Question

How does diversification impact firms’ transaction and production costs?

Answer 1

Introduction

Diversification is an important phase in most company’s progress that become bigger organizations with time. Over a period of time, most companies that see increasing profits, want to diversify their business so that they are not dependent upon one source of income for earning and can find better profits in other emerging sectors also.

This occurs for small and medium to larger organizations also, which decide on merging their business to incorporate other products and services also which they can give to the users respectively.

With diversification of a company, along with a possible chance of increased profits, the costs of the enterprise also change. Usually a new entry requires additional capital sources to be pulled up.

However, these largely are determined by the kind of diversification strategy which is adopted by the firm respectively. Generally speaking each firm can have the following kinds of strategies which it may follow and the impact of this on the firms transaction and production costs are as mentioned below. Here, it is important to note, that transaction costs usually relate to a firms cost of transporting the goods and the profit margins which it has to give to each subsequent level to reach the end customer respectively. In some cases advertising expenses are also included in the transaction costs respectively.

Types of Diversification Strategies and their impact on firm’s costs:-

The following are the kinds of diversification strategies which a firm can typically engage itself in respectively.

Concentric Diversification:-

The first kind of diversification method which a firm may want to adopt into is a concentric diversification technique. Under this, a company or a firm engages in a similar kind of business and reaches out to the needs and wants of those customers it already caters to respectively.

This can be explained from a simple example of a manufacturer of laptops starting to manufacture tablets is a form of concentric diversification respectively.

The impact of this, on transaction and production cost is relatively lower respectively. These products, can be sold easily using the same method of reaching out to the consumers. A laptop manufacturer can easily sell tablet computers in the same facility. Also, the parts that are used are relatively same therefore the production costs also tend to be relatively lower than other forms of diversification respectively.

Horizontal Diversification:-

This form of diversification is one which provides new and relatively unrelated products or services but to the existing customers. In this, the simple example of a notebook manufacturer, offering a pen for sale is a similar example. The transaction costs remain relatively similar since, a notebook and a pen can sell at the same time these indeed vary from industry to industry & are relatively higher than concentric diversification

However, the production materials are relatively different in nature, and these tend to be higher. A notebook and a pen have different forms of production techniques and materials to purchase

Conglomerate Diversification:-

This targets a new industry and a new set of consumers and aims to fulfill different needs which are unrelated to the industry or products which it has no prior knowledge of.

This requires a company or firm to largely change its production methods and adopt new ones respectively. Also, it requires higher transaction costs since the firm does not have a prior network, to reach out to the consumers respectively.

Conclusion:-

In terms of the cost of diversification a related product or industry will always see lower production and transaction costs, this happens because companies tend to have connections and can modify current production methods to produce similar goods in a relatively cheaper manner. Therefore, concentric diversification as a strategy sees lesser transaction and production costs followed by Horizontal diversification and the last is conglomerate which sees relatively extremely high levels of costs and investments respectively.

Please feel free to ask your doubts in the comments section.