Diversification is the practice of investing in a range of industries and asset classes in order to mitigate risk. Related diversification is a sub-type, referring to diversification into an industry or business that is related to your main business’s core competency.
Companies that diversify into related products and services can leverage existing knowledge, skills, and networds to get a competitive advantage. It can also be advantageous to the existing products and services when they two work in synergy.
A prime related diversification example is a company’s diversification from software products into hardware products to sell them to the existing audience.
Related Diversification Definition
Related diversification is a strategy used by companies and investors to expand their business operations. It involves entering new markets or industries that are closely related to the core competencies of the existing business or investment.
This strategy can achieve quick success because the diversifying entity can leverage their existing resources, knowledge, and expertise in the “shoulder niche” to grow rapidly (Sadler, 2003; Chatterjee & Wernerfelt, 1988).
Commonly, related diversification will involve vertical integration, where a company diversifies up or down the supply chain. In these instances, the strategy can also leverage the fact that your existing company can act as a first customer of your new company, giving a much-needed initial cash injection.
The diversifier often attempts to leverage a core competency, which is the key capability of the original business that may be challenging for competitors to imitate. This may happen, for example, because you’ve already achieved economies of scale or have a strong network in the undustry (Prahalad & Hamel, 1990).
Strengths Related Diversification
1. Leverages Existing Resources
The main advantage of related diversification is that it allows companies to leverage their current market expertise and resources to achieve market advantage.
For example, if your company sells apples, you may already have contacts with the large supermarket chains and distributors. Diversification into oranges can leverage those contacts to ensure you have a built-in customer base. Furthermore, your agricultural skills are transferable.
This can also lead to cost savings, as the company can leverage its existing resources (transport vans, farming equipment, etc.) for the new product.
2. Risk Mitigation
Related diversification can mitigate risk in several ways.
Diversification can increase your control over the supply chain (if it’s vertically integrated diversification) which can minimize the chances that others within the supply chain can negatively impact your business.
However, risk is often still higher in related diversification than unreltaed diversification, because a related business may be exposed to the same risks as the original one.
3. Helps Achieve Economies of Scale
Related diversification can help companies achieve economies of scope (which refers to the reduction in costs when you have a larger company that can produce products more efficiently).
For example, a small company may produce products for $15 per item. But if they’re a larger company with a lot of demand, it makes sense to purchase a factory that more efficiently produces the products.
You may also have more market power, enabling you to sign better deals for your products or services.
Limitations of Related Diversification
1. Complexity
Related diversification often leads to increased complexity as the one head company now has to manage multiple business units with different but related foci.
For example, producing just one product means you have just one goal. There are no distractions and very clear goals.
But if you’ve diversified into two different but related companies, you now have to learn to divide your time and efforts across the companies, and manage those companies’ competing needs and demands for resources.
2. Competition
If a company is not careful, they will find that their two related brands or companies are in direct competition with one another.
For example, if you own the largest basketball brand and buy the second largest, you may end up realizing that it’s become inefficient to market two brands to the same consumer market.
Your two brands may also compete for the same keywords on search engines, meaning your two different businesses are spending a lot of search engine optimization resources to one-up each other.
Related Diversification Examples
- From Auto Parts to Heavy Equipment Parts: A company that manufactures automotive parts might diversify into heavy equipment parts. Both industries are closely related because they both involve producing mechanical parts. This company may be able to transfer it skills and employees for the new business (e.g. casting, forging, welding, etc.). This can give them a big headstart when starting off in the new industry.
- From Consumer Electronics to Home Appliances: A company that produces consumer electronics such as USB devices might choose to diversify by starting a branch that produces home appliances such as smart switches in the home. Both industries involve the production of electronic devices and require similar engineering skillsets, making this another example of related diversification. Because of the synergy between these two markets and the fact they share a common core competency, the company could leverage its existing resources such as existing proprietary research to enter into the home appliance market.
- From Beauty Products to Personal Care Products: A beauty products brand might choose to purchase a personal care products brand. They do this because the personal care brand appears to have a synergy with their existing consumer base. They believe they can use their existing email lists to sell the new products. As a result, it seems like a clever purchase that both diversifies the company and complements the existing products to give something new to sell to the existing market base.
- From Clothing to Footwear: A company that produces clothing can diversify into footwear while leveraging existing relationships with sporting goods stores. They may even reach out to the stores in advance and secure procurement agreements so the footwear will instantly have a spot on the shelves. The result is less initial risk and less time spent trying to make contacts.
