Round Table
Diversification Strategy and
Firm Performance
Madhusudhan
Prasad Varanasi
Madhusudhan Prasad Varanasi is Associate
Professor, School of Management Studies,
Jawaharlal Nehru Technological University,
Hyderabad.
drvmprasad@yahoo.com.sg
IIMB Management Review, September 2005
C
orporate diversification has long been the engine of new product
development. Yet, of all the outstanding characteristics of business
firms, perhaps the most inadequately treated aspect is the
diversification of their activities1. This article examines the core issues behind
product diversification — its conceptualisation, categorisation and
measurement, and the rationale behind constructing a theoretical framework
of diversification – through the Traditional Theory and Neoclassical Theory
approaches of Economics, and the managerial explanation or the doctrine of
managerialism. It surveys the studies on diversification and firm performance,
in particular those that have addressed themselves to the relationship between
a firm’s degree of diversification and subsequent performance – a question
that has been in the forefront of issues relating to corporate strategy.
Diversification has been employed by business firms since early days. In its
early application, diversification came either by intuition or by accident. In
several cases, the desire to reduce the risk of an existing line of business led to
organisations embarking on a new project. Historically, in India, business
houses floated firms and projects which had great diversity of products,
processes, markets and technology.
Diversification emerged as a phenomenon coincidental with rapid spurts in
technology and breakthrough research in electronic and digital control systems
that produced revolutionary changes in consumer and capital markets and
substantially leveraged the utilisation of the resources of an organisation.
Governmental policies and regulations can also be considered as a spur to
corporate diversification in countries like India.
Montogmery2 identifies three basic reasons that drive a firm’s decision to
diversify. The first one, identified as the Market-power view, is seen in
conglomerate firms. The second reason confirms the Agency view: as a
consequence of a separation of ownership from control in modern firms, it
is in the interest of managers to adopt diversification, for it may ensure a
97

The problem in the area of
corporate diversification is the need
to evolve an appropriate approach
to classify firms and then examine
the relationship between
diversification and performance,
particularly financial performance.
Attempts to evolve a commonly
accepted measure of
diversification have met with only
partial success.
number of benefits to this group. It may mean enhancement
of status, flow of additional remunerative benefits and finally,
provide an insurance against economic failures. The third
reason, termed the Resource view, emanates from the
possibilities that arise when a firm has excess resources that
can be put into productive use elsewhere.
The Concept of Diversification
The conceptualisation of diversification has closely followed
industry practice over a long period. The primary emphasis
of researchers has been on new products, new processes and
new markets as indicators of diversification by an existing
firm. Steiner describes diversification as entering new into a
product or service or new markets involving significantly
different skills, processes and knowledge; Gort defines
diversification in terms of heterogeneity of output serving
separate markets with low cross elasticities of demand and
non-shiftability of resources in the short run. Berry identifies
diversification with just an increase in the number of industries
where firms are active. Kamien and Schwartz consider
diversification when firms classified in one industry produce
goods classified in another. According to Pitts and Hopkin
firms diversify when they operate in different businesses
simultaneously. Booz, Allen and Hamilton perceive
diversification when firms spread the base of their business
to improve growth and/or reduce overall risk3.
A more recent development is the concept of related
diversification. This occurs when a company manufactures
products using a common production facility or a technology
which is already being used by it or gets vertically integrated
i.e., it integrates successive stages of production (backward
98
or forward) into one common unit or enters into markets
characterised by identical distribution and other marketing
systems. When firms produce goods and services which are
not related technology wise or market wise then the firm is
said to be following pure diversification mode or unrelated
diversification strategy4.
Classifying and Measuring Firm Diversity
The problem in the area of corporate diversification is the
need to evolve an appropriate approach to classify firms in
various diversification groups and then examine the
relationship between diversification and performance in
general and financial performance in particular.
Attempts to evolve a commonly accepted measure of
diversification have met with only partial success. Research
in the area has been prompted by a spectrum of academic
interests, being anchored to Business History, Economics,
Business Policy, and Public Policy each with its main focus of
study. All these studies have defined diversification in the
context of their respective objectives. A survey of literature
on diversification suggests that there are two fundamental
ways of conceptualising and measuring firm diversity viz., by
Business Count and by Strategy.
