Synergies of Product Diversification Strategy
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Published: Wed, 07 Mar 2018
Nowadays large firms have to survive in the face of economic competition. They have to keep an eye on the competitors’ performance. Managers try to progress and run their businesses well in order to grow and be competitive.
When a large firm has reached a mature life-cycle stage it often has to explore the possibility of how to still grow. Ansoff (cited by Johnson, Scholes and Whittington, 1998) presents four basic growth alternatives: a) increased market penetration, b) market development, c) product development and d) diversification. Choosing the right path is major decision for managers.
Finding out if there are reasons which may lead a large firm to prefer diversification, more specific, product diversification as the growth alternative strategy instead of other strategies is a main question.
Firms who spread their activities and businesses across different product markets that are more or less related between each other are said to follow a product diversification strategy. (Pils, 2009, p.10) Product diversification strategy definition has evolved during the last decades. Some definitions are evolutional and complementary but some others contradict each other (Goold and Luchs, 1993). Therefore, it is important for managers to have a clear definition.
The benefits of product diversification have been divided into two categories depending on the type of diversification: related or unrelated. Related product diversification refers to entries into new products or service businesses that have a connection to the firms existing markets (Peng, 2008). Researches (Hoskisson, 2007) and business experiences (such as Mondi AG, Procter & Gamble, CHR plc., etc.) have proven that some of the benefits of this type of diversification are:
- Operational synergy: economies of scale
- Utilizing excess productive capacity
- Reinvesting earnings
Unrelated product diversification refers to the development of products or services beyond the current capabilities and value network (Johnson et al. 2008).
Some of the benefits and reasons for this type of diversification are:
- Financial synergy: economies of scope
- Increasing market power
- Spreading risk across a range of businesses
The challenge for any large firm, once product diversification is chosen as the growth path, is to decide which type of diversification is most appropriate and what strategic plan to follow.
Product diversification gives also other challenges to managers such as the need of new skills to manage a wider group of businesses, new techniques, sometimes new facilities, large capital to test the viability of the new product, produce it and market the product, hire and train new employees, etc. Therefore, diversification has some inconveniences as it involves taking a step into a territory where the parameters are unknown to the firm (Peng, 2008).
Product diversification can be achieved by acquiring an existing firm in the business it wants to enter, starting up a new business subsidiary or entering into joint ventures.
For large firms knowing the different growth strategies including its benefits and inconveniences is fundamental to giving managers practical recommendations. For a better understanding of these fundamental issues this research will analyze whether related or unrelated product diversification strategy leads large firms to exploit more synergies and creates more value for the firm.
Based on this research question, the following sub-questions are going to be addressed in this research:
- Should large firms, such as Mondi AG, aim to focus on related or unrelated businesses to exploit operational synergies?
- How is Mondi’s life cycle related to the ‘right time’ of diversifying?
- Which recommendations on product diversification strategy can be given to large firms regarding financial synergy?
To answer the above questions, I will present a detailed and methodical literature review on product diversification strategy concept, categories, synergies, its relation with large firms’ life cycle and explore the effects of a financial crisis on large firms who have chosen this type of diversification to identify the appropriate strategy for the research goal. This research is based on the hypothesis that related product diversification is the right strategy to be chosen if operational synergies are to be achieved while for financial synergies, unrelated product diversification strategies are more appropriate. The strength of this hypothesis is tested through a case study of a large firm: The Mondi Group.
The Mondi Group has been chosen as the large firm to be explored in this research because it is an international firm with one of its largest teams and headquarters in Austria. ‘Trend’, an Austrian financial magazine, ranked Mondi as the 13th top Austrian large firm out of 500 firms in 2008 having 5.159,00 Mio. Euro net sales and 26.425 employees’ worldwide.
In the 20th century many researchers have written about product diversification strategy (PDS). This research will analyse how PDS is seen by managers because of the larger experience there is nowadays. Diversification has been specially growing after the whole post-war period. Whereas in 1950 only around one third of large firms in France, Germany, and the United Kingdom were diversified, by the 1990s it increased to two thirds or more (Whittington and Mayer 2003).
