A company that produces toys is considering backward integration into production

Question

A company that produces toys is considering backward integration into production of a certain type of oil, an important component in making the rubber-like material required for the toys. This oil is traded in world commodity markets and its price fluctuates as supply and demand conditions change. The argument has been made in favor of vertical integration: “Toys production is very utilization sensitive, i.e., a plant that operates at full capacity can produce toys at a much lower cost per unit than a plant that operates at less than full capacity. Owning our own source of supply of rapeseed oil insulates us from short-run supply-demand imbalances and therefore will give us a competitive advantage over rival producers.” Do you agree with this argument? Why?

Please be detailed as possible.

Explanation / Answer

I do not agree with this argument at all. i have elucidated the reasons below :-

a) Toy manufacturing and oil production are totally different lines of businesses. Management of the toy manufacturing company will have no experience of an oil production firm and by integrating two firms may result in suboptimal output for the combined firm. They will not be aware of best practices in the oil industry and this may increase production costs for oil defeating the very purpose of vertical integration. In general, outsourcing of a non-core activity is the best solution. For the company, toy manufacturing is a core activity and all other activities including oil production is non-core.

b) This is an upstream integration which means that there has to be an excess supply of oil so that there is no shortage for the toy manufacturing unit so that utilization is maximized. In doing so, there will be excess oil which the firm may or may not be able to sell in the market which will reduce profit margins. If market prices are lower than what the firm is producing at, the company will be at a competitive disadvantage over rival firms using oil from market. In owning the oil production unit, the company will lose supplier or market competition which leads to reduction in prices over the long term

c) This vertical integration will be hard to reverse. Costs may increase in the short run too because there is a need to supervise the new oil production firm.

The company should look at long term contracts with suppliers or looking at futures/options as a hedging tool to tide over supply imbalances instead of vertical integration.

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