Diversification Effects On The Competitive Advantage Business Essay

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For companies operating in very efficient markets, investors can cheap diversify their assets building a portfolio balanced between risk and return. Corporate enterprise that sees a great investment opportunity, but has no funds can raise capital in the public markets. Successful enterprises with limited access to capital markets can, however, legitimately create value by diversifying to regularize performances and create internal capital markets. Business groups which dominate many emerging economies were intended in this way. Likewise sole proprietorships or family whose owners wish to maintain control and to avoid use of public funds often diversify to minimize risk.

The diversified enterprises can be managed in many different ways, which (as well as shown in the figure below) can be summarized in three models of management:

Figure Models of corporate management of different types of diversification strategy

Companies with a dominant business consist of a few business units, surrounded by a number of other small business units devices. This sort of diversified company is opposed to alternatives to common property, requiring a set of highly specialized resources that usually cannot be combined in the event of single-business companies and which often require a strong coordination between units. Since corporate level infrastructure requires the development of specialized resources and their close coordination that may have high costs, companies with dominant business have a very large staff;

Companies with diversified business related have number of business more than those with dominant business but nevertheless keep one or more points in common between them. They transfer one-off specialized resources and skills to new lines of business or share resources and activities that are developed each time in the different business. Collaboration between many business leads to inevitable conflicts and trade-offs that are difficult to control through multilateral agreements. This requires a great need to carry out financial audits with corporate managers directly involved in achieving coordination among different businesses. This kind of undertaking aims as broad as possible at sharing and coordination among his many business;

Companies with diversified business conglomerate or unrelated businesses are firms that often maintain a number of heterogeneous businesses increased in a disorderly way. They usually try to develop their corporate strategies around generic and not specialized resources. Because of the difficulty of creating value using this management model these firms are inclined to have very small corporate offices and a complex budgetary stance which often leads to create strong relationships network with venture capitalists and other private equity groups.

The first systematic empirical analysis on implications of different types of diversification can have on performance have been realized during the '70s, these as analysis suggested at least in the U.S. strategy of related diversification (presence in more business very similar) had achieved the performance better than the conglomerate diversification strategies (business presence in more diverse). Technical forms of portfolio diversification dominated for the 80s: the most famous strategies was the one carried out by Jack Welch he focused on the axis market share in the BCG matrix being interested precisely to maximize the revenue growth of various business.


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Growth market and innovative financial instruments such as bonds encouraged by internal deregulation and external competition increasing in several sectors, stimulated a surge of mergers and corporate restructuring that forced many men of strategy to evolve how of understanding strategy.

Planning portfolio pushes managers to focus primarily on minimizing financial risks and to overlook long-term investments with returns that require long-term commitments.

Prahalad & Hamel opposed resistance to the basic principles of the techniques of portfolio planning at the individual business and introduced the concept of core competence. They claim that in a structured organization at the SBU level:

None business feels responsible individually to maintain a profitable position or feels responsible on core competence involving several business;

Skills developed within the SBU are not shared between SBU;

Opportunities for business growth are not taken into account in comprehensive.

In alternativa essi raccomandano l'importanza di un'archittettura strategica a livello corporate nella definizione delle competenze e assicurano che le organizzazioni che potervano avere successo nel futuro erano quelle che non si interessavano tanto alle SBU ma alla core competence, che di fatto erano utili nel determinare le basi concrete per la crescita futura.

La definizione di core competence di un'impresa deve basarsi su una complessa analisi esterna che conduca ad individuare le attività che l'impresa svolge megli dei suoi concorrenti, attività per le quali il termine competenze distintive è più appropriato. Il concetto di core competence implica che la diversificazione in business correlati è capace di apportare dei ritorni maggiori rispetto alla diversificazione non correlata.

Literature Review

Diversification can generally be definite as "production of goods or services belonging to a different sectors or segments, that is…. dispersal of production operations of firms in different business. There is diversification when a company embarks itself in the production of goods so much different from the previous ones to bring changes in schedules and distribution" [1] .

The traditional economic theory teaches us that diversification is good and positive both in terms of efficiency and risk management. Thanks to the scope economies a joint production of a wide range of financial services should increase bank efficiency through the use of innovative facilities.

The modern portfolio theory [2] invites us to diversify investments, this means investing in assets with low returns' correlations. H. Markowitz proves that in this way, it is possible get more returns with the same portfolio risk compared to use all investments with a high yield expected for a given level of risk.