Size and Product diversification strategy
This research is focused on how large firms have reacted to the different paths of growth. The firm size: small, medium or large is an important parameter while analysing a firm strategy. In the financial and economical studies and researches the relation between size and firm variables remains a controversial subject. Some argue that “size is the primary factor that determines structure” whether others say that “size is irrelevant” (Jackson and Morgan, 1978). In my opinion, it is true that product diversification can be applied both by small and large firms, but I believe that a small firm has more limitations and can not fully develop this strategy in its organization due to limited resources: human, financial and technological. I also believe that as a consequence a firm applying product diversification strategy will increase its size. With larger number of products, the complexity of processes and production is greater. Therefore the craft needed is greater. As mentioned before, some researchers agree with this point of view like the study realized by Dewar and Hage (n.d., cited by Jackson and Morgan, 1978) which suggests that large firms facilitate changes in structure in a way that small firms can not afford. On the other hand, Woodward, Zwerman and Harvey (n.d., cited by Jackson and Morgan, 1978) concluded that instead of size, the production systems used by the firms are more connected and explain better the firm structure and feature. In other words, an efficient production system can explain the success of one large or small firm and therefore the relationship between size and differentiation is not linear.
Diversification and Product Diversification Strategy Terminology
The root of the word is, obviously, “diverse”. Pitts and Hopkins (1982) define it as literally meaning “different, unlike, distinct, and separate” (p.620).
Therefore, if this definition is applied to the context of product diversification, we can say that it means firms having their products in various and different lines. Pils (2009) also confirms this definition as he points out that “product diversified firms are understood to be active in multiple, distinct product-markets” (p.10).
The various definitions, forms and ways of managing diversification are the main topics of this research.
Product diversification strategy
There is a common denominator in the way product diversification is defined in the literature. For instance, Pils (2009) defines it as firms spreading their activities and products across different product-markets that are more or less related between each other. He also affirms that product diversification strategy determines which businesses a corporation should be in, defining the scope of the firm’s activities and being of high relevance for creating value for the firm. Berry (1971, p.380) defines product diversification as an increase in the number of industries in which firms are active. However, he does not point out that it can be also increasing the number of products in the current industry. Pitts and Hopkins (1982, p.620) consider firms’ product diversification if operating multiple different businesses at the same time. Hoskisson (2007), on the other hand, says that the firm’s level of diversification is a function of decisions about the number and type of businesses in which it will compete as well as how it will manage the business.
These definitions have surely been influenced by the work of Ansoff (1957) in which he presented diversification as a possible growth strategy as mentioned in the introduction. Ansoff presented two ways of diversification: market diversification and product diversification. Although this research only focuses on the product diversification side, few lines are dedicated to explain the difference and characteristics of these two strategies. Market diversification is a strategy that takes the firm from its existing market to new ones. It exploits the current products and capabilities in new markets looking for geographical spread. This strategy is more and more used in the current times where globalization is facilitating the firm’s internationalisation. It also presents some challenges like cultural barriers, adding management costs and government restrictions among others. Product diversification is about adding new product to the firm’s portfolio whereas market diversification is about entering in new markets offering the firm’s current products.
Reasons and Challenges
Reasons and Motivations for Diversification:
Any firm has a start. Normally starting as a small business it focuses on a single product. This is known as a single business strategy. The natural reasons are commonly due to a lack of cash, experience and know-how. Over time, the resources, capabilities and core competences are rooted and stabilized. At that point, firms may choose product diversified strategy, with two broad categories (related or unrelated).
Large firms use product diversification strategy for a variety of reasons. Pearce and Robinson, (2005) and Hoskisson ( 2007) mention among others, the following reasons:
- To increase the growth rate of the firm
- For a better use of the companies’ funds than investing them into internal growth
- To balance the product line
- Diversifying the product line when the firm has reached its mature life cycle
- To increase efficiency and profitability, especially, if there is operational or financial synergy
- To increase the firm’s value by improving its overall performance
- To increase revenues or reduce costs
- To match and neutralize competitor’s market power
- To reduce managerial risk
- To increase the firm’s size and thus managerial compensation
Product diversification challenges
The above mentioned reasons and motivations for PDS can also bring along challenges and costs. One could say that PDS needs new facilities, technologies, skills, know-how, employee and managerial training, etc. It is important to know that it can have a great negative impact on the firms’ current products if a new product is launched with the firm’s brand name and the product is not well accepted in the market. The reasons for the market rejection can be e.g. lower quality than expected from the firm, high price, poor distribution, etc. At that point, the whole company will be negatively affected by a bad move. This argument is also supported by various authors such as Hoskisson, (2007); Grant, Jammine, and Thomas (1998); Goold and Luchs (1993), (cited by Pils, 2009). They state that some of the challenges are information processing, coordination, and control problems due to increase of information asymmetries difficult for a single business to deal with. In case of applying a PDS a firm has to change its structure and adopt new systems. Moreover Hoskisson (2007) elaborates that the data and information a firm using PDS requires is substantially greater.
Furthermore increasing portfolio diversity may involve inefficiencies due to growing conflict on top management and a lack of adaptability to environmental change.
