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Here is a method for measuring the profit potential

of alternative product-market strategies, starting with a


forecast of trends and contingencies and then work-
ing toward company needs and long-run objectives.

Strategies
for Diversification
By H. Igor Ansoff aU growth pattern, diversification decisions pre-
sent certain unique problems. Much more thaii
The Red Queen said, "Now, here, it takes all other growth alternatives, they require a break
the running you can do to keep in the same place. with past patterns and traditions of a company
If you want to get somewhere else, you must run and an entry onto new and uncharted paths.
at least twice as fast as that!" ^ Accordingly, one of the aims of this article
So it is in the American economy. Just to re- is to relate diversification to the over-all growth
tain its relative position, a business firm must perspectives of management, establish reasons
go through continuous growth and change. To which may lead a company to prefer diversifica-
improve its position, it must grow and change at tion to other growth alternatives, and trace a re-
least "twice as fast as that." lationship between over-all growth objectives and
According to a recent survey of the ioo larg- special diversification objectives. This will pro-
est United States corporations from 1909 to vide us with a partly qualitative, partly quanti-
1948, few companies that have stuck to their tative method for selecting diversificatiian strate-
traditional products and methods have grown in gies which are best suited to long-term growth of
stature. The report concludes: "There is no a company. We can use qualitative criteria to
reason to believe that those now at the top will reduce the total number of possible strategies to
stay there except as they keep abreast in the the most promising few, and then apply a return
race of innovation and competition." ^ on investment measure to narrow the choice of
There are four basic growth alternatives open plans still further.
to a business. It can grow through increased
market penetration, through market develop- Product-Market Alternatives
ment, through product development, or through
diversification. The term "diversification" is usually associ-
A company which accepts diversification as ated with a change in the characteristics of the
a part of its planned approach to growth under- company's product line and/or market, in con-
takes the task of continually weighing and com- trast to niarket penetration, market development,
paring the advantages of these four alternatives, and product development, which represent other
selecting first one combination and then another, types of change in product-market structure.
depending on the particular circumstances in Since these terms are frequently used inter-
long-range development planning. changeably, we can avoid later confusion by de-
While they are an integral part of the over- fining each as a special kind of product-market
strategy. To begin with the basic concepts:
^ Lewis J. Carroll, Through the Looking-Glass (New
York, The Heritage Press, 1941), p. 41. e The product line of a manufacturing company
" A. D. H. Kaplan, Big Enterprise in a Competitive
System (Washington, The Brookings Institution, 1954), refers both to (a) the physical characteristics of
p. 142. the individual products (for example, size, weight,
113
114 Harvard Business Review
materials, tolerances) and to (b) the performance company which adapts and sells its passenger trans-
characteristics of the products (for example, an air- port for the mission of cargo transportation is an
plane's speed, range, altitude, payload). example of this strategy.
C In thinking of the market for a product we e A produet development strategy, on the other
can borrow a concept commonly used by the mili- hand, retains the present mission and develops
tary the concept of a mission. A product products that have new and different characteris-
mission is a description of the job which the tics such as will improve the performance of the
product is intended to perform. For instance, one mission.
of the missions of the Lockheed Aircraft Corpora-
tion is commercial air transportation of passengers; C Diversification is the final alternative. It calls
another is provision of airborne early warning for for a simultaneous departure from the present
the Air Defense Command; a third is performance product line and the present market structure.
of air-to-air combat.
Each of the above strategies describes a dis-
For our purposes, the concept of a mission is
more useful in describing market alternatives than tinct path which a business can take toward
would be the concept of a "customer," since a future growth. However, it must be emphasized
customer usually has many different missions, each that in most actual situations a business would
requiring a different product. The Air Defense follow several of these paths at the same time.
Command, for example, needs different kinds of As a matter of fact, a simultaneous pursuit of
warning systems. Also, the product mission con- market penetration, market development, and
cept helps management to set up the problems in product development is usually a sign of a pro-
such a way that it can better evaluate the per- gressive, well-run business and may be essential
formance of competing products. to survival in the face of economic competition.
A product-market strategy, accordingly, is a The diversification strategy stands apart from
joint statement of a product line and the corre- the other three. WhUe the latter are usually
sponding set of missions which the products are followed with the same technical, financial, and
designed to fulfill. In shorthand form (see EXHIBIT merchandising resources which are used for the
i), if we let n represent the product line and fi original product line, diversification generally
the corresponding set of missions, then the pair
requires new skills, new techniques, and new
of IT and ^ is a product-market strategy.
facilities. As a result, it almost invariably leads
With these concepts in mind let us turn now to physical and organizational changes in the
to the four different t5^es of product-market structure of the business which represent a dis-
strategy shown in EXHIBIT I : tinct break with past business experience.
