Vertical Integration: Owning More of the Chain

What Is Vertical Integration, and Which Way Does It Run?

Start with a caterer who does weddings. The cooking is his. The tents, the lights and the stacking chairs are not: a fortnight before every booking he telephones a tent contractor, agrees a rate, and then spends the last three days hoping the lorry turns up when it said it would. One year he stops telephoning and buys the tent contractor outright. Notice what did and did not change. The tents are the same tents. The lorry is the same lorry. The only thing that moved is that a step in the work he was already paying for is now a step he runs himself.

Buying the tent contractor is the entire idea, and every remaining question is about when it is worth the money. The test for whether a move counts as vertical integration is not size and not variety: it is whether the stage was previously bought from somebody else. A shop that opens a second shop has not integrated vertically. A shop that takes over the small workshop that used to supply it has. A payment that used to leave the business now stays inside it, and a decision that used to be somebody else's is now the shop's to make.

There are two directions to travel in, and both have names worth knowing. Moving towards the inputs is called going upstream: the mill that makes the paper, the workshop that binds the books, the transporter who brings the board to the gate. Moving towards the buyer is called going downstream: the distributor who carries the goods to the shops, or the shop itself. The labels describe who was paying whom, not where the machine physically sits in the line, and that catches people out often enough to be worth saying twice. A binder is upstream of the maker who sends him the money, even though the binding happens right at the end of the making.

Anjani Stationers Private Limited makes hard-bound registers. Anjani cuts its own paper and prints its own sheets, both on lines inside its own worksThe buildings and machines where the making actually happens. In Indian usage a factory floor is very often called the works, and the word takes a singular verb even though it ends in an s.. Binding it did not do. Finished sheets went out to Chitra Binding Works Private Limited, a separate company under separate control. Chitra bound them and sent an invoice. At the start of its second year Anjani Stationers took over most of Chitra. Chitra was somebody Anjani paid, so taking it over is an upstream move. The move is vertical rather than anything else because binding was a stage Anjani was already buying and had never run.

What Is Vertical Integration Not, and Where Does Horizontal Integration Sit?

Anjani Stationers could have done something quite different with the same money. The company could have opened a second works making the same registers on the same kind of machines, or taken over a rival register maker down the road. Both of those are growth at a stage it already runs, and both have their own name: that is horizontal integration, sideways rather than along. Horizontal integration is covered separately.

The distinction is easy to hold on to if one question keeps being asked. Before the money moved, was the business running this stage itself? If the answer is no, and somebody else was being paid to do it, the move is vertical. If the answer is yes, and the business is simply going to do more of what it already does, the move is horizontal. A dairy that takes over the tanker fleet bringing milk to its plant has gone vertical. A dairy that takes over a second dairy has gone horizontal. Nothing about the size of the cheque tells the two apart.

Which direction a business ought to grow in, and the circumstances in which each of the two is the wrong move, are set out on Vertical vs Horizontal Integration: Which Way to Grow.

Why Would a Business Hold a Stage It Could Simply Buy From?

There are three ordinary reasons, and the list is worth being strict about. A fourth reason usually turns out to be one of the three wearing a different hat.

The first is that the stage has a margin of its own, and at the moment that margin leaves the business every time an invoice is paid. The trade binderA business that binds printed sheets into finished books for whoever sends work to it, charging by the job. It is nobody's in particular and works for many printers at once. is not doing the work for free. Somewhere inside the price he charges is the difference between his cost and his bill, and if his business is taken over that difference stops leaving. Consider a household that pays rent for twenty years and then buys the flat it was renting. The rent stops going out of the door. The saving is real, and it is also the reason people reach for most quickly. Being the first reason to hand is exactly why it deserves the least trust on its own.

The second is that supply stops depending on somebody else's willingness. A tenant can be asked to leave. A contractor can take a better job in the very week he was needed. When a stage of the work sits inside another company, that company decides its own priorities, and in a busy season one order and somebody else's order are competing for the same machine. Taking over the stage does not create capacity out of nothing, but it does mean the queue is now the buyer's to order.

The third is the one that matters most here and gets talked about least: capacity at that stage becomes the owner's to change. Running that machine faster, or for longer, or with a second shift on it, becomes a decision the business can take. No such decision could be taken about a contractor's machine, and no amount of paying him more makes it so. None of the three reasons is automatic, all three have to be demonstrated rather than assumed, and only the third one can change the number of finished goods that physically leave the building.

Keep that last distinction close. The whole case for buying a stage leans on it. The first two reasons change who keeps money and who takes risk. The third changes what the machines can do. The two kinds of gain are not the same, and they should never be added together as though they were.

Which Stage Is Actually Worth Holding, and How Would a Buyer Know Before Paying?

The answer below is much less useful without a guess committed to first.

Anjani Stationers runs two lines. Each runs eight hours a day, and the works runs 250 working daysA day the works actually opens and makes something. It is a shorter year than the calendar one, because holidays, maintenance shutdowns and weekly offs are all taken out of it. a year. Two lines times eight hours times 250 days gives 4,000 line-hoursOne hour of work by one production line. Two lines running side by side for an hour give two line-hours, which is how machine time is counted once a works has more than one line. of machine time in the year, and that is the whole stock of time the business has to play with.

