Diversification Strategy: Need, Types and Risks

“Growth without diversification, technological improvement, and increased productivity is easily reversed: all it takes is a dip in commodity prices.”

- Arancha Gonzalez

 

Ignor Ansoff, a mathematician and a business manager came up with 4 different growth strategies for businesses. These were top level or corporate level strategies and one of them was Diversification Strategy.

 

Diversification strategy involved introducing new products in new markets. But the main question was- Is it an ideal strategy? Is it reliable and worth formulating? In this blog, we will get answers to all such questions as we will learn in detail about the Diversification Strategy.

 

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What is a Diversification Strategy and Why is it Needed?

 

Think about starting a new business, it can be daunting to think about the whole process as it is very complex. The first step is investing money and if you are investing in a risky idea then chances of losing your money are damn high.

 

What can you do to make your current business more profitable, known and famous? The answer is simple- Diversify it. Investors will be attracted to your business. Experienced companies often diversify themself to stay strong. 

 

If one unit is making a loss then the other one will cover it. Simple. But it is not as easy as it sounds. Let us understand the meaning of Diversification Strategy first. Just as the name suggests a Diversification Strategy is related to diversifying, expanding and growing. In business, this strategy is followed to expand and grow the business. 

 

It is a simple process in which a business enters new industries which are different from the company's current core activities. The main goal is to sell new products and capture new markets to make new customers. Obviously, entering new markets will change the focus area of companies but many times this strategy has proven to be a survival mode for industries. 

 

The definition merely states what is diversification, but it does not explain the need and why companies do it. The main aim of business is profit making and Diversification is a good way to increase the overall profitability of the firm. 

 

By entering the markets you have not explored till now you get the benefit of either the first mover or a chance to make new customers. You can introduce new products and features that people have not seen before and this appeal will attract them to you. 

 

Once you have successfully captured the market and appealed, you can increase your sales by lifting the prices. This will give you more profit margins. Apart from profit making there are other reasons for diversifying as well. 

 

Like, companies can improve their brand value and goodwill by adding new products and making more customers. Sometimes the industry downturn can create havoc, to minimize such risk diversification is a good option. 

 

Not only this but through diversification, companies can beat the competition i.e. they get a competitive advantage and diversification acts as a defense mechanism. Here are some examples of Diversification Strategy to understand it better.

 

1. General Electric, popularly called GE. It was primarily an electric goods company. But with time it acquired and got into aeronautics, gas, power, rail and even kitchen related appliances.

 

2. Apple is another company that has gained so much advantage through diversification. They expanded from computers and started making iPods. 

 

Because of this horizontal expansion a link was made between the products and the products complimented each other. Now we have Apple iPhones in the market as well. 

 

3. Disney has also used diversification to enter theme parks from their initial service of movies, animation and Tv. Disney has successfully used its TV cartoons and figures and commercialized them and made them a center of attraction in their theme parks. 

 

Apart from theme parks, you can buy their merchandise and products and even tech related products like watches etc.

 

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Types of Diversification Strategies

 

There are multiple types of Diversification Strategies. These include :

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Types of Diversification Strategies

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1. Concentric Diversification

 

Concentric Diversification can be said as a type of Horizontal Diversification. The reason being that in this also we add new products, services or both in the market which are similar or closely related to the current product or the service line of the business. 

 

In short, you do not enter new markets but develop a larger market share in the existing market. With the help of Concentric Diversification you can increase:

 

• Brand Image
• Brand Recognition
• Customer Base
• Customer Loyalty
• Distribution channels and Logistics
• Resources

 

The main aim of this strategy is to increase the revenue or generate additional revenue from your current customers. It does not mean that you don’t make new customers, in fact it is the opposite. 

 

While dealing with current customers you make additional customers from the existing markets. New products and services will appeal to new customers in case your old one’s were not effective enough.

 

Examples of Concentric Diversification include- Apple, Samsung. They both sold smartphones but now they are selling smart watches too and capturing a larger audience. Likewise, If a paper manufacturing company starts selling notebooks and diaries it will be counted as a Concentric Diversification Strategy 

 

2. Horizontal Diversification

 

Horizontally diversifying your business means introducing and adding newer products in your existing market. It is done to increase the market share of the company. 

