Advantages and disadvantages of diversification

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Advantages and disadvantages of diversification

This article examines some of the key advantages and disadvantages of diversification strategy. Diversification is the practice of investing in more than one business to benefit from that activity independently. In other words, it means investing in different ventures. Investing in more than one business has many opportunities; however, it can be very risky as well.

 

What is diversification?

Diversification is the practice of investing in more than one business or industry. It is the strategy of spreading money around so that a business does not have to keep all its eggs in one basket. If one thing goes wrong in one industry, it can still have something to fall back on.

 

According to Berger and Curry (2021) diversification is strategy that businesses sometimes use to manage risk. Rather than piling money on a single company, industry, or sector, entrepreneurs may diversify their investments across a range of different businesses.

 

According to Proctor (2020) diversification refers to spreading money into multiple investments and multiple types of investments. The wisdom behind it is that if one business loses money, entrepreneurs can fall back on to other businesses.

 

A growing company should invest in more than just one industry. It should expand its customer base by expanding its product portfolio or expanding its service territory.  Companies that are consistent in growth are likely to succeed in the long run. However, there are some challenges associated with diversification strategies.

 

Examples of diversification

Many companies around the world have applied diversification strategies. There are generally two types of diversification strategy i.e. related diversification and unrelated diversification.

 

Related diversification strategy is when a company goes beyond its current products and markets, however, stays within its capabilities or value network. In other words, the new business has important similarities with the company’s existing business/industry. For example, Disney’s purchase of ABC was a related diversification strategy as both television and films are two key areas of the global entertainment industry.

 

On the other hand, unrelated diversification is about entering in new industries. For instance, General Electric’s initial focus was on electronics. However, with the passage of time, it diversified into power plant, gas, kitchen appliances, aeronautic, and rail   industries. Likewise, Amazon has entered the grocery store business with its purchase of Whole Foods.

 

Advantages of diversification strategy

 

Spreading risks across different businesses

One of the major advantages of diversification strategy is that businesses can increase their chances for success by ensuring that even if one part of their business fails, there are others that are more likely to succeed.

 

Increased overall return

Entrepreneurs can hope for higher returns with diversification strategies than what they would get by putting all their money into one venture. If they invest in a variety of different industries, they are likely to increase their return.

 

Likewise, sometimes the market’s fluctuation can negatively affect the rate of return of a single industry. That is why it is a good idea to diversify by spreading the money around.

 

Moving away from a dying industry

Some industries may become obsolete due to the advent of new technologies and markets shift. Imagine, using floppy disk today! Likewise, what happened to rental Video/DVD business? Therefore, diversification can sometimes be necessary to move away from a failing core industry to enter an emerging one.

 

Market share

Implementation of a successful diversification strategy can help a business generate revenue from new streams and grow market share accordingly.

 

Disadvantages of diversification strategy

 

Increased risk

One of the biggest disadvantages of diversification strategy is that it is considered the riskiest business growth option in Ansoff Matrix as the product and the market are both new. Therefore, businesses need to be careful while considering adopting this as an expansion strategy.

 

Negative impact on core products

Diversifying into new markets too quickly may cause a business to reduce focus on its key products and services. In addition, just because a company has huge capital and experience in one industry, does not mean that it would succeed in a different industry. For example, British supermarket and grocery company Morrisons had to sell its troublesome baby goods retailer Kiddicare within three years of acquisition.

 

Cost

Implementing diversification strategies can be very costly. For instance, Amazon spent $13.7 billion to buy Whole Foods Market. Likewise, failure of diversification strategies may cost a company badly as well.

 

Summary of the advantages and disadvantages of diversification

Diversification is a great way for business expansion. It is important to remember that one industry does not have a guarantee to make a company rich. That is why it is important to diversify by spreading money around so that businesses do not have to put all eggs in the same basket.

 

Certainly, diversification can help improve a business’s chances of success. However, to diversify, it must accept higher levels of risk, and reduce its short-term profits. Diversification is a strategy that is going to require some short-term sacrifices. However, in exchange for that, the potential rewards are worth the gamble.

 

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Last update: 16 May 2022

References:

Berger, R. & Curry, B. (2021) How diversification work and why you need it, available at: https://www.forbes.com/advisor/investing/what-is-diversification/ (accessed 16 May 2022)

Proctor, C. (2020) What is diversification? A portfolio strategy that uses a variety of investments to limit risk, available at: https://www.businessinsider.com/personal-finance/what-is-diversification?r=US&IR=T (accessed 15 May 2022)

Author: M Rahman

M Rahman writes extensively online with an emphasis on business management, marketing, and tourism. He is a lecturer in Management and Marketing. He holds an MSc in Tourism & Hospitality from the University of Sunderland. Also, graduated from Leeds Metropolitan University with a BA in Business & Management Studies and completed a DTLLS (Diploma in Teaching in the Life-Long Learning Sector) from London South Bank University.