One of the best business books I have ever read, and one of my favorite books of all time, is Peter Lynch’s classic, One Up On Wall Street. Lynch recounts many of the techniques he used during the 1980s to make the Fidelity Magellan mutual fund one of the best performing mutual funds in history.

One of the lessons he shared in his book was to be cautious investing in a company that had achieved long term success in a particular area but then decides to buy or invest in another endeavor that they know nothing about. In the book, Lynch relays the stories of several very successful companies who made the mistake of putting their energy toward questionable ventures with the idea of diversifying their business.

Lynch coined the term, “diworsification” to describe the unforeseen negative impact of companies that follow these strategies. He notes that this is type of mistaken strategy is often the first step toward the company slipping into mediocrity.

I was reminded of Lynch’s diworsification concept this past week when I was reviewing the year to date financials for one of my clients. Up until this spring, my client had three successful divisions. Two of the divisions were moderately successful. Both of these generated enough direct contribution (defined as gross margin less direct costs) required to cover their share of the company’s overhead. If the company was made up of these two divisions alone, the company would achieve slight profits each year after paying the owner a modest salary.

The third division of the company has significantly higher gross margins than the other two divisions. It also has grown rapidly in the last few years to where it makes up nearly half of the company’s sales. The direct contribution from this division not only covers its share of overhead but it also generates a significant profit. This division’s performance is the secret sauce for the company. It is the magic that makes the entire company a highly profitable operation.

Late last year, the owner decided to make a significant investment to open a new division that is related to the existing businesses but which has very different labor, cost, and margin characteristics. The new division also requires more space, and space that is more expensive.

The projections for the new division indicated that it would be moderately profitable at best. However, after the first couple of months, it became clear that the new division was losing a significant amount of money on a direct cost basis. If its share of overhead and the indirect costs of the division were accounted for properly, the new division was extremely unprofitable.

Because of this, the owner concluded that the answer to improving profitability was to hire a person to run the new division who knew the industry. This move has helped. The business now is revenue neutral, which means there is enough revenue to cover the direct costs of the division.

However, the new division does not make enough to offset any overhead or recoup the costs of the investments required to launch the new division. More critically, the owner’s infatuation with the new division has caused many of the key long term employees in the highly profitable division to question the owner’s commitment to their division.

These employees’ concerns were enhanced recently when the owner disclosed plans to take on more space so that the new division could grow into profitability. The investments in the new unprofitable division made these employees wonder why the owner was willing to invest more in the unprofitable division while being unwilling to invest more in their profitable division to obtain equipment that they need to improve productivity and generate more profits.

This is a perfect real world example of diworsification.

Diversification can be a good thing for a business and an excellent next step toward growing the business overall to a new level of sales and profits. But, to be successful, the new initiative must have good gross margins and be able to cover its share of the company’s costs. If it can’t, it will become a drag on profitability and – just as importantly – on the morale of employees.

If you want to expand your business by getting into an area where you have limited or no knowledge of, there are a number of things that you should do:

  1. Before you start, make sure you have an accurate projection of the revenue and expenses you should expect from the new operation. The direct profitability of the new operation should be able to cover all of its costs plus its share of overhead and still be highly profitable.
  2. Validate the profitability model you have developed by comparing your projections to actual industry data of your new competitors. If your modelling tells you that the new division is going to be a low margin operation, question whether or not the new division is really where you want to invest your capital. In addition, if your projections suggest that you will be much more profitable than the people you are competing with, those who have been in the industry a long time, it might suggest that you are missing some key information.
  3. If possible, contract with an industry specialist to make sure your business assumptions are reasonable. The specialist should be able to quickly validate your forecast assumptions.
  4. While it is reasonable to not make a profit immediately, the trends of sales and gross margin for your new division should show constant and significant improvement. If profitability, sales, or both are stuck, then it is time to question the viability of the new initiative.
  5. Finally, make sure your fascination with the new operation doesn’t distract from the successful parts of your business. Don’t pour so much time and money into a low margined new operation that you let your existing profitable operations decline and imperil the financials and the loyalty of long term staff.