Economics of industry

According to Daniel O. Klier, diversification is defined as a process when the firm enters into a new product category than the industry that it is currently working in. Thus, diversification leads to the firm entering into new markets by offering new product range. Currently, many companies have been initiating to enter into diversification since it helps to reduce their dependency on a single product range and its limited market. Over a period of time, many companies have been diversifying to reduce their risks. For instance, Wipro which is an IT firm few years back diversified into fast moving consumer goods industry, Giorgio Armani which is a fashion luxury goods brand diversified into hotel industry, Hindustan unilever limited diversified into water purifiers etc.
A firm can diversify into three categories:
Concentric diversification: in this type of diversification the companies would like to generate those product categories which require the same technology inputs. Thus, the company will be using the same research and development and technological knowhow and enter into a new product category. For instance, for instance, Maggie has introduced soups and ketchups where the technological efforts in the food processing market remain the same but the product is new.
Conglomerate diversification: in this type of diversification, the company is entering into a new industry with a new product range which is not similar to its products in any form. for example: Wipro which is a IT firm few years back diversified into fast moving consumer goods industry.
Horizontal diversification: in this type of diversification, the company would enter into a industry which may not be similar to its existing product range in technological sense but the customers would be the same for the company. For example Reynolds was initially selling pens and later in entered into selling notebooks. Thus, the two products are not similar in technological sense but are for the same customers.
Reasons for diversification by companies:
Companies have been diversifying for various reasons such as:
In order to reach Economies of scale and of scope: economies of scale means when the firm produces more number of similar goods to reduce the average cost of the goods. An economy of scope means when goods are produced together, then the overall cost of production is reduced. Thus for either of the above reasons many firms would like to diversify and it leads to economic gains for the firm in the long run. An example of a firm which have diversified to meet economies of scale or scope is airtel which diversified into broadband services, DTH services along with its existing business of providing network service provider. Thus, the technology required for airtel is similar with similar investment but the returns from diversification are increased manifolds.
Increasing growth opportunities: many companies which have attained a considerable high market share and are looking for more growth opportunities would generally like to enter into new product categories since the scope of growth with the existing product range remains less. Thus, with the expertise of the market and knowledge about the existing trends in the market and skilled employees, the companies tries to pursue growth by diversifying into a new product category. For example: when dabur foods limited attained 55% of the market share with real juices, it realized that it was already a market leader in the packaged juices segment, in order to grow revenues further from here dabur foods limited had to introduce new product categories. Thus it launched brands such as burrst, lemoneez and hommade offering different products such as homemade pastes, lemon juice etc.
Reducing risk and managing portfolio: diversifications helps to reduce dependence of a company on a single product or limited product categories and helps to balance the revenues earned by the company from different product category. Thus, even if one product phases out from the market, the company would still get returns from other products. A Firm which have been diversifying to reduce their risk in future would be ITC which was initially into cigarettes business and has diversified into hotels business, paper and packaging business, consumer goods business such as packaged foods, FMCG industry with bingo etc. Thus, today, ITC earns balanced revenue from different businesses.
Synergy: many firms diversify into to achieve synergies i.e. to develop a strategic fit by diversification through acquisition or mergers. Thus, when a firm feels that it is at a better position and can be benefitted in the long run if it combines its operations with another firm, the firm would like to diversify. Reliance telecommunications diversified into DTH services and broadband services along with providing CDMA services because it realised that it will be strategically in a better position if it does so.
Better utilization of core assets: another reason for companies to diversify is of the core assets of the firm could help in producing new products and enter new markets which are lucrative, the firm at some point of time will like to make best use of its core assets and diversify into new product categories also. For example: if a firm believes that its core assets have the ability to produce new type of products which have a demand in the market and the firm has a basic expertise about dealing with the new product, it would like to diversify with the new product to increase the returns.
Enhancing shareholders return: Some firms also diversify to increase returns and boost its revenues any provide maximum returns to its shareholders.
Limitations of diversification:
Even though diversification has various advantages, certain limitations of diversification are as follows:
Lack of focus on a single business: when the firm diversifies into different fields, the management may lose its focus on a single product or a single business since it would be catering to different issues of the different business on daily basis and would not be getting enough time to concentrate on a single business.
Losing opportunities arising in single business: the company may lose out on new demands and changing preferences of the consumers in the market which may lead to negative returns of the company in the future. It may also lead to fall of the product in the market.
Negative synergy: in order to make a strategic fit, the firm may increase its debt or costs which could result in negative synergy in the long run.
Lack of follow up and timely action: the management may not be able to timely follow up with all the individual business which may result in delaying in addressing the issues on every business and take timely action.
There may be bureaucratic problems within the management of the firm.
Example of a diversified firm:
One of the classic examples of a diversified firm is bharti group. bharti group is one of the leading company in India which has seen the maximum growth and diversification of different types over a period of last 30 years. The bharti group was formed in 1983 by sunil mittal for manufacturing and distribution of tyre business.
By 1986 it ventured into, the bharti group formed the Bharti Telecom Limited (BTL) a formed on conglomerate diversification where bharti was offering fixed line telephones to customers.
In 1992, bharti group ventured as a network service provider in India and won the bid in the government and this move could be termed as concentric diversification strategy.
Ever since 1992, Bharti renamed its cellular business and fixed line to airtel and has been acquiring small network service provider all over India and subsequently bought stake in companies of Kuwait and South Africa.
It also diversified into life insurance business and merged with AXA in 2006 to have better synergies in the industry.
In 2005, bharti opened a subsidiary called fresh fields limited and entered into a joint venture with Delmont into offer processed and packaged food in the FMCG industry of India.
In 2006, Bharti entered into a joint venture with Wal-Mart to enter into the retail industry which is a conglomerate diversification.
Further, bharti airtel has entered into concentric diversification of its telecom business into related fields such as DTH services, broadband services etc which is concentric diversification.
Thus, it can be seen that ever since the last 30 years, bharti airtel has been diversifying into different industries and this diversification has helped bharti enterprises to reduce in dependency on one or two services and it has become one of the biggest conglomerate in India.
Conclusion:
In the end it can be concluded that diversification is an essential part of the firm if it wants to continuously grow since the current markets may become saturated. Thus, at some stage, the firm will have to resort to diversification in order to grow ahead and balance its reveuens and reduce its dependency on a single product and a single market. Even though there are various limitations of diversification, the management can work towards these limitations by planning, executing, decentralization of authority etc and continue to diversify and expand.

References:
Daniel O. Klier; (2009); Managing Diversified Portfolios: What Multi-Business Firms Can Learn from Private Equity, Springer
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