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Diversification Strategy Explained

Diversification Strategy Explained

Last Updated on September 5, 2022 by DMEditor

According to data from the U.S Bureau of Labor Statistics, only 25% of businesses survive 15 or more years. 45% of companies don’t make it past the five-year mark. So, what separates the long-term survivors from the one-hit wonders? Of course, there’s no surefire answer, but many experts agree that diversification is one of the keys to longevity. 

For many businesses, the path to success is to focus on a single product or service and perfect it. While this may work in the short term, eventually, all businesses will face external forces beyond their control that can threaten their very existence. By diversifying, companies can insulate themselves from these shocks and continue to thrive even when the market turns for the worse. 

In this article, we’ll discuss what diversification is and the different types of diversification strategies. We’ll also cover choosing the right strategy for your business and the benefits and risks of using a diversification strategy. 

Bottom Line Up Front

Diversification is essentially spreading your eggs into multiple baskets. For businesses that pursue a diversification strategy, this means expanding into new markets, products, or services. The goal is to reduce risk by not putting all your eggs in one basket. An effective diversification strategy can lead to increased profits and market share, but it can also be risky.

What Is Diversification Strategy?

A diversification strategy is a business growth tactic whereby a company expands its operations into new markets or product lines. Diversification aims to reduce risk by adding new products, services, or businesses that are not directly related to the company’s current offerings. Most importantly, a diversification strategy seeks to generate new growth opportunities for the business and increase profitability.

Igor Ansoff, a renowned Russian-American mathematician and business consultant, developed the Ansoff Matrix– a tool to map out an organization’s strategic direction. This matrix suggests that there are four main growth strategies that a company can pursue: market penetration, product development, market development, and diversification. 

Of these four strategies, diversification is the riskiest because it involves the company venturing into uncharted territory. However, it also offers the highest potential rewards if executed successfully. Although diversification has risks, it can be an essential tool for companies looking to stay ahead of the competition and ensure long-term viability. 

Why Companies Should Diversify?

Types of Diversification Strategies

No business is immune to external shocks, and even the most successful companies can find themselves in a precarious position if they don’t diversify. For example, Blockbuster was once the undisputed king of the home entertainment industry.

But when Netflix introduced a new business model that allowed customers to stream movies and TV shows online, Blockbuster was slow to adapt. As a result, the company filed for chapter 11 bankruptcy in 2010.

Diversification can also insulate companies from economic downturns. For example, when the 2008 financial crisis hit, many businesses in the real estate industry were forced to close their doors. However, companies that had diversified their portfolios into other sectors such as healthcare and technology weathered the storm much better.

In addition to reducing risk, diversification can also lead to new growth opportunities. Companies can tap into new customer segments and generate additional revenue streams by venturing into new markets or product lines. For example, Apple was initially known for its personal computers. However, when the company diversified into new product categories such as smartphones, tablets, and wearable devices, it found astronomical success. 

Types of Diversification Strategies

Six common types of diversification strategies exist. Companies must carefully weigh each option’s risks and potential rewards when choosing a diversification strategy. 

1. Horizontal Diversification

Horizontal diversification is the most common type of diversification strategy. It involves a company expanding its operations into new markets similar to its current market. For example, a fast-food chain that primarily sells hamburgers may decide to expand its menu to include hot dogs and fries. 

This expansion allows the company to tap into a new customer base without radically changing its business model. If executed correctly, horizontal diversification can be a low-risk way to boost growth. One way to reduce the risks associated with horizontal diversification is to partner with an established company in the new market. It could be through an acquisition or a joint venture. 

For instance, when Disney acquired Pixar in 2006, it not only gained access to Pixar’s successful lineup of animated films but also its team of world-renowned artists and filmmakers. The acquisition helped Disney strengthen its animation market position and diversify its business portfolio. The company can also license a new product or innovate its current offerings to serve its target market better.

2. Vertical Diversification

Vertical diversification occurs when a company expands its operations upstream or downstream in its current value chain. Upstream diversification involves a company moving into businesses closer to the raw materials production stage. For example, a clothing retailer may vertically diversify by acquiring a fabric manufacturer. 

On the other hand, downstream diversification occurs when a company moves into businesses closer to the end customer. For example, a company that manufactures bicycles may vertically diversify by setting up its chain of retail stores. 

