Vertical Integration And How It Works In The Tech World In 2022

In business, vertical integration means a whole supply chain of the company is controlled and owned by the organization. Thus, making it possible to control each step through customers. in the digital world, vertical integration happens when a company can control the primary access points to acquire data from consumers.

Vertical integration in the physical world

On FourWeekMBA, I discussed the Luxottica business model, which is a great example of vertical integration:

Luxottica controls the whole supply chain, which goes from product development to manufacturing, and logistics.

This helps it gain control over the quality of the final product, and connect its product development processes with the distribution and customer experience.

While this strategy is more expensive in the short-run, over the years can turn into a competitive advantage.

As the Luxottica case shows, the company grew and integrated more brands within its portfolio (iconic brands like Ray-Ban and Oakley are part of the Luxottica Group), by both having Luxottica-owned brands and by producing sunglasses for other major luxury brands.

By controlling the supply chain, and taking a step further in its retail strategy, Luxottica can connect the dots between product development and final customers to make sure quality and customer demand are aligned.

This process is used also in the digital world, by players like Google or other tech giants, that over the years have developed products and distributed them directly to customers to gain control over the whole supply chain.

Google vertical integration explained

Google (now Alphabet) primarily makes money through advertising. The Google search engine, while free, is monetized with paid advertising. In 2021 Google’s advertising generated over $209 billion (beyond Google Search, this comprises YouTube Ads and the Network Members Sites) compared to $257 billion in net sales. Advertising represented over 81% of net sales, followed by Google Cloud ($19 billion) and Google’s other revenue streams (Google Play, Pixel phones, and YouTube Premium).

In early 2018, Sundar Pichai, Google’s CEO, highlighted how AI for humanity is more important and profound than what fire was.

To keep using an analogy, the real fuel that keeps the AI fire going is data.

Indeed when we go from atoms to bits, the strategic thinking behind an organization changes.

For instance, for a traditional company, one of the long-term success of the organization is based on keeping control of its processes and being able to control the whole supply chain.

While this strategy is expensive, it is also what drives sustainable growth. For instance, traditional companies operating in “slower” sectors (think of Luxottica in the eyewear industry) managed to gain control over the supply chain and also became the world’s leaders in their markets.

In short, the idea is that the closer you get to the customer (in case you’re a manufacturer) or the closer you get to the producer of a good or service (if you’re a retailer) the more control you have over the whole experience.

This, in turn, might allow you to dominate your industry over time and keep tight control over processes, quality, and operations:

While this is intuitive in the world of atoms. It gets a bit trickier in the bits world.

For the sake of understanding how vertical integration and supply chain work in the bits world, we’ll look at how Google is going up – or down (depending on where you look) in the supply chain of data.

Atoms vs. bits

As the web has become so ingrained in the way we interact with the world and with each other, it is easy to forget between companies that operate purely in the atom world, compared to that operating in the bits world.

Just to keep a clear distinction a business based on bits is mostly a software business or any organization that makes money primarily by selling digital goods or services, compared to a traditional atoms business.

It is important to remark that bits businesses are not entirely so, as they rely on massive physical infrastructure (think of Google data centers) which allow the company to operate.

However, a bits company’s mission is to provide goods or services, often at scale.

Where in the world of atoms, a key ingredient for an organization’s success is made of raw materials.

In the bits world, that raw material is even more critical.

That is the crucial ingredient for their success, and the raw material in the bits world is data.

Google and the supply chain of data

A classic supply chain moves from upstream to downstream, where the raw material is transformed into products, moved through logistics and distribution to final customers. A data supply chain moves in the opposite direction. The raw data is “sourced” from the customer/user. As it moves downstream, it gets processed and refined by proprietary algorithms and stored in data centers.

Before understanding vertical integration in the bits world, made primarily of data it is critical to understand how it flows to realize how tech companies are trying to gain control of it.

Often the supply chain of data needs to rely on the physical supply chain and vice versa.

