Diversification and firm competence and performance

1. Diversification and firm competence

In general, scholars agree that core competence of the firm is the primary driver of its successful diversification. By definition, core competency is the expertise in profession, skills in the main and direct business giving a competitive advantage over competitors (Prahalad and Hamel, 1990); they are built from valuable, rare, inimitable and non-substitutable ressources (Barney, 1991).

Wang Jiang (2007) considers core competencies as the foundation for firm diversification. It means that firms should diversify on the basis of combining core competencies, but not just focusing on specific products and services. This combination, whether in the form of “diversification” or “specialization”, is still essentially based on the core competencies of firms.

Similarly, Cao Yanai (2009) believes that firms decide to diversify or specialize mainly on the productivity and flexibility of their core competencies. Specifically, firms possessing strong but less flexible core competencies should adopt the related specialization and diversification strategy. On the contrary, firms having both strong and flexible core competencies can choose the strategy of related and unrelated diversification. This confirms that core competencies play a critical role in choosing diversification strategy of firms. Yanqing (2014) also pointed out that the core competency is a factor of internal dependence and the basis of diversification; and diversification becomes the driver encouraging the firm’s core competencies. The diversification and core competencies should be integrated and developed together on the basis of firm’s core competencies.

Wang Wangyu (2009) also agree with the impact of core competencies on corporate diversification strategy. Accordingly, firms will develop important management resources and the ability to transfer their core competitiveness from the current industry to the target one. The core competitiveness is vital for diversification strategy of the firm.

Thus, successful diversification must be based on firm’s core competencies; core competitiveness plays a moderator role on the relationship between diversification degree and firm performance. The application and development of core competitiveness must be based on effective diversification management (Sun Lei, 2005). Core competitiveness is at the heart of diversification strategy.

2. Diversification and firm performance

In the litterature, there are four different points of views on the impact of the diversification strategy, or the relationship between the degree of diversification and firm performance. Specifically:

Firstly, many scholars point out that the higher the degree of diversification, the higher the firm performance. Varadarajan (1986) argues that the larger the number of products, which means the higher the degree of diversification, the higher the firm performance. John and Ofek (1995), studying a random sample of 321 firms in different fields; confirm that the profits of firms implementing unrelated diversification strategy (developing markets, products beyond their own capabilities) increase significantly compared to those of other firms. Amit and Livnat (1988) also draw same findings about the positive impact of diversification on firm performance by reducing cash flow fluctuations and reducing business risks. According to Li and Kami (2010), diversification can form an internal capital market by reducing the cost of raising capital, thereby improving the firm performance.

Secondly, some scholars argue that the degree of diversification has a negative impact on firm performance. In the investor’s perspective, Comment and Jarrel (1995) indicate that diversification does not have a positive effect on firm performance; in contrast, the higher the degree of diversification, the lower the equity’s ability to payback. Doukas et al. (2002), studying a sample of 100 Swedish firms, find that indiscriminate mergers and acquisitions of unrelated business fields reduce firm performance. In US property insurance industry, Li Benberg (2008) shows also that specialized firms have higher performance than diversified firms.

Thirdly, some studies show that the degree of diversification has a non-significant impact on firm performance. Ravenscraft (1987) does not find a clear relationship between the HHI (Herfindahl – Hirschman Index, a measure of capital market concentration) and the gross profit margin of firms. Montgomery (1985) finds also that firms involving in higher degree of diversification have lower rates of ROI (return on investment) than firms having no or less diversification; however, taking into account the influence of technology, this relationship is not clear, diversification does not have a significant impact on the financial performance of firms. Ferris et al (2002) argue that it is impossible to confirm an absolute relationship between the degree of diversification and firm performance; so that diversification decisions should be based on firms’ resources and growth opportunities in each period.

Fourthly, some scholars find that the degree of diversification and firm performance has an inverse “U”-shaped relationship. According to Markides (1995), the greater the degree of diversification increases, the lower the marginal benefit of the firm. These findings is similar to the ones of Palich, Cardinal and Miller (2000).

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