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Diversification Besanko Chapter 5 ies/catalogue/Business%20Strategy1 /ITC%20Diversification%20Strategy.

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Lecture overview
This lecture will cover the following points: The rationale for diversification" Economics based reasons" Economies of scale/ scope" Transaction costs" Incentives and agency costs" Efficiency arguments" Evidence on diversification" Summarise key points

Lecture overview
This lecture will cover the following points: The rationale for diversification Economics based reasons
Economies of scale/ scope Transaction costs Incentives and agency costs

Efficiency arguments Evidence on diversification Summarise key points

Why are these topics relevant?

Krugman s New Trade Theory - Why does Toyota sell cars in Germany and Mercedes sell cars in Japan?
International Trade and Economic Geography What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanisation? many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another. Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. - Royal Swedish Academy of Sciences

Most well known firms serve multiple product markets
Apple: Music/ computers/ software/ operating systems Virgin: Transport/ communications/ media


Vertical Integration - Firm decides to enter one or more parts of
its value chain that it has hitherto not entered. An automobile firm that has only been assembling cars might decide to produce some critical sub assemblies or components. E.g. Maruti used to initially only assemble cars. It progressively introduced engine and transmission manufacture into its operations. On the other hand a firm might decide to move up the value chain. Reliance, in its textile operation only manufactured the cloth. Later on it opened exclusive retail outlets which addressed not only the sales and distribution aspects of its business, but also contributed to brand building.


Horizontal Integration or Related Diversification - Firm
enters businesses that are related to its existing businesses. Hindustan Lever, the FMCG major, used to be largely in the soaps and detergents business. In the last ten years, it has diversified into the foods and beverages business largely through the acquisition of first Lipton the tea company and later the acquisition of Brooke Bond. Larsen & Toubro a leading engineering firm who has been dominant in the construction equipment industry entered the cement industry which is a related business. IBM has entered the Infotech consultancy business another example of related diversification. Looking at the factors that have been compelling for these firms it would be obvious that The growth compulsion was stronger here than the capacity utilisation imperative that drives other firms to go in for VI


Unrelated or Conglomerate Diversification. This at times takes place when a firm wishes to or is forced to exit from an unattractive or undesirable industry. The tobacco firms who have diversified out of tobacco are the obvious examples. American firms Phillip Morris and R.J. Reynolds entered the FMCG arena specifically in Food and Beverages, General Electric is the ultimate example of a firm which has pursued unrelated diversification with dizzying success for several years. Kingfisher ITC Reliance 9





Wants to operate only those businesses about which it has some special knowledge and expertise Instant coffee, infant foods, milk products UHT Milk, butter and curd and noodles, chocolates, confectioneries and other semi processed food products, mineral water Leading brands Cerelac, Nestum, Nescafe, Maggie, Kitkat, Munch, Pure Life


Global Diversification - Firms that have successfully dominated their home markets are attracted by the prospect of growth in the markets of other nations. Enter markets in emerging economies. The diversifying firm adjusts its strategies to comply with the cultural requirements and preferences of the countries that it enters. Kellogg the giant breakfast food cereal marketer made the cardinal error of assuming that Indian families would accept and adopt the concept of cold breakfasts. Indians have a unanimous preference for hot meals especially the morning repast. As a result of this critical oversight, Kellogg has failed to make a major impact in India. McDonalds on the other hand has with great marketing sagacity exploited the Indian preference for vegetarian food, and spiciness of a high order, understood that Chicken is the favoured meat, appealed to the Indian orientation towards family and scored significant successes in it s foray into the fast food industry in our country.

Measuring/levels of Diversification: relatedness

To identify economies of scale in multi business firms, the relatedness concept was developed by Richard Rumelt. Two businesses are related if they share technological characteristics, production characteristics and/ or distribution channels.

