Diversification: Definition, Levels, Strategy, Risks, Examples

Definition of DiversificationGenerally, diversification means expansion of business either through operating in multiple industries simultaneously (product diversification) or entering into multiple geographic markets (geographic market diversification) or starting a new business in the same industry.

At the business-unit level, diversification occurs when a business unit expands into a new segment of the present industry in which the company is -already doing business.

At the corporate-level, diversification occurs when the diversified company enters into business outside the scope of. the existing business units. Diversification is sought to increase profitability through greater sales volume.

However, it is not free from risk?

And,” therefore, it requires careful investigation before entering into an; unknown market with an unfamiliar product offering.

Many companies have experienced failure with diversification, while/ many others have been greatly successful such as Wait Disney (it moved from producing animated movies to theme parks and vacation properties) and Canon (moved from camera-making to producing a whole new range of office equipment)’.

The popular forms of diversification are vertical integration/ horizontal diversification; and geographic diversification.

Vertical integration involves integrating business along with the company’s value: chain, either backward or forward. Horizontal diversification involves moving into new businesses at the same stage of production as the company’s current operations.

Geographic diversification involves moving into new geographic areas.

The three forms of diversification may be related (adding or expanding existing product lines or markets) or unrelated (adding new or? ‘unrelated’ product lines or markets, i.e. entering into a business in ‘ a different industry).

Levels of Diversification

Some management experts have tried to show that diversified firms? vary according to their levels of diversification.

According to them, three levels of diversification exist;

  1. Low Levels of Diversification.
  2. Moderate to High Levels of Diversification.
  3. Moderate to High Levels of Diversification.

Low Levels of Diversification

This level of diversification is seen in a company that operates its activities mainly on a single or dominant business. The company is in a single business if its revenue is greater than 95 percent of the total sales.

If the generated revenue is between 70 percent and 95 percent, the company’s business is dominant. 5M Security Services Limited is an example of a firm with little diversification as its primary focus is on the ‘security guards market’.

Kellog is an example of a dominant business firm because its major sales come from breakfast cereals’ and ‘snack foods’.

However, the firms that generate their income from single products cannot be called diversified firms in the true sense of the term.

Moderate to High Levels of Diversification

In this level, two types of diversification are evident – ‘related constrained’ and ‘related linked’, in the case of related constrained diversification, less than 70 percent of revenue comes from the dominant business and ail SBUs/divisions share product, technology, and distribution channels.

If the firm has related linked diversification, less than 70 percent of revenues come from the dominant business but there are only limited links between and among the SBUs. Procter and Gamble is an example of a related constrained firm, while Johnson and Johnson is an example of a related linked firm.

Very High Level of Diversification

This level applies to companies that have unrelated diversification. It earns less than 70 percent of its revenues from the dominant business but there are no common links between the SBUs.

Diversification strategy

Can an organization continue to manufacture the same product/service forever?

In the history of man-made institutions, universities are the only organizations that have survived through the same product-knowledge for more than 11 centuries!

However the content packaging and delivery of knowledge have changed immensely and not all universities have survived.

This exception only proves the rule that organizations have to develop new business as they grow even unrelated businesses. Another pathway to growth is to venture away from the known turf.

The premise of diversification is to explore attractive business opportunity areas unrelated to the present business. Ponder an analogy here. As an individual investor, you are advised to spread your risk.

Why? Because a diversified portfolio insulates you from risk more than a single product investment portfolio does.

Similarly, an organization cannot expect the conditions in which it may have done good business to last forever. It spreads its risks by venturing into new and different areas of business with better prospects.

When an organization moves away from its known and tested product-market technology sphere to offer new products (related/unrelated) or enter new markets (related/unrelated) using new/modified/allied technology it is said to be following the diversification pathway.

Diversification is endemic in the corporate world; almost all the fortune 1,000 organizations are diversified. You will observe that most family-held businesses are also highly diversified.

The diversification is an attractive option to meet the growing aspirations of an increasing number of family members. The relentless pursuit of diversification as a strategy has given way to reasoned diversification.

Instead of many businesses in unrelated areas, it makes sense to have a portfolio of related or aligned businesses. The logic is that such diversification allows an organization to harness linkages to create a competitive advantage.

Still, the diversification patterns in the Asian countries suggest unrelated diversification to be common among larger business groups.

