14 Diversification Strategy

1.      Learning Outcomes

2.      Introduction

3.      What is Diversification Strategy?

4.      Advantages and Disadvantages of Diversification Strategy

5.      Types of Diversification Strategy

6.      Typology of Diversification Strategy

7.      Levels of Diversification Strategy

8.      Diversification Decisions

9.      Mode of Diversification

10.  Sumamry

1.  Learning Outcomes

• After studying this module, you shall be able to
• Understand the role of diversification as a growth strategy
• Differentiate between various types of diversification strategy.
• Understand the advantages and disadvantages of various diversification strategies Study the various issues and risks of diversification
• Understand managerial challenges of diversification Strategy.

2.  Introduction

The sustainability of the organizations depend largely its ability to make and sustain profits in the long. To achieve this, organizations always intend to grow through various corporate strategic moves. There are multiple expansion growth strategies available to corporate including concentration strategies, integration strategies, cooperation strategies, internationalization strategies, digitalization strategies and also diversification strategies. As discussed in earlier module, in case of integration strategies the firm has a choice to move up and down in the value chain by adopting forward and backward integration or also has an option to merge, acquire or takeover a competitor to achieve higher economies of scale. Diversification strategy is another strategic alternative available to the firm to expand and grow. In this strategy, the firm moves into new territory in terms of the nature of business, in terms of the customers, distributors, suppliers and is ready to experiment into newer business landscape. This strategy has been adopted by various firms across the world to become large conglomerates. To understand the nature of diversification strategy, let us first understand what diversification strategy is and use the Ansoff matrix to put this strategy in perspective.

3. What is Diversification Strategy?

Diversification is defined as “the entry of a firm or a business, either by processes of internal business development or acquisition, which entails changes in administrative structure, systems and other management processes. As the saying goes, “Don’t put all your eggs in one basket”, a company is diversified when it is in two or more lines of business. Diversification is a strategy for company growth through starting by new business outside the current markets. This strategy could be understood through the lens of Ansoff Matrix proposed by Igor Ansoff in 1957. This matrix classifies and explains different growth strategies for a company and is a strategic planning tool to devise the growth strategy. According to this matrix, there are four growth alternatives which are based on two dimensions i.e. markets and products. Each of these are taken at two levels i.e. new and existing. The figure below describes the Ansoff Matrix. There are four options as proposed

Market Penetration – When the company uses existing products to penetrate deep into existing markets. The firm can achieve this by improving quality, marketing and productivity. The firm can also consider collaborating with distributors and network partners to penetrate into the market. For example, when McDonalds introduced the Happy Meal option for its customers.

Market Development – When the company using existing products to enter into new markets, it is called as the market development strategy. The company can go into new sales areas, segments or find out new uses. The firm can also consider exporting, buying competitors or engage into licensing. For example when McDonalds entered India and simultaneously started entering various states and cities of India

Product Development – When the firm develops new products for the existing markets, this strategy is known as product development. The company invests in R&D, modifications or extensions or could even go in for buy in products. For example, when McDonalds introduced McPizza or Royal Paneer exclusively for the Indian market.

Diversification – When the firm develops new products for new markets, this strategy is known as diversification. There is a need to switch internal focus and the company creates new business units, buy subsidiaries, get engaged in technology share or build consortiums. For example, McDonalds started its coffee-house-style food and beverage chain under the brand name McCafe The focus of this module will be on this strategy of expansion and growth.

Corporate Strategists often ask this question – “What is the appropriate scale and scope of a firm?” The answer to this question influences how large and how diversified the firms will be. Firms look forward to leverage their existing capabilities or competencies and therefore intends to diversify.

4. Advantages and Disadvantages of Diversification

There are various advantages and motivation to use the diversification strategy. Most companies use diversification strategies in order to capitalize on synergies. Some of them are as follows

Risk Reduction

To move out of unattractive and undesirable industries To ensure stability of cash flows

To use surplus cash

To avoid hostile takeovers To build shareholder value

To create synergies among the business of firms Exploit better and additional opportunities

Efficient capital allocation

Builds corporate brand equity

Facilitates cross selling and gives access to more markets. Increased flexibility

Increased profitability Ability to grow quickly

Better access to capital markets Diversification of Risk

While diversifying the major objective of firms is to look for synergistic effects. These synergies are obtained by exploiting economies of scale, economies of scope and efficient allocation of capital.

Though the lists of benefits are enormous, this strategy has also some limitations and disadvantages. These are

Shareholders have no say in capital allocation process. It is easier to hide poorly performing business.

