Business Strategic Assignment

Additional assignment on

Growth through Diversification

Submitted to Prof. G. Jaswal

Submitted by: Atul Sharma (501104006)

Growth Through Diversification

Diversification strategies are used to expand firms' operations by adding markets, products, services, or stages of production to the existing business. The purpose of diversification is to allow the company to enter lines of business that are different from current operations. When the new venture is strategically related to the existing lines of business, it is called concentric diversification. Conglomerate diversification occurs when there is no common thread of strategic fit or relationship between the new and old lines of business; the new and old businesses are unrelated.

Why Diversification?
The two principal objectives of diversification are 1. improving core process execution, and/or 2. enhancing a business unit's structural position. The fundamental role of diversification is for corporate managers to create value for stockholders in ways stockholders cannot do better for themselves1. The additional value is created through synergetic integration of a new business into the existing one thereby increasing its competitive advantage.

Forms and Means of Diversification

Diversification typically takes one of three forms: 1. Vertical integration along your value chain 2. Horizontal diversification moving into new industry 3. Geographical diversification open up new markets Means of achieving diversification include internal development,acquisitions, strategic alliances, and joint ventures. As each route has its own set of issues, benefits, and limitations, various forms and means of diversification can be mixed and matched to create a range of options.

Capitalizing on Core Competencies

Your company's core competencies things that you can do better than your competitors can often be extended to products or markets beyond those in which they were originally developed. Such extensions represent excellent opportunities for diversification. Any core competence that meets the following three requirements provides a viable basis for your corporation to create or strengthen a new strategic business unit (SBU) 1. The core competence must translate into a meaningfulcompetitive advantage. 2. The new business unit must have enough similarity to existing businesses to benefit from your corporation's core competencies. 3. The bundle of competencies should be difficult for competition to imitate.

How diversification may reduce risks

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As mentioned earlier, applying a diversification strategy involves conquering new markets and/or developing new products. A broader market helps to minimize risks considering for example cyclical fluctuations or, for farmers etc., weather bound conditions (Proctor). Related diversification can, in best case, lead to synergies when functions that are already developed within the company can be used of the new product as well and thereby increase cost efficiency. Related products can for example take advantage in using the same distribution channels, facilities, production processes, staff needs or in efforts in among other things sales and advertising or research and development. Also, if the company grows bigger, it might get more power and be more able to influence suppliers and so on. If the company uses related diversification there will most probably be a positive correlation of the profitability between the diversified parts of the company, which truly will increase revenue (Proctor).Unrelated diversification lacks these synergies, but, if successful, it tends to reduce fluctuations in cash flow. Also, for a corporation to rely on only one or a couple of product lines is united with large risks as the market fluctuates over time. Therefore, both related and unrelated diversification can be motivated as risk reducing factors. A corporation that uses unrelated diversification can in the best case get a negative correlation of the probability between the diversified parts in the corporation, which hopefully leads to increased stability (Grant). It is not clear whether the related or unrelated diversification reduces risk in the best way. With unrelated diversification you might get a negative correlation of the return but on the other hand it is harder to diversify into a new market where you cant use the knowledge and experience of the related market that is within the corporation (Grant).

Risks related to diversification

Even though the method of diversification can be used to decrease the dependence of the market fluctuations, a company that diversifies their business often exposes itself to other risks. There are many puzzle pieces that have to fall into place to get a diversification to be successful. One issue is that a corporation that diversifies might lose commitment to its core business, and a possibleconsequence is therefore that it harms the core business (Grant). Another risk is that the corporation will need new proficiency, new facilities and the organization may have to change rapidly in order to make a diversification successful. This risk is extra big when a corporation diversifies into new, unrelated markets. This means that corporations must have an initial capital that weigh up the startup costs that arise when they expand their business. If not, the diversification risks being a failure and the corporation might experience major losses (Grant). A risk of diversification into a related market is that expected synergies dont arise, which might lead to increased, unexpected costs. Another problem that can occur is that the brand reputation gets damaged. If for example a corporation that is associated with luxury products starts to sell lowbudget products, the luxury association might disappear (Grant). According to Does corporate diversification reduce firm risk?, a study made by Randy I Anderson, John D Stowe and Xuejing Xing, it is not clear that diversification reduces risk. The findings of their study was that diversification in many cases seemed to increase the risk, even though it sometimes worked successfully as a risk reducing method. The study showed that corporate diversification had different effects on risks in different firms, but that one cant say that it reduces risks in general. Some of the reasons for this are that it seldom is managers alone who have the power to determine diversification strategies; it often requires shareholders approval. Risk-increasing strategies are in general more preferred by shareholders, because it often takes risks to earn big (Xing). The companies that seemed to decrease their risks when diversifying were those who prediversification was high risk companies. One reasons for this is that diversification in