Levels and Types of Diversification


Classification by relatedness
Proportion of Example revenue from primary activity Single > 95% Daimler Benz, DeBeers, KLM-airlines, Wrigleychewing gum Dominant 70 to 95% Nestle Abbott Labs, Daewoo, Related <70% Phillip Morris Conglomerate <70% 3M, General Electric, Tata Type

Most well known firms serve multiple product markets Apple: Music/ computers/ software/ operating systems Virgin: Transport/ communications/ media Diversification across products and across markets can be due to economies of scale and scope Diversification that occur for other reasons tend to be less successful Nokia - wood pulp and paper/ footwear/ televisions/ capacitors

Relatedness in Indian Industry

Kaura (1987) took a sample of 251 private sector firms in India. He divided the firms into three categories as Single business, related business and unrelated diversified. He found that out of the total sample only 63% of the firms followed diversification strategy, with unrelated diversification as the most popular strategy among Indian companies. Diversification was followed more intensively in Indian subsidiaries of MNCs rather than whole Indian companies, 36.7% of the Indian companies followed SB* strategy as against only 25% of MNCs in SB strategy. RB* strategy was followed only by 25.8% Indian companies and by 37.5% MNCs. However, 37.5% of the companies both for Indian companies and Indian subsidiaries of MNCs favored UB* strategy equally.

Relatedness in Indian Industry

Raman (1991) has measured the pattern of diversification of 67 Indian companies from the private sector. The pattern was studied over 1 1 -year period from 1979-89 at three points of time, that is, 1979, 1984 and 1989. Using Rumelt's classification the firms were divided into nine categories. It was observed that companies preferred going in for Unrelated Business rather than Single Business. Among the Dominant Business, Dominant Vertical was the same for each year while Dominant Linked was larger in 1989 as compared to 1979. The number of companies in related linked also increased as compared to related constrained. However, between 1980-90, studies also show that companies started favoring refocusing rather than diversification. Lichtenberg (1992) showed that the level of diversification declined between 1985 and 1989 in a sample of 6,505 firms. Spender and Grant (1996) also reported that the average index of diversification for Fortune 500 companies declined from 1.00 to 0.67.

Entropy measures of classification

Entropy measures diversification as information content. If a firm is exclusively in one line of business (pure play), its entropy is zero. For a firm spread out into 20 different lines equally, the entropy is about 3.

Entropy Decline in 1980 s

Study by Davis, Dieckman, Tinsley (1994): During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67 Study by Comment and Jarrell (1995): Fraction of U.S. businesses in single business segments increased from 36.2% in 1978 to 63.9% in 1989 Firms have become more focused in their core businesses

Entropy In Management Strategy I

Managers are interested in knowing how diversified are the firm s lines of business It has been considered (and aptly discussed and hotly debated) that more diverse businesses are more profitable
May not always be the case though


Entropy In Management Strategy II

In diversification we need to consider related (similar to the firm s core business) versus unrelated (dissimilar) diversification In related diversification the firm s several lines of business, even though distinct, still possess some kind of fit shared technology, common labor skills and requirements, common suppliers and raw material sources, similar operating methods, kinds of managerial know-how, ), complementary channels or customer overlap In unrelated diversification there is no common linkage or element of fit among the firm s lines of business - pure

Diversity An Example
If we take a beaker of water (H2O) and a very concentrated solution of red food coloring and we then add a drop of the coloring to the water we will see the red color diffusing throughout the water and thus, we go from concentration to diversification Economists, as well as chemists and physicists, want to define concentration vs. diversification Concentration and diversification are two ends of the spectrum

Ways to diversify
Firms can diversify in different ways They can develop new lines of business internally. They can form joint ventures in new areas of business. They can acquire firms in unrelated lines of business.(M&A)

Why do Firms Diversify?

Efficiency based reasons a) Economies of scale and scope b) Economizing on transactions costs c) Financial Synergies
Internal capital markets Shareholder diversification Identifying undervalued firms Managerial Reasons for Diversification

Reasons for diversification a) Economies of Scale and Scope

The idea is that it is less costly or more valuable to producers for two activities to be pursued jointly than separately Economies of scope might arise because of relatedness among products in terms of: raw materials and/or technology and/or output markets

Reasons for diversification - Evidence

of a) Economies of Scale and Scope
If a merger is motivated by scale economies, the market share of the merged firm should increase immediately following the merger (scale). Data from manufacturing industries show that changes in market share were in line with expectations (scale).

