Where to Diversify: Consider Barriers to Entry

A common theme in recent years is the thirst to diversify. Often organizations wish to minimize customer concentration risk, or seek out new markets with less competition.

Competition is a matter of degrees, and one can predict which markets will attract competitors based on the ease by which they can enter or exit. While there are industry specific hurdles to consider in any business, barriers to entry include:*

Economies of Scale– Companies seek out volume or vertical integration in an effort to control raw materials or create a cost advantage.

Capital Requirements– The need for access to heavy equipment, factories, or labor is so expensive to fund that only large competitors enter the fray.

Switching Costs– The cost for customers to switch suppliers becomes too high.  When one takes on a new cell phone contract, the price penalty to switch is punitive. By the end of the contract, when switching costs are low, providers offer incentives to keep customers in their network.

Access to Distribution– Companies such as Coke, Pepsi, Nabisco and Frito Lay control distribution at retail outlets, keeping competitors off the shelf. Once distribution is established, it is relatively easy to expand into new categories such as bottled water and iced tea.

Cost Advantages- In some instances cost advantages have nothing to do with scale, but are a function of strategic alliances or bets that provide cost savings.  During the last run up of fuel prices, Southwest Airlines’ clever hedge only expanded their cost advantage.

Government Policy– Government is unpredictable and is an X factor in many businesses. Government contracts often exclude suppliers who cannot meet or choose not comply with a myriad of requirements from eco standards, to minimum labor rates.

When analyzing which business you should be “in”, it is not enough to consider the current state of competition. How might competitors behave in the future?  Is the market large enough to attract behemoth companies?  How have such companies reacted to price competition in other markets?

Another consideration is the cost of exit. Companies who provide parts may have legacy costs that may last many years and erode profits. There are many variables to consider in any new endeavor, and diversification offers both opportunities and a myriad of risks.

*Adapted from Competitive Strategy by Michael Porter

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