Download On over Diversification in Operation Strategies

On over Diversification in Operation Strategies
WEI Guangxing1, 2, LIU Wenyao2
1. Research Center of Sustainable Construction and Risk Management, Chongqing Jiaotong University,
Chongqing, P.R.China, 400074
2. School of management, Chongqing Jiaotong University, Chongqing, P.R.China, 400074
[email protected]
Abstract: The strategy of diversification is one of the basic operation strategies. But, many corporations
are prone to get into over diversification subconsciously, by which too many business units belong to
different industrial fields are engaged in and hereby the performance becomes bad. This paper firstly
analyzes the reasons for over diversification, and then investigates how to qualitatively judge and
quantitatively evaluate it. Qualitatively, corporation value, customer value, management performance,
operation risk and management cost can be taken to judge the extent of over diversification.
Quantitatively, market value added and economic value added can be adopted to evaluate whether the
corporation as a whole and every individual business unit individually has been in the state of over
diversification respectively.
Keywords: Operation strategy, Over diversification, Strategy management, Diversification strategy
1 Introuction
As economy develops globally and competition becomes intensely, many corporations always try to
diversify in order to accumulate sustainable competitive advantages in several different industrial fields
[1]
. Actually, the strategy of diversification is one of the most important ways to get sustainable core
competence [2]. Firstly, as the industry and the related products or services turn into the period of mature
and recession gradually, the market become saturated and the profit margins begins to decline or even
become negative, while the strategy of diversification is an important way to explore some new business
units with higher profits. Secondly, the various, changeful and individualized customer requirement in
the new economic era provides new investment opportunities and wider operation spaces. Only if
corporations can customize the individualized demand efficiently, they could accumulate competitive
advantages and hereby enter a new industrial field through diversification [3]. Thirdly, operation risks can
be decentralized by diversification. The losses in some business units can be offset by the increasing
profits of the other beneficial fields, by which corporations can gain relatively stable profits as a whole
and hereby enhance the ability to resist risks. As a result, the strategy of diversification is often taken by
many corporations in the course of development, especially there are enough residual resources and the
managers feel pressure from objective of growth. Actually, diversification is a successful strategy for
many corporations, who in the course of diversification new origins of profit and growth by entering
new business units are expanded, decentralizing operation risk, accumulating competitive advantages [4].
However, just as the portfolio in financial investment may be diversified overly [5], many corporations
unconsciously get into over diversification in the course of expansion, by which they actually develop
business in too many industrial fields and the performance becomes bad. The “too many industrial
fields” of over diversification means that it is difficult to coordinate all the business units or the cost of
coordination is so high that to withdraw or abandon some business units and hereby develop business in
fewer and narrower industrial fields can achieve better operation performance such as higher profits [6].
The static diversification comparatively means that corporations operate in two or more related or
unrelated industrial fields at the same time, while by the dynamic diversification corporations enter
some new industrial fields related or unrelated to the existing fields to implement expansion [7]. Similarly,
by the static over diversification corporations operate business in too many different industries at the
same time, while the dynamic over diversification refers to the process that corporations enter some new
industrial fields to operate new business activities, which they should not enter or enter too many
industrial fields, where the “should not enter” means that after entering the new industrial fields the
corporation performance such as profits declines, and “enter too many” means that too many industrial
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fields have been chosen to develop business and hereby most business units can not reach the certain
scale of economy. The outstanding point of over diversification is that there is no core business unit, and
no core competence embedded in one or more business unit to support sustainable development.
However, many corporations always want to diversify in the course of expansion [8] and furthermore
subconsciously plunge into over diversification. There are many literatures about the strategy of
diversification, while only a few discussed over diversification briefly up to now. The following will
explore the reasons of over diversification, and further investigate how to qualitatively judge and
quantitatively evaluate over diversification.
The remainder of this paper is organized as follows. Section 2 investigates the reasons why corporations
run into over diversification. Section 3 probes the method of qualitative judgment of over diversification,
while how to quantitatively evaluate over diversification is examined in Section 4. And finally, Section 5
draws the conclusions.
2 Reasons for Over Diversification
Generally speaking, all the motivations for corporations to diversify can result in over diversification as
long as they are emphasized excessively. The following analyzes only three of the most important
reasons briefly.
