What is diversification? This term refers to allocating resources to different projects to reduce risks and increase profits. Diversification is actively used in business, in the stock market, in production, savings, and even in relation to the economy as a whole.
But still, the main goal of diversification is to reduce risks. If, for example, different assets are purchased on the stock market, then the risk that the investor will be adversely affected by a decrease in the price of one of them is significantly reduced. A drawdown can easily be offset by an increase in the price of other acquired assets. The same thing happens in business: the company can develop new areas, diversify products, occupy new niches, and thereby insure against possible drawdowns in one of the areas of its activity.
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What is company diversification in business?
Business diversification is a development strategy that involves the entry of enterprises into new markets or industries. It is carried out to improve the quality and efficiency of production. In addition, the diversifying business helps prevent the company’s bankruptcy and obtain economic benefits.
Despite the potential difficulties associated with market diversification, this is one of the most effective ways to achieve a company’s stability and growth in the long term.
What are diversification strategies? The types of business diversification include:
- Horizontal diversification is when businesses develop new products or services for a similar market. Thanks to this business diversification strategy, new assets can complement the core business and please the existing target audience. This company diversification type is also called related diversification strategy. Related diversification examples include a hairdressing salon that produces its own line of hair care products.
- Concentric diversification. Similar to horizontal diversification, this company diversification growth strategy sees a company expand its current portfolio by offering related products or services. However, this strategy assumes that the company creates offerings that are more in line with the core business. For example, if an ice cream maker launches a new line of ice cream, it will diversify business concentrically.
- Vertical diversification is a growth strategy in which companies diversify their activities throughout the supply chain. This method may include forward or reverse expansion and may consist of processes such as purchasing raw materials or transporting goods for sale. For example, a confectionery manufacturer can diversify its activities vertically by creating its own distribution channel.
- Conglomerate diversification. Conglomerate diversification occurs when the company expands its offerings to attract new customers. Unlike horizontal business expansion, in this case, the company usually deviates from its core business model. A conglomerate diversification example is when a technology company starts making office supplies.
Deciding how and when to diversify the company will require:
- Conducting detailed diversification marketing research for a new product or service.
- Carefully studying the target audience and determine customers’ needs.
- Developing a clear product diversification and development strategy and market testing.
It is also recommended to examine the existing infrastructure in the form of supply chains, marketing, and sales departments for strength due to additional load.
Reasons for diversification and its advantages
In the case of business diversification, the risks of a complete loss of capital are significantly reduced. After all, if one project turns out to be unprofitable, then drawdowns can be covered by other, more successful areas.
Increasing the number of clients
A business would be nothing without its customers. And the more of them, the better it is for the company. Unfortunately, many small and medium-sized enterprises (SMEs) with limited supply find it extremely difficult to get new customers. That’s why diversification of products and services can be an excellent decision for them.
In particular, vertical and conglomerate diversification are some of the easiest ways companies can reach a much broader consumer audience. This is because vertical diversification allows business to benefit from B2B and B2C sales. Conglomerate diversification will help draw the attention of a pool of new consumers to the product.
Why is diversification important for small and medium-sized enterprises? It allows for attracting new customers without investing heavily in new staff and infrastructure. Thus, for business owners seeking to attract new customers without creating a new company or radically restructuring their current business model, diversification will prove to be the best solution.
Increasing company profit
The concepts of business and risk always go together. The stable operation of any company, and, accordingly, the size of its profit, can be affected by:
- market fluctuations
- public health emergencies (recent coronavirus pandemic, for example)
- geopolitical tensions, etc.
Due to relatively limited income streams, small and medium-sized enterprises are more vulnerable in this regard. By applying industry diversification and taking care of several sources of income from different projects, the company will insure itself against possible shocks and increase profits along the way.
More stable demand
A company offering a limited number of products and services will likely deal with cyclical demand patterns. When it comes to, for example, the hotel business, it is known for its seasonality. After all, there are usually more visitors in the summer, while the hotel may be idle in winter. In this case, the company should take care of the provision of related services in the winter. These may include snow removal services and maintenance of heating systems.
To overcome these quiet periods, many companies invest resources in developing less seasonal products to balance their sales and make them more independent of the season. Such measures will allow companies to be more resilient to market fluctuations and more flexible in the long term.
Reduced production costs
When retailers choose to diversify, they typically produce products similar to those they already have in stock. This allows them to achieve economies of scale.
There is a theory that producing a similar product at facilities that were previously used (and are currently being used) for creating similar goods can significantly save money on purchasing new equipment. Economies of scale enable small and medium-sized enterprises to diversify their inventory and increase their revenues without having to invest in new production equipment. This reduces the production cost without sacrificing the final product’s quality.
By producing goods in large quantities, the company also has the opportunity to maximize its income. This effect would not be achieved by SMEs using conglomerate diversification, in which new products have nothing to do with their current line. It requires the purchase of new equipment, investment in a new type of raw material, etc.
Increasing brand awareness
Business owners should never underestimate the importance of branding. Their company’s visibility allows them to build relations with customers and expose them to new audiences. The higher the brand awareness is, the more successful it will be. That is why small and medium enterprises need to do everything possible to make the brand as famous as it can be.
Diversification is an almost universal business tool that, in addition to the previously announced benefits in the form of increasing profits and attracting a new target audience, can also make the brand even more recognizable. By affixing their logo to a range of new products and services, an entrepreneur is promoting their company in this way.
The promotion’s success level among a similar audience or different demographic groups will depend on what type of diversification is chosen. This market diversification strategy is one of the most effective in terms of expanding brand reach compared to other tools.
Does diversification carry any risks?
A diversification marketing strategy, like any other marketing tool, hides not only benefits but also certain risks. As with starting any other business, when diversification is involved, there is always the possibility that the effort will not succeed. And these risks do not depend on the sector in which the business operates because there is no guarantee that new products will be well received by customers. It is incredibly difficult to predict how an attempt to diversify will end up, whether the new offering continues the main product line or represents something radically new.
Therefore, to prevent the failure of a potentially profitable project, it is essential to conduct as much research as possible before bringing a new proposal to the market. Business expansion, in any case, requires certain cash injections. Since small businesses rarely have excess free cash in their reserves, they usually resort to loans or the help of investors to cover these initial expenses.
Disadvantages of diversification
Often, a company that has expanded through diversification has multiple divisions and a large number of new products. This dramatically complicates the overall control of all processes. As a result, there are failures in deliveries and other working moments. Therefore, it is first essential to take care of the optimal levels of management and control over new units.
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When launching a new product radically different from anything previously offered to customers, there is a risk of no or limited success in the new area.
Other cons of diversification:
- a new activity may require new skills that are not available in an existing company
- any diversification is a long-term strategy that may not bring immediate benefits
- resources will be needed – new production facilities, staff, additional time, funds, etc.
But despite all this, diversification still has more advantages. Among them:
- minimization of risks of losing capital
- reducing dependence on external sources of financing
- growth of the company’s competitiveness.
With the help of a diversification strategy, you can increase the profitability of production, prevent a drop in demand for goods, and prevent a company from going bankrupt. The main principle of diversification is a competent balance of existing risks and the level of the potential profitability of projects.
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