At the basis of Markowitz's studies is the fact that in order to obtain an efficient portfolio is necessary to identify a combination of securities to minimize the risk and maximize the overall efficiency offsetting trends of single models asynchronous of the individual securities. To do that, portfolio securities may not be perfectly correlated, even better if they are completely unrelated. This allows decrease of risk portfolio since this is lower than the weighted average risk that characterize the single activity of which is composed; the diversification benefits are highest under the perfectly negative correlation hypothesis (-1) and null if opposite (while the yield is equal to the weighted average of returns on assets in the strategic portfolio).

The diversification is besides considered one of the many strategies that a company has to hold his competitive advantage and to protect itself from risk of losses.

In a study of 1962 by Gort diversification is described in terms of heterogeneity of outputs: two products belong to two distinct markets when the cross-elasticity of demand is low and when in short term the resources, used in manufacturing and distribution of a product cannot be transferred to another. The diversification's idea is based on two factors: i) behaviour analysis; ii) transferability of resources in manufacturing different goods.

Another important contribution was given by I. Ansoff [3] , he consider diversification as the birth of a new product through four stages: market penetration, market development, product development and diversification.

Figure Ansoff' Matrix

The Ansoff' matrix shows how diversification is aimed to new markets and new products, and it is also diversified that firm who operate in several fields.

Ansoff identifies four steps for the diversification:

Horizontal, new products to existing customers

Relative or concentric, new strategic activities

Conglomerate, extension of the activities in new areas

Vertical, emission of new products

Subsequently, according to the definition of M.E. Porter [4] , diversification is read as a model of intermediation between the company and the environment it occupies. Porter identifies in diversification the research by an undertaking of the maintenance of competitive advantage in a specific field. He supports the thesis that the diversify company compete as well as in their business.

Diversification can be seen not only as business strategy but also as corporate strategy that is companies that work in several sectors dealing with sundry goods and making use of various technologies. It's a strategy that incorporates every goods and every activities subject of study. This strategy is split into many businesses because so many are the products' strategies and the company's activities.

The corporate strategy defines the meaning of use resources in functional areas of marketing, production, finance, research and development, human resource with the aim to achieve organizational goals.

A business strategy shapes not only the aim of the undertaking activities, but also the usage of its assets, its competitive advantages and the overall coordination of the functional areas. Moreover the corporate strategy is interested in define the range of the firm through market decisions and fields where to compete. This kind of decisions incorporates investments diversification, vertical integrations, acquisitions and new alliances, as well as transfers and resources allocation between different areas [5] .

Consistently with the theory the firms diversified responding to needs of overcapacity production of factors that may be subject to market failure. Probing heterogeneity of these factors C.A. Montgomery & B. Wernerfelt [6] develop the corollary that companies that decide to diversify shuold expect lower average profits. Two are the points that support this theory:

A broader diversification suggests the presence of factors that normally produce less specific competitive advantage;

A given factor loses more value when it is transferred to those markets less similar respect the ones they are originated.

Mostly a company will decide to diversify, moving away from its current scope, and mostly will be the loss of efficiency, while the competitive advantage for that specific factor will be less.

Teece [7] testing the diversification in Petroleum sector forward the proposal that a cost function, which represents the economies of scope, has no direct implications on the context of the company's business. However, if the economies of scope are based on common and recurrent use of know-how, on skilled and indivisible physical activity, then the multiproduct undertaking has an efficient organization. After all, companies are not available in predetermined shapes and so do markets. He claims that multiproduct enterprise is a right choice when transaction costs, necessary to coordinate the independent firms, are high.

Furthermore browsing the business diversification Teece discovers that the theoretical framework developed by Williamson [8] to explain vertical integration can be easily extended to multi product diversification. This because the main differences between vertical integration and diversification refer to the types of transactions subjects to internalization.

Considering that vertical integration implies internalization of supply of the materials production' factors into unique manufacturing process (e.g. components and raw materials), the interests integration implies internalization of know-how and other factors' supply common to two or more processes of production.

It appears that diversification may represent a mechanism of integration economies associated with provision of common simultaneous inputs to manufacturing processes aimed at different markets of the final product.

Still according to Teece, scope economies exist when for all the outputs y1 and y2 the cost of joint production is less than the cost of every single output production.