Risk of inferior investment in new businesses

Overextension of company’s resources

Lack of expertise in running the diversified business as different business require different skill sets

May result in reduced innovation because of increased bureaucratic procedures and ability to quickly respond to market changes

As the firm diversifies there is a risk of decreased commitment on the core business. Increases the overall administrative costs and often result in losses.

There are limits to diversification as the firm should ensure that the extent of diversification must be balanced with its bureaucratic costs.

As the scope of diversification widens, control and bureaucratic costs increases there is difficulty in coordination among various businesses.

As the scope of diversification widens, information overload can lead to poor resource allocation decisions and create inefficiencies.

5. Types of Diversification Strategy

Though there are various ways in which the diversification strategy can be looked upon, but at the initial level, we classify this at two levels. These include

Related Diversification – This strategy is based on transferring and leveraging competencies, sharing resources, and bundling products. The value chain possesses competitively valuable cross business strategic fits. In this case, a firm enters into a new business activity in a different industry that has common features with the existing value chain of the business. In other words, the new business is related to the company’s existing business activities. This strategy of growth and expansion is based on transferring and leveraging competencies. There has to be a strategic fit between the existing business and the new business that the firm intends to diversify. For example when a newspaper company like Times of India intends to venture into TV Channel like Times Now. Another example can be when PepsiCo entered into snack business by introducing snack brand like Fritos, Lays etc. In this case, the firm can leverage its skills, competencies, brand name, marketing skills and knowledge, sales and distribution capacity, R&D, new product capabilities etc to develop the new business it has diversified into. This form of diversification is also viewed as synergistic diversification as it involves harnessing product and market knowledge.

Unrelated Diversification – This strategy is based on using the general organizational competencies to increase profitability of each business unit. The new business wherein the firm intends to diversify has no connection with the existing value chain of the company. Infact the value chains are so dissimilar that no competitively valuable cross-business relationship exists. This strategy involves diversifying into business that has no strategic fit, no meaningful value chain relationships and no unifying strategic theme. The firms which pursue unrelated diversifications are generally known as conglomerates. Firms can build shareholder value through unrelated diversification through astute corporate parenting by management, cross business allocation of financial resources; and acquiring and restructuring undervalued companies. The basic approach is to diversify into any industry where potential exists and through diversification the firm can realize higher profits. For example Samsung operates in electronic, shipbuilding, insurance etc. Similarly Tata Group is in multiple business like airlines, telecom, steel etc.

6.   Typology of Diversification Strategy

In addition to the above framework, the typology of diversification strategies can also be viewed as

Concentric Diversification – This is similar to related diversification where the company seeks  new  products  that  have  technologically  or  marketing  synergy  with  the  existing product lines. In terms of the business definition, the firm takes up an activity in such a manner that is related to customer group, customer function or alternative technologies. For example,  Philips  which  is  strong  in  lighting  and  electronics  business  entered  into communication systems, telecommunication equipment and other businesses. Similarly if a sewing machine manufacturer starts manufacturing kitchen appliances considering women as their target customers. In this grand strategy, the new business has a high degree of compatibility with the firm’s current business. The underlying objective behind adopting the concentric diversification strategy is to benefit from synergy effects by attracting new groups of customers. The synergy happens because of the interactions and the interrelatness of the combined operations and the sharing of resources, capabilities and distinctive competencies. This strategy is useful under the conditions when adding new and related products increases overall sales, current products are at decline of product life cycle. The concentric diversification can be of further three types. These are

o Marketing Related Concentric Diversification – When a similar product is offered with the help of unrelated technology. For example a printer manufacturing company starts selling stationery products

o  Technology Related Concentric Diversification – When a new type of product is provided with the help of related technology. For example electronic major diversifies into telecommunication equipment

o Marketing and Technology related Concentric Diversification – When a similar type of product is provided with the help of related technology. For example books, maps and calendars are sold in same shop.

The advantage of concentric diversification strategy is that it brings in synergy by exchange of resources and skills. Further this strategy also helps in achieving economies of scale. The disadvantage is risk and commitment of resources and reduction in flexibility to carry out the operations.

Horizontal Diversification – When new products are introduced to current markets it is known as horizontal diversification. In other words, adding new unrelated products or services for present customers is known as horizontal diversification strategy. In the present era of high competition, this strategy often results in desirable outcomes. As compared to other strategy, this is less risky as the firm is familiar with its present customers. This strategy is desirable when the overall revenues from the current products will significantly increase by adding new products. Further under conditions where the existing product is seasonal / cyclical in nature and the new product have counter cyclical patterns. The advantage of horizontal diversification is opportunities to achieve economies of scale and scope. Further there shall be opportunities to expand product offering or expand into new geographical areas. One of the major disadvantage of this strategy is the difficulty and complexity of managing different businesses which require different competencies and skill sets.

