Contribution of Diversification Strategy for Sustainable Development of Corporate sector

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1 Contribution of Diversification Strategy for Sustainable Development of Corporate sector Umang Verma Asst. Professor, BIT Group of Institutions, Delhi-Meerut Bypass, Partapur, Meerut Abstract: Diversification of business activities brings competitive advantages allowing companies to reduce business risks. That is why it is a great tool for business development. A diversification strategy stands apart from the other three strategies such as merger and acquisition, internal start up, Joint Venture. These are usually pursued with the same technical, financial, and merchandise resources used for the original product line, whereas diversification strategy usually requires a company to acquire new skills, new techniques and new facilities. Efficiency gains, where an organisation has underutilized resources and competences that it cannot effectively close or sell then it make business sense to use the resources and competences by diversifying into a new activity. Judgments about the timing of a company s diversification effort are best made instance by instance, according to company s own unique situation. Present study aims to analyze the role of diversification strategy for sustainable development of corporations. Key words: Related diversification, unrelated diversification and sustainable development. Introduction: Meaning of Diversification: - Diversification is a business development strategy allowing a company/ firm to enter additional lines of business that are different from the current products, services and markets. Diversification of business activities brings competitive advantages allowing companies to reduce business risks. That is why it is a great tool for business development. However, its successful implementation requires profound knowledge and thorough preliminary assessment of the company and its environment. Although sometimes diversification is difficult for the small companies, it can prove to be inevitable when their original markets become unviable. A diversification strategy stands apart from the other three

2 strategies such as merger and acquisition, internal start up, Joint Venture. These are usually pursued with the same technical, financial, and merchandise resources used for the original product line, whereas diversification strategy usually requires a company to acquire new skills, new techniques and new facilities. To measure how diversified a firm is at a given point of time, Richard Rumelt developed the notion of relatedness. Rumelt focused on three characteristics of firms: the proportion of a firm s revenue derived from (1) its largest business, (2) its largest group of related business, and (3) the stages of a vertically integrated production process. 1 Related diversification, occurs when a company/firm develops beyond its present product and market at the same time as remaining in the same area. It will use its present strengths by using its expertise to develop new interests in same area. Meaning of sustainable development of corporations:. Sustainable development is a broad concept in that it combines economics, social justice, environmental science and management, business management, politics and law. It is a dialectical concept in that, like justice, democracy, fairness, and other important societal concepts. sustainable development is as much an economic necessity as it is an environmental and social necessity for the corporate sector. Objective: To Diversify the Risk of corporate sector. Diversification has the highest level of risk and requires the most careful investigation. Going into an unknown market with an unfamiliar product offering means a lack of experience in the new skills and techniques required. Therefore, the company puts itself in a great uncertainty. Moreover, diversification might necessitate significant expanding of human and financial resources, which may detract focus, commitment, and sustained investments in the core industries. Therefore, a firm should choose this option only when the current product or current market orientation does not offer further opportunities for growth. COMPANIES THAT HAVE DIVERSIFIED INTO RELATED BUSINESS

3 Samples of companies that have pursued a strategy of related diversification are illustrated below. JOHNSON & JOHNSON PEPSICO Baby products Fruit juices (Tropicana) First aid products Soft drinks Medical devices Contact lenses Other beverages (Aquafina bottled water etc.,) Sports drinks (Gatorade) Personal Care products Snack foods (Lays, Chee tos etc.,) Surgical & Hospital products Breakfast products Unrelated diversification is used to describe a company moving its present interests into unrelated markets or products. Companies that pursue a strategy of unrelated diversification generally exhibit a willingness to diversify into any industry where there is potential market for a company to realize consistently good financial results. RELIANCE TABLE 2 COMPANIES IN UNRELATED DIVERSIFICATION WIPRO

4 Petro chemical products Electrical appliances Telecom services Information technology Power Computer accessories Mobile phones Toilet soap (Santoor) Construction GE medical system Textiles Baby care products Mutual funds, Life Insurance Others Types of Diversification: - Diversification is a strategic approach adopting different forms. Depending on the applied criteria, there are different classifications. Horizontal Diversification: - Acquiring or developing new products or offering new services that could appeal to the company s current customer groups. In this case the company relies on sales and technological relations to the existing product lines Vertical Diversification: - Occurs when the company goes back to previous stages of its production cycle or moves forward to subsequent stages of the same cycle - production of raw materials or distribution of the final product. Concentric Diversification: - Enlarging the production portfolio by adding new products with the aim of fully utilising the potential of the existing technologies and marketing system.