Indeed, when you’re able to get your hardware in the hands of users that is the best it can happen if you run a company that makes money based on data it collects from its users.

The reason is that data is first quality data, and it carries a deep connection to the person using the device.

That’s why when Google moves toward hardware it isn’t just like Google is trying to dominate the smartphone market.

That move needs to be understood in terms of a supply chain of data.

A manufacturer in the real world starts to integrate its supply chain by getting control over the wholesale side and retail side until it can finally access its consumers.

On the other hand, the interesting part about data is that a consumer is also the producer of data.

Where the data collector goes up in the chain by manufacturing the device sold to consumers, those devices also become the producer of raw data.

That raw data gets assembled in multiple ways and sold to another side of the chain, which is the business willing to spend money on advertising.

Google business of collecting data

At its core, Google is a data collecting organization. Indeed, in search, Google is the best collector of users’ data to capture commercial intent sold as advertising.

In a research made by Professor Douglas C. Schmidt, Professor of Computer Science at Vanderbilt University, and his team it is interesting to see how Google collects way more data in the ecosystem created by it, such as the devices using Android.

Just as a quick reference from the research, one of the key findings highlighted:

Google learns a great deal about a user’s personal interests during even a single day of typical internet usage. In an example “day in the life” scenario, where a real user with a new Google account and an Android phone (with new SIM card) goes through her daily routine, Google collected data at numerous activity touchpoints, such as user location, routes taken, items purchased, and music listened to. Surprisingly, Google collected or inferred over two-thirds of the information through passive means. At the end of the day, Google identified user interests with remarkable accuracy.

This ability to identify users’ interests with “remarkable accuracy” comes from Google investments over the years in creating the proper infrastructure that could support its supply chain of data.

As voice search is approaching Google needs to be on top of the data game, and that explains the next run to dominate the voice assistants devices market.

From the search page to the voice assistant

When you type something on Google’s search box, you’re making its search engine better and better.

That is the power of network effects. In short, the more users keep using Google, the better its search engine can capture users’ commercial intent.

TAC stands for traffic acquisition costs, and that is the rate to which Google has to spend resources on the percentage of its revenues to acquire traffic. Indeed, the TAC Rate shows Google’s percentage of revenues spent toward acquiring traffic toward its pages, and it points out the traffic Google acquires from its network members. In 2017 Google recorded a TAC rate on Network Members of 71.9% while the Google Properties TAX Rate was 11.6%.

However, even though Google has a high gross margin, people still have to keep going back to its search pages.

As I pointed out in Google’s TAC strategy, the company managed to keep having billion of users each day going back to it thanks to a massive distribution network, both driven by distribution agreements and its networks (like AdWords and AdSense).

Yet that data is precious it is still coming from third parties. Therefore, Google is investing massive resources to make sure that data can get acquired via its devices so that it can finally have control of the overall chain.

As I pointed out in Google’s hardware plans in January 2018, Google completed the agreement with HTC with the acquisition of the team of engineers and a non-exclusive license of intellectual property from HTC for $1.1 billion in cash.

Another example is how Google invested in KaiOS, an operating system, that transforms feature (dumb) phones into smartphones, providing them also of a default voice assistant (KaiOS phones use by default the Google Assistant).

That works as a window into the Indian market, where Google can access voice data, directly from those devices, thus bringing it closer to over a billion consumer base, that in the future might turn into a great business opportunity.

KaiOS is a mobile operating system built on the ashes of the discontinued Mozilla OS. Indeed, KaiOS has developed a robust standalone mobile operating system that turns feature phones (so-called “dumb phones”) into smartphone-like phones.
As feature phones powered by KaiOS have access to mobile apps, connectivity, and voice search. KaiOS feature phone business model wants to bring connectivity and the digital revolution to those developing countries (like India and Africa) that have missed out on the smartphone wave due to too high costs of those devices.
Besides, KaiOS might be well suited for the IoT revolution!

