Diversification is fundamentally a negative strategy... diversifiers are always running away from something
Category : Business Essay Samples
THE DISADVANTAGES OF DIVERSIFICATION STRATEGY
The turbulent business environment in the contemporary world is characterized by rigid competition, changing customer preferences, technological innovations and rapid flow of products, services and skills across national boundaries. Business organizations are constantly faced with these realities that effective marketing and strategic planning become a necessity. Today, a business organization is not only concerned with how it is to produce products and goods and how these goods would reach the market. This simplicity is gone. The trend now is focusing on product development and efficient delivery mechanisms while maintaining competitive edge through corporate strategies that balance organizational objectives, marketing techniques and fulfillment of organizational goals.
One corporate strategy gaining much interest and focus in the recent years is diversification strategy. Corporate diversification strategy is a long-term continuing strategy of growth adopted by business firms through expansion in new markets by introducing new product lines and services (2002). The decision to diversify and become a multi-product corporation is basically aimed at increasing market profitability, smoother earnings, greater capital markets and accumulating diverse expertise in diverse environments (2002). However, M.L. Kastens asserted that “diversification is fundamentally a negative strategy since diversifier firms are always running away from something.” This paper would focus on justifying this assertion by discussing supporting ideas from various authors and presenting cases on the disadvantages of diversification strategy.
THE DISADVANTAGES OF DIVERSIFICATION STRATEGY
Diversification has two major objectives: enhancing the implementation of core business processes and strengthening the structural situation of a business unit. Diversification basically incorporates new business efforts with existing strategies in order to increase a firm’s competitive advantage. Diversification can be done in three ways: vertical integration which means integrating business in the value chain to share efficiency; horizontal diversification which refers to expansion into new business industries by collaborating with conglomerates; and geographical diversification which is entering new geographical locations to pursue extensive opportunities for business growth ( 2006).
Diversified business organizations are categorized as related or unrelated based on the company's pre-existing products, services and activities (1995). Related diversification strategy occurs when corporations expand operations with similar product lines. For example, an automobile corporation decides to venture into production of passenger vehicles or light trucks to diversify its products (2002). Unrelated or conglomerate diversification, on the other hand, happens when companies are diversified in areas without sharing of physical or knowledge resources, only financial resources. These firms set out operations in industries not related to the core business ().
Diversification has its disadvantages. It makes diversifying firms turn their backs on the present situation of the business. First, diversifying firms disregard business costs in order to fulfill the purpose of coming up with varying products and achieve extensive market penetration. (2001) stated that diversification is inefficient and costly. It requires a large capital to test the viability and start operations of the new business. Research must be conducted beforehand to assess the feasibility of the new product or new area of expansion. Research expenses are costly and can affect the financial resources of the firm. There is also a need to conceptualize a new product line, produce the new products and market these products. Sometimes, diversification makes firms ignore their current financial situation to make way for costly expansion and thus, long-term debts for the company ( 2006). The diversified corporation spends too much financial expenses in acquiring new assets, and in hiring, training and even firing people for the new organization, and may allocate extensive scarce and essential managerial resources to the integration process between the new assets and existing ones. One relevant result from a research conducted is that rents are dispersed in the diversification process because of the vast operation of business (2001). Lohse (2001) reported that E*Trade, a leading financial services provider, is facing serious strains in the company’s resources due to its diversification efforts. E*Trade aspires to become a broad-based online broker, lender, banker and financial manager of resources and has acquired an online bank, mortgage lender, more than 10,000 automated teller machines, and a software company in a span of eighteen months. Now, the company is estimated to spend about $200 to $250 million to support its expanding bank and brokerage services and analysts are worried that its resources would be confronted with severe strains (p.1).
