Diversification Diversification can be briefly defined as the expansion of a firm into a range of different product areas. Firms may choose to diversify for either of two reasons. First, diversification may benefit the firm’s owners by increasing the efficiency of the firm. Second, if the firm’s owners are not directly involved in deciding whether to diversify, diversification decisions may reflect the preferences of the firm’s managers.
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Singapore Airlines (SIA) serves as a typical example of diversification in a certain degree as SIA dedicates to providing air transportation services of the highest quality and to maximizing returns for the benefit of its shareholders and employees via different ways of diversification since it was founded in 1972. Ways to Diversify As is mentioned above, firms generally diversify based on two reasons: efficiency based reasons and managerial based reasons. • Efficiency based reasons Efficiency based reasons of diversifications are able to benefit the shareholders and they are generally divided into five categories.
These categories are: (a) Economies of Scale and Scope A study by Thomas Brush supports the plausibility of scale and scope economies as a starting point for understanding the performance of diversified firms. If a merger is motivated by scale economies, the market share of the merged firm should increase immediately following the merger. And the data from manufacturing industries, conducted by Thomas Brush, show that changes in market share were as expected, which means the gains expected from mergers were substantial.
Yet in the case of SIA, SIA operates passenger services to more than 60 cities in over 30 countries around the world. Within Asia, passengers can connect to over 30 cities served by SilkAir, the regional wing of SIA. The variability of routes apparently attracts more passengers to fly with SIA and therefore gain more market share for SIA. Besides, SIA also provides the online booking service; passenger can book tickets online without going to the specific selling spots of SIA. Economies of scale can be obtained through this kind of technology in the long run.
Other methods such as effective advertisement and keeping smaller inventories via promotion or special offer on ticket price also distribute to obtaining economies of scale. Economies of scope can, however, come from other resources. It can be achieved by spreading a firm’s underutilized organizational resources to new areas. At any given time, a firm may possess specific resources that it cannot fully utilize in its current product market. Such resources might be effectively applied in other product markets, and doing so would give rise to economies of scope.
In the case of SIA, the airline has announced plans to launch a new no-frills, low-fare airline operating widebody aircraft on medium- and long-haul routes named Scoot. The new subsidiary will begin operations on April, 2012 and will be operated independently, while being managed separately from SIA. Initial destinations singled out include China, India, Africa, the Middle East and America. (b) Economizing on transaction costs The issue of transaction costs is relevant if diversification occurs through mergers or acquisitions which are only legal basis for combining firms.
The transaction costs are more likely to arise in relationships with the independent firms when the production process involves specialized assets, such as human capital, organizational routines or other forms or proprietary knowledge. In the absence of specialized assets, transaction costs are not likely to be a problem. In this case, market coordination may provide superior incentives and flexibility. In the case of SIA, it is a member of Star Alliance member airlines. This joint venture of airlines includes separate airlines, each of which could, in principle offer flying plans contiguously but operated independently of each other.
Passengers can look forward to seamless travel to many more destinations through SIA’s codeshare arrangements with many of the Star Alliance members. In addition, passengers can enjoy a range of Star Alliance benefits such as flight redemption and upgrade redemption awards on most member carriers. Consequently, the transaction cost can be economized via the method of joint venture. (c) Internal capital markets In a diversified firm, some units generate surplus funds that can be channeled to units that need the funds. For example, the budget airline of SIA, Scoot, may need funds in the early period when operating.
In such circumstances, SIA will support Scoot for the funds. The key issue is whether the firm can do a better job of evaluating its investment opportunities than an outside banker can do. (d) Diversifying shareholder’s portfolio This rationale for diversification begins with the observation that individual shareholders benefit from investing in a diversified portfolio. By purchasing small holdings in a broad range of firms, investors can reduce the chance of incurring a large loss due to the failure of any single firm and thus insulate themselves from risk.
Since SIA is cooperating with some hotels and retailing brands. The shareholders can purchase small holdings of these hotels and retailing shops in order to gain more profit. (e) Identifying undervalued firms A firm’s shareholders may benefit from diversification if its managers are able to identify other firms that are undervalued by the stock market. Suppose, for example, one airline company’s stock is currently trading at $80 per share, but the manager of SIA determines that the airline company is actually worth $100 per share.
If SIA can purchase the airline company for $80 per share, SIA will profit by $20 for each share of the airline company purchased. • Managerial based reasons a) To increase his empire Managers could be engaged in empire building and enhancing their status in their network at the expense of the shareholders. For instance, SIA set up SilkAir targeting at the Asia market and planned to come up with the budget airline Scoot operating on medium- and long-haul routes. All these moves taken by SIA to diversify can be seen as ways to increase the empire of the management. ) To increase his power base In order to increase the power base, it is pivotal for the firm to take measures to influence the market further. With the operating of Scoot, SIA can further occupy the market share and keep its leading position in this industry. In addition, joining the Star Alliance members airline can also be seen as a way to increase the power base. c) To increase the market value Market value is often different from book value because the market value takes the future growth potential into account.
Most investors who use fundamental analysis to pick stocks are generally focus on the firm’s market value and then determine whether the market value is adequate or if it’s undervalued in comparison to its book value, net assets or some other measurements. In this case, SIA has built a good reputation for itself through all these years efforts and SIA also joined the Star Alliance members airline to increase the market value and seek cooperation with other powerful airlines. Good market value can help to increase the revenue of LVMH because it can attract investors to invest the company. ) To increase his portfolio Growth may benefit managers even when it does not add value for the shareholders. When growth cannot be achieved through internal development, diversification may be an attractive route to growth. By increasing managers’ portfolio, they will feel secure and perform with their skills to the specific task. Advantages of Diversification • Control of inputs, leading to continuity and improved quality. SilkAir and Scoot, which are the subsidiaries of SIA, provide SIA with a wider platform for consolidation its related activities. Control markets by guaranteeing sales and distribution. This can arise through a combination of linkages in the value chain. For example where production and distribution channels are combined, or where a company uses its well-established brand names or corporate identity to gain benefits in new markets. Although Scoot is a newly established budget airline, if people know it is operated by SIA, they will have a good image of this new airline and therefore it can guarantee sales and distribution for Scoot. Take advantage of existing expertise, knowledge and resources in the company when expanding into new activities. This may result in transfer of skills, such as research and development knowledge and sharing of resources. It is also suitable in the case of SIA and Scoot. • Provide better risk control through no longer being reliant on a single market Diversification can spread risk by avoiding having all eggs in one basket. Operating new airline or new routes is a way for SIA to spread the risk of staying in a single market. Disadvantages of Diversification • May result in slowing growth in its core business
When Scoot has a similar flying route with SIA selling at a lower price, it may affect the growth of SIA. So they must find a way to avoid such kind of confliction • Adding management costs. The management cost will increase for SIA to operate its subsidiaries. And sometimes SIA might have to put in additional funds when its subsidiaries need support to enhance their operation. • Adding bureaucratic complexity. In addition to direct financial costs, there may additional bureaucratic complexities necessitated by the need to coordinate and control core activities with additional activities. .