Product Diversification Strategy Categories: Related & Unrelated Product Diversification Strategy
As mentioned before, there are two broad categories of PDS: Related and Unrelated. Some authors such as Richard Rumel (cited by Lovallo and Mendoca, 2007), Peng (2008) also categorize PDS as: focused, moderately and highly diversified. These three categories are not deeply explored in this research. But to dedicate some words, it should be mentioned that Richard Rumelt, in 1972, was the first person to statistically prove the linkage between corporate strategy and profitability. He concluded that moderately diversified firms outperform more diversified ones. Lovallo and Mendoca (2007) sustain that this finding has been valid more than 30 years of research. Moreover, a contemporary author, Peng (2008), also points out that some moderate level of diversification is the most optimal.
The main focus of this research is whether a related or unrelated strategy is more suitable for large firms while diversifying. Therefore, in the following lines a definition and a detailed explanation of both is presented.
Related product diversification can be defined as a strategy that firms can choose as a growing path. As the word “related” signals, this diversification strategy is focused on products that have a correlation between each other and are related in some way, especially in their core competences. Normally, firms that choose related product diversification as a strategy are sharing a common factor such as the raw material, the technology or the know-how needed to produce different products. Moreover, the products offered by the firm do not necessarily need to be similar. For instance, a firm running a cinema complex and also offering soft-drinks to be sold at the movie theatres is using a related PDS. Even if their products may not be related, they must share some common ground on their value or supply chain. In this case, the customers targeted are the same. Pearce and Robinson,(2005) confirm this by defining related businesses as those relying on same or similar capabilities in order to have success and achieve competitive advantage in their product markets. Major advantages of related PDS are: concentration of strength, exploitation of a market niche, and the development of synergies.
A good example, of a firm applying this strategy is CRH, an Irish company who operates in 35 countries with more than 93.500 employees. The CRH Corporate Social Responsibility Report (2007) states that the firm “is a diversified building materials group which manufactures and distributes building material products from the fundamentals of heavy materials and elements to construct the frame, through value added products that complete the building envelope, to distribution channels which service construction fit-out and renewal.” CRH has three closely related core businesses: “primary materials (aggregates, cement, asphalt and ready mixed concrete); value-added building products (pre-cast, architectural, construction accessories, clay, gas, insulation, building envelope products); and specialist building materials” (CRH, 2009). CRH initially decided to diversify to gain economies of scope and also to stretch the corporate parenting capabilities. While CRH diversified its market its power increased and consequently it could afford to “cross-subsidise” one business from the surpluses earned by another, in a way that competitors could not. As an effect, it could drive out competitors.
Before going into further details regarding related PDS, a definition of Unrelated Product Diversification is given. In this case, as the word “unrelated” points out this diversification strategy focuses on firms offering products that have no relation, are not complementary between each other and do not have necessarily the same raw material as their prime and main composition. Moreover, they do not need to share any part of their supply chain (customers, distributor, manufacturer, logistics, etc). For instance, the Easy Group Company is present in several industries and services that have actually no relation. Some of them are: travel companies, car rentals, internet-cafes, cinemas, cosmetics, etc. Stelio Haji-Ionannou, the founder of the company has developed a cost strategy that pretends to apply in all its businesses. It seems that he believes that his formula is valid for any business. Normally the reason why firms choose this path is known to reduce their financial risks.
Peng (2008) refers to unrelated PDS as firms entering into industries new lines that have no evident connections to the present firm line of businesses. Furthermore, Hoskisson (2007) says that unrelated PDS occurs when there are no overlapping capabilities other than financial resources. This strategy is also known in the financial literature as conglomerates (Hoskisson, 2007; Peng, 2008; Pearce and Robinson, 2005)
It has been widely discussed whether related is more successful or unrelated. To be able to answer this fundamental question the following pros and cons are explored:
Related product diversification is characterized by the ease of human resources relocation because the skills and capabilities needed for the introduction of the new products are very similar. On the other hand, unrelated PDS requires recruiting new personnel or training current employees in the new fields. (Tallman, 2003)
Obviously, if a firm chooses unrelated PDS, it will probably not be able to share technologies. Therefore, the investment needed to apply this kind of diversification is greater than by applying a related one. Related PDS is characterised by sharing technologies needed to produce the new products. For example, a firm which produces shampoo and introduces hair conditioner may use the same technology. In that way it reduces the investment costs for the new production and gain economies of scope (also see 2.5). Tallman (2003) confirms that related products can increase the use of existing fixed investments and existing capacity for more purposes and more intensively, gaining efficiencies that reduce costs. Additionally, he says that it can “improve the efficiency of its existing resource infrastructure by increasing the flow of product to a wider range of customers”.
