Diversification Strategies in Business

Expanding a business can be quite hard so business owners and their teams tend to use a diversification strategy to be able to increase their sales and be successful in their expansion.

The business diversification strategy is what companies’ do (increasing the sales volume) in order to increase their profits.

The increase in the volume of sales can be done by developing new products and targeting new market. The diversification strategy can be used at the unit level of a business as well as in their corporate level. In a company expansion in unit level of a business, the strategy can be a new segment idea that is related exactly to the existing business. For the corporate level, the new business can be without relation to the existing business.

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Different Types of Diversification Strategies

There are three basic types of diversification strategies that may composed of several plans that range from the designed and development of new products to the licensing of these new technologies. They may also be a combination of these plans with two or more of it included. They are the concentric diversification where the technology stays the same while its marketing plan alters significantly. The technical knowledge is an edge when it comes to this type of strategy.

The next one is called horizontal diversification. In this type, the technology used is somehow far from the existing business. Though the new products are not related to the existing ones, the customers who are loyal still patronized the products. This is very effective when a business have many loyal customers. Last but not the least is the lateral diversification. This strategy is almost similar to the horizontal diversification. The only thing that differentiates it from horizontal diversification is that lateral strategy targets new customers instead of targeting their existing loyal customers.

Diversification’s Advantages and Disadvantages

When using the business diversification strategy, you must consider some things to succeed. Diversification can really help businesses achieve its full potential in the market. It helps the company increase their customers by attracting new ones and retaining loyal ones. Furthermore, it enhances the product portfolio of the business by launching products which compliments their existing products in the market. Nevertheless, the company must hire or have sufficient knowledge about diversification so that no problem can arise in the future. The management team of the company must be well trained and educated about the processes that must be followed. Lack of information and knowledge about the latest trend in the market can really be upsetting in your business’ goals. You must ensure that all are taken care of and you have the ability and capability of handling those things. If not, hire someone who is a professional in this kind of situation.

Types of Diversification

The different types of diversification strategies include the modernization and development of new products, updating the market, new technology licensing, distribution of products by another company and even the alliance with the said company.

The three types of diversification strategies include the concentric, horizontal and conglomerate.

Diversification is a method of risk management that involves the change and implementation of different investments stated in a specific portfolio. This is practices because of the rationale that a portfolio containing a variety of investments can yield higher profits and serve as a lower risk to the independent investments in the same portfolio. It is only through investing more securely that the benefits of diversification may be fully reaped. Investment through foreign securities may also reap benefits because of the decreased correlation between local investments.

The concentric diversifications specify that there exists similarities between the industries in terms of the technological standpoint. It is through this that the firm may compare and apply its technological know how to an advantage. This is through a careful change or alteration in the marketing strategy performed by the business. This strategy aims to increase the market value of a particular product and therefore gain a higher profit.

The horizontal diversification tackles products or services that are in a sense, not related technologically to certain products but still pique the interest of current customers. This strategy is more effective is the current clientele is loyal to the existing products or services, and if the new additions are well priced and adequately promoted. The newest additions are marketed in the same way that the previous ones were which may cause instability. This is because the strategy increases the new products’ dependence on an existing one. This integration normally occurs when a new business is introduced, however unrelated to the existing.

Conglomerate or lateral diversification is where the company or business promotes products or services with no relation commercially or technologically to the existing products or services, however still interest a number of customers. This type of diversification is unique to the current business and may prove quite risky. However, it may also prove very successful since it independently aims to improve on the profit the company accumulates with regards to the new product or service.

At times there are certain defensive actions that may promote to the risk of contraction within the market, or that the current product market seems to have no more growth opportunities. This must also be considered before initiating a certain type of diversification strategy. Another factor is the outcome of the chosen diversification strategy. The expected result is expected to generate a profitability growth that will complement the ongoing activities within the company.

Diversification strategies are used to expand firms’ operations by adding markets, products, services, or stages of production to the existing business. The purpose of diversification is to allow the company to enter lines of business that are different from current operations. When the new venture is strategically related to the existing lines of business, it is called concentric diversification. Conglomerate diversification occurs when there is no common thread of strategic fit or relationship between the new and old lines of business; the new and old businesses are unrelated.

DIVERSIFICATION IN THE CONTEXT OF GROWTH STRATEGIES

Diversification is a form of growth strategy. Growth strategies involve a significant increase in performance objectives (usually sales or market share) beyond past levels of performance. Many organizations pursue one or more types of growth strategies. One of the primary reasons is the view held by many investors and executives that “bigger is better.” Growth in sales is often used as a measure of performance. Even if profits remain stable or decline, an increase in sales satisfies many people. The assumption is often made that if sales increase, profits will eventually follow.