5 Heterogeneous (conglomerate) diversification: - Heterogeneous (conglomerate) diversification is moving to new products or services that have no technological or commercial relation with current products, equipment, distribution channels, but which may appeal to new groups of customers. Corporate Diversification: - Corporate Diversification involves production of unrelated but definitely profitable goods. The pros and cons of diversification We are all aware of the famous saying: Don t put all your eggs in one basket. When a firm operates in many businesses, the downs in one can be compensated by the ups in another. According to portfolio theory, unsystematic risk, the risk particular to a company or an industry, can be eliminated by building a diversified basket of stocks. Pros Economies of scale and scope Operational synergies can be realized. Spreading the firm's unutilised organizational resources to other areas can create value. Leveraging skills across businesses can create value. Transaction costs Coordination among independent firms may involve higher transaction costs. Internal capital market Cash from some businesses can be used to make profitable investments. External finance may be more costly due to transaction costs, monitoring costs, etc. Diversifying shareholders portfolios Individual shareholders may benefit from investing in a diversified portfolio. Cons

6 Combining two businesses in a single firm is likely to result in substantial influence costs. Resource allocation can be influenced by lobbying. Costly control systems may be needed that reward managers based on division profits and discipline managers by tying their careers to business unit objectives. Internal capital markets may not work well in practice. KEY BARRIERS/PROBLEMS FACED WHILE DIVERSIFICATION Lack of Skills Specialist business advisor Capacity to develop a business case Regulatory controls Planning controls Access to finance Validity of Marketing Research INDUSTRY (FIRMS/COMPANIES) THAT WE HAVE CHOOSEN In India, the mild mannered and impeccably behaved legendary businessman, JRD Tata successfully built a portfolio of diverse businesses, even though his management style was quite different. But Tata had the extraordinary knack of selecting some truly outstanding managers to run the different companies. He kept Russi Modi at Tata Steel, Sumant Mulgaonkar at Telco, Darbari Seth at Tata Chemicals and Ajit Kerkar at India Hotels. Some of these managers like Russi Modi had a higher profile than JRD himself. But the visionary Tata did not have any problems in providing space to these gifted managers. When the young Azim Premji took charge of the group after the untimely demise of his father, Wipro was essentially involved in the vegetable oils business. Premji had the vision to take Wipro into new unrelated businesses including computer hardware, lighting soaps, medical equipment and computer software.

7 APPLYING THE CONCEPT OF DIVERSIFICATION Whenever a single business companies faced with diminishing market opportunities and stagnating sales in its principal business, it is the signal for diversification. The other key factors are, a) When it has a powerful and well-known brand name that can be transferred to the product of other business. b) When diversifying into closely related business opens new avenue for reducing costs. c) When it can expand into industries whose technologies and products complement its present business? Judgments about the timing of a company s diversification effort are best made instance by instance, according to company s own unique situation. Reasons for diversification Efficiency gains, where an organisation has underutilized resources and competences that it cannot effectively close or sell then it make business sense to use the resources and competences by diversifying into a new activity. Increasing market power, an organisation can afford to cross-subsidize one business from the surpluses earned by another in a way that competitors may not be able to. Stretching corporate parenting capabilities into markets and products. Responding to market decline Spreading risk A firm may choose the strategy of diversification under the following situations: (a) When diversification promises greater profitability than expansion. (b) When the firm cannot attain its growth target by the strategy of expansion alone. (c) When the financial resources of the firm are much in excess of the requirements of expansion.