For managers it is easier to introduce related products than unrelated ones because they are familiar to the industry and can apply the same or similar strategies. For unrelated ones, managers have to learn about the new products and often the strategy used for the current products is not applicable for the new ones. Therefore, managers should experience new strategies which at the beginning may fail. Prahalad and Hamel (1990), said that it is likely that firm managers of unrelated products may be ineffective because the routines and capabilities they have already developed are not applicable one to one to the entire range of businesses. On the other hand it could be argued that it can be effective as top management can concentrate on financial management and costs controls while leaving operational control with each business unit.
It is easier for competitors to imitate the financial economies of a firm than the operational synergies derived from a related PDS. This is due to the fact that operational synergies derived from the use of current know-how, facilities, capabilities and experiences are more difficult to imitate than realizing that a firm is diversifying into new unrelated products based on the percentage of the revenue it can gain. Therefore, it is less likely that competitors will imitate a firm which introduces new related products. Peng and Delios, (2006), and Khanna and Palepu, (2005), (cited by Hoskisson, 2007) sustain that competitors find it easier to imitate financial economies than replicating the value gained by related PDS from the economies of scope developed through operational relatedness.
The principle control mechanism for related diversification is strategic control with rich communication between corporate and business units’ managers. Financial results are obviously not a fair means to measure the functioning of each business unit. One business unit may have low revenues but its main function is to support the others. For unrelated products, the best way to control is exactly the opposite. The emphasis has to be on financial control (return and investment) to evaluate the unit’s performance. (Peng, 2008)
When the product a firm is offering is close to a market saturation or obsolescence, the best thing a firm can do is to enter into another market offering unrelated products. In that way the company has an opportunity to grow. It would be a great mistake in a saturated market to introduce related products because the competition is already very high and to get a profitable market share is unlikely.
Another reason would be to stabilize the earnings and dividends of a firm in a cyclical industry. In that case, the firm should diversify into an industry with complementary cycles independent of the relation with the current products.
Firms that are uncomfortable to be dependent on one product line should diversify into other businesses or industries. In that way the risk is spread and all the weight is not in one product line.
All in all the benefits of both categories of diversification do not appear as the result of a magic formula that just happens but as Tallman (2003) and Peng (2008) also sustain it is the result of an active management of resources and capabilities with potential for broader application.
Product diversification synergies need to be explored in more detail. Therefore the following section is dedicated.
Product Diversification Synergies
Pils (2009) explains that the word synergy is derived from the Greek word “synergos” and literally means “working together”.
In business terminology, synergy is used to describe the ability of two or more business units or firms to make greater value working together than they would do independently (Goold and Campbell, 1998, p.133). Diversifying a large firm is considered economically positive only if synergetic effects between the different businesses units are achieved. As a consequence, the idea of maximizing synergies as the main objective of diversification strategy is presented below.
The emphasis of product related diversification is on operational synergies because in this strategy production resources are shared to have a cost competitive advantage. In the financial literature, the term operational synergy has been used as a synonym for economies of scope (Tanriverdi and Vendkatraman, 2005). Economies of scope and/or operational synergies are the result of two or more business units that share and transfer factors of production, its resources and capabilities. As a consequence the shared production costs will be lower than production costs of each one separately.
Peng (2008) defines it as competitiveness increase beyond what can be achieved by engaging in two product markets separately. In other words, firms benefit from lowering unit costs by gaining advantage from product relatedness, i.e. “2+2=5”.
Some sources of operational synergy are (Peng, 2008):
- Technologies, such as common platforms
- Marketing, such as common brands, and
- Manufacturing, such as common logistics
Conscious of these possible synergies, Zodiac a French large firm who in 1930 was focused on inflatable boats and had strong ties to the French army started to introduce new related products to its portfolio. Zodiac created 5 different divisions having inflatable materials as a common denominator. These divisions have been: marine division (recreation, military, professional, safety of life at sea, environmental solutions); pool division (pool sector and pool care and water cleaning, heating, pumps, filters); airline equipment division (passenger seats and on-board toilets and sanitation systems); aerosafety systems division (aircraft escape slides, parachute systems, helicopter floats, and flexible fuel tanks); technology division and aircraft system division. (Zodiac Aerospace, 2009) Zodiac has benefited from the operational synergies through the use of inflatable products technology and has also used market synergies because it has supplied the same customers with different products.
