Vertical integration is a matter of control. In some cases, it can be the key to profitability and cost reductions. In other cases, rapid vertical expansion without the skills to create valuable processes can lead to poor performance. By the textbook definition, vertical integration is the process of acquiring capabilities up or down-stream in your supply chain. The idea behind it is to control as much of your supply chain as possible, seek efficiencies in every process, and ultimately offer more value to your customers.
Over the past few months, we have continued exploring the foundations of Industry 4.0, and implementing new systems to prepare for a digital future. One such project was focused on dramatically reducing lead time and costs by vertically integrating machining into our business. Beyond just lead time reductions, the addition of machining to our capabilities provides us with far more control over our supply chain than we’ve ever had. Supply chain management is imperative to the success of our long-term vision and implementation of Industry 4.0. In the following section we’ll discuss a little bit more about what vertical integration provides us, and how it will help us long-term.
Challenges in the industry
As a contract manufacturer, one of the challenges we face is the breadth of services and specification requirements by the many different customers with whom we work. For this reason, the industry has a unique feature: competitors will often use each other as subcontractors for certain processes on a job. For example: when subcontracted to, our wide range of services makes us attractive for jobs with highly complex assembly work (cutting, bending, and welding).
While some manufacturers choose to specialize in one process, our goal is to offer all the required capabilities under one roof. Our WIP (work in progress) is heavily monitored and process paths are designed to maximize speed and efficiency. Hence, when we subcontract work to other facilities we lose control over our process, and add a step in the supply chain. This has two major implications: cost and speed – better known as: price and lead times.
Our exploration into the industry and future development has led us to think about our capabilities in a unique way. Traditionally, B2B is known to be highly price sensitive and branding is not as important as in B2C. The way we classify these is “Expected” and “Unexpected” factors of evaluation. The “Expected” factors are the factors that customers expect from our service: competitive price, competitive lead times, quality, on-time delivery, etc. The “Unexpected” factors include items that go above and beyond what customers are expecting: a well-designed website, technological innovation, unmatched customer service, etc. One key thing to consider about this methodology is that while the “Unexpected” aspects are important, focus and priority should always go to projects that will directly impact the “Expected”.
As an expected aspect of the business, we now reconsider the impact a subcontractor can have on price. When a subcontractor adds their markup to parts, this creates higher prices for us, which ultimately impacts the final price for our customers. This is one reason why OEM’s (original equipment manufacturers) prefer to do work with companies who have the all the necessary capabilities in-house.
As mentioned above, another expected aspect of the industry is competitive lead times. When anything leaves our facility for subcontracted work, the part is subject to capacity constraints from our facility and the subcontractor’s. In some cases, we have experienced subcontractors who require parts in their warehouse a week before they even start working on it. This drastic increase in lead time is extremely inconvenient for customers and manufacturers alike, but can easily be solved through vertical integration.
Vertical integration as a solution
As mentioned above, vertical integration can help organizations reduce costs, but its impact is dependent on transaction costs in the industry. Industries with very low transaction costs and paper-thin margins don’t focus on vertical integration because it will cost a similar amount to produce in-house as it does to buy the services elsewhere. Consider a new clothing brand, looking to design and manufacturing in Canada. As a Canadian brand, producing clothing domestically will be significantly more expensive than overseas (economies of scale, mass production techniques, labour regulations, etc.). For this reason, there is no desire to vertically integrate. For our service, however, costs are inflated by the custom nature of the products and the logistics involved in transporting such heavy and differently shaped parts. So, vertical integration is an excellent way for us to cut costs and reduce price for our customers.
It may seem obvious, but by cutting down on subcontracting our processes will become much more efficient. As mentioned above, subcontractors will typically increase lead times dramatically. Between transporting WIP to their facility, bringing it back to our facility, doing a quality inspection, and ultimately getting it out the door, the process becomes tedious and costly. By bringing capabilities in-house, parts only need to travel 100 feet instead of 100km.
Finally, another result of vertical integration is control improvements. At Chrima we are proud to put our name on the products we make, and we are confident in the quality of our work. In fact, of the quality related issues we have found during our WIP inspection, 77% have been as a result of subcontractor error. Vertical integration is clearly the solution to improve control of the supply chain. The increased control will allow us to reduce costs, improve our quality, our speed, and our ability to innovate.
How this will impact us long term
In recent years, we have been working on developing innovative processes, integrating data tracking and analytics, and implementing industry 4.0 (see: Vision). Greater control over the supply chain will provide us an opportunity to explore cost reductions and technological innovation in our facility. To call back to the first description of vertical integration: the idea is to control as much of our supply chain as possible, seek efficiencies in every process, and ultimately offer more value to our customers.
It’s clear that vertical integration efforts are going to have an impact on delivering value to our customers. A decrease in price, lead times, and an increase in quality will allow us to deliver on the expected aspects of the industry while developing ways to deliver value in completely unexpected ways.