C Market penetration is an effort to increase
company sales without departing from an original Forecasting Growth
product-market strategy. The company seeks to
improve business performance either by increasing A study of business literature and of com-
the volume of sales to its present customers or by pany histories reyeals many different reasons for
finding new customers for present products. diversification. Companies diversify to compen-
C Market development is a strategy in which sate for technological obsolescence, to distribute
the company attempts to adapt its present product risk, to utilize excess productive capacity, to re-
line (generally with some modification in the prod- invest earnings, to obtain top management, and
uct characteristics) to new missions. An airplane so forth. In deciding whether to diversify, man-
agement should carefully analyze its future
EXHIBIT I. PRODUCT-MARKET STRATEGIES FOR
growth prospects. It should think of market
BUSINESS GROWTH ALTERNATIVES
V.MARK.ETS
penetration, market development, and product
development as parts of its over-all product strat-
LINE ^ egy and ask whether this strategy should be
Wo
MARKET
MARKET DEVELO 'MENT
broadened to include diversification.
fenetraUon
TT, Long-Term Trends
O z DIVE RSIFICNATION1 A standard method of analyzing future com-
IT.
pany growth prospects is to use long-range sales
22 forecasts. Preparation of such forecasts involves
UJ
simultaneous consideration of a number of major
factors:
Strategies for Diversification 115
General economic trends. EXHIBIT II. TREND FORECASTS
Political and international trends. SALES
VOLUME
Trends peculiar to the industry. (For ex-
ample, forecasts prepared in the airplane in-
dustry must take account of such possibilities
,^' INDUSTRY
as a changeover from manned aircraft to
missiles, changes irt the government "mobili-
zation base" concept with all that would mean SLOW GROWTH
for the aircraft industry, and rising expendi-
tures required for research and development.) CYCLIC
GROWTH
Estimates of the firm's competitive strength
relative to other members of the industry.
DECLINE
Estimates of improvements in the company
performance which can be achieved through I9S5 I960 1965
market penetration, market development, and
product development. spective growth rate is unsatisfactory in com-
parison to the industry growth rate.
Trends in manufacturing costs.
Making trend forecasts is far from a precise
Such forecasts usually assume that company science. The characteristics of the basic envi-
management will be aggressive and that manage- ronmental trends, as well as the efEect of these
ment policies will take full advantage of the op- trends on the industry, are always uncertain.
portunities offered by the different trends. They Furthermore, the ability of a particular business
are, in other words, estimates of the best possi- organization to perform in the new environment
ble results the business can hope to achieve short is very difficult to assess. Consequently, any
of diversification. realistic company forecast should include sev-
eral different trend forecasts, each with an ex-
Different patterns of forecasted growth are
plicitly or implicitly assigned probability. As
shown in EXHIBIT II, with hypothetical growth
an alternative, the company's growth trend fore-
curves for the national economy (GNP) and the
cast may be represented by a widening spread
company's industry added for purposes of com-
between two extremes, similar to that shown
parison. One of the curves illustrates a sales
for GNP in EXHIBIT II.
curve which declines with time. This may be
the result of an expected contraction of demand,
the obsolescence of manufacturing techniques, Contingencies
emergence of new products better suited to the In addition to trends, another class of events
mission to which the company caters, or other may make diversification desirable. These are
changes. Another typical pattern, frequently certain environmental conditions which, if they
caused by seasonal variations in demand, is one occur, will have a great effect on sales; however,
of cyclic sales activity. Less apparent, but more we cannot predict their occurrence with cer-
important, are slower cyclic changes, such as tainty. To illustrate such "contingent" events,
trends in construction or the peace-war variation an aircraft company might foresee these possi-
in demand in the aircraft industry. bilities that would upset its trend forecasts:
If the most optimistic sales estimates which A major technological "breakthrough" whose
can be attained short of diversification fall in characteristics can be foreseen but whose tim-
either of the preceding cases, diversification is ing cannot at present be determined, such as
strongly indicated. However, a company may the discovery of a new manufacturing process
choose to diversify even if its prospects do, on for high-strength, thermally resistant aircraft
the whole, appear favorable. This is illustrated bodies.
by the "slow growth curve." As drawn in EX- An economic recession which would lead to
HIBIT II, the curve indicates rising sales which, loss of orders for commercial aircraft and
in fact, grow faster than the economy as a whole. would change the pattern of spending for
Nevertheless, the particular company may be- military aircraft.
long to one of the so-called "growth industries" A major economic depression.
which as a whole is surging ahead. Such a com- A limited war which would sharply increase
pany may diversify because it feels that its pro- the demand for air industry products.
116 Harvard Business Review
A sudden cessation of the cold war, a currently correction to be applied only after the trends
popular hope which has waxed and waned have been taken into account. The emphasis is
with changes in Soviet behavior. on planning for growth, and planning for con-
The two types of sales forecast are illustrated tingencies is viewed as an "insurance policy"
in EXHIBIT H I for a hypothetical company. Sales against reversals.
curves Si and S2 represent a spread of trend People familiar with planning problems in
forecasts; and S3 and S4, two contingent fore- the military establishment will note here an in-
casts for the same event. The difference be- teresting difference between military and busi-
tween the two types, both in starting time and ness attitudes. While business planning em-
effect oh sales, lies in the degree of uncertainty phasizes trends, military planning emphasizes
associated with each. contingencies. To use a crude analogy, a busi-
In the case of trend forecasts we can trace a ness planner is concerned with planning for
crude time history of sales based on events which continuous, successful, day-after-day operation
we fuUy expect to happen. Any uncertainty of a supermarket. If he is progressive, he also
arises from not knowing exactly when they will buys an insurance policy against fire, but he
take place and how they will influence business. spends relatively little time in planning for fires.
