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Capture and defend margin

Forward vertical integration

Examples checked

In one minute

Taking over a step closer to the customer: distribution, retail, delivery or processing.

The big idea: You stop selling to a middleman and do its job yourself, so you keep its margin and own the customer. It pays when the middleman's margin and the customer data are worth more than the cost and capital of doing the job well.

Works when
When middlemen keep a fat margin, the customer experience decides who wins, and you have the volume to run the channel well.
Fails when
When the step needs skills you lack, or your volume is too small to run it as cheaply as a specialist who serves many brands.
Check this number first
Middleman margin on your sales. The size of the prize.
In the worked example
Extra profit a year: USD 12 (USD millions a year). See it add up

What it is

A company sells to whoever is next in the chain: a wholesaler, a retailer, a refiner, a delivery firm. Forward integration means doing that next step yourself. An oil producer that builds chemical plants, or a retailer that runs its own delivery vans, has integrated forward.

  • Into processing. Turn your raw material into a higher value product yourself, such as crude oil into chemicals.
  • Into distribution and logistics. Run your own warehouses and delivery instead of paying carriers.
  • Into retail. Open your own stores or website instead of selling through retailers (see going direct to consumer).

Why companies do it

The economic logic, most important first. A move usually rests on one or two of these.

  • Margin capture. The middleman's margin becomes yours: a wholesaler that keeps 20 percent of the retail price is 20 percent you could keep.
  • Customer relationship. Owning the last step gives you the customer data, the pricing and the experience, rather than a retailer deciding them.
  • Control of a bottleneck input. If a few distributors control access to customers, owning your own route stops them squeezing you.
  • Utilisation. A producer of a raw material can guarantee a buyer for its own output, so its upstream plants run full.

When it creates value, and when it destroys it

Creates value when

  • The next step keeps a fat margin and you can run it at a similar cost.
  • Service decides who wins, for example delivery speed in online retail, so control is worth paying for.
  • You have enough volume to fill the trucks, warehouses or plants you build.
  • Owning the step makes your upstream assets run fuller or earn a more stable price.

Destroys value when

  • The middleman is efficient because it serves many brands; on your volume alone you run it at a higher cost.
  • You compete with your own customers (retailers, distributors) and they drop your products.
  • The downstream business is cyclical too, so you double the risk instead of spreading it.
  • Capital tied up in stores, fleets or plants earns less than the cost of capital.

The numbers to check

Ask for these, in this order, before you recommend the move.

  1. Middleman margin on your sales. The size of the prize.
  2. Your cost to run the step versus the specialist's cost. Scale matters: a carrier serving thousands of shippers is often cheaper per parcel.
  3. Capital needed and the return on it. Warehouses, fleets, stores and plants tie up money.
  4. Sales at risk from channel partners you now compete with. Retailers or distributors may cut your shelf space.

Worked example (illustrative)

Rounded numbers for a made-up business, shaped like real ones. Positive lines add to profit; negative lines are costs.

A household goods maker sells products worth USD 200 million at retail through wholesalers, who keep 20 percent. It could run its own warehouses and delivery to stores. That needs USD 80 million of warehouses and trucks.

Worked example for Forward vertical integration, in USD millions a year. Illustrative figures.
LineUSD millions a year
Wholesaler margin now kept: USD 200 million x 20 percentUSD 40
Running warehouses and trucksminus USD 22
Ordering systems and customer serviceminus USD 6
Extra profit a yearUSD 12

Check: the lines above add up to the total.

The numbers that decide it

Return on USD 80 million of warehouses and trucks
15 percent
Payback
6.7 years

So what: A 15 percent return beats a typical 8 to 10 percent cost of capital, so on paper it works. The test is the USD 22 million running cost: wholesalers spread their trucks across many brands, and if your trucks run half full that cost could rise by half and the gain would almost vanish.

Real examples

Companies that made this move, by region, with what happened and a source checked on the date shown.

How to recommend it in a case

Answer first, then the reasons with numbers, then the risk and the next step. Three sentences, said out loud.

I recommend we take over distribution in our two densest regions first, because it adds about USD 12 million of profit a year on USD 80 million of capital, a 15 percent return.

We keep the wholesalers' 20 percent margin on USD 200 million of sales, and we gain direct data on what stores sell, which helps pricing and stock.

The risk is that our trucks run emptier than the wholesalers' and costs rise; next I would check our drop density per route and how the wholesalers would react in the regions we keep.

The numbers to quote: Middleman margin kept; Running cost versus the specialist; Return on capital; Sales at risk from channel partners.

The figures in the answer come from the illustrative worked example above. In a case, use the client's own numbers.

Classic interview traps

  • Taking the middleman's margin as pure gain. You also take on its costs, and it may run them cheaper than you can.
  • Forgetting channel conflict. Retailers and distributors you now compete with can punish you.
  • Not asking what makes the middleman efficient: scale across many brands, routes and customers.

Where it is common

Sources

Practise it

Where this move comes up in cases

Related moves