Which is better related business diversification or unrelated business diversification?

Introduction:

“Strategies are the means by which long-term objectives will be achieved. Business strategies may include geographic expansion, diversification, acquisition, product development, market penetration, retrenchment, divestiture, liquidation, and joint ventures” (David, 2011). According to Thompson and Strickland (1999), the business strategy of a company is a game plan in order to achieve organizational objectives by attracting and pleasing customers, staking out a market position, conducting operations, competing successfully and growing the business. Kotler and Armstrong (2012, p.44) state, “companies need growth if they are to compete more effectively, satisfy their stakeholders and attract top talent.” Marketing is the main tool for achieving profitable growth and the market expansion grid (figure 1.0) identifies growth opportunities like diversification (Kotler and Armstrong, 2012). This essay aims to give information about the diversification, reasons of diversification, types of diversification, capabilities of companies and the impact of capabilities on narrow spectrum diversification.

Strategic directions for growth:

The scope, breadth and growth of organizations are the main issues of corporate level strategy. “Should the firm be very focused on current products and markets?” or “Should it be diversified in terms of both products and markets?” are very important questions for a company (Johnson et al., 2008). Ansoff’s matrix (figure 1.0) shows four alternative strategic directions of growth. First direction is the penetration of existing markets with current products. Second direction is market development such as building new markets in new customer segments. Third direction is product development, referring to product improvement and innovation. Last direction is diversification, which means expansion of an organisation’s scope in terms of both markets and products (Johnson et al., 2008).

Diversification:

Diversification is the increase in the number of markets in which the company competes (Berry, 1975). According to Johnson et al. (2008), diversification takes the company away from its current markets, which means it changes the scope of the company. Rumelt (1982) states that when companies need to expand, they can develop new products that have no market interaction with current products of the company. The companies can get advantages of diversification through greater market power, more efficient asset deployment and transfer of human resources. In other words, the benefit from such strategy encompasses the dimension of growth, resources synergy and risk reduction (Pandya and Rao, 1998).

Value creating reasons of diversification:

Diversification is the most risky and radical direction of growth and it can be chosen for a variety of value creating reasons as listed below (Johnson et al., 2008).

• If a company cannot effectively underutilise its resources or competences for the current markets and products, it is logical to use these resources or competences for diversification into new markets and products in order to increase the efficiency of the organization.

• If a company has strong corporate capabilities, it can gain advantage by extending these capabilities into new markets and products.

• If a company can afford to finance one business from the surpluses earned by other businesses, this can give an organisation a competitive advantage for the subsidised business.

Johnson et al. (2008) states that there are also logical but less value creating reasons for diversification.

• Responding to market decline.

• Spreading risk across a range of businesses. 

• The expectations of powerful stakeholders.

According to Johnson et al. (2008, p.265), “in order to decide whether or not such reasons make sense and help organisational performance, it is important to be clear about different forms of diversification, in particular the degree of relatedness of business units in a portfolio.”

Types of diversification:

There are two general types of diversification strategies: related and unrelated. Related diversification is a corporate expansion beyond current products and markets, but within the capabilities or the value network of the organisation (Johnson et al., 2008). “Most companies favour related diversification strategies in order to capitalize on synergies as follows” (David, 2011, p.143).

• Transferring technological knowledge and other capabilities from one business to another.

• Combining the related activities of separate businesses into a single operation.

• Creating collaboration between businesses to strengthen valuable resources and capabilities.

Unrelated diversification is the development of products beyond the current capabilities or value network of the organization and it is often described as a conglomerate strategy (Johnson et al., 2008). According to David (2011), if the value chains of businesses are different and there are no competitively valuable cross-business relationships, such diversification is unrelated.

There are several studies, which measures the diversification of the companies. The theory of Rumelt (1974), the most used in practice, classifies firms into four types of diversification categories. The specialization ratio (rs) is the proportion of total firm sales attributed to the firm’s largest single business and the related ratio (rr) is the proportion of a firm’s annual sales corresponding to its largest group of related business.