Business Count Approach
This approach is premised on a head count of the number of
products manufactured by a firm. These products are then
disaggregated for the revenue they generate for the firm
during an accounting period. The information thus derived is
utilised to construct an index of diversification like the
Herfindahl Index and Entropy Measure5. Though the business
count approach appears numerically straight and
mathematically specific, there are limitations in using the
business count approach for a causal relationship between
diversification and performance. Hence, statistically and
logically, the more acceptable approach is the strategy based
measure.
Strategy Approach
Organisations the world over have chosen to follow different
growth paths whether by intuition or accident or rational
choice. In most cases, the goal was to achieve better results
and financial performance, but this did not always follow.
Consequently, the connection between diversification and
firm performance was not seen as an undisputed relationship.
In the process of investigating the relationship, attempts were
Diversification Strategy and Firm Performance
made to define both the dependent and the independent
variables i.e. financial performance and diversification,
respectively. Diversification has been classified and
categorised variously. While classifications of diversification
such as Rumelt’s seminal one (see box) help establish a ‘pattern
of relationships’ among businesses, the lack of ‘objective
standards’ raises the possibility of several researchers studying
the same firms but arriving at somewhat different
classifications6.
Simultaneously, measures of financial performance are also
identified to reflect both the financial health and the revenue
yielding capacity of the firm. The dependent variable is
invariably expressed in the form of ratios.
A firm’s diversification strategy is defined as its commitment
to diversity per se, together with the strengths, skills or
purposes that span this diversity, shown by the way in which
business activities are related to one another.
Categorisation of Diversification
Rumelt defined four major categories of diversification, further
divided into sub categories. According to him in any given year
a firm’s diversification strategy may be described as
corresponding to one of the following categories:
Single Business
Business: A firm deriving more than 95% of annual
revenues from the base business, i.e., firms that are basically
committed to a discrete business area.
Dominant Business
Business: A firm deriving 70-95% of annual revenues
from the base business. Firms that have diversified to some
extent but still obtain the preponderance of their revenues from
a discrete business area.
Dominant Constrained
Constrained: A dominant firm in which all component
businesses are directly related to the base business.
Dominant Linked
Linked: A dominant firm in which all component
businesses are related but are not related to the base business.
Related Business
Business: A firm deriving less than 70% of revenues
from the base business and where diversification has been
achieved by “relating” new activities to old. This relatedness is
defined in markets served, distribution systems, production
technologies, or the exploitation of science-based research.
Related Constrained
Constrained: A related firm in which all component
businesses are directly related to the base business.
Related Linked
Linked: A related firm in which component businesses
are not all directly related to the base business.
Unrelated Business
Business: A firm deriving less than 70% of revenues
from the base business and where diversification is unrelated.
Source: Rumelt, R P, 1974, Strategy, Structure and Economic
Performance, Harvard University Press, Cambridge, M A.
IIMB Management Review, September 2005
The primary measure of diversification is taken to be the
specialisation ratio, defined as the proportion of a firm’s
revenues that is attributable to its largest discrete product-
market activity. A discrete business (or product-market
activity) is one that is strategically independent of the firm’s
other businesses, so that basic changes in its nature and scope
can be made without meeting constraints imposed by the
firm’s other businesses and without materially affecting the
operation and strategic direction of the firm’s other
businesses7.
Businesses are related to one another when a common skill,
resource, market, or purpose applies to each. A firm’s related
ratio is defined as the proportion of its revenues attributable
to the largest group of businesses that are related in some
way to one other business in the group (linked relatedness),
though it may be related to all and all may be directly related
to one another (constrained relatedness).
There have been several attempts to build a theoretical
framework of diversification. Economists have attempted to
build theories of diversification based on the traditional and
neo-classical theories of firm.
