Maria Cristina Fenoglio The independent and joint effects of the skill and physical bases of relatedness Farjoun, Moshe (1998) Strategic Management Journal, 19 (7): 611-630 Maria Cristina Fenoglio

Relatedness “The logic and extent by which a firm’s different lines of business (or industries) are connected” Important research and practical implications (Rumelt, 1974; Wrigley, 1970) Firms and industries can be viewed as collection of interrelated activities (Porter, 1985) and resources (Penrose, 1959) Relatedness between a firm’s different lines of business (or industries) can manifest itself along many different dimensions Fundamental bases of relatedness (Chandler,1962; Chatterjee and Wernerfelt, 1991; Penrose, 1959; Rumelt, 1974; Teece,1982): Physical base Skill base

Motivation and Main objective Motivation: to present a recently developed approach that captures the skill base of relatedness (Farjoun, 1994), coinciding with growing interest in intangible resources (Barney,1991; Mahoney and Pandian, 1992; Penrose, 1959; Teece, 1982; Wernerfelt, 1984) Objective: to develop the notion of Relatedness as multidimensional, juxtaposing physical and skill bases

Research questions How do the skill and physical bases differ in the ways they identify relatedness in the same set of industries (or lines of business)? What are the separate and joint contributions of the two approaches in explaining firm performance differences?

Effects of physical and skill bases Their indipendent effects: each base highlights a distinct view of firms, production and diversification, pointing to particular benefits associated with relatedness Economies of scope Physical base ‘s performance benefits (Teece, 1982) Economies of scale (Porter, 1985) Skill base’s performance benefits Learning Innovation Cost reduction

Effects of physical and skill bases Hypotesis 1a: The level of related diversification as indicated by the physical base of relatedness will be positevely associated with financial performance Hypotesis 1b: The level of related diversification as indicated by the skill base of relatedness will be positevely associated with financial performance

Effects of physical and skill bases Their joint effects: strong complementary nature each base extends the other combination of the physical and skill bases may affect performance Hypotesis 2: The level of related diversification as indicated by a combination of both the physical and skill dimensions will be positevely associated with financial performance

Method Focus: manufactoring sector Sample selection: Diversified firms (operating in more than one 3-digit SIC *code), based in manufacturing industries, in 1985 Fortune 500 list, with at least 90% of sales in manufacturing final sample set of 158 firms *Standard Industrial Classification

Method Skill base of relatedness: Physical base of relatedness: Construction of industry skill profiles, using Occupational Employment Survey (OES) at the Major Group level of detail and further differentiating groups primarily relevant to manufacturing final profile includes 38 occupational variables Physical base of relatedness: Determined from the SIC code (relation assessed on physical attributes of the product) 96 manufacturing industries

Method

Method Identifying relatedness by the skill and physical bases: The two systems will agree that industries are related when they employ similar production technology and they require similar skills and use similar physical processes

Method Measures of level of relatedness (extent of a firm’s within group diversification): Entropy measure of diversification (Amit and Livnat,1988; Hall and St. John, 1994; Palepu, 1985), which uses in its computation only sales from manufacturing lines of business. For each of the 158 diversified firms, lines of business belonging to the same industry group were given the same industry group identification: the less a firm’s sales were dispersed across different industry groups, the higher was the related component of the Entropy measure. The ratio to related-to-total diversification indicates the extent to which a firm’s diversification is related (3 measures: Ratio Physical; Ratio Skill; Ratio Joint).

Method Performance measures Representing both accounting and market-base indicators of performance: Return on Assets (ROA); Return on Sales (ROS); Market-to-book ratio (MBOOK); Jensen’s alpha (ALPHA) (Hoskisson et al., 1993; Nayyar, 1992b): firm performance against a portfolio with similar market risk

Analyses and results (Q1)

Analyses and results (Q2)

Analyses and results (Q2) Effects of firm-related diversification on ROA

Analyses and results (Q2) Effects of firm-related diversification on market-to-book ratio

Conclusions Industries or lines of business viewed as related from one standpoint can be viewed as unrelated from another (Q1 supported) Neither base by itself is associated with strong performance effects (Q2 Hypothesis 1 non supported) When diversification is related on both the physical and the skill base a strong effect of relatedness on performance emerges (Q2 Hypotesis 2 supported)

Conclusions “A multidimensional view of relatedness can further our understanding of cooperation, competition, and, even more fundamentally, the underlying reasons for the existence of firms as value-creating institutions”