The goal of every business is to grow and be productive. A particular point comes in the product and company’s life when the industry stops growing. The management expands their business into other areas. Diversification is also about expansion and growth.
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What is Diversification Strategy?
Diversification strategy is when a business or a company proceed with the growth and development and expand its business in different markets and product areas. In other words, it means letting your business enter into the new markets and creating a new product.
We can say that diversification is a growth and development strategy of your business by exploring new possibilities. When you follow this strategy, you diversify the product portfolio and increase the horizon of your business. Most importantly, it helps the company to amplify sales and profitability.
Igor Ansoff developed the market/product matrix for the growth strategy. The matrix comprises four parts; market development, product development, diversification, and market penetration. Ansoff said that the diversification strategy is entirely different from the other matrix strategies. It’s because all three methods deal with utilizing the resources of the original product. Diversification strategy is all about developing new features, techniques, and skills.
Why Do Companies Diversify?
Businesses and companies follow the diversification strategy for three significant reasons. They are as follows;
Expand business growth
One of the primary reasons companies follow the diversification strategy is to expand their business’s growth rate. The investors have made up their mind that bigger is better. They want a high growth rate, whether in terms of productivity, sales, or revenue. All of these growth factors act as performance measurement tools for outsiders and investors.
Maximum Utilization of Resources
When it comes to launching something new into the market, businesses have to utilize all the available resources. The equipment and material they haven’t used for years will have to use all of these resources to develop something new.
To find Attractive Industries
When companies develop something new and launch it in the market, it’s also one of their goals to attract the attention of other relevant businesses and customers. It helps them to increase the chances of mergers and acquisitions.
Levels of Diversification
Low Levels of Diversification
Low levels diversification has two sub-types; single business and dominant business. In a single company, 95% of the revenue/profit is from a single business. In the prevailing industry, 70% to 95% of the revenue is from the dominant company.
Moderate to High-Level Diversification
Moderate to high-level diversification has two sub-types; related constrained & related linked. In case of a related constrained, if all the businesses share technological, product, and distribution linkage, then the revenue is lower than 70% from the dominant companies.
In related links, the links among business are limited, and then the revenue is lower than 70% from the dominant companies.
Very High Level of Diversification
In unrelated links, the links between businesses aren’t familiar, and the revenue is lower than 70% from the dominant companies.
Types of Diversification Strategies with Examples
Some of the main types of diversifications strategies are as follows;
Concentric diversification is when a business introduces a new product into the new market. The product is similar to its current offer. But the company manages to get a competitive advantage by using the manufacturing process, technology advantage, and industry experience.
Concentric diversification is beneficial if your business’s sale is decreasing, and you can cover the loss by increasing the sale of other products.
A computer manufacturing company has expanded from the production of desktop computers to laptops. It would help the company to exploit the new trending laptop user market.
Conglomerate diversification is when a company introduces an entirely new product and enters into the new market by targeting new customers market. The term conglomerate means a corporate group is managing various businesses in different categories. The parent company of all the sub-brands is a conglomerate. The conglomeration is a very successful diversification strategy.
Tata Group started as hotel industry, and it diversified its business into a conglomerate. Currently, the Tata Group conglomerate comprises more than 100 companies in various categories like consumer products, information systems, telecommunication, engineering, automobiles, steel, and chemicals.
Horizontal diversification is when a business introduces different and unrelated products/services. The goal of launching the related product is to satisfy the needs of customers. It involves a limited amount of risk because you’re dealing with the same customer market.
For instance, you’re running a paper sale company, and you launch a new and different product, printers. It would attract the attention of potential customers.
Vertical integration or vertical diversification is when a business integrates two or more production processes by moving up/down the supply chain. The company takes control over some of the core production, distribution, raw material, and assembly line processes.
You own a retail store, and you expand/diversify your business by buying your products’ production facility that you’re selling. It helps you to decrease many variable costs. The flaw of vertical integration is that your business loses the flexibility of using horizontal integration.
Internal diversification is when a business launches its current/existing product into the new market. The goal is to increase the customer market by expanding the geographic borders. Companies do it by locating the new users of their existing products/services.
Internal diversification is also about introducing a new product to the current market. Businesses use their existing distribution channel to launch a new product.
Johnson & Johnson launched toys for children to its existing infant market.
Fast-food companies have started offering the low calories and salt-free food items to the current product line.
External diversification is when a business launches a new product/service by going out of its current business operations. A merger is also a form of external diversification when two companies integrate their business operations to create something new. The merging companies usually comprise of a similar size.