Organizations diversify to:

  • Circumvent government policy restrictions on growth as was the case with pre-liberalisation caps on capacity expansion in India. These led Indian companies to diversify in many unrelated areas.
  • New technologies/substitute products may have made existing domain unprofitable or likely to be so. Diversification may offer better opportunities.
  • Utilize fully the depth and breadth of managerial skills and competencies.
  • Utilize surplus or retained cash for a higher rate of return.
  • To enter a hitherto virgin area of immense potential. For example, in India, the privatization of higher education has attracted many players from fields as diverse as steel manufacturing to foods business to set up broad-based and specialty universities.
  • Information asymmetry in the existing business may be too high to permit new plans.
  • Spread Risk. In a diversified, portfolio risk is distributed among multiple businesses.
  • Leverage the commonality among businesses. This leveraging creates economic benefits.

Diversification risks

Diversification is an interesting but complicated strategy.

First, the skills needed to run the diversified entity may be different and at variance with the parent entity Diversification poses a challenge to the managerial skills/aspirations of managers.

It provides an opportunity to exhibit personal mettle at the same time as it requires managers to be open to learning and quick at adaptation.

Each business requires different skill sets provided by professionals and supervised by an independent board of directors.

The common thread running through such diverse business is the ethical and governance standards of the corporate parent. Diversification is risky.

It entails decision risk (choice and means of diversification may be wrong), implementation risk (structure, processes, systems, leadership, talent may be inadequate) and financial risk (the return to stockholders may be considerably reduced.)

According to Michael Porter (1987), the three tests should be applied before diversification decisions are taken.

Industry attractiveness testCost of entry testBetter off test

Is entry business high?

Are competitive conditions favorable?

Is the market conducive to growth?

Is the cost of entry low?

What is the sunk cost of specific equipment?

What are proprietary and other blocks to entry?

To what extent does synergy exist with on­going operations?

Can managerial skills, capability brand equity be leveraged?

Diversification pathways

Diversification is an investment-intensive option and an organization can diversify through different pathways. The different pathways have different levels of risk and resource requirements

The organization has to decide which pathway to take and whether to go it alone or seek some kind of partnership options (licensing, joint ventures, and strategic alliances).

Table below explains; higher the relatedness in domain of products, customer segments, technology, transference of management skills in diversification, lower is the risk from diversification, (this does not preclude the risk of the wrong strategic choice) and lower the relatedness, the higher is the risk from diversification (this does not take in to account the depth of the managerial skills that can steer diversification.).

There are four broad routes to diversification concentric, horizontal, vertical and conglomerate. The salient features of each of these are discussed below;

FeaturesExamples

Horizontal diversification.

The organization takes over those organizations which manufacture the same/ similar product or marketing functions.

Increase in size expected to infuse economies of scale and scope. An expected increase in market share.

Entertainment industry.

Film production houses also distribute movies through DTH networks.

Walt Disney( movies and distribution)

Vertical integration.

The organization takes overproduction of raw material, (backward) intermediary or key process (forward) to realize cost advantage.

Lower costs lead to lower prices which leads to higher market share.

Reduces flexibility. Extensive barriers that may limit to one industry are created.

Cement, steel and textile companies are vertically diversified. In India, cement manufacturers have captive power generation plants.

Excess power is sold to either state-run utilities or other industries.

Soap/detergent manufacturer setting up linear alkylbenzene (LAB a key ingredient for soaps) plant for supply-side advantage.

Concentric diversification.

Diversification into broadly related areas (product-market/ technology).

The market is regarded as a domain of related but heterogeneous needs that an organization can meet with heterogeneous but allied offerings.

Pharmaceutical companies’ product range includes Prescription drugs, nonprescription drugs, drug delivery systems, eye, and skincare products.

There is s difference between the products and technology but a broad marketing scope enables to leverage of brand value.

Conglomerate diversification.

Diversification in totally unrelated areas. New areas may present better growth options, entry barriers may be low as must be the investment required.

Resource/ capabilities are spread across. Organizations can diversify globally also.

Rolls Royce( cars, engines), General Electric, Samsung Electronics, Tata.

Two different situations from the contemporary business world are presented for your analysis and discussions.

Present your analysis as a report covering some aspects of SWOT (you may refer to official websites), and review of options in the light of course material. Be specific in your recommendation.

How does an organization diversify?

This is the second option that an organization has to decide on, whether to go it alone and set up a greenfield project or develop a diversified entity through mergers, acquisitions/alliances or joint ventures.

Most of these options are similar in the sense they are based on the principle of creating collaboration for the growth of two different entities. The differences among them are more of a degree than direction.

The subtle differences between joint venture alliances and between mergers and takeovers are more for conferring the legal status on the entity as well as the transfer of funds and resources.

Diversification Approaches

A company needs to choose a path or approach to diversify its business. It may choose either related diversification approach or unrelated diversification approach or a combination of both, depending on circumstances.

