Interrelationships and diversification strategy of the firm

Diversification based on interrelationships is the form of diversifi­ cation with the greatest  likelihood   of increasing competitive advantage in existing   industries   or   leading   to   sustainable  competitive   advan­ tage in new industries. Both tangible and intangible interrelationships have an im portant role in diversification strategy. Tangible interrela­ tionships should be the starting point for formulating  diversification strategy. Intangible interrelationships have a less certain effect on com­ petitive 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 .2 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 interrela­ tionships. Hence  profits associated   with   the acquisition   are   less likely to be bid away in setting the purchase price. The presence of interrela­ tionships 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 exist­ ing 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 interre­ lationships 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 struc­ ture and interrelationships that will yield the firm a competitive advan­ tage in competing in those industries are the dual guides to diver­ sification 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 m arket-oriented  diversification strat­ egy aims to sell new products to common buyers, channels,  or geo­ graphic 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 interrela­ tionships. 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 devel­ oped in one business to enter another.  Small m otor technology  from the original sewing machine business led to entering  small appliances and electric typewriters,  while electronics expertise gained in typewrit­ ers has led to entering electronic  printers.

These three broad  diversification paths often lead a firm in differ­ ent directions. Broadening  the range  of products  sold to common buyers, channels or geographic areas often involves different technolo­ gies 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 electron­ ics, for example, firms such as Sony and M atsushita  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 M atsushita  (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 interre­ lationships involving small electric motors  used in its core business, power tools.

Diversification will offer the greatest potential for enhancing over­ all firm position when several im portant  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-technol­ ogy 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 im portant interrelation­ ships 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 ex­- ploited.
  • 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 indus­- 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 inter­ relationships to existing business units than industries with tangible interrelationships. Finding opportunities in which intangible interrela­ tionships 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 advan­ tage. 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 interrelation­ ships. A good example is Procter & Gam ble’s initial acquisition of Charmin Paper Company, a beachhead which allowed Procter & Gam ­ ble 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 interrelation­ ships, with the clusters related by intangible interrelationships.  A key test of diversification opportunities  based on intangible interrelation­ ships, 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 m ajor contribu­ tion 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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