Theoretical Framework of Diversification
The theory of the firm has yet to formally incorporate the
multi-product character of business enterprises in the main
body of its analysis. As a first step, this may require a
modification of the Neoclassical theory of the firm so that
the distinctive properties of organisational knowledge and
the cost properties of various transactions are emphasised. It
is also necessary to make an analytical separation between a
theory of diversification and a theory of growth since growth
and diversification do not seem inextricably linked. A central
issue for a theory of multi-product organisation is to explain
why firms diversify into related and unrelated product lines
rather than reinvesting in traditional lines of business or
transferring assets directly to shareholders.
Firms and markets interact with each other to evolve a
configuration which continually builds on complementary
products and yields economies in production and transaction
costs. This would imply that firms add to the range of their
products depending on the market conditions and also on
the extent to which they can reduce their production and
transaction costs. Such a situation could lead a firm to
produce a heterogeneous output which serves several
markets. Two views can be combined to work out the initial
constructs of a theory of diversification. One approach focuses
99

Another class of theories explaining
diversification is based on the
doctrine of managerialism. In Marris’s
growth maximising managerial
enterprise, managers bring not only
the existing supply and demand for
resources into line, but also their
future rates of growth. Firms are
usually multi-product, and
diversification into new products
is the main engine of
corporate growth.
on the same firm engaged in a vertical integration process as
determined by market forces8 while the other focuses on
two or more firms integrating together within a market
determined framework9. The principal difference between
the two can be explained in terms of the type of transactions
being internalised. Whereas vertical integration internalises
the supply of tangible inputs to a single production process, the
integration of firms (or diversification) internalises the supply
of know-how and inputs common to two or more production
processes. In fact, diversification can act as a vehicle for realising
interaction economies associated with the simultaneous
supply of inputs and processes, geared to distinct final-product
markets.
Traditional Theory
Traditional theories of the firm concentrate on profit
maximisation as the basic tenet for manufacturing more than
one product. A multi-product firm will decide about the
amount of each product to be manufactured in a way that
the ratio of marginal revenues of each pair of products equals
the ratio of their marginal costs. Such optimum solution
strategies may, however, be disturbed in cases of imperfect
competition, by the efforts of entrepreneurs to manage
uncertainty according to their respective attitudes toward
risk, and the eternal quest for new products given the tendency
of on-going products to stagnate on saturated demand.
While the economic case for a maximising firm is strong, the
traditional theory ignores the non-economic reasons
influencing the empirical behaviour of firms10.
100
Neoclassical Theory
The Neoclassical theory of firm generally assumes profit
maximising entities operating in competitive product and
capital markets exhibiting zero transactions costs and
competitive equilibrium. Under these assumptions, it is
virtually impossible to erect a theory of the multi-product
firm11. A pure diversification rationale for a multi-product
firm is not valid within the context of orthodox theories of
financial markets. Multi-product firms can merge within an
economy operating under neoclassical competitive
assumptions, but they must do so only by accident. Whether
firms are organised along specialised or multi-product lines
is economically irrelevant since market arrangements and
internal organisation are perfect substitutes. Thus, divesting
multi-product firms or diversifying specialised ones is a
transformation lacking economic significance in the context
of a neoclassical economy. Jensen and Meckling pointed out
that ‘the literature of economics has several references to the
theory of firm, they actually reflect a theory of markets in
which the firms are important actors’12.
Managerial Explanation
As an adjunct to economic analysis to determine reasons and
formulate theories as to why firms diversify, is another class
of theories explaining diversification based on the doctrine
of managerialism or strategic management. Marris13 and
Mueller14 have made important contributions in this area. In
Marris’s growth maximising managerial enterprise, managers
not only bring the existing supply and demand for resources
into line, but also their future rates of growth. Thus, the
equating of the growth of supply of resources and that of
demand for them is in an equilibrium condition. In identifying
the main determinants of the growth of demand, Marris
recognises that firms are usually multi-product and that
diversification into new products is the main engine of
corporate growth. Thus, in order to grow any faster than the
rate of growth of the market in which the firm establishes
itself, it must carry out further successful diversification.
However, there are significant costs attached to successful
diversification and these costs reduce the firm’s rate of return
on capital. The growth of demand is, thus, an inverse function
of the rate of return on capital because faster growth of
demand via more rapid diversification either requires a lower
profit margin, or leads to a higher capital output ratio, both
of which reduce the return on capital.
