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DIVERSIFICATION

Advantages of Diversification

Companies have increasingly adopted diversification strategy due to the following reasons:

i. Better use of its resources. By adding up related products to its existing product
portfolio, a company can more effectively utilize its managerial personnel, marketing
network, research and development facilities, etc.
ii. Reduce the decline in sales. By developing new products the sales revenue and earnings
can be maintained or even increased. For example, Bajaj Scooters India Ltd. entered in
the field of mopeds.
iii. More competitive with greater resources, more products and higher profits, the
diversified firm is more competitive than a single product firm.
iv. Minimize risk. When one line of business faces recession, another line may be in high
growth stage. For example, a well-diversified engineering firm146like Larsen and
Toubro did well even when the engineering industry was facing recession.
v. Use of cash surplus of one business to finance another business having good potential for
growth.
vi. Economies of scale Diversification adds to size of business which improves the
competitiveness of a firm. It offers a lot of economy in operations because common
facilities can be used for several products.

Limitations of Diversification

1. Huge funds are required for diversification. The internal savings of the business may not
be sufficient to finance growth.
2. The functions and responsibilities of top executives increase because of need to handle
new product, technology and markets. They may find problems in coordination which
may lead to inefficient operations.
3. Diversification may involve new technology and new markets and the present staff may
face problems in adjusting to this growth pattern.
4. Diversification may lead to unknown products and markets leading to more risk.

Types of Diversification

1. Horizontal Integration,
2. Vertical Integration,
3. Concentric, and
4. Conglomerate






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Horizontal Integration

It involves addition of parallel new products to the existing product line.
This may happen internally or externally, internally, a company may decide to enter a parallel
product market in addition to the existing product line. Externally, a company combines with a
competing firm. For example, Sparta Ceramics India Ltd. took over Neyveli Ceramics and
Refractoriness Ltd. (Neycer). Both the companies are in sanitary ware and tiles business. Two or
more competing firms are brought together under single ownership and control. Seven small
cement firms combined and formed Associated Cement Companies (ACC).

Horizontal integration has the following advantages

I. Wasteful competition among the combining firms is removed.
II. It provides economies of large-scale production and distribution.
III. It provides better control over the market and increases the competitiveness of the
company.
IV. The firm gets better control over supply and prices of the product.

Horizontal integration has the following limitations:

I. The firm is not confident of supply of raw materials.
II. If many firms combine to form horizontal integration, there is a risk of over-
capitalization.
III. The management of the firm may become bureaucratic and inflexible.
IV. The firm may acquire exploit consumers and labor by becoming a monopoly.

Vertical Integration

In vertical integration new products or services are added which are complementary to the
present product line or service. New products fulfill the firms own requirements by either
supplying inputs or by serving as a customer for its output. In vertical integration the firm moves
backward or forward from the present product or service.
Vertical integration may be of two typesbackward and forward.

Backward integration: It involves moving toward the input of the present product. It is aimed at
moving lower on the production process so that the firm is able to supply its own raw materials
or basic components. For example, a Car manufacturer may start producing tire tubes; Reliance
Industries Ltd. Has been able to grow largely through backward integration. It started business
with textiles and went for backward integration to produce PFY and PSF critical raw materials
for textiles, PTA and MEG raw materials for PFY and PSF, propylene raw materials for PTA
and MEG, and finally naphtha for producing propylene.





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Backward integration has the following advantages:

i. Regular supply it ensures regular supply of raw materials or components.
ii. High return on investment It facilitates higher return on investment for the company as a
whole through better use of overhead facilities
iii. Competitiveness It improves the competitive power of the company. As it controls more
elements of the production process, it has advantages over the uninterested firms in the
form of lower costs, lower prices and lower risks.
iv. Quality control it improves quality control over imports for the final product.
v. Bargaining power It improves the company's power of negotiation with suppliers on the
basis of known costs.
vi. Tax saving It saves indirect taxes payable on the purchase of inputs.

Disadvantages/Backward integration has the following limitations:

i. If an existing input producing unit is taken over, it may involve large investment
ii. By investing heavily in backward integration the developments of the final products nay
get hampered. This in turn may lead to undue pressure on pricing and sales effort.
iii. In the absence of backward integration the firm may purchase at a lower cost from
technically more efficient suppliers. With backward integration, this opportunity gets
lost.
iv. Any adverse Changes in the economy affecting the present product market will also
affect adversely the production of inputs.
v. When the divisions using the inputs do not have the freedom of comparing market
conditions of supply, the problem of transfer pricing may become acute.

Forward integration: Forward integration means the firm entering into the business of
distributing or selling its present products. It refers to moving upwards in the
production/distribution process towards the ultimate consumer. The firm sets up its own retail
outlets for the sale of its own products. For example, many companies like Bata, DCM, Bombay
Dyeing, Raymonds and Reliance have set up their own retail outlets to sell their fabrics.

Forward integration has the following advantages:

I. The firm can exercise greater control over sales and prices of its products. This is very
useful in an oligopolistic market.
II. The firm's own retail stores serve as better source of customer feedback. Thus the firm
gets better control over quality
III. The firm can improve its profits by reducing the costs of distribution and the costs of
middlemen.
IV. The firm can secure the economies of integration. Handling and transportation costs can
be reduced.




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Forward integration suffers from the following drawbacks:

i. The proportion of fixed costs in the firms costs increases. As a result the firm is exposed
to greater cyclical changes in earnings. Moreover, the fortunes of business are tied to the
in-house distribution system. From this point of view, forward Integration increases
business risk.
ii. Since its processes are interdependent, a slight interruption in one process may dislocate
the entire production system.
iii. In the absence of proper balance between up-stream and down-stream units, the firm has
to buy from or sell in the open market. The firm may be competing with its own
customers.
iv. It is very difficult to efficiently manage an integrated firm because every business has its
own structure, technology and problems.


Concentric Diversification

When a firm diversifies into some business which is related with its present business in terms of
marketing, technology, or both, it is called concentric diversification. When in concentric
diversification new product or service is provided with the help of existing or similar technology
it is called technology-related concentric diversification. For example, Mother dairy has added
'curd and Lassi to its range of milk products. In marketing-related concentric diversification, the
new product or service is sold through the existing distribution system. For instance, a bank may
start providing mutual fund services to its customers.

Concentric diversification is suitable for the following purposes:

i. When cyclical fluctuations in the present products or services are to be counteracted;
ii. When the cash flows generated by the existing product or service are in surplus;
iii. When demand for present product or service has reached saturation point;
iv. To gain managerial expertise in new field of business; and
v. When reputation of present product or service is high and can be used for new products
or service.

Conglomerate Diversification

When a firm diversifies into business which is not related to its existing business both in terms of
marketing and technology it is called conglomerate diversification. Several Indian companies
have adopted this strategy. Reliance, Sahara, DCM, Essar group, ITC, Godrej, HMT are
examples of conglomerate diversification.

Conglomerate diversification strategy is suitable for the following purposes:

i. To grow faster than the growth realized through expansion;
ii. To avail of potential opportunities for profitable investment;
iii. To achieve competitive edge and greater stability
iv. To make better use of cash surplus of present products or service;
v. To allocate the risks.