Understand the Advantages and Disadvantages of Unrelated and Related Diversification
As a small business owner looking for business growth, a diversification strategy of acquisition can be very attractive. But you need to understand the differences between related diversification and unrelated diversification before you invest. To diversify in your business, your markets, or your products can be costly; therefore, invest in efficient diversification.
Typically businesses diversify through acquisition. Why diversify? The reasons need to be focused on quick growth and/or less expensive growth. However, conduct a strategic analysis to investigate whether or not the growth decision will result in a return on investment that is high enough to cover the risks associated with acquisitions.
What are the most efficient diversification strategies for your business? To diversify efficiently through acquisition means ensuring that you have built, or will build, strategies to increase your competitive advantage, to improve economies of scale and to improve your cost structure, to satisfy customers’ needs quickly, or to achieve your business plan.
Business owners need to assess the advantages and disadvantages of related or unrelated diversification.
Advantages and Disadvantages of Related Diversification:
A related strategy is when you add or expand existing products, services or markets. For example, an automotive dealership that buys a detailing business (cleans, washes, polishes cars – both inside and outside) has engaged in related diversification.
The advantage of this kind of related strategy is that it provides easier expansion: you already know the industry you operate in and you can leverage that knowledge.
The disadvantage of this strategy is that if there is a seasonal or cyclical downturn in the industry, you will feel the decline in both the dealership and the detailing business. The impact could be severe. There can also be issues with integrating two businesses, and with over-estimating the financial returns. Would it have been more cost effective to simply contract-out the detailing in the example above?
Advantages and Disadvantages of Unrelated Diversification:
An unrelated strategy is when you add new, or unrelated, products, services, or markets. For example, the same automotive dealership may decide to purchase the restaurant next door. There is no direct fit between the two businesses (although maybe employees and customers eat at the restaurant next door). The reason to buy the business is that the owner of the dealership wanted to get into a business that was dissimilar, had different seasonality, good potential for high returns (although the restaurant business has some high risk/high failure statistics).
The advantage of buying an unrelated company is that you reduce the risk of putting “all your eggs in one basket”; if the business, or the industry, is hit hard by the economy, or competition, or other success factors, then owning an unrelated business may help to offset the slump. In this example, you can also control some of the customer base for the restaurant (e.g. give your automotive customers waiting for a service a coupon for the restaurant).
Why invest in unrelated diversification? Because you may be able to invest in a new product or new market that has “peaks” when your business has “valleys”. Many businesses have seasonality highs and lows; if you can acquire a business that has a high when your business has a low, you can offset the low periods. Or the unrelated diversification investment may bring with it cost efficiencies (such as subletting some of your office or plant space to the new business; or sharing/consolidating some of the administration costs of running a business – human resources, accounts payable and receivable, shipping and warehousing, sales, and more). Increased profit potential drives an investment in unrelated acquisition.