This condition is valid for all y1 and y2 outputs,


In Figure 2 according with Panzar and Willing' theories [9] , it's clear that the presence of scope economies (joint production of two goods from one single firm) is less expensive than combined cost of production of two specialized firm. But the analysis use in this case shows that the Panzar e Willing' finding are too strong. Scope economies don't provide a necessary and sufficient condition for the cost savings to be achieved through the merger of specialized companies.

c(y1, y2) <c(y1,0)+c(y2,0) for each output (y1, y2)C:\Documents and Settings\Gia\Desktop\Figure\illustration of scope economies.PNG

Figure Illustration of scope economies

Even if the technology is characterized by scope economies, the joint production of two firms should not be more expensive than the single production of the two goods by a single company.

Landi [10] during his studies in 2001 on the paths of European banks diversification uses two criteria to classify diversifications:

Principle of interdependence between product-market activities;

Extension degree of diversified activities respect to the main activity.

From the combination of these criteria is possible to identify two kind of diversification: related (which aims to benefit from economies of joint production leading to the choice of management) and conglomerate (which aims of reducing the risk through the entry in sectors characterized by cyclical trends unrelated to the core business [11] . Economically two activities are related when they use the same distribution channels, the same markets and when they use the same technologies, on the contrary when a firm walk in a sector with products that are independent from markets in terms of technology and distribution and if they are related to outlet market we are in presence of conglomerate diversification.

Rumelt in Strategy, Structure, and Economic Performance classified nine categories of strategy:

SV Single-Vertical

DV Dominant-Vertical

SB Single-Business

DC Dominant-Constrained

DL Dominant-Linked

DU Dominant-Unrelated

RC Related-Constrained

RL Related-Linked

UB Unrelated-Business

Diversification is seen more in terms of goods sold than those produced. Item sold can be linked to each other in the following ways:

Bundled: interrelated goods that need to be managed as one product to form a packet and be considered a single business unit;

Vertically: the products sold are the results from materials vertically integrated in the chain process. A vertical chain is composed of sequential processing stages in the transformation of raw materials into finished goods

Horizontally: products share resources, but could be handled with a high level of strategic autonomy

Unrelated: products do not share resources and are managed independently

If vertically related products account for 70 percent or more of revenues the firm is classified as Single Vertical or Dominant Vertical. If the largest business-unit within the vertically related set accounts for 95 percent or more of revenues, the firm is classified as Single Vertical, else it is Dominant Vertical.

If the firm is not Single Vertical or Dominant Vertical then classification proceeds by examining the specialization (Rs), related (Rr), and related-core (Rc) ratios.

The specialization ratio Rs is given by the impact of revenue attributable to the most important area of activity in the field of company revenues.

The related core ratio Rc, is the fraction of revenues accounted for by the largest set of businesses which draw on some common core skill, resource, or strength.

The Related ratio Rr derived from the incidence of revenues attributable to the other areas of activities which have affinity and ties with the core business, on total enterprise revenue.

Given that the firm is not vertically integrated, it is classified as follows:

Table Categories of diversification by Rumelt






Single business

Rs ≥ 0.95


Dominant vertical

Rv ≥ 0.70


Dominant contraint




Dominant linked-unrelated




Related contrained



Rc> (Rr+Rs)/2


Raleted linked



Rc< (Rr+Rs)/2


Unrelated business


According to Rumelt if Rs > 70% and Rr < 70% the diversification is correlated, while if Rs < 70% and Rr < 70% it is conglomerate. Actually this approach was much criticized because it has strict boundaries and his evaluation is considered subjective.

The structural categories are:

FU Functional organization. Top-level organizational units are functions such as marketing, engineering, etc.

FS Functional with subsidiaries. Functional organization that also has business units reporting to the CEO, normally organized as subsidiaries of the company.

GD Geographic divisions. Top-level organizational units are geographic divisions within the country.

GW Geographic worldwide. Top-level organizational units are worldwide geographic units, sometimes taking responsibility for products within geographic regions.

PD Product Division. Top-level organizational units are product divisions.

HC Holding Company. Company is organized as a holding-company in which the headquarters does not actively manage the operating businesses.