Reasons for diversification - Evidence of a) Economies of Scale and Scope

If firms pursue economies of scope through diversification, large firms should be expected to sell related set of products in different markets (scope). Evidence indicates that this happens only occasionally (scope).

Reasons for diversification a) -Scope Economies outside technology and markets : Unrelated activities
Several firms produce unrelated products and serve unrelated consumer groups (scope). Firms that produce unrelated products and serve unrelated markets could be pursuing scope economies in other dimensions. Two explanations that take this approach are Resource based view of the firm (Edith Penrose). Dominant general management logic (C K Prahlad).

Reasons for diversification a) Scope Economies outside technology and markets Unrelated activities
Resource based view of the firm (Edith Penrose) utilize managerial and organizational underutilzed resources in new areas when growth in existing market is constrained Dominant general management logic (Prahalad and Bettis): Managers of diversified firms may spread their own managerial talent across nominally unrelated business areas. Management has specific skills that can be applied in different areas of activity e.g. information systems, finance, advertising etc.

Reasons for diversification b) Economizing on Transactions Costs

If transactions costs complicate coordination among independent firms, merger may be the answer Transactions costs arises in relationships with independent firms when production process involves specialized assets such as human capital, organizational routines or other forms of proprietary knowledge. Transaction costs are not likely to be a problem Market coordination may be superior in the absence of specialized assets

Example:The University as a Conglomerate

An undergraduate university is a conglomerate of different departments Economies of scale (common library, dormitories, athletic facilities) dictate common ownership and location Value of one department s investments depends on the actions of the other departments (relationship specific assets)

Reasons for diversification 3. Financial synergies

a) Internal capital markets b) Diversifying Shareholder s diversification c) Identifying undervalued firms

Reasons for diversification 3. Financial synergies : a)Internal Capital Markets

In a diversified firm, some units generate surplus funds that can be channeled to units that need the funds (Internal capital market) The key issue is whether the firm can do a better job of evaluating its investment opportunities than an outside banker can do Internal capital market also engenders influence costs

Reasons for diversification - 3. Financial synergies :

Individual shareholders benefit from investing in diversified portfolios and smoothens the earnings stream A broadly diversified firm may receive only a small % of its revenues from any one line of business. So shareholder can invest in a single diversified firm and achieve the benefits of portfolio diversification. But the shareholders do not benefit from this since they can diversify their portfolio themselves. Only when shareholders are unable to diversify do they benefit from firm diversifying into different products.

b)Diversifying Shareholder s Portfolios

Reasons for diversification 3. Financial synergies : c) Identifying Undervalued Firms

Firm s shareholders may benefit from diversification if its managers are able to identify other firms that are undervalued by the stock market. When the acquired firm is in an unrelated business, the acquiring firm is more likely to have overvalued the target The key question is: Why did other potential acquirers not bid as high as the successful acquirer? Winner s curse could wipe out any gains from financial synergies ( paying the highest price as compare to other bidders)

Managerial Reasons for Diversification

Growth may benefit managers even when it does not add value for the shareholders When growth cannot be achieved through internal development, diversification may be an attractive route to growth When related mergers were made difficult by law (anti trust law) conglomerate mergers became popular

Managerial Reasons for Diversification

Managers may feel secure if the firm performance mirrors the performance of the economy (which will happen with diversification) Diversification will offer managers room for lateral movement and allow them to invest in firm specific skills

Potential Costs of diversification

Diversified firms may incur substantial influence costs and may need elaborate control systems to reward and punish managers. Internal capital markets may not function well. Growth may benefit managers even when it does not add value for the shareholders. Managers could be engaged in empire building and enhancing their status in their network at the expense of the shareholders. If managers undertake unwise acquisitions, the stock price drops, reflecting overpayment for the acquisition

Corporate governance issues

Shareholders are knowledgeable regarding the value of an acquisition to the firm. Shareholders have weak incentive to monitor the management. Acquiring firms tend to experience loss of value.