Rewards for managers are usually greater when a firm is pursuing a growth strategy. Managers are often paid a commission based on sales. The higher the sales level, the larger the compensation received. Recognition and power also accrue to managers of growing companies. They are more frequently invited to speak to professional groups and are more often interviewed and written about by the press than are managers of companies with greater rates of return but slower rates of growth. Thus, growth companies also become better known and may be better able, to attract quality managers.

Growth may also improve the effectiveness of the organization. Larger companies have a number of advantages over smaller firms operating in more limited markets.

Large size or large market share can lead to economies of scale. Marketing or production synergies may result from more efficient use of sales calls, reduced travel time, reduced changeover time, and longer production runs.

Learning and experience curve effects may produce lower costs as the firm gains experience in producing and distributing its product or service. Experience and large size may also lead to improved layout, gains in labor efficiency, redesign of products or production processes, or larger and more qualified staff departments (e.g., marketing research or research and development).

Lower average unit costs may result from a firm’s ability to spread administrative expenses and other overhead costs over a larger unit volume. The more capital intensive a business is, the more important its ability to spread costs across a large volume becomes.

Improved linkages with other stages of production can also result from large size. Better links with suppliers may be attained through large orders, which may produce lower costs (quantity discounts), improved delivery, or custom-made products that would be unaffordable for smaller operations. Links with distribution channels may lower costs by better location of warehouses, more efficient advertising, and shipping efficiencies. The size of the organization relative to its customers or suppliers influences its bargaining power and its ability to influence price and services provided.

Sharing of information between units of a large firm allows knowledge gained in one business unit to be applied to problems being experienced in another unit. Especially for companies relying heavily on technology, the reduction of R&D costs and the time needed to develop new technology may give larger firms an advantage over smaller, more specialized firms. The more similar the activities are among units, the easier the transfer of information becomes.

Taking advantage of geographic differences is possible for large firms. Especially for multinational firms, differences in wage rates, taxes, energy costs, shipping and freight charges, and trade restrictions influence the costs of business. A large firm can sometimes lower its cost of business by placing multiple plants in locations providing the lowest cost. Smaller firms with only one location must operate within the strengths and weaknesses of its single location.

CONCENTRIC DIVERSIFICATION

Concentric diversification occurs when a firm adds related products or markets. The goal of such diversification is to achieve strategic fit. Strategic fit allows an organization to achieve synergy. In essence, synergy is the ability of two or more parts of an organization to achieve greater total effectiveness together than would be experienced if the efforts of the independent parts were summed. Synergy may be achieved by combining firms with complementary marketing, financial, operating, or management efforts. Breweries have been able to achieve marketing synergy through national advertising and distribution. By combining a number of regional breweries into a national network, beer producers have been able to produce and sell more beer than had independent regional breweries.

Financial synergy may be obtained by combining a firm with strong financial resources but limited growth opportunities with a company having great market potential but weak financial resources. For example, debt-ridden companies may seek to acquire firms that are relatively debt-free to increase the lever-aged firm’s borrowing capacity. Similarly, firms sometimes attempt to stabilize earnings by diversifying into businesses with different seasonal or cyclical sales patterns.

Strategic fit in operations could result in synergy by the combination of operating units to improve overall efficiency. Combining two units so that duplicate equipment or research and development are eliminated would improve overall efficiency. Quantity discounts through combined ordering would be another possible way to achieve operating synergy. Yet another way to improve efficiency is to diversify into an area that can use by-products from existing operations. For example, breweries have been able to convert grain, a by-product of the fermentation process, into feed for livestock.

Management synergy can be achieved when management experience and expertise is applied to different situations. Perhaps a manager’s experience in working with unions in one company could be applied to labor management problems in another company. Caution must be exercised, however, in assuming that management experience is universally transferable. Situations that appear similar may require significantly different management strategies. Personality clashes and other situational differences may make management synergy difficult to achieve. Although managerial skills and experience can be transferred, individual managers may not be able to make the transfer effectively.

CONGLOMERATE DIVERSIFICATION

Conglomerate diversification occurs when a firm diversifies into areas that are unrelated to its current line of business. Synergy may result through the application of management expertise or financial resources, but the primary purpose of conglomerate diversification is improved profitability of the acquiring firm. Little, if any, concern is given to achieving marketing or production synergy with conglomerate diversification.