Montgomery for example gives an illuminating representation of the concept of correlated diversification processed by Zen, whom divided this kind of diversification into:

Related constrained provides circular arrangement of the production lines around the core business

Related linked provides that each activities is not necessarily linked to all the other, in this way the interactions tend to decrease bringing the company far away from the core business


Regarding the theories about explain diversification exist two approaches: the demand-side and the supply-side. The first look at the diversification as an answer to the variation in demand; the supply-side instead recognize the choice of diversify as something endogenous and therefore it is not affected by changes in market demand. Indeed is rather impossible to be able to recognize which of two approaches is mostly used, generally demand-side prefigures the minimum border of diversification that company should use to avoid losing market share, while supply-side represents the maximum level of diversification that the company might achieve.

Between the two approaches is preferred the second, this because the firm's resources represent the key factor of diversification strategy, and the resources capacity unused (that is the disproportion in current and future needs) form the incentive that persuades the company to use such surplus in other areas. If the existing lines will not provide the possibility of expansion the diversification might be a good strategy.

It is therefore fundamental recognize where the excess of capacity is from, it could came from a changing in markets that bring an underutilizing of resources, which could be used for new products. But the unused resourced might be come from an over efficiency from the company. Teece [12] supports that "…unused resources exist not only because of indivisibilities, but also because of the learning process of operating a business. Thus, even with a constant managerial workforce, managerial services are released for expansions without any reduction in the efficiency with existing operations are run. Not only is there a continuous learning, but also as each project becomes established so its running becomes more routine and less demanding on managerial resources.".

But the existence of excess of resources, even if represent a basic condition, is not enough to have diversification, it is in fact necessary that these resources will be used and/or redevelopment in a new product-market combo.

If the point of a diversification strategy should be identified, for the supply-side approach, in the existence of fungible resources in excess of demand, this surplus of resources may, in fact, be intended in alternative uses such as return to capital firm.

"…a profit seeking firm confronts three fundamental choices:

It can seek to sell the services of its unused assets to other firms in other markets.

It can diversify into other markets, either through acquisition or de novo entry.

If the unused resource is cash, it can be returned to stockholders through higher dividends or stock repurchase.

A theory of diversification…emerges when conditions are established under which the second options appears the more profitable." [13] 

A couple of years before Teece argued that when the joint production of multiple outputs is based on the same know-how diversification is the most efficient way compared with the market to organize the surplus, and it is also advisable when the resource is specific and indivisible.

Rumelt's studies lead to the conclusion that the appropriate level of diversification is that one that adjusts economies of scope with the organization diseconomies of scale. The purpose of diseconomies is more likely to occur through the loss of control that can be seen as the failure of the allocation and internal control system to perform better than the market. Basically, diversification should be realized and advance until the benefits of scale economies and scope economies are offset by diseconomies are undone from the organizational structure resulting from the bureaucratization of the structure by cultural or legislative problems or from the birth of conflicts of interest related to the expansion of product range [14] .

Resuming the concept of diversification offered by Montgomerry described above, we can show how the bank positions in the case of related diversification, in fact all the product lines and services are provided in all markets. The expansion of product range of the bank results from the development of each product line, families of new and different services compared to that one's more established. Figure 2 developed by Venturelli in 2009 testifies the expansion of the product range intermediary within each service line; there are shown strategic business areas that can most commonly be found within the structure of the intermediary highly diversified bank.

Table Strategic Business Areas in Diversified Banks [15] 

Each of these product lines has an own and different process technology, and it is the own technology to constitute the substantial element of diversification. This diversification is realized in a new family of products and services offered to customers who maintain significant correlation factors with the existing products.

The main services related to new business areas that make up the production of the intermediary highly diversified are:

Traditional banking activities;

Investment banking;

Bank - insurance


Brokerage and property management.

Servaes (1996) proved that the relationship between diversification and performance took on an inverse U-shaped curve as Fig.3 described.

Figure The Relationship of Diversified Level and Performance [16] 

So we can find out that over diversification will decrease companies' performance. In other words, diversification cannot bring high efficiency to the companies at any time. Usually, related diversification outperforms un-related diversification and single business strategy.

Some diversification measure

Total diversification

P=proportion of each firm's product line on the firm's total business sales (from i)

M = number of segments

Related Diversification

diversification of firm i, within product line j at time t

The market Model

Ï€i = equity return on firm i in t

rmt = market equity return

ε = residual where risk is diversifiable

the extent to which equity performance of the firm is explained by the market performance. The greater R2 the longer is the level of diversification of risk  firm's diversification approaches that in the market

The Berry's Index

α = share of turnover

i = segments / sectors


equipartition of turnover in all fields

the undertaking is active in a single sector



H=1 and B=0 no diversification