Market for corporate control: Evidence

Hostile takeovers tend to occur in declining industries and industries experiencing drastic changes where managers have failed to readjust scale and scope of operations. Corporate raiders have profited handsomely for taking over and busting up firms that pursued unprofitable diversification. Such redistribution of wealth may adversely affect economic efficiency.

Evidence: Diversification and Operating Performance

Operating Performance is usually measured as accounting profits or as productivity. Major results are: Unrelated diversification harms productivity Diversification into narrow markets does better than diversification into broad markets

Evidence: Diversification and Operating Performance

Improvements in newly acquired plants may come at the expense of performance at the existing plants. Gains from diversification depends on specialised resources of the firm.

Evidence : Diversification and long term performance

Long term performance of diversified firms appear to be poor. One third to one half of all acquisitions and over half of all new business acquisitions are eventually divested. Corporate refocusing of the 1980s (and later) could be viewed as a correction to the conglomerate merger wave of the 1960s. Past conditions could have favoured unrelated diversification and these conditions could since have changed (example: anti-monopoly behaviour based regulations).

Evidence: Valuation and Event Studies

Compare stock market valuations of diversified to those of undiversified firms shares of diversified firms trade at a discount relative to those of their undiversified counterparts (up to 15%): diversification discount

Evidence: Valuation and Event Studies

Why? a) Combining two unrelated businesses reduces value in some way or b) Unrelated businesses elected to combine had low market values even before the combination Recent empirical evidence shows that b) might be motivation, at least partly

Evidence: Summary
Diversification can create value, although its benefits relative to non-diversification are unclear Diversifications in related activities outperform those in unrelated activities

The Transition Process in India from Diversified to Focused

Conglomerates are leveraging their existing setups (internal funds, brand equity, trust and relationships) into venturing and streamlining their processes. There is a transition happening with a move towards focusing on core competencies and outsourcing all the secondary domains. Focused approaches would reduce gross inefficiencies, accelerate the decision making process and also enhance entrepreneurship. When the conglomerates would become successful in establishing themselves as global players in their core areas, they might hive off or sell off their peripheral areas of business. 49

Indian Business
Building on Core Competencies Outsourcing Secondary Activities: The contender is most comfortable in building on its core abilities and competes in proven grounds. Hence many emerging Indian companies have decided to refocus on core competencies, while outsourcing or shedding off secondary operations.

Lecture summary
We have considered the rationale for diversification. We have assessed some examples and some trends related to diversification. We have employed ideas such as: Economies of scale and scope Transaction costs. Efficiency factors.

The Extent of Diversification

What factors determine the extent to which a firm diversifies across different industries?
Diversification will be efficient if there is SYNERGY SYNERGY can come from economies of scope exploitation of specific assets reduction of risk and uncertainty BUT DOES IT REALLY EXIST IN PRACTICE?


The history of diversification is not good

In the 1960s and 1970s the conglomerate was a favourite form of business Although the purchased firms were usually good performers, the merged firm tended to have poor performance It became clear in the 1980s and 90s that there is a diversification discount of about 15% on average WHY? Firms seemed to not understand the sectors they entered


Alternative forms of of merger

Horizontal: with competitors Vertical: with suppliers or customers Conglomerate: with unrelated firms

Mergers in a perfect world

All managers are efficient;they work in the interests of shareholders; stock markets price shared efficiently;no uncertainty; everyone uses the same discount rate In that situation there are only two reasons for mergers to take place: SYNERGY: 2+2>4; economies of scope or scale, joint use of key resources or capabilities MARKET POWER: merger gives some degree of monopoly power


The performance consequences of mergers

Shareholders of the acquired firms gain because the acquiring firm pays a premium The pattern of results for the acquiring firm is very mixed with values tending to fall, not rise!


Are mergers really for managers?

