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Original written by professors David Allen and Arnaud Gorgeon at IE Business School.
Original version, 21 May 2002. Last revised, 20 December 2007. (R.L.)
Published by IE Publishing Department. María de Molina 13, 28006 – Madrid, Spain.
©2002 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.
INTRODUCTION
We are all familiar with the concept of diversification in finance. In this context, diversification is
related to the concept of risk. A diversified portfolio is a portfolio that has been structured in such
away as to spread risk. In the context of strategy, however, diversification has a different meaning.
In this context, we will consider diversification as doing something new.
Firms that are successful seek to transfer their winning business know-how to new activities. For
these firms diversification means looking at new industries or new markets as exciting opportunities
for growth and profits. Firms that have been successful but face mature, less profitable markets,
frequently seek to regain old glory in new businesses. For these firms diversification is about
survival, often including avoiding take-over. In all, diversification is about taking risks and venturing
into the unknown to seek greater competitive advantage and /or higher profit.
Diversification is a corporate strategy decision matter. It is a decision taken at the highest level that
impacts on the fundamental direction of firm. Moving towards diversification has sometimes been
compared to passing through the Bermuda triangle. While some firms succeed, many others get
lost forever. In fact, in no other area of corporate strategy do so many companies made such
disastrous decisions. Nonetheless, the attraction of growth and new opportunities continues to be
irresistible for most companies.
You probably already know that the majority of big companies are diversified companies. Microsoft,
Walt Disney, Telefónica, Respol, El Corte Inglés, Nokia, General Electric, Mitsubishi, Shell are all
examples of diversified firms. What is vital is that each of these firms seeks to find a coherent path
of profitable growth as it takes on new challenges.
What does the diversified company look like? Picture a diversified firm as a collection of individual
businesses competing in diverse industry environments. In a diversified firm, corporate managers
must craft a multi-business, multi-industry corporate strategy.
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ANDALUCÍA
03/2001
Barbadillo Winery and Sierra Morena Group Finalize their Strategic Alliance
08:00 a.m
Sanlucar winery Antonio Barbadillo and the Sierra Morena food group are finalizing a strategic alliance that
will combine the synergies of their products (wines and Iberian pork products), as well as their use of
traditional and new distribution channels and the launching of new offers in the market.
The two companies are undertaking regional and national market expansion, emulating alliances such as the one
between the Osborne Group and Jabugo.
A letter of intent was signed yesterday by Pascual Caputto, Managing Director of Antonio Barbadillo, and José
Enrique Rosenda, Managing Director of Sierra Morena. The strategic alliance seeks to divesify through a product
range of “of extraordinary quality, as provided by the Sierra Morena Group,” using the recently created Sierra de
Sevilla brand for acorn-fed hams.
Participating in Sierra de Sevilla are some hundred Sierra Norte de Sevilla livestock raisers, industrialists and
investors who have joined together to make the area the processer and marketer of its own production.
The alliance between Barbadillo and Sierra Morena will put 40,000 acorn-fed hams on the market in 2004. In 2008,
the projection is for over 100,000 hams, with a turnover of €36 million.
GALICIA
12/17/2001
Babío plans expansion across Galicia by 2004
Juan I. Cudeiro. A Coruña
06:00 a.m.
Jesús Babío’s family business sings the praises of diversificación and offers keys to survival in the
home furnishings and appliances sector, in which he has acquired successful experience over two
decades.
Jesús Babío’s children say their father is a true entrepreneur. His beginnings in real estate development were
the embryo of what is today a group with a yearly turnover of €7.21 millon with 25% growth this year, seven
points over the average for its last 5 years.
“The experience and contacts my father has acquired in housing led us to open bathroom and home furnishing
divisions,” explained Victor Babío, the firm’s managing director.
He and his brother, Jesús Babío López, Vice President of the firm, are the driving forces of a group with its
sights set on a clear three year goal… “Our idea is to be present in all of Galicia, by opening in Pontevedra and
Vigo, and consolidating our presence in A Coruña,” explained Victor. The expansion plan does not stop at the
border, because they have had an offer from a Portuguese group to set up shop in Oporto. “They would provide
the premises and we would provide the commercial side”. The offer is tempting, but the Babios have some
reservations.
It’s not a question of the solvency of their Portuguese partners, but rather the nature of the family business that
they hold so dear. “Father and sons meet every Sunday to talk and review how things are going, because we
are all in the same boat,” he says. “We have a 115 employees whom we relate to on a personal basis.” In
Victor’s opinión, this is one of the keys to their firm’s survival. He affirms that “profit is reinvested in the company;
the money we spend is from our own resources.” He insists that the day they don’t do so will be their demise.
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We should not think, however, that diversification is only vital for huge multi-nationals. As can be
seen in Exhibits 1 and 2, entrepreneurs and small business owners face the same challenges. In
the corporate life-cycle, success nearly always brings opportunities for diversification. Let’s
consider the following classic case.
You are a successful, French-trained chef who has just opened his second restaurant. The media,
the gastronomic guides and reviews, all rave about you. As a chef you have mastered your art, you
keep abreast of the new trends and fashions, but you also are a trend-setter, investigate new
cooking technologies. You are renowned for your impressive spice research center. Even your
peers recognize you as an authority. You have fame, success and, not surprisingly, a lot of free
cash and all the credit you could ever use. So what else could you wish for? May be you would like
to open a third restaurant, in an other city. But you are also thinking of doing something totally
different from what you have been doing so far? On the other, perhaps it would be better to use
what you know best, cooking, but use this know-how in a new way.
Let’s take the case of Karlos Arguiñano, one of the most famous Chef the Basque country has
produced and see how he has tackled the diversification process.
Born in 1948, in Beasain, Guipuzkoa, Karlos was the oldest of 4 brothers. He studied cooking in
the Escuela de Hosteleria del hotel Euromar en Zarautz (Gipuzkoa) managed by the Master Luiz
Irizar. Among his classmates were Pedro Subijana and Ramón Roteta, now famous chefs as well.
Arguiñano opened his first restaurant in 1978. After a long period of success, he began presenting
a cooking show on Spanish television, later expanding internationally to Argentina and the United
States, producing over 1,000 programs. In 1996 he opened his cooking academy-where over 1.000
people have been trained, including in the academy’s installations a four star hotel. Throughout the
80’s and 90’s Arguiñano has published many cookbooks; he even has his own web Page
(www.karlosnet.com) where fans can get recipes and advice.
Up to here, there is nothing terribly surprising in Arguiñano’s diversification path. It’s not difficult to
see how it all fits together, what we called earlier the coherent path to profitable growth. At every
step, Arguiñano was building on his knowledge of cooking, a know-how that he had developed for
years as he became one of the world’s best chefs.
But the Arguiñano took a riskier step. Using his experience in television as a springboard, he
entered the film industry as a producer and actor. His first project, Airbag, the #1 box office hit of
1997, with ticket sales of Euro 6.9 millions1. His second project, El Año Mariano, developed with
the leading actors from Airbag, was also a huge success. Arguiñano had successfully transferred
the skills he had learned in television to a new and risky enterprise. In effect, he had to answer the
two basic questions every firm contemplating diversification must face2:

Does the industry I want to enter offer more attractive opportunities for profit than those
available in the industry I am in now?

Can I establish a competitive advantage over the firms already established in the industry I
want to enter?
For Arguiñano, the answer to both questions was clearly, yes. The film industry offered exceptional
opportunities for profit, accompanied, of course, with the expected risk. Given the high risk,
diversification would only make sense if Arguiñano could establish a clear competitive advantage.
As a producer, Arguiñano used all the ingredients at his disposal to make a film that would beat the
competition: sex, action, focus groups to test scenes, and of course a very able director, Bajo
Ulloa. He turned out to be right.
1
2
European Cinema Yearbook 1997, Media Salles 1998.
Adapted from Grant R., “Diversification Strategy in Contemporary Strategy Analysis, Concepts, Techniques,
Applications”.
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Before turning to our discussion of how firms go about diversifying and how to decide whether they
are right to do so, a brief overview of the history of diversification might be useful.
Diversification is hotly debated subject in corporate strategy, with supporters and detractors on
both sides of the issue. During the expansion of U.S. multinationals in the 1950’s and 1960’s,
diversification was considered a necessary route to corporate success. The adage was «diversify
or die».3 Throughout the postwar period, the trend toward diversification was persistent and strong,
and debate focused on how much and to what extent to diversify.
However, when in the 1980’s the success of Japanese manufacturing firms created a new
competitive advantage based on quality and low cost for which U.S. firms seemed to have no
immediate answer, top management began to reconsider corporate strategies based on answering
just the industry attractiveness question without a clear view for creating a competitive advantage.
Suddenly, the new adage became «stick to knitting» and «back to basics».4 (put in footnote Tom
Peters In Search of Excellence). Throughout the 1980’s and early 1990’s, U.S. companies shed
unprofitable and “unrelated” businesses. After this period of restructuring, firms began once again
to think about growth, but this time with a much more sophisticated view. Firms began seeking
synergies (relatedness), looking for the right fit between its resources and capabilities and
opportunities for growth. Today, few firms believe in unrelated diversification. Nearly all insist that
the new products launched and the new markets being entered make an excellent fit with the firm’s
core businesses. Our job in the rest of this article is to understand exactly what that means and if
top management is right.
THE ROAD TO DIVERSIFICATION
Most firms begin as small single-business enterprises serving a local market with a single product.
Firms then grow broadening their product, geographical and vertical scope. Firms, as we shall see,
can grow in several ways, and diversification is only one of them.
A single business strategy has clear advantages. In a single-business firm there is less ambiguity
about “who the firm is”; all energies of the firm, those of the management team and the work force,
are directed down one path. A single business firm focuses all its entrepreneurial efforts on being
responsive to industry changes, making sure that the firm’s limited resources go where they are
truly needed. In a single-business firm, managers maintain hands-on contact with core business
activities.
However, a single business strategy may present several risks. First, there is the risk of putting all
firm’s “eggs” in one industry basket. If the industry stagnates, then the firm’s growth rate will fall;
this is usually accompanies by declining margins and profits. Second, a change in customer needs,
the emergence of technological innovation, or the apparition of substitute products can undermine
a single-business firm.
3
4
Steiner, 1964.
Peters, Tom. “In Search for Excellence”.
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TABLE 1
ADVANTAGES AND DISADVANTAGES OF A SINGLE BUSINESS FIRM
DIVERSIFICATION – MOTIVES FOR GROWTH
Diversification is, first and foremost, an alternative for growth. In Exhibit x, we see the relationship
between markets and products and firm growth. We need to keep in mind very clear problem: how
much change can we successfully manage? On the one hand, we can simply sell more of the
same to the same type of customer; on the other we can go after new products and new markets.
Before plunging into diversification, a smart firm usually considers the other, easier options. Later,
when we consider the diversification decision, we need to make sure that we have considered
these other strategies.
Firstly, firms can grow via Market penetration -- focus on increasing sales volume in current
businesses. When the overall market is growing, penetration may be relatively easy to achieve,
because the absolute volume of sales of all firms in the market is growing and some firms may not
be able to satisfy demand. In static or declining markets, a firm pursuing a market penetration
strategy is likely to face intense competition.
