Diversification and Synergy of the Companies - Coursework Example

Diversification Diversification and Synergy Introduction A business firm can hardly rest on its laurels and hope to survive in the long run. Inorder to remain in business and be in a profitable way, it has to literally keep looking over its shoulders all the time, and find new sources of energy – ideas that will keep it ahead of competition. Such ideas could be in the form of expansion into related (synergistic) or unrelated products or services, thus increasing the portfolio of activities. Each type of diversification calls for a different type of management strategy to reap the benefits fully. For related diversification, benefits accrue due to economies of scale of operations, sharing / reduction in operating costs, and due to more efficient allocation of resources. In case of unrelated diversification, the economic benefits are said to accrue due to superior internal governance mechanisms. While the down side for related diversification is limited, unrelated diversification may have its share of risks due to unfamiliarity both with the internal and external situations. This essay considers the various aspects of business expansion (with or without synergy), evidence for and against synergistic expansion, and concludes that searching for synergies in business units is an appropriate perspective, in view of the potential for improved performance. Strategies for growth Igor Ansoff’s ‘growth-vector or the product-market matrix’ is a well-known analytical tool for planning business expansion. (Unknown, Ch. 9, Diversification and synergy, Virginia.edu). The four cells of Ansoff’s product/market matrix identify the business expansion route as: growth through market penetration (cell 1), growth through new customers / markets Diversification 2 (cell 2), growth through product development (cell 3), and through new products to new markets i.e., through unrelated diversification (cell 4). Product Market According to Ansoff, most companies progress through all the four stages of strategies in sequence and hence this kind of analysis is important to formulate strategy for diversification and to know the current status of development of a firm. It is in this process of analysis that a firm comes across the options like related (synergistic) and unrelated growth. Many a time, synergistic growth into new products is justified on the basis that the existing infrastructure and skills can be utilized even in the new product offerings, and hence it would not be difficult to expand into those lines. Competitive advantage Michael Porter’s approach to the subject is more fundamental and analytical. He dwells up on the concept of analysis of ‘value chain’ i.e., the chain of activities in any business along with their relative costs and role in product differentiation, the two most important components of competitive advantage of a firm. In the ultimate analysis, value chain is what a firm offers to a buyer and is therefore strategic to competitive positioning. He argues very convincingly that a firm must undertake a deep analysis of activities (value chain) in search of synergy either within Diversification 3 the existing lines of business or in any potential acquisition. This analysis is for the purpose of satisfying a customer need. Its focus is the customer and therefore ‘external’ rather than complementarities and conveniences within a firm which are ‘internal’. Internal factors are certainly important if only to serve the ultimate goal of sustaining competitive advantage over a long period of time. Looking for synergies for diversification or re-organizing of existing operations is thus important and helpful in formulating strategies. Strategy, in Porter’s words, is ‘the particular combination of activities a firm adopts compared to its rivals’ (Porter 2004, p.xviii). Related diversification has been accepted as more appropriate and a majority of corporations follow it as a matter of strategy (Porter 2004, p.323). Related and unrelated expansion To consider some examples, a mild steel re-rolling mill firm procures its raw materials in the form of blooms or hot rolled coils and re-rolls them to finished products such as rods or plates & sheets. To expand its business activities, it has the choice of continuing to be an intermediary and diversify into rolling of other products such as stainless steel, electrical steel, aluminum or copper. The idea here is to remain essentially a re-roller, use the existing facilities and skills, but to expand business by horizontal expansion. On the other hand, if the same steel re-rolling firm decides to manufacture its steel ingots or coils by creating its own iron and steel melting facilities, it is said to be expanding its business vertically through backward integration. If the firm further expands its business to manufacture of the end products (using rods or plates or sheets) it is expanding its business vertically through forward integration. These are examples of ‘related diversification’ type expansion. A vast majority of expansions are of this type as per Diversification 4 common knowledge. The high profile Virgin Group of companies is a prime example of diversification into unrelated activities – music industry, films, railways, airlines, and a variety of consumer products. “…It is so great being in so many different businesses. That is the fun of it” said Richard Branson, Chairman of the Virgin Group, in his interview with the Forbes magazine (Forbes, 1997). Other companies with significantly diverse product and service offerings include Hitachi, Yamaha, Reliance and Mitsubishi – to name just a few of the giants, and these are successful companies too. Firms are thus continually looking to ways to expand their business operations, vertically horizontally and indeed into any and all directions. Apart from the related / unrelated