In the case of contingency forecasts, we can The military is more like the fire engine com-
again trace a crude time history, but our uncer- pany; the fire is the thing. Day-to-day opera-
tainty is greater. We lack precise knowledge tions are of interest only insofar as they can be
of not only when the event will occur but also utilized to improve readiness and fire-fighting
whether it will occur. In going from a trend techniques.
to a contingency forecast, we advance, so to
speak, one notch up the scale of ignorance. Unforeseeable Events
In considering the relative weight we should So far we have dealt with diversification fore-
give to contingent events in diversification plan- casts based on what may be called foreseeable
ning, we must consider not only the magnitude market conditions conditions which we can
of their effect on sales, but also the relative prob- interpret in terms of time-phased sales curves.
ability of their occurrence. For example, if a Planners have a tendency to stop here, to disre-
severe economic depression were to occur, its gard the fact that, in addition to the events for
effect on many industries would be devastating. which we can draw time histories, there is a
Many companies feel safe in neglecting it in recognizable class of events to which we can
their planning, however, because they feel that assign a probability of occurrence but which we
the likelihood of a deep depression is very small, cannot otherwise describe in our present state
at least for the near future. of knowledge. One must move another notch
It is a common business practice to put pri- up the scale of ignorance in order to consider
mary emphasis on trend forecasts; in fact, in these possibilities.
many cases businessmen devote their long-range Many businessmen feel that the effort is not
planning exclusively to these forecasts. They worthwhile. They argue that since no informa-
usually view a possible catastrophe as "some- tion is available about these unforeseeable cir-
thing one cannot plan for" or as a second-order cumstances, one might as well devote the avail-
able time and energy to planning for the fore-
EXHIBIT III. A HYPOTHETICAL COMPANY FORE-
seeable circumstances, or that, in a very general
CAST NO DIVERSIFICATION
sense, planning for the foreseeable also prepares
SALES one for the unforeseeable contingencies.
VOLUME

In contrast, more experienced military and


business people have a very different attitude.
Well aware of the importance and relative prob-
ability of unforeseeable events, they ask why one
should plan specific steps for the foreseeable
events while neglecting the really important pos-
sibilities. They may substitute for such plan-
ning practical maxims for conducting one's busi-
ness "be solvent," "be light on your feet," "be
time flexible." Unfortunately, it is not always clear
118 Harvard Business Review
proved position in their own industry may be to diversify, commonly known as vertical diversifi-
identified as companies that are notable for dras- cation, is to branch out into production of com-
tic changes made in their product mix and meth- ponents, parts, and materials. Perhaps the most
ods, generating or responding to new competition. outstanding example of vertical diversification is
"There are two outstanding cases in which the the Ford empire in the days of Henry Ford, Sr.
industry leader of 1909 had by 1948 risen in At first glance, vertical diversification seems in-
position relative to its own industry group and also consistent with our definition of a diversification
in rank among the 100 largest one in chemicals strategy. However, the respective missions which
and the other in electrical equipment. These two components, parts, and materials are designed to
(General Electric and DuPont) are hardly recog- perform are distinct from the mission of the over-
nizable as the same companies they were in 1909 all product. Furthermore, the technology in fabri-
except for retention of the name; for in each case cation and manufacture of these parts and materials
the product mix of 1948 is vastly different from is likely to be very different from the technology
what it was in the earlier year, and the markets of manufacturing the final product. Thus, vertical
in which the companies meet competition are in- diversification does imply both catering to new
comparably broader than those that accounted for missions and introduction of new products.
their earlier place at the top of their industries.
They exemplify the flux in the market positions (2) Another possible way to go is horizontal di-
of the most successful industrial giants during versification. This can be described as the intro-
the past four decades and a general growth rather duction of new products which, while they do not
than a consolidation of supremacy in a circum- contribute to the present product line in any way,
scribed line." * cater to missions which lie within the company's
know-how and experience in technology, finance,
and marketing.
This suggests that the existence of specific
undesirable trends is not the only reason for di- (3) It is also possible, by lateral diversification,
to move beyond the confines of the industry to
versification. A broader product line may be
which a company belongs. This obviously opens
called for even with optimistic forecasts for pres- a great many possibilities, from operating banana
ent products. An examination of the foresee- boats to building atomic reactors. While vertical
able alternatives should be accompanied by an and horizontal diversification are restrictive, in the
analysis of how well the over-all company prod- sense that they delimit the field of interest, lateral
uct-market strategy covers the so-called growth diversification is "wide open." It is an announce-
areas of technology areas of many potential ment of the company's intent to range far afield
discoveries. If such analysis shows that, because from its present market stmcture.
of its product lines, a company's chances of tak-
ing advantage of important discoveries are lim- Choice of Direction
ited, management should broaden its technolog- How does a company choose among these di-
ical and economic base by entering a number of versification directions? In part the answer de-
so-called "growth industries." Even if the de- pends on the reasons which prompt diversifica-
finable horizons look bright, a need for flexi- tion. For example, in the light of the trends de-
bility, in the widest sense of the word, may pro- scribed for the industry, an aircraft company
vide potent reasons for diversification. may make the following moves to meet long-
range sales objectives through diversification:

Diversification Objectives 1. A vertical move to contribute to the techno-


logical progress of the present product line.
