Interrelationships and diversification strategy of the firm

Diversification based on interrelationships is the form of diversification with the greatest likelihood of increasing competitive advantage in existing industries or leading to sustainable competitive advantage in new industries. Both tangible and intangible interrelationships have an important role in diversification strategy. Tangible interrelationships should be the starting point for formulating diversification strategy. Intangible interrelationships have a less certain effect on competitive advantage and are more difficult to achieve in practice than tangible interrelationships.

Interrelationships can allow a firm diversifying through internal development to overcome entry barriers into a new industry more cheaply than other potential entrants that lack them.80 The presence of interrelationships also facilitates entry through acquisition because an acquisition candidate will have greater value to the firm than it does to its present owners or to other bidders without similar interrelationships. Hence profits associated with the acquisition are less likely to be bid away in setting the purchase price. The presence of interrelationships also means that diversification through either an acquisition or internal development will benefit existing business units that have interrelationships with the new business unit.

Any diversification move must also pass the test of structural attractiveness (Chapter 1). Industries that are related to a firm’s existing business units are not more structurally attractive simply because of their relatedness. A new business unit must be in an industry that is actually or potentially structurally attractive. The presence of interrelationships per se is not sufficient justification for entering an industry unless they allow a firm to transform an unattractive industry into an attractive one. Thus seeking industries with both an attractive structure and interrelationships that will yield the firm a competitive advantage in competing in those industries are the dual guides to diversification strategy.

1. Diversification Based on Tangible Interrelationships

Diversification strategy can seek to extend any of the types of tangible interrelationships described in Table 9-1. The most desirable directions for diversification are those that lead to interrelationships offering the greatest impact on competitive advantage, using the criteria described earlier. In some cases, diversification will strengthen a firm’s position against key competitors, while in others it will be dictated by the need to match competitors’ diversification defensively. A firm may also enter industries where it can use interrelationships to overwhelm single-business competitors or competitors with poorly conceived arrays of business units. The benefits of tangible inter- relationships can flow in two directions. It is just as valuable to pursue interrelationships that enhance the position of existing units as it is to use existing unit positions to improve new business units.

Three of the broad types of tangible interrelationships shown in Table 9- 1—market, production, and technological—represent three broad diversification avenues. A market-oriented diversification strategy aims to sell new products to common buyers, channels, or geographic markets in order to reap the benefits of market interrelationships. A production-oriented diversification strategy aims to produce similar products with shared production value activities. Procurement interrelationships often stem from production interrelationships. A technology-oriented diversification strategy aims to de- velop or enter new industries based on similar core technologies, that involve products sold to either existing or new markets. The successful Japanese typewriter firm Brother, for example, uses its “technology tree” in driving diversification. Brother has built on technologies developed in one business to enter another. Small motor technology from the original sewing machine business led to entering small appliances and electric typewriters, while electronics expertise gained in typewriters has led to entering electronic printers. These three broad diversification paths often lead a firm in different directions. Broadening the range of products sold to common buyers, channels or geographic areas often involves different technologies and production processes, while broadening the range of products with similar technologies or production processes implies getting into new markets. This is not always true, however. In consumer electronics, for example, firms such as Sony and Matsushita have diversified into new products with technology shared with their existing products. Opportunities also existed at the same time for market and production interrelationships. Sony and Matsushita (Panasonic) have each devel- oped shared value activities such as brand names, service organizations, plants, and procurement across wide product lines. Interrelationships, in fact, are one of their primary sources of competitive advantage. Another example is Black and Decker’s entry into small appliances, which exploits  technological interrelationships and production interrelationships involving small electric motors used in its core business, power tools.

Diversification will offer the greatest potential for enhancing overall firm position when several important value activities can be shared. The most successful diversifiers do not view market-, production-, and technology- oriented diversification as mutually exclusive, but seek ways to combine them. In my study of interrelationships in 75 Fortune 500 companies in 1971 and 1981 described in Chapter 9, high-technology companies showed the greatest ability to increase interrelationships in markets, production, and technology simultaneously. This finding is consistent with the role of electronics/information processing tech-nology in linking industries together. As technology develops, firms should be able to find more avenues for diversification where multiple forms of interrelationships can be exploited.

2. Diversification Through Beachheads

Firms will differ in their ability to achieve important interrelationships through diversification. The opportunities a firm has may be limited by a number of factors:

  • The existing mix of business units in the firm may enjoy few meaningful interrelationships with other industries.
  • The significant interrelationships may have already been exploited.
  • The industries that are related to a firm’s existing industries may be structurally unattractive.
  • No feasible strategy may exist for entering related industries because competitors have preempted.
  • Antitrust considerations preclude entry into some related tries.

When opportunities to diversify along tangible interrelationships are few or exhausted, a firm should consider diversification based on intangible interrelationships. Since intangible interrelationships involve the transference of generic skills and not actual sharing of activities, there will usually be more industries with potential intangible interrelationships to existing business units than industries with tangible interrelationships. Finding opportunities in which intangible interrelationships will lead to competitive advantage is a subtle process, though, because it requires that a firm understand a new industry well enough to see how transference of skills will really make a difference.

Generic similarity of a new industry to an existing industry does not itself imply that transference of skills will create competitive advantage. Competitors in the new industry can have equal or superior skills themselves. The relevance of a firm’s skills in a new industry must also be questioned, and superficial analyses of generic similarities can be very misleading. Basing diversification on imagined or irrelevant generic similarities among industries led to the failure of diversification strategies in the 1960s and 1970s. All these caveats aside, however, careful industry analyses can uncover new industries in which intangi- ble interrelationships are a sound basis for diversification.

Diversification based on intangible interrelationships should be viewed not only as a stand-alone opportunity, however, but also as a potential beachhead. Once a firm enters a new industry based on intangible interrelationships, it can then use this beachhead to spawn new opportunities for diversification based on tangible interrelationships. A good example is Procter & Gamble’s initial acquisition of Charmin Paper Company, a beachhead which allowed Procter & Gamble to build the highly interrelated cluster of paper products business units described earlier. Figure 10-2 illustrates schematically the process of diversifying through beachheads. An intangible interrelationship with the original cluster of tangibly related business units becomes the foundation for a new cluster. The diversified firm emerges as a number of clusters of business units related by tangible interrelationships, with the clusters related by intangible interrelationships. A key test of diversification opportunities based on intangible interrelationships, therefore, is their potential as a beachhead.

Figure 10-2. Interrelationships and the Pattern of Diversification

3. Diversification and Corporate Resources

The unique corporate assets of a diversified firm are the existing and potential interrelationships that reside in the value chains of its business units. These interrelationships represent the major contribution of a diversified firm to its business units, and to the new industries it might enter. The central role of the diversified firm is to nurture and expand these interrelationships.

Diversification is a means to widen a firm’s stock of assets and skills by expanding the perimeter of the value activities in which it participates. Each new industry not only may be related to existing ones, but also may bring value activities to the firm that are the sources of new interrelationships. The best diversification is that which does both—it reinforces the firm’s existing strengths and creates the basis for new ones.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.

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