The principal difference between the two is that related diversification emphasizes some commonality in markets, products, and technology, whereas unrelated diversification is based mainly on profit considerations. The strategists must consider the realities of the situations for selecting the right approach for diversification.

Related Diversification Approach

Your company is pursuing a strategy of related diversification if you find that multiple lines of businesses are finked with your company. Also known as ‘concentric diversification,’ related diversification involves diversifying into a business activity that is related to the core (original) business of the company.

The new business is operated in the same industry. Both the new business and the core business have some commonalities in their value chain activities such as production, marketing, etc. The value chains of both businesses possess strategic ms.’

In the language of Hill and Jones, “related diversification is diversification into a new business activity or activities by commonality between-one or more components’ of each activity’s value chain.

Because of the existence of commonality in value chains in both the existing and new businesses, business-to-business transfer of key skills, technological expertise or managerial know-how is possible.

Commonality and/or strategic fits in value chains also help the company achieve competitive advantage through reducing costs; sharing a common brand-name dr creating valuable resource strength.

Companies usually implement related diversification strategies to build a competitive advantage and achieve economies of scope.

The Ways for Related Diversification

An analysis of the practices of various diversified companies reveals that they seek related diversification in either of the two ways or a combination of the two.

These ways are (a) related- constrained, and (b) related-linked. When the business-units of a company share the inputs, production technologies, distribution channels, etc. among themselves, the diversification, is known as related-constrained.

For example, BIC is said to follow a related- constrained diversification, as all of its products (razors, cigarette lighters, and pens) share significant commonalities in the areas of plastic injection molding, brand name, and retail distribution. On the other hand, in the case of related-linked diversification, the business-units are linked on a few dimensions.

The products are sold under various brand names, and they do not share common technology or inputs across segments. For example, Walt Disney was a related-constrained firm until the early 1990s. But it moved to related-linked firms gradually when it started making movies for mature audiences and acquired ABC television.

Why Do Companies Use Related Diversification?

Many companies prefer a related diversification strategy to an unrelated diversification strategy.

There are several grounds for choosing related diversification strategy:

  1. It has the potential of cross-business synergies.Value chain relationships between the core and new businesses produce the synergies. In other words, we can argue that a company . may follow related diversification strategy when strategic fit exists between some or all of the value chain activities in both the core and new businesses.

    Along the value chain, cross-business strategic fit can exist in, for example! production activities, distribution activities, sales and marketing activities, supply chain activities, managerial and administrative support activities, and R&D activities.

    Gross- business strategic fits in production activities can be valuable when the company’s expertise in such activities can be transferred to another business. If two or more businesses under the parent company can share the same distribution facilities (e.g., same distributor, dealers, and retailers), the company can create synergistic effects.

    Businesses with closely related sales and marketing activities can perform better together because of reduced sales costs (reason: sharing of the same sales force). Strategic fits in supply chain activities help in skills transfer in procuring materials in achieving stronger bargaining power in negotiation with suppliers, etc.

    When managerial know-how and competencies can commonly be ‘used in different businesses, the company can achieve more competitive advantages. Similarly, sharing common technology or using the same R&D facilities for more than one, business is §n important way to achieve a competitive advantage.

  2. It has strategic appeal because it allows a company to build a stronger competitive advantage through skill transfer, lower costs, common brand name and better competitive capabilities.
  3. it is possible to create ‘economies of scope’ through diversifying businesses into related areas. Economies of scope (as contrasted to ‘economies of scale’) occur due to savings from cost reduction. Costs are reduced when cross­business strategic fits exist. Related diversification has the potential of achieving economies of scope. (It may be noted that economies of scale are achieved when the unit cost of products are reduced as the volume of production increases).
  4. It provides a sharper focus for managing diversification because of concentration in similar businesses.
  5. It can result in greater consolidated performance than a single-business concentration strategy. A stand-alone enterprise cannot perform better than a company having related businesses.
  6. It can create value through resource sharing between various businesses.
  7. It involves fewer risks because the company moves into business areas about which top management already has some knowledge.

Situations Favorable for Related Diversification

Research evidence suggests that related diversification does not always yield more benefits than unrelated diversification.

So, the question is: When should a company opt for related diversification?

Experience shows that it is useful for a company to concentrate on related diversification:

  1. When the core competencies of the company apply to a variety of business, situations.
  2. When the management of the company is capable enough to manage the affairs of several businesses simultaneously.
  3. When trade unions in the company do not create resistance to the cross-business transfer of manpower and other resources.
  4. When ‘bureaucratic costs’ of implementation do not outweigh the benefits derived from resource-sharing between businesses. Bureaucratic costs arise mainly from coordination efforts that are required among different businesses of the company.

