Understanding unrelated diversification
Unrelated diversification is when firms expand from one industry or area into another unconnected industry or area. There is no connections between the underlying resources and capabilities, customers served, or other reasons to think that these areas would be better performed by one company as opposed to two separate ones.
For example, if a show company was to get into software production, this would be an example of unrelated diversification. It may be possible to generate some argument for why this makes sense (and most managers would be able cobble-together a justification for the diversification), but it is hard to see significant shared resources or customer overlap.
Understanding related diversification
While unrelated diversification involves going into markets that are not connected to the firm’s prior activities, related diversification specifically tries to move to areas that the firm already has some strengths. Some different dimensions on which diversification can relate to the firm’s existing operations include:
- Related by resources: The firm can utilize the same resources across the new area
- Related by products: Similar types of products to which the company already produces
- Related by customers: The diversification expands to cover the same customer base.
Identifying related vs unrelated diversification
The key thing to be considering is whether the area that the company is expanding into will be better in one firm as opposed to two. This better-off test helps justify whether there is a basis to believe that the expansion is related or not: unrelated diversification has little to no reason to believe that the activities would be better performed together, while in related diversification there is a clear justification as to why this is better performed in one company.
There are typically two reasons to believe that the diversified area would be better performed in the company as opposed to as a separate firm:
- Revenue enhancing synergies: Where sales volumes or the sales price can be increased because the activities as performed together (possibly due to sharing the brand or other integration between products).
- Cost-saving synergies: Where costs can be reduced relate to two separate firms, often due to sharing resources.
Why related diversification typically viewed better than unrelated diversification
It used to be common for large conglomerates to operated in unrelated areas. These conglomerates were often seen as poorly managed – there were additional costs associated with managing the different areas (including management being spread too thin), and because the different business units were unrelated to one another, limited opportunities for either revenue-enhancing or cost-saving synergies.
The prevalence of conglomerates has substantially declined. They often traded at a discount on the stock market (the conglomerate discount) many former conglomerates were purchased by corporate raiders who split the unrelated areas up.
Be wary of justifications used for relatedness
If you are considering diversification, it is easy to develop a long list of reasons why it makes sense. Managers can convince themselves that what they are considering is actually related to the core business of the firm. It is important however to critically examine the supposed relatedness, assessing whether it is likely to result in cost-saving or revenue-enhancing opportunities. The risk is that some of the expected synergies of diversification may be purely imaginary and don’t materialize in reality.