One of the most common reasons for pursuing a conglomerate growth strategy is that opportunities in a firm’s current line of business are limited. Finding an attractive investment opportunity requires the firm to consider alternatives in other types of business. Philip Morris’s acquisition of Miller Brewing was a conglomerate move. Products, markets, and production technologies of the brewery were quite different from those required to produce cigarettes.

Firms may also pursue a conglomerate diversification strategy as a means of increasing the firm’s growth rate. As discussed earlier, growth in sales may make the company more attractive to investors. Growth may also increase the power and prestige of the firm’s executives. Conglomerate growth may be effective if the new area has growth opportunities greater than those available in the existing line of business.

Probably the biggest disadvantage of a conglomerate diversification strategy is the increase in administrative problems associated with operating unrelated businesses. Managers from different divisions may have different backgrounds and may be unable to work together effectively. Competition between strategic business units for resources may entail shifting resources away from one division to another. Such a move may create rivalry and administrative problems between the units.

Caution must also be exercised in entering businesses with seemingly promising opportunities, especially if the management team lacks experience or skill in the new line of business. Without some knowledge of the new industry, a firm may be unable to accurately evaluate the industry’s potential. Even if the new business is initially successful, problems will eventually occur. Executives from the conglomerate will have to become involved in the operations of the new enterprise at some point. Without adequate experience or skills (Management Synergy) the new business may become a poor performer.

Without some form of strategic fit, the combined performance of the individual units will probably not exceed the performance of the units operating independently. In fact, combined performance may deteriorate because of controls placed on the individual units by the parent conglomerate. Decision-making may become slower due to longer review periods and complicated reporting systems.

DIVERSIFICATION: GROW OR BUY?

Diversification efforts may be either internal or external. Internal diversification occurs when a firm enters a different, but usually related, line of business by developing the new line of business itself. Internal diversification frequently involves expanding a firm’s product or market base. External diversification may achieve the same result; however, the company enters a new area of business by purchasing another company or business unit. Mergers and acquisitions are common forms of external diversification.

INTERNAL DIVERSIFICATION.

One form of internal diversification is to market existing products in new markets. A firm may elect to broaden its geographic base to include new customers, either within its home country or in international markets. A business could also pursue an internal diversification strategy by finding new users for its current product. For example, Arm & Hammer marketed its baking soda as a refrigerator deodorizer. Finally, firms may attempt to change markets by increasing or decreasing the price of products to make them appeal to consumers of different income levels.

Another form of internal diversification is to market new products in existing markets. Generally this strategy involves using existing channels of distribution to market new products. Retailers often change product lines to include new items that appear to have good market potential. Johnson & Johnson added a line of baby toys to its existing line of items for infants. Packaged-food firms have added salt-free or low-calorie options to existing product lines.

It is also possible to have conglomerate growth through internal diversification. This strategy would entail marketing new and unrelated products to new markets. This strategy is the least used among the internal diversification strategies, as it is the most risky. It requires the company to enter a new market where it is not established. The firm is also developing and introducing a new product. Research and development costs, as well as advertising costs, will likely be higher than if existing products were marketed. In effect, the investment and the probability of failure are much greater when both the product and market are new.

EXTERNAL DIVERSIFICATION.

External diversification occurs when a firm looks outside of its current operations and buys access to new products or markets. Mergers are one common form of external diversification. Mergers occur when two or more firms combine operations to form one corporation, perhaps with a new name. These firms are usually of similar size. One goal of a merger is to achieve management synergy by creating a stronger management team. This can be achieved in a merger by combining the management teams from the merged firms.

Acquisitions, a second form of external growth, occur when the purchased corporation loses its identity. The acquiring company absorbs it. The acquired company and its assets may be absorbed into an existing business unit or remain intact as an independent subsidiary within the parent company. Acquisitions usually occur when a larger firm purchases a smaller company. Acquisitions are called friendly if the firm being purchased is receptive to the acquisition. (Mergers are usually “friendly.”) Unfriendly mergers or hostile takeovers occur when the management of the firm targeted for acquisition resists being purchased.

DIVERSIFICATION: VERTICAL OR HORIZONTAL?

Diversification strategies can also be classified by the direction of the diversification. Vertical integration occurs when firms undertake operations at different stages of production. Involvement in the different stages of production can be developed inside the company (internal diversification) or by acquiring another firm (external diversification). Horizontal integration or diversification involves the firm moving into operations at the same stage of production. Vertical integration is usually related to existing operations and would be considered concentric diversification. Horizontal integration can be either a concentric or a conglomerate form of diversification.