those cases leads to less fluctuation in cash flow but also that leaders of such companies in addition to the diversification implement other risk reducing actions (Xing). Findings show that diversification in companies associated with low growth opportunities and weak cash flow often leads to bad consequences (Chiu).

How to analyze the consequences of diversification

A way to investigate whether a diversification was successful or not from a risk reducing point of view, is to calculate the variation of the profits from a corporation before and after the diversification. Before a company decides to diversify it is reasonable to theoretically estimate what consequences it will have on the variance of the profit of the company. One way to do that is to estimate the correlation between the new business and the present. After that, one can estimate the expected variance of the present and new businesses. The variance formula for a sum of random variables can be used to estimate the risk reduction, which if the correlation isnt one gives that the risk will be reduced. The biggest risk associated with diversification lay in connection with the time of the diversification and the period after that. At the time of diversification money is invested and it takes some time before your diversified business can stand on its own, this is associated with great risks. So in a short period diversification is most likely to increase risk (variance), and those risks (variance) are difficult to estimate (Xing). When measuring the variance of the return (or log return) before and a time after the period using data you can see how the deviation changed. If the variance is lower after the diversification that might indicate that the diversification was successful, but it is important to remember that deviations of the returns might vary in time and there are several factors that affects this variance (Xing).

DIVERSIFICATION IN THE CONTEXT OF GROWTH STRATEGIES

Diversification is a form of growth strategy. Growth strategies involve a significant increase in performance objectives (usually sales or market share) beyond past levels of performance. Many organizations pursue one or more types of growth strategies. One of the primary reasons is the view held by many investors and executives that "bigger is better." Growth in sales is often used as a measure of performance. Even if profits remain stable or decline, an increase in sales satisfies many people. The assumption is often made that if sales increase, profits will eventually follow. Rewards for managers are usually greater when a firm is pursuing a growth strategy. Managers are often paid a commission based on sales. The higher the sales level, the larger the compensation received. Recognition and power also accrue to managers of growing companies. They are more frequently invited to speak to professional groups and are more often interviewed and written about by the press than are managers of companies with greater rates of return but slower rates of growth. Thus, growth companies also become better known and may be better able, to attract quality managers. Growth may also improve the effectiveness of the organization. Larger companies have a number of advantages over smaller firms operating in more limited markets.
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1. Large size or large market share can lead to economies of scale. Marketing or production synergies may result from more efficient use of sales calls, reduced travel time, reduced changeover time, and longer production runs. 2. Learning and experience curve effects may produce lower costs as the firm gains experience in producing and distributing its product or service. Experience and large size may also lead to improved layout, gains in labor efficiency, redesign of products or production processes, or larger and more qualified staff departments (e.g., marketing research or research and development). 3. Lower average unit costs may result from a firm's ability to spread administrative expenses and other overhead costs over a larger unit volume. The more capital intensive a business is, the more important its ability to spread costs across a large volume becomes. 4. Improved linkages with other stages of production can also result from large size. Better links with suppliers may be attained through large orders, which may produce lower costs (quantity discounts), improved delivery, or custom-made products that would be unaffordable for smaller operations. Links with distribution channels may lower costs by better location of warehouses, more efficient advertising, and shipping efficiencies. The size of the organization relative to its customers or suppliers influences its bargaining power and its ability to influence price and services provided. 5. Sharing of information between units of a large firm allows knowledge gained in one business unit to be applied to problems being experienced in another unit. Especially for companies relying heavily on technology, the reduction of R&D costs and the time needed to develop new technology may give larger firms an advantage over smaller, more specialized firms. The more similar the activities are among units, the easier the transfer of information becomes. 6. Taking advantage of geographic differences is possible for large firms. Especially for multinational firms, differences in wage rates, taxes, energy costs, shipping and freight charges, and trade restrictions influence the costs of business. A large firm can sometimes lower its cost of business by placing multiple plants in locations providing the lowest cost. Smaller firms with only one location must operate within the strengths and weaknesses of its single location.

