Meaning of Diversification
Diversification is an act of an existing entity branching out into a new business opportunity. This corporate strategy enables the entity to enter into a new market segment which it does not already operate in. The decision to diversify can prove to be a challenging decision for the entity as it can lead to extraordinary rewards with risks.
Some very famous success stories of diversification are General Electric and Disney. However, the entry of Quaker oats into the fruit juice business, Snapple lead to a very costly failure.
After knowing the meaning, we’ll see the reasons why companies opt for the same.
Why Do Companies Diversify?
The following are the reasons why firms opt for diversification:
- For growth in business operations
- To ensure maximum utilization of the existing resources and capabilities
- To escape from unattractive industry environments
On gaining knowledge on the concept of diversification, let’s have a look at the advantages and disadvantages of the same.
Advantages Of Diversification
The following are the advantages of diversification:
- As the economy changes, the spending patterns of the people change. Diversifying into a number of industries or product line can help create a balance for the entity during these ups and downs.
- There will always be unpleasant surprises within a single investment. Being diversified can help in balancing such surprises.
- It helps to maximize the use of potentially underutilized resources.
- Certain industries may fall down for a specific time frame owing to economic factors. Diversification provides movement away from activities which may be declining.
Disadvantages Of Diversification
The following are the disadvantages of diversification:
- Entities entirely involved in profit-making segments will enjoy profit maximization. However, a diversified entity will lose out due to having limited investment in the specific segment. Therefore, it limits the growth opportunities for an entity.
- Diversifying into a new market segment will demand new skill sets. Lack of expertise in the new field can prove to be a setback for the entity.
- A mismanaged diversification or excessive ambition can lead to a company over expanding into too many new directions at the same time. In such a case, all old and new sectors of the entity will suffer due to insufficient resources and lack of attention.
- A widely diversified company will not be able to respond quickly to market changes. The focus on the operations will be limited, thereby limiting the innovation within the entity.
On understanding the advantages and disadvantages, we’ll see the types of diversification strategies.
Types Of Diversification Strategies
The following are the types of diversification strategies:
This strategy refers to an entity offering new services or developing new products that appeal to the firm’s current customer base. For example, a dairy company producing cheese adds a new variety of cheese to its product line.
This form takes place when a company goes back to the previous or next stage of its production cycle. For example, a company involved in the reconstruction of houses starts selling construction materials and paints. It may be forward integration or backward integration.
In a concentric diversification strategy, the entity introduces new products with an aim to fully utilize the potential of the prevailing technologies and marketing system. For example, a bakery making bread starts producing biscuits.
In this form, an entity launches new products or services that have no relation to the current products or distribution channels. A firm may adopt this strategy to appeal to an all-new group of customers. The high growth scope and return on investment in a new market segment may prompt a company to take this option.
Decision Making: Whether to Diversify or not.
For the purpose of decision making, we can adopt the technique of capital budgeting along with CAPM (Capital Asset Pricing Model). For that, first of all, we should project the cash flows for the new line of business. These cash flows should be discounted with the risk-adjusted discounting rate. In order to find risk-adjusted discounting rate, we have to take help of proxy firm. Proxy firm means a company already dealing in that new line of business.
A diversification must be a well thought out step for an entity. It can boost the growth of the firm thereby leading it towards wealth maximization. However, it can also prove to be a costly failure for certain entities. A detailed analysis of the potential market must be conducted before opting for diversification.