Example: Johnson and Johnson accomplished one of the great successes in market penetration
with its baby shampoo. When the birth rate started to slow down, the company became concerned
about sales growth. Johnson and Johnson’s marketers discovered that other members of the family
occasionally used the baby shampoo for their own hair. Johnson and Johnson launched an
advertising campaign aimed at adults, and soon the baby shampoo became the leading brand in
the total shampoo market.
Firms can also choose to enter a new market with a new product. New Product development
strategy involves the firm in substantial modifications, additions or changes to it's present product
range. But a firm following such a strategy operates from the security of its established customer
base. In research and development-intensive industries, product development may be the strategy
to follow, first because in such industries product life cycles tend to be short, and second because
new products may be a natural spin-off form the research and development process. New product
development can be risky and expensive.
Example: Product development strategies are common in the car and the aircraft industry. Aircraft
manufacturers like Boeing and Airbus Industry have launched a number of variants of their
commercial aircraft, in order to meet the differing operating demands of the world’s airline
companies.
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FIGURE 1
ALTERNATIVES FOR GROWTH (ANSOFF’S MATRIX)
Firms may decide to stay within the same market offering the same products and services but to
grow by entering new geographical areas, promoting new uses for an existing product or entering
new market segments. Market development, is an appropriate strategy to pursue when the
organisations distinct competence rests with the product rather than the market.
Example: During the 1980s, British Steel launched a marketing campaign to convince architects,
builders and engineers to design multi-story office blocks using steel rather than concrete for the
structural frame of buildings.
Finally, we come to the subject of this article: diversification. Diversification, as Ansoff succinctly
describes in Exhibit X, requires doing something new on both dimensions, markets and products.
Firms diversify for both proactive and defensive reasons. Top management may sense that there is
an opportunity out that’s just too good to not to go after – e.g., Karlos Arguiñano producing his first
cookbook. On other occasions, the desire to escape stagnant or declining industries has been one
of the most powerful motives for diversification – Altadis, the tobacco company, launching Logista,
to get into the express package delivery business.
Unfortunately, the sheer desire to grow is all-too-frequently the principal motivation for senior
managers and employees. Growth is especially beneficial to top management whose salaries tend
to be determined more by the size of the company than its profitability; middle managers are
delighted to know that new position with power and status will be created.
Diversification tends to spread through industries where growth and profits decline. In the example
below, Exxon diversified into areas that seemed similar to what they had done before as well as
into other areas that seemed completely new. We will take a closer look at what firms like Exxon
have tried to do as they enter new businesses, as we delve into related diversification and
unrelated diversification.
Example: Declining demand for oil during the late 70s and early 80s translated into the drive to
diversify in order to sustain growth. Almost all the companies diversified into minerals, coal, and
alternative energy sources.
While Exxon established large computer and office automation subsidiary, Mobile acquired retailer
Montgomry Ward, and British Petroleum built a large animal feeds subsidiary. By 1992, pressure
on profitability and increased attractiveness to shareholder value resulted in the divestment of
almost all the diversification of the previous decade.
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General Electric
5
General Electric (GE) is probably the most famous example of what we have called an unrelated diversified
company. Over the years, GE has been able to sustain a #1 or #2 position in a vast range of industries.
The company produces aircraft engines, locomotives and other transportation equipment, appliances (kitchen and
laundry equipment), lighting, electric distribution and control equipment, generators and turbines, nuclear reactors,
medical imaging equipment, and plastics. GE Capital Services, the financial subsidiary of GE, accounts for half of
sales and is one of the largest financial services companies in the US.
GE operates in more than 100 countries and employs 313,000 people worldwide. The Company traces its
beginnings to Thomas A. Edison, who established Edison Electric Light Company in 1878. In 1892, a merger of
Edison General Electric Company and Thomson-Houston Electric Company created General Electric Company.
GE is the only company listed in the Dow Jones Industrial Index today that was also included in the original index
in 1896.
Nokia: from Paper to Phones
6
Nokia is a good example of a firm that has diversified itself along the years in response to the changes of its
