Unit 6 - Diversification

Learning Objectives of Diversification

  1. Corporate-Level Strategy: Understand the definition, purpose, and expected benefits of corporate-level strategy designed to earn above-average returns by creating additional value.

  2. Levels of Diversification: Recognize the various levels of diversification — low, moderate, high, and very high — and relate them to corporate-level strategy implementations.

  3. Reasons for Diversification: Discuss three principal reasons companies choose to diversify: value creation, value neutrality, and value reduction.

  4. Value Creation via Related Diversification: Determine how firms can achieve value creation through related diversification strategies.

  5. Unrelated Diversification: Utilize two methods to create value through an unrelated diversification strategy.

  6. Incentives for Diversification: Identify resources and motivations that drive firms toward diversification.

  7. Managerial Over-Diversification: Discuss the motives that may lead managers to diversify beyond optimal levels.

Corporate-Level Strategy and Its Value

Corporate-level strategy refers to how a firm manages a portfolio of businesses. The primary value of this strategy is assessed by whether the company’s businesses yield greater profitability under its management versus others. It is expected to provide lucrative returns by enhancing value through efficiency, economies of scale, or distinctive competencies.

Understanding Diversification

Diversification is the strategy of expanding operations into new markets or product lines to mitigate risks and tap into new sources of revenue. It is generally classified into two categories: related diversification, where new ventures align with existing operations, and unrelated diversification, which involves entering entirely different fields from current operations. This strategy can leverage excess resources effectively, allowing firms to compete in multiple product markets while forming distinct business-level strategies for each.

Levels of Diversification

Diversification can be classified into low, moderate, high, and very high levels:

  • Low Levels: (1) Single Business: 95%+ revenue from one business; (2) Dominant Business: 70%-95% revenue comes from a primary business.

  • Moderate to High Levels: (1) Related Constrained: Less than 70% of revenue from the core business, with shared technological and product linkages; (2) Related Linked: Similar to related constrained but with less connection between businesses.

  • Very High Levels (Unrelated): Less than 70% revenue from the primary business, lacking substantial connections across operations.

Value-Creating Diversification Reasons

  1. Economies of Scope: Achieved through shared activities and transferring competencies, enhancing operational efficiency.

  2. Market Power: Firms create value by blocking rivals and optimizing vertical integrations.

  3. Financial Economies: Generated through better internal capital allocations and effective restructuring of underperforming assets.

Strategic Relatedness and Core Competencies

Firms enhance value through operational relatedness by sharing primary support activities, such as using common distribution systems and manufacturing processes. A solid example is P&G, where multiple businesses share infrastructure for cost savings. Additionally, through corporate relatedness, firms can transfer core competencies and knowledge across units, fostering innovation without necessitating duplicated investments.

Unrelated Diversification Strategies

Unrelated diversification encompasses ventures into businesses lacking meaningful strategic fits. This strategy can generate financial savings through efficient internal capital market allocations, whereby the cash flows of divisions are pooled creatively to derive optimal investments. Example: General Electric exemplifies robust management of diversified operations across industries without synergy, focusing on profit-making rather than strategic alliances.

Value-Neutral Diversification

Firms may diversify not for value creation but due to external circumstances, such as regulatory stipulations or low performance metrics. External factors, including antitrust regulations, necessitate diversification to maintain competitive viability without financial advantage.

Addressing Managerial Motives

Managers sometimes diversify for reasons outside rational strategy, such as seeking to mitigate personal employment risks or inflate compensation packages. Diverse organizational expansion may stem from managerial incentives rather than a calculated strategy aligning with firm value creation.

Potential Pitfalls of Diversification

While diversification can offer growth and financial strength, it also harbors risks. Over-diversification can lead to management inefficiency and resource misallocation, diluting a firm’s core competencies and overall market focus. Additionally, firms risk higher operational costs due to complexity and interdependence among diverse business units.