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Backward Integration

Guide to Understanding Backward Integration

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Backward Integration

Backward Integration – Vertical Integration Strategy

How Backward Integration Works (Step-by-Step)

Backward integration, one of the two types of vertical integration, occurs when a strategic acquirer moves upstream, i.e. closer to the product manufacturing and supplier aspects of the value chain.

Upon completion of the acquisition, the company moves further from serving its end markets directly and is now more oriented around product development and manufacturing.

Backward integration strategies are completed to obtain greater control over the earlier stages of the value chain, which encompass the functions performed by specialized manufacturers and suppliers.

Common examples of business activities categorized as downstream functions are as follows.

  • Product Manufacturing (i.e. Parts, Components)
  • Research and Development (R&D)
  • Raw Material Supplier
  • Commodity Producers

As a result of backward integration, the acquiring company obtains more control over the earlier phases of the supply chain cycle, which refers to the manufacturing and supply side of the process.

Most often, companies that outsource manufacturing to third parties develop products that are highly technical and require an extensive number of parts or components.

Therefore, it can be more cost-efficient to outsource those tasks to third parties that specialize in developing those parts and components, especially since many of those companies operate overseas where labor is cheaper.

Once a company reaches a certain size and has enough funds, however, it can decide to pursue backward integration to obtain more ownership over the entire production process.

Direct ownership over those processes does not guarantee higher quality products by any means, but the opportunity is present where the company can manage the process and quality internally, i.e. resulting in less reliance on external parties.

Acquisition Strategy vs. In-House Build

While companies often opt to acquire and take over third parties, an alternative strategy is to build the required operations in-house.

However, building in-house operations to perform technical tasks can be costly and time-consuming, which is most often the reason for outsourcing in the first place.

Still, certain companies with enough funds and resources in terms of technical capabilities and employees (and the formation of a dedicated division) choose to proceed with in-house development instead of pursuing acquisitions.

Backward Integration vs. Forward Integration

The other type of vertical integration is “forward integration”, which describes companies moving closer to the end customers.

  • Backward Integration → The company moves upstream and acquires suppliers or manufacturers of the product that the company sells.
  • Forward Integration → The acquirer moves downstream and purchases companies that work closer to its end customers.

Forward integration, as implied by the name, results in the company moving closer to directly serving its end customers, such as product sales, distribution, and retailing.

Generally speaking, the functions closer to the customer tend to be less technical but represent more opportunities for active engagement and relationship-building with the customer base.

In contrast, backward integration involves greater control over upstream activities, which are further away from the end customers (in many cases, those upstream companies might not even be recognized by end customers).

Moreover, upstream activities like product development and manufacturing are more technical (i.e. R&D oriented) and contribute more to the product quality and its capabilities.

While certain companies seek to become closer to the end customer, such as a manufacturer offering more after-sale support services, other companies would rather prioritize ensuring the highest product quality by better controlling the product development and manufacturing side.

Backward Integration Example: Apple M1 Chips (AAPL)

One recent real-life example of backward integration is Apple (AAPL), which in the past couple of years has gradually become less reliant on chip makers and manufacturers of their product components.

Of course, Apple will realistically always continue to rely on outsourcing to some extent, given how technical its products are (and would probably never have full control over its entire value chain).

But in 2020, Tim Cook – the CEO of Apple – publicly announced Apple’s intention to part ways with Intel and confirmed rumors that the company would transition toward using its own custom-built ARM processors in its laptops and desktops.

In summary, Apple decided to build its own proprietary chips, M1, in-house rather than relying on Intel.

Apple-Intel 15 Year Partnership Ending

“Apple announced three new Mac computers on Tuesday: a MacBook Air, a 13-inch MacBook Pro, and a Mac Mini. They essentially look the same as their predecessors.

What’s new this time is the chip that runs them. Now they’re powered by Apple’s M1 chip instead of Intel processors. Tuesday’s announcement marks the end of a 15-year run where Intel processors powered Apple’s laptops and desktops, and a big shift for the semiconductor industry.”

– “Apple is Breaking a 15-year Partnership with Intel on its Macs” (Source: CNBC)

The Apple Silicon chips, per statements made by Apple, would facilitate more powerful Macs, and developing their own advanced chips would increase performance speed and extend battery life (and be more energy-efficient as a result of additional power management capabilities).

The first Mac with Apple Silicon was released in late 2020, and Apple expects to separate from Intel – for these particular components – in a gradual phase-out that’ll take approximately two years.

And on schedule, in the fall of 2022, news sources reported that Apple had removed the last remaining traces of Intel Silicon from its Mac product line.

Horizontal Integration Example

“Apple Unleashes M1” (Source: Apple Press Research)

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