industry competitive environment and structure. Along its history, Nokia understood that to escape form mature or
dying industries that would not be profitable anymore it had to diversify.
Nokia's history dates back to 1865, when the Finnish mining engineer Fredrik Idestam established a wood-pulp mill
in Southern Finland and began manufacturing paper. Since then, the company has evolved dramatically, growing
first into a conglomerate encompassing industries ranging from paper to chemicals and rubber, and streamlining in
the 1990s into a dynamic telecommunications company.
1865 to 1960 - from paper to electronics
From its inception, Nokia was in the communications business as a manufacturer of paper - the original
communications medium. Then came technology with the founding of the Finnish Rubber Works at the turn of the
20th century.
Rubber, and associated chemicals, were leading edge technologies at the time. Another major technological
change was the expansion of electricity into homes and factories, which led to the establishment of the Finnish
Cable Works in 1912 and, quite naturally, to the manufacture of cables for the telegraph industry and to support
that new-fangled device - the telephone!
After operating for 50 years, an Electronics Department was set up at the Cable Works in 1960 and this paved the
way for a new era in telecommunications. Nokia Corporation was formed in 1967 by the merger of Nokia Company
- the original papermaking business - with the Finnish Rubber Works and Finnish Cable Works.
5
6
Adapted GE capsule in www.hoovers.com
Adapted from Nokia’s history in www.nokia.com
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1960s to '80s - setting new trends
The '60s, were important as the start of Nokia's entry into the telecommunications market. A radiotelephone was
developed in 1963 followed, in 1965, by data modems - long before such items were even heard of by the general
public.
In the 1980's, everyone looked to microcomputers as the next 'big thing' and Nokia was no exception as a major
producer of computers, monitors and TV sets. In those days, the prospect of High Definition TV, satellite connections
and teletext services fuelled the imagination of the fashion conscious homeowner.
In the background, however, changes were afoot. The world's first international cellular mobile telephone network,
NMT, was introduced in Scandinavia in 1981 and Nokia made the first car phones for it.
1987 to today - the digital 'Big Bang'
It took a technological breakthrough and a change in the political climate to create the wire-free world people are
increasingly demanding today. The technology was the digital standard, GSM, which could carry data in addition to
high quality voice. In 1987, the political goal was set to adopt GSM throughout Europe on July 1st 1991. Finland met
the deadline, thanks to Nokia and the operators.
Politics and technology have continued to shape the industry. The '80s and '90s saw widespread deregulation that
stimulated competition and customer expectations. Nokia changed too and in 1992 Jorma Ollila, then President of
Nokia Mobile Phones, was appointed to head the entire Nokia Group. The corporation divested the non-core
operations and focused on telecommunications in the Digital Age.
RELATED DIVERSIFICATION: THE QUEST FOR SYNERGIES
Diversification is related when a firm seeks to enter a business that, although distinct, possesses
an identifiable strategic fit with its core business; in short, two businesses have strategic fit when
their value chains offer potential for synergies. Not surprisingly, diversification is called unrelated
when there is no strategic fit among the diversified firm’s lines of business, nor meaningful value
chain interrelationships.
The goal of the related diversification is to exploit competitive advantages arising from the
relationships between its different business activities – these are known as synergies. Synergies
emerge when the joint effect of merged activities is greater than the sum of the separate effects. In
other words, synergies exist when two plus two adds up to five. When we refer to synergies, we are
not referring to some abstract, made up connections, but specific resources (financial, human,
technological) and capabilities (R&D, brand management, customer service) that can be shared
and transferred between businesses . Resources and capabilities are discussed more fully in an
other lesson.
TANGIBLE SYNERGIES
Synergies are both tangible and intangible. Tangible synergies are the ones we are all familiar with.
My division of the firm has a factory, and we have excess capacity, we share this capacity with a
new division the firm has just bought. Almost every activity of the value chain can be exploited in
the manner. Sharing technology, facilities, functional activities, distribution outlets, or other
resources often leads to economies of scale and scope.
To help firms facilitate the identification of possible sources of tangible synergies, we can use
Porter’s value chain as a checklist. The following tables give examples of possible sources of
synergies according to these categories.
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INTANGIBLE SYNERGIES