CONCENTRIC DIVERSIFICATION
Concentric diversification occurs when a firm adds related products or markets. The goal of such diversification is to achieve strategic fit. Strategic fit allows an organization to achieve synergy. In essence, synergy is the ability of two or more parts of an organization to achieve greater total effectiveness together than would be experienced if the efforts of the independent parts were summed. Synergy may be achieved by combining firms with complementary marketing, financial, operating, or management efforts. Breweries have been able to achieve marketing synergy through national advertising and distribution. By combining a number of regional breweries into a national network, beer producers have been able to produce and sell more beer than had independent regional breweries.

Financial synergy may be obtained by combining a firm with strong financial resources but limited growth opportunities with a company having great market potential but weak financial resources. For example, debt-ridden companies may seek to acquire firms that are relatively debt-free to increase the lever-aged firm's borrowing capacity. Similarly, firms sometimes attempt to stabilize earnings by diversifying into businesses with different seasonal or cyclical sales patterns. Strategic fit in operations could result in synergy by the combination of operating units to improve overall efficiency. Combining two units so that duplicate equipment or research and development are eliminated would improve overall efficiency. Quantity discounts through combined ordering would be another possible way to achieve operating synergy. Yet another way to improve efficiency is to diversify into an area that can use by-products from existing operations. For example, breweries have been able to convert grain, a by-product of the fermentation process, into feed for livestock. Management synergy can be achieved when management experience and expertise is applied to different situations. Perhaps a manager's experience in working with unions in one company could be applied to labor management problems in another company. Caution must be exercised, however, in assuming that management experience is universally transferable. Situations that appear similar may require significantly different management strategies. Personality clashes and other situational differences may make management synergy difficult to achieve. Although managerial skills and experience can be transferred, individual managers may not be able to make the transfer effectively.

CONGLOMERATE DIVERSIFICATION
Conglomerate diversification occurs when a firm diversifies into areas that are unrelated to its current line of business. Synergy may result through the application of management expertise or financial resources, but the primary purpose of conglomerate diversification is improved profitability of the acquiring firm. Little, if any, concern is given to achieving marketing or production synergy with conglomerate diversification. One of the most common reasons for pursuing a conglomerate growth strategy is that opportunities in a firm's current line of business are limited. Finding an attractive investment opportunity requires the firm to consider alternatives in other types of business. Philip Morris's acquisition of Miller Brewing was a conglomerate move. Products, markets, and production technologies of the brewery were quite different from those required to produce cigarettes. Firms may also pursue a conglomerate diversification strategy as a means of increasing the firm's growth rate. As discussed earlier, growth in sales may make the company more attractive to investors. Growth may also increase the power and prestige of the firm's executives. Conglomerate growth may be effective if the new area has growth opportunities greater than those available in the existing line of business.

