What is Backward Integration?

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.