After a business operates for several years, it may choose to expand its operation. Many businesses choose to expand by merging with another company or by acquiring a different company. Sometimes companies choose a diversification strategy of merging or acquiring companies in different industries. These businesses often fail to consider the disadvantages of diversification.
Lack Of Knowledge
A small businesses owner gains a great deal of knowledge about the industry his company operates in. He learns what type of marketing the customers respond to, which products his customers prefer and where best to serve his customers. His customers gain respect for the business and the business owner grows his business based on these relationships.
When the business owner expands by taking on a company in a different industry, he lacks the marketing knowledge, customer preference knowledge and relationships that he maintains with his current customers. The new business maintains relationships with customers who respond to different marketing techniques, preferences and locations. His tendency is to apply his current knowledge to the new business, which has the potential to alienate the new customers and destroy the business.
Double Sales Team Expenses
Each company starts the process with their own sales team. Each sales team understands the details of the product they sell, but do not understand the other business. If both companies sell to the same customers, each customer will have two sales people visiting their company. This creates duplicate expenses for the company.
Risk of Incompatible Businesses
Some businesses complement each other, while others do not. When diversifying, many business owners choose a company that operates in a completely separate environment than the current business. The two companies may advertise using different methods. If the companies sell to different customer bases and use different materials obtained from different vendors, the two companies will need to continue operating separately.
The common hope of business owners who expand with new companies is to combine the activities of both companies. This is not possible with incompatible businesses. An example of two incompatible businesses is a potato chip company buying a motor oil manufacturer.
Overestimate Synergy Savings
Business owners often choose to diversify, citing anticipated synergy savings as a win for both companies. Synergy savings represent cost savings that occur by reducing duplicated services and by choosing the best processes after evaluating the processes of both companies. One of the risks of diversification is that anticipated synergy savings are often calculated without considering the level of employee abilities and commitment to the new company. Anticipated synergy savings also often miss the cost of maintaining local services in lieu of creating a centralized location.