Vertical diversification can allow companies to exert more control over their operations and increase profitability. For instance, when Coca-Cola acquired a majority stake in Monster Beverage in 2015, it diversified its business portfolio and gained control over the production and distribution of Monster’s energy drinks. The move helped Coca-Cola compete in the growing energy drink market and boost its bottom line.

3. Conglomerate Diversification

Conglomerate diversification is when a company expands its operations into new, unrelated products or markets. It’s the most aggressive diversification strategy, requiring a company to enter entirely new businesses. If executed correctly, conglomerate diversification can lead to significant growth opportunities. 

However, it’s also the riskiest type of diversification strategy as it usually requires a company to make substantial changes to its business model. For example, when General Electric (GE) entered the financial services business in the 1980s, it was a conglomerate diversification move.

The company acquired several financial service firms and created GE Capital, a wholly-owned subsidiary offering various financial products and services. 

Although the move helped GE diversify its business portfolio and achieve significant growth, it also exposed the company to greater risks during the 2008 financial crisis. GE had to sell several business units and scale back its operations to stay afloat. 

4. Concentric Diversification

Concentric diversification is a strategy involving a company expanding its operations into new products or markets related to its existing business. It’s a less aggressive form of diversification than conglomerate diversification as it doesn’t require a company to enter entirely new industries. 

For example, a company that manufactures sportswear may diversify by expanding into the production of sports equipment. Or, a company that sells books online may diversify by adding a line of e-books or audiobooks. Concentric diversification can be a good way for companies to enter new markets without straying too far from their core business. 

5. Defensive Diversification

Defensive diversification is a strategy involving a company expanding its operations into new products or markets to reduce its reliance on its existing business. It’s usually undertaken as a response to changes in the marketplace that threaten a company’s core business. Think of it as a “why” than a “how” type of diversification strategy. 

For example, a company that sells books in brick-and-mortar stores may defensively diversify by adding an online sales component to its business. The move would help the company reduce its reliance on physical bookstores, which are struggling to compete with online retailers. 

Another defensive diversification example occurred when Kodak entered the digital camera market in the early 2000s. The move was a response to the declining sales of its film products, which were being replaced by digital cameras. Although the strategy didn’t save Kodak from bankruptcy, it did help the company stay afloat for a few more years. 

6. Offensive Diversification

When a company wants to take advantage of new market opportunities proactively, it may use an offensive diversification strategy. The goal is to enter new markets or launch new products before the competition does. Unlike defensive diversification, businesses undertake offensive diversification as a means to achieve growth rather than a response to changes in the marketplace. 

In cases where a company can’t organically develop new products or enter the new markets it wants to, it may use mergers and acquisitions (M&A) as part of its offensive diversification strategy. For example, Facebook’s acquisition of Instagram was an offensive move to enter the photo-sharing market before its competitors could establish a foothold. 

How to Choose the Right Diversification Strategy for Your Business

There’s no one-size-fits-all answer to the question, “What is the best diversification strategy for my business?” The right strategy depends on several factors, including your company’s goals, resources, and the industries in which you operate. 

That said, there are a few general guidelines you can follow when choosing a diversification strategy for your business: 

1. Define Your Objectives

Objetives

The first step is to define what you want to achieve with your diversification strategy. Are you looking to enter new markets? Launch new products? Or reduce your reliance on your existing business? Once you have a clear idea of your objectives, you can start to narrow down your options. 

2. Consider Your Resources

When choosing a diversification strategy, it matters what resources you have available. If you don’t have the financial resources to launch a new product or enter a new market, then an acquisition may not be the right option for you. The same goes for companies with limited human resources.

If you don’t have the internal expertise to execute successfully on a new venture, you may want to consider partnering with another company that does. 

3. Assess the Risks

Of course, no business decision is without risk. When choosing a diversification strategy, it’s essential to consider each option’s risks and potential challenges. Now, this doesn’t mean you should avoid all risks. But you should have a clear understanding of the risks involved and have a plan to mitigate them. 

4. Analyze Your Current Industry and Markets

Analyze Your Current Industry and Markets

It’s also essential to have a good understanding of the industries and markets in which you operate. For instance, when considering expanding into a new market, you’ll want to ensure enough demand for your products or services. And if you’re thinking about launching a new product, you’ll need to ensure that it doesn’t cannibalize sales of your existing products. 