Second, diversification makes companies look beyond the existing core competencies among the staff, results to inefficient management of fundamental activities and assets, and lose their corporate focus. Diversification thinly spreads the firm’s managerial resource by devoting too much management effort and time to the newly acquired components. Thus, the existing activities and endeavors of the company are put to second priority. Also, the diversified firm becomes preoccupied with training and developing new staff that would run and facilitate the new expansion operations. This activity entails cost and the firm deviates from a more crucial focus of managing the existing core competency among the existing employees (2001). According to (2004) diversification does not necessarily result to high performance because the process basically creates deviations from present organizational competencies. Effective business performance entails embracing new methods but also recognizing existing strengths and competencies. Most firms that are undergoing diversification have the tendency to disregard present competencies as they concentrate on developing new expertise to handle the greater volumes of products or increasing proportion of services and new markets. The consequence is the inability to manage and make the most of present competencies to deliver the desired results. (2006) reported that diversification does not work for Commercial Net Lease Realty as well. Commercial Net, a leading USA-based real estate investment trust, has a long-term goal relative to portfolio to consist of 60 percent retail, 25 percent office and 15 percent industrial assets. However, the company lacks a little expertise in the office arena. Thus, CNLR decided to hire about six new employees with experiences in the new areas that the company wants to pursue. This action is deemed risky by some analysts since the new staff may still not have sufficient knowledge and competence to operate along with experienced real estate investment trusts specializing in office and industrial sectors. Moreover, diversified firms tend to lose their corporate focus when they resort to diversification. Many authors say that success of geographic diversification depends on certain characteristics of the firm prior to the diversification or maintained while in the diversification process. Geographic diversification in the form of foreign direct investment outside the core business of the company or that extends the industrial diversification of a firm is said to aggravate any operating inefficiencies that the company is facing mainly due to the profit margin losses in years prior to the investment. It is also said to create severe negative synergies among the various segments of the firm leading to short-term and long term losses (2003). Synergies are threatened when the diversified firms do not have thorough understanding of the appropriate ways to incorporate diversification activities into the existing strategies and businesses, when the firm is exposed to the normal risks related to business acquisition and expansion, and when there are problems with the development of internal business ( n.d.). Diversified firms which pursue expansion in non-core business operations tend to lose corporate focus when they encounter reduction in existing operating efficiencies as they strive to expand their assets across various global locations. Corporate cohesion is also lessened when the firms’ new global investments separate from the core business do not fit the key business operations (2003). One example is Walgreens, a leading American online pharmacy that offers services for prescription, health and wellness products, and information on health and wellness, and has been recognized for its emphasis on providing customers with a “convenient shopping experience”. There are recommendations that the company can diversify by either acquiring a drug manufacturing company or actual production of medicines and health products that the company sells. Diversification makes the company shift its focus from the traditional businesses to expansion. It would force the company to set aside the primary factors that made it successful in the first place. The company would render extensive time, effort and human intellect in conceptualizing and launching new products or new markets. Its reputation for being a top online pharmacy provider has been achieved through hardwork and enormous strategies on the part of the management. If Walgreens would resort to diversification, its market position would be put at stake and everything that the staff and management have worked hard to maintain would be exposed to risks (2006). Geiger and Hoffman (1998) suggested that diversifying firms should take into account the level of diversification applicable to the company to avoid over-diversification. It is said that over-diversification results to lower firm performance as diversified companies turn away from their core business focus ().
Corollary to the risks in firm efficiency, diversification especially conglomerate strategy, poses regulatory issues. Conglomerate strategy connotes that investors in a firm take a more subdued responsibility. This means that the firm’s management assumes the task of making decisions and activities relative to diversification for the investors, or for the firm to pay out a dividend by letting every single investor to diversify their own investment portfolio. Diversification strategy in regulated business firms call for a need to communicate with the board of directors who would allow the diversification strategy to take place. A regulated public entity, on the contrary, can resort to diversification through acquisitions of non-regulated non-related subsidiaries or by creating a holding company to diversify separately from the firm. Either way, regulating bodies would monitor the diversification process to guarantee that the diversification strategy would not deliver costs that exceed the firm’s capital cost, impose additional risk to the firm, or transfer any unnecessary expenses to the subsidiary. Furthermore, the regulating body can arrange for legislative controls against investment in a particular business setting. One example is when the state of Wisconsin passed legal restrictions on the diversification selections of utility holding companies in the 1980s (2005). According to (1996) companies planning to diversify or launch large-scale diversification activities allow doubtful assumptions on the impact of diversification on stakeholder value. One research has found out that diversified companies have to adhere to a crucial requirement of transparency regarding various strategic information to key stakeholders. This requirement correlates with the fact that stakeholders of diversified firms manifest increased interest and inquiry regarding corporate information due to the extensive market operation and array of products. Thus, diversified corporations are more likely to be influenced by decisions and concerns of their primary stakeholders ().
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