That move is toward creating a vertically integrated supply chain of data!

Vertically vs. horizontally integrated

Horizontal integration refers to the process of increasing market shares or expanding by integrating at the same level of the supply chain, and within the same industry. Vertical integration happens when a company takes control of more parts of the supply chain, thus covering more parts of it.

For instance, in horizontal integration, the companies that take part in it, either merge or acquired the other (the same process can happen through vertical integration). However, in horizontal integration, this usually happens in the same industry and segment of the supply chain.

Therefore, imagine a wholesaler’s leader buying another leading company, to take a bigger chunk of the same market.

An example of horizontal integration might be the acquisition from Uber of Postmates.

Integrating Uber Eats with Postmates, will create a bigger player in the same market and segment of the supply chain (last-mile meal delivery).

Uber Eats is a three-sided marketplace connecting a driver, a restaurant owner and a customer with Uber Eats platform at the center. The three-sided marketplace moves around three players: Restaurants pay commission on the orders to Uber Eats; Customers pay the small delivery charges, and at times, cancellation fee; Drivers earn through making reliable deliveries on time.

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Uber Eats is a three-sided marketplace connecting a driver, a restaurant owner, and a customer with the Uber Eats platform at the center. The three-sided marketplace moves around three players: Restaurants pay commission on the orders to Uber Eats; Customers pay the small delivery charges, and at times, cancellation fees; Drivers earn through making reliable deliveries on time.

An example, instead of vertical integration, in the bits world, as highlighted in Google’s data supply chain, the company is able to integrate its supply chain from upstream (in this case the upstream side starts with customers who become the sources of the raw data), to downstream.

Apple’s Vertical Integration case study

When Apple launched the iPhone, back in 2007, it was a moderately successful product.

Yet what really made it take off, was the combination of hardware, software, and marketplace.

In 2008 that was introduced as App Store, and that is when iPhone sales took off.

Combined with a strong distribution strategy, the iPhone became a business platform, which enabled Apple to keep tight control over the ecosystem built on top of it, while generating revenues, ad high margins.

It costs Apple $570 to make an iPhone 13 Pro, and the company sells it at a base price of $999 to $1499.

With that strategy, Apple mastered vertical integration, and it managed to keep control over its distribution, to create a trillion-dollar empire.

Apple has a business model that is broken down between products and services. Apple generated over $365 billion in revenues in 2021, of which $191.9 came from the iPhone sales, $35.2 came from Mac sales, and $38.3 came from accessories and wearables (AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch, and accessories), $31.86 billion came from iPad sales, and $68.4 billion came from services.

In 2022, Apple is worth two and a half trillion dollars. Apple generated over $191 billion from iPhone sales, in 2021, which accounted for over 52% of its net sales. Followed by services revenues at $68.4 billion, wearables and accessories at $38.3 billion, Mac sales at $35.2 billion, and iPad sales at $31.86 billion.

Why Vertical Integration is a key competitive moat

By 2021, Facebook announced a complete rebrand, and it became Meta.

Why did Facebook, now called Meta, made such a move?

It’s possible to analyze this move according to vertical integration.

Indeed, there is a key distinction to make between Meta and other tech giants like Google or Apple.

Where Google and Apple have built vertical integration, thanks to the control over a whole ecosystem.

Facebook didn’t manage to build that, over the years. And as Apple tightened its App Store’s rules around privacy, that had the potential to crash the whole Facebook Business Model.

Thus, the Facebook move into the Metaverse wasn’t just a strategic move, it was a survival move.

And now Facebook (Meta) is trying to build the same kind of ecosystem and vertical integration that Apple and Google had built, which is what made them thick, in the long run.

Other connected business phenomena

Decoupling

According to the book, Unlocking The Value Chain, Harvard professor Thales Teixeira identified three waves of disruption (unbundling, disintermediation, and decoupling). Decoupling is the third wave (2006-still ongoing) where companies break apart the customer value chain to deliver part of the value, without bearing the costs to sustain the whole value chain.