 

Sometimes, companies do not wish to enter a new market because of risks or technology. So they add new features to current products or introduce brand new services/goods to attract a larger audience in the present markets. 

 

Horizontal Diversification can be done in 2 ways. One is innovation and second is Merging or acquiring a new business. In some cases you will find that Concentric and Conglomerate Diversifications are a part of Horizontal Diversification. 

 

Examples of Horizontal Diversification are- Disney which acquired Pixar and Facebook which acquired Whatsapp.

 

3. Vertical Diversification

 

Vertical Integration is another name of Vertical Diversification Strategy. In this the business expands by entering the markets through backward and forward integration. 

 

It means that in the present supply chain, business will diversify and merge with the activities of its suppliers as well as its distributors. Examples of backward integration are:

 

• Companies selling cars can start selling tires as well.
• Painting companies can start selling paints.

 

The main focus area in backward integration is to make the inputs of a company its output. Whereas, Example of forward integration is: Toy company buying a toy store. The main focus area in forward integration is to make use of the end portions of the supply chain into profitable business activities.

 

Vertical Diversification can be useful because it enhances and improves the supply chain of the business. It also helps to minimize the cost of production. Real life examples of Vertical Diversification include-

 

Ikea which invested in buying forests for its own raw material supply as well as Amazon which started making Kindle by investing into hardware.

 

4. Conglomerate Diversification

 

Often included as a type of Horizontal Diversification, Conglomerate Diversification means adding new products and services into the markets that have no relation to the core activities of industry. 

 

It involves exploring and entering new markets with new products and making new customers. It is like starting from scratch because new customers have no interest in the present product or service line of the company before. 

 

There are two main reasons for pursuing a Conglomerate Diversification. One is high returns on investment and growth options. Examples of Conglomerate Diversification are-

 

• Clothing industry entering into home decor.
• Toy industry makes smartphones.

 

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Risks Involved in a Diversification Strategy

 

“Diversification is an established tenet of conservative investment.”

- Benjamin Graham

 

By now it is clear that Diversification Strategy involves either of the three:

 

• Product Diversification

 

• Entering new Markets

 

• Expanding in the same industry

 

Diversification is carried at different levels depending upon the type of industry. It is often said that- Diversification Strategy is a corporate level strategy. It is because of the tough investment and implementation decisions involved.

 

Diversification Strategy is worth implementing but at the same time is both complex and risky. Following are the risks involved in a diversification strategy:

 

1. Sometimes when firms diversify, they adopt an entirely new method of production. Such changes mean new skills are needed which are totally different from what the company did before. 

 

Such changes can demotivate the staff and managers and it can create a threat to the present skills of the workers. 

 

2. Sometimes the overall cost of a diversification is so high, that it is impossible for the company to diversify. In short, entry into new markets and making the new product require a lot more cost than anticipated.

 

3. It also includes a decision risk. Choosing the type of diversification is a big task. If done wrong, the whole business will be impacted with the wrong choice.

 

4. It includes implementation risks. Creating a structure, organizing the activities, carrying out the processes and hiring the best and talented workers everything can become a tedious process.

 

5. It also included Financial risks. Once you decide to diversify, the shareholding patterns will also change and the stakeholders might lose some of the portions.

 

6. The parent company has to take licenses, approvals, and permissions before making a new product. They also have to act ethically and ensure all the government guidelines and standards are properly followed.

 

7. Each business after diversification will need a separate workforce as per the required skill set and also a separate board for management.

 

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Diversification Strategy is one of the ways in which you can grow your business. If done right, you get so many options through which you can expand your business and create a strong foothold in the markets. You can become one of the best players and a strong competitor for others in the market.

 

If done wrong, it can be the worst decision and become a very costly mistake. Therefore, analyzing the pros and cons and deciding upon the type of diversification is a crucial point before implementing the strategy.