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C H A P T E R

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What is Diversification?

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Chapter 2 What is Diversification?

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What is diversification? It turns out that this isn’t an easy question to answer – not for academics, nor for managers. In their conclusion to a review of many diversification studies, academics James Robins and Margarethe Wiersema came to a conclusion in 2003 that is both stark and startling for researchers and managers: “One of the most striking problems introduced by the ambiguity of these [diversification/relatedness] indexes is the fact that findings which previously appeared to support the same position may actually contradict each other … The fact that the most widely used indicators of related diversification cannot be treated as reliable measures of ‘relatedness’ within corporate portfolios creates a real dilemma for researchers.”1 It creates a real dilemma for managers too! It also does little to give managers confidence in the results of diversification research. I’ve observed that one of the problems managers face in dealing with diversification is its definition. What stands as diversification for one manager within an organization may not for another. This leads to confusion on what action to take. Because of diversification’s complexity, its definition proves in practice to be very subjective.2 When McDonald’s introduces salads into its product range, is this diversification? The accepted answer is “no,” since it has stayed within its original fast food industry and has only extended its product line. If the same company went into clothing retailing, would this be a diversification? The accepted answer is “yes,” since it has moved into a different industry, but here managers hedge their bets. One may say, “Yes, but it’s related to what it currently does. It’s in retailing.” Another may reply, “Yes, it’s diversification, but it’s unrelated. It’s not in food.” So the diversification waters get muddied and managers are left not sure what a diversification really is. Fortunately, a study has been undertaken to help us identify the dimensions of relatedness/diversification. In 1997, J. L. Stimpert and Irene Duhaime identified 25 dimensions of

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relatedness.3 These were derived from the literature and from interviews with managers. They are shown in Figure 2.1, which provides a broad range of items on which any two businesses in a diversified company may differ. The greater the number of dimensions on which there is variation, the greater the diversity.

Figure 2.1 Dimensions of Relatedness/Diversification

Businesses – are cost leaders produce commodity products emphasize new product development are market share leaders have strong brand names produce high value-added products serve niche markets share customers emphasize advertising emphasize customer service emphasize product design emphasize R&D require same raw materials are vertically linked share manufacturing process share distribution network share quality emphasis share investment requirements are about the same size similarly impacted by economy in same stage of life cycle share cash flow characteristics share management skills are required to meet financial targets share accounting system

Chapter 2 What is Diversification?

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My definition of diversification is the variation between businesses within a company. This variation can be by products or services, e.g., food vs. clothing, in the McDonald’s example above; customer type, e.g., domestic versus industrial customers in washing machines; manufacturing processes, e.g. tailor-made clothing versus factory-made clothing, and so the variations go on. The degree of diversity is determined by two factors. The first is the degree of difference in one dimension, such as products produced. The second is the number of dimensions in variation – products produced, customer type, technology employed, delivery mechanism, and so on. Mining iron ore and running a general hospital are highly diverse because differences exist in a number of dimensions, e.g., skills, clients, processes, risk to life, etc., and because these differences are, in most cases, extreme, e.g., client needs. It’s the definition above that I’ll have in my mind as we proceed.

1

Robins, J.A. & Wiersema, M.F. 2003. The measurement of corporate portfolio strategy: Analysis of the content validity of related diversification indexes. Strategic Management Journal, 24: 39-59.

2

Stimpert, J.L. & Duhaime, I.M. 1997. The eyes of the beholder. Conceptualizations of relatedness held by the managers of large diversified firms. Strategic Management Journal, 18(2): 111-125.

3

Ibid.

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