Related vs. Unrelated Diversification
Diversification is a complex concept and can be broken down into related and unrelated diversification. Related diversification is when a company operates several businesses that are linked together in some way or has several related product lines. Unrelated diversification occurs when an organization attempts to diversify into the industries and businesses that hold the promise of the most financial gain for an organization. Finding a strategic fit is less important here than generating profit (Nickel, McHugh, & McHugh, 2004).
Competitive strengths of related diversification vary based on the firm in question. One major advantage is that there is less ambiguity about the company’s identity. Because the organization is managing similar businesses, stakeholders do not feel that they don’t know what the company is focusing on. Another advantage of related diversification is that all the energy of the company is directed to one path. An organization that owns three of the same type of businesses does not need to worry about developing products or services in other, unrelated industries. Leaders of an organization are also better able to focus on being responsive to changes in their particular industry. Using the firm’s full resources and strengths to concentrate on a single business strategy
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There are also risks of using related diversification as a competitive advantage. One major disadvantage is that organizations are using all of their strengths and resources to concentrate on one industry. If this one industry begins to stagnate or decline in growth, the growth rate of the firm will come to a plateau or begin to decline. Related diversification is also not an appropriate option in industries where customer needs or technological innovation can undermine a single strategy firm (Nickel, McHugh, & McHugh, 2004).
Unrelated diversification involves no common strategic fit of the diversified firms lines of business. A firm that is pursuing unrelated diversification takes the position of pursuing any avenue that may generate profit rather than being concerned with creating a strategic fit. There are several criteria to examine when considering unrelated diversification. Businesses must examine whether they can meet targets for profitability and return on investment, if the business will require substantial capital infusions, if the business is an industry with growth potential, if the business is big enough to contribute to the parent firm’s growth, if there is potential for union or legal difficulties, and if the business is vulnerable to recession, inflation, or high interest rates.
Unrelated diversification is appealing to businesses for several reasons. One major appeal is that the risk is distributed over different industries. Profits are also likely to be more stable, as hard times in one industry may be offset by good times in another industry. Unrelated diversification can also enhance shareholder wealth if management can spot firms with good profit potential. There are also drawbacks to unrelated diversification. One of the major disadvantages is that it places a major strain on management of the parent company. It is harder to oversee each subsidiary and spot potential problems and weaknesses. In addition, the consolidated performance of an unrelated portfolio tends to be no more profitable than the sum of individual businesses performing on their own (Nickel, McHugh, & McHugh, 2004).