A diversification strategy is the strategy that an organization adopts for the development of its business. This strategy involves widening the scope of the organization across different products and market sectors. The strategy is to enter into a new market or industry which the organization is not currently in, whilst also creating a new product for the new market.
Diversification strategy is a form of growth strategy which helps the organizational business to grow. It opens up new possibilities for the organization. By adopting this strategy, the organization not only diversifies its products offerings in the target markets but also expands its business horizons. The strategy helps the organization to increase sales volume and revenues while keeping costs to minimum.
Diversification is part of the four main growth strategies defined by Igor Ansoff’s Product/Market matrix (Fig 1). The other three strategies in this matrix are market penetration, product development, and market development. Ansoff pointed out that a diversification strategy stands apart from the other three strategies. These other three strategies are usually pursued with the same technical, financial, and merchandising resources used for the original product line, whereas diversification usually requires an organization to acquire new skills, new techniques and new facilities.
Fig 1 Igor Ansoff’s Product/Market matrix
Growth strategies adopted through diversification involve a significant increase in performance objectives 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 that ‘bigger is better’. Growth in sales is often used as a measure of performance based on the assumption that if sales increase, profits will eventually follow.
Diversion strategy is associated with higher risks as it requires the organization to take on new experience and knowledge outside its existing markets and products. The organization may come across issues that it has never faced before. It may need additional investment or skills. On the other hand, however, it provides the opportunities to explore new avenues of business. This can spread the risk allowing the organization to move into new and potentially profitable areas of operation. Enterprise’s values help to define what the organization stands for. They also identify its capabilities and competencies. Its core values of ‘brand, honesty, service, fun, hard work, listening, inclusion and community’ are transferable. This means that the skills from the main business can be applied to other business opportunities through diversification, potentially reducing the risks associated with this strategy.
A product diversification strategy is a form of business development. Organizations that implement the strategy can diversify their product range by modifying existing products or adding new products to the range. The strategy provides opportunities for the organization to grow the business by increasing sales to existing customers or entering new markets.
Organizations diversify for a number of reasons. Perhaps the most basic of these is survival. By definition, an organization that focuses on a narrow range of products will only have access to a finite number of customers. That is fine if the market as it stands is big enough to support several competing organizations, but if the pool of customers is small, the cost of running the organization may outstrip the potential for revenue. In these circumstances, diversification into new product lines becomes essential to the long term viability of the organization.
But diversification is not just about survival. It is a well tried and trusted strategy for growth. New products or business lines enable the organization to make more sales to existing and new customers and expand into markets that would otherwise have been closed to the organization.
In the present scenario of dynamic markets and strong competition, a successful instrument of risk management is to avoid focusing on a single product, service and/or their distribution to a single limited market. When implemented wisely diversification strategy contributes to keeping the organization stable even in hard times since the economic downturn usually occurs simultaneously in all sectors and all markets.
Diversification of business activities brings competitive advantages allowing the organization to reduce business risks. That is why it is an excellent tool for business development. However, its successful implementation requires profound knowledge and thorough preliminary assessment of the environment by the organization. Also sometimes diversification is inevitable though difficult to adopt, when the original markets become unviable for the organization.
Diversification is a strategic approach that adopts different forms. Diversification can be classified into the following types depending on the applied criteria as well as the direction of the diversification.
Organizations carry out concentric diversification through enlarging the production portfolio by adding new products with the aim of fully utilizing the potential of the existing technologies and marketing system. It occurs when the organization adds related products or markets. The goal of such diversification is to achieve strategic fit. Strategic fit allows the organization to achieve synergy. In essence, synergy is the ability of two or more parts of the organization to achieve greater total effectiveness together than would be experienced if the efforts of the independent parts were summed.
Synergy may also be achieved by combining different organizations with complementary marketing, financial, operating, or management efforts.
Financial synergy can be obtained by combining an organization with strong financial resources but limited growth opportunities with an organization having great market potential but weak financial resources.
