In this exclusive article, the Head of NBC (Nordic Baltics Countries) Torbjörn Lundberg from SMC shares insights on the ever-evolving world of automation and its profound impact on various industries.
Vertical integration of the supply chain provides increased competitiveness while minimising risks with suppliers and distributors with a different strategy than your own - but it is not for everyone.
Vertical integration, what is it?
Vertical integration is when a company incorporates parts of the supply chain under its own auspices, parts that are normally done by other companies. The parts you usually talk about are: Raw material – component manufacturing – product manufacturing – system/machine manufacturing – distribution.
You can integrate backwards, forwards or both. Backward means that e.g. a system manufacturer also begins to manufacture the components and products included in the system. This can be done by building up such a production, but it is more common to buy a suitable company. Forward is when the manufacturer incorporates the distribution of the systems. So what are the benefits and what are the risks of vertical integration?
Independence from subcontractors
One of the biggest advantages of vertical integration is that you become independent of subcontractors and thus the costs and unpredictability that can exist with subcontractors. In a boom, who prioritises the subcontractor if supplies are not enough for everyone and what effect does that have on the price? In a recession, the subcontractor can simply go out of business.
The independence of subcontractors also reduces the risk of disruptions through e.g. strikes at the subcontractor. It is also significantly easier to streamline your own process if you have full control over all the steps in the process, which results in faster processing times.
In other words, owning previous steps in the supply chain gives better control of the business and you control the previous steps completely yourself and, again, become independent of subcontractors. This is particularly noticeable in industry segments with few and large competitors, e.g. automation with compressed air, so-called industrial pneumatics. One company that has made this vertical integration a strategy is SMC Corporation, the world leader in pneumatic automation.
Cost control
With everything in your own house, you automatically get better control over costs. If you can then allocate overhead costs, transport costs and other operating costs to more cost centres, the end result is a lower total cost. This lower cost can then be used for lower prices and increased competitiveness. The economies of scale are clearer the larger the integrating company is. One must also not forget that each step in the supply chain, if it is a separate company, must have its own margin. With vertical integration, it becomes the integrating company that gets the margin on all steps that are integrated.
Are there any downsides to vertical integration?
The biggest challenge with vertical integration is the investment cost of having factories for every link in the supply chain. You can hardly have a factory that manufactures for others, which is naturally the case for an independent subcontractor's factory that has many customers. This means that only the very largest players can fully vertically integrate.
A risk is also that the vertically integrated conglomerate becomes less immune to changes. Depending on the structure of the company, which is integrated, it may be more difficult for an integrated company to change manufacturing to new products than it is for more specialized companies.
If the conditions change, it is more difficult to take advantage of this if you have responsibility for the entire production chain. This is about e.g. the impact of exchange rates, production in low-cost areas, more efficient and modern production machinery, etc.
It's also not that easy to handle big changes in demand, you have your factories and can't adapt the suit quickly, as when working with subcontractors. This limits the company's flexibility.
With a significantly more complex production and distribution apparatus, there is also a risk of losing focus. A CEO of a component manufacturer who suddenly has to be the boss of system sales doesn't always have the right experience to draw on either. Cultural differences between different parts of the integrated company are also a challenge, especially if the integration was done through acquisitions of other companies.
Most of these inconveniences become easier to deal with the larger the company. Again vertical integration is not for everyone but only for the very largest.
An example of successful vertical integration
As mentioned above, industrial pneumatics manufacturer SMC Corporation is an example of successful vertical integration. Here everything is really done in-house, maybe not really everything, e.g. the aluminium for the products is purchased externally in the form of aluminium ingots and extrusion blanks. They are used for casting light metal components as well as extruding cylinder tubes. Having your own foundry and extrusion plant is not very common in the industry.
In fact, it is not just a foundry SMC casts components in several of its factories.
Today, a lot of electronics are included in the pneumatic components, and what SMC has done, among other things, is to build its own surface assembly factory in Japan. Actually, it is only the semiconductor process itself, the silicon wafers that are made outside the own company, the rest is done in-house.
Forward integration is done by investing in a large sales organization but also using third-party distributors. Different segments of the market require different types of processing.
This with the limited flexibility is handled by having as a main strategic goal to always grow and increase sales. The production facilities are also designed for a growth of 20% in one year. In 2017, when the company increased sales by roughly 21%, the delivery situation for some product areas became a bit strained, but in general, the volume increase was managed with existing manufacturing resources. Considering that the group has a turnover of SEK 50 billion, it is a real achievement.
Here, the vertical integration played a big part in the deliveries working so well, despite the large increase in sales, which they did. The company had full control over the entire process from aluminum ingot to delivered products and subsystems.
Torbjörn Lundberg 2019-03-05 SMC Automation
