Diversification

Encyclopedia of Small Business, 2nd ed., (2002)

DIVERSIFICATION

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."

DIVERSIFICATION THROUGH ACQUISITION AND EXPANSION

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.

FACTORS TO CONSIDER WHEN WEIGHING DIVERSIFICATION

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.

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.