Strategic fit in operations can result in synergy by the combination of operating units of an organization to improve overall efficiency. Combining two units improve overall efficiency since the duplicate equipment or parallel work on research and development are eliminated. Concentric diversification can be a lot more financially efficient as a strategy, since the business may benefit from the synergies in this diversification model. It may enforce some investments related to modernizing or upgrading the existing processes or systems.
It is also known as heterogeneous diversification. It relates to moving to new products or services that have no technological or commercial relation with current products, equipment, distribution channels, but which may appeal to new groups of customers. The major motive behind this kind of diversification is the high return on investments in the new industry. Furthermore, the decision to go for this kind of diversification can lead to additional opportunities indirectly related to further developing the main business of the organization such as access to new technologies, opportunities for strategic partnerships, etc
In this type of diversification, synergy can result through the application of management expertise or financial resources, but the primary purpose of conglomerate diversification is improved profitability of the organization. In this type of diversification there is little or no concern that is given to achieve marketing or production synergy.
One of the most common reasons for pursuing a conglomerate diversification strategy is that opportunities in the organizational current line of business are limited. Finding an attractive investment opportunity requires the organization to consider alternatives in other types of business.
Organizations may also pursue a conglomerate diversification strategy as a means of increasing the growth rate. Growth in sales can make the organization more attractive to investors.
The disadvantage of a conglomerate diversification strategy is the increase in administrative problems associated with operating unrelated businesses.
Horizontal integration occurs when an organization enters a new business (either related or unrelated) at the same stage of production as its current operations. It involves acquiring or developing new products or offering new services that could appeal to the organization´s current customer groups. In this case the organization relies on sales and technological relations to the existing product lines.
Horizontal diversification is desirable if the present customers are loyal to the current products and if the new products have a good quality and are well promoted and priced. Moreover, the new products are marketed to the same economic environment as the existing products, which may lead to rigidity or instability.
Vertical diversification occurs when an organization goes back to previous stages of its production cycle (backward integration) or moves forward to subsequent stages of the same cycle (forward integration). This means that the organization goes into production of raw materials, distribution of its products, or further processing of the present end product.
Backward integration allows the diversifying organization to exercise more control over the quality of the supplies being purchased. Backward integration can be undertaken to provide a more dependable source of needed raw materials. Forward integration allows the organization to assure itself of an outlet for its products. Forward integration also allows the organization better control over how its products are sold and serviced. Furthermore, the organization may be better able to differentiate its products from those of its competitors by forward integration.
Corporate diversification involves production of unrelated but definitely profitable goods. It is often tied to large investments where there may also be high returns.
One form of internal diversification is to market existing products in new markets. An organization may elect to broaden its geographic base to include new customers. The organization can also pursue an internal diversification strategy by finding new users for its current product.
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
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.
External diversification occurs when an organization 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 organizations combine operations. These organizations 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 organization loses its identity. The acquiring organization absorbs it. The acquired organization and its assets may be absorbed into an existing business unit or remain intact as an independent subsidiary within the parent organization. Acquisitions usually occur when a larger organization takes over a smaller organization.
Rationale for diversification
According to Calori and Harvatopoulos, there are two dimensions of rationale for diversification. The first one relates to the nature of the strategic objective: Diversification may be defensive or offensive.
Defensive reasons may be spreading the risk of market contraction, or being forced to diversify when current product or current market orientation seems to provide no further opportunities for growth. Offensive reasons may be conquering new positions, taking opportunities that promise greater profitability than expansion opportunities, or using retained cash that exceeds total expansion needs.
The second dimension involves the expected outcomes of diversification: Management may expect great economic value (growth, profitability) or first and foremost great coherence with their current activities (exploitation of know-how, more efficient use of available resources and capacities). In addition, organizations may also explore diversification just to get a valuable comparison between this strategy and expansion.