Conglomerate Diversification –  Adding  new,  unrelated  products  or  services  is  called conglomerate diversification. This is similar to unrelated diversification as this strategy takes the organization beyond both its existing markets and products. For example, ITC which is basically a tobacco company is also into hotel industry which is totally unrelated in terms of products, customers and markets. Infact there is no technological or commercial synergy with the existing business of the firm in terms of customer groups, customer functions and alternate technology. The underlying motive behind adopting this strategy is to improve the overall profitability of the firm as well as develop its ability to get access to capital. Though this is a high risk strategy, yet if properly implemented can yield higher shareholder value in the long run. For example Tata Group is India largest conglomerate with its presence in chemicals, consumer products, energy, engineering, information systems, steel and services. Similarly ITC is a multi business conglomerate with its presence in diversified business ranging from hotels, agri-business, fast moving consumer goods, paper, information technology. In the same way Aditya Birla Group is a Indian multi national congolomerate with its presence in metals, cement, textiles, chemicals, fertilizers, financial services, telecom, IT and branded apparels.

7.   Levels of Diversification

The extent to which a firm diversifies can be understood by looking into the revenue that flows in from the dominant business. The following are the various levels at which the diversification can take place

Low Diversification (Single Business) – When more than 95% of the revenue comes from single business unit. In this the firm could be either in single business or single vertical.

Low Diversification (Dominant Business) – When70 – 95% of the revenue comes from a single business unit. The firm could be in either of these options – dominant vertical, dominant constrained, dominant linked, dominant unrelated

Moderate Diversification – When all business share product, technology linkages and less than 70% of the revenue comes from the dominant business.

High Diversification – With limited linkages between various business, less than 70 percent of revenue comes from dominant business.

Very High Diversification – When the firm adopts unrelated diversification strategy and none of the business have interlinkages. The firm could choose either multi business or unrelated portfolio.

8.   Diversification Decisions

The decision whether to diversify or not to diversify largely depends on the following two major issues

Is the existing industry less attractive as compared to the new industry where the firm intends to enter?

Will the firm able to establish competitive advantage in the new industry where the firm intends to enter?

As the superior profit derives from the two sources – industry attractiveness and competitive advantage, it is important for any firm to find answers to these questions before making decision to diversify. Diversification decisions include the scope of the industries and markets in which the firm competes. In addition to this it is also important to understand how managers buy, create and sell different businesses to match skills and strengths. In other words, we say that the diversification decision has to pass through three tests

The industry-attractiveness test The cost-of-entry test

The better-off test

There are various drivers of diversification including exploiting economies of scope, stretching corporate management competencies, exploiting superior internal processes and increasing market power.

9. Mode of Diversification

The following are the mode of diversification

Internal Development – Also known as Corporate venturing, under this strategy the firm always goes for organic growth model by investing its own resources for building up new business.

Acquisition – Under this mode as discussed in previous module, the firm acquires an existing established business and enters into new business.

Joint Venture – Under this mode, the firm enters into an alliance with the partner and both share each other expertise to enter into new business.

Licensing – It is a strategy for technology transfer wherein two firms enter into contractual arrangement whereby the licensor (selling firm) allows the use of its technology, patents, designs, processes etc. The sharing of its tangible and intangible assets is done for a fee or royalty.

10. Summary

Diversification is a growth strategy in which a firm decides to enter into new markets with new products. While making diversification decision, the firm should look carefully look into the attractiveness of the new industry and also the cost of entering the new industry. There are various drivers of diversification including exploiting economies of scope, stretching corporate management competencies, exploiting superior internal processes and increasing market power. There are numerous benefits of diversification including reduction of risk, increasing shareholder value, build corporate brand equity and get access to capital markets. While there are numerous benefits of diversification strategy, a firm should be careful while making diversification decisions because of the risk factors involved in it. Some of the risk factors include reduced innovation, lack of expertise, information overload and risk of making inferior investments. We discussed about various types of diversification which included related diversification, unrelated diversification, concentric diversification, horizontal diversification and conglomerate diversification. Each of these strategic alternatives has relative merits and demerits. The firm also has to decide the level of diversification which can vary from low diversification to very high diversification. Once the firm decides to diversify it can choose any one of the mode of diversification including internal development, acquisition, joint venture and licensing.