2.1 Changeful Market
The market is changeful in the new economic era. For example, the sellers' market has turned to the
buyers' market, the market spectrum has changed from the regional to the global, and the customer
demand has moved from mass to individualized requirement. After such a series of changes, it is easy
for corporations to get into over diversification even though they diversify suitably before. For example,
in the environment of sellers' market, almost any rational investment in almost every industrial field is
profitable. So, corporations will invest in not only the industries whose profits are higher than existing
business units but also those industries whose profits are more or less than existing business units as
long as there are investment returns, which can promote competence and prevent potential competitors.
But, in the buyers' market, only those investments with core competence can gain enough profits. Then,
corporations should engage in the industrial fields with competitive advantages, and expand into the
industrial fields which the existing core competence can support. Consequently, the former fit
diversification will turn to the over diversification as the seller' market turn to the buyers' market. On the
other hand, the previous regional market limits the development opportunities, and thus restricts the
business mode, by which corporations make decision on production scale based on the regional market
demand. In this way, corporations cannot help adopting the diversified expansion, and the diversified
expansion in a smaller space will distribute the limited resource into too many industrial fields inevitably.
As a result, the scale of each business unit becomes too small after the regional market turns to global
market, and even is far to achieve scale economy, which hereby will finally leads to small business scale
in each individual industrial field and over diversification as a whole.
2.2 Scope Economy
The existence of scope economy indeed makes corporations receive a higher profit rate with the same
resources. However, the premise and precondition of the scope economy or the synergy effect is that the
different business units are complementary with each other, which is ignored by many corporations
when pursuing scope economy blindly. If corporations expand into some business units which are not
complementary or are lowly complementary with existing business units, the resource allocation and the
production efficiency will not be effective, and hereby it is difficult to form core competence in the new
industrial fields. Maybe, corporations hope to set up new origins of profit growth by entering some new
industrial fields, but they ignore the importance of creating corporation value. As a result, corporate
capital structure is irrational, the core business units are not fully developed or even there are no core
business units at all, and at the same, the scale of each business unit is too small to support long-term
development. Therefore, in the process of expansion through diversification, corporations should attach
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enough importance to establishing competitive advantages based on complementary synergy gradually.
If corporations pursue scope economy blindly, they will plunge into over diversification subconsciously.
Then, the new industrial fields corporations plan to enter is not in accordance with the competitive
advantage, or the core competence can not support the new business units, or the existing business units
conflict with the new business units. In such a state of over diversification, it is difficult not only to
acquire scope economy but also to strengthen core competence.
2.3 Management Pressure
If managers face management pressure about such as growth and risk, they are prone to get into over
diversification. On one side, if growth is an important objective and there are remaining resources that
corporations still failed to make full use of, which is common in reality, the managers usually will face
the pressure from the shareholders who urge to make full use of resources in order to raise more profits.
Once the managers decide to diversify, they tend to enter the profitable industrial fields in their own
eyes. Obviously, their judgment might be incorrect. Even if their judgment is correct, it is possible that
the industrial fields, which are selected according to standard of profit, is not complementary with the
existing business units, or is not in accordance with the competitive advantage, which actually has
results in over diversification. On the other side, the incentive to disperse operation risk also can lead to
over diversification. For the managers, the most important is to avoid bankruptcy, which is a deathblow
to their professional reputation. So, as an important means to control operation risks, the strategy of
diversification is chosen and implemented right. However, if the capacity of diversification to disperse
risk is weighted excessively and blindly, and there is no scientific prediction for future market or the
development of innovative industry, corporations will take on the same business units as others take
because they face the same entry barriers. As a result, it is difficult to create effective scale economy in a
specific industrial field because of fierce competition. Moreover, each business unit doesn’t reach the
scale of economy at all. In such a business structure, there is no conspicuous core business unit with
core competence. Consequently, such over diversification resulted from disperse operation risk increases
business risk by contraries.