Intangible synergies are much more difficult to visualize than tangible synergies, but are probably
more value. For a quarter century, GE was famous for adding value to the firms it buys in large part
because of the management skills of Jack Welch. A recent example of seeking to create value via
intangible synergies is Vodafone’s action immediately following its acquisition of Airtel. The Airtel
unit’s name was changed to Vodafone to take advantage of a broad range of intangibles -- brand
name, corporate reputation, technology, specific relationship with third parties (e.g. governments,
regulatory bodies), which are clearly more important than the tangibles of scale economies in
production and advertising. In the case of mobile telephone business in which product
differentiation is extraordinarily difficult, the intangibles tend to be paramount.
Figure 2, “Value Chain Synergies” schematically shows the tangible and intangible (managerial
activities and technology) synergies that can arise between two business units.
FIGURE 2
VALUE CHAIN SYNERGIES
UNRELATED DIVERSIFICATION: THE QUEST FOR FINANCIAL GAIN
As you will recall, diversification is un-related when there is no strategic fit between the business
the firm is already in and the business the firm is about to enter.
Nokia is a wonderful example of a successful un-related diversification. Nokia´s President,
understood very well that to escape from the mature or dying industries it was operating in (paper
and rubber) it had to diversify. It was clear to that telecommunications “was the future”.
Unfortunately, Nokia neither had the technology nor the human resources. However, it had
something important working in its favor: top management understood that it was change or die,
and they convinced the workforce to go along for the ride.
Other reasons for unrelated diversification include (1) spreading business risk over a variety of
industries, (2) achieving greater earnings stability over the business cycle, and (3) taking
advantage of opportunities for quick financial gain, frequently termed corporate turnaround.
All three of these approaches require having corporate executives who are smart enough to avoid
the pitfalls of unrelated diversification. The greater the number and diversity of businesses a
conglomerate is in, the harder it is for corporate executives to know distinguish a good acquisition
from a risky one, select capable managers, or have the time to monitor what is going on. Unless
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corporate managers are exceptionally shrewd and talented, unrelated diversification is a dubious
and unreliable approach to building shareholder value when compared to related diversification.
Nokia’s and GE’s success are the exceptions. Most unrelated diversification efforts have been less
successful -- for example, Exxon’s leap into the computer business – and today unrelated
diversification has a bad name.
As a result, top management usually finds some pretext for calling all its diversification strategies
related. Nokia, see Exhibit x, defended its jump from the paper business to the phone business
arguing that the move was just a shift inside the communications industry. Of course, this probably
didn’t fool anybody.
In the end, related and unrelated diversification are, just like beauty and ugliness, not absolute but
a continuum, and frequently judged by the eye of the beholder. In short diversification is as much
art as science. Whatever its justifications, diversification must always seek to create shareholder
value.
HOW TO ENTER A NEW BUSINESS?
Firm can diversify in several ways. They can acquire a new business or start one up internally.
Joint ventures are also another way firm can diversify.
ACQUIRING AN EXISTING BUSINESS
Acquiring an existing company allows quick entry into the target market by hurdling various entry
barriers. One major barrier is technology in a given business or industry. Buying a company that
has the technological know-how gives the firm access to processes and expertise it is lacking.
Acquiring a company may also allow the firm to gain access to reliable suppliers or more adequate
distribution channels. Frequently a mid-size firm will acquire an existing company to achieve the
size to match rivals in terms of efficiency & costs
INTERNAL START-UP
Diversification via internal start-up is more attractive when time is not an issue. Indeed, such an
enterprise usually requires ample amounts of time and resources, though is usually less expensive
than buying an existing firm as no premium needs to be paid. The internal start-up strategy
assumes that the firm has most of the needed skills in house. In the case that the firm is a new
entrant in an existing industry, the firm must be sure that the additional productive capacity it brings
on line will not adversely impact supply-demand balance in industry.
JOINT VENTURE
When the diversification is too risky or costly to do it alone, a joint venture may be appropriate. In
industries such as the pharmaceutical business where product development may take a decade
and the investment runs to billions of US dollars, frequently firms use joint venture structures. In the
mobile telephone business, when UMTS licenses were auctioned, the expense and risk made for
