Diversification and Vertical Integration

A single product strategy is always a risky one. Because the firm has staked its survival on a single product (or a small basket of products like Colgate) the organization has to work very hard to ensure the success of that product. If the product is not accepted by the market  or is replaced by a new one the firm will suffer. Given the risk of a single product strategy, most large organizations today operate in several different businesses, industries or markets.

Diversification describes the number of different businesses that an organization is engaged in and the extent to which these businesses are related to one another. Diversification involves entry into fields where both products and markets are significantly different than those of a firm’s initial base. Related diversification occurs when a firm expands into industries similar to its initial business in terms of at least one major function. Unrelated diversification involves expansion into fields that do not share any financial or skill based interrelationship with a firm’s initial business.

Why Diversification?
–When their objectives can no longer be met by merely expanding within their existing product market.
–Because the retained cash exceeds the investment demand for more expansion.
–If there are greater profit opportunities than in its present product market.
–Firms may explore diversification possibilities if the information available does not permit a conclusive comparison between expansion and diversification.
–Firms diversify to avoid dependence on one product line, to achieve greater stability of profits, to make greater use of an existing distribution system and to acquire know how.
–Firms diversity because it helps them avoid the danger of over specialization, helps in balancing the vulnerabilities due to one’s own wrong size. Further, the firm’s technology research and development may also help in finding our products which appear to have promise.

The company can put its resources and related capabilities to good effect. The existing businesses might have saturated a bit and the only way to grow could be through diversification, exploiting opportunities in the environment. Diversification, of course is not a sure bet. Diversification may lead to neglect of old business. The managers may fail to understand the intricacies of new business as well because they have entered the field without full knowledge and adequate preparation. To make matters worse, competitors may retaliate with full force, adversely impacting even the existing businesses. To be successful, diversification requires careful planning and meticulous preparation. The company must have deep pockets and strong staying power. The company must have relevant core competency in the field that it is trying to look at. The chosen field must be attractive and the company should have capable managers to handle the associated risks in a competent way. The cost of entry should also be reasonable.

Vertical integration allows the firm to enlarge its scope of operations within the same overall industry. It takes place when one firm acquires another that is involved either in an earlier stage of the production process (backward or upstream) or a later stage of the production process (forward or downstream).
Backward vertical integration occurs when the companies acquired supply the firm with products, components or raw materials. Reliance Industries for example, started its business with textiles and went for backward integration to manufacture PFY and PSF critical raw materials for textiles, PTA and MEG raw materials for PSF and PFY, para- xylene – raw materials for PTA and MEG, and ultimately naptha for producing para-xylene. The company has also gone in favour of forward integration by opening retail shops for marketing its textile products.  The main reason for backward integration is to gain a firm grip over supply and quality of raw materials. Backward integration is quite common in industries where low cost and certainty of supply are important to maintaining the firm’s competitive advantage in its end markets.

Forward integration on the other hand helps a firm gain control over sales and prices of its existing products. However, increased risks are inherently present in both types of integration. It is not easy to share  the additional burden and diverse responsibilities are thrust upon the managers  in the changed scenario. The longer chain increases the costs of coordination and bureaucracy. At times, a technological innovation in the vertical channel may compel all of the vertically linked businesses to modify their operations. In a dynamic setting where changes in technology and demand are highly unpredictable outsourcing may be a better option.

Apart from forward or backward integration firms can vertically integrate in varying degrees. Full integration occurs when the firm seeks to control all stages  of the value chain related to the final end product or service. At the same time, a firm can also have a limited  form of vertical integration known as partial integration. Partial integration here refers to a selective choice of those value  adding stages that are brought in-house. Two such partial vertical integration strategies are taper  integration and quasi integration. Taper strategies demand firms to manufacture a  portion of their requirements and purchase the rest from outside suppliers. For example most of Automobile’s spark plugs, instruments and ignition equipment are supplied externally.