Diversification Strategy

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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.

SEE ALSO: Strategic Planning Failure; Strategy Formulation; Strategy Implementation;

Strategy in the Global Environment

Joe G. Thomas

Revised by Wendy H. Mason

FURTHER READING:

Amit, R., and J. Livnat. "A Concept of Conglomerate Diversification." Academy of

Management Journal 28 (1988): 593–604.

Homburg, C., H. Krohmer, and J. Workman. "Strategic Consensus and Performance: The
Role of Strategy Type and Market-Related Dynamism." Strategic Management Journal 20,
339–358.

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): 452–
469.

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, 83–90.

St. John, C., and J. Harrison, "Manufacturing-Based Relatedness, Synergy, and

Coordination." Strategic Management Journal 20 (1999): 129–145.