CEOs and senior managers like mergers
larger firms involve more prestige and often more pay larger and more diverse firms reduce risk for managers (but not for shareholders who could do it another way) publicity is welcomed by many CEOs


Partnerships and Value Constellations


Diversification among Large UK Corporations, 1950-93

70 60 50 40 30 20 10 0 1950 1960 1970 1983 1993 Single business Dominant business Related business Unrelated business

Diversification: The Evolution of Management Thinking and Management Practice


Quest for Growth

Financial problems of conglomerates

Refocusing on shareholder value

Competitive advantage through Speed, flexibility, and capability


Rise of conglomerates Emphasis onrelated Refocusing on Related diversification core businesses & concentric by industrial firms Divestment diversification

Joint ventures, Alliance, corporate venturing

Financial Analysis Diffusion of M form structures

Analysis of economies of scope & synergy

Portfolio planning models

Value based Transaction management cost analysis Core competences Dominant logic Dynamic capability


Capital asset Development of corporate planning systems pricing model

1950 1990




Motives for Diversification

GROWTH --The desire to escape stagnant or declining industries a powerful motives for diversification (e.g. tobacco, oil, newspapers). --But, growth satisfies managers not shareholders. --Growth strategies (esp. by acquisition), tend to destroy shareholder value


--Diversification reduces variance of profit flows --But, doesnt create value for shareholdersthey can hold diversified portfolios of securities. --Capital Asset Pricing Model shows that diversification lowers unsystematic risk not systematic risk.


--For diversification to create shareholder value, then bringing together of different businesses under common ownership & must somehow increase their profitability.

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests: 1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive). 2. The Cost of Entry Test : the cost of entry must not capitalize all future profits. 3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of synergy must be present)
Additional source of value from diversification: Option value

Competitive Advantage from Diversification

Predatory pricing/tie-in sales Reciprocal buying Mutual forbearance Evidence of these is sparse


Sharing tangible resources (research labs, distribution systems) across multiple businesses Sharing intangible resources (brands, technology) across multiple businesses Transferring functional capabilities (marketing, product development) across businesses Applying general management capabilities to multiple businesses

Economies of scope not a sufficient basis for ECONOMIES diversification ----must be supported by transaction costs FROM Diversification firm can avoid transaction costs by INTERNALIZING operating internal capital and labor markets TRANSACTION Key advantage of diversified firm over external markets--S superior access to information

Relatedness in Diversification
Economies of scope in diversification derive from two types of relatedness: Operational Relatedness-- synergies from sharing resources across businesses (common distribution facilities, brands, joint R&D) Strategic Relatedness-- synergies at the corporate level deriving from the ability to apply common management capabilities to different businesses. Problem of operational relatedness:- the benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.

Branson & the Virgin Companies: Making strategic sense of apparent entrepreneurial chaos

Virgin brand Branson -charisma/image --PR skills -networking skills -entrepreneurial flair


Seek competitive advantage by start-up cos. pursuing innovative differentiation in underserved market with sleepy incumbents


Whats the business model? (Does Virgin create value by being an entrepreneurial incubator, a venture capital fund, a diversified corporation, or what?) Which businesses to divest? Criteria for future diversification What type of structure?Is there a need for greater formalization?

consumer dominant incumbent scope for new approaches to customer service high entry barriers to other start-ups Branson/Virgin image appeals to customers

Virgin Conglomorate
Business opportunities are like buses, there s always another one coming Richard Branson Virgin Group is a diversified group of more than 200 privately held companies. The largest of these are Virgin Atlantic Airways, the number two airline in the United Kingdom; Virgin Holidays, a vacation tour operator; the Virgin Retail Group, which operates numerous Virgin Megastores, a retail concept featuring videos, music CDs, and computer games; and Virgin Direct, which offers financial services. Other Virgin businesses include beverage maker Virgin Cola, a record label, book and music publishing operations, hotels, an Internet service provider, movie theaters, a radio station, cosmetics and bridal retailing concepts, and a line of clothing. Holding this disparate group of companies together is the combination of Richard Branson and the Virgin brand name. British entrepreneur Branson dropped out of boarding school at the age of 17, in 1967, to start his own magazine. That venture called Student was an immediate success, establishing the foundation for what would become a multibillion-dollar conglomerate.