8 DISCUSSION & FINDINGS From the above analysis of both diversification strategies the below are the findings Why is related diversification only marginally profitable than unrelated? How can diversification dissipate rather than create value? Michael Porter s research suggests that average related company is at best only marginally more profitable than the average unrelated company. He found that most of the companies had divested many more diversified acquisitions than they had kept. He and its team have concluded that the corporate diversifications strategies pursued by most companies can dissipate value rather than creating it. Accomplishments of unrelated diversification business are, Cutting unrelated cost Concentrating on core areas Seeking external markets RESULTS Diversification Strategies Characteristics Growth Profit Risk Related Diversification Operates in a few related industries Low High Low

9 Unrelated Diversification Operates in many unrelated industries High Low Medium DIVERSIFICATION STRATEGY MATRIX Growth High Low High Mixed Diversification Related Diversification Profit Low Unrelated Diversification Disinvestment INFERENCE When companies mainly focusing on profit, they can prefer unrelated or mixed diversification strategy. When companies mainly focusing on growth, they can prefer related diversification or mixed diversification strategy. When the company s growth and profit are at low, suggest that they can go for disinvestment the business operations.

10 Three ways a firm may Grow 1. Strengthen the execution infrastructure by investing in safe bets : Regardless of which growth strategy is selected, a firm s infrastructure must be up to a standard that supports successful execution. An on-going commitment to creating such an infrastructure is a safe bet. Achieving this requires (1) eliminating departmental or regional silos, (2) utilizing leading indicators and performance drivers that align with the strategy and (3) growing leaders at all levels managerial and non-managerial. 2. Diversify: Small-business consultant McGuckin offers several ideas for diversifying your product or service line: Sell complementary products or services Teach adult education or other types of classes Import or export yours or others' products Become a paid speaker or columnist "Diversifying is an excellent growth strategy, as it allows you to have multiple streams of income that can often fill seasonal voids and, of course, increase sales and profit margins," says McGuckin, who diversified from an accounting, tax and consulting business to speaking, writing and publishing. Expand to the Internet. "Bill Gates said that by the end of 2002, there will be only two kinds of businesses: those with an Internet presence, and those with no business at all," Focus on different motives of diversification GROWTH The desire to escape stagnant or declining industries has been one of the most powerful motives for diversification (tobacco, oil, and defense). But, growth satisfies management not shareholder goals. Growth strategies (esp. by acquisition), tend to destroy shareholder value. RISK Diversification reduces variance of profit flows.

11 SPREADING But, does not normally create value for shareholders, since shareholders can hold diversified portfolios. Capital Asset Pricing Model shows that diversification lowers unsystematic risk not systematic risk. PROFIT For diversification to create shareholder value, the act of bringing different businesses under common owner- ship must somehow increase their profitability. CONCLUSION It is very tempting for a business leader to diversify with related or unrelated business activities carried out in a company. But it must be understood that it is a very complex task. Hence any such move must be planned & executed with great care. And diversification strategy matrix is given above for the business leader to help in choosing the strategy for diversifying the business activities. Reference: Arthur.A. Thompson, A. J. Strickland, John. E. Gamble on Crafting and Execution Strategy, vol.14, Tata McGraw-Hill Publication. Galbraith, J.R. and R.K. Kazanjian, Strategy Implementation, 2nd ed. St. Paul, MN, West Publishing, 1986 Nathanson, D. and J. Cassano, Organization, Diversity, and performance, The Wbarton Magazine, summer 1982, pp Prahalad, C.K. and R.A. Bettis, The Dominant Logic: A New Linkage Between Diversity and Performance, Strategic Management Journal, 7, 1986, pp Peter Drucker, in his book, Managing for Results, pp

12 Chatterjee, S. and B. Wernerfelt, The Link Between Resources and Type of Diversification, Strategic Management Journal, 12, Special Issue, 1991, pp didn%e2%80%99t-work-crash-353 Company websites for the following: 1. Reliance 2. Wipro 3. Johnson & Johnson 4. Pepsico