very strange joint ventures with competitors joining together in different markets.
But, joint ventures also raise important questions. Conflicts between partners over who should take
what role are common.
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TABLE 1
MANAGERIAL INFRASTRUCTURE
Source of synergies
Common firm infrastructure needs
Common capital
Possible form of sharing
Shared accounting
Shared legal department
Shared government relations
Shared hiring and training
Shared raising of capital
Shared cash utilization
Potential
Advantage
Smaller support staff
Lower costs
Critical mass to attract top-level managers
Lower cost of financing
Competitive
Compromise cost
Need for coordination is higher
People may have different interests
Conflicts may occur more often
Need of different types of people
Increased complexity leads to higher overhead
TABLE 2
TECHNOLOGY CAPABILITIES
Source of synergies
Common product technology
Common process technology
Common technology in other value activities
One product incorporated into another
Interface among products
Possible form of sharing
Joint technology development
Joint interface design
Potential
Advantage
Lower product or process costs
Larger critical mass in R&D
Enhanced differentiation
Lower interface design cost
Competitive
Compromise cost
Technologies are the same, but the tradeoffs in applying the
technology are different among business units
A non-standard interface reduces the available market
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TABLE 3
PROCUREMENT INTERRELATIONSHIPS
Source of synergies
Common purchased input
Possible form of sharing
Joint procurement
Potential
Advantage
Lower cost of input
Improved input quality
Improved service from vendors in terms of responsiveness,
holding of inventory, conditions of sale
Competitive
Input needs are different in terms of quality or specifications,
leading to higher cost than necessary in business units requiring
less quality
Compromise cost
Technical assistance delivery needs vary
Centralization can reduce the information flow from factory to
purchasing, and make purchasing less responsive
TABLE 4
MANUFACTURING INTERRELATIONSHIPS
Source of synergies
Common location of raw materials
Identical or similar fabrication process
Identical or similar assembly process
Identical or similar testing/quality control procedures
Common factory support needs
Possible form of sharing
Shared inbound logistics
Shared component fabrication
Shared assembly facilities
Shared testing/quality control
Shared indirect activities
Potential
Advantage
Competitive
Compromise cost
Lower costs
Better capacity utilization, lower costs
Improved quality
Plants are located in different areas
Needs for components design and quality differ
Less flexibility OJOJOJO falta trexto
Testing procedures and quality standards differ
More difficult to manage larger work force
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TABLE 5
MARKETING INTERRELATIONSHIPS
Source of synergies
Common buyer
Common channel
Common geographical market
Possible form of sharing
Shared brand name
Shared advertising
Shared promotion
Cross selling of products to each other’s buyers
Shared channels
Shared sales force
Shared service network
Shared order processing
Potential
Advantage
Lower advertising costs
Reinforcing product images
Greater leverage in purchasing advertising space
Lower promotion costs
Lower cost of finding buyers
Lower cost of selling
Higher bargaining power
Lower infrastructure cost
Better sales force utilization
Lower servicing costs
More responsive servicing
Better capacity utilization
Lower order processing costs
Better capacity utilization
Competitive
Compromise cost
Product images are inconsistent. Diluted reputation
if one product is inferior
Appropriate media or message are different.
Advertising effectiveness reduced by multiple products
Appropriate forms and timing of promotion differ
Product images are inconsistent or conflicting
Buyer is reluctant to purchase too much from one firm
Too much dependency on channel.
Channel unwilling
to allow a single firm to account for a major portion of its sales
Different buyer purchasing behavior.
Different type of salesperson is more effective
Different equipment necessary to make repairs
Different needs of buyers
Differences in the firm and composition of typical orders.
Differences in ordering cycles
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DIVERSIFICATION STRATEGY
ASSESSING THE DIVERSIFICATION DECISION
Diversification is a corporate strategy decision that will affect the firm as a whole, and as such the
decision of whether to diversify or not must be assessed with great care. Every diversification
decision of course needs careful financial analysis. But that is not all. The diversification decision
must be also assessed on its potential to create shareholder value.
Michael Porter’s, “From Competitive Advantage to Corporate Strategy”, presents the mostly used
diversification decision model. In the section that follows, we work through Porter’s approach to
evaluation diversification opportunities.
THE THREE TESTS OF MICHAEL PORTER7
There are three essential tests to be applied in deciding whether diversification will truly create
value for the shareholders:

