Every entrepreneur seeks ways to grow their business and increase revenue. Often, however, the market they operate in does not allow for sustainable growth, leading to the consideration of business diversification.
Such situations frequently arise in small countries, where low purchasing power and limited sector sizes offer few growth opportunities for local companies. Therefore, every entrepreneur should fully understand diversification to advance their business or protect it from external risks.
WHAT IS BUSINESS DIVERSIFICATION
Diversification is a strategic orientation towards developing a business across different areas. The term diversification originates from the Latin words diversus – different and facere – to make. Business diversification is one of the most critical aspects of corporate strategy.
TYPES OF BUSINESS DIVERSIFICATION: RELATED VS INDEPENDENT SECTORS
There are two types of diversification, each with distinct advantages and disadvantages:
- Diversification in related sectors and markets. For example, a wine producer could diversify through “horizontal expansion,” by starting vodka production, or through “vertical expansion,” by investing in grape cultivation or an FMCG distribution system. This model’s primary advantage is achieving greater economic results and competitive advantages through synergy. Additionally, expansion may be relatively straightforward and less risky, as the skills and knowledge required are similar to those the company already possesses.
- Diversification in independent sectors. An example of this model would be a wine producer expanding into industries like car manufacturing, computing, or hospitality. This model requires the company to gain new skills in product development and an in-depth understanding of consumers in entirely different sectors. In addition to acquiring “know-how,” substantial resources, technologies, and new facilities are often needed. These challenges make entering independent sectors significantly complex. The main advantages of this model include risk distribution across different sectors and the ability to use financial surpluses from saturated sectors in areas with high growth potential.
* Synergy refers to a situation in which two or more businesses produce a greater cumulative result together than they would if operating separately.
WHEN BUSINESS DIVERSIFICATION IS CONTRAINDICATED</>
Focusing on a single business has numerous managerial and strategic advantages. In this approach, it is much easier to define the company’s mission and strategic vision. The company’s full potential is focused on one business, avoiding the risk of inadequate resources allocation for multiple ventures. By concentrating on a single field, management develops a deep understanding of the core business and its processes. Top managers focus on a single market, consider only one set of competitors, and create one strategy (a competitive strategy). Managerial capacities and financial resources are thus sufficient for rapid adaptation to changes in the external environment. Experience shows that companies active in a single field find it easier to secure a strong competitive position and become market leaders.
Managing a diversified company is significantly more complex. A diversified company must integrate these into a single corporate strategy. Sometimes, losses incurred by one business can negatively impact the financial situation of other businesses within a diversified company.
Here are some reasons for caution when considering business diversification:
- The company operates in a sector with strong growth potential and a positive outlook for increased sales and profit;
- The company is well-positioned with substantial competitive advantages;
- The company lacks the financial resources necessary for diversification;
- There is a shortage of skilled human resources needed for diversification;
- The costs and/or risks of diversification are very high, with projected benefits being minimal.
WHEN BUSINESS DIVERSIFICATION IS JUSTIFIED
A single-focus enterprise, figuratively speaking, risks “putting all its eggs in one basket.” Due to market saturation or unexpected external events, the company could lose its development opportunities. Often, shifts in consumer needs, technological innovations, or substitute products reduce the profitability of a single-profile company and can even lead to bankruptcy. We can look back on how the advent of digital cameras affected the photography industry or how CDs replaced audio cassettes.
No “formula” exists to determine a company’s readiness for diversification. Multiple factors need to be carefully analyzed to make the right decision and avoid costly mistakes.
Conditions favorable for diversification include the following negative premises:
- The company operates in a saturated market;
- Opportunities for expanding the current business are exhausted;
- Current trends suggest future market contraction;
- Competition within the sector is intensifying (more competitors, stronger competitive advantages, frequent price wars, poor differentiation opportunities, emergence of substitute products, etc.);
- Significant shifts in consumer preferences are impacting company sales.
and/or the following opportunities and positive conditions:
- Opportunities exist to improve products and services for consumers;
- There is potential to strengthen the company’s competitive position through diversification;
- There are ways to transfer “know-how,” competencies, technologies, and strong brands to other businesses;
- Diversification offers negotiating power with customers and business partners (distributors, suppliers, importers, etc.);
- Opportunities for cost reduction through synergy exist;
- The company has the necessary resources for diversification.
