The Independent and Joint Effects of the Skill and Physical bases of Relatedness in Diversification Farjoun, 1998, Strategic Management Journal Presented by Jenna Moore

Overview  Motivation of study: Present approach that captures the skill base of relatedness (i.e., the human element)  Purpose: Develop a conceptualization of relatedness that is multi-dimensional  No prior study had used a skill-based measure of relatedness  Through juxtaposition of physical and skill bases, Farjoun (1998) elucidates a better understanding of underlying assumptions and advantages/ disadvantages of these bases

Overview  Research questions: 1.How do the skill and physical bases differ in the ways they identify relatedness in the same set of industries (or lines of business)? 2.What are the separate and joint contributions of the two approaches in explaining firm-level performance differences?

Separate effects of physical & skill Bases of Relatedness  Physical bases: firms and industries as collections of material resources (e.g., raw materials, plant and equipment, etc.)  More observable than skills  More product-specific, so range of applicably across industries is limited  Performance benefits are through economies of scope and scale

Separate effects of physical & skill Bases of Relatedness  Human bases: firms as interrelated bodies of human knowledge  Can be difficult to observe  Have room for improvement and learning, knowledge transfer across domains  Performance benefits are through continued learning, knowledge transfer, and innovation  ‘Dynamic reciprocity’

Separate effects: Hypotheses  Hypothesis 1a: The level of related diversification as indicated by the physical base of relatedness will be positively associated with financial performance  Hypothesis 1b: The level of related diversification as indicated by the skill base of relatedness will be positively associated with financial performance

Joint effects of Physical & Skill Bases of Relatedness  Physical and skill bases are complementary— each base extends the other  They interact and overlap (e.g., as in car production)  Affect performance in 2 ways: 1.More potential interrelationships are identified 2.When physical resources (e.g., common components) and skill resources (e.g., precision production skills) are combined, cost and learning benefits will accrue

Joint effects: Hypothesis  Hypothesis 2: The level of related diversification indicated by a combination of both the physical and skill dimensions will be positively associated with financial performance

Method  Sample Selection: Diversified manufacturing firms on the 1985 Fortune 500 list  Manufacturing focus because: (1)vertical integration is widespread and (2) the occupational skill profile should be refined to sector-specific occupations  Each industry was characterized by skill and physical bases of relatedness  Levels of relatedness were measured using Entropy measure of diversification

Method  Performance measures: (1)ROA, (2) ROS, (3) MBOOK (market to book ratio), and (4) Jensen’s alpha  Taken together, they represent accounting and market-based performance indices  Industry control variables: used industry dummy variables for the firm’s primary industry  Controls for industry structure effects on performance

Results  Identifying physical relatedness: Share similar raw materials, end use, or physical aspects of production  Identifying skill relatedness: Share similar production, engineering, administration, and marketing and service skills

Results  Relationship between relatedness and performance:  H1a: The level of related diversification as indicated by the physical base of relatedness will be positively associated with financial performance (Not supported)  H1b: The level of related diversification as indicated by the skill base of relatedness will be positively associated with financial performance (Not supported)  H2: The level of related diversification indicated by a combination of both the physical and skill dimensions will be positively associated with financial performance (Supported)

Conclusions  When diversification was related on physical and skill bases, relatedness had a strong effect on performance  Provides support for the complementary benefits of the two bases  Joint effects influence performance by: (1) extending range of benefits, and (2) reinforcing those benefits when the two bases agree  A multi-dimensional view of relatedness furthers our understanding of the reasons underpinning the existence of firms as value creating entities

Implications  Practical implications (diversification decisions):  A more conservative definition of relatedness is important—include combination of key bases  Integrating across business units with highly complementary skill and physical bases is most beneficial  Theoretical implications:  Future research should examine other important bases of relatedness (e.g., customer group similarity in service industries), other measures of performance, and should better isolate effects of within-sector vertical integration