Excess Capacity as a Reason for Expanding Product-line
The presence of excess production capacity is, perhaps, the most important single factor leading to product-line diversification. Broadly conceived, excess capacity is said to exist when it would cost the multiple-product firm less to make and sell the new product than it would cost a new company set up to produce only that product.
Excess capacity may occur for several reasons. It may be the result of an unduly over-optimistic estimated market for the firm’s products. In such a case, if anticipated level of demand is not forthcoming, the firm develops excess capacity.
Excess capacity may be due to seasonal variations in demand also, the latter being a result of weather and custom, e.g., greeting cards, ice-cream, etc. Companies faced with seasonal demand for their products would certainly find it advisable to add to their product-line in off-season a new product to make up for the loss because of idle capacity. OCM, manufacturers of carpets, have taken up the manufacture of synthetic fibre fabrics to avoid the disadvantage of seasonal sales of worsted woollen fabrics.
Over-capacity may further be caused by cyclical fluctuations in sales. Excess capacity may result from secular shifts in markets, tastes, buying habits, etc., leaving the firm with underutilized capacity and know-how. TISCO management was fully aware of the vulnerability of the steel industry to business cycles. With this in view, the company promoted a large number of industries in and around Jamshedpur with a view to disposing of most of its steel at the minimum cost. In this process, a number of companies including India Tube Company, Tata Robins Fraser, TELCO and Tinplate Co. were established.
Finally, the existence of an excess capacity may be the result of vertical integration. The reasons for vertical integration may, however, be many. The most obvious reason is to get a strategic market advantage. There may be an economic motive to integrate if fuller utilization of plant capacity or managerial, marketing and research capacities leads to lower production costs. Moreover, a purchasing firm can supply its own needs of raw materials and semi-finished components more economically through integration than by directly purchasing them from the market. Sometimes, a firm may have to pay lower prices if it purchases two or more products simultaneously. Vertical integration makes this possible.
To utilize unused capacity, some units in the public sector have also added to their product lines. The Mining and Allied Machinery Corporation (MAMC), manufacturers of coal-mining equipment, have taken up manufacture of earth-moving equipment and washeries for the coal industry. Jessops, manufacturers of rail wagons, have added specialized cranes in their product-line. West Bengal Scooters has diversified into steel rolling.
Profit as Criterion of Optimum Product-line
Granted that there are sufficiently strong pressures on the part of the firm to diversify its product line, the question is : what are the goals sought to be achieved by the firm in increasing its product-line? In the long-run, profit maximization may be the objective of optimum product-line. In the short-run, however, income stability may be the more important goal. Other short-run objectives are continued existence of the firm, market share, volume growth, comfortable cash reserves, cordial labor relations, etc. Even these objectives, however, may merge with the long-run objective of the profit maximization. Thus, profitability is the crucial test of adding to the product-line.
In fact, the decision about adding a new product is not different from other managerial decisions. Incremental costs of adding the product are to be compared with incremental returns. If the net return is more than the returns provided by alternative investment opportunities, a product may be added to the product-line, a forecast of the demand for that product and the costs involved in the addition will have to be made.
Diversification as Response to Change
Many companies find it profitable to diversity and add to their product-line in response to change. Changes may occur in the demand for their products, in the scope for further expansion or in the overall economic, political or social environment in which the company operates. Hindustan Lever started in the 18th century as a sales organization and became a marketing company early in the 19th century. By 1930, it commenced manufacturing vanaspati and soaps. Between mid-fifties and the mid-sixties, it diversified its activities into synthetic detergents, convenience foods, animal feeds and dairy products. By the late sixties and early seventies, it was evident to the company that its future was more secure with further diversification into the ‘core sector’.
Facit India, manufacturers of adding machines and calculators, sensed in time, that its market domination for these products is likely to be eroded by electronic substitutes. Hence it took up the manufacture of typewriters. It was easier to switch over to the production of typewriters as some production techniques were overlapping. Due to the prohibition policy of the Government, Mohan Meakins, brewers and distillers, have taken to cement, steel products, dyes and chemicals, hotels and packaging machinery.
Due to oil price hike and the resultant cost compulsion, Daimler-Benz that built its reputation on limousines, had to introduce a compact car for those who want “less the comfortable interior than the exciting driving experience’. The objective was to lure customers away from rivals such as BMW, Audi or Opel in Germany.
Diversification as Response to Restrictive Government Regulations
To avoid the rigors of the various restrictive regulations, many multinational companies and those belonging to big houses, have decided to diversify. Associated Cement Companies have diversified into high technology areas like castable refractories. BASF, German multinational, has diversified to include leather chemicals in its product-line because they were compatible with the technological and marketing expertise of the company.
ITC has added the Marine Foods Division, the Hotels Division and the General Exports Division to its traditional tobacco and cigarette operations. It also promoted a paperboard project, as a separate company.
The steadily increasing taxes and duties on major packaging raw materials and the reservation of much of the packaging industry for the small-scale sector, have led Metal Box to diversity into manufacture of a variety of engineering products like off-set printing machinery and automobile bearings.
Other Considerations
- A company may take advantage of its own strong points, e.g. sound distribution network. WIMCO’s diversification into processed food industry is an example of this type. Crompton Greaves took up TVs because their household products, lights and fans, had given them a lot of goodwill.
- A company may look for backward or forward integration and diversify into allied lines. OCM, manufacturer of woollen carpets and worsted woollen fabrics, went in for production of synthetic fibre fabrics. This also reduced the company’s dependence on seasonal products.
- A company may go into totally unrelated products (i) because of incentives given by the Government for the growth of a particular industry or a region, or (ii) to provide a hedge against business cycles and recession. Brooke Bond diversified rapidly into non-beverage lines. Shriram Fabrics is taking up manufacture of auto-ancillaries because of DCM-Toyota tie-up.
In product-line decisions, the management should also keep in view, the following points:
- The management should not introduce a new product if an even better new product is available. Before taking a final decision, all the available opportunities and alternatives should be explored and examined and the best one chosen. In other words, the opportunity costs of alternative uses of excess capacity must be estimated.
- The management should also appraise the impact of the new product on the products already manufactured. If the product complements the product-line, it will increase the sales of other products. In such a case, the contribution to overheads and profits by introducing the new product will be greater than the direct contribution of the product itself. If, however, the product competes with existing items of the product-line, the contribution estimates will have to be adjusted downward.
- If the excess capacity is temporary, management must look whether the product can be abandoned when demand for other products recovers. For it may well be preferable to accept temporary excess capacity than to create production bottlenecks when the excess disappears.
Management must examine whether it has the requisite know-how to produce and sell the product.