What is diversification?
Diversification is a risk management technique in which a corporation enters a market that is unrelated to its primary business. It is an essential aspect of achieving long-term financial goals while reducing risk.
Investors accept a certain level of risk, but they also need to have a backup plan if things don’t go as planned.
While some business leaders believe in allocating capital to reduce exposure to any particular asset or risk, others believe specialization is the only practical way forward in today’s economy.
Advantages of diversification
One of the advantages of diversification is it helps in balancing unpleasant movements within a single investment and helps maximize the effectiveness of resources and capabilities.
Diversification also helps create a balance for the entity in several industries or product lines during these ups and downs. It removes businesses from potentially decreasing activities to avoid shutting down firms.
Types of diversification
There are four types of diversification strategies including:
Horizontal diversification refers to a firm delivering new services or producing new goods that appeal to its existing customers.
For example, a pencil manufacturer that enters the notebook market is pursuing a horizontal diversification strategy.
Another form of diversification is vertical diversification, which occurs when a business returns to its production cycle’s previous or next stage.
For example, a pastry manufacturer producing a new flavor of cookies to its product line.
In this type of diversification strategy, the company introduces new products and services to the company’s existing product line.
It is pursuing a concentric diversification strategy when a computer company that primarily produces desktop computers starts manufacturing laptops and tablets.
Conglomerate diversification introduces new items or services to companies with nothing to do with their current product line or distribution channels.
Conglomerate diversification is the riskiest strategy among others. It requires the company to offer products or services in a new market and unfamiliar consumer base.
Why do companies diversify?
There are reasons why companies diversify. Here are some:
- For business operations’ growth
- To ensure maximum effectivity of existing resources and capabilities
- To escape from unattractive industry environments
- For cost-saving opportunities in the field of business
- To spread business risk
- To leverage the brand name
When should companies diversify?
An organization should consider diversifying when:
- Cost can be reduced by cross-business sharing or transferring of resources and liabilities of the company.
- It can expand into organizations whose technologies and products complement its present business.
- Its resources and capabilities can be used as valuable competitive assets in other things concerning the business.
- Transferring a solid brand name to the products of other businesses helps drive up the sales and profit of the company. It can also boost customer satisfaction and loyalty.