What is the attractiveness test in diversification decisions?

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Understanding the attractiveness test in diversification decisions

The attractiveness test is a key test in diversification decisions – helping to determine if the diversification makes sense for the company or not. The test considers whether the industry is attractive or not – is this a setting where the firm is likely to achieve above-normal returns.

We can use Porter’s Five Forces to help determine if the industry structure is desirable for a company, which explains the profitability of the industry as depending on the power of the buyers, suppliers, threat of substitutes, industry rivalry, and the threat of entrants. If the industry is not attractive, it may not be a desirable industry for the company to move into.

The ability of existing firms to diversify into attractive industries

High entry barriers are a key component of an attractive industry. Without high entry barriers lots of firms rush in to seemingly profitable industries, reducing the industry profitability due to the increased competition. A diversifying firm may already have some of the resources to overcome entry barriers – thus making it possible for diversifying firms to enter an attractive industry that entrants would typically be prevented from entering.

Remember it is important to consider the attractiveness of the industry after you have entered

When considering the attractiveness of the industry, it is important to consider the attractiveness after you have entered. It is possible for industries to be profitable before you enter, only for the entrance of your firm to change the industry dynamics. Your entry may increase competition, resulting in a previously attractive industry no longer being as profitable as it once was.