IFRS 8 defines an operating segment as a ‘component of an entity that engages in business activities from which it may earn revenues and incur expenses’. This recognises that not all business activities earn revenues.
Where transfer prices are charged between an entity’s stages of production (for example, with oil and gas companies), the fact that the transfer prices are not assessed by the Chief operating decision maker (CODM) would not exempt such activities from being considered operating segments. The operating segments of an oil and gas company may include exploration, development, production, refining and marketing – if the CODM manages the entity in this way.
A vertically integrated business model means that you consolidate multiple steps in the typical distribution process. Instead of operating solely as a manufacturer, distributor or retailer, a vertically integrated company performs tasks commonly carried out by suppliers or trade buyers. Vertical integration has several pros and cons relative to specializing in one business function.
In many cases, a company expands from a single trade focus to become vertically integrated. One way this can happen is for a manufacturer or wholesaler to carry out its own distribution processes to consumers. A manufacturer might decide to set up distribution centers and manage its own distribution arrangements with retailers, or even sell directly to consumers. A manufacturer assuming management of its own distribution is engaging in forward integration.
Backward Integration Operating segments – Vertically integrated operation
The opposite approach to vertical integration occurs when a product reseller decides to acquire its supplier or start its own manufacturing or distribution operation. When a distributor engages in manufacturing, or a retailer engages in manufacturing or distribution activities, it is referred to as backward integration. Retail stores that sell private label, or store brands, engage in this form of vertical integration.
Benefits Operating segments – Vertically integrated operation
Vertical integration has a few core benefits. One is control. The more activities you carry out in the manufacturing and distribution process, the more control you have over the entire flow of goods until they reach the end customer. You may also benefit from lower costs. If you make goods, you only pay for the costs of manufacturing. When a wholesaler or retailer acquires goods from a manufacturer, a markup is added to the cost.
Concerns Operating segments – Vertically integrated operation
A major concern of vertical integration is that it requires your company and its leadership to have expertise in multiple distribution channel activities. The roles of manufacturer, wholesaler and retailer are distinct. A manufacturer wanting to distribute its goods directly to customers must not only have production strengths, but also the ability to market and efficiently distribute goods. Additionally, expanding into vertical integration can have significant upfront costs. You typically must either acquire existing suppliers or merchandising businesses, or build and develop them on your own.