Synergy, Coordination Costs and Diversification Choices

Sharing common inputs across business lines can potentially generate synergy that justifies related diversification. The pursuit of such synergy through diversification is, however, fundamentally driven by the indivisibility of inputs between firms. Following Penrose’s insight, I argue that to realize the synergy a firm needs to actively manage the interdependencies between different business lines, which increases its coordination costs. The coordination costs may increase faster than synergy and set a limit to related diversification. This is particularly salient when the firm’s existing business lines already have complex interdependencies among them. I test these arguments on a dataset of U.S. equipment manufacturers from 1993 to 2003. 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.