The advantage of doing it yourself

According to conventional thinking, vertical integration is yesterday’s strategy. Retailers should focus on whatever they do best: range selection, visual merchandising, customer service… the core competence that uniquely defines the brand in the mind of customers, and outsource the rest.

Owning both factories and shops inevitably results in compromising one for the sake of the other. So Asda is no longer Associated Dairies, The Body Shop has sold its toiletries and cosmetics factories and local electricity networks gave up their stores long ago.

Only in sectors where very profitable producers are attempting to defend upstream margins - despite the commodity nature of their end products - do we see the need to own the route to market. Mobile phone networks, banks and oil companies worry that leaving their distribution to third parties would lay bare the undifferentiated nature of their products and put share positions up for grabs. In these cases, retailing is not profitable in its own right but necessary to defend incumbency.

But there are exceptions. Some retailers have shunned the conventional wisdom and maintained their own factories. Inditex, DFS, Morrisons and Card Factory all own factories and claim this brings a competitive advantage.

Inditex is only about 50% vertically integrated, but this is in the lines with the shortest lead times and most volatile demand. Even the most effective ‘virtual integration’ with suppliers cannot match the speed and flexibility of its own fast fashion manufacturing.

DFS sources about 20% of its sofas from its own UK factories. Not only does this give consistent quality at a short lead time that the market finds difficult to match, it gives essential insight into production economics that enables more effective sourcing of the non-integrated volumes.

Morrisons tends to supply internally in relatively mature, stable and low margin categories such as fruit and vegetables, bakery or meat. Stripping out transaction costs contributes a material uplift to profitability while the low rate of category innovation means that the retail business does not suffer from being tied to one source of supply.

And Card Factory found no suppliers that could, or were willing to, produce the range of low-priced cards that it needed to support its high-volume retail model. Its solution: do it yourself.

So vertical integration can work where there is a failure in the supply markets or where gaining a full view of end-to-end costs can provide the retail business with valuable intelligence. It can also make sense where a retailer achieves the scale to capture supplier margin that exists because customers have previously been sub-scale: so Asda has recently acquired IPL, the UK’s largest fruit importer.

In a world where commodity input costs are becoming more volatile and security of supply may begin to become a competitive advantage again, and where retail has become sufficiently consolidated to enable efficient manufacture, we are likely to see more retailers integrating upstream and owning their own supply.

Michael Jary is worldwide managing partner of OC&C Strategy Consultants