The attractiveness test. The industry chosen for diversification must be structurally attractive or
capable of being made attractive.

The cost-of-entry test. The cost of entry must not capitalize all the future profits.

The better-off test. Either the new unit must gain competitive advantage from its link with the
corporation, or vice versa.

The attractiveness test
Industries are profitable not because they are sexy or high-tech; they are profitable only if
their structures are attractive.
An attractive industry is an industry whose structure can offer returns exceeding the firm’s cost of
capital. If the industry doesn’t have such a structure, the company must be able to restructure the
industry or gain a sustainable competitive advantage that leads to returns well above the industry
average.
From the point of view of the firm that is planning to diversify, it is better if it is not obvious that the
industry is attractive. A company should choose to enter a new industry before the industry shows
its full potential.
BEWARE OF:

Comfort fit: often companies have the vague feeling that there is a good «fit» between the new
and old businesses. Put baldly, firms sometimes don’t do their homework. They ignore poor
industry structure; nor do they make sure that the synergies are there to leverage resources
and capabilities.

Low cost of entry: companies will fall into the trap of buying a company because it is cheap.
Once again, there are not many bargains to be found. This is like turning on the radio and
waiting for analysts to tell you about undervalued companies. (see Cost of entry test)

Fast growing industries: companies that rush into fast growing industries (e.g. PC, video
games, on-line banking, etc.) frequently get burned. They mistake early and potential growth
7
Porter, M.E.(1987). “From Competitive Advantage to Corporate Strategy”. Harvard Business Review, May–June,
43-59.
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for long term profit potential. They frequently lack the resources and capabilities to manage
these businesses.
Example: Royal Dutch Shell and other leading oil companies have had this unhappy experience in
a number of chemical businesses, where unattractive industry structure eliminated the benefits of
vertical integration and skills in process technology. These firms also underestimated the difference
between the oil business (where exploration is key) and the chemical business (where R&D is
vital).

Cost of entry test
The more attractive a new industry, the more expensive it is to get in.
Let’s consider more carefully the analysis of how much to pay to get into a new business. Entering
a new industry is a costly exercise, and diversification cannot build shareholder value if the cost of
entry into a new business eats up expected returns. As we have seen, a company can enter new
industries by acquisition or by internal start-up.
As we indicated earlier, financial markets become more and more efficient, acquiring a company at
a bargain has become more and more difficult. Moreover, when a company sees a competitor
vying to buy an attractive company, it may join in the bidding, with the result that the price paid is
greater than real value. Unsurprisingly, today most announcements of a purchase of a firm are
accompanied by a reduction in the share price of the acquiring company.
Internal start-ups must overcome entry barriers. Attractive industries have high entry barriers -- for
example, high advertising costs. Bearing the full cost of the entry barriers might well dissipate any
potential profits.
Example of acquisition:: Philip Morris paid more than four times book value for the Seven-Up
Co., for example. Simple arithmetic meant that profits had to more than quadruple to sustain the
pre-acquisition return on investment. Following the purchase, Philip Morris’s share prices fell.

