Summary papers Corporate Level
Strategy
2021 –2022
MSc. Strategic Management
Tilburg University
1
,Synergy, coordination costs, and diversification choices (Zhou, 2011)
Week 2
This paper examines whether the pursuit of synergy itself explains limits to related
diversification and therefore the choice for unrelated diversification. It argues that to realize the
potential synergy, a firm must actively manage the interdependencies between new and
existing businesses, which results in coordination costs. Net synergy may decline not because
of exogenous opportunity constraints but because of the rising costs of coordinating
interdependencies across an increasing array of related business lines. Therefore, while
diminishing synergistic benefits limit diversification in general, increasing coordination costs
moderate the impact of synergy on the choice of industries and set a limit to related
diversification.
Main contribution
The paper operationalizes a mechanism that causes both synergy and coordination costs to
rise with related diversification: input sharing between business lines. The pursuit of synergy
through input sharing within a firm is fundamentally driven by the indivisibility of these inputs
between firms: if these inputs were divisible, firms could share them through contracting. At
the same time, indivisibility creates coordination costs within diversified firms. Therefore, the
potential for input sharing between a firm’s existing businesses and a new business can both
attract and deter entry into the new business, depending on the synergy vis-a-vis the attendant
coordination costs.
Second, the paper specifies a contingency under which marginal coordination costs surpass
marginal synergistic benefits: corporate-level complexity in the firm’s existing business lines,
or the extent of their interdependence. Complexity increases the prevailing coordination
demand. Complexity also exacerbates the coordination problem associated with input sharing:
it increases the number of existing interdependencies that must be adjusted when a new
business imposes its own requirements on the same pool of inputs that are shared across
business lines. Therefore, firms with greater complexity in the mix of their existing business
lines are more likely to see marginal coordination costs surpass marginal synergistic benefits
and face tighter constraints on the degree of input sharing they pursue by diversification.
Theory & Hypotheses
Coordination costs of diversification
Diversification can represent a mechanism for capturing integration economies associated with
the simultaneous supply of inputs common to several production processes geared to distinct
final product markets.
Sharing common inputs creates interdependencies between business lines. It requires joint
designing, joint scheduling, and mutual adjustments, as well as setting transfer prices and
designing incentive schemes for cooperation. These interdependencies challenge three
elements of coordination: communication, information processing, and joint decision making.
Even though at the transaction level the costs of managing interdependent activities within an
integrated firm may be less than between two separate firms, at the firm level such costs rise
dramatically as the firm’s total coordination demand approaches its coordination capacity. To
reduce transaction costs between firms, firm boundaries should be located such that
interdependencies between integrated activities and outsourced activities are weak.
H1: A firm is less likely to diversify into a new business when its existing business lines are
more complex.
Coordination costs of related diversification
2
,While coordination costs pose a challenge to diversification in general, they are greater for
firms pursuing more related diversification. More input sharing between a firm’s existing
business lines and a new business adds more interdependencies. Coordination costs go up
more than linearly with the number of business lines; they increase with the amount of
interdependencies among them. Therefore, coordination costs increase with firm scope at a
greater rate for more related than for less related diversification. Depending on how quickly
coordination costs and synergy increase relative to each other, the difference in marginal
coordination costs between more and less related diversification may become greater than the
difference in marginal synergistic benefits between the two. In that case, diversification into a
less related business becomes more attractive than a more related business.
In sum, related diversification is more costly to coordinate than unrelated diversification. It also
exacerbates the problem of coordinating a complex portfolio more than unrelated
diversification. The more inputs that are shared between the new and old business lines, the
more existing relationships need to be adjusted (i.e., the greater the ‘ripple’ effect).
H2: A firm’s likelihood of diversifying into a new business decreases more with the complexity
in the firm’s existing business lines if they share more inputs with the new business.
Results
The results show that a firm is more likely to diversify into a new business when its existing
business lines can potentially share more inputs with the new business; however, the firm is
less likely to diversify into any new business when its existing business lines are complex.
Importantly, the firm’s likelihood of diversifying into a new business decreases more with the
complexity in the firm’s existing business lines if they share more inputs with the new business.
These results suggest that increasing coordination costs counterbalance the potential
synergistic benefits associated with related diversification.
Managerial implications / main take away
1. In making diversification choices, a firm needs to balance the potential synergy with the
associated coordination costs and evaluate the impact of complexity. All else equal, a
firm’s performance will suffer if it diversifies into a highly related industry when its
existing business lines are already complex, or if it diversifies into unrelated industries
when its existing business lines are not so complex.
2. Because a firm’s overall coordination capacity is limited, its scope choices may be
substitutive: a firm may not expand into all markets where it can apply excess
resources, since doing so will impose coordination burden on the company. Therefore,
in making integration and diversification decisions, the firm needs to be aware of the
potential constraints in terms of coordination capacity these decisions will impose on
its future integration and diversification choices.
3. Firm-specific organizational capabilities may offset some limitations of coordination
costs.
