What is Diversification Strategy?

Diversification Strategy

A single-product strategy is always a risky one. Because the firm has staked its survival on a single product (or a small basket of products like Colgate) the organization has to work very hard to ensure the success of that product. If the product is not accepted by the market (like taking a big call on Indica by TELCO) or is replaced by a new one (the challenge of Close-Up from HLL to Colgate) the firm will suffer. Given the risk of a single-product strategy, most large organizations today operate in several different businesses, industries, or markets.

Diversification describes the number of different businesses that an organization is engaged in and the extent to which these businesses are related to one another. Diversification involves entry into fields where both products and markets are significantly different than those of a firm’s initial base.

Related diversification occurs when a firm expands into industries similar to its initial business in terms of at least one major function (when the firm enjoys distinctive competence such as marketing, distribution, engineering, etc). Unrelated diversification involves expansion into fields that do not share any financial or skill-based interrelationship with a firm’s initial business.

Diversification is said to minimize risks associated with confining the business to one or very few products. The company can enter new lines of business to preempt potential competitors or to gain superiority over competitors entering the market at an early stage. It can introduce new products, satisfying a variety of needs. This helps in consolidating its position in the industry. The company can put its resources and related capabilities to good effect.

The existing businesses might have saturated a bit and the only way to grow could be through diversification, exploiting opportunities in the environment. Diversification, of course, is not a sure bet. Diversification may lead to neglect of old businesses. The managers may fail to understand the intricacies of new business as well – because they have entered the field without full knowledge and adequate preparation. To make matters worse, competitors may retaliate with full force, adversely impacting even the existing businesses. To be successful, diversification requires careful planning and meticulous preparation.

The company must have deep pockets and strong staying power. Building competitive advantages takes time and involves a lot of money. The company must have a relevant core competency in the field that it is trying to look at now. The chosen field must be attractive and the company should have capable managers to handle the associated risks competently. The cost of entry should also be reasonable. To be safe, the company should screen and pretest the proposals carefully and proceed cautiously.

Related Diversification

Horizontal integration takes place when some firms expand by acquiring other companies in the same line of business (adding new products or services to the existing product or service line). Such acquisitions eliminate competitors and provide the acquiring organization with access to new markets. Horizontal integration could come, thus, through mergers and acquisitions.

The purchase of one firm by another firm of approximately the same size is called a merger. It is called an acquisition when one of the organizations involved is considerably larger than the other. Most software companies use the mergers and acquisitions route to acquire complementary businesses, products, or services linked by a common technology and common customers.

Concentric Diversification

It occurs when an organization diversifies into a related, but distinct business. With concentric diversification, new businesses can be related to existing businesses through products, markets, or technology. The new product is a spin-off of the existing facilities, products, and processes.

For example, Philip’s the electronics major decided to diversify into related businesses such as cellular phones, telecommunication equipment, electronic components, etc. to exploit its core advantages in the form of related technology, strong distribution network, etc. IBM has used a concentric diversification strategy right from the 60s onwards. In the early 60s, IBM concentrated on the mainframe computer business. Today the company’s products include small computers, terminals, communication equipment, etc.

Concentric diversification may occur due to factors such as common distribution channels, marketing skills, common brand names, and common customers. Organizations such as Philip Moris, Nabisco, and Proctor & Gamble operate multiple businesses related to a common distribution network (grocery stores) and common marketing skills (advertising).

Disney and Universal rely on strong brand names and reputations to link their diverse businesses which include movie studios and theme parks. Pharmaceutical firms such as Cipla, and Ranbaxy sell numerous products to a single set of customers: hospitals, doctors, patients, and drugstores.

Unrelated Diversification

Conglomerate diversification takes place when an organization diversifies into areas that are unrelated to its current business. The decision to diversify into unrelated areas is generally undertaken by firms in volatile industries that are subject to rapid technological change. The obvious purpose is to reduce risk. It is also assumed that by restructuring the portfolio of businesses, the firm would be in a position to create value. The similarity in products, technology, or marketing knowledge between the two firms is not an issue here, the acquiring firm simply wants to make an attractive investment.