Unrelated Diversification Approach

Unrelated diversification is also known as ‘conglomerate diversification’ or ‘lateral diversification.’ An unrelated diversified company is known as a conglomerate. Unrelated diversification involves entering into new businesses that are not related to the core business of the company.

An unrelated diversified company has more than one businesses which are operating their activities in different industries. As Hill and Jones remarked, “Unrelated diversification is diversification into a new business area that has no obvious connection with any of the company’s existing areas.” The value chains of the businesses are dissimilar.

As a result, the diversified company has little opportunity to transfer skills, technology or other resources from one business to another. Each business-unit in the unrelated diversified company is a stand-alone entity. Each SBU remains responsible for profit-making.

For example, Company A started initially with the business of producing a marker pen. Subsequently, it started a business in mosquito coil and later in laundry soap production. We can say that Company A is an unrelated diversified company because its subsequent businesses have no similarity with its core business (marker pen business).

The distinction between Related and Unrelated Diversification

Some differences between related and unrelated diversification approaches are obvious:

  1. Related diversification occurs within the same industry. New businesses are related to the core business of the company. Unrelated diversification occurs in different industries. It involves diversifying into totally new businesses that have no relationship with the core business of the company.
  2. Resource-sharing and skills-transfer between different businesses are the focus of the related diversification approach. The main focus of the unrelated diversification approach is to create shareholder value by acquiring new market segments.
  3. Related diversification is conspicuous by the value-chain commonalities among the businesses. However, we find the absence of commonalities in the value-chains of different businesses in an unrelated diversified company.
  4. Related diversification can create value in more ways than unrelated diversification.
  5. Since management has prior knowledge about managing a similar type of enterprise, they are better capable of managing related businesses Therefore, related diversification involves fewer risks than unrelated diversification.
  6. Higher bureaucratic costs arise from coordination among business units in a related diversification company. In the unrelated diversified companies, there is no question of cross-units coordination. As a result, their bureaucratic costs are much less than the related ones.

When Should a Company Adopt Unrelated Diversification?

An unrelated diversification strategy may work well in certain specific situations. The strategy-makers need to assess these situations and then they should decide on adopting unrelated diversification. Some of the favorable situations for unrelated diversification are as follows:

  1. When the core functional skills of the company cannot be easily used in a business other than the original business.
  2. When the management of the company can establish backward or forward linkage.
  3. When the value created by adopting restructuring structure is not suppressed by the bureaucratic cost of the implementation of the strategy.
  4. When a company sees is that entering into a different type of business in a different industry offers a good profit opportunity.
  5. When the prospective business in a different industry not related to the core business has significant profit potential.
  6. When the company is least interested in achieving competitive advantage through establishing strategic fits between the value chains of the SBUs.

Advantages of Unrelated Diversification

Unrelated diversification has certain merits.

The business enterprises usually adopt related diversification for enjoying a few advantages, such as the following:

  1. Spreading of risks over different industries
  2. Profit prospects in other industries
  3. Opportunities to offset losses
  4. Increase in shareholder value
  5. Quick financial gain
  6. Greater earnings stability

Spreading of risks over different industries

Unrelated diversification involves entering into new industries.

Thus, it is possible to spread the business risks over different industries. Businesses with different technologies, markets and customers have the potential of absorbing j^isks related to the investment of the company.

However, research evidence indicates that related diversification is less risky than unrelated diversification from a financial point of view.

Profit prospects in other industries

Unrelated diversification provides an opportunity to enter into any business in any industry which has profit prospects. The company may acquire a business in another industry having high-profit potentials.

Opportunities to offset losses

Because of investment in diverse areas of business activities, there is a possibility of offsetting losses in one business with the gains in another business in another industry.

Cross-industry offsetting of losses is very dim in related diversification due to the operation of businesses in the same industry. In a diversified company, the cyclical downswing in one business can be counterbalanced by a cyclical upswing in another business.

Increase in shareholder value

Skilled corporate mangers can increase shareholder-value by taking over highly prospective businesses in different industries.

Quick financial gain

There are opportunities for quick financial gain if the parent company resorts to diversification through acquisition of businesses having under-valued assets that have good profit potential. Financial gain can also be achieved if the new businesses can be acquired with a bargain-price.

Greater earnings stability

Unrelated diversification offers greater earnings stability over the business cycle. However, stability in earnings depends on managers’ ability to avoid the disadvantages of unrelated diversification.