3
, Within-industry diversification and firm performance – an S-shaped hypothesis
(Hashai, 2015)
Week 2
How does within-industry diversification affect performance, regardless of firm and industry
development?
Main contribution
- The current study presents a novel theory regarding the costs and benefits of within-
industry diversification and empirically investigates the performance implications of
within-industry diversification and its rate of change, while controlling for firm and
industry stages of development.
- The study makes an important distinction between “adjustment” and “coordination”
costs. The theoretical framework treats the two concepts together, while distinguishing
between their independent effects, arguing that adjustment costs are more dominant
determinants of performance decline at low levels of within-industry diversification,
while coordination costs gain dominancy at high levels. Importantly, the study shows
that coordination costs are not only significant in the case of inter-industry
diversification but are already meaningful in the case of within-industry diversification.
Theory
Benefits of within-industry diversification
Within-industry diversification may allow firms to leverage specific knowledge on technologies,
the firm’s customer base, its sales and distribution facilities or its experience with existing
products, to enhance their performance as well as penetrate additional product categories
within their core industry. Engaging in multiple product categories within the same industry can
also help enhance the firm’s technological knowledge base, capabilities, and competitiveness
through intra-firm knowledge diffusion. Within-industry diversification further helps to increase
the firm’s revenues by strengthening its market power over competitors, suppliers, distributors,
and customers, as well as reducing fluctuations in revenue by spreading investment risks over
different product categories. Taken together, within-industry diversification therefore enables
firms to realize multiple economies of scope by exploiting synergies between different product
categories to increase their performance.
Costs of within-industry diversification
When diversifying within their industry, managers contend with the need to transfer indivisible
resources to new product categories as well as the need to share resources between different
product categories, which respectively leads to two major types of costs: “adjustment costs”
and “coordination costs.” Adjustment costs are stimulated by the need to transfer and adapt
resources to different product categories, while coordination costs result from the need to share
and create effective linkages between the resources used for different product categories. In
essence, adjustment costs relate to the imperfect utilization of resources in specific domains,
whereas coordination costs relate to the simultaneous use of resources across domains. Both
types of costs imply a suboptimal utilization of firm resources where within-industry
diversification is concerned.
To a large extent, the two types of costs are shaped by an important attribute of resources,
that is whether resources are “scale free” or “non-scale free”.
- Scale-free resources: Resources whose use for a given task is independent of their
use for other tasks. In many respects, such resources constitute a within-firm “public
good.” Technological knowledge is a typical example of this kind of resources.
4
Strategy
2021 –2022
MSc. Strategic Management
Tilburg University
1
,Synergy, coordination costs, and diversification choices (Zhou, 2011)
Week 2
This paper examines whether the pursuit of synergy itself explains limits to related
diversification and therefore the choice for unrelated diversification. It argues that to realize the
potential synergy, a firm must actively manage the interdependencies between new and
existing businesses, which results in coordination costs. Net synergy may decline not because
of exogenous opportunity constraints but because of the rising costs of coordinating
interdependencies across an increasing array of related business lines. Therefore, while
diminishing synergistic benefits limit diversification in general, increasing coordination costs
moderate the impact of synergy on the choice of industries and set a limit to related
diversification.
Main contribution
The paper operationalizes a mechanism that causes both synergy and coordination costs to
rise with related diversification: input sharing between business lines. The pursuit of synergy
through input sharing within a firm is fundamentally driven by the indivisibility of these inputs
between firms: if these inputs were divisible, firms could share them through contracting. At
the same time, indivisibility creates coordination costs within diversified firms. Therefore, the
potential for input sharing between a firm’s existing businesses and a new business can both
attract and deter entry into the new business, depending on the synergy vis-a-vis the attendant
coordination costs.
Second, the paper specifies a contingency under which marginal coordination costs surpass
marginal synergistic benefits: corporate-level complexity in the firm’s existing business lines,
or the extent of their interdependence. Complexity increases the prevailing coordination
demand. Complexity also exacerbates the coordination problem associated with input sharing:
it increases the number of existing interdependencies that must be adjusted when a new
business imposes its own requirements on the same pool of inputs that are shared across
business lines. Therefore, firms with greater complexity in the mix of their existing business
lines are more likely to see marginal coordination costs surpass marginal synergistic benefits
and face tighter constraints on the degree of input sharing they pursue by diversification.
Theory & Hypotheses
Coordination costs of diversification
Diversification can represent a mechanism for capturing integration economies associated with
the simultaneous supply of inputs common to several production processes geared to distinct
final product markets.
Sharing common inputs creates interdependencies between business lines. It requires joint
designing, joint scheduling, and mutual adjustments, as well as setting transfer prices and
designing incentive schemes for cooperation. These interdependencies challenge three
elements of coordination: communication, information processing, and joint decision making.
Even though at the transaction level the costs of managing interdependent activities within an
integrated firm may be less than between two separate firms, at the firm level such costs rise
dramatically as the firm’s total coordination demand approaches its coordination capacity. To
reduce transaction costs between firms, firm boundaries should be located such that
interdependencies between integrated activities and outsourced activities are weak.