• Single Business: Rs ≥ 95%

• Dominant Business: 70% ≤ Rs ≥ 95%

• Related Business: Rs< 70% and Rr ≥70%

• Unrelated Business: Rs <70% and Rr < 70%

Johnson et al. (2008) state, the research studies about diversification proved that diversification is good but going further decreases the performance. In other words, an average related diversification pays better than unrelated diversification. According to Sveiby (1999), it is much easier to manage a narrowly focused knowledge company than conglomerates because it is very difficult for the conglomerates to achieve better quality than focused companies.

Narrow spectrum diversification:

Wood (1971) classified diversification into two types that are narrow spectrum diversification (NSD) and broad spectrum diversification (BSD). NSD is an expansion outside a four-digit SIC industry but within a two digit SIC industry and it is measured by the number of four-digit categories of the industrial classification system in which the firm is active, divided by the number of two-digit categories in which the firm operates. BSD is an expansion into a different two-digit SIC industry and it is measured by the number of two-digit categories of the industrial classification system in which the firm is active. The SIC system is a numerical system developed by the U.S. government for classifying all types of economic activities (Montgomery, 1982). Jacquemin and Berry (1979) state that narrow spectrum diversification is closely related to a firm’s primary activities and areas of technical expertise. On the other hand, broad spectrum diversification is unrelated and it is less closely related to a firm’s primary activities and areas of technical expertise. The theory of Wood (1971) is too complicated and the theory of Rumelt (1974) is able to overcome the limitations of the measures based on SIC codes with respect to identifying the nature of the diversification strategy. Varadarajan and Ramanujam (1987, p.383) state, “the diversification conceptualization does not require data on revenues of business segments, but still provides insights into both the degree of diversification, high versus low, and its direction, predominantly related or predominantly unrelated.” Figure 3.0 shows that low NSD is low-related diversification and high NSD is high-related diversification.

Capabilities of companies:

“Capabilities are complex bundles of skills and knowledge embedded in organizational processes that a firm performs well relative to rivals and which transform the firm’s available resources into valuable outputs” (Feng et al., 2016, p.1). Kozlenkova et al. (2014) state that the capabilities of organizations enable them to perform value-creating tasks effectively and efficiently as well as gain competitive advantage and superior performance over time. According to Krasnikov and Jayachandran (2008), marketing, R&D, and operations capabilities are the core functional capabilities for an organization and they create sustainable competitive advantage. According to Sveiby (2001), organizations have tangible and intangible assets as resources. Tangible assets are properties, plants, equipment and financial resources such as cash and trade receivables (Atrill and Mclaney, 2015). There are three kinds of intangible assets: internal structure such as patents, concepts and systems, external structure such as brands, trademarks and reputation and individual competence such as capabilities of employees (Sveiby, 2001). According to Ciprian et al. (2012, p.688), the intangible assets are “knowledge, experience and intellectual force of employees, as resources and knowledge stored in the databases of the organization, in systems, in processes, in culture and philosophy, all managed and used to obtain services and products with the ultimate aim of obtaining benefits.” Zack (1999) states that knowledge is the major strategic resource of business organizations.

Impact of capabilities on related (narrow spectrum) diversification:

Faulkner and Campbell (2003) states, companies see better diversification opportunities when they have excessive resources and capabilities in investment capital, management talent, brands, distribution and research. Growing into new markets is more beneficial than further expansion of familiar products and diversification is compatible with resource-based or capability models of strategy (Faulkner and Campbell, 2003). The companies that use their resources and capabilities can easily diversify into closely related fields. When the degree of relatedness is closer, the company can run relevant existing management capabilities and routines into the new business more efficiently. In addition, the company can transfer its human resources more easily and it can share more physical resources such as industrial plants. Furthermore, the company can gain economies of scope and scale by using its resources while expanding into related areas. It can use the existing capacity intensively to reduce costs and sell new products without significant investment. “Related diversification can bring in more revenues with less new fixed investment and improve the efficiency of its existing resource infrastructure by increasing the flow of product to a wider range of customers” (Faulkner and Campbell, 2003, p.279).

