A lot of companies are diversified, from huge multinational corporations to small family businesses, and many of them to a huge p. There a lot of reasons why companies diversify, and some of them are the following. Diversifications help companies to convert present internal costs into future revenue producers. Moreover, as said by Aaker (1984), a basic diversification motivation is to improve ROI (Return on Investment) by moving into business areas with high ROI prospects. By this, the firm can enter a high growth area.
For example, in 1979, Heinz purchased Weight Watchers International, the largest Weight-control chain and a companion firm that produces Weight Watchers Frozen Food entrees. Here, Heinz planned to exploit the Weight Watchers name by starting restaurants and health resorts and by marketing the food line aggressively, thereby achieving a profit growth substantially exceeding that of its exceeding business areas. (Sample case taken from David A. Aaker, 1984). According to Jauch & Glueck (1988), another reason why companies want to diversify is the fact that nowadays, technology and research leads to the development of new products.
This can promise new revenue sources for the firm. Moreover, the reduction of risk may also be another motivation for unrelated diversification. The reliance on a single product line can stimulate a diversification move. For example, Hershey was almost a totally dependant on candy and confectionary business, a business that was vulnerable to the increased interest in health and health foods. Thus, it purchased Friendly ice cream, a chain of family restaurant based in Massachusetts and also the Skinner Macaroni company. The expectation is that Hershey's nonconfection revenues will be about 30% of sales.
In order to reduce risk, firms can enter business areas that are very stable so that the risks are dampened. Another positive point that brings companies to diversify is that it sometimes can provide economies of scale. For example, two small firms may not be able to afford effective advertising programs which are expensive. But the combination of those two firms may give them a chance to do so and operate at an efficient level. Additionally, these two firms may afford to buy expensive automated heavy equipment which they need. Another reason of diversification is that companies will be able to exchange of skills and resources.
This is very useful for many small companies. Skills or resources that can be imported and exported are usually associated with any functional are such as production, R;D, marketing skills, etc. Popular brand names can also be a reason for diversification. For example, Pillsbury bought Green Giant in part because Green Giant name and image would help Pillsbury introduce new food products. Other than the reasons, we should also consider carefully about the types of risks in diversification. There are two types of risks, they are systematic risk and unsystematic risk.
Systematic risk is "the risk which remains even after extensive diversification" (Bodie, Kane ; Marcus, 2002). This is a risk that influences a large number of assets. An example is an economic crisis that struck the country. It is virtually impossible to protect investors against this type of risk. This systematic risk is also known as nondiversifyable risk. Whereas, unsystematic risk is sometimes referred to as a "specific risk". "It's risk that affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. " (Investopedia. com, 2003).
This unsystematic risk can be eliminated by diversification. It is also known as diversifiable risk There are some risks that can be faced by a company during diversification. Some form of diversification can divert attention from main product. This actually damages the original business by diverting attention and resources from it. For example, Quaker Oats embarked on an aggressive acquisition program in the early 1970s, going into toys and theme restaurants. In the process, however, the company allowed its core business areas to deteriorate. Only one major new product was introduces in the U. S. market during 1970-1978, 100% Natural Cereal.
The marketing program by measures such as share and shelf facings suffered (Sample case taken from Aaker, 1984). This type of diversification cost is often overlooked. Another risk is management difficulties. According to Aaker (1984), a firm's potential difficulties in managing diversification is magnified when an unrelated business is involved. Numerous firms have found they could not manage a diversification. The management team of the acquired firm might leave and are difficult to replace. The new business may be difficult to learn because the management skills and practices may be different from its previous or main business.