3 Qualitative Judgment of Over Diversification
Since the strategy of diversification is advantageous of growth and acquirement of core competence,
while over diversification which is prone to get into is disadvantageous, how to evaluate and judge
whether a corporation is in the sate of right diversification or over diversification is an important topic
deserving to probe deeply. This section try to research how to evaluate over diversification qualitatively,
and the quantitative evaluation is investigated in the next section.
Actually, the key to judge whether a corporation is in the sate of over diversification is to judge whether
each business unit which the corporation carries on or plans to enter makes positive contribution to the
corporation, that is to say, whether each existing business unit makes positive statically contribution and
each new business unit makes positive contribution dynamically. In a static strategic view, if there are
some business units with negative contribution, the corporation is just in the state of over diversification.
And it is reasonable for the corporation to withdraw from those industrial fields, by which they will
achieve better operation performance. On the contrary, if each business unit contributes positively to the
corporation, the corporation is in the state of right diversification, should keep staying in all the existing
industrial fields and may try to search some new business opportunities. In a dynamic strategic view, the
corporation should strengthen business units with positive contribution, abandon business units with
negative contribution, and enter new business unit which will makes positive contribution. Then, how to
evaluate the contribution which each existing or would-be business unit makes to the corporation? The
following standards or criterions can be taken accordingly.
3.1 Corporation Value
Whether the technical innovation such as discovering new elements and inventing new production
equipments, resources allocation, or organization learning within each business unit can increase the
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corporation value is an internal criterion to judge whether a corporation is in the state of over
diversification. If within a business unit, any technical innovation, resources allocation, or organization
learning can not increase the corporation value, the corporation should abandon it. While the corporation
should strengthen or enter those business units whose technical innovation, resources allocation, or
organization learning makes positive contribution to the corporation value definitely.
3.2 Customer Value
Customer value creation and customer value maximum is the external standard to judge whether a
corporation is in the state of over diversification. Creating and maximizing customer value is an
important source of competitive advantages. If there are some business units whose products or services
can not create customer value, the corporation is in over diversification and should withdraw those
business units. Furthermore, if the cost invested in some business units exceed their contribution, these
business units are also excessive and hereby should be abandoned, while those business units whose cost
is less than their contribution should be widen in order to create customer value or achieve maximum
customer value.
3.3 Management Performance
Corporate profits can not reflect management performance accurately, while the maximum financial
market value, or the stock price, can show business performance more accurately. The financial market
value normally is represented in the form of expected discounted value. If after the corporation enters a
new business unit, the financial market value such as the expected discounted stock price drops, it has
been in the process of over diversification, while if when the corporation enters a new business unit, the
management performance rises, it has been diversifying rightly. Because the management performance
can also be effected by other factors, the influence of a business unit on the management performance
should be predicted correctly, which was been discussed in literature [6] briefly.
3.4 Operation Risks
Operation risk stems from the uncertain environment. The uncertainty results in not only operation risks
but also additional profits. Then, the corporation predicting the outcome of uncertainty more accurately
will obtain profits above the average. However, the uncertainty exists in each business unit. The more
business units the corporation engages in, the more difficult to predict the result of the overall
uncertainty. The operation risk is correlated with the scope of business units negatively. A business unit
increases the corporation profit while also increases the operation risk. If the former effect is weaker
than the later, the corporation is in the state of over diversification. Therefore, the tradeoff between the
corporation profit and the operation risk added by each would-be business unit decides whether the
corporation is in over diversification.
3.5 Management Cost
One of the most important aspects of management is the coordination among employees and the
incentive of employees. In order to urge employees to work hard and collaborate with each other
harmoniously on behalf of the corporation, an optimal incentive system and monitor system should be
designed, and hereby enough and suitable payment has to be paid to them, which is called management
cost. For the corporation engaged in diversification, if the cost of coordination and incentive is
increasing with a higher growth rate than that of corporation value, or if the internal incentive system
can not meet the requirement of creating corporation value, by which too much incentive is attached to
some business units with low capacity of value creation, it has been in over diversification.
4 Quantitative Evaluation of Over Diversification
The above value criteria of qualitative judgment also can be referable to evaluate the degree of over
diversification quantitatively. As a general assumption in literatures, the creation of corporation value is
restricted in a corresponding certain period of time. Then, the qualitative judgment and the quantitative
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evaluation of over diversification are to judge and evaluate whether the referred corporation is in the
state of over diversification at a specific point of time. The following will probe the quantitative
evaluation of the whole corporation and the individual business unit respectively.
