Royal Holloway University of London

“SYNERGY IS THE ONLY JUSTIFICATION
FOR A FIRM’S DIVERSIFICATION.” DISCUSS. 

by

Rüdiger Wolf

1. IS SYNERGY THE ONLY JUSTIFICATION FOR A FIRM’S DIVERSIFICATION?  4

a. What are Synergies?  4
b. What is Diversification?  5

2. POSSIBLE MOTIVES FOR DIVERSIFICATION 6

a. Growth 6
b. Risk Reduction  6
c. Profitability 7
d. Increased Market Power  7
e. Economies of Scope 8
f. Internalizing Transactions 8
g. Information Advantages  9
h. Reducing Entry Barriers 9

3. CONCLUSIONS  9

1. Is synergy the only justification for a firm’s diversification?

Synergy is commonly regarded as a justification for a firm’s diversification. But, is it the only one? Or to continue that thought, is it a justification for a firm’s diversification at all? My intention in this essay is to investigate the role of synergies in the decission-making process that leads to the diversification of a company. To find an answer to that problem, we will first have to take a look at what the terms “synergy” and “diversification” actually mean. After that, I will go on to discuss what possible other reasons there might be for a firm to diversify.

a. What are Synergies?

To find out about their role in that process, it is necessary to first have a look on what synergies are and how they can be created. Obviously it is possible to create synergies by diversification. Sharon M. Oster writes: “The strategic management literature emphasizes the role of diversification in creating synergies. Two business units have synergies if their union allows for opportunities not available to either seperately.”⁰ So, this definition of synergy says that new opportunities emerge from making use of shared resources. If we take that as given, it is of course important to distinguish between real and imagined synergy. “Even synergy that is clearly defined often fails to materialize. Instead of cooperating, business units often compete.”¹ Here, Porter mentions imagined synergies and also gives us an explanation why diversifcation does not necessarily lead to real synergies. Because of competition rather then cooperation among business units. Why is it then, that diversification is so popular among managers? We will return to that interesting point in more detail further down the text.

b. What is Diversification?

As synergy can be created through diversification, it is of course essential to find out about the different manifestations of diversification. “The lack of a clear-cut definition of diversification stands as both a problem and an opportunity for the researcher; he shoulders the burden of developing his own concept of diversification, but enjoys the freedom of tailoring a concept to suit his interests.”²

Generally, diversification can be devided into three groups: horizontal, vertical and geographical diversification. Horizontal diversification describes companies that are engaged in several different industries, whereas vertical diversification or integration exists in two variations. “An organization that begins to produce its own inputs is said to have vertically integrated in the upstream market, or, equivalently, to have engaged in backward integration.[…] An organization which begins to market its own goods has vertically integrated downstream, or in a foreward direction”3 The third possibillity of diversification describes the geographical spread of the firm’s activities.

Those definitions lead us directly to the next question: up to which dimensions does diversification actually make sense? Concerning horizontal dversification, a possible answer to that question is as follows: “To the extent that an organization extends its product line to take advantage of synergies or economies of scope, it will look for products that are related to its current offerings. 

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0 Sharon M. Oster, Modern Competitive Analysis, Second Ed., Oxford University Press, 1994, 184

1 Michael E. Porter, Competitive Strategy, The Free Press, 1980, 244

2 Richard P. Rumelt, Strategy, Structure and Economic Performance, Harvard Business School Press, 1974, 9