The acquisition is also the second form and type of external diversification where one company buys another. The acquired company loses its identity and completely absorbs the buyer company.
Porter’s Three Tests for Diversification
Michael Porter offers three tests that the companies should perform to check whether their diversification would become successful or not. The Michael Porters’ three tests for diversification are as follows;
The purpose of an attractive test is to check the appeal and attractiveness of the latest market before entering it. However, it’s essential to answer this question because diversification incurs costs to add some value. The market diversification should generate enough revenue to cover the expenses. Here are some of the points of an attractive Test;
- You shouldn’t check the attractiveness during the peak season of growth.
- What benefits you’ll get earlier on by entering into the market in the lifecycle of the product.
- It should have a long term growth potential for your business.
- The attractiveness doesn’t mean entering into the market at a lower cost.
- The attractiveness also doesn’t mean that there should be a similarity between your business and the market.
Cost Entry Test
As the name implies, the cost entry test analyzes the cost and profitability of entering the new market. If it’s not profitable and the price is higher, you should avoid entering the market.
You have to conduct thorough research about the latest market and gather all the relevant costs and data. You should consider studying the competitors that have already done the scaling up and checking how much resources you have to consume to complete them. Here are some points you should keep in mind while performing the cost entry test;
- Instead of launching a new product/service, you should consider buying an already established business.
- You should utilize tools like Five Forces to comprehend the ups and downs of the market.
- Make sure that you’re analyzing the activity of your competitors on LinkedIn.
Better Off Test
Better off Test would help you check whether the new company would get a competitive edge by diversification. If the company wants to pass the test, then the acquired company, existing business, or the new unit should have a tangible benefit.
The benefit could be in the form of success in the long term, access to the distribution or market channels, and more capabilities. Here are some points you should keep in mind while performing the better off Test;
- The benefits should be consistent and gradual rather than a one-time payment.
- You should check every faction of your business and analyze its capacity for diversification.
- Make sure that you acquire the right set of skills to achieve diversification.
- You should evaluate the diversification test to check whether you’ve achieved all the benefits or not.
Advantages of Diversification Strategy
More Revenue & Sale
The most apparent advantage of diversification strategy is that businesses want to increase their revenue and sale. Primarily if the company has gathered enough customer shares, there would be little room left for improvement.
When the company enters into the new market and launches a new product, it provides the company an opportunity to expand its business growth and brand recognition.
Small businesses and companies usually have limited clients and sources of revenue. It makes them vulnerable to the country’s economic condition. The diversification strategy allows them to reduce the risk factors and expand the company’s profitability.
Disadvantages of Diversification Strategy
If your company has limited resources and the customer wants a new product. If you start developing the latest product and the current one, your workforce’s performance will fall because they aren’t accustomed to multitasking. when you take the debt to fund the diversification, it will increase the cost.
With the availability of limited resources, the supply chain of your business won’t bear the burden. Therefore, you should consider the impact of diversification on various departments of your company before implementing.
If a company doesn’t diversify carefully, then it would result in the form of extra delays of resources. Every department of the company needs timely availability of resources to run various operations. If they don’t receive it on time, their productivity will decrease. It usually happens when the management becomes over-excited and starts expanding in a different direction by avoiding resources’ availability.
The innovation usually comes from the small businesses that are highly focused on technology. If small companies diversify into different areas, they will lose focus on innovation and creativity. With technology innovation, they won’t have any competitive edge, and that would decrease their growth.
Examples of Diversification
General Electric has a long history of diversification, and the company started its business in 1892. Today, it’s the world’s largest multi-billionaire company. It ranks at the 26th position of the US top companies. GE diversified its product portfolio into various industries like healthcare, aviation, oil and gas, transportation, water, power, and many others. In other words, we can say that General Electric is the world’s lead diversifying company.
CAT used to be the Ring Power Company in Florida. The company’s construction equipment and other products were top-rated among the users of its target. The brand started diversifying its product portfolio in 1862 and offering products to the entertainment industry, government contracting, pipeline, marine, demolition, and agriculture.
Hubspot started as a small Software Solution Company, and its target market was small businesses comprising ten employees. The clients of Hubspot require the company to manage their customers and content. The publicity of the Software Company started growing.
Hubspot exploited its publicity and diversified its business, and started offering services to the enterprises. The company’s profitability increased from 255,000 dollars in 2007 to 15.6 million dollars in 2010. The Software Solution Company went public in 2014; it raised 125 million dollars, and the company’s market value reached 880 million dollars.