Probably the biggest disadvantage of a conglomerate diversification strategy is the increase in administrative problems associated with operating unrelated businesses. Managers from different divisions may have different backgrounds and may be unable to work together effectively. Competition between strategic business units for resources may entail shifting resources away from one division to another. Such a move may create rivalry and administrative problems between the units. Caution must also be exercised in entering businesses with seemingly promising opportunities, especially if the management team lacks experience or skill in the new line of business. Without some knowledge of the new industry, a firm may be unable to accurately evaluate the industry's potential. Even if the new business is initially successful, problems will eventually occur. Executives from the conglomerate will have to become involved in the operations of the new enterprise at some point. Without adequate experience or skills (Management Synergy) the new business may become a poor performer. Without some form of strategic fit, the combined performance of the individual units will probably not exceed the performance of the units operating independently. In fact, combined performance may deteriorate because of controls placed on the individual units by the parent conglomerate. Decision-making may become slower due to longer review periods and complicated reporting systems.

DIVERSIFICATION: GROW OR BUY?

Diversification efforts may be either internal or external. Internal diversification occurs when a firm enters a different, but usually related, line of business by developing the new line of business itself. Internal diversification frequently involves expanding a firm's product or market base. External diversification may achieve the same result; however, the company enters a new area of business by purchasing another company or business unit. Mergers and acquisitions are common forms of external diversification.

INTERNAL DIVERSIFICATION.
One form of internal diversification is to market existing products in new markets. A firm may elect to broaden its geographic base to include new customers, either within its home country or in international markets. A business could also pursue an internal diversification strategy by finding new users for its current product. For example, Arm & Hammer marketed its baking soda as a refrigerator deodorizer. Finally, firms may attempt to change markets by increasing or decreasing the price of products to make them appeal to consumers of different income levels. Another form of internal diversification is to market new products in existing markets. Generally this strategy involves using existing channels of distribution to market new products. Retailers often change product lines to include new items that appear to have good market potential. Johnson & Johnson added a line of baby toys to its existing line of items for infants. Packaged-food firms have added salt-free or low-calorie options to existing product lines.

It is also possible to have conglomerate growth through internal diversification. This strategy would entail marketing new and unrelated products to new markets. This strategy is the least used among the internal diversification strategies, as it is the most risky. It requires the company to enter a new market where it is not established. The firm is also developing and introducing a new product. Research and development costs, as well as advertising costs, will likely be higher than if existing products were marketed. In effect, the investment and the probability of failure are much greater when both the product and market are new.

EXTERNAL DIVERSIFICATION. External diversification occurs when a firm looks outside of its current operations and
buys access to new products or markets. Mergers are one common form of external diversification. Mergers occur when two or more firms combine operations to form one corporation, perhaps with a new name. These firms are usually of similar size. One goal of a merger is to achieve management synergy by creating a stronger management team. This can be achieved in a merger by combining the management teams from the merged firms. Acquisitions, a second form of external growth, occur when the purchased corporation loses its identity. The acquiring company absorbs it. The acquired company and its assets may be absorbed into an existing business unit or remain intact as an independent subsidiary within the parent company. Acquisitions usually occur when a larger firm purchases a smaller company. Acquisitions are called friendly if the firm being purchased is receptive to the acquisition. (Mergers are usually "friendly.") Unfriendly mergers or hostile takeovers occur when the management of the firm targeted for acquisition resists being purchased.

DIVERSIFICATION: VERTICAL OR HORIZONTAL?

Diversification strategies can also be classified by the direction of the diversification. Vertical integration occurs when firms undertake operations at different stages of production. Involvement in the different stages of production can be developed inside the company (internal diversification) or by acquiring another firm (external diversification). Horizontal integration or diversification involves the firm moving into operations at the same stage of production. Vertical integration is usually related to existing operations and would be considered concentric diversification. Horizontal integration can be either a concentric or a conglomerate form of diversification.