H1: A firm is less likely to diversify into a new business when its existing business lines are
more complex.
Coordination costs of related diversification
2
,While coordination costs pose a challenge to diversification in general, they are greater for
firms pursuing more related diversification. More input sharing between a firm’s existing
business lines and a new business adds more interdependencies. Coordination costs go up
more than linearly with the number of business lines; they increase with the amount of
interdependencies among them. Therefore, coordination costs increase with firm scope at a
greater rate for more related than for less related diversification. Depending on how quickly
coordination costs and synergy increase relative to each other, the difference in marginal
coordination costs between more and less related diversification may become greater than the
difference in marginal synergistic benefits between the two. In that case, diversification into a
less related business becomes more attractive than a more related business.
In sum, related diversification is more costly to coordinate than unrelated diversification. It also
exacerbates the problem of coordinating a complex portfolio more than unrelated
diversification. The more inputs that are shared between the new and old business lines, the
more existing relationships need to be adjusted (i.e., the greater the ‘ripple’ effect).
H2: A firm’s likelihood of diversifying into a new business decreases more with the complexity
in the firm’s existing business lines if they share more inputs with the new business.
Results
The results show that a firm is more likely to diversify into a new business when its existing
business lines can potentially share more inputs with the new business; however, the firm is
less likely to diversify into any new business when its existing business lines are complex.
Importantly, the firm’s likelihood of diversifying into a new business decreases more with the
complexity in the firm’s existing business lines if they share more inputs with the new business.
These results suggest that increasing coordination costs counterbalance the potential
synergistic benefits associated with related diversification.
Managerial implications / main take away
1. In making diversification choices, a firm needs to balance the potential synergy with the
associated coordination costs and evaluate the impact of complexity. All else equal, a
firm’s performance will suffer if it diversifies into a highly related industry when its
existing business lines are already complex, or if it diversifies into unrelated industries
when its existing business lines are not so complex.
2. Because a firm’s overall coordination capacity is limited, its scope choices may be
substitutive: a firm may not expand into all markets where it can apply excess
resources, since doing so will impose coordination burden on the company. Therefore,
in making integration and diversification decisions, the firm needs to be aware of the
potential constraints in terms of coordination capacity these decisions will impose on
its future integration and diversification choices.
3. Firm-specific organizational capabilities may offset some limitations of coordination
costs.
3
, Within-industry diversification and firm performance – an S-shaped hypothesis
(Hashai, 2015)
Week 2
How does within-industry diversification affect performance, regardless of firm and industry
development?
Main contribution
- The current study presents a novel theory regarding the costs and benefits of within-
industry diversification and empirically investigates the performance implications of
within-industry diversification and its rate of change, while controlling for firm and
industry stages of development.
- The study makes an important distinction between “adjustment” and “coordination”
costs. The theoretical framework treats the two concepts together, while distinguishing
between their independent effects, arguing that adjustment costs are more dominant
determinants of performance decline at low levels of within-industry diversification,
while coordination costs gain dominancy at high levels. Importantly, the study shows
that coordination costs are not only significant in the case of inter-industry
diversification but are already meaningful in the case of within-industry diversification.
Theory
Benefits of within-industry diversification
Within-industry diversification may allow firms to leverage specific knowledge on technologies,
the firm’s customer base, its sales and distribution facilities or its experience with existing
products, to enhance their performance as well as penetrate additional product categories
within their core industry. Engaging in multiple product categories within the same industry can
also help enhance the firm’s technological knowledge base, capabilities, and competitiveness
through intra-firm knowledge diffusion. Within-industry diversification further helps to increase
the firm’s revenues by strengthening its market power over competitors, suppliers, distributors,
and customers, as well as reducing fluctuations in revenue by spreading investment risks over
different product categories. Taken together, within-industry diversification therefore enables
firms to realize multiple economies of scope by exploiting synergies between different product
categories to increase their performance.
Costs of within-industry diversification
When diversifying within their industry, managers contend with the need to transfer indivisible
resources to new product categories as well as the need to share resources between different
product categories, which respectively leads to two major types of costs: “adjustment costs”
and “coordination costs.” Adjustment costs are stimulated by the need to transfer and adapt
resources to different product categories, while coordination costs result from the need to share
and create effective linkages between the resources used for different product categories. In
essence, adjustment costs relate to the imperfect utilization of resources in specific domains,
whereas coordination costs relate to the simultaneous use of resources across domains. Both
types of costs imply a suboptimal utilization of firm resources where within-industry
diversification is concerned.
To a large extent, the two types of costs are shaped by an important attribute of resources,
that is whether resources are “scale free” or “non-scale free”.
- Scale-free resources: Resources whose use for a given task is independent of their
use for other tasks. In many respects, such resources constitute a within-firm “public
good.” Technological knowledge is a typical example of this kind of resources.
4
