Cross Business Synergies

EXPLORING CROSS-BUSINESS SYNERGIES

JEFFREY A. MARTIN Department of Management Science and Engineering

Stanford University 395 Terman

Stanford, California 94305 Tel: (650) 723-5736 Fax: (650) 723-8799

Email: [email protected]

KATHLEEN M. EISENHARDT Department of Management Science and Engineering

ABSTRACT

Our contribution is an integration of a vast literature on cross-business synergies. First, we observe three major sources of synergy: economies of scope, market power, and internal governance advantages. Second, we identify three important processes that become particularly important to synergies as market dynamics increase: knowledