Diversification Strategy - Essay Example

Due to stiff competition in the business environment globally, firms in emerging economies have commenced to adopt diversification strategies. The diversification concept implies that firms need to engage in something new and hence face various kinds of transformation. Generally, it is divided into two categories; related diversification strategy whereby a firm engages in related activities or core business of the organization by building competency through complementary markets and technologies, and unrelated diversification strategy which does not depend on any pattern of relatedness and often seek to reduce risk. As such, this paper will critically examine the argument that firms in emerging economies should pursue a diversification strategy. Firms in emerging economies should consider diversification because this corporate strategy may have a positive impact in their organization as it generally contributes to wealth creation (Whittington, 2002). Moreover, in order to survive in today’s market and especially when SMEs experience high competition from the rival companies or a decline in their profit levels, a diversification strategy will be of great importance to the continuity of the SMEs. Emerging economy firms tend to expand culturally, geographically and economically. As such, diversification may enable these firms to gain various benefits. Diversification entails three dimensions: the product, the market, and the technology of the firm (Suzue et al. 1990). Another definition by Chandler (1998) is that diversification refers to simultaneous departure from the present product line and the present market structure. Also, Ansoff (1957) defined diversification as entailing product, market and change in the role of the management of the firm. During this process, a firm has to acquire new competencies, skills and techniques both for the new market and the also for the new product (Hake, 1999). He further emphasizes that the firm has to engage in changing the role of management of the firm. Further, Grandstand (1998) defined technology diversification as a move in which the firm improves the performances or the number of functionalities of existing products through the use of new technology. Therefore, diversification can also be defined as the process by which a firm enters into a new market, without essentially leaving its obtainable products, such that it produces a new product or products (Yahagi, 1982). These strategy needs change in the organization; it should also develop new technologies within the firm. In addition, Rumelt (2008) implied that there is global diversification which is defined as a strategy of locating production activities in foreign jurisdiction that are relatively diverse in terms of legal structures, national cultures, ways of doing business, planning and implementation of international manufacturing, which is a process that deals with issues that arise when SMEs firms in emerging economy locate production facilities in a particular site. SMEs in emerging economies should pursue the diversification strategy since the strategy is a key aspect to the survival of SMEs in today’s competitive business environment (Ireland, Hoskisson & Hitt, 2007). Firms should diversify so as to maintain their stability, since, if the emerging firms decide to relay on one industry its profitability will be unstable due to the fact that demand fluctuates. However, if the firms engage in diversification, their profits are likely to increase. Moreover, the firms should engage in diversification so as to maintain their competitive advantage over other firms, this is because, if the firm does not diversify for instance in terms of its products, it will lose its market niche to other competitors who are ready to satisfy the needs of their consumers (Texier, 2006). Another reason is that firms should diversify so as to copy the advantageous factors of developed firms in the market. This will enable a firm to gain over the imperfections that exist in the market such as enforcement of contracts, imperfections in the capital market, imperfections in the product markets and labor markets which makes it hard for some firms to go on. Therefore, the firms can take advantage of these factors and engage in diversification strategies as this will help the SMEs in developing economies to take responsibility for a wide range of functions in order to conduct its business in the most successful way. Diversification also helps the SMEs in emerging economies to take advantage of economies of scope, since related business usually use similar method of production operations, marketing ,financing and administrative activities, related diversification will provide the emerging firms with opportunities such as cutting on the cost of manufacturing, it will be able to share on its distribution activities such as sharing of distribution trucks or distribution personnel, rationalize its sales and marketing activities or in other term, trim down its sales and marketing activities, rationalize the managerial costs and administrative costs too. Thus the SMEs should diversify because economies of scope will enable them perform better when they are together than apart. Since management of all businesses under one mother company helps save on costs, for example