The most successful firms of the last few decades, like Apple, Tesla, and fast-fashion retailers, achieved such success with extreme vertical integration strategies. These strategies were driven by two assumptions which don’t fit the classical rationale for vertical integration. First, hand-off firms simply weren’t up to the task of achieving the “going beyond” innovation that was needed and created onerous coordination problems. Second, owning innovation and its subsequent refinement and enhancement helps to foster future innovation that’s faster and more impactful and provides protection against competitive followers. There are three brands that serve as good examples of this:
Apple is one of the most vertically integrated firms. They control the software, customer interface, product design, retailing, and have close watch on manufacturing.
Apple’s control over most elements of new products from concept to product introduction allows them to create advances that are ahead of the market and protected from competition. The retailing innovations provide a brand experience that would not happen if it was farmed out to others that don’t share Apple’s knowledge and passion for the brand and its customer experience.
Tesla has created a set of “must haves” that define a new subcategory based on innovation throughout the vertical channel. Tesla controls the software, manufacturing (done in a plant a few miles from their headquarters), battery chargers, retail presence, and will soon control the battery supply.
They’ve created a host of innovations for which potential supplier firms were simply not motivated or equipped to take on; in part because the needed innovation was a moving target and required cross-technology capability. Further, ongoing design, production, and customer experience evolutions are so intertwined that it would be virtually impossible to disaggregate to outsourced firms.
The retail clothing industry saw H&M and other fast-fashion firms create a new subcategory that hinged on their ability to bring design, manufacturing, and retail stores into their firm. Vertical integration made possible their ability to turn around fashions from idea to design to manufacture to retailer in a matter of weeks instead of months. The model would not work without the almost complete vertical integration.
Vertical integration was once a staple of firms. Henry Ford was one that believed in integration so much he was involved in getting raw materials like rubber and coal to make parts for his cars. The conventional reason to integrate was to guarantee supply at a reasonable price or to control access to the market. Today innovation in a complex and fast moving environment has become an essential for some leading firms. The two influential management theories which helped firms move away from vertical integration do not apply to firms like Apple, Tesla, and H&M.
The first was the shareholder value theory which posited that each business unit needs to create shareholder value by maximizing return on assets. The obvious way forward was to reduce assets by outsourcing the business areas they represent. As a result, many firms sold off assets and used outsourcing to fill in the gaps. This rather artificial theory really is not very relevant with businesses whose value is not asset dependent but rather based on IP and people, neither of which appear on the balance sheet.
The second was the concept of core competence. Those business elements downstream or upstream from your core competence were simply assumed to be a diversion that a firm was unlikely to be good at. The advice was to focus on that part of the supply chain that is most variable and for which you firm has a core competence and let the outside specialist firm handle the rest whether in manufacturing, component design, or retailing. The assumption that others in the supply chain are capable and motivated to do the necessary innovation, or even to know what innovation is needed, does not hold for firms like Apple, Tesla, and H&M.
Further, even if it did hold, the job of coordinating outsource suppliers becomes difficult with fast moving marketing and technology dynamics. I was at the Samsung headquarters some years ago and was surprised that they believed that Samsung success in smart phones and associated devices would be driven by the fact that they controlled the semiconductors that were the heart of the devices. They noted that their semiconductor R&D was informed by the device businesses and, in turn, the device businesses got access to R&D breakthroughs some months before competitors even knew about them.
Many of the leading success stories of today are based on an ability to innovate all through the supply chain in a way that results in a seamlessly coordinated system. A key success factor to be a leader in many of these areas is to have core-competence in many relevant areas and an organization that melds those core competence areas together.