Academic journal article The McKinsey Quarterly

How Vertical Integration Can Sap Profits

Academic journal article The McKinsey Quarterly

How Vertical Integration Can Sap Profits

Article excerpt

Recent studies in the chemicals industry have shown that poor profitability can sometimes be attributed to the way in which vertically integrated companies price their products.

The main concern of an upstream business, where the cost of capacity is high, should be to ensure high plant utilization. Many upstream producers have therefore integrated with downstream ones in an effort to guarantee a market for their output. But such an insurance policy can turn out to be extremely expensive. For when demand is low, the upstream operator is tempted to offer discounts to its downstream associates to maximize market share. Armed with this perceived cost advantage, the downstream operators is in turn inclined to compete for market share by cutting prices.

In the most extreme cases, downstream prices can fall as low as the full chain's cash cost, which is likely to be below the cash cost of independent producers. As a consequence, independent producers may find themselves pushed out of the market. The customer, meanwhile, has not only been handed a windfall in surplus, but has also gained an insight into the cost structure of the supply chain, making it difficult for the downstream producer to raise prices again. That, of course, prevents the upstream producer from raising its prices and leaves the price of the product permanently depressed [ILLUSTRATION FOR EXHIBIT OMITTED].

To counter the problem, some companies have tried to stop giving their downstream partners preferential treatment; instead, they base their transactions on market prices. But many are still unwittingly supporting downstream activities that are performing poorly and have no real chance of improvement. Identifying vertically integrated pricing behavior can be tricky, but the following symptoms are likely to give an indication of its presence:

* Continual discussions between upstream and downstream parts of the business about what the transfer price should be.

* Few or no remaining independent downstream producers with significant market share. …

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