centralizing overlaps managerial and administrative activities such as finance, accounting, marketing, customer support services and R&D among others. Diversification is necessarily in SMEs in emerging economies as these firms normally have weak law enforcement and they lack adequate, timely and accurate information. This issue makes it hard for customers to verify claims by firms concerning the quality and performance of their products. Since the firms will incur a higher cost in building a trusted brand, it will undertake a strategy such as marketing to enable the consumers know the kind of brands that they produce hence maintaining their credibility and trust from customers, after pursuing this strategy, the firm can diversify by producing different brand in different businesses as long as they have developed a good reputation with their customers. A firm benefits from economies of scale especially when they expand into other emerging economies where institutional and cultural environments are similar and there are opportunities to exploit their resources and their capabilities.Moreover,it may lead to use of cross-subsidies so as to drain resources from other subsidiaries which are in the upper hand concerning their perfomance.Diversification enables the poor performing firms to access resources as they are still part of the mother firm, rather than being on their own as they will not have this advantage. Another reason is that the diversification helps in evasion of downturns. This is whereby there could be decline in sales of a certain product or market share of the firm; therefore, diversification would enable the firm to continue its operations even if the profitability of a certain product has declined. The firm diversifies in order to build up or extend its resources and capabilities so as to create value, i.e. the company that uses diversification strategy develops and exploits economies of scope between its businesses. Economies of scope are cost savings that the firm creates by successfully sharing some of its resources and capabilities or transfer its corporate competencies to another business. SMEs in emerging economies should diversify in order to make use of an internal capital market. This is by combining cash –rich businesses and cash poor businesses into a single firm. This strategy allows profitable investments in the cash poor business to be funded without accessing external sources of capital (Czinkota, Ronkainen & Kotabe, 2009). If there are frictions in the capital market, the strategy can create value.Further,companies in emerging markets operate in markets which lack effective security regulation or venture capital firms, as a result ,focused firms may not be able to raise adequate financing to start or support an existing firm ,therefore they assume that the firm will generate its cash internally,hence,for the firms in emerging economy to succeed in generating their own funds internally, they need to diversify so as to expand their business or venture a new opportunity. Diversification may also reflect the preferences of the firm’s managers rather than the owners, as if issues of corporate governance deter shareholders from bringing to an end value-reducing activities, managers may diversify in order to fulfill their need for growth, to increase their salary package as well as mitigate their risks. Finally SMEs in emerging economies should pursue diversification since the government is usually unpredictable and it is very hard to maintain government relations due to the fact that the government keeps on changing its policies and regulations year after year, therefore for the SMEs to counter themselves against the risk, they have to engage themselves in diversification strategies so as to spread the risk of government behavior. Mellahi (N.D.) stated that global diversification in emerging firms also helps enhance value by enabling the firm to be flexible internally so as to respond to the changes in relative prices, change their production or shift the production to another area where the cost of production is considered low, thus cutting on the cost of inflation (Jemaneh Seid & Bekele, 2013). They could also shift their distribution to another region where the demand is high. As such, if SMEs in emerging economies undertake the diversification strategy, they may be able to cut on tax liability too. Key theories and models supporting diversification of SMEs in emerging economies Geographic risk diversification theory The geographic risk diversification theory which was proposed by Lessard and Rugman, predicts the location of potential investment which is a function of geographic distribution of existing assets and the perceived uncertainties of potential investments. The theory assumes that markets in different geographical locations are not highly correlated with each other. As such, the strategy will enable SMEs in emerging economies to lower the risk and effect of currency volatility. This is a significant strategy in that emerging economies experience currency volatility frequently. Also, the strategy will profit the SMEs since areas experiencing high growth will offset the negative effects of areas experiencing lower growth rates (Ireland, Hoskisson & Hitt, 2007). However, this theory is criticized because it takes everything as a