Entry Strategies

When entering the market, as a startup you can use different approaches. Some of them can be based on the product, distribution, or value. A product approach takes existing alternatives and it offers only the most valuable part of that product. A distribution approach cuts out intermediaries from the market. A value approach offers only the most valuable part of the experience.

Disintermediation

Disintermediation is the process in which intermediaries are removed from the supply chain, so that the middlemen who get cut out, make the market overall more accessible and transparent to the final customers. Therefore, in theory, the supply chain gets more efficient and, all in all, can produce products that customers want.

Reintermediation

Reintermediation consists in the process of introducing again an intermediary that had previously been cut out from the supply chain. Or perhaps by creating a new intermediary that once didn’t exist. Usually, as a market is redefined, old players get cut out, and new players within the supply chain are born as a result.

Scientific Management

Scientific Management Theory was created by Frederick Winslow Taylor in 1911 as a means of encouraging industrial companies to switch to mass production. With a background in mechanical engineering, he applied engineering principles to workplace productivity on the factory floor. Scientific Management Theory seeks to find the most efficient way of performing a job in the workplace.

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Poka-Yoke

Poka-yoke is a Japanese quality control technique developed by former Toyota engineer Shigeo Shingo. Translated as “mistake-proofing”, poka-yoke aims to prevent defects in the manufacturing process that are the result of human error. Poka-yoke is a lean manufacturing technique that ensures that the right conditions exist before a step in the process is executed. This makes it a preventative form of quality control since errors are detected and then rectified before they occur.

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Gemba Walk

A Gemba Walk is a fundamental component of lean management. It describes the personal observation of work to learn more about it. Gemba is a Japanese word that loosely translates as “the real place”, or in business, “the place where value is created”. The Gemba Walk as a concept was created by Taiichi Ohno, the father of the Toyota Production System of lean manufacturing. Ohno wanted to encourage management executives to leave their offices and see where the real work happened. This, he hoped, would build relationships between employees with vastly different skillsets and build trust.

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Dual Track Agile

Product discovery is a critical part of agile methodologies, as its aim is to ensure that products customers love are built. Product discovery involves learning through a raft of methods, including design thinking, lean start-up, and A/B testing to name a few. Dual Track Agile is an agile methodology containing two separate tracks: the “discovery” track and the “delivery” track.

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Scaled Agile

Scaled Agile Lean Development (ScALeD) helps businesses discover a balanced approach to agile transition and scaling questions. The ScALed approach helps businesses successfully respond to change. Inspired by a combination of lean and agile values, ScALed is practitioner-based and can be completed through various agile frameworks and practices.

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Kanban Framework

Kanban is a lean manufacturing framework first developed by Toyota in the late 1940s. The Kanban framework is a means of visualizing work as it moves through identifying potential bottlenecks. It does that through a process called just-in-time (JIT) manufacturing to optimize engineering processes, speed up manufacturing products, and improve the go-to-market strategy.

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Toyota Production System

The Toyota Production System (TPS) is an early form of lean manufacturing created by auto-manufacturer Toyota. Created by the Toyota Motor Corporation in the 1940s and 50s, the Toyota Production System seeks to manufacture vehicles ordered by customers most quickly and efficiently possible.

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Six Sigma

Six Sigma is a data-driven approach and methodology for eliminating errors or defects in a product, service, or process. Six Sigma was developed by Motorola as a management approach based on quality fundamentals in the early 1980s. A decade later, it was popularized by General Electric who estimated that the methodology saved them $12 billion in the first five years of operation.

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Supply Chain

A classic supply chain moves from upstream to downstream, where the raw material is transformed into products, moved through logistics and distributed to final customers. A data supply chain moves in the opposite direction. The raw data is “sourced” from the customer/user. As it moves downstream, it gets processed and refined by proprietary algorithms and stored in data centers.

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