type expansion, the other choices for diversification are either growing organically (i.e., through in-house expansion) or acquiring outside firms. While choosing the route, an analysis of the firm’s current competitive position as well as the potential position after the choice is implemented, is made. The objective for diversification has to be to retain, improve and sustain the competitive advantage of the firm. Over a period of time, expansion creates a portfolio of business lines, with good synergies among them. Thus, a petrochemical conglomerate may have in its portfolio, business units engaged in exploration and production of crude and natural gas, refining, gas liquefaction, power, fertilizer and chemical units, polyester filament yarns and textile units. Each business unit can be sized to suit to the upstream and downstream capacities and characteristics. Such expansion of activities is the norm and not an exception, in the corporate world. The rationale behind this phenomenon is discussed below, commencing with a brief explanation of the terms portfolio and synergy. Diversification 5 Different business units of a firm, offering products or services to the market are its portfolio. Not long ago, it was considered prudent to engage in diverse lines of activities in order to spread the risks of business failure and the overhead costs of the top management. The concept was borrowed from share market operations, where it is the norm not to put all the ‘eggs in a single basket’ and hold a portfolio of investments. While the practice of business expansion into related and unrelated areas continues unabated, the management thinking behind such expansion has metamorphosed from one of simple risk reduction to exploiting synergies and / or addressing strategic concerns of management. Related diversification Synergy is described as the transference of skill set of one business unit to another. Its purpose is to locate and exploit transferable skills for the purpose of growth of an organization by sharing costs of activities, which are common. In contrast to the above view, Michael Porter in his book The Competitive Advantage, offers a holistic explanation. According to him, “…interrelationships are not fuzzy notions of ‘fit’ which underlay most discussions of synergy, but tangible opportunities to reduce costs or enhance differentiation in virtually any activity in the value chain”(Porter, 2004, p.318). Thus synergy is all about achieving interrelationships among business units for competitive advantage and that such activities must be significant to the overall operations to make an impact. He goes on to add that, “…cost reduction by sharing occurs, if the cost of a value activity is determined by the economies of scale of operations, learning or pattern of utilization” (p.328). According to Porter, synergistic diversification enables reduction in overall operating costs or to realize higher prices for similar products from different divisions of a firm, by achieving product differentiation (Porter, 1987). On the face of it, firms Diversification 6 with related lines of business can enjoy significant cost reductions at the corporate level, since a number of duplicate operations of the individual units such as engineering, procurement, marketing and logistics can be centralized. This would enable cost and skill sharing; bargaining power for negotiations on inputs; and realization of economies of scale of operations. Once diversification is in place, management takes action to exploit the synergies. In this process, the first search is for familiarity of operations! This is followed by other synergies such as upstream and downstream linkages with attendant economies of expanded business at incremental costs, bringing in increased profits, etc. Based on these reasons, organizational changes are put in place combining businesses and / or activities on location or product or market segment or some such strategic basis. Porter points out that such changes ought to be strategic management actions for sustaining competitive advantage (Porter, 2004). The most recent high profile examples of synergistic diversification through acquisitions are those of Mittal Group, UK, acquisition of Arcelor, Luxembourg / Spain (steel industry); Tata Steel, India, acquisition of Corus, Anglo-Dutch (steel industry) in the face of stiff competition from CSN, Brazil, and Vodafone, UK, acquisition of Hutchison’s, Hong Kong, share in the latter’s Indian joint venture (telecom industry). In the first two cases, the obvious reason for acquisition has been to dominate the world steel market exploiting the capacities and synergies. Arcelor-Mittal steel is now in number one position in the world market while Tata-Corus is at number five. In the third case, it was the desire of Vodafone to grab a share of the phenomenal growth of the telecom sector in India, other developed / developing markets having been mostly saturated. Stock Analyst Scott Burns reports that the Arcelor-Mittal was on track to achieve its synergy targets, “…having realized annual savings of $269 million in Q4, 2006… This is Diversification 7 expected to jump to $500 million by the end of Q1, 2007” (Burns, 2007). B Muthuraman, Managing Director of Tata Steel termed the acquisition as part of the companys strategic planning, and that the company was looking at a synergy value of $300 to $350 million a year and that the company would benefit from synergies realizable in about three years’ time (Rediffnews, 2007). Evidently, synergistic expansion has strong economic rationale. One of the main arguments against synergistic diversification is the difficulty to achieve the stated objectives – failure to integrate certain activities. If the line and staff managers in individual business units are not fully committed to the idea of centralization of certain activities, the efficiencies and