Different Types Of Diversification
There ae a number of different types of diversification, the main goals being to reduce risk, increase revenue, access new markets, and utilise competencies across different business units. There are four main types of diversification: concentric, horizontal, vertical, and conglomerate. Each has its own rationale and associated risks and rewards.
Concentric diversification involves expanding into product and service offerings that are closely related to the company’s current offerings. For example, a soft drink manufacturer launching a bottled water brand leverages similar production and distribution capabilities. The key benefit is the ability to utilise existing competencies in the new business area. However, significant differences in marketing, competitive dynamics, and other factors can still make concentric diversification challenging. Simply having production similarities does not guarantee success in the new market.
Horizontal diversification refers to entering a new business area that serves the same customer base, but with an unrelated offering. Supermarkets providing an ever-expanding range of products from groceries to clothing demonstrate this strategy. It allows companies to leverage their existing customer relationships and distribution channels to cross-sell new products. However, it also requires developing expertise in very different product areas, which increases risk and complexity. Just because a customer shops at a store does not mean they will purchase unrelated products from the same retailer.
Vertical diversification includes forward and backward integration along the supply chain. For example, an automobile manufacturer may acquire a steel manufacturer to control inputs or a dealership network to control distribution. This can allow for lower costs, improved coordination, and greater differentiation. However, it also concentrates exposure within a single supply chain, loses benefits of specialisation, and requires learning very different businesses. Owning the entire chain is not always optimal.
Finally, conglomerate diversification involves expanding into completely unrelated businesses to spread and mitigate risk. Many investors actually oppose this level of diversification at the company level, as they can achieve diversification themselves across stocks. Conglomerates also rarely have any synergies across business units, instead operating largely as financial holding entities. There are few competencies to leverage, so the businesses must largely stand alone.
In considering diversification, companies must weigh carefully the risks and rewards. Expanding into unfamiliar areas introduces many new risks that could destabilise existing operations. Companies lose focus, spread themselves too thin, take on excessive debt, and find they have no particular advantage in the new market. Resources should play a role – are there sufficient financial, physical, and human resources to support diversification? Strong leadership and clarity around the rationale and execution plan are also critical. Setting expectations on costs, timeline, growth rates, and financial returns is important.
However, when done thoughtfully and strategically, diversification can substantially benefit companies and investors. It allows companies to expand revenue opportunities and mitigate reliance on any single product, market, or industry. Cyclical industries in particular may pursue diversification to smooth earnings over economic cycles. For investors, diversification reduces portfolio volatility and concentration risk. Overall, diversification tends to reduce risks more than maximise returns, as diversion from specialisation comes at a cost. Companies must find the right balance for their situation and objectives.
Diversification has been used successfully by many prominent corporations to grow profits while managing business risks. However, haphazard diversification without a strategic rationale or adequate commitment of resources is unlikely to pay off. Companies must carefully weigh costs and benefits as the strategy substantially increases complexity. With thoughtful planning and disciplined execution, diversification can meet objectives around risk management, revenue growth, market expansion and use of competencies. But it is not automatically the right choice for every company in every circumstance. Ultimately diversification must align with stated goals and be carefully shepherded to realise expected gains.
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