Vertical Integration Model

The construction of a fully integrated poultry processing operation in or around the Fremont area—operated by Costco Wholesale and Lincoln Premium Poultry—would represent an example of a corporation possessing many aspects of vertical integration, a common structural business model applied throughout the world.

According to David Swenson, an associate scientist at the department of economics at Iowa State University, two driving forces propelled an emergence of vertical integration of the poultry industry in the 1980s, later followed by pork, cattle and dairy production. 

First, Swenson explains, was the antiregulatory, pro-business approach of the Reagan administration that supported ideas of market concentration in the food industry. Second was the farm debt crisis of the 1980s.  It put farmers at a disadvantage in terms of market (and lobbying) power. 

Today, agricultural integration has expanded to become the norm in the poultry, eggs and pork industries.

In the United States over 90 percent of all the chicken products consumers eat, are produced under some form of vertical integration, such as backwards and “forward” integration. Today the Fremont Tribune aims to lay the groundwork for defining vertical integration.  Tomorrow, advantages and disadvantages will be discussed.

Many everyday commodities originate from vertically integrated production models. Everything from our smart phones to the barbequed chicken legs on our dinner plates, materializes from companies operating with a vertically integrated structure. 

A 2012 research paper out of the University of Padua in Italy, published in the journal Economic Geography, defined vertical integration in a few concise words: “the ownership and control of activities along the production chain.” Each business is either "upstream" (like the farmer in poultry production) or "downstream" (such as the consumer) along the chain.

In other words one company controls the manufacture or production of a commodity from start to finish.  First,  the company procures the natural resources (upstream), such wheat for bread, materials for computer components, eggs for chickens and many other examples.  Then the company moves those resources downstream to the processing and/or assembly rung of the chain.  Finally, the company distributes those components to its own wholesale or retail outlets for purchase by consumers – the last rung.

Dr. Kate L. Brooks of the department of Agricultural Economics at University of Nebraska-Lincoln, explains that in the case of livestock and food production, vertical integration streamlines the process, eliminating some of those “disconnects” in communication that can occur when activities at each level of production are carried out by separate entities or firms. When a company controls all levels of production it is better equipped to respond to the consumers’ evolving needs; it can better track each individual product through the system to quickly address problems, changes or other issues before they spiral out of control.

Eric Thompson, director of the Bureau of Business Research at the UNL agrees with Brooks.

“The demand for vertical integration is ultimately coming from the consumers. Usually in (economic) markets, consumers rule,” Thompson says. “In vertical integration, a company and consumers want to understand and have good information about the supply.”

Dr. Lee Schultz, an expert in agricultural and natural resource economics at Iowa State University, says that vertical integration facilitates an industry’s response to changing consumer preferences, allowing them to streamline for changes or adjustment in quality and convenience of the products consumed.  

Sometimes, as with poultry operation, such vertical streamlining involves “agglomeration,” – the process of amassing each level of production into the same, or nearby, geographical location. Brooks points out, agglomeration, especially in the poultry industry, can eliminate some of the cost of distribution and transportation, leading to a key component of vertical integration: “economies of scale.”

Economies of scale come about from a decreased cost of production with an increased ability to produce a commodity/item in large volumes.  That is, it is often cheaper and more efficient in time and money – per unit-item – for a company to produce 100 items than to produce only one. 

“It reduces the cost throughout the system,” Brooks said. 

As an analogy, imagine a grandmother and her homemade rhubarb pie. Perhaps she lives on a farm, with a sizeable garden.  In the garden she grows her own rhubarb.  In a field nearby, she raises sugar cane.  In another nearby field, wheat grows.; and in the big red barn next to the garden lives Betsy, the dairy cow. 

This agglomeration of resources allows the grandmother to produce/grow all her own basic materials for the pie: rhubarb, sugar, butter, and the crust.  She also acts as an intermediate distributor, transporting materials into her kitchen where she processes those material using equipment like a rolling pin, measuring cups and her oven. 

The central feature of economies of scale: instead of making just one pie at a time she makes ten and freezes the rest.  By making ten all at once, the result is a beneficial economies of scale with regard to time, energy and money spent producing each pie.  

She saves time because in one trip outside to her garden, fields and the cow, she gathers enough ingredients for 10 pies.  If she only made one at a time she would be making multiple trips between the baking of each pie.

Second, she saves energy. Since her oven is big enough for ten pies, she powers it up for just one hour bake them instead of an hour each time to bake each pie separately (i.e. ten hours all together).  Using less electrical energy equates to a fiscal savings on her electrical bill.

In the proposed poultry operation, Costco Wholesale, Lincoln Premium Poultry and the farmers of the grower’s network all encompass a vertically integrated structure of poultry production and processing. Initially the Costco poultry facility would hatch the chickens.  Flocks would then be transferred to the contracted farmers.  They would raise the chickens to the specified weights.  Costco would then retrieve the flocks for processing.  Finally, the processed chicken would be distributed to the Costco stores for purchase by consumers.  From start to finish the production, processing and distribution remains under the umbrella of the corporate relationship between Costco and Lincoln premium poultry …

And thus, vertically integrated. Coming tomorrow, pros and cons of vertical integration.        


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