VERTICAL INTEGRATION.
The steps that a product goes through in being transformed from raw materials to a finished product in the possession of the customer constitute the various stages of production. When a firm diversifies closer to the sources of raw materials in the stages of production, it is following a backward vertical integration strategy. Avon's primary line of business has been the selling of cosmetics door-to-door. Avon pursued a backward form of vertical integration by entering into the production of some of its cosmetics. Forward diversification occurs when firms move closer to the consumer in terms of the production stages. Levi Strauss & Co., traditionally a manufacturer of clothing, has diversified forward by opening retail stores to market its textile products rather than producing them and selling them to another firm to retail.
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Backward integration allows the diversifying firm to exercise more control over the quality of the supplies being purchased. Backward integration also may be undertaken to provide a more dependable source of needed raw materials. Forward integration allows a manufacturing company to assure itself of an outlet for its products. Forward integration also allows a firm more control over how its products are sold and serviced. Furthermore, a company may be better able to differentiate its products from those of its competitors by forward integration. By opening its own retail outlets, a firm is often better able to control and train the personnel selling and servicing its equipment. Since servicing is an important part of many products, having an excellent service department may provide an integrated firm a competitive advantage over firms that are strictly manufacturers. Some firms employ vertical integration strategies to eliminate the "profits of the middleman." Firms are sometimes able to efficiently execute the tasks being performed by the middleman (wholesalers, retailers) and receive additional profits. However, middlemen receive their income by being competent at providing a service. Unless a firm is equally efficient in providing that service, the firm will have a smaller profit margin than the middleman. If a firm is too inefficient, customers may refuse to work with the firm, resulting in lost sales. Vertical integration strategies have one major disadvantage. A vertically integrated firm places "all of its eggs in one basket." If demand for the product falls, essential supplies are not available, or a substitute product displaces the product in the marketplace, the earnings of the entire organization may suffer.

HORIZONTAL DIVERSIFICATION.
Horizontal integration occurs when a firm enters a new business (either related or unrelated) at the same stage of production as its current operations. For example, Avon's move to market jewelry through its door-to-door sales force involved marketing new products through existing channels of distribution. An alternative form of horizontal integration that Avon has also undertaken is selling its products by mail order (e.g., clothing, plastic products) and through retail stores (e.g., Tiffany's). In both cases, Avon is still at the retail stage of the production process.

DIVERSIFICATION STRATEGY AND MANAGEMENT TEAMS

As documented in a study by Marlin, Lamont, and Geiger, ensuring a firm's diversification strategy is well matched to the strengths of its top management team members factored into the success of that strategy. For example, the success of a merger may depend not only on how integrated the joining firms become, but also on how well suited top executives are to manage that effort. The study also suggests that different diversification strategies (concentric vs. conglomerate) require different skills on the part of a company's top managers, and that the factors should be taken into consideration before firms are joined. There are many reasons for pursuing a diversification strategy, but most pertain to management's desire for the organization to grow. Companies must decide whether they want to diversify by going into related or unrelated businesses. They must then decide whether
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they want to expand by developing the new business or by buying an ongoing business. Finally, management must decide at what stage in the production process they wish to diversify.

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Case Study
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Toyota, Nissan, and Honda

In late 1980s, Toyota , Nissan, and Honda moved into adjacent market segments. They launched luxury cars Lexus, Infinity, and Acura respectively to compete with BMW and Mercedes. The Japanese cars were priced about one-third lower and had a superior service network. The value proposition was solid enough to win over potential and current BMW and Mercedes customers, despite the power of their brands. Yet the Japanese also expanded this profitable segment as a whole.

GE
Jack Welch transformed GE from a purely manufacturing company into a more diversified company with an increasingly important service component. In his 1996 annual report, Welch wrote: "Services is so great an opportunity for the Company that our vision for the next century is GE that is 'a global service company that also sells high-quality products.'" When asked if GE was going to become a more product-oriented or service-oriented company, Welch replied, "It's got to be a big combination... It's an integrated game." In 1996, GE Capital Services earned US$4 billion. In 2005, GE services agreements increased to $87 billion, up 15% from 2004. In particular, financial services revenues increased 12% to $59.3 billion.

Moserbear
Moser Baer India (Moser Baer), incorporated in 1983, started producing digital storage media (floppy disks) in the year 1986 and went on to become the second largest optical storage media (CDs, DVDs, etc.) company in the world by 2007.

