WHEN DIVERSIFICATION BECOMES THE BUSINESS OPTION
Diversification is the process of entering new business markets with new products. Such efforts may be undertaken either through acquisitions or through extension of the company’s existing capabilities and resources. The diversification process is an essential component in the long range growth and success of most thriving companies, for it reflects the fundamental reality of changing consumer tastes and evolving business opportunity.
But the act of diversification requires significant outlays of time and resources, making it a process that can make or break a company. Business owners, then, should carefully study diversification options – and their own fundamental strengths – before proceeding. Analysts of diversification generally break such efforts down into two categories:
- Related or concentric diversification.
- Unrelated or conglomerate diversification.
In related diversification, there is evident potential synergy between the new business and the core one, based on a common facility, asset, channel, skill, even opportunity. However, no matter how it bases, every related diversification is also fundamentally an unrelated one, as many diversification organizations have discovered to their regret. That is, no matter what is common between two different businesses, many other things are not.
Diversification Through Acquisition and Expansion
Companies diversify either by acquiring already existing businesses or by expanding their business into new markets and new areas of production or service. Acquisition is generally used more frequently by big companies than smaller ones, since most acquisitions require a degree of financial leverage and health that only larger firms can bring to bear.
Indeed as organizations grow large, they become inclined to diversify and then to divisionalize. One reason is protection. Large organizations tend to be risk averse – they have too much to lose – and diversification spreads the risk. Another is that as firms grow large, they come to dominate their traditional market, and so must often find growth opportunities elsewhere through diversification.
Moreover, diversification feeds on itself. It creates a cadre of aggressive general managers, each running his or her own division, who push for more diversification and further growth. Thus most of the giant corporations, not only were able to reach their status by diversifying but also feel great pressures to continue doing so.
Diversification through acquisition has its detractors. Acquisition has been criticized as sometimes stifling innovation. A company deploys its resources to take over an existing business rather than to pursue innovation. But acquisition can actually liberate creativity if executed for the right reasons.
If driven by visions of diversification, acquisition can be an innovative impetus for that company in pursuing new opportunities and moving in directions that might otherwise be blocked and which might have greater incremental potential than its existing business opportunities.
Diversification by expansion, on the other hand, is much more likely to be utilized by small-and mid-sized companies. This strategy typically requires smaller, though still significant, up-front financial obligations, and generally involves moving into a market or service/product with which the business already has at least some passing acquaintance.
Consider These Factors When Weighing Diversification
Although diversification into new markets and production areas can be an exciting and profitable step for business owners, however, they must look before they leap. Many factors should be considered before a company launches a course for diversification.
This is the most basic consideration of all. Business owners should undertake a comprehensive and clinical review of their present fiscal standing – and future prospects – before expanding a business into a new area.
Cost of Entry
This factor is closely linked to a business’s examination of its fundamental financial health. Diversification, whether through expansion or acquisition, typically requires financial outlays of significant size. Does your company have the means to meet those requirements while simultaneously keeping the existing business running smoothly?
Attractiveness of the Industry and/or Market
Analysts attach varying level importance to this factor. Obviously, diversification into an industry or market that is flagging, whether because of general economic conditions or local problems, can result in a significant loss of income and security. Some businesses attach little significance to this, relying instead on vague beliefs that the industry or market is a good fit with its existing operations, or that the industry or market is headed for an upturn.
Another common reason for ignoring the attractiveness test is low entry cost. Sometimes the buyer has an inside track or the owner is anxious to sell. Even if the price is actually low, however, a one-sort gain will not offset a perpetually poor business.
Finally, some businesses mistakenly interpret recent market or industry trends as indications of long term health.
When considering diversification, companies need to analyze the ways in which such a step could impact their current employee work forces. Are you counting on some of those employees to take on added duties with little or no change in their compensation? Will you ask any of your workers to relocate their families or their place of work as a consequence of your business expansion? Does your current workforce possess the skills and knowledge to handle the requirements of the new business, or will your company need to initiate a concerted effort to attract new employees? Business owners need to know the answers to such questions before diversifying.
Access to Distribution Channels
A company engaged in introducing a new product or service into the marketplace should first ensure that it will have adequate access to distribution channels within the targeted market. The more limited the wholesale or retail channels for a product are and the more existing competitors have these tied up, obviously the tougher entry into the industry will be.
Existing competitors may have ties with channels based on long relationships, high-quality service, or even exclusive relationships in which the channel is solely identified with a particular manufacturer. Sometimes this barrier to entry is so high that to surmount it a new firm must create an entirely new distribution channel.
Government regulatory policies at the local, state and national level can also have an impact on the diversification decision. For instance, a successful restaurateur may want to open a bar and grille in a certain area, only to learn that the city council has imposed an indefinite moratorium on granting liquor licenses in the area in question.
Government can limit or even foreclose entry into industries with such controls as licensing requirements and limits on access to new materials. Regulatory controls on air and water pollution standards and product safety and efficacy should also be weighed. Pollution control requirements can increase the capital needed for entry and the required technological sophistication and even the optimal scale of facilities.
Standards for product testing, common in industries like food and other health-related products, can impose substantial lead times, which not only raise the capital cost of entry but also give established firms ample notice of impending entry and sometimes full knowledge of the new competitor’s product with which to formulate retaliatory strategies. Many of these regulations, while enormously beneficial to society, can have a bearing on the ultimate wisdom of a diversification strategy.