Now put the three rates against it. Cutting turns out 150 registers in a line-hour. Printing turns out 125. Binding turns out 100. Every single register gets cut, then printed, then bound, with no way round any of the three, so nothing can leave the works faster than the slowest stage lets it out and the rate of the whole system is 100 an hour. Multiply that by the 4,000 line-hours available and the works has a rated capacity of 4,00,000 registers a year. Against that, 2,50,000 registers were actually made, and a great deal of the year's machine time went unused. How full a works runs, its utilisationThe share of what a works could have produced that it actually produced. How the figure is computed, and what a single number for it hides, is set out on Capacity Utilisation: How to Compute It and What It Hides., is covered separately.

The slowest stage governing the whole is Eliyahu Goldratt's argument from The Goal in 1984, and the argument matters for a purchase decision because it sorts the stages into two piles before anybody has discussed a price. Cutting and printing both have spare rate. Binding has none. Binding is the stage the whole works waits on. Why binding rather than printing turns out to be the stage that governs is worked through on Throughput: The Rate the System Actually Produces. Buying into a stage with rate to spare buys that stage's margin, not one extra register.

The most useful property of this test is how cheap it is. The test needs three line rates. Any works manager can read those off a machine or a shift log in an afternoon, and the test needs no negotiation, no valuation and no access to anybody else's accounts. The rate test can be applied to a business nobody has approached, in a week when nothing is for sale, and it settles in advance which stage would be worth the conversation.

What Did Anjani Stationers Actually Buy for Rs 21,00,000/-?

At the start of its second year, Anjani Stationers paid Rs 21,00,000/- for 70 per cent of Chitra Binding Works Private Limited. Chitra became a subsidiaryA company in which another company holds a large enough share to decide how it is run. The larger company does not have to hold all of it, and usually does not. of the group from that day.

Read that purchase next to the three line rates and it stops being corporate news and starts being an operating decision. Chitra binds. Binding turns out 100 an hour where cutting manages 150 and printing manages 125. Of the three stages a register passes through, Chitra was the one that governed the pace of all of them, and it was the only one of the three that Anjani did not run. Anjani Stationers did not buy a supplier: it bought the constraint.

There is a second thing worth noticing, and it takes some of the drama out of the purchase in a useful way. Anjani had been paying Chitra Rs 8,00,000/- a year for binding. Across the year's output that works out at Rs 3.20/- a register. The commercial relationship already existed. The registers were already being bound. Nothing about who did the work or how it got done was in question on the day the shares changed hands. The purchase bought the right to decide about that stage, and nothing else.

What Does Holding the Stage Make Possible, and What Has It Not Yet Done?

Here is the payoff the arrangement makes available. Take binding up from 100 an hour to 125. Printing also sits at 125 and cutting sits above both, so the slowest of the three becomes 125. The system rate goes to 125, and running 4,000 line-hours at that pace gives a rating of 5,00,000 registers a year in place of 4,00,000. The gain is 1,00,000 registers of extra rated capacity, and it comes from moving one stage.

Now try it the other way round. Lift cutting from 150 an hour to 200 and the slowest stage is still binding at 100, so rated capacity is still 4,00,000. Lift printing from 125 to 150 and the slowest stage is still binding at 100, so rated capacity is still 4,00,000. Lift both of them, cutting to 200 and printing to 150 in the same year, and rated capacity is still 4,00,000 registers. The works still cannot bind faster than 100 an hour. Two stages got quicker and the gate produced exactly what it produced before.

So the arrangement is worth something. But be precise about what happened and when. Holding the stage bought the right to make the change, and it did not buy the change. On the day the Chitra shares moved, binding still ran at 100 an hour, rated capacity was still 4,00,000 registers, and the works still turned out registers at the pace it had turned them out the week before. Getting binding from 100 to 125 is somebody's project: new machines, or a second shift, or a different method, all of which cost money and take months and can fail. Nothing about a line rate moves because a shareholding moved.

The distance between the right and the act is the part that gets skipped in the retelling, and skipping it is how a business ends up disappointed by a purchase that did exactly what it was supposed to do. Buying the right to act is a real thing to buy, and it is simply not the same thing as having acted.

What Does Holding a Stage Not Buy?

Three things, and the first one has a number attached, which makes it the easiest to be careless about.

Anjani Stationers holds 70 per cent of Chitra, not all of it. Chitra earned Rs 10,00,000/- in the year. Seventy per cent of that, Rs 7,00,000/-, is the group's share. The remaining Rs 3,00,000/- belongs to the shareholders who still hold the other 30 per cent, and in a set of group accounts their claim has a name of its own, the non-controlling interestThe slice of a held company that belongs to shareholders outside the group, together with the slice of that company's profit which goes with them. How it is presented in a set of group accounts is settled elsewhere.. The outside shareholders did not sell, they are not going away, and their claim on the profit is as good as the group's own. A controlled business is not a wholly held business, and the difference between them has a number written on it.

The second thing not bought is any improvement in how the binding is done. Chitra binds exactly as well or as badly on the day after the sale as on the day before, with the same people, the same machines and the same habits. Control creates the possibility of changing all three, and control changes none of them by itself. If the binding was slow because the machines are old, the machines are still old.

The third is more subtle and worth an everyday picture. A promoterIn Indian usage, the person or people who started a business and still hold enough of it to decide what happens to it. The word describes a position rather than a job title. who takes over a business is now responsible for it, and that responsibility runs in both directions. If binding work dries up, that is now the group's problem to solve rather than a contractor's. A household that buys the flat it was renting no longer has a landlord to ring when the roof leaks. The leak has not become cheaper. The leak has become the owner's.