Market creating innovations and vertical integration

Anand Laishram *

In the previous weeks, we have talked about the pull strategy for economic development, Market Creating Innovations, non-consumption and business model innovation. This week let’s look at something called vertical integration in the context of market creating innovations.

To understand vertical integration, we need to first understand what a value chain is.

A value chain can be at the firm level or the industry level. At the firm level, it means the set of activities that a business performs in order to produce its goods/ services. The activities can be divided into primary & supporting activities.

For example, for a firm making potato chips, the value chain would involve procuring the raw materials (such as potatoes, oil, salt etc.), the manufacturing process, packaging, marketing, sales etc. At the industry level, a value chain represents the various processes, involving multiple businesses, involved in the production & distribution of products/ services.

For example, for the potato chips industry, the value chain would involve the raw material production (growing potatoes, oil production, salt production etc.), the manufacturing of the potato chips, the distribution through wholesale & retail outlets etc.

When a business, at a certain stage of the industry value chain, creates forward or backward linkages, it is said to be vertically integrated. In the case of the potato chips industry, if a manufacturer of potato chips starts growing its own potatoes or starts running its own retail outlets, then that will be termed vertical integration.

Vertical integration can be backward or forward. If a potato chips manufacturer grows its own potatoes, they are backward integrated. If they start distributing themselves, they are forward integrated. If the business supplying potatoes to manufacturers starts making their own chips, they are forward integrated.

The decision to vertically integrate needs to be taken with a lot of due diligence, as the business would need to start performing activities outside of its current core competencies.

That’s the reason why, in more developed economies, businesses tend to specialize and avoid vertical integration. It is more efficient to rely on other specialists for other processes involved in the value chain.

For example, it is efficient for a car manufacturer to focus on building cars, instead of also get in the business of refining the steel or mining the iron ore it needs for building cars. The manufacturer is better off procuring the steel from a specialized steel supplier. The core competencies required for building cars and steel refining are quite different.

However, this emphasis on specialization in developed economies doesn’t translate well to developing economies. This is because a business operating in a developing economy may not have reliable suppliers or distributors they can work with.

It is easy to hyper specialize in a place like Silicon Valley. But in a place where the business ecosystem is not well developed, specialization may not be a viable option. Therefore, in order to reliably get its products or services to the consumers, a business operating in a developing economy may need to vertically integrate.

For example, during the early years of the Ford Motor Company, when America wasn’t the economic powerhouse it is today, they had to refine their own steel and make their own glass. This is important to understand in the case of market creating innovations.

By definition, Market Creating Innovations allow non-consumers to consume the solutions they need to make progress in their lives, by making those solutions affordable, accessible & simple. Market Creating Innovations are more relevant in the case of developing economies, where the business ecosystem is not well developed.

Therefore, in order to successfully meet the needs of their market, businesses will need to vertically integrate. Let’s illustrate this with an example. Tolaram started out as a trading company based in South East Asia. They were involved in the business of trading garments & textiles. They also had a presence in Africa.

In the poverty-stricken country of Nigeria, Tolaram saw a business opportunity. Nigerians had low per capita incomes & a large percentage of their incomes had to be spent on purchasing foods. They were in need of foods that were more affordable & easier to prepare.

Therefore, starting in the 1980s, Tolaram started shipping Indomie noodles (manufactured in Indonesia) all the way to Nigeria. The noodles became a massive hit. It was easy and quick to prepare and quite affordable. It became an important part of the diet of Nigerians, even though historically, noodles didn’t feature quite a lot in their cuisine.

However, Tolaram had to ship the manufactured noodles all the way from Indonesia. It could save oncosts & pass on the savings onto the customers if they manufactured the noodles right in Nigeria itself. Therefore, they set up a manufacturing plant in Nigeria.

However, since Nigeria’s business ecosystem wasn’t well developed, they couldn’t find reliable distributors to work with. Therefore, they went into the logistics business themselves and set up their own network of trucks & staff. They also faced hurdles in getting a reliable supply of electricity, therefore they had to set up their own power plants as well.

These vertical linkages were costly, but Tolaram had to make the investments in order to reliably manufacture & get the product to their customers. This is quite common when doing business in developing economies. They have untapped markets but serving those markets require costly investments. However, the investments can be justified if the market opportunity is attractive enough.

Moreover, by investing in building the proper infrastructure where they didn’t exist before, businesses can supply other businesses also interested in entering that market. In the example above, Tolaram had to basically create its own logistics & electric utilities businesses, in order to be able to manufacture & distribute their manufactured noodles.

However, when other food companies entered the Nigerian market, they outsourced transportation & power supply to Tolaram. Their logistics & utilities businesses started out as cost centres, but later became profit centres on their own. In 2015, they sold a 50% stake in their logistics business to American giant Kellogg for $450 million.

Therefore, if a business intends to target non-consumption in a developing economy, it may have to roll up its sleeves & vertically integrate.