Reducing Business Risk and Expanding Market Size

Diversification - Reducing Business Risk and Expanding Market Size

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Building strength from diversity.

For many people, diversification is about growing revenue.

Almost every day, when times are good, there seems to be news about one company buying another.

Some of the most recognizable organizations in the world – like GE, Honeywell, and Siemens – operate a collection of diversified businesses across many industries and in many different countries.

For other people, diversification is about reducing risk. Investors diversify their portfolios so that losses in one sector won't necessarily mean financial disaster. And one of the reasons that farmers diversify their crops is to have different harvest times, which reduces the likelihood of a spell of bad weather destroying a year's work.

Corporations use diversification as a risk-reduction strategy, because it can make company profits less vulnerable to industry-specific changes. For example, when energy prices rise, the cost of many consumer goods increases. If your main business is in transportation/shipping then, following this thinking, your company may want to buy a company serving the oil industry – this could help to protect your overall profits.

But while diversification as a strategy can reduce risk, it can also introduce significant new risk, because it can take a corporation away from its core competences.

This article gives you an understanding of what diversification means, the different types of diversification, and why companies and investors diversify in the first place.

What Is Diversification?

Looked at from one perspective, diversification means bringing together a collection of investments or business units in such a way that overall losses are limited if a particular industry, area or business experiences hard times.

Looked at from another perspective, diversification refers to a company entering into a line of business that's outside the business area in which it currently operates.

Unfortunately, this can mean that the company moves into areas where it has limited expertise. This is usually a high-risk endeavor, and is therefore one that needs a great deal of care.

There are four main types of diversification:

1. Concentric Diversification

Here, the new business is strategically related to the existing lines of business, and the parent company can use its technologies and competencies to operate the new business effectively. For example, when Coca-Cola launched its bottled water, it used concentric diversification. However, even though the products use related technology, the marketing efforts are often different.

You can also use operational competence to achieve concentric diversification. If your company has an excellent sales and distribution system, for example, then adding new products is a good way of taking advantage of these existing competencies, and pursuing strategic growth.

It's important to remember that even if two businesses have many things in common, there may also be many things that are different, and that require new skills and knowledge to be developed if the new business is to be run effectively.

2. Horizontal Diversification

With this type of diversification, the new business provides a product or service that's unrelated to the parent, but has the same customer base. These are often considered parallel businesses.

Large supermarkets often use horizontal diversification very effectively when they provide not only groceries, but a wide range of household consumer goods, small appliances, clothing, banking services, phone services, and more. These companies have become very good at getting consumers into their stores, where they then sell them a diversified line of products.

3. Vertical Integration and Diversification

Here, entire business networks – from the purchasing of raw materials through to the selling of finished goods – can be linked within one parent company. Specific types of combined integration-diversification strategies include the following:

  • By-product diversification – The parent company sells by-products to other companies. A manufacturing plant that generates a large amount of plastic, metal, and cardboard waste may choose to enter the recycling business and sell these byproducts. They might then start a metal recycling facility, which in turn sells its products to companies needing recycled metal. These consumer companies may even include the parent manufacturing company. Any number of revenue streams and business can flow from the byproducts of an original organization.
  • Linked diversification – Businesses pursue the operating chain in any direction possible. Suppose that a toothpaste manufacturing company has an idea for a new way to package its product. They discover that no suppliers can build exactly what they want so they start a plastics company and supply themselves with what they need. To use the excess capacity of the plastics plant they start to produce other plastic products. Their need for an efficient flow of raw materials leads them to purchase a shipping company. Environmental pressures on the plastics industry leads to the creation of a research facility that develops new forms of plastic. Finally the company invests in a plastics recycling operation. All of this from toothpaste!

4. Conglomerate Diversification

With this type of diversification, the new business is completely unrelated to the parent, and the acquisition doesn't rely on any technological or other competence. The most common reasons for this strategy are to reduce risk, increase overall profits, access new capital or cash, attract new customers, or become a larger force in the capital markets.

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Many investors oppose corporate diversification, where this is done on grounds of risk. These people believe that investors – not corporations – are responsible for their own diversification, and that they can do that for themselves by investing across a variety of businesses and industries.

They argue that corporations should focus on maximizing shareholder value using their existing assets and core competences – i.e. they should "stick to their knitting". Moving away from core competencies is likely to lead to mistakes, unnecessarily risking shareholder return.

Key Points

Diversification can help you spread some of the risk in your current operations, but it has risks of its own.

It's a strategy that can be used very effectively to build large and highly profitable companies. However, many organizations have been harmed by diversifying without fully understanding the risks and consequences of diversification. Before you adopt a diversification strategy, make sure that you're absolutely clear about what you expect to gain from the strategy, and make an honest assessment of the risks.