Product diversification: why and how to develop it

Product diversification is a very common business strategy.

It is used by both B2B and B2C companies, and it is the former that we will focus on in this article.

Diversifying production involves expanding the range of products developed by a company in order to reach new customer segments within markets other than those in which it already operates.

Those who work in the business-to-business world have to deal with situations that might push them towards a diversification strategy. Here are some of them:

• A market crowded with competitors with an established position.
• A drop in sales, resulting in a decrease in profitability.
• An obsolete product that needs to be upgraded or discontinued.

There are also opportunities that this strategy enables:

• The possibility of enhancing internal skills and resources;
• Access to foreign markets not yet covered;
• The chance of entering into new sectors using the know-how and skills already acquired throughout the company’s history.

In any case, in order for the operation to be successful, some crucial aspects must be kept in mind.

Diversification is, in fact, a process with medium to long timelines, compounded by the need for high investment.

Not only that: the organization must be ready to adapt to change and to develop new logics and procedures to make the most of the fruit of product diversification.

Before addressing the ways in which the process can be implemented, let us look at the types and characteristics of each.

Product diversification: types and features

Diversification is one of the four basic parts of Ansoff’s matrix.

It is a theoretical framework for describing the growth strategies adopted by firms taking into account two variables: product and market.

As can be seen, product diversification also involves a change in the organization’s market of action.

This change usually occurs on two levels:

• Within the same industry in which the company operates, but in a different segment of it. An example is when a company specializing in the design of woodworking machinery develops a new line of sheet metal cutting machines. The process can also be called related diversification in this case.
• In completely different sectors than the one in which the company operates. Imagine, for example, a company producing pneumatic components for the automotive industry that decides to start producing PVC pipes for agriculture. In this case, we speak of unrelated diversification.

Let us now look at advantages and risks for each of the two approaches.

Related diversification: advantages and risks

Choosing related diversification is usually the safest route for a company.

Aiming at a market similar to the one your company already operates in reduces the risks, while still achieving a positive return on investment.

How? Thanks to:

• A reduction in operational uncertainty in the light of the similarity of new products with those already on the market.
• A lowering of average production and service delivery costs;
• The possibility of exploiting the brand awareness already acquired within their inudstry.
• A more efficient R&D activity thanks to the knowledge and skills possessed.

As academic research in the field also shows, related diversification is usually characterized by more stable and predictable financial indicators such as ROI (Return on Investment) and ROE (Return on Equity).

This means that a company diversified into sectors similar to its own will usually benefit from more stable performance over time, and less complex financial planning than those who have chosen the path of unrelated diversification.

In the first case, in fact, the transfer of technologies and processes touches an industry with characteristics close to that in which the company already operates.

The example of the machinery company used above helps to understand the concept: although machine tools for wood are different from those for sheet metal, they still belong to the machinery macrosystem.

It is therefore likely that the skills used to design the former can also be exploited for the latter, more quickly and at a lower cost than those entering this market for the first time.

Unrelated diversification: avdantages and risks

B2B companies venturing into unexplored markets for the first time that face the greatest risks.

Unrelated diversification in fact requires developing from scratch new strategies with which to position oneself within the chosen target market.

The lack of specific knowledge of the latter may in fact result in greater difficulty in foreseeing and managing changes, as well as in longer timeframes for developing products that can differentiate themselves from those of the competition.

For this reason, an operation of this type is usually preceded by preliminary analysis, most often by external consultants to assess the feasibility of the operation.

Once the necessary conditions have been verified, it is not uncommon for this type of diversification to bear fruit. In particular:

• Higher profitability despite market fluctuations.
• Distribution of business risk over a broad base of assets in different markets.
• Easier to attract new investors due to potentially higher profitability.

However, it is the greater operational uncertainty that makes it more difficult to make predictions on the performance of these transactions.

Moreover, in these cases it can be more complicated to exploit brand awarenesses already acquired, since the company will not be recognized in the same way by the new audience.

Let us now see what solutions are available to companies to implement product diversification, both related and unrelated.

Diversification: the ways to develop it

The ways for B2B companies to diversify are internal development, joint ventures and M&As.

Let’s look closer to them.

• Internal development is the route usually taken in cases of related diversification. This involves internalizing processes with which to develop new products. In this case, management decides to focus on the company’s own resources, sometimes integrating them with external forms of financing. It is often the case that the company has to hire staff to face the process or acquire new infrastructure such as a larger factory or a dedicated research centre. This entails high costs, but usually lower than those of unrelated diversification.
• Joint ventures allow two or more companies to develop joint projects. One example is when two electrical manufacturers specializing in cables enter into a joint venture to develop a line of junction cabinets. The union between the two companies allows them to share the risks of the operation and its costs, as well as the know-how needed to expand the product range.
• M&A (mergers & acquisitions) activities are the most complex, but most commonly used in cases of unrelated diversification. Acquiring another organization or starting a merger is indeed the optimal choice when it comes to entering unknown competitive scenarios. This makes it possible to exploit the reputation and structures of already established brands, as well as to reduce the timeframe for internal development. Operations of this kind certainly have high costs, but they reduce the planning difficulties and timeframes of processes such as internal development.

Conclusions

We have seen how product diversification is a strategy with different purposes.

It can be useful to cope with a drop in sales, or to respond to the challenges of a market populated by fierce competitors.

It involves, as Ansoff’s matrix shows, both a change in the company’s product range and an evolution of its target markets.

This transformation may be related or unrelated to the company’s core business. In the case of related diversification, expansion occurs in a market related to the company’s current market.

Conversely, in the case of unrelated diversification, the development of new products allows entry into sectors distant from the current ones.

Both types of operation entail high costs and varying lengths of time.

Related diversification is usually the less risky and more controllable option, since the similarities between old and new productions allow processes to be set up more readily.

In contrast, unrelated diversification is usually more difficult to manage, but characterized by higher financial results, as confirmed by economic research in this area. Especially in this case, it is common to rely on consultancy and market studies to assess the feasibility of the operation.

The solutions adopted in both cases are usually internal development, joint ventures and M&As.

Internal development has medium to long timeframes as the company will have to implement internally what is planned in the diversification strategy, integrating new professional skills – if necessary – and acquiring state-of-the-art infrastructure.

Joint ventures allow companies to share the risks and costs associated with diversification operations, while at the same time bringing together the necessary expertise. Joint ventures also usually have long times, mainly due to the definition of the details underlying the agreement between the companies.

Finally, M&As represent the most complex but also the most effective choice, especially in cases of unrelated diversification: in particular, acquisitions of companies that are already established make it possible to enter unexplored markets without developing activities from scratch.