If an analysis of trends and contingencies in- 2. A horizontal move to improve the coverage
dicates that a company should diversify, where of the military market.
should it look for diversification opportunities? 3. A horizontal move to increase the percen-
Generally speaking, there are three types of tage of commercial sales in the over-all sales
opportunities: program.
4. A lateral move to stabilize sales in case of a
(1) Each product manufactured by a company recession.
is made up of functional components, parts, and
basic materials which go into the final assembly. 5. A lateral move to broaden the company's
A manufacturing concern usually buys a large technological base.
fraction of these from outside suppliers. One way Some of these diversification objectives apply
* Ibid., p. 142. to characteristics of the product, some to those
Strategies for Diversification 117
EXHIBIT IV. CHANGES IN LIST OF THE IOO LARGEST INIJUSTRIAL CORPORATIONS

(even to the people who preach it) what this primary means of transportation, have given
flexibility means. way to the automobile and the airplane; the tex-
An interesting study by The Brookings Insti- tile industry, which appeared to have a built-in
tution ^ provides an example of the importance demand in an expanding world population, has
of the unforeseeable events to business. EX- been challenged and dominated by synthetics;
HIBIT IV shows the changing make-up of the radio, radar, and television have created means
list of the I oo largest corporations over the last of communication unforeseeable in significance
50 years. Of the 100 largest on the 1909 list and scope; and many other sweeping changes
(represented by the heavy marble texture) only have occurred.
36 were among the 100 largest in 1948; just
about half of the new entries to the list in 1919 Planning for the Unknown
(represented by white) were left in 1948; less The lessons of the past 50 years are fully ap-
than half of the new entries in 1929 (repre- plicable today. The pace of economic and tech-
sented by the zigzag design) were left in 1948; nological change is so rapid that it is virtually
and so on. Clearly, a majority of the giants of certain that major breakthroughs comparable to
yesteryear have dropped behind in a relatively those of the last 50 years, but not yet foreseeable
short span of time. in scope and character, will profoundly change
the structure of the national economy. All of
Many of the events that hurt these corpora- this has important implications for diversifica-
tions could not be specifically foreseen in 1909. tion, as suggested by the Brookings study:
If the companies which dropped from the orig-
inal list had made forecasts of the foreseeable "The majority of the companies included among
kind at that time and some of them must the IOO largest of our day have attained their posi-
tions within the last two decades. They are com-
have they would very likely have found the panies that have started new industries or have
future growth prospects to be excellent. Since transformed old ones to create or meet consumer
then, however, railroads, which loomed as the preferences. The companies that have not only
' A. D. H. Kaplan, op. cit. grown in absolute terms but have gained an im-
Strategies for Diversification 119
of the product missions. Each objective is de- Under trend conditions the growth rate of sales
signed to improve some aspect of the balance after diversification should exceed the growth rate
between the over-aU product-market strategy and of sales of the original product line by a minimum
the expected environment. The specific objec- specified margin. Or to illustrate in mathematical
tives derived for any given case can be grouped shorthand, the objective for the company in EX-
HIBIT V would be:
into three general categories: growth objectives,
such as I, 2, and 3 above, which are designed S3 S i ^ jO

to improve the balance under favorable trend where the value of the margin p is specified for
conditions; stability objectives, such as 3 and 4, each year after diversification.
designed as protection against unfavorable
EXHIBIT V. DIVERSIFICATION OBJECTIVES
trends and foreseeable contingencies; and flexi-
SALES
bility objectives, such as 5, to strengthen the VOLUME
company against unforeseeable contingencies.
A diversification direction which is highly de-
sirable for one of the objectives is likely to be
less desirable for others. For example:
C If a company is diversifying because its sales
trend shows a declining volume of demand, it
would be unvdse to consider vertical diversification,
since this would be at best a temporary device to
stave off an eventual decline of business.
If a company's industry shows every sign of T t-Ume
healthy growth, then vertical and, in particular, Some companies (particularly in the growth
horizontal diversification would be a desirable de- industries) fix an annual rate of growth which
vice for strengthening the position of the com- they wish to attain. Every year this rate of
pany in a field in which its knowledge and ex- growth is compared to the actual growth during
perience are concentrated. the past year. A decision on diversification ac-
e If the major concern is stability under a con- tion for the coming year is then based upon the
tingent forecast, chances are that both horizontal disparity between the objective and the actual
and vertical diversification could not provide a suf- rate of growth.
ficient stabilizing influence and that lateral action
is called for. Stability. The second effect desired of diver-
e If management's concern is with the narrow- sification is improvement in company stability
ness of the technological base in the face of what under contingent conditions. Not only should
we have called unforeseeable contingencies, then diversification prevent sales from dropping as
lateral diversification into new areas of technology low as they might have before diversification,
would be clearly indicated. but the percentage drop should also be lower.