Diversification and Corporate Strategy

A company is diversified when it is in two or more lines of business Strategy-making in a diversified company is a bigger picture exercise than crafting a strategy for a single line-of-business A diversified company needs a multi-industry, multi-business strategy A strategic action plan must be developed for several different businesses competing in diverse industry environments

When Does Diversification Start to Make Sense?

Strong competitive position, rapid market growth -- Not a good time to diversify Strong competitive position, slow market growth -- Diversification is top priority consideration Weak competitive position, rapid market growth -- Not a good time to diversify Weak competitive position, slow market growth -- Diversification merits consideration

Strategies for Entering New Businesses

Acquire existing company Start-up new business internally

Joint venture with another company

Acquire a Company Already in the Target Industry

Most popular approach to diversification Advantages Quicker entry into target market Easier to hurdle certain entry barriers Technological inexperience Gaining access to reliable suppliers Being of a size to match rivals in terms of efficiency and costs Getting adequate distribution access

Diversification via Internal Startup

More attractive when Ample time exists to create a new business from ground up Incumbents slow in responding to new entry Less expensive than acquiring an existing firm Company already has most of needed skills Additional capacity will not adversely impact supply-demand balance in industry New start-up does not have to go head-to-head against powerful rivals

Diversification via Joint Ventures

Good way to diversify when

Uneconomical or risky to go it alone Pooling competencies of two partners provides more competitive strength Foreign partners are needed to surmount Import quotas Tariffs Nationalistic political interests Cultural roadblocks

What Is Related Diversification?

Involves diversifying into businesses whose value chains possess competitively valuable strategic fits with the value chain(s) of the present business(es) Capturing the strategic fits makes related diversification a 2 + 2 = 5 phenomenon

Benefits of Related Diversification

Preserves unity in its business activities Reap competitive advantage benefits of Skills transfer Lower costs Common brand name usage Spread investor risks over a broader base Achieve consolidated performance greater than the sum of what individual businesses can earn operating independently

Concept: Economies of Scope

Arise from ability to eliminate costs by operating two or more businesses under same corporate umbrella Exist when it is less costly for two or more businesses to operate under centralized management than to function independently Cost saving opportunities can stem from interrelationships anywhere along businesses value chains

Capturing Benefits of Strategic Fit

Benefits don t occur by themselves ! Businesses with sharing potential must be reorganized to coordinate activities Means must be found to make skills transfer effective Benefits of some strategic coordination must exist to justify sacrificing business-unit autonomy Competitive advantage potential exists To expand resources and strategic assets and To create new ones faster and cheaper than rivals

What Is Unrelated Diversification?

Involves diversifying into businesses with

No strategic fit No meaningful value chain relationships No unifying strategic theme

Approach is to venture into any business in which we think we can make a profit Firms pursuing unrelated diversification are often referred to as conglomerates

Post-Diversification Strategies

Divestiture and liquidation Corporate turnaround Corporate retrenchment Portfolio restructuring Multinational diversification

Comment: Trend in Diversification

The present trend toward narrower diversification has been driven by a growing preference to gear diversification around creating strong competitive positions in a few, wellselected industries as opposed to scattering corporate investments across many industries!

Procter & Gamble s Diversification Strategy

Purpose of diversification: Use expertise and knowledge gained in one business by diversifying into a business where it can be used in a related way
Builds synergy: value added by corporate office adds up to more than the value if different businesses in the portfolio were separate and independent

Procter & Gamble (P&G)

Product mix: beauty products targeting women and baby care products 2005: Acquired Gillette (consumer health care products) focused on masculine market

Procter & Gamble s Diversification Strategy

Procter & Gamble (P&G)
(Cont d)