The better-off test
This test addresses the following issue: what competitive advantages are created by
diversification? If we buy a company, can we add value to any of there current activities? Can the
acquired firm add value to what we do? If we diversify via internal start-up, do we have resources
or capabilities superior to the current competitors? To put in terms we all understand: will we be
more profitable?
Firms frequently assume that size alone means that they can add value. As we know this is not
always the case, and in the last decade strategists have begun to talk about “destroying value”.
Example: Movie and TV production appeared to be an attractive industry during the late 1980s and
early 1990s as firms manoeuvred to diversify across the broad range of entertainment business.
Sony bought Columbia Pictures, Matsushita bought MCA, Philips set up Poligram Pictures, only to
suffer years of losses as they sought to learn about the new businesses they had entered.
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THE CRITICAL QUESTIONS FOR DIVERSIFICATION SUCCESS
Finally, firms should have a checklist that allows them to evaluate diversification decisions in a
rigorous manner. Building on Porter’s work, Constantinos Markides8 offers a series of question
managers should ask themselves when considering whether or not to diversify.

Has the industry our company wants to enter passed the three tests of Porter?
Thoroughly apply the three tests of Porter: the attractiveness, the cost-of-entry, and the better-off
test to the industry your company is considering entering. Remember, only when these three tests
are passed, diversification will contribute to the firm’s value If you ignore one or two of them, the
results can be disastrous.

What can our company do better in than any of its competitor in its current market?
The basis of your decision to diversify must rely on a systematic and thorough analysis of your
business. Vague definitions and approximations are not enough. Define what and where are your
strengths, strategic assets). Think about what do best, but more importantly think about what you
do better than your competitors.

What strategic assets do we need to succeed in the new market?
Your success in one industry doesn’t guaranty your success in an other. When considering
diversification you need to ask yourself whether your company has all the strategic assets
necessary to succeed in the market you want to enter.

Can we catch up or leapfrog competitors at their own game?
If you lack a major strategic asset, you can always buy it or develop it in-house or render it
unnecessary by changing the competitive rules of the game.

Will diversification break up strategic assets that need to be kept together?
Are the strategic assets you wan to use in the new industry transportable to this new industry?
Some groups of competencies, or skills work very well because there combined together they
reinforce and support one another. By breaking them apart you may loose these synergies. You
cannot take the engine out of plane and expect it to fly.

Will we be simply a player in the new market or will we emerge a winner?
Entering a new industry with all the required competencies, in the right combination is not a
guaranty of success. Diversifying companies are often quickly outmaneuvered by their competitors,
because they have failed to consider whether their strategic assets can be easily imitated,
purchased on the open market or simply replaced.
KEY CONCEPTS

Diversification is about doing something new, taking risks and venturing into the unknown to
seek greater competitive advantage and increased income and profits.

Diversification is a corporate strategy decision taken at the highest level that impacts on the
fundamental direction of firm.
8
Markides, C. (1997). “To Diversify or Not to Diversify”. Harvard Business Review, November-December.
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
Firms can grow via market penetration, market development, product development and
diversification (related and unrelated).

Diversification is related when a firm seeks to enter a business that, although distinct, possess
some kind of strategic fit with its core business. Businesses have strategic fit when their value
chains offer potential for synergies.

Diversification is called unrelated when there is no strategic fit among the diversified firm’s
lines of business nor meaningful value chain interrelationships. Unrelated diversification is
focuses solely on the potential financial returns of individual business units.

The decision of whether to diversify or not must be assessed with great care. Rigorous
financial analysis is vital, as in all major business decisions; the key challenge is to assess
how management can create shareholder value via entering a new competitive arena.

Michael Porter’s develop three tests of diversification – attractiveness, cost-of-entry and betteroff – help us to assess the diversification decision. All three tests must be passed, ignoring one
or two of them, may lead to disaster.
CONCLUSION
Diversification is like politics. Everybody talks about it, everybody thinks he knows the answer to
big questions, but very few manage to do it very well or stay in power for very long. In fact,
empirical research about the performance of diversified firms shows that it is difficult to generalize
about the performance outcomes. In other word what works for some, doesn’t for others.
What is can say is that when firms diversity, success depends almost always on a clear strategic
vision and the commitment of an effective top management team. The best way to make sure that
there is a clear strategic vision is to probe and question. Question number #1 should always be the
same: Is top management on an ego trip, caught up in the “bigger is better, this company is mine”
trap? Once we have clear that this is not the case, we can apply Porter’s three tests. To get to the
right answer, rigorous analysis of synergies (resources and capabilities) is fundamental. ■ ■ ■
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