cost reductions are not realized. There may also be a tendency to shirk responsibility or even leakage of information since there will now be outside layers of staff handling the part of the work, and these layers are not working directly or are accountable to the unit head (Markides, 1995). The spirit of competition between the individual units, which is the hallmark of high efficiency performance, may also be diluted, thus negating the benefits of synergies. Unrelated diversification While the above discussion and examples cautiously support the search for synergy in business units by corporations, there is a fair amount of support for unrelated diversification as well. There is no synergy in unrelated diversification. “Unrelated diversification if unsuccessful may actually damage the original core business”, says a study by the Sloan School of Management. It goes on to add, “Management of new business is difficult because it requires different assets and resources.” It is essentially the mindset of the entrepreneur to accept new challenges, which goads him into new lines of business. To take an example, McKinsey Diversification 8 Consultants advised the Piramal Group, a relatively dormant player in the textile industry in India, to enter into pharmaceutical business by acquiring Nicholas Inc. This totally unrelated diversification has been a resounding success for the Piramal Group. “For a company to grow it needs a healthy mix of all four routes: organic, diversification, alliances and acquisitions at all stages” Says Gita Piramal, Managing Director of The Smart Editor (Piramal 2005). As already noted above, the Virgin Group follows an aggressively unrelated diversification. Unrelated business units in a group compete hard with each other on performance and profitability to prove their superior management skills, as a prelude to promotions to corporate hierarchy. This competitive spirit justifies unrelated diversification. Diversification Vs. focus Brand dilution, losses of one unit being covered by the profits of another, and reduced transparency of operations are some of the criticisms against large-scale diversification or multi-product business operations. It means that at least some of the individual business units are not running efficiently, thus diluting the rationale for diversification. By mid 1980s, a strong argument has surfaced in favor of efficient ‘focused’ business operations as against diluted attention on a number of units, related or not. Markides points out that by 1990s, a high percentage of the firms are again resorting to corporate restructuring by moving out of many of the diversifications undertaken in the earlier years and concentrating on running focused operations (Markedis, 1993, Robert et al., 1992). Conclusion Diversification is a fact of life for every business looking to survival and sustainable growth. Growth and expansion bring about a portfolio of business units under a firm’s Diversification 9 umbrella. Majority of diversification is into related business activities for strategic reasons. Analysis of the activities of the individual business units of a firm or those of a firm targeted for acquisition will reveal the strategic fit. Such analysis will help to unlock the hidden values, which can be used to sustain competitive advantage and thus support acquisition decisions. Unrelated diversifications, though foster competitive spirit among the individual units, have the greater risk of diverting the attention of top management to the detriment of existing business operations. Majority of successful business expansions have been of related type. However by 1990s, the phenomenon of corporate restructuring has gained increasing acceptability, whereby a large number of firms had started shedding many of the diversified lines of businesses with a view to get back to ‘focused’ operations. References Burns S (2007), ‘Stock analyst notes’, Available: http://quicktake.morningstar.com/Stock/san.asp?id=187117 [28 Feb 2007]. Charles W. L. Hill CWL, Hitt MA, Hoskisson RE (1992), ‘Cooperative versus Competitive Structures in Related and Unrelated Diversified Firms’ Organization Science, Vol. 3, No. 4. (Nov., 1992), pp. 501-521. Dalal S (2006), ‘Cheques and balances: Mittal vs. Arcelor – The hypocrisy within’, Indian Express, March 6, 2006. Available: rhttp://www.indianexpress.com/res/web/pIe/columnists/full_column.php?content_id=89048 [26 Feb 2007]. Dan M, Lamont BT, and Geiger SW (2004), ‘Diversification strategy and top management team fit’, Journal of Managerial Issues, p.361. Forbes magazine, February 1, 1997. Markides CC (1995), Diversification, Restructuring and Economic Performance, Strategic Management Journal, Vol. 16, No. 2. (Feb., 1995), pp. 101-118. Piramal G (2005), ‘7 Great strategies to succeed’, The Smart Manager. Available: http://www.rediff.com/money/2005/jun/23bspec.htm [15 Feb 2007]. Porter ME (2004), Competitive advantage, Free Press, New York. Rediff.news (2007), ‘Corus buy is moment of fulfillment: Tata’. Available: http://www.rediff.com/money/2007/jan/31corus3.htm [5 March, 2007] Robert O. Hoskisson RO, Johnson RA (1992), ‘Corporate Restructuring and Strategic Change: The Effect on Diversification Strategy and R&D Intensity’, Strategic Management Journal, Vol. 13, No. 8. (Nov., 1992), pp. 625-634. Sloan School of Management (2002), ‘Entrepreneurial marketing: Focus vs. diversification’. Available: http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-835Entrepreneurial-MarketingSpring2002/121D12AB-EF68-4D9D-88EE-69DD660E6C9D/0/session10.pdf [5 March 2007]. Thomas JG, Mason WH (2007), ‘Diversification strategy’. Available: http://www.referenceforbusiness.com/management/De-Ele/Diversification-Strategy.html [23 Feb 2007]. Unknown, ‘Ch. 9 - Diversification and synergy’, Available: http://faculty.darden.virginia.edu/bourgeoisj/files/Chapter%209.html [3 march 2007] Read More