4.6. Diversification Flashcards
Define diversification
It is a corporate strategy to enter into a new industry/market which the business is not currently in whilst also creating a new product for that new market.
Types of diversification
- related diversification
- unrelated diversification
hard to define what related really means
Related diversification
expanding into businesses that have a lot in common with each other, for example in terms of:
– Skills
– Sharing manufacturing plants
– Shared R&D
Unrelated diversification
expanding into business that do not have a lot in common with each other
– The current wisdom is that “unrelated” diversification is not good for firm performance: remember Parmalat?
– There are exceptions (e.g. Virgin)
Reasons to diversify
- Behavioral (related to limits of human rationality) - people are more stupid than we think
- Managerial Reasons(related to opportunism) - selfish behaviour, benefit for top leaders/managers
- Economics Reasons
In general, the first 2 bullet points are bad reasons for diversifying
Behavioral reasons
- Naive(imitation of successful firms,did not listen to Porter about being ”unique”)
- Emotional attachment (e.g. Parmalat, likes football -> invest in that business)
- Need to spend cash( ”free cashflow” hypotheses by Jensen (1988)) :
+ If managers are given the chance not to pay out dividends (”retained earnings”) they usually waste that money
Managerial reasons
a) Empire building
– ”I was the presiding CEO when we grew the company from selling milk to sellling everything under the sun”)
b) Larger compensation (more money)
c) Diversifying risks for managers
– Often managers’compensation is in stock(so unlike investors they cannot diversify risk by buying different stock)
Economics reasons
a) Internal capital markets
– Existing firms can fund projects that would not get funded through the market:
• Information asymmetry: funders do not hold enough information about entering companies to give out capital
(existing companies have more credibility and experience -> more likely to receive funds
b) Diversifying risk for shareholders
– The counter argument says that shareholders can do that themselves by buying different stock
c) Gaining market power
d) Economies of scope
Define economies of scope
Reductions in unit costs deriving from the fact that the total cost of producing a two different goods together in one firm is lower than the cost of producing them separately in two firms.
Differences between the economies
- Scale: looks at average costs across two different capacity levels of the same good
- Fixed cost absorption: looks at average costs across two different utilization rates of the same good
- Learning: looks at average costs across two different cumulative production rates of the same good
- Scope: look at average costs of several goods done jointly vs. done separately
Example of economies of scope
• Poste Italiane: postal services but also communications, logistic and financial products and services:
– It uses its wide network of local branches to sell a range of services ranging from postal service and
financial service, to mobile telephony, stationery, books and music
• Sources of economies of scope may be material (shared distribution networks, customer care) but also intangible (shared brand and corporate image, know- how)
• Proctor & Gamble (P&G): Given the high need for marketing in consumer goods, P&G can market toothpaste, razors, soap etc with lower average costs than specialized firms (shared graphic designers, skills for advertising)
2 specific types of diversification
- vertical integration
- horizontal integration
Horizontal integration
The introduction of additional business activities that are at the same level of the value chain in different industries.
Advantages of horizontal integration
- Eliminates one competitor -> increased market powers over suppliers and distributors
- Possible economies of scale
- Economies of scope: achieved by sharing resources common to different products
- Scope for rationalising
- Customer perception of quality: Linkages between products
Disadvantages of horizontal integration
- Lack of competition means the consumers have less choice => prices are higher => may react negatively
- Lack of experience in this sector of the industry - a successful manufacturer does not necessarily make a good retailer