financial risk, thus it is rather a blunt portfolio approach to reducing risks as it does not consider subsidiary change. Nevertheless, SMEs in emerging economies should diversify geographically to safeguard themselves against the often irregular growth rates experienced in different regions of emerging economies (TEXIER, F. 2006). Uppsala Model of evolutionary internalization The Uppsala model of evolutionary internalization focuses on the internalization process of firms. This model was developed by Johansson and Vahne in (1975), and they subsequently postulated that the firms need to take baby steps before they decide to operate in foreign countries. Such steps incuded, the firm should not engage in frequent exportations of their products, secondly, the exports were to be conducted by an agent, thirdly, there were sales in subsidiaries and finally overseas manufacturing of products. This model predicts that firms need to invest initially in a physically proximate country before moving further out into a larger or wider region. SMEs in emerging economies should start by carrying out simple business activities such as exporting some of their products to foreign markets (Mellahi, Frynas & Finlay, 2010). This act will increase their market base while simultaneously leading to higher revenue. In the long run, the SME in an emerging economy will graduate and commence operating in that foreign nation. The Uppsala model of evolutionary internalization applies only to smaller firms in the emerging economies with less internalization experience and not to huge firms. The Uppsala model also implies that firms in SMEs emerging economies should have a basic knowledge about the foreign market before commencing their business. They should also have market commitment whereby, they ensure that they can afford all the required resources and should have a high degree of commitment to the market. Further, the increased knowledge on foreign market will enhance their commitment as they will be able to make realistic business strategies and decisions in future. This model also examines the choice of decisions that firms in emerging economies should pursue when there is a choice of market to enter or a choice of country to enter (Chandra, 2009). These two decisions are so critical to emerging firms, as the choice of market or country to enter will be determined by the psychic distance, and the mode of entry by the firm which will depend on the less risky venture through a wholly owned subsidiary. SMEs diversification strategy becomes an increasingly important corporate strategy in emerging economies. Research findings from studies carried out about this topic indicate that the institutional investors are effective monitors and their influence on emerging economies is rising (Kim, 2008). Furthermore, there are optimistic aspects of principle-principle agency relationships in emerging economies. This provides a reason why foreign investors like to invest in emerging firm’s economy, although they may not be free from principle-principle agency problem. SMEs should embrace these foreign investors who will inject the much needed capital for the diversification process. Managers of large firms in emerging economies are required to diversify into different lines of business unless they have another reason not to. This is the reason behind the existence of highly developed companies in the developed economies, since in developed economies; institutions that support key business activities are well developed (Kenny, 2009). Hence this calls for the need for enhancement of key institutions in emerging economies. The importance of diversification for emerging economies cannot be undermined because it will help to generate capital needed to expand the business, since the firms will be able to do that internally without seeking external sources. There is also weak information system and law enforcement hence a great need for diversification in the SMEs emerging economies so as to counter this issue of weak and imperfect information Conclusion SMEs in the emerging economies have decided to pursue diversification as their major strategy which simultaneously provides both benefits and costs to the firm; thereby making diversification an important corporate strategy for the firms in emerging economy. Finally, diversification moves beyond the value creation and appropriation perspectives of the principle-principle agency theory. Thus there is need to engage in diversification by emerging firms in the economy. References Chandra, P. (2009). Projects: Planning, Analysis, Selection, Financing, Implementation And Review. New Delhi, Tata Mcgraw-Hill. Czinkota, M. R., Ronkainen, I. A., & Kotabe, M. (2009). Emerging Trends, Threats, And Opportunities In International Marketing: What Executives Need To Know. New York, Business Expert Press. Hake, B. (1999). New-Product Strategy: Innovation And Diversification Techniques. London, Pitman Publishing. Ireland, R. D., Hoskisson, R. E., & Hitt, M. A. (2007). Understanding Business Strategy: Concepts And Cases. [Mason, Oh], Thomson South-Western Ireland, R. D., Hoskisson, R. E., & Hitt, M. A. (2007). Understanding Business Strategy: Concepts And Cases. [Mason, Oh], Thomson South-Western. Jemaneh Seid, M., & Bekele, A. (2013). 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