Idea 16 - Diversification (50 Management ideas you really need to know)

Idea 16 -  Diversification

Web overlords Amazon and Google have grown so fast that they arrived at the 'what next?' moment rather more quickly than most companies. Speed is uncommonly integral to the industry they inhabit but when it comes to sustaining growth, they have the same strategic options as anyone else: expand or diversify, build or buy. Amazon, the retailer, now wants to sell online storage and computing power. Google, the search engine, is squaring up to Microsoft with its own office software package. Can they pull it off? Diversification, the route both are now taking, is never the safe option.

Diversification is a classic growth strategy, and every successful company will consider it, at the very least, at some point in its evolution. In its pure form - new product, new market - it is the riskiest of the four growth options in Ansoff's product-market matrix, advocated and deplored with equal passion. Diversification strategy set off an early US merger wave around 1916, but it had its heyday in the 1960s and early 1970s, the age of the corporate planner. Top managers regarded themselves as professionals who could manage anything and some built empires of completely unrelated businesses as a result. Harold Geneen's ITT was a stark example of the conglomerates that emerged, acquiring a family as dysfunctional as Sheraton Hotels, Avis Rent-a-Car, insurer The Hartford and Continental Baking.

The conglomerate has fallen from grace since then, at least in Europe and the US, and many diversified companies began disposing of unprofitable non-core businesses in the 1980s. Many of the conglomerates were taken over or broken up, or both. The pendulum started to swing back in the 1990s, though it has stopped well short of a return to the lTT model: The taste has been more for strategic restructuring around a common theme, and the acquisition of related businesses that offer some kind of industrial or market synergy.

Shareholder muscle one reason for the decline of the diversified conglomerate was the 1980s flexing of shareholder muscle. In many cases, stockholders felt that acquisitive diversification was being driven more by size and managerial ego than by any desire to increase profitability. Since most mergers do not, in the end, increase profitability, the shareholders
had a point. They were able to press it home by ousting the management or selling the stock, so depressing the share price of the company in question and leaving it vulnerable to predators. The corporate bloodshed that followed, culminating in the record-breaking 1988 takeover of RJR Nabisco by a leveraged buyout firm, has been a powerful incentive for managers to behave in a more constrained manner ever since.

Another justification put forward for high-proof diversification was that it spread risk. There is some basis for this - if a firm is in non-correlated industries which tend to be in different phases of the business cycle, its income is likely to be less volatile. But the shareholders have spiked that argument too, insisting that they can diversify their holdings more widely than conglomerate can, thank you, and that they prefer to invest in 'pure plays'.

Less risky-In this post-conglomerate age, 'diversification' is often more loosely applied to include the introduction of new products to existing markets and vice versa. Bearing in mind that diversification can be built as well as bought, shareholders see such variations as less risky, as long as they can be convinced that the motives are sound. One of the most common
Motives is economies of scope, where several products can share the same resources, such as marketing, distribution, research and development, or even brand names. Another is to extend one's core skills into a related segment, as Gillette did when it began making toiletries, or as clothes retailer Marks & Spencer did when it diversified into food.

Some argue that geographical expansion is preferable to industrial diversification. This provides economies of scale (lower unit costs from producing more of the same) and allows the firm to use its marketing resources more effectively. Multinationals are more flexible than domestic companies, because they can move production around to where raw materials prices or labour rates are low or falling. And this kind of geographic spread provides more opportunities for moving profits or tax losses to wherever they will have the best tax advantages. Rule one of diversification is don't even think of it until the original business is on a sound footing. Diversification will suck time, money and concentration away from the main enterprise.

Does the new market offer better prospects for profit than the existing one? If not, you could be better advised to grow your share of the market you're already in. It may be that the existing market is mature or declining and simply doesn't offer any more growth potential. In that case, diversification might be a viable defensive strategy. But what is the cost of entry, and can you afford it? Finally, do you have, or can you establish, a competitive advantage over companies that are already occupying the intended space?

While failures by far outnumber the successes, there have been some triumphal moves into new markets, often by leveraging an existing corporate brand. Virgin makes lTT look like a focused business. It started as a record label, but now embraces an airline, drinks, cable TV, mobile phones, financial services, health clubs and wedding dresses. Canon has made the leap from cameras to office equipment.
There is plenty of opinion on the wisdom or otherwise of Amazon's and Google's diversification strategies. Some say Amazon should move next door into other forms of retailing, instead of crossing the road to computer services. Others believe that, whatever the outcome of Google's software excursions, it has already invoked the 'winner's curse' by winning a costly bidding war for YouTube. Whether these roads lead to green pasture or the wilderness, they will be required reading in business schools some years hence - guaranteed.

Reference: 50 Management Ideas You Really Need to Know

Book by Edward Russell-Walling

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