Introducing Tom and John – our guinea pigs today

Tom is a bread seller and buys his flour from John who is the cheapest flour producer in the market. Tom considering buying over John’s business because he thinks it will increase his own profitability. Is this true or false?

Let’s find out using some hypothetical numbers

For simplicity, we assume that flour is the only raw material required for bread making and both Tom and John only sell 1 unit of product each year.

Vertical Integration 1

Post-acquisition, Tom’s cost of flour will be reduced to $8 as he is able to buy produce it in-house via the purchase of wheat (raw material for flour) at $8. His bread still sells for $15. By fully acquiring John’s business, it seems that Tom will be able to massively increase his profitability from 33% to 47%. However, was any marginal value actually created in the acquisition?

The importance of opportunity cost

The economic value added (EVA) is an estimate of a firm’s economic profit. We can take the gross profits of John and Tom to be the EVA of their individual entities. We can also see that the consolidated gross profit is merely the same of the individual gross profits. This implies that zero additional economic value has actually been created from the acquisition, even though margins have optically improved for Tom.

To better understand this, we need to bring in the concept of opportunity cost. Opportunity cost refers to the loss of the next best alternative forgone. By selling (what used to be) John’s flour to himself at $8, John’s entity now has zero EVA from the previous $2. There is an opportunity cost of $2 – the flour could have been sold on the open market for $2. This $2 has been transferred to Tom’s bread entity, as reflected by the consolidated numbers. The conclusion is that while margins have improved, there is actually no economic benefit from Tom’s acquisition.

Does this mean vertical integration is useless?

We have only considered the quantitative aspects of vertical integration and we have demonstrated that the concept of accounting and economics are vastly differently. Accounting numbers do not always accurately reflect economic reality, but there can be some economic benefit from vertical integration – just that it is usually significantly lesser than what accounting figures would suggest.

Economic benefits allow arise from synergies which include lower supply chain risk, better quality control etc. For example, if Tom and John both had a receptionist each, Tom would be able to increase the profitability of the combined business by letting go one of them. Economic value/profits thus increases.

In bringing up the concept of opportunity cost, we have also implicitly assumed that John is operating at maximum utilization and there is always a willing buyer on the open market. If John had spare capacity which would be used upon vertical integration with Tom, then there is no opportunity cost and the economics would be different.

Final words

The common perception among investors is that vertical integration via acquisitions will result in better margins. That is true, but not necessarily in the economic sense. Consequently, the risk of overpaying for such acquisitions is high as the quantitative effects can be misleading. Premium should only be paid for operational synergies, not for mathematical improvements in margins. Investors should be wary of such supposed ‘benefits’ in evaluating the true value of acquisitions.