In the business world, diversification occurs when a firm tries to enter a new market with a new product or service. The firm is diversifying because it is adding to the range of markets in which it competes. The firm typically hopes to make itself more profitable and more secure by diversifying.
Related diversification occurs when the new market that the firm enters is in some way connected to the firm’s existing strengths. For example, one strength of the Coca-Cola company is the fact that it understands the market for consumer beverages. It has been selling colas and other soft drinks for decades. If Coca-Cola diversifies its product line by starting to sell water or bottled tea drinks, it is entering a market that is similar to its own, but slightly different. This is an example of related diversification because Coca-Cola’s existing strengths should help it compete in the new market.
Unrelated diversification occurs when the new market that the firm enters is not connected to the firm’s existing strength. Imagine a company that has been specializing in chemicals. It decides to buy a company that is in the medical services business. There is no real connection between these markets. The company is entering a totally new market where its existing strengths cannot really help it compete. This is an example of unrelated diversification.
The basic reason for any firm to diversify is to enhance its strength and stability. A firm might want to diversify so as not to “put all its eggs in one basket.” By diversifying, it can ensure that it will continue to be profitable even if it starts to struggle in one of its markets. A firm might want to diversify simply so it can become bigger. It might feel that it can realize some economies of scale or other benefits that come to large companies. The firm might feel that the opportunities for growth in its own core market are dwindling, leading it to diversify in search of new growth. What all of these things mean is that companies diversify because they feel that growing and moving into new markets will make them financially stronger and more stable.