Conversely, unrelated diversification does not need to have advanced levels of operational relatedness. Rather, each business unit has its own strategic and operational responsibility and the management can focus on the financial synergies. (Tallman, 2003)
Investment synergies are very much related to the operational synergies. It can be argued that one is the consequence of the other or that they are developed hand in hand. Investment synergies are the result of products sharing the same plant, resource and development (R&D) and machinery. This is more probable to happen with a related product diversification because of the previous explanations. For unrelated products, the machinery is improbable the same and each product need its own R&D.
The means obtaining financial synergy is different from obtaining operational synergies. The key role of firms is to identify and find profitable investment opportunities. The parameter to measure if financial synergies are to be achieved is whether managers can exceed the job of identifying and taking advantage of profitable opportunities compared to “external capital markets” (Peng, 2008).
Hoskisson (2007) defines financial synergies as cost savings realized through a better use of financial assets based on investments inside or outside the firm. Competent internal capital distribution can lead to financial synergies and reduces risk between the firm’s businesses (Higgings and Schall, 1975).
A firm using unrelated PDS may grow, but only internally in each business unit and will not reach operational efficiencies but financial ones. That means, the revenue of each business unit will be greater when functioning as a conglomerate rather than functioning independently. This idea is supported by Peng (2008) who states that competitiveness increases for each unit financially further than what can be achieved by each unit competing independently as an individual firm.
Many different products that are not necessarily related offer opportunities of high returns. If a firm is only interested in the returns, unrelated product diversification may be a right path of growth.
These occur from sharing salespeople, warehouses, distribution channels, and advertising. Salespeople have more chances to be able to sell to the same customer a wide range of related products than unrelated ones. Salespeople will try to sell a complete pack of product to the same customer and in that way take advantage of the sales synergies that related product diversification presents. Imagine a company selling sport shoes and refrigerators, in a selling process it is more unlikely to be able to sell both products to the same customer than if he would offer sport shoes and sport clothes. On the other hand, if a firm has developed a well-known brand, the use of the brand-name in other products, related or unrelated, can increase and facilitate sales because it can have build before customer loyalty to the brand. For example, Mars chocolate confectionery successful launched ice-creams. Much of it success could be related to the brand name. So, sales synergies do not occur only within related products but also within unrelated ones if the brand name is positively perceived and recognized by the customers.
It arises from managers accumulating experiences from handling problems in one business unit that can be applied and used to solve problems in a related business unit. Even more, the accumulated experience and know-how allows answering faster to the industry trends and challenges. Managers are able to transfer their skills, experiences and strategies (Enz, 2009, p.222). Contrarily, unrelated product managers can not apply the experience gained from solving the problems of one unit to the other in most cases because the problems are specific for each product.
All these synergies can be undermine due to additional layers of management, delays due to organization and information complexity, communication costs for coordination, imaginary synergies that in fact do not exist, incompatible production processes, etc.
Therefore while choosing between related and unrelated PDS the mentioned synergy risks have to be taken into account.
In this section an explanation of how the data for the case study was collected and how it was analyzed is presented. It is important to know how the data was collected because the method chosen affects the final findings. The information and content of The Mondi Group Case Study was obtained through an expert interview with Mr. Wolfgang Kropiunik, Mondi’s Marketing Manager of Uncoated Fine Paper. A questionnaire was sent as a guide and overview of the face-to-face interview questions. A meeting for a 40 minutes exploratory semi-structured interview was organized on the 24th of November 2009 at Mondi Headquarter, Vienna.
Mondi Group was chosen as the large firm to be analyzed as it is a large firm with more than 33.000 employees worldwide and has its headquarter in Vienna (Mondi, 2009). Therefore the results presented in this research are very much related to Mondi’s functioning and successful method. It might be possible that if the studied firm had been another one, the results of the research question could have been different.
The interview was recorded and the data obtained was transcribed (see appendix). The transcription of the interview allowed a deeper comprehension of Mondi’s product diversification strategy, synergies and challenges. Moreover, the recommendations presented to the company (see 4.7) are inspired from the challenges Mr. Kropiunik mentioned during the interview. The interview gave a number of information about Mondi’s life cycle, PDS and challenges especially during the current financial crisis
The Mondi Group – Case Study
Mondi is a large and international packaging and paper firm represented in around 35 countries. In 2008, it had revenues of 6.3 billion EUR and about 33.400 employees (Mondi, 2009). It has a strong presence in Western Europe, Russia and South Africa. Mondi’s Europe and International Division has its headquarter in Vienna while the corporate headquarter is located in Johannesburg. In Vienna, there are three businesses: Uncoated Fine Paper, Corrugated and Bags & Specialties. Mondi has reached to be fully integrated having the control of its supply chain. “It grows trees, manufactures pulp and paper and converts packaging paper into corrugated packaging an
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