Unrelated diversification was a very popular strategy in the 1960s and early 1970s. For example, the ITC’s diversification into edible oils, hotels, financial services, etc. is conglomerate (likewise NEPC group’s foray into agro foods, textiles, paper, airlines, wind energy, tea plantations, etc; Ballarpur Industries’ unrelated diversification, into chemicals, nylon fiber, leather, etc. in addition to paper. Essar’s foray into shipping, oil, sponge iron, marine construction, telecom, power, etc.).

Economic Motives

It is worth noting the principal difference between concentric and conglomerate diversification here. Concentric diversification emphasizes some commonality in markets, products, or technology, whereas conglomerate diversification is based on profit considerations only. The firm thinks that it can spot an attractive investment opportunity faster than the market and commits its resources accordingly. Of course, it is always open to doubt whether the new business justifies its acquisition cost.

Thus, the selection of attractive acquisition candidates is largely a matter of managerial judgment. The basic source of value in a conglomerate is senior management’s ability to time the market to buy and sell businesses. Consistent success in such matters, however, cannot be guaranteed. Throughout the 1990s, not surprisingly, many conglomerates failed to deliver the goods.

Unrelated diversification moves have destroyed value instead of creating it (dyssynergy, in which individual businesses may be worth more on their own rather than when placed under a larger corporate umbrella with other unrelated units). Conglomerates have failed in most cases because of various reasons: inadequate focus, failure to understand the business fully, and competitive disadvantage compared to organizations that use related diversification.

Costs of Diversification

Diversification into related or unrelated areas is not a sure bet. Problems could surface suddenly from multifarious – known as well as unknown factors. Let’s examine these more closely (Pitts and Lei).

• Cost of Ignorance: Entering a new, unknown field is risky. The firm does not know the extent of the competition. It may fail to read the mind of the consumer properly. Technological developments and environmental factors may compel the firm to shift gears continuously. Mistakes might be committed when the firm is navigating through uncharted waters.
  
  
• Cost of Neglect: A company trying to expand through unrelated diversifications may have to divert its attention from its core businesses – at least temporarily. First, it must decide the areas where it wants to operate. Second, if acquisition is the route; it must identify suitable targets for purchase. Third, top managers must integrate the new units with the existing businesses.
  
  
  All these steps would dilute the attention of the firm towards its own, original business. The costs of ignorance and neglect might prove to be crippling, especially in a highly competitive rapidly changing environment. Let’s consider the cases of Indian companies which have gone out of business, because of hasty, unrelated diversifications into too many different areas.

When to Diversify?

Diversification will be fruitful only when the benefits generated by diversification outweigh the related costs. To contain costs, the firm should focus attention on familiar fields and by diversifying internally rather than by acquisition. In any case, as summarised by Pears and Robinson, diversification is the most preferred route:

• When the firm intends extraordinary growth in assets, revenues, and profits.
  
  
• When the firm wants to counter vulnerability arising out of a single-product concentration – by creating a large portfolio of diverse businesses.
  
  
• When the environment presents an unusually large number of exciting opportunities to be exploited by the firm’s resource base.
  
  
• When there is great environmental uncertainty, firms embark on a constant search for new businesses.
  
  
• When the firm finds diversification to be more profitable than intensification.
  
  
• When the firm has surplus resources that could be profitability deployed in new ventures.
  
  
• When the firm finds synergy between its existing businesses and the new ones that it intends to set up.

When diversification is likely to produce fewer benefits than costs, the firm should turn its attention to restructuring its operations to enhance shareholder value. The various possibilities in this connection include:

• Selective Focus: Target carefully selected new segments when the firm can expand its market share quickly even though the industry in which it operates is on the decline.
  
  
• Spin-off: Spinning off businesses means selling those units or parts of a business that no longer contribute to or fit the firm’s core competence. Spinning off non-core or less related businesses help produce a renewed focus on remaining core operations. It also helps shareholders capture the full value of assets being used by management.