The second sales objective is thus a stability ob-
Measured Sales Goals jective. It can be stated as follows:
Management can and should state the objec-
Under contingent conditions the percentage de-
tives of growth and stability in quantitative cline in sales which may occur without diversifica-
terms as long-range sales objectives. This is il- tion should exceed the percentage drop in sales
lustrated in EXHIBIT V. The solid lines describe with diversification by an adequate margin, or
a hypothetical company's forecasted perform- algebraically:
ance without diversification under a general Si ^ S2 S3 ^ S4
trend, represented by the sales curve marked Si,
and in a contingency, represented by Sa. The
dashed lines show the improved performance as Using this equation, it is possible to relate
a result of diversification, with S3 representing the sales volumes before and after diversifica-
the curve for continuation of normal trends and tion to a rough measure of the resulting stability.
S4 representing the curve for a major reverse. Let the ratio of the lowest sales during a slump
to the sales which would have occurred in the
Growth. Management's first aim in diversify- same year under trend conditions be called the
ing is to improve the growth pattern of the com- stability factor F. Thus, F = 0.3 would mean
pany. The growth objective can be stated thus: that the company sales during a contingency
120 Harvard Business Review
amount to 30% of what is expected under trend setting minimum, rather than maximum, limits
conditions. In EXHIBIT VI the stability factor of on growth, it leaves room for the company to
the company before diversification is the value take advantage of unusual growth opportunities
Fl = S2/S1 and the stability factor after diver- in order to exceed these goals, and thus provides
sification is F3 = S4/SS, both computed at the definite goals without inhibiting initiative and
point on the curve where S2 is minimum. incentive. (2) It takes account of the time-
Now let us suppose that management is con- phasing of diversification moves; and since these
sidering the purchase of a subsidiary. How moves invariably require a transition period, the
large does the subsidiary have to be if the parent numerical values of growth objectives can be
is to improve the stability of the corporation as allowed to vary from year to year so as to allow
a whole by a certain amount? EXHIBIT VI shows for a gradual development of operations.
how the question can be answered:
On the horizontal axis we plot the different Long-Range Objectives
possible sales volumes of a smaller firm that might
be secured as a proportion of the parent's volume. Diversification objectives specify directions
Obviously, the greater this proportion, the greater in which a company's product-market should
the impact of the purchase on the parent's stability. change. Usually there will be several objectives
On the vertical axis we plot different ratios of indicating different and sometimes conflicting
the parent's stabihty before and after diversifica- directions. If a company attempts to follow all
tion (F3/F1). of them simultaneously, it is in danger of spread-
The assumed stability factor of the parent is ing itself too thin and of becoming a conglom-
0.3. Let us say that four prospective subsidiaries eration of incompatible, although perhaps indi-
have stability factors of i.o, 0.9, 0.75, and 0.6. vidually profitable, enterprises.
If they were not considerably higher than 0.3, of
course, there would be no point in acquiring them There are cases of diversification which have
(at least for our purposes here). followed this path. In a majority of cases, how-
ever, there are valid reasons why a company
EXHIBIT VI. IMPROVEMENT IN STABILITY FACTOR should seek to preserve certain basic unifying
AS A RESULT OF DIVERSIFICATION FOR FJ = 0.3 characteristics as it goes through a process of
RATIC) OF STABILITY fACTORS
growth and change. Consequently, diversifica-
. , F J - STAB/J-/TY OF >/i//?S/F/C4T/OA/ tion objectives should be supplemented by a
F -ST-ABIL/TY BFOR.B D/VBR.S/F/CAT/C F, -1.0
statement of long-range product-market objec-
f, =0.9
1
tives. For instance:
^ ^
18
^ ^
^* a=0.75 e One consistent course of action is to adopt a
product-market policy which will preserve a kind
*
!:
==-
MB
Ft-as of technological coherence among the different
.
^ ^ manufactures with the focus on the products of
11
the parent company. For instance, a company
that is mainly distinguished for a type of engi-
OT. ae O.8 /.o neering and production excellence would continue
SALES OF SUBSIDIARY AS A riSACTION OF
PARNT SALS BEFORE DIVERSIFICATION to select product-market entries which would
strengthen and maintain this excellence. Perhaps
On the graph we correlate these four stability the best known example of such policy is exempli-
factors of the subsidiary with (i) the ratio F3/F1 fied by the DuPont slogan, "Better things for
and (2) different sales volumes of the subsidiary. better living through chemistry."