5. Do Your Research

Research is as vital when choosing a diversification strategy as it is when launching a new product. When looking at different options, analyze past case studies and speak with industry experts. The more information you have, the better equipped you’ll be to make a decision. 

Benefits of Using a Diversification Strategy

Several benefits come with using a diversification strategy, including: 

1. Increased Revenue Potential

One of the primary advantages of diversification is that it can help you tap into new revenue streams and generate more sales. Businesses introduce new products to attract customers and enter new markets to expand their customer base. The results are a more diverse customer base and increased revenue potential. 

2. Reduced Dependence on a Single Product or Market

Several Products

Another critical benefit of diversification is that it can help you reduce your dependence on a single product or market. More doesn’t always mean merrier in the business world. It could sometimes make sense to focus on a single product or market. 

But if that product or market experiences a decline, it could significantly impact your business. Diversifying your business can help mitigate this risk by ensuring you’re not too reliant on any product or market. 

3. Enhanced Brand Recognition and Loyalty

People love an organization that offers a variety of products or services. It shows that the company is innovative and always looking for new ways to serve its customers. When we look at companies like Coca-Cola and Pepsi, we see two organizations that have diversified their product portfolios to include a wide range of beverages. 

Brand presence in different sectors also helps with overall brand recognition. For a customer, it’s easier to remember a company like Coca-Cola that sells numerous drinks than one that just sells soda. 

4. Increased Efficiency and Productivity

Increased Efficiency and Productivity

Diversifying your business can also help increase efficiency and productivity. You can leverage your existing business’s knowledge, experience, and resources to venture into new products or markets. The more you diversify, the more you can share resources across your organization, leading to increased efficiency. You can also benefit from economies of scale in cases where you produce multiple products. 

 

5. Increased Valuation

There’s no better way to define growth potential than by looking at a company’s valuation. Companies with a diversified product portfolio operating in multiple markets often have a higher valuation than companies without such a presence. 

Investors perceive these companies as having higher growth potential, so they’re willing to pay more for their shares. When done correctly, diversification can help you maximize shareholder value. 

Risks Associated With Using a Diversification Strategy

Chasing growth and diversifying your business aren’t without their risks. Some of the risks you need to consider include: 

1. Overstretching Your Resources

One of the primary risks of diversifying your business is that you could overstretch your resources, leading to a decline in quality. You often compromise on quality when trying to do too many things simultaneously. It’s essential to have a clear understanding of your capabilities before venturing into new products or markets. 

2. Reduced Focus

It won’t always be possible to maintain the same level of focus when you have a more diversified product portfolio or are operating in multiple markets. It’s essential to have systems and processes to help you maintain focus across your organization. Otherwise, you risk losing sight of your core objectives, which could lead to problems. 

3. High Implementation Costs

Venturing into new products or markets often requires a significant investment. You must conduct market research, build new infrastructure, and train your workforce. All of this costs money, which could impact your bottom line in the short term. In some cases, the high implementation costs might outweigh the potential benefits of diversification. 

FAQs

Question: What is product diversification, with example?

Answer: Product diversification is expanding a company’s offerings into new areas. Businesses usually do this by either developing new products or acquiring new businesses. For example, a bicycle company might diversify its product line by adding motorcycles. Or, a company that makes only pet food might acquire a business that also sells pet toys.

Question: Was Disney’s diversification strategy successful?

Answer: The Walt Disney Company is an excellent example of a company that has used diversification to its advantage. Disney started as an animation studio in the 1920s and has since transformed into a global entertainment conglomerate. Today, the company operates in various businesses, including media networks, parks and resorts, studios, consumer products, and more.

Question: What is the main objective of diversification?

Answer: The main objective of diversification is to increase returns for shareholders by giving the company exposure to new growth opportunities. Additionally, diversification can also help to reduce risk because it reduces the dependence of the company on any one particular business.

Conclusion

Diversification is an excellent way for businesses to grow and expand their operations. By diversifying into new markets and product lines, companies can mitigate risks and take advantage of new opportunities. However, choosing the right diversification strategy for your business is essential, as there are risks associated with this growth strategy. Diversification can increase your business’s profits and market share when done correctly.

The most important thing to remember when implementing a diversification strategy is to do your research. Make sure you understand the new market you’re entering and have a solid plan for how you’ll succeed. With careful planning and execution, diversification can help your business reach new levels of success.

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