Diversification of Firms: Horizontal and Vertical

After reading this article you will learn about the horizontal and vertical diversification of firms.

Horizontal Diversification of Firms:

It means adding parallel products or services to the existing product/service line. The existing technical, marketing and financial expertise is applied to new products also.

Horizontal diversification can take the following forms:

1. Concentric diversification:

It is a form of horizontal diversification where companies:

(a) Add new products to existing products to serve similar customers in similar markets through same distribution system. This is known as market related concentric diversification. If a company selling food products starts selling kitchen ware, it will cater to similar customers in similar markets.

(b) Add new products to existing products using similar technology. This is known as technology related concentric diversification. If a company selling televisions adds music systems and washing machines also, it is said to result in technology related concentric diversification; though however, this is market-related diversification also as the same consumers may buy these products.

Thus, adding new products, markets or technology related (similar) to the existing products/ markets/technology is known as concentric diversification.

Reasons for concentric diversification:

Companies prefer concentric diversification because of the following reasons:

1. Declining sales in one product can be offset by rising sales in the other. The effect of cyclical fluctuations is, thus, reduced.

2. It increases the cash flows and profits.

3. It increases managerial expertise and efficiency as companies enter into new areas.

4. It utilizes surpluses into new profitable areas. Profits that cannot be reinvested in the same business can be invested in products that provide better returns.

2. Conglomerate diversification:

While the ‘related’ approach to diversification is concentric diversification, the ‘unrelated’ approach is conglomerate diversification. It means adding dissimilar products or services to the existing products. It is diversification into new products, new markets, new technologies or new market functions not related to the existing business. Tata industries have followed conglomerate diversification by diversifying into unrelated areas such as automobiles, iron and steel, telecommunication, consumables (salt) etc.

Reasons for conglomerate diversification:

Companies prefer conglomerate diversification because of the following reasons:

1. To grow at a rate faster than what can be achieved through expansion or aggregation.

2. To enter into international markets.

3. To increase the managerial expertise.

4. To take benefit of senior and experienced executives who can venture into new profitable ventures.

5. To optimise the use of existing resources.

6. To improve earning capacity and market value of the firm.

Vertical Diversification (Integration) of Firms:

Vertical diversification is also known as vertical integration. In this growth strategy, a company expands its business in the forward or backward direction. Firms add new products (or services) complementary to the existing products. If a firm manufactures rayon and textiles, it grows through vertical diversification.

When a firm converts inputs into output, transformation takes place in a number of stages, for example, purchase of raw material, manufacturing processes, assembly, distribution and sale. Vertical diversification defines whether to perform some or all of these functions. It is joining together of two or more firms producing goods which are in successive stages of production.

There are two forms of vertical integration:

1. Backward Integration:

It is a form of vertical integration where firms integrate backwards to produce the inputs or raw materials. Rather than buying inputs from outside, firms manufacture their own inputs. If sugar mills own sugarcane farms, they are said to have diversified through backward integration. It helps in reducing selling price and increases turnover and profits.

Merits:

Backward integration has the following merits:

(a) If offers regular supply of inputs to the firms.

(b) It speeds up the transformation process and ensures adequate and regular supply of outputs in the market.

(c) Firms maintain quality control over the inputs.

(d) It ensures better utilisation of facilities resulting in low cost of production. This increases the return of firms.

(e) It increases competitive strength of firms with their former suppliers of inputs.

Limitations:

Backward integration suffers from the following limitations:

(a) It requires huge amount of capital to buy machines to produce inputs.

(b) Firms lose the advantage of buying inputs at lower price from suppliers who deal in them at large scale.

(c) If companies invest in machines that supply them inputs, it may require technology up gradation. Delay in technology upgrading will result in inefficient or delayed outputs.

(d) Updating technology also requires huge amount of capital investment. This may increase the prices of outputs.

(e) Fast changing environmental conditions do not support backward integration as continuous changes in demand for outputs require continuous changes in inputs.

2. Forward Integration:

“Forward integration is a type of diversification strategy which involves the entry of a firm into the business of finishing, distributing, or selling of some of its present outputs.” It refers to “moves altering the nature of the distribution of the firm’s output (toward end users).”

It involves entry of firms into distribution outlets to maintain direct contact with consumers. Rather than selling through intermediaries, firms that diversify through forward integration maintain their own sales outlets. Bombay Dyeing, DCM etc. have own retail outlets. This enables them to maintain control over the channel of distribution.

Benefits:

Forward integration offers the following benefits:

(a) It enables firms to control the prices of outputs through control over the channels of distribution.

(b) Control on prices helps in maintaining competitive strengths.

(c) Sales through own retail outlets are preferred by quality conscious consumers.

(d) Firms receive feedback from consumers which helps in improving the quality of products.

(e) Elimination of middlemen reduces the cost and price of products. This widens market base of the firms and increases their profitability.

Limitations:

Forward integration suffers from the following limitations:

1. It is not easy for firms to sell through own outlets in fast changing environmental conditions. It is better to sell through distribution channels who specialize in the distribution business.

2. Maintaining own retail outlets is costly for the firms. While eliminating the channels of distribution reduces the price, maintaining retail outlets negates this effect. A cost- benefit analysis must, therefore, be carried before the firms decide to diversify through forward integration.

3. For firms producing multiple products, there can be problems in coordinating multiple retail outlets.