Disadvantages of Unrelated Diversification

The common drawbacks or disadvantages of unrelated diversifica­tion are as follows:

  1. Unreliability in building shareholder value
  2. Business-jungle and managerial difficulties
  3. Dangers in screening businesses through acquisitions
  4. Risk of the unknown
  5. Insignificant contributions in building competitive strength

Unreliability in building shareholder value

Management experts are of the view that unrelated diversification is an unreliable approach to building shareholder value unless corporate mangers are exceptionally talented.

Business-jungle and managerial difficulties

When a conglomerate has a large number of diverse businesses, corporate managers may find it difficult to manage effectively the ‘jungle’ of businesses.

Difficulties may abound in selecting right mangers, undertaking appropriate measures when problems; arise, and making decisions when a business unit stumbles.

Dangers in screening businesses through acquisitions

Unrelated diversification through acquisition of other firms requires a sound screening from among the available firms. The’ diversifier-company may be at a loss if it fails to astutely screen out the unattractive firms.

Screening out requires an assessment of the firms to be acquired by using different criteria such as expected return on investment, growth potential, cash flow, environmental issues, government policies, etc. In reality, only companies with undervalued assets and companies that are financially distressed are good candidates for unrelated diversification.

Risk of the unknown

A new business, acquired by the diversifier-company is an unknown entity to the corporate managers. This may pose a risk to them. Any mistake in asses­sing industry attractiveness or predicting unusual problems (such as forcefully taking into possession by local terrorists in connivance with the owner-group) may prove fatal.

Wise men say; “Never acquire a business you don’t know how to run.”

Insignificant contributions in building competitive strength

Experience shows that a strategy of unrelated diversification cannot always create competitive strength in the individual business units.

Diversification Examples

Google and diversification

Google founded in 1998 is a leading search engine. Google wrested its dominant position in the search engine from Alta Vista, which was taken over by Yahoo. Google’s diversified portfolio of businesses includes YouTube, Picasa, Google+, Gmail, Google Earth, Chrome, and Android.

Almost 90 percent of its revenue comes from advertising on Google. So far Google does not face any major imminent threat in this area.

The slowdown of the economy does indicate that Internet advertising will be down and the revenues for Google may dip.

Google may fail as Gmail and Chrome business as risky, data privacy and customer support as being inefficient concerning customer demand.

Google is also planning a foray into the mobile handset and e-books market. Is this diversification in consonance with Google’s strengths is a big question. Does Google have the capacity to out-compete rivals such as Apple?

Goggle’s core business is its search engine. Is its diversification into the smartphone a smart move? Would this diversification make Google lose focus on its core business? Should Google rather focus attention on the search engine and scale up its capabilities for better services and privacy?

Armani’s diversification

The house of Armani is an Italy-based international fashion house whose products spell ultra-luxury. Its products include men’s and women’s clothes (some worn by Hollywood celebrities), eyewear, cosmetics, perfumes, and accessories.

Armani clothes and other allied products are sold through Armani Exclusive Stores spread over most cities associated with glitz and glamour and very high-end departmental stores. Armani men’s clothing has so far been sought after, however, in the U.S., which is one of Armani’s main markets, the loyal male customer base is shrinking and the women who supported Armani are getting older.

The U.S. and Japan which were Armani’s main markets are now shrinking. The economic downturn and the rising rate of unemployment in its main markets forced Armani to look for new markets. The Chinese luxury market growing at 30 percent per annum may be the new Armani market and attention area. Can Armani, who is older than the new crop of designers, hold his own?

In 2010 Giorgio Armani extended his luxury line to include the unrelated business of hotels.

In 2010, Armani opened his first hotel at Burj Khalifa having166 guest rooms and suites and 144 residences. The idea was to extend the association of luxury to houses to somehow make it appear that your address can also spell luxury.

Burj Khalifa’s exclusivity matched Armani’s. Armani plans to associate with the aesthetics and interior design of ultra-premium properties across the world.

It already has a tie-up with Lodha Builders for their upcoming property in South Mumbai. Can the foray of Armani in the ultra-luxury housing segment pay off?

Is luxury the criteria for a buyer or is it an idea with novelty appeal. If Armani was to be associated with luxury housing across the emerging economies, would the appeal last?

Armani, in association with Samsung, also launched the Armani- Samsung phone which didn’t take off as expected. The phone was available at outlets different from other Armani products.

Perhaps the concept of luxury to a mobile phone was better captured by Apple. Perhaps Armani sought to leverage in a segment that wasn’t ready for it yet. The luxury appeal did not work.

Armani is a closely family-held company, its patriarch is old and the world around it is changing.

What is the option for it to sustain the growth?