A well-managed marketing information system is crucial in the diversification decision-making process, as lacking it may lead to a severe information deficit, hindering sound diversification decisions.
Once the decision to diversify is made, management must decide on the diversification model – in related or independent sectors.
ADVANTAGES AND CHALLENGES OF DIVERSIFYING IN RELATED SECTORS AND MARKETS
This is the most common model of diversification, as it promotes higher efficiency through synergy and strengthens the existing business.
Advantages
- Offers business development opportunities,
- Greater possibilities for synergy utilization,
- Enhances competitiveness of the current business,
- Reduces costs,
- Utilizes skills and resources relevant to the current business,
- Provides negotiation power with business partners.
Challenges:
- Exposes business to sector crises and/or macroeconomic crises,
- Increases sensitivity to unforeseen changes in the sector (changes in consumer preferences, technological innovations, substitute products, intensifying competition, etc.).
This type of diversification is justified when there is a strategic connection between activities in the “value chain” of the parent and subsidiary companies. Strategic relevance can be found in any link of the value chain: supply and procurement, production and technology, marketing and distribution channels, after-sales services.
Examples of Strategic Relevance in Value Chain Activities:
ADVANTAGES AND CHALLENGES OF DIVERSIFYING IN INDEPENDENT SECTORS
Despite the advantages of diversifying into related sectors and markets, many companies choose to diversify into entirely independent sectors, investing in any sector that offers significant profits. In this case, diversification is not based on strategic relevance. It’s enough that the selected sector meets certain attractiveness criteria and has relatively low entry costs.
Advantages:
- Provides business development opportunities,
- Allows resilience to economic-financial crises over time,
- Enables efficient use of surplus resources,
- Directs investments towards promising sectors unrelated to the current business,
- Reduces business units portfolio risks.
Challenges:
- Requires significant investments, technologies, facilities, resources, etc.,
- Necessitates know-how and skills irrelevant to the current business,
- Does not offer competitive advantages to the current business.
- Profit generation in the new business often takes a long time.
IMPORTANT! The volume of investment in independent sector expansion must not destabilize the economic situation of the parent company. Otherwise, growth potential may decrease, reducing the overall return on investment. A mandatory condition is that diversification into independent sectors must be economically viable for the core business.
METHODS FOR BUSINESS DIVERSIFICATION: MERGERS, FRANCHISING, JOINT VENTURES, AND MORE
- Purchasing an existing company (merging with another company). This approach is widely used in western countries but is less popular in countries with small economies, limited transparency in local business practices, and an underdeveloped capital market.
- Creating and developing a subsidiary from scratch (internal startup). This method is generally easier to implement than acquiring an existing company.
- Forming a joint venture. This option is useful for complex, high-risk diversifications that may be economically challenging. Partnering with another company allows a business to share resources, expertise and costs, increasing the likelihood of success in a new market. However, this approach can lead to misunderstandings or disagreements over company management.
- Franchising. A popular option for diversifying into independent sectors, franchising significantly reduces startup risk. Here, the entrepreneur acquires a proven business model, brand, technology, etc., in exchange for a fee.
- Exporting. Expanding into a new geographic market can be an effective diversification strategy for related sectors, particularly when the company offers a competitive product.
COMMON MISTAKES TO AVOID IN BUSINESS DIVERSIFICATION
How is diversification practically usually carried out? Based on observed cases, more than 30% of companies encounter significant challenges when diversifying. These issues are often not minor errors but rather costly projects that drain essential resources from the core business, sometimes pushing it to the brink of bankruptcy.
The most frequent mistakes include:
- Lack of a clearly defined strategic purpose for diversification;
- Failure to analyze the external environment or interpret analytical data;
- Failure to consider multiple diversification options;
- Lack of sufficient resources to support diversification.
SUMMARY: KEY FACTORS TO CONSIDER DEFORE DIVERSIFYING YOUR BUSINESS
In summary, business diversification offers valuable strategies for companies seeking growth and resilience, especially in markets with limited expansion opportunities. Two primary approaches—related sector diversification and independent sector diversification—present distinct advantages and challenges. While related sector diversification leverages strategic synergy and resource sharing, independent sector diversification provides opportunities to enter profitable yet unfamiliar markets, though it often requires substantial resources and management adaptation. Key success factors include having a clear diversification purpose, assessing external conditions, and securing necessary resources. By carefully analyzing these elements, companies can optimize diversification to strengthen their market position and achieve sustainable growth.