- From one Type of Equipment to Another: An agricultural equipment manufacturer (combine harvesters, lawn mowers, etc.) may venture into the associated realm of construction machinery (Asphalt Pavers, Backhoe Loaders, etc.). Both of these sectors deal with the fabrication of heavy-duty equipment and may even have transferrable parts. This move could prove to be advantageous for the company, as it already possesses the technical know-how, the manufacturing facilities, and necessary resources for the production of such machinery.
- From Food to Beverages: It makes sense for a company that produces packaged foods to diversify into packaged beverages. The company can leverage its packaging expertise and knowledge of supermarket logistics to enter the beverage market. They likely have all the right phone numbers to call!
- From Pharmaceuticals to Medical Devices: A company that produces pharmaceutical products might naturally diversify into the production of medical devices. Both the pharmacy and medical device industries deal with the production of healthcare products. The existing company likely has strong relationships in the healthcare industry and will know how to navigate the bureaucracy well.
- Google Building Laptops: Google, primarily a software company, diversified into hardware with their Chromebook. This is classic related diversification: they leveraged their brand name and reputation to sell their consumers another product that is related but different. Furthermore, Chromebooks come with all the Google software installed, meaning it also improves the reach of the original product.
Other Types of Diversification
There are three main types of diversification: related, unrelated, and geographic (Kennedy et al., 2020). Here’s a brief description of each:
- Related diversification occurs when a company expands into new businesses or industries related to its core competencies or products. For example, a manufacturer of automotive parts might diversify by entering the market for aftermarket car accessories. This type of diversification can allow a company to leverage its existing knowledge, skills, and resources to enter new markets and increase its revenue streams. Kennedy et al. (2020) offer the example of Volkswagen acquiring Audi.
- Unrelated diversification occurs when a company expands into businesses or industries unrelated to its core competencies or products. For example, a manufacturer of automotive parts might diversify by entering the market for consumer electronics. This type of diversification can be riskier, as the company may not have the same level of expertise or resources in the new industry. However, it can also offer the potential for greater returns if the new business is successful. Amazon entering the grocery store business by acquiring Whole Foods is a real-life example of unrelated diversification (Kennedy et al., 2020).
- Geographic diversification occurs when a company invests in (or conducting business in) a variety of locations or regions around the world in order to spread risk across multiple economies. This can help, for example, if one area of the world is suddenly hit by a natural disaster or war. A company might pursue geographic diversification by selling products or services to customers in different countries or regions, having geographical redundancies in supply chains, or investing in real estate assets in different geographic areas. This strategy is used by Starbucks, Target, KFC, and many more (Kennedy et al., 2020).
Conclusion
Diversification refers to the practice of investing or conducting business in a variety of markets to spread risk and reduce the impact of negative events on a portfolio. There are three main types of diversification: (1) related, (2) unrelated, and (3) geographic (Kennedy et al., 2020).
Related diversification, as the name suggests, refers to the expansion of a company into related markets. By leveraging their existing resources, companies can enter new markets and achieve greater profits.
Successfully implementing strategies of related diversification can lead to cost savings, risk mitigation, and revenue growth.
References
Chatterjee, S., & Wernerfelt, B. (1988). Related or Unrelated Diversification: A Resource Based Approach. Academy of Management Proceedings, 1988(1), 7–11. https://doi.org/10.5465/ambpp.1988.4979378
Kennedy, A. by R., Jamison, with E., Simpson, J., Kumar, P., Kemp, A., Awate, K., & Manning, K. (2020). 8.3 Diversification. https://pressbooks.lib.vt.edu/strategicmanagement/chapter/8-3-diversification/
Prahalad, C. K., & Hamel, G. (1990). The core competencies of the corporation. Harvard Business Review, 86(1), 79–91. https://hbr.org/1990/05/the-core-competence-of-the-corporation.
Sadler, P. (2003). Strategic Management. Kogan Page Publishers.
Tio Gabunia (B.Arch, M.Arch)
Tio Gabunia is an academic writer and architect based in Tbilisi. He has studied architecture, design, and urban planning at the Georgian Technical University and the University of Lisbon. He has worked in these fields in Georgia, Portugal, and France. Most of Tio’s writings concern philosophy. Other writings include architecture, sociology, urban planning, and economics.
Chris Drew (PhD)
This article was peer-reviewed and edited by Chris Drew (PhD). The review process on Helpful Professor involves having a PhD level expert fact check, edit, and contribute to articles. Reviewers ensure all content reflects expert academic consensus and is backed up with reference to academic studies. Dr. Drew has published over 20 academic articles in scholarly journals. He is the former editor of the Journal of Learning Development in Higher Education and holds a PhD in Education from ACU.