Related Diversification
Related diversification is a corporate strategy where a company expands into new product lines or markets that are linked to its existing operations through tangible or intangible assets. This approach, falling under the broader umbrella of corporate strategy, seeks to leverage existing capabilities, technologies, distribution channels, or brand recognition to achieve synergy and competitive advantages. By staying within a related field, businesses aim to minimize risk compared to unrelated diversification, where expansion occurs into entirely new and unfamiliar areas. Related diversification focuses on creating value through shared activities and the transfer of core competencies across business units.
History and Origin
The concept of related diversification gained significant traction with the work of management theorist Michael E. Porter. In his seminal 1987 Harvard Business Review article, "From Competitive Advantage to Corporate Strategy," Porter challenged the prevailing wisdom that diversification inherently created shareholder value. Instead, he argued that successful diversification, including related diversification, must create competitive advantage for the newly acquired or entered businesses. Porter emphasized that corporations should add value to their business units that individual shareholders could not achieve on their own. He identified two primary mechanisms for value creation in related diversification: transferring skills among similar activities and sharing activities (e.g., a common sales force, shared manufacturing facilities). This perspective shifted the focus from merely managing a portfolio of businesses to actively seeking interrelationships and synergies across diversified operations.5, 6, 7
Key Takeaways
- Related diversification involves expanding into businesses that share connections with a company's existing operations.
- The goal is to create synergy by leveraging shared resources, capabilities, or market knowledge.
- This strategy is often contrasted with unrelated diversification, which involves entering entirely new and distinct industries.
- Successful related diversification aims to enhance competitive advantage and shareholder value through efficiency gains or revenue opportunities.
- Key mechanisms include transferring skills between business units and sharing operational activities.
Interpreting the Related Diversification
Related diversification is interpreted by assessing the degree to which new ventures can genuinely benefit from and contribute to the existing strengths of the parent company. When evaluating a related diversification move, analysts often look for clear evidence of potential synergies in areas like marketing, research and development (R&D), production, or distribution. For instance, a food company diversifying into beverage production is considered related diversification if it can utilize its existing supply chain, manufacturing expertise, or brand loyalty. The success of related diversification hinges on the effective integration of the new business and the realization of anticipated synergies, which can lead to enhanced profit margins or market share. The effective transfer of organizational capabilities is critical for this strategy to succeed.
Hypothetical Example
Consider "TechSolutions Inc.," a successful company primarily known for developing enterprise resource planning (ERP) software. TechSolutions decides to diversify by acquiring "DataAnalytics Corp.," a firm specializing in business intelligence and data visualization tools. This is an example of related diversification because DataAnalytics' products are highly complementary to TechSolutions' existing ERP offerings.
Here’s a step-by-step breakdown:
- Existing Strength: TechSolutions has a large client base of businesses that generate vast amounts of data using its ERP software.
- Related Acquisition: DataAnalytics offers tools that can process and present this data in meaningful ways.
- Synergy Realization:
- Cross-selling: TechSolutions can now offer DataAnalytics' solutions to its existing ERP clients, and DataAnalytics can offer its tools to TechSolutions' clients, leveraging a shared customer base.
- Product Integration: The two companies can integrate their software platforms, creating a more comprehensive solution for clients.
- Shared Sales Force: The sales teams can be trained to sell both product lines, reducing selling, general, and administrative (SG&A) expenses.
- R&D Collaboration: Their R&D departments can collaborate on new features, sharing expertise in data architecture and user interface design, leading to more efficient product development.
This move allows TechSolutions to expand its offerings, increase its value proposition to existing clients, and attract new clients seeking integrated data management and analysis solutions, all while leveraging its core strengths in business software.
Practical Applications
Related diversification is a prevalent strategy across various industries, appearing in investment decisions, market expansion, and strategic corporate planning. Companies frequently employ this approach through mergers and acquisitions (M&A), seeking to combine with businesses that offer complementary assets or capabilities. For instance, an automotive manufacturer might acquire a company specializing in electric vehicle battery technology, leveraging existing engineering expertise and supply chain networks.
In financial markets, investors might see companies pursue related diversification to enhance their competitive positioning or create new revenue streams. For example, a financial services firm specializing in retail banking might expand into wealth management, utilizing its existing client relationships and financial expertise. The OECD's work on corporate governance often touches upon how diversification strategies, including related diversification, are overseen by company boards to ensure they align with shareholder interests and contribute to long-term sustainability. T2, 3, 4he pursuit of financial synergy is a key driver for many such transactions, as companies aim for improved performance through cost savings or increased revenue by combining operations.