VERTICAL INTEGRATION.

The steps that a product goes through in being transformed from raw materials to a finished product in the possession of the customer constitute the various stages of production. When a firm diversifies closer to the sources of raw materials in the stages of production, it is following a backward vertical integration strategy. Avon’s primary line of business has been the selling of cosmetics door-to-door. Avon pursued a backward form of vertical integration by entering into the production of some of its cosmetics. Forward diversification occurs when firms move closer to the consumer in terms of the production stages. Levi Strauss & Co., traditionally a manufacturer of clothing, has diversified forward by opening retail stores to market its textile products rather than producing them and selling them to another firm to retail.

Backward integration allows the diversifying firm to exercise more control over the quality of the supplies being purchased. Backward integration also may be undertaken to provide a more dependable source of needed raw materials. Forward integration allows a manufacturing company to assure itself of an outlet for its products. Forward integration also allows a firm more control over how its products are sold and serviced. Furthermore, a company may be better able to differentiate its products from those of its competitors by forward integration. By opening its own retail outlets, a firm is often better able to control and train the personnel selling and servicing its equipment.

Since servicing is an important part of many products, having an excellent service department may provide an integrated firm a competitive advantage over firms that are strictly manufacturers.

Some firms employ vertical integration strategies to eliminate the “profits of the middleman.” Firms are sometimes able to efficiently execute the tasks being performed by the middleman (wholesalers, retailers) and receive additional profits. However, middlemen receive their income by being competent at providing a service. Unless a firm is equally efficient in providing that service, the firm will have a smaller profit margin than the middleman. If a firm is too inefficient, customers may refuse to work with the firm, resulting in lost sales.

Vertical integration strategies have one major disadvantage. A vertically integrated firm places “all of its eggs in one basket.” If demand for the product falls, essential supplies are not available, or a substitute product displaces the product in the marketplace, the earnings of the entire organization may suffer.

HORIZONTAL DIVERSIFICATION.

Horizontal integration occurs when a firm enters a new business (either related or unrelated) at the same stage of production as its current operations. For example, Avon’s move to market jewelry through its door-to-door sales force involved marketing new products through existing channels of distribution. An alternative form of horizontal integration that Avon has also undertaken is selling its products by mail order (e.g., clothing, plastic products) and through retail stores (e.g., Tiffany’s). In both cases, Avon is still at the retail stage of the production process.

DIVERSIFICATION STRATEGY AND MANAGEMENT TEAMS

As documented in a study by Marlin, Lamont, and Geiger, ensuring a firm’s diversification strategy is well matched to the strengths of its top management team members factored into the success of that strategy. For example, the success of a merger may depend not only on how integrated the joining firms become, but also on how well suited top executives are to manage that effort. The study also suggests that different diversification strategies (concentric vs. conglomerate) require different skills on the part of a company’s top managers, and that the factors should be taken into consideration before firms are joined.

There are many reasons for pursuing a diversification strategy, but most pertain to management’s desire for the organization to grow. Companies must decide whether they want to diversify by going into related or unrelated businesses. They must then decide whether they want to expand by developing the new business or by buying an ongoing business. Finally, management must decide at what stage in the production process they wish to diversify.

FURTHER READING:

Amit, R., and J. Livnat. “A Concept of Conglomerate Diversification.” Academy of Management Journal 28 (1988): 59304.

Homburg, C., H. Krohmer, and J. Workman. “Strategic Consensus and Performance: The Role of Strategy Type and Market-Related Dynamism.” Strategic Management Journal 20, 33958.

Luxenber, Stan. “Diversification Strategy Raises Doubts.” National Real Estate Investor, February 2004.

Lyon, D.W., and W.J. Ferrier. “Enhancing Performance With Product-Market Innovation: The Influence of the Top Management Team.” Journal of Managerial Issues 14 (2002): 45269.

Marlin, Dan, Bruce T. Lamont, and Scott W. Geiger. “Diversification Strategy and Top Management Team Fit.” Journal of Managerial Issues, Fall 2004, 361.

Munk, N. “How Levi’s Trashed a Great American Brand.” Fortune, 12 April 1999, 830.

St. John, C., and J. Harrison, “Manufacturing-Based Relatedness, Synergy, and Coordination.” Strategic Management Journal 20 (1999): 12945.