Synergy created with combining toothbrush and toothpaste businesses

Had to sell off product lines with Gillette acquisition, lost some prospective market power Good for retailers (shelf space) Although strategy appeared to have potential, it was more difficult to create actual operational relatedness between the products
Comingle employees requiring actual physical re-location/talent exit Different ways to make business decisions Conflicting organizational cultures


Levels of Diversification
1. Low Levels
Single Business Strategy
Corporate-level strategy in which the firm generates 95% or more of its sales revenue from its core business area E.g. Daimler Benz, DeBeers

Dominant Business Diversification Strategy

Corporate-level strategy whereby firm generates 70-95% of total sales revenue within a single business area


Levels of Diversification
2. Moderate to High Levels
Related Constrained Diversification Strategy
Less than 70% of revenue comes from the dominant business(from primary activity) Direct links (I.e., share products, technology and distribution linkages) between the firm's businesses Abott Labs

Related Linked Diversification Strategy (Mixed related and unrelated)

Less than 70% of revenue comes from the dominant business Mixed: Linked firms sharing fewer resources and assets among their businesses (compared with related constrained, above), concentrating on the transfer of knowledge and competencies among the businesses

Levels of Diversification
3. Very High Levels: Unrelated (Conglomerate)
Less than 70% of revenue comes from (primary activity)dominant business No relationships between businesses E.g. 3M, General Motors


Cost of Diversification: Internal Capital Market in Oil Companies

If internal capital markets worked well, nonoil investments should not be affected by the price of oil. Lamont (1997) found on the contrary that investments in non-oil subsidiaries fell sharply after the drop in oil prices. Managerial reasons may dominate the investment decisions

Indian companies 1979-89

Raman (1991) has measured the pattern of diversification of 67 Indian companies from the private sector. The pattern was studied over 1 1 -year period from 197989 at three points of time, that is, 1979, 1984 and 1989. Using Rumelt's classification the firms were divided into nine categories. It was observed that companies preferred going in for Unrelated Business rather than Single Business. Among the Dominant Business, Dominant Vertical was the same for each year while Dominant Linked was larger in 1989 as compared to 1979. The number of companies in related linked also increased as compared to related constrained. However, between 1980-90, studies also show that companies started favoring refocusing rather than diversification. Lichtenberg (1992) showed that the level of diversification declined between 1985 and 1989 in a sample of 6,505 firms. Spender and Grant (1996) also reported that the average index of diversification for Fortune 500 companies declined from 1.00 to 0.67.

Why do firms diversify

Diversification across products and across markets can be due to economies of scale and scope. Diversification that occurs for other reasons tends to be less successful.
Nokia - wood pulp and paper/ footwear/ televisions/ capacitors


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.

Identifying undervalued firms

Shareholders may benefit from diversification if its managers are able to identify firms that are undervalued by the stock market.

Why do firms diversify

Growth is an implicit objective in nearly all organisations. Stock markets tend to reward growing companies. Managers find growth extremely attractive because it hold out the prospects of increased earnings for the firm leading to increased compensations for themselves. They also see the acquisition of new knowledge as instrumental in improving their self actualisation prospects. Fuller utilisation of Resources and Capabilities - Firms find that they have un utilised or under utilised capacities sometimes in manufacturing some times in Alternatively a firm could find that it can perform a business activity at a lower cost and with better timeliness than if it utilised its internal capabilities.

Why do firms diversify

To make use of surplus Cash flows. There are several examples of this to be found in Indian Industry. Bajaj Auto and Bombay Dyeing have consistently over the last few years invested surplus cash from their core businesses in Two Wheelers and Textiles respectively into treasury operations mostly short term lending to other cash strapped Corporates. At times a firm might use surpluses from one of its cash rich businesses to cross fund other businesses. Managerial Reasons - Managers find growth extremely attractive because it hold out the prospects of increased earnings for the firm leading to increased compensations for themselves. They also see the acquisition of new knowledge as instrumental in improving their self actualisation prospects.


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. Shareholders can diversify their own personal portfolios. Corporate managers are not really needed to do this. Identifying undervalued firms may not be as easy as it sounds.