We find, for example, that if the parent is to
double its stability (point 2.0 on the vertical axis), C Another approach is to set long-term growth
it must obtain a subsidiary with a stability of i.o policy in terms of the breadth of market which
and 75% as much sales volume as the parent, or the company intends to cover. It may choose to
a subsidiary vdth a stability of 0.9 and 95% of the confine its diversifications to the vertical or hori-
sales volume. If the parent seeks an improvement zontal direction, or it may select a type of lateral
in stability of, say, only 4 0 % , it could buy a diversification controlled by the characteristics of
company with a stability of 0.9 and 25% as much the missions to which the company intends to
sales volume as it has. cater. For example, a company in the field of air
transportation may expand its interest to all forms
This particular way of expressing sales ob- of transportation of people and cargo. To para-
jectives has two important advantages: ( i ) By phrase DuPont, some slogan like "Better trans-
Strategies for Diversifcation 121
portation for better living through advanced en- Division; military, industrial, and consumer elec-
gineering," would be descriptive of such a long- tronic products in the Stromberg-Carlson Division;
range policy. electric motors in the Electro Dynamic Division.
C A gready different policy is to emphasize pri-
marily the financial characteristics of the corpo-
ration. This method of diversification generaQy Selecting a Strategy
places no limits on engineering and manufacturing In the preceding sections qualitative criteria
characteristics of new products, although in prac- for diversification have been discussed. How
tice the competence and interests of management should management apply thse criteria to in-
will usually provide some orientation for diversifi-
cation moves. The company makes the decisions dividual opportunities? Two steps should be
regarding the distribution of new acquisitions ex- taken: (i) apply the qualitative standards to
clusively on the basis of financial considerations. narrow the field of diversification opportunities;
Rather than a manufacturing entity, the corporate (2) apply the numerical criteria to select the
character is now one of a "holding company." Top preferred strategy or strategies.
management delegates a large share of its product-
planning and administrative functions to the divi- Qualitative Evaluation
sions and concerns itself largely with coordination,
The long-range product-market policy is used
financial problems, and with building up a bal-
anced "portfolio of products" within the corporate as a criterion for the first rough cut in the quali-
structure. tative evaluation. It can be used to divide a large
field of opportunities into classes of diversifica-
Successful Alternatives tion moves consistent with the company's basic
character. For example, a company whose policy
These alternative long-range policies demon- is to compete on the basis of the technical ex-
strate the extremes. No one course is necessar- cellence of its products would eliminate as in-
ily better than the others; management's choice consistent classes of consumer products which
will rest in large part on its preferences, ob- are sold on the strength of advertising appeal
jectives, skiUs, and training. The aircraft in- rather than superior quality.
dustry illustrates the fact that there is more than
Next, the company can compare each indi-
one successful path to diversification:
vidual diversification opportunity with the in-
e Among the major successful airframe manu- dividual diversification objectives. This process
facturers, Douglas Aircraft Company, Inc., and tends to eliminate opportunities which, while
Boeing Airplane Company have to date limited still consistent with the desired product-market
their growth to horizontal diversification into mis- make-up, are nevertheless likely to lead to an
siles and new markets for new types of aircraft.
imbalance between the company product line
Lockheed has carried horizontal diversification fur-
ther to include aircraft maintenance, aircraft serv- and the probable environment. For example, a
ice, and production of ground-handling equipment. company which wishes to preserve and expand
its technical exellence in design of large, highly
C North American Aviation, Incorporated, on stressed machines controlled by feedback tech-
the other hand, appears to have chosen vertical niques may find consistent product opportunities
diversification by establishing its subsidiaries in both inside and outside the industry to which it
Atomics International, Autonetics, and Rocketdyne,
thus providing a basis for manufacture of com- caters, but if one of its major diversification ob-
plete air vehicles of the future. jectives is to correct cyclic variations in demand
that are characteristic of the industry, it would
e Bell Aircraft Corporation has adopted a policy choose an opportunity that lies outside.
of technological consistency among the items in
its product line. It has diversified laterally but pri- Each diversification opportunity which has
marily into types of products for which it had pre- gone through the two screening steps satisfies at
vious know-how and experience. least one diversification objective, but probably
e General Dynamics Corporation provides a fur- it will not satisfy all of them. Therefore, before
ther interesting contrast. It has gone far into lat- subjecting them to the quantitative evaluation,
eral diversification. Among the major manufac- it is necessary to group them into several alterna-
turers of air Vehicles, it comes closest to the "hold- tive over-all company product-market strategies,
ing conipany" extreme. Its airplanes and missile composed of the original strategy and one or
manufacturing operations in Convair are paralleled more of the remaining diversification strategies.
by production of submarines in the Electric Boat These alternative over-all strategies should be
122 Harvard Business Review
roughly equivalent in meeting all of the diver- return on investment, a ratio between earnings
sification objectives. and the capital invested in producing these earn-
At this stage it is particularly important to ings. While the usefulness of return on invest-
allow for the unforeseeable contingencies. Since ment is commonly accepted, there is consider-
the techniques of numerical evaluation are ap- able room for argument regarding its limitations
plicable only to trends and foreseeable contin- and its practical application.^ Fundamentally,
gencies, it is important to make sure that the the difficulty with the concept is that it fails to
different alternatives chosen give the company provide an absolute measure of business per-
a broad enough technological base. In practice formance applicable to a range of very different
this process is less formidable than it may ap- industries; also, the term "investment" is sub-
pear. For example, a company in the aircraft ject to a variety of interpretations.