Limitations and Criticisms
While related diversification offers significant advantages, it is not without limitations or criticisms. One common challenge lies in the actual realization of expected synergies. Although potential synergies might seem clear on paper, successfully integrating different organizational cultures, operational processes, and information systems can be complex and costly. Companies often overestimate revenue synergies and underestimate the difficulty of executing cost synergies. D1ifficulties in integration can lead to unexpected expenses, management distractions, and ultimately, a failure to achieve the anticipated benefits.
Another critique is the potential for increased organizational complexity. As a company diversifies, even into related areas, it adds layers of management, coordination, and reporting, which can strain resources and reduce agility. While related diversification aims to leverage existing capabilities, a mismatch in scale or operational philosophy between the parent company and the new venture can still lead to inefficiencies. Some studies suggest that excessive diversification, even related, can sometimes lead to a "diversification discount," where the market values a diversified company less than the sum of its individual parts due to a perceived lack of focus or increased managerial discretion. Effective risk management and a strong investment policy statement are crucial to mitigate these potential drawbacks. A clear capital allocation strategy is also vital to ensure resources are deployed effectively across diversified business units.
Related Diversification vs. Unrelated Diversification
Related diversification and unrelated diversification represent two distinct approaches to corporate expansion, both falling under the broader concept of corporate diversification. The fundamental difference lies in the nature of the relationship between the new business and the existing operations.
| Feature | Related Diversification | Unrelated Diversification (Conglomerate) |
|---|---|---|
| Connection | Strong operational or strategic linkages to existing businesses | No direct operational or strategic linkages |
| Value Creation | Leveraging shared resources, skills, and activities for synergy | Financial engineering, portfolio management, or risk reduction |
| Risk Profile | Generally lower risk due to familiarity and synergy potential | Higher risk due to lack of expertise in new areas |
| Example | A car manufacturer buying a truck manufacturer | A technology company buying a hotel chain |
| Key Advantage | Synergistic benefits, competitive advantage | Spreading risk across disparate industries, access to new markets |
| Managerial Focus | Operational integration, resource sharing | Financial oversight, capital allocation |
Confusion often arises because both strategies involve expanding a company's business scope. However, related diversification aims to create value by exploiting tangible and intangible connections, such as shared distribution channels or technological expertise, resulting in genuine operational efficiencies or enhanced market power. In contrast, unrelated diversification, often seen in conglomerates, seeks value primarily through financial means, such as internal capital markets or general management expertise, without significant operational synergies between the diverse business units. While unrelated diversification can offer portfolio diversification benefits by reducing overall company risk through exposure to different economic cycles, it often lacks the direct competitive advantages sought through related diversification.
FAQs
What are examples of related diversification?
Examples include a company that manufactures smartphones diversifying into smartwatches, using shared technology and distribution networks; a food processing company expanding into the production of packaged beverages, leveraging existing supply chains and brand recognition; or an airline acquiring a regional commuter service to expand its route network and feeder traffic. Each example demonstrates a clear connection to the original business, allowing for the transfer of skills or sharing of activities.
Why do companies pursue related diversification?
Companies pursue related diversification to achieve synergies, which can lead to increased efficiency, reduced costs, and enhanced revenues. By leveraging existing assets like brand reputation, technological know-how, or customer relationships, firms can enter new markets or offer new products more effectively than if they were starting from scratch. This strategy aims to build a stronger competitive position and ultimately increase shareholder value.
How does related diversification differ from vertical integration?
Related diversification involves expanding into businesses that are related but not necessarily sequential in the value chain. For instance, a coffee shop chain diversifying into selling coffee beans for home brewing. Vertical integration, conversely, involves a company taking over more steps in its own production process, either backward (e.g., a car manufacturer buying a tire factory) or forward (e.g., a clothing designer opening its own retail stores). While both can involve internal expansion, vertical integration focuses on controlling the supply chain, whereas related diversification focuses on leveraging core competencies across connected, but not necessarily sequential, industries.
What is the role of core competencies in related diversification?
Core competencies are the unique skills, knowledge, and capabilities that give a company a competitive advantage. In related diversification, these core competencies are the foundation upon which new ventures are built. For example, a company with a core competency in precision engineering might diversify into different types of machinery that require similar engineering expertise. By effectively transferring and applying these core competencies to new, related areas, a company can achieve economies of scope and create a sustainable competitive advantage. This strategic leveraging of competitive advantage is central to the success of related diversification.