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 diversifying requires significant outlays of time and resources, making it a process that can make or break a company. Small business owners, then, should carefully study diversification options—and their own fundamental strengths—before proceeding. "The range of success [of diversification efforts] varies considerably," observed the editors of the Complete MBA Companion. "The odds of success decline precipitously the further the firm strays from existing competencies."
Analysts of diversification generally break such efforts down into two categories: 1) related or concentric diversification, and 2) unrelated or conglomerate diversification. "In related diversification," wrote Henry Mintzberg and James Brian Quinn, authors of The Strategy Process: Concepts and Contexts, "there is evident potential synergy between the new business and the core one, based on a common facility, asset, channel, skill, even opportunity." But they also noted that "no matter what its bases, every related diversification is also fundamentally an unrelated one, as many diversifying organizations have discovered to their regret. That is, no matter what is common between two different businesses, many other things are not."
Companies diversify either by acquiring already existing businesses or by expanding their own businesses 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, Mintzberg and Quinn remarked that "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 further 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," noted the Complete MBA Companion. "A company deploys its resources to take over an existing business rather than to pursue innovation." But the editors contend that 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.
Although diversification into new markets and production areas can be an exciting and profitable step for small business owners, consultants caution them to "look before they leap." As entrepreneur Steven L. Marks remarked in Inc., when presented with opportunities to diversify, "we view them against our focus criteria: Is the idea consistent with our mission statement? Will it dilute our current efforts? How will it affect our operations?" Indeed, many factors should be considered before a small company launches a course of diversification:
FINANCIAL HEALTH 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 of 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. As Mintzberg and Quinn observed, though, 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 a low entry cost," they added. "Sometimes the buyer has an inside track or the owner is anxious to sell. Even if the price is actually low, however, a one-shot gain will not offset a perpetually poor business." Finally, some businesses mistakenly interpret recent market or industry trends as indications of long term health.
WORK FORCE RESOURCES 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 work force 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," wrote Michael E. Porter in Competitive Strategy: Techniques for Analyzing Industries and Competitors. "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."
REGULATORY ISSUES Governmental regulatory policies at the local, state, and national level can also have an impact on the diversification decision. For instance, a successful restauranteur 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 raw materials," confirmed Porter, who added that regulatory controls on air and water pollution standards and product safety and efficacy should also be weighed. "For example, 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.
Amihud, Yakov, and Baruch Lev. "Does Corporate Ownership Structure Affects Its Strategy Toward Diversification?" Strategic Management Journal. November 1999.
Byrd, John, Kent Hickman, and Hugh Hunter. "Diversification: A Broader Perspective." Business Horizons. March-April 1997.
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McCallum, John S. "Dusting Off Diversification." Business Quarterly. Spring 1997.
Mintzberg, Henry, and James Brian Quinn. The Strategy Process: Concepts and Contexts. Prentice-Hall, 1992.
Porter, Michael E. Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press, 1980.