Vertical integration: when is it appropriate and what are the risks?

Vertical integration can benefit the construction industry, but contractors, clients and the supply chain must understand when it's most appropriate – and what the potential risks are


  • Chris Green

11 April 2020

Vertical integration is the practice of combining adjacent stages in an industry's supply chain  normally operated by separate firms  for economic benefit. In other words, the supply chain, generally a group of companies that produce a different product or service that combines to satisfy a common need, is owned by one company. Vertical integration can take the form of full integration of the whole supply chain or partial integration of several stages of the supply chain.

Many industries have adopted this practice successfully. In the petrochemical industries, for example, companies such as Shell and Exxon that operate across all elements of their sector  from exploration and extraction to retail sales  vertically integrate the entire supply chain.

Can the construction industry learn from these examples of vertical integration and improve its own performance? Could integrating the parties that oversee the tendering, design, procurement and delivery be advantageous?

The economic theory

There are a number of market conditions in the construction industry where vertical integration can be beneficial.

  • Risk of supply chain failure.

    Supply chain failure can occur when there are too few buyers or sellers of a product or service. Where there is high trading risk between adjacent stages in the supply chain it may be beneficial for these stages to integrate. For example, those companies involved in the maintenance and construction of the rail network rely on specialist road and rail vehicles to perform certain types of works. This specialist plant is mostly owned by the companies as it would be too risky to rely on availability from general plant hire companies. The nature of the product or service coupled with the frequency of transaction may also suggest that a benefit can be derived from vertical integration. If a product or service is highly unique for its intended purpose has high durability or requires an unusually large amount of research and development cost this may determine whether its supply should be vertically integrated with the relevant stage in the supply chain. This could apply to a specialist item or plant a modular housing factory or an organisation with specialist skills.

  • Supply chain balance of power.

    Where adjacent supply chain members have an imbalance of market power vertical integration may be beneficial. Vertically integrating these adjacent supply chain members may increase the profitability of the weaker supply chain member or raise barriers to other businesses to enter into that segment of the market. If a specialist subcontractor is making excess profits, for example a general contractor may benefit from acquiring the subcontractor. Likewise, if a specialist claims consultant is making excess profits, a multi-disciplinary consultancy firm could potentially benefit from acquiring the claims consultant.

  • Market maturity

    Whether a market is emerging or declining may drive the need for vertical integration. If a market is emerging a company may derive a benefit by vertically integrating supply chain members closer to the end customer. As an example a specialist technology provider may benefit from acquiring a consultancy who has direct access to its target customers. Conversely, when a market is declining and suppliers are exiting, it may be beneficial to vertically integrate the relevant part of the supply chain to ensure its ability to deliver.

Market drivers

Clients strive to achieve better value for money, security of delivery and optimum health and safety management from the industry's supply chain. In recent years, clients have demanded greater integration of the whole supply chain by main contractors through, for example, the advent of the design and build contract form in the 1980s, which allowed for vertical integration of the design process and construction activities. Clients then wanted to integrate the total delivery of built environment projects through design build finance and operate procurement routes  such as private finance initiatives and public-private partnerships and build-own-operate-transfer contracts.

"There is an increasing appetite for direct delivery models where the contracting organisation employs the whole workforce directly"

In current projects, many clients are highlighting shortening the supply chain and becoming closer to the delivery teams as key objectives. Clients are questioning the value of having too many layers of management above the workforce that ultimately builds the project. There is an increasing appetite for direct delivery models where the contracting organisation employs the whole workforce directly.

From a clients point of view, the benefits of vertical integration include:
  • better value for money due to reduced requirements for layers of both overhead and profit
  • greater control of the workforce
  • the ability to establish a permanent and consistent health and safety culture among the workforce.

Project 13 an industry-led response to improve infrastructure delivery models that 'fail not just clients and their suppliers, but also the operators and users of our infrastructure systems and networks', attempts to integrate the supply chain into a temporary enterprise that is wholly focused on project outcomes. A new integrator role has therefore emerged, someone tasked with vertically integrating the supply chain to deliver the project through shared goals. Some clients are bringing the entire supply chain in-house to gain the benefits of vertical integration.

  • Financial services company Legal and General for example have invested heavily in a modular homes manufacturing business to support their investment in the housing market.
  • Several utility companies, which operate in tightly regulated industries, continue to build their in-house construction capabilities to guarantee delivery of their services and avoid the layers of external supply chain overheads and profit. Some electricity distribution network operators employ their own workforce to respond to emergency network repairs, while others competitively tender a service from utility contractors.

The vertical integration model can also benefit contractors. At present some contractors are moving away from the management of subcontractors and instead vertically integrating specialist skills and plant into their businesses largely driven by the economic factors outlined above.

For contractors  as with clients  the ability to develop specialist in-house capability control the culture of the workforce, and avoid the market risks of subcontracting is attractive. There's also an added benefit: operating through a model of vertical integration can make contractors more attractive to clients - the fact that the goals of the two parties align can become a key selling feature.

Some contractors are vertically integrating in a backward direction  down the supply chain  by amalgamating core component manufacturing, such as pre-cast concreting facilities, plant fleets and materials supply. Others are vertically integrating forward  up the supply chain  to move closer to the end customers. One contractor has bought a train operating company to maximise the benefit of its rail construction capability.

Risks to integration

Despite the benefits, vertical integration is not without risk. The very factors that originally drove the industry to segregate into discrete suppliers still exist and are difficult to control. Specialist resources are only economic if their utilisation is maintained at a high level. If such resources cannot be continually deployed, then an inefficiency of standing cost rapidly emerges, which can outweigh the economic benefits of vertical integration.

"The frictional cost of acquisition and disposal can make vertical integration decisions expensive, so it is important to understand these dynamics fully"

The frictional cost  that is, the total direct and indirect costs of acquisition  and disposal can make vertical integration decisions expensive, so it is important to understand these dynamics fully before decisions to vertically integrate are made.

The legal, financial and management costs of acquisitions and disposals can be significant and should be considered and accounted for when appraising a potential acquisition or disposal. A secondary cost inefficiency in vertically integrated organisations is the difficulty to maintain a balanced spectrum of people costs  from trainees to industry specialists.

People are generally ambitious and want career progression so contractors can find they have developed a workforce of fully-skilled operatives when a blend of semi-skilled operatives are actually the right economic workforce. Equally, consultants can rapidly develop to become fully-skilled experts when a blend of experience and lower cost is required to deliver the best value for money. All these risks are surmountable, but require active management to maintain the economic benefit of vertical integration.

Contracting organisations should examine their supply chains and determine whether vertical integration would be of benefit to the industry, or whether existing bilateral integration  more common across the UK construction industry  serves their business better. Consultancies should examine the demand and supply of specialist expertise and determine whether there is an economic benefit for vertically integrating this expertise.

For us, as quantity surveyors and project managers, irrespective of the types of firms we work for, it is important that we are aware of the dynamics of the industry supply chain and apply this understanding to improve industry efficiency for our clients. When advising clients, we should look at the length and degree of integration of the supply chain and question value for money security of delivery and health and safety management. Project 13 is gathering momentum, so it is worth reading the guidance material.

Chris Green is group commercial director at J. Murphy & Sons Limited

Related competencies include: Business planning, Supplier management

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