Case study: Narrow Spectrum Diversification Failure

It is important to recognise the capabilities of the company before diversification. In some cases, the companies see close value links to their current business. For example, some car manufacturers decided to integrate repairing and servicing into their businesses in 1990s. The companies thought they would be able to create value by diversifying into repairing and servicing to ensure a better overall customer experience. However, repairing and servicing business is different from car manufacturing and it requires quite different capabilities like managing many scattered small units rather than managing big manufacturing factories (Johnson et al., 2008). As a result, the absence of necessary capabilities outweighed the potential value links and the car manufacturers started to withdraw from repairing and service business. It is important to recognise that strong relationships between businesses can have potential disadvantages and related diversification can be problematic in some cases (Johnson et al., 2008).

Case study: Microsoft

“Microsoft Corporation is a multinational technology company headquartered in Washington, that develops, manufactures, licenses, supports and sells computer software, consumer electronics and personal computers and services” (Wikipedia, 2017b). The company is known for its high-demanded software products Microsoft Windows, Microsoft Office and Internet Explorer. In addition, Microsoft produces and sells hardware products like the Xbox video game consoles, Surface tablets and Lumia smartphones. Microsoft was founded in April 1975 to develop and sell software and it is the world's largest software maker by revenue as of 2016 (Wikipedia, 2017b). The business scope of Microsoft has changed radically over time and the company has evolved from being a software supplier to a company that epitomizes the new developments in technology, information services, entertainment and networking. Microsoft has captured various segments of the IT industry by diversifying gradually their portfolio into related areas by using their resources. Until 2001, the main focus of the company was operating systems, office suites and computer games for windows based platforms. Since Microsoft had experience with computer games, they decided to enter game consoles market, which was dominated by Sony PlayStation consoles. The company revealed Xbox game console in 2002 and released Xbox 360 in 2005 to compete with Sony’s PlayStation 3 and Nintendo’s Wii. Microsoft sold 67.2 million Xbox 360 consoles worldwide until April 2012 (Qureshi, 2012). Microsoft entered hardware production business and increased their technical capabilities by Xbox. In addition, Microsoft decided to introduce a search engine to compete with Google and developed Bing by using the structure of “MSN” and advantages of “internet explorer”. As Microsoft Windows is the leader operating system for personal computers worldwide, it was very easy to increase the popularity of “Bing” by making it the opening page and main search engine of the internet explorer. In October 2011, Microsoft bought Skype with all technology and teams of engineers in order to converge communication, information and entertainment (Qureshi, 2012). The company saw tendency to tablets and decided to develop them to compete with Apple’s iPad by using the power of Microsoft Windows. Microsoft introduced “Microsoft Surface” in 2012, which was the first integration of Windows operating system with its own hardware and was the first PC designed and distributed solely by Microsoft. Microsoft also bought mobile division of Nokia to enter the smartphone hardware market in 2013. Microsoft phones use windows mobile as operating system. The tablets, smartphones, notebooks and computers that use windows operating systems, are compatible with each other and each device can run any program developed for Microsoft. Finally, Microsoft announced the acquisition of LinkedIn at $26.2 billion and entered social media industry in 2016 (Wikipedia, 2017b). Microsoft revenues have increased from 25 B$ in 2001 to 94 B$ in 2015 (Microsoft, 2017). 