industry has to consider the areas of technology But, since our aim is to use the concept as a
in which major discoveries are likely to aflEect measure of relative performance of different di-
the future of the industry. This would include versification strategies, we need not be con-
atomic propulsion, certain areas of electronics, cerned with its failure to measure absolute
automation of complex processes, and so forth. values. And as long as we are consistent in our
In designing alternative over-all strategies the definition of investment in alternative courses
company would then make sure that each con- of action, the question of terminology is not so
tains product entries which will give the firm troublesome. We cannot define profit-produc-
a desirable and comparable degree of participa- ing capital in general terms, but we can define
tion in these future growth areas. it in each case in the light of particular business
characteristics and practices (such as the extent
Quantitative Evaluation of government-owned assets, depreciation prac-
Will the company's product-market strategies tices, inflationary trends).
make money? Will the profit structure improve For the numerator of our return on invest-
as a result of their adoption? The purpose of ment, we can use net earnings after taxes. A
quantitative evaluation is to compare the profit going business concern has standard techniques
potential of the alternatives. for estimating its future earnings. These de-
Unfortunately, there is no single yardstick pend on the projected sales volume, tax struc-
among those commonly used in business that ture, trends in material and labor costs, produc-
gives an accurate measurement of performance. tivity, and so forth. If the diversification oppor-
The techniques currently used for measurement tunity being considered is itself a going concern,
of business performance constitute, at best, an its profit projections can be used for estimates of
imprecise art. It is common to measure differ- combined future earnings. If the opportunity
ent aspects of performance by applying different is a new venture, its profit estimates should be
tests. Thus, tests of income adequacy measure made on the basis of the average performance
the earning ability of the business; tests of debt for the industry.
coverage and liquidity measure preparedness
for contingencies; the shareholders' position Changes in Investment Structure
measures attractiveness to investors; tests of A change in the investment structure of the
sales efficiency and personnel productivity meas-. diversifying company accompanies a diversifica-
ure efficiency in the use of money, physical tion move. The source of investment for the
assets, and personnel. These tests employ a va- new venture may be: (i) excess capital, (2) cap-
riety of different performance ratios, such as re- ital borrowed at an attractive rate, (3) .an ex-
turn on sales, return on net worth, return on change of the company's equity for an equity in
assets, turnover of net worth, and ratio of assets another company, or (4) capitd withdrawn from
to liabilities. The total number of ratios may run present business operations.
as high as 20 in a single case. If we let ii, ig, is, and i^, respectively, repre-
In the final evaluation, which immediately ^ See Charles R. Schwartz, The Return-on-Investment
precedes a diversification decision, management Concept as a Tool for Decision Making, General Manage-
would normally apply all of these tests, tem- ment Series No. 183 (New York, American Management
pered with business judgment. However, for Association, 1956), pp. 42-61; Peter F. Drucker, The
Practice of Management (New York, Harper & Brothers,
the purpose of preliminary elimination of al- 1954); and Edward M. Barnet, "Showdown in the Mar-
ternatives, a single test is frequently used ket Place," HBR July-August 1956, p. 85.
Strategies for Diversification 123
sent investments made in the nevp product in be greater. The profit potential yardstick must
the preceding four categories during the first take account of this nonlinear characteristic.
year of diversified operations, we can derive a (3) Each diversification move is characterized
simple expression for the improvement in return by a transition period during which readjustment
on investment resulting from diversification: of the company structure to new operating condi-
tions takes place. The benefits of a diversification
move may not be realized fully for some time, so
I + is-l-i
the measurement of profit potential should span a
where pi and p2 represent the avera;ge return sufficient length of time to allow for effects of the
on capital invested in the original product and transition.
in the nevp product, respectively, and quantity (4) Since both profits and investments will be
I is the total capital in the business before spread over time, the yardstick should use their
diversification. present value.
We can easily check this expression by assum- (5) Business performance will differ depend-
ing that only one type of new investment will be ing on the particular economic-political environ-
made at a time. We can then use the formula to ment. The profit potential yardstick must some-
compute the conditions under which it pays to how average out the probable effect of alternative
diversify (that is, conditions where AR is greater environments.
than zero): (6) The statement of sales objectives, as pointed
out previously, should specify the general charac-
(1) If excess capital is the only source of new teristics of growth and stability which are desired.
investment (i2 = i3 = i4 = o), this condition is Profit potential functions should be compatible
P2 r > o. That is, return on diversified opera- with these characteristics.
