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In the world of business, it is not unusual for one company to acquire another corporation that has resources or produces goods or services that are important to the welfare of the company. When a company chooses to buy a corporation that has been a steady supplier or vendor, this is referred to as backward integration. Here is some background on how backward integration works, and why this type of transaction may be appealing.
The process of backward integration usually begins when a company becomes aware that the product of service line offered by one of the company’s vendors is especially attractive. This attraction may be built on the fact that the products that are currently purchased have worked out very well, and are helping to improve the quality and bottom line.
As it appears that a long-term relationship with the vendor seems imminent, a company will often begin to look at the overall costs of doing business with the vendor. If it appears that acquiring the vendor and integrating the supply chain into the corporate family would reduce input costs in the long run, then the vendor may be approached about the change of an acquisition. Assuming both parties are open to the idea of acquisition, negotiations are opened and eventually a deal that is attractive to both parties is drafted.
In some cases, backward integration occurs not because a single company wishes to acquire a company, but because several customers of the vendor wish to ensure that the entity survives. As an example, a vendor who supplies goods to three companies may be in financial trouble. Because the three companies do not want to seek out a new vendor, a working relationship is established where each of the three contributes resources to the purchase and continued operation of the vendor. This is often a win-win situation for everyone. The vendor stays in business, and the customers continue to get the products they have come to rely upon, often at a reduced rate.
Another application of backward integration involves dealing with supply chains where there is a need to reduce supplier power over unit cost. As a means of minimizing input costs, a customer or group of customers may initiate a buyout of the vendor. This helps to bring supplier power under their control, allowing each customer to better manage their individual input costs, and perhaps generate more revenue from other clients of the newly acquired vendor.
@miriam98 - On the other hand, you also have forward integration. This is where the business merges with its distribution channels, so it can control how and where to sell its products.
I work for a software company and we tried backward integration with one of our vendors. One of the items that we bundle with our software is a USB-style license key known as a “dongle.” We rely on a small, private firm to produce these hardware devices for us.
One year we approached them with the offer of an acquisition, because we calculated that if we bought them out, then our unit cost on each key would be much less and we could maximize our profits. The deal almost succeeded, but fell through at the last minute because they decided they could be more profitable as an independent vendor, and were beginning to branch out into multiple markets.
That’s just one backward integration example from the information business. I think the key point to take away is that a backward integration strategy involves a company and a supplier, not just a company and a competing company.
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