Case study: Apple

“Apple is a multinational technology company headquartered in California that designs, develops, and sells consumer electronics, computer software, and online services” (Wikipedia, 2017a). The company produces and sells the iPhone smartphone, the iPad tablet computer, the Mac personal computer and the iPod portable media player as hardware products. Apple was founded in April 1976 to develop and sell personal computers and now Apple is the world's largest IT company and the world's second largest mobile phone manufacturer (Wikipedia, 2017a). The company was producing mainly computers until 2001, the revenue maker products “Power Mac” and “iMac” were at the end of their product life cycle. The company had to revamp the product range and develop new products for new markets. After careful analysis, the company choose portable music player market because the market was attractive in terms of size and growth potential and the products of other competitors were outdated like Sony Walkman. Key success factors in the portable music player market were identified as design, size, capacity, battery life and software. Apple was an expert in software and hardware production. The first iPod was launched in October 2001. Without technical capabilities and knowledge of Apple, it would have been very difficult to develop and produce such a device in one year but Apple succeeded. Apple also decided to develop a web platform to help users access their music through internet. The iTunes Music Store opened in April 2003. Apple was selling over 50 million iPods a year worldwide, with a 75% share of the US market by 2008. The iTunes Music Store accounted for 87% of all legal digital music sales in the USA. Although the iPod was comprehensive, it was lacking internet connectivity and mobile connection. Apple decided to introduce a new product in 2007. Apple used software and hardware of iPod as a base and developed iPhone 2G as a music player and smartphone together. The iPhone had captured 25% of the US smart phone market in 2008 by challenging the Blackberry and Nokia. IPhone was not the end of diversification story of Apple. Apple saw a potential market in personal computers, tendency to notebooks and decided to develop a portable revolutionary device for browsing the web including emails, watching videos, listening to music, playing games, reading e-books and much more. Apple introduced iPad in 2010, which was thinner and lighter than any notebook or netbook. IPad used the software and hardware structure of iPhone and became the most popular tablet worldwide. The company sold over 330 million iPods, 200 million iPhones and 55 million iPads until 2012. Over 75% of sales were from products, which did not exist before 2000 (Ashcroft, 2012). Apple revenues have increased from 5 B$ in 2001 to 234 B$ in 2015 (Wikinvest, 2017).

Case study comparison:

Both Apple and Microsoft used their resources in order to diversify in new markets with new products. Both companies were very experienced in software production. The main difference between Apple and Microsoft is that Apple was generally the founder of the products, on the other hand Microsoft was the follower. For example, iPod, iPhone and iPad were the first popular types of their kind and many companies followed them. However, Microsoft developed Xbox but Sony PlayStation is/was the market leader, it developed Bing but Google is/was the market leader, it developed tablets but Apple and Samsung have already dominated the market, it started to produce smartphones but Apple and Samsung are/were the market leaders. In short, Apple was more innovative than Microsoft. Apple diversified less narrowly than Microsoft by using the hardware and software technology of their previous products. Microsoft was not experienced in hardware production when they decided to enter game consoles industry. In addition, Apple had the technical capabilities to develop smartphones but Microsoft had to buy Nokia in order to enter smartphone industry. Furthermore, Apple developed iPad from iPhone, on the other hand, Microsoft Surface was the first integration of its own software and hardware. In short, Microsoft used their financial power mostly but Apple used their knowledge and experience mostly as a resource to diversify. Moreover, both companies were successful in new markets with their new products due to image value of their brands and experience of human resources.

Conclusion:

Assessing growth opportunities is one of the most important aspects of corporate level management that need to develop or acquire new businesses to fill the gap between desired and projected revenues (Kotler and Keller, 2012). The most risky way of expanding business is diversification according to Ansoff matrix. Johnson et al. (2008) state that diversification is good but the performance decreases when it becomes unrelated with current businesses. The companies can diversify to related businesses by using their resources and technical capabilities. Apple and Microsoft are leading companies of the world in IT industry. Each company used its own different resources in order to develop new products in new markets and both succeeded. Microsoft mostly preferred to acquire with other companies by using its financial resources, on the other hand Apple used its own knowledge and experience to develop innovative products. In addition, both companies used the power of their brand names for new products. Based on the increase in annual revenues, Apple is much more successful. Now both companies compete in some similar markets like tablets and smartphones, which none of them was producing before 2000s and Apple is much more successful in both products in terms of sales. It proves that the power of knowledge and experience is much more efficient than the power of financials while diversifying.

Serkan Baran ÖZ

19.04.2017

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Why is related diversification better?

Which type of diversification strategy shows the best performance?

Is unrelated diversification good?

Why is unrelated diversification successful?