tions should he more attractive than current rates
for capital on the open market. We can generalize our formula in a way
(2) If only borrowed capital is used (ii = i3 = which will meet most of the preceding require-
i4 = o), it pays to diversify if p2 pi > r. That ments. The procedure is to write an expression
is, the difEerence between return from diversifica- for the present value of AR for an arbitrary year,
tion and return from the original product should t, allowing for possible yearly diversification in-
be greater than the interest rate on the money. vestments up to the year t, interest rates, and
(3) If the diversified operation is to be ac- the rate of capital formation. Then this present
quired through an exchange of equity or through value is averaged over time as well as over the
Internal reallocation of capital, p2 pi > o is the alternative sales forecasts. The procedure is
condition under which diversification will pay ofE. straightforward (although the alegebra involved
is too cumbersome to be worth reproducing
A Comprehensive Yardstick here*). The result, which is the "average ex-
The formula for AR just stated is not suffi- pected present value of AR," takes account of
ciently general to serve as a measure of profit conditions (i) through (5), above. Let us call
potential. It gives improvement in return for it (AR)e. It can be computed using data nor-
the first year only and for a particular sales mally found in business and financial forecasts.
trend. In order to provide a reasonably compre-
hensive comparison between alternative over-all Final Evaluation
company strategies, the yardstick for profit po- This brings us to the final step in the evalua-
tential should possess the following properties: tion. We have discussed a qualitative method
(1) Since changes in the investment structure for constructing several over-all product-market
of the business invariably accompany diversifica- strategies which meet the diversification and the
tion, the yardstick should reflect these changes. long-range objectives. We can now compute
It should also take explicit account of new capital (AR)e for each of the over-all strategies and, at
brought into the business and changes in the rate the same time, make sure that the strategies
of capital formation resulting from diversification, satisfy the sales objectives previously stated, thus
as well as costs of borrowed capital. fulfilling condition (6), above.
(2) Usually the combined performance of the If product-market characteristics, which we
new and the old product-market lines is not a sim- have used to narrow the field of choice and to
ple sum of their separate performances; it should compute (AR)e, were the sole criteria, then the
" See H. Igor Ansoff, A Model for Diversification (Bur- Burr Williams, The Theory of Investment Value (Am-
bank, Lockheed Aircraft Corporation, 1957); and John sterdam, The North-Holland Publishing Co., 1938).
124 Harvard Business Review
strategy with the highest (AR)e would be the This discussion has been devoted primarily to
"preferred" path to diversification. The advan- selection of a diversification strategy. We have
tages of a particular product-market opportunity, dealt with what may be called external aspects
however, must be balanced against the chances of diversification the relation between a com-
of business success. pany and its environment. To put it another
way, we have derived a method for measuring
the profit potential of a diversification strategy,
Conclusion but we have not inquired into the internal fac-
A study of diversification histories shows that tors which determine the ability of a diversifying
a firm usually arrives at a decision to make a company to make good this potential. A com-
particular move through a multistep process. pany planning diversification must consider such
The planners' first step is to determine the pre- questions as how the company should organize
ferred areas for search; the second is to select a to conduct the search for and evaluation of
number of diversification opportunities within diversification opportunities; what method of
these areas and to subject them to a preliminary business expansion it should employ; and how
evaluation. They then make a final evaluation, it should mesh its operations with those of a sub-
conducted by the top management, leading to sidiary. These considerations give rise to a new
selection of a specific step; finally, they work set of criteria for the lousiness fit of the prospec-
out details and complete the move. tive venture. These must be used in conjunc-
Throughout this process, the company seeks tion with (AR)e as computed in the preceding
to answer two basic questions: How well will a section to determine which of the over-all prod-
particular move, if it is successful, meet the uct-market strategies should be selected for
company's objectives? What are the company's implementation.
chances of making it a success? In the early Thus, the steps outlined in this article are
stages of the program, the major concern is with the first, though an important, preliminary to a
business strategy. Hence, the first question plays diversification move. Only through further care-
a dominant role. But as the choice narrows, ful consideration of probable business success
considerations of business ability, of the particu- can a company develop a long-range strategy that
lar strengths and weaknesses which a company will enable it to "run twice as fast as that" (using
brings to diversification, shift attention to the the Red Queen's words again) in the ever-chang-
second question. ing world of today.

I Nassign
a highly diversified company . . . there is a natural tendency to
a single executive the responsibility for so many diverse businesses
that he becomes a jack of all trades and a master of none
This is serious, because American business competition no longer per-
mits survival of businesses without managers of special intelligence and
competence in their individual fields. Therefore, as a continuing process,
we attempt to organize our company [W. R. Grace h Co.] so that the
manager for any business or group of businesses is as expert in them as his
competition. This is sometimes difficult. As one important aid, we have
tried to minimize the number of management levels; we have tried to keep
the organization "flat." The more management levels you have, we
feel, the more friction, inertia and slack you have to overcome, and the
greater the distortion of objectives and the misdirection of attention. In
this you must always be on your guard, because levels of management,
like tree rings, grow with age. As one company president put it, "If aU an
executive does is agree with his subordinate executive, you don't need both
of them."
Ernest C. Arbuckle, "Diversification," Management for Growth, edited by
Gayton E. Germane
Stanford University, Graduate School of Business, 1957, pp. 85-86.