware of a company earlier in the supply chain that uses outstanding state-of-the-art technology.
Combining could help your company:
- Gain productivity
- Reduce costs
- Create a competitive advantage through added competencies
Pitfalls of Backward Integration
Pitfalls of backward integration include:
- Large upfront investment through M&A deal, possibly increasing the debt level
- Poor culture fit and added bureaucracy, resulting in key talent and technological knowledge loss
- Potential delays if the supplier’s manufacturing plant is relocated to buying company’s site
- Risks from inadequate due diligence
- Market risk of decreased sales and profits during economic slowdowns
- Loss of flexibility to switch to new suppliers with better technology later
Backward integration is generally achieved through a large investment that could increase your company’s financial leverage through added debt and increase its riskiness. Some companies use cash from equity capital raises. A few fortunate companies, like Microsoft and Apple, have excess cash on their balance sheet; they can choose to invest in the backward vertical integration of some smaller companies.
The state of corporate culture in U.S. and international companies varies. Companies can be autocratic with lots of bureaucracy or they can be agile, encouraging employee empowerment and decision-making. If the acquirer or merger partner has a completely different corporate culture style, some employees may voluntarily leave the company. This could result in a talent and knowledge void in certain areas, detrimentally affecting the expected results of backward integration.
Initially, the supplier will continue to manufacture the acquirer’s parts in their manufacturing plant. Later, the acquirer may decide to achieve economies of scale by moving that manufacturing to the company’s current plant. The supplier’s plant can be sold or the lease may be terminated early with a penalty if the landlord agrees to a deal.
If the acquirer moves the product line to a combined manufacturing location, it may be able to reduce transportation costs. Fixed overhead will be spread over more units produced at the combined factory.
But if it’s not managed well, production delays and startup problems could occur when manufacturing begins at the new location.
Due diligence documents inspection, warranties, communications, and analysis to investigate a potential acquisition candidate must be comprehensive and accurate. M&A transactions often don’t achieve the desired and projected synergies. Other significant problems may surface that aren’t detected through the due diligence process. That presents a risk to the acquirer that’s a backward integration pitfall.
If your company completes an M&A deal for backward integration, it owns the supplier’s company, product line, or service. And it has transferred the risk of reduced sales level in an economic downturn from the supplier to your business. You can no longer just reduce the size of your orders from that previously external vendor to respond to changing events.
What if a supplier’s technology or business that your company buys is superseded by new game-changing technology? Will you still be able to buy the new competitor to gain a competitive advantage? Or was the original investment so large that you’re not able to also buy the advanced supplier?
Importance of Backward Integration
Backward integration is an important part of the business model. It uses a vertical integration strategy to ensure your company has an adequate and timely supply of raw materials. Backward integration can improve control, efficiency, and quality of raw materials, reducing costs to increase profitability from finished goods sales.
This increased control in manufacturing results in better inventory availability for customer sales. It makes your company more stable with fewer operational disruptions from raw inventory delays. Backward integration is a strategy that all growing companies, including those planning on going public eventually, should consider.
Backward integration brings risks as well as rewards to a viable acquirer or merger partner. Adequate due diligence, a strong corporate culture, and effective M&A integration are keys to enhanced success in achieving the advantages of backward integration. AP automation software can help you manage your growing business and achieve better M&A systems integration.
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