What is the Optimal Level of Diversification for Firm Performance?

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Stefka Nenkova
Student (University), Netherlands

What is the Optimal Level of Diversification for Firm Performance?

The relationship between diversification and financial performance has been a topic of research for many years but is yet to reach a consensus. However, there are several suggestions on how diversification could influence a company's performance, depending on the type or level of diversification:
  • LINEAR MODEL – Gort (1962) argues that diversification has a linear and positive influence on performance based on the concepts of market power advantages (involving tactics like predatory pricing or reciprocal buying and selling) and internal market efficiencies (an argument pointing that a diversified firm is more flexible in capital formation since it has an access to internally generated sources in addition to any other external sources and could “shift” capital between business units in its portfolio). However, albeit their conceptual appeal, this notion has little empirical evidence as it yields mixed results in practice.
  • INTERMEDIATE MODEL – Markides (1992) supports the view that diversification leads to increasing returns up to a point of optimization, beyond which the level stays relatively the same.
  • INVERTED-U MODEL – Parish, Cardinal and Miller (2000) hypothesize that “diversification is positively related to performance across the low to moderate range of diversification and it is negatively related to performance across the moderate to high range of diversification”, meaning that the relationship is inversely U-shaped.
Here is some explanation on the range of diversification, which could be:
- single, for a firm that does not diversify,
- limited for a firm that focuses on a single industry thus limiting its leverage opportunities,
- related for firms that become involved in several different but related industries, or
- unrelated for firms that diversify in multiple different unrelated industries.

Note that single and limited diversification are not really diversification in the strategic sense of introducing new products in new markets. Parish, Cardinal and Miller’s results suggest that firms with limited and related diversification strategies have in general better performance than single-business firms and firms with unrelated diversification strategies. In other words, diversification leads to increase in the performance up to a point, after which the costs of the diversification become greater than the benefits and that leads to decrease in the performance.

The relationship between diversification and performance is still not completely conceptualized and the reasons could be found in the presence of different external and internal factors that can influence and change the shape of that relationship.
Sources:
Gort, M. (1962) “Diversification and Integration in American Industry”, Princeton University Press, Princeton, NJ.
Markides, C. C. (1992). “Consequence of Corporate Refocusing: Ex Ante Evidence”, Academy of Management Journal, 35, pp. 398–412.
Palich, L., Cardinal, L., Miller, C. (2000) “Curvilinearity in the Diversification-Performance linkage: An Examination of over Three Decades of Research”, Strategic Management Journal, 21, pp. 155-174

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