DIVERSIFICATION STRATEGY
DIVERSIFICATION
STRATEGY
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.
1. 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.
2. 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).
3. 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.
4. 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.
5. 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.
6. 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.
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