Recent studies in the chemicals industry have shown that poor profitability can sometimes be attributed to the way in which vertically integrated companies price their products.

The main concern of an upstream business, where the cost of capacity is high, should be to ensure high plant utilization. Many upstream producers have therefore integrated with downstream ones in an effort to guarantee a market for their output. But such an insurance policy can turn out to be extremely expensive. For when demand is low, the upstream operator is tempted to offer discounts to its downstream associates to maximize market share. Armed with this perceived cost advantage, the downstream operator is in turn inclined to compete for market share by cutting prices.

In the most extreme cases, downstream prices can fall as low as the full chain’s cash cost, which is likely to be below the cash cost of independent producers. As a consequence, independent producers may find themselves pushed out of the market. The customer, meanwhile, has not only been handed a windfall in surplus, but has also gained an insight into the cost structure of the supply chain, making it difficult for the downstream producer to raise prices again. That, of course, prevents the upstream producer from raising its prices and leaves the price of the product permanently depressed (see exhibit).

To counter the problem, some companies have tried to stop giving their downstream partners preferential treatment; instead, they base their transactions on market prices. But many are still unwittingly supporting downstream activities that are performing poorly and have no real chance of improvement. Identifying vertically integrated pricing behavior can be tricky, but the following symptoms are likely to give an indication of its presence:

• Continual discussions between upstream and downstream parts of the business about what the transfer price should be.
• Few or no remaining independent downstream producers with significant market share.
• Aggressive price competition for what should be a "value-added" downstream product. In extreme cases this might push prices down to the full chain cash costs of the marginal player.
• Cyclical downstream returns that mirror upstream capacity utilization.

To prevent vertical integration from sapping profitability, companies first need to understand the price they are paying for the insurance provided by downstream integration, and whether the price justifies the risk of lost upstream production. If downstream operators have to pay a market-based price for their supplies, their true profitability will soon be revealed.

Prices should be set at a level that finances periodic build of new upstream capacity to ensure balance of supply and demand over the long term. Producers can then assess the relative attractiveness of the captive market compared with the independents, using a measure of full chain (upstream plus downstream) return on invested capital. Their downstream operations should not receive preferential treatment even in periods of tight supply unless the risk/return profile is better than that of other customers.

Companies need to consistently price their output in this way, carefully monitor the response of their competitors and find ways of introducing more flexibility into their vertical integration structures. This can be achieved through a range of short- and medium-term third-party supply contracts and more varied upstream capacity and downstream production ownership (for example, through partnerships or shared facilities). If, eventually, it becomes clear that the full chain economics are likely to remain poor, companies should be prepared to exit the downstream business, or at least gradually reduce their exposure. The insurance policy really has little value.