4.1 Evaluation of Corporation As a Whole
When the corporation as a whole is judged and evaluated whether it runs into over diversification, the
value creation level produced by capital investment is an important indicator. Concretely, the market
value added, which is called MVA in many literatures and textbooks, is used to describe the level of
corporation value creation. The market value added is the margin between the market value of the total
corporation capital (MVTAC), which includes the stocks of the stockholders and the liabilities capital,
and the account value of corporation capital employed (AVCCE), which is the capital that shareholders
and creditors invest in the corporation. Therefore, the market value added can be denoted as
MVA=MVTAC-AVCCE
(1)
The market value of capital is the market value of stocks of the specific listed corporation. If the referred
corporation is not a listed, the market value of capital can be estimated with proposed purchase price or
other methods. And the account value of corporation capital employed can be calculated according to
the balance sheet, where the debt capital includes short-term borrowings and long-term loans, as well as
the sources of capital equivalent to the nature of the liabilities, such as pension of workers. The method
is offered in literature [6] in detail.
According to the calculated result of the market value added based on the above formula, whether the
whole corporation is in over diversification can be analyzed and evaluated. If the market value added is
positive, by which the market value of the total corporation capital is bigger than the account value of
corporation capital employed, the corporation has the ability to create additional value, and hereby the
corporation as a whole is in the appropriate state of diversification. On the contrary, if the market value
added is negative, by which the account value of corporation capital employed is bigger than the market
value of the total corporation capital, the corporation can not create additional value and the strategy of
diversification reduces the ability of creation value, and hereby the corporation as a whole is just in the
state of over diversification.
4.2 Evaluation of Business Unit Individually
The value created by a business unit can be denoted as economic value added, which is called EVA in
literatures. The economic value added is the margin between the net operation profit after tax (NOPAT)
and the capital cost, which can be represented by the weighted average capital cost (WACC) multiplied
the total invested capital (TIC). Therefore, the economic value added can be illustrated as
EVA=NOPAT-WACC ×TIC
(2)
in which the weighted average capital cost is the weighted average of the capital cost of stocks and loans,
and the total invested capital equals the sum of the stocks from shareholders and the capital invested by
creditors.
According to the calculated result of the economic value added based on the above formula, whether the
business unit is a part of over diversification can be judged and evaluated. If the economic value added
is positive, which indicates that the business unit has the ability to create value and also make positive
contribution to the corporation, the business unit is not a part of over diversification, and the corporation
should expand into the business unit supporting and supported by the core competence. On the contrary,
if the economic value added is negative, which indicates that the business unit can not create value and
neither makes active contribution to corporation, the business unit is just a part of over diversification,
and hereby the corporation should withdraw the business unit to refocus on the core unit with
sustainable competitive advantages.
5
Conclusion
As one of the basic operation strategies, the strategy of diversification is often taken by many
corporations in the course of expansion. However, many corporations plunge into over diversification
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subconsciously, by which there is no core business unit, and furthermore no core competence embedded
in one or more business units to support sustainable development. The above analysis shows that
changeful market, blind pursuit of scope economy, and management pressure are the reasons for
resulting in over diversification. The indicators such as corporation value, customer value, management
performance, operation risks and management cost can be taken to judge over diversification
qualitatively, while market value added and economic value added can be adopted to quantitatively
evaluate whether the corporation as a whole and every business unit individually is in over
diversification respectively. Once the corporation is found with the market value added to be in over
diversification as a whole, the economic value added should be taken to further identify which business
units lead to over diversification. Then, in order to ensure that every business unit contributes positively
to maximizing both corporation value and customer value synchronously, the business structure should
be adjusted properly by entering business units with potential opportunities, strengthening business units
with prominent growing rate, weakening business units with positive but mature value and withdrawing
business units with negative effect.
All these findings are referable for corporation strategy management. Nevertheless, the above analysis
only gives some theoretical principles on over diversification without actual applications. Positive
investigations, especially case studies integrating practical operation, are essentially necessary for future
work.
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