The core of Mueller’s theory is that managers are motivated
to increase the size of their firms further. He assumes that the
Diversification Strategy and Firm Performance
compensation to managers is a function of the size of the
firm and he argues, therefore, that managers adopt a lower
investment hurdle rate. The lower investment hurdle rate
prompts the managers of older, larger and mature firms to
invest more heavily than they would if they were confronted
with a higher hurdle, and represents a basic motivation for
diversification. However, the basic premise of the theory that
the compensation is a function of the size of the firm is
problematic. In a study critical of earlier evidence, Lewellen15
found that managers’ compensation is significantly correlated
with the firm’s profit rate and not its level of sales. Thus,
Mueller’s theory has to fall back on the non-pecuniary
benefits such as status and visibility in the business community
which managers may obtain from managing larger
enterprises.
Managerial motives may well explain a portion of observed
diversification activity. Diversification can also be efficiency
driven. Managerial explanations delineate the nature of
possible efficiencies, thereby providing the foundations for
an efficiency-based theory of the multi-product firm. This
theoretical exploration is of relevance to managers and policy
analysts since a framework is developed within which it is
possible to assess the likelihood that economies can be
captured through corporate diversification strategies. Within
this framework, the firm is conceptualised as a structure
designed to organise the employment of various assets which
have greater value when employed under the internal control
apparatus of a firm than under the external control apparatus
of a market.
Studies on Diversification and Firm Performance
Studies of corporate diversification have provided much of
the grist for managerialist theories. They have explored several
hypotheses in the field, focusing on knotty issues and
contributing to theory building. Over the last two decades,
the relationship between a firm’s degree of diversification
and subsequent performance has been extensively researched
in the literature on strategy16.
A question that has been in the forefront of issues relating to
corporate strategy is whether firms that diversify into related
lines of business outperform firms that choose
conglomeration. Since the publication of Rumelt’s study17, a
number of efforts have been made to replicate18, refine19 and
explain20 his diversification framework and findings. Rumelt
investigated the relationships among diversification strategy,
organisational structure and economic performance. Using
a carefully conceptualised measure of diversification, Rumelt
IIMB Management Review, September 2005
A question that has been in the
forefront is whether firms that
diversify into related lines of
business outperform firms that
choose conglomeration.
Investigating the relationships
among diversification strategy,
organisational structure and
economic performance, Rumelt
found that related diversification
strategies outperformed other
diversification strategies.
was able to demonstrate a clearer linkage between
diversification category and performance compared to other
researchers who used simpler measures of diversification.
Related diversification strategies were found to outperform
the other diversification strategies on the average.
Other researchers across nations, mainly from the UK, Europe
and Japan, based on partial replication of Rumelt’s study, also
observed similar patterns of diversification with some
differences. Research studies on diversification in the Indian
context though few and far between, have been found to
support Rumelt’s findings. Shekhar Choudhuri et al and
George Paul21 performed a statistical analysis and found that
firms pursuing related diversification outperform firms
pursuing unrelated diversification in general and in particular
on indicators of growth, profitability, safety and market
evaluation. Differences in performance on account of
industry characteristics remain unaffected by diversification.
Thus, while firm level diversification is meaningful, industry
level diversification may not be fruitful. A study on
diversification and financial performance of a sample 117
Indian companies from the Forward Cash and B1 group
listed on the Bombay Stock Exchange22, followed the
methodology similar to the Rumelt’s categorisation of product
diversification and found some interesting insights into the
relationship between strategic categories and financial
performance.
However, studies centred on the hypothesis that unrelated
diversifiers outperform related diversifiers are growing in
number23. At the same time there are studies which did not
101

Cross-sectional studies do not
seem to be successful in
determining the true causal
relationship between diversification
and performance for the reason
that they employ a number of
diverse industrial units across
industry groups. The industry
specific effects of diversification
which are quite powerful, and the
complexities of the relationship, are
lost in the analytical procedure.
find any relationship between diversification and
performance24. They also found no significant difference
between related and unrelated diversification strategies.
Later studies employing Rumelt’s sample and diversification
categories incorporated market characteristics, such as
market share, market growth and firm size, and measures of
risk in the analysis of the relationship between diversification
and performance. These studies indicated that the type of
market in which a firm operates affects performance and
that related diversification aids, but does not insure favourable
performance. Montgomery25 observed that performance
differences across diversification strategies occurred due to
differences in industry structures and performance at business
unit level. Christensen and Montgomery26 noted that market
structure variables have a moderating effect on the
diversification- performance link. Montgomery27 found that
highly diversified firms compete in less-attractive markets,
have lower market share, and are less profitable than less-
diversified firms. Wernerfelt and Montgomery28 reported that
efficient diversifiers, which they defined as firms pursuing
related types of diversification focusing on specific related
skill, perform better than inefficient diversifiers when they
compete in highly profitable industries. On the other hand,
they found that inefficient diversifiers were found to benefit
more from markets with high growth compared to efficient
diversifiers.
Bettis and Hall29 observed that the superior returns attributed
by Rumelt to related diversification may be due largely to
industry effects. Further, unrelated firms do not have superior
risk pooling characteristics. They also noted that different
102
diversification strategies have different risk profiles. However,
different diversification strategies could also result in similar
risk/return profiles30. Performance differences between
related and unrelated firms in Rumelt’s study were largely
due to the over representation in the related constrained
category of firms from one industry noted for high levels of
profitability (pharmaceuticals). The differences noted by
Rumelt disappeared after correcting for this bias in the sample.
Bettis and Mahajan31 remarked that related diversification is
a necessary but not a sufficient condition to achieve a
favourable risk/return performance. Firms in efficient clusters
(relatively high performance at a medium risk level) tend to
be in higher growth industries and have relatively lower level
of debt financing.
Apart from studies relating diversification strategies and
financial performance, many researchers attempted to know
the impact of structure of the organisation, compensation,
R&D intensity, promotional intensity, internal diversification
mode vs external diversification mode, nature of acquisitions,
conglomerate mergers, managing diversification, the process
of management of change, regulatory environment, intensity
of monitoring, age and size of the firm, stage of industrial
growth, and so on.
Conclusion
While there is much scope for further research in the area of
diversification and firm performance, there have been two
major lacunae in the existing studies on diversification.
• Cross-sectional studies do not seem to be successful in
determining the true causal relationship between
diversification and performance for the manifest reason
that a cross-section study employs a number of diverse
industrial units across industry groups at a given point of
time and it would appear that the industry specific effects
of diversification which are quite powerful, are lost in the
analytical procedure. In fact, by examining diversification
independent of its industry context, prior studies may have
glossed over the complexities of the relationship and
performance.
• A more meaningful causal relationship between
diversification and financial performance can be focused
if the product-wise revenues of a business firm are
appropriately and consistently disaggregated. Most existing
studies have not done this, more particularly in the Indian
context.
Ideally speaking the relationship between diversification and
Diversification Strategy and Firm Performance
financial performance at the business unit level must be
focused (from the stand point of building a theory of
diversification) on a product or service division of a firm. But
evaluation of performance on this basis is handicapped by
non-availability of normative criteria like divisional
performance evaluation bench-marks. Another important
aspect relates to the mode in which firms diversify. There are
two known modes in which firms can possibly diversify, viz.,
through internal business development and by acquisitions
and mergers. It is obvious that financial performance would
be variously affected when internal business development
leads to the emergence of a ‘core competency’ or when an
existing firm acquires another firm in related or unrelated
areas of activity. Though it may not be possible to say which
of the two routes would be more conducive to superior
performance, differences do exist and research would
produce mixed results. Research studies on diversification in
the Indian context are few and far between. In the light of the
above mixed results and the impact of liberalisation,
privatisation, globalisation, increasing foreign investments,
geographic diversification strategies and the like, there is much
scope for further research in this area of strategic importance.
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IIMB Management Review, September 2005
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104
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2 5 Montgomery, C, ‘ Diversification, Market Structure and Firm
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3 1 Ibid.
Reprint No 05307b
Diversification Strategy and Firm Performance