What is Product Diversification?

Product diversification is a strategy employed by a company to increase profitabilityProfitability RatiosProfitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets to produce profit and achieve higher sales volume from new products. Diversification can occur at the business level or at the corporate levelCorporate StructureCorporate structure refers to the organization of different departments or business units within a company. Depending on a company’s goals and the industry.

Business-level product diversification – Expanding into a new segment of an industry that the company is already operating in.

Corporate-level product diversification – Expanding into a new industry that is beyond the scope of the company’s current business unit.

Diversification is one of the four main growth strategies illustrated by Igor Ansoff’s Product/Market Matrix:

Diversification Strategies

There are three types of diversification techniques:

1. Concentric diversification

Concentric diversification involves adding similar products or services to the existing business. For example, when a computer company that primarily produces desktop computers starts manufacturing laptops, it is pursuing a concentric diversification strategy.

2. Horizontal diversification

Horizontal diversification involves providing new and unrelated products or services to existing consumers. For example, a notebook manufacturer that enters the pen market is pursuing a horizontal diversification strategy.

3. Conglomerate diversification

Conglomerate diversification involves adding new products or services that are significantly unrelated and with no technological or commercial similarities. For example, if a computer company decides to produce notebooks, the company is pursuing a conglomerate diversification strategy.

Of the three types of diversification techniques, conglomerate diversification is the riskiest strategy. Conglomerate diversification requires the company to enter a new market and sell products or services to a new consumer base. A company incurs higher research and development costsCost of Goods Manufactured (COGM)Cost of Goods Manufactured (COGM) is a term used in managerial accounting that refers to a schedule or statement that shows the total and advertising costs. Additionally, the probability of failure is much greater in a conglomerate diversification strategy.

Why Companies Diversify?

In addition to achieving higher profitability, there are several reasons for a company to diversify. For example:

• Diversification mitigates risks in the event of an industry downturn.
• Diversification allows for more variety and options for products and services. If done correctly, diversification provides a tremendous boost to brand image and company profitability.
• Diversification can be used as a defense. By diversifying products or services, a company can protect itself from competing companies.
• In the case of a cash cow in a slow-growing market, diversification allows the company to make use of surplus cash flows.

Risks in Product Diversification

Entering an unknown market puts a significant risk on a company. Therefore, companies should only pursue a diversification strategy when their current market demonstrates slow or stagnant future opportunities for growth.

To measure the riskiness or the chances of success of diversification, there are three tests used:

1. The Attractiveness Test – The industries or markets chosen for diversification must be attractive. Porter’s 5 Forces Analysis can be done to determine the attractiveness of an industry.
2. The Cost-of-entry Test – The cost of entry must not capitalize on all future profits.
3. The Better-off Test – There must be synergy; the new unit must gain a competitive advantage from the corporation or vice-versa.

Before considering diversification, a company must consider the three tests above.

Examples of Successful Diversification

Here are two notable examples of successful diversification:

General Electric

General Electric commonly comes into discussions when talking about successful diversification stories. GE began as an 1892 merger between two electric companies and now operates in several segments: Aviation, energy connections, healthcare, lighting, oil and gas, power, renewable energy, transportation, and more.

Walt Disney

Walt Disney Company successfully diversified from its core animation business to theme parks, cruise lines, resorts, TV broadcasting, live entertainment, and more.

Additional Resources

Thank you for reading this guide. CFI’s mission is to empower anyone to become a great financial analyst through our Financial Modeling & Valuation Analyst programBecome a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today!.  As you continue your progression, these additional CFI resources will be helpful:

• Market PositioningMarket PositioningMarket Positioning refers to the ability to influence consumer perception regarding a brand or product relative to competitors. The objective of market
• Network EffectNetwork EffectThe Network Effect is a phenomenon where present users of a product or service benefit in some way when the product or service is adopted by additional users. This effect is created by many users when value is added to their use of the product. The largest and best-known example of a network effect is the Internet.
• Law of SupplyLaw of SupplyThe law of supply is a basic principle in economics that asserts that, assuming all else being constant, an increase in the price of goods
• Bargaining Power of SuppliersBargaining Power of SuppliersThe Bargaining Power of Suppliers, one of the forces in Porter’s Five Forces Industry Analysis Framework, is the mirror image of the bargaining power