Diversification is a strategic business move that improves a company’s financial health and opens up many opportunities for growth by capturing a larger market share outside its current market. The core idea of business diversification is to spread out investments to stabilise earnings and increase profitability.
It also allows companies to leverage their strengths and capture new customer segments, whether introducing new products, entering different industries, or expanding into newer locations.
In this Tax Natives blog post, we’ll look at examples of real-life business diversification, its pros and cons, and tax implications to understand it better.
Key Points
- What are the different types of business diversification?
- What are the benefits of business diversification?
- What are the drawbacks of business diversification?
- What tax considerations should be made when diversifying a business?
What are the different types of business diversification?
There are several types of diversification, each serving unique purposes within the growth strategy of a parent company.
Concentric Diversification
Concentric diversification involves introducing new, related products or services that capitalise on existing capabilities or markets. This allows companies to exploit technological or marketing harmonies, leading to better market penetration and a larger customer base.
A real-life example of concentric diversification is Apple’s expansion into wearable technology with the Apple Watch. Already a dominant player in personal computing, smartphones, and digital music players, Apple leveraged its brand reputation and tremendous resources to introduce a smartwatch to achieve the following:
- Complement its existing ecosystem of devices
- Appeal to its current customer base
- Attract a new customer base interested in fitness and health tracking
This move into wearable technology was a natural extension of its existing product lines. It capitalised on the growing market for health and fitness gadgets, demonstrating how companies can successfully diversify their offerings while staying true to their core business strengths.
Horizontal Diversification
Horizontal diversification is when a company introduces new products or services that do not necessarily relate to the existing lines but still cater to the established customer base. This strategy can quickly increase a company’s footprint by staying within its core remit.
Amazon.com is a clear example of horizontal diversification. Initially an online bookstore, Amazon expanded its offerings to include electronics, clothing, and a wide range of consumer goods.
This expansion into numerous product categories allowed Amazon to capitalise on its established customer base and distribution network, transforming it into a one-stop online retail giant.
Conglomerate Diversification
Conglomerate diversification is more risky and involves moving a business into completely unrelated business areas. It is often used to hedge against sector-specific risks, allowing the parent company to venture into new territories regardless of their connection to current business operations.
General Electric (GE), founded initially as an electrical company focused on lighting, has transformed its business model through strategic conglomerate diversification. Over the decades, GE has expanded into industries far removed from its origins, notably aviation, healthcare, power generation, and financial services.
This approach diversified GE’s business risks and positioned the company to capitalise on cross-industry growth opportunities, stabilising its financial outlook across economic cycles.
Vertical Diversification
Also known as vertical integration, this sees a company expanding into its supply chain. This strategy can control costs and improve supply chain coordination, providing more control over the production process from raw materials to final sales.
A notable example of vertical diversification, or vertical integration, is Starbucks’ strategic approach to its supply chain.
Traditionally, Starbucks purchased its coffee beans from various global suppliers. However, to gain more control over the quality and supply of its primary raw material, Starbucks began investing in coffee farms directly.
By growing and processing its coffee beans, Starbucks was able to oversee the entire coffee production process—from farming and harvesting to roasting and serving the final product in stores.
This level of control ensures consistent quality across their products. It helps stabilise supply chain costs, which can fluctuate due to market changes or external factors like weather affecting crop yields.
This strategy exemplifies how a company can expand its operational control within its existing industry, aligning closely with its core business while optimising its end-to-end production processes.
What are the benefits of business diversification?
As seen in the real-life examples of business diversification, it offers several benefits, including:
- Broadening a company’s business activities and market exposure to improve its financial stability and growth potential.
- Optimising investment portfolios to strike an ideal balance between achieving attractive returns and maintaining the lowest risk.
- Spreading economic risks across various sectors and markets reduces the impact of negative performance in any single area on the company’s overall health.
What are the drawbacks of business diversification?
While diversification is a good strategy for targeting aggressive growth, it comes with its own set of financial risks that need careful managing, such as:
- The potential of capital risk – Expanding into new markets or sectors demands substantial investment, and the returns might only sometimes justify the initial investment.
- Fluctuations in annual returns – Targeting new areas for expansion can expose a company to unpredictable market fluctuations, including consumer preferences, new regulatory environments, and market conditions.
What are the tax considerations for business diversification?
Businesses must consider various tax implications that can affect their financial health and capital strength when diversifying. Here’s how different aspects of diversification impact a company’s tax situation.
Capital Risk and Tax Liability
Entering new markets or industries often requires major capital investment, such as purchasing equipment or property, which may be subject to different tax depreciations or credits.
Market Risk and Operating Losses
Diversification into new areas can involve substantial market risk, which might lead to initial operating losses. However, these losses can be carried forward to offset future taxable income, which could improve the company’s annual returns in the long term.
Financial Risks and Tax Structuring
Expanding into new business areas or geographical markets might require restructuring the business. This could involve setting up new entities or reorganising existing ones. This restructuring can minimise the tax burden and shield core assets from financial risk.
Growth Potential and Tax Incentives
Many governments offer tax incentives for companies that invest in certain industries or areas, like technology, green energy, or underdeveloped regions. These incentives can include reduced tax rates, credits, or deductions.
Negative Correlation and Tax Efficiency
If the diversified business sectors have a negative correlation in terms of performance, this can be beneficial from a tax perspective.
For example, if losses in one sector can offset profits in another, this can lead to an overall more efficient tax rate for the entire business, stabilising financial results across various market conditions.
Read our latest guide if you are looking to find ways to reduce corporation tax in the UK.
Making the most out of your tax position with Tax Natives
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Whether you’re exploring aggressive growth strategies or seeking to minimise financial risks through diversification, Tax Natives connects you with a global network of professionals who can offer strategic insights to optimise your tax position and improve your company’s capital strength, no matter where your business is located.
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