Andrew Carnegie was the inventor of vertical integration.
There's an old joke that after a businessman saw the name "Carnegie" on several libraries he realised that he'd been in the wrong business for all of his life; he never knew that there was so much money to be made in lending books!
If you ask most people what the name Carnegie means to them and, if you get an answer, it will probably be something to do with libraries, museums, concert halls or universities. But to students of economic history, Andrew Carnegie was the inventor of vertical integration, a process whereby a manufacturing company brings every stage of production in-house, making it far easier for its management to control the entire production process.
Vertical integration, when applied to businesses which requires large amounts of capital to purchase factories, machinery and materials, can also give the business tremendous economies of scale at every stage of the production process. These benefits enable the business to drastically reduce its production costs, thus undercutting the competition and in some cases dominating its particular market.
Many of today's capital intensive industries, such as oil producers, are dominated by giant vertically-integrated companies like BP (LSE: BP). Some Japanese and Korean car manufacturers, such as Toyota (more on them later) exercise such close control over their suppliers that they are effectively vertically integrated companies.
Vertical integration is something that investors should be aware of because vertically integrated companies can produce exceptional returns for its investors.
The American Dream
Andrew Carnegie emigrated with his parents from Scotland to America when he was a child. His story is a great example of the American dream, despite some controversy over his methods, and he was one of the most generous philanthropists that the world has ever seen.
Carnegie's first job was as a telegraph messenger boy but he soon moved to the Pennsylvania Railroad Company where his talent for business swiftly propelled him up the management ladder.
Carnegie was a firm believer in spending less than he earned, like us here at The Motley Fool, and whilst working for the railroad accumulated a considerable amount of capital by investing the difference between his income and expenditure in ironworks, railroads and oil producers. To be sure, some of his investments would be seen as insider trading in today's markets, but these were different times.
During the Civil War Carnegie was appointed as the Superintendent of the Military Railways during the Civil War, putting him in charge of armament and troop transportation for the Union. By the end of the war Carnegie had turned his considerable business expertise towards the industry which ultimately made his fortune; steel.
The Great Consolidation
Over the next twenty-five years Carnegie created a massive steel industry by acquiring companies which operated in every stage of the production process, from coal mines to rolling mills. In 1892 Carnegie merged all of his interests to form the Carnegie Steel Company which, thanks to its economies of scale soon became the dominant company in the steel market.
Other industrialists soon copied Carnegie's methods, most notably Henry Ford whose factories were legendary for taking in raw materials at one end and turning out cars at the other end.
Whilst the dominance of vertically integrated firms was bad for investors (and employees) in their competitors, the creative destruction which is wrought by capitalism invariably benefits society as a whole in the long run although it doesn't appear to be so at the time, particularly to those who lose their jobs.
A big part of Carnegie's philosophy was that "huge fortunes that flow in large part from society should in large part be returned to society." Carnegie was a great philanthropist whilst he was working and, having sold Carnegie Steel to J.P. Morgan, in 1901 he turned his attention to full-time philanthropy. The sheer size of his fortune and the zeal with which Carnegie went about distributing it is the reason why so many libraries and other institutions bear his name.
The End Of Vertical Integration?
Over the last few decades governments have taken a dim view of vertical integration by passing competition laws and in some cases have even broken up dominant businesses. Furthermore in the western world globalisation has undermined many of the benefits of vertical integration because overseas competitors with far lower labour costs can easily undercut vertically integrated western producers.
Today many companies which would have used vertical integration have instead chosen to outsource much of their supply chain and intermediate goods manufacturing to other companies, often in other countries.
Another problem is that vertical integration encourages a firm to grow rapidly but once it reaches a certain size its economies of scale all too often turn into "diseconomies of scale" because the business has become too large to effectively manage. When this happens any further growth can be disastrous as it brings a host of problems.
Toyota, whose recent quality control difficulties have led to its cars being recalled across the world, can testify to the problem caused by diseconomies of scale. Toyota's boss recently admitted that the firm grew too fast and that "priorities became confused" when reports of problems with accelerators were swept under the proverbial carpet.
Vertical integration lives on in many Japanese and South Korean conglomerates, the keiretsu & chaebol. But some of these companies are not exactly good advertisements for investors because their managers are far more concerned with personal status and preserving market share than in making money for their shareholders.
More from Tony Luckett:
> Tony owns shares in BP.