3M
3M is a diversified manufacturer with one of the highest international presences of any multi-industry company. With products such as Post-It Notes and Scotch Tape as well as high-tech LCD films, 3M develops innovative new products while turning a profit off of old favorites. 3M operates in six business segments: Healthcare, Industrial & Transportation, Consumer & Office, Display & Graphics (D&G), Electro & Communications, and Safety, Security & Protection.

Google and diversification

Google were founded in 1998, and soon it became the leading search engine. Since then, Google have expanded, and have today a diversified business that includes YouTube, Picasa, Google+, Gmail, Google earth, chrome, Android and much more. Google also has the upcoming mobile phone Galaxy Nexus, manufactured by Samsung. Theirdiversification strategy includes both development of own products and services and acquaintances with companies like YouTube and Picasa. Even though Googles business is widely diversified, they are still mainly in the internet market and almost 90 % of their income comes from the ads on their search engine (Wikipedia). Is Google reducing their risks with the diversification strategy? Today it feels distant that Google will not maintain its position as the leading web browser. In the late nineties the web browser AltaVista was the leading web browser, but Google took the position from
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AltaVista. In 2010 Yahoo, the owner of AltaVista, announced that AltaVista was to be shot down. Today Yahoo search and AltaVista is practically the same search engine. Is this scenario possible today, will there be a search engine that can outcompete Google? If so, their diversification strategy might be a good move in a risk reducing manner (Socialmachinery). Googles strategy makes it possible to move their focus into what they find important. So if their search engine would fail in the future they have other services they can focus on. As long as Google search is the leading search engine, they will not lose focus on this service and if someone starts a search engine war against them they have built up a huge organization that can be mobilized to fight back. Two possibly great competitors against Googles search engine in the long run might come from Apple or Microsoft mainly due to their big organizations and financial resources

Personal conclusions
Because the fact that portfolio diversification is in most cases a good way of reducing risks, one might believe that the even corporate diversification is a solid risk reducing strategy. Although it in these terms theoretically seems to be a successful strategy, it appears to often not work out in practice. We believe that diversification under certain conditions might be a good way of reducing risks, for example for companies that are affected by external conditions such as season changes, weather and climate changes. But in even in these cases, it is important for the company in mind not to lose focus on its core business and always remember why it chose to diversify its business. This is to ensure that the diversification doesnt damage the public view of the corporation if the new area for example is inconsistent with what they normally stand for. Also, for diversification as a risk reducing strategy to be successful, it is important for the corporation to only focusing on those aspects, and not trying to combine the risk reducing benefits with for example growth benefits. It seems like many diversifications fail because of mixed interests. The management might want to reduce risks, while shareholders want to increase revenues. Shareholders therefore are more likely to prefer to enter businesses with more growth potential. But where there is big growth potential, there are often big risks. This might lead to that a strategy aimed to reduce risks, actually turns out to increase risks instead. Therefore, before a corporation diversifies it seems to be important to carefully analyze for example the attractiveness of the new market, what mutually benefits that exists and what the cost of entry is. I further believe that diversification within the land area might lead to simplification to relocate staff and maybe other resources from one kind of business to another if the market goes down in one area. The ability to keep the knowledge and resources within the corporation therefore increases, which hopefully will lead to that it will be easier to restart, or increase, production when the market changes and better times comes along. Different types of diversification lead to different kinds of risks. One risk considering related diversification might be that the expected synergy gain simply does not exist, and therefore the costs of the corporation rise. Risks with unrelated diversification might be that the corporation lacks knowledge in the new industry and therefore fails. This might lead to economic problems and, even worse, damage to the brand. Sometimes consequences of diversification might be quite obvious, especially when crisis occur. If the core business crashes due to for example the market of the core business crashes an earlier, unrelated diversification can keep the company alive.
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References
Randy I Anderson, John D Stowe, Xuejing Xing. Does Corporate Diversification Reduce Firm Risk? Evidence from Diversifying Acquisitions.(2011)www.ssrn.com/abstract=1755654 (2011-11-09) Google diversification strategy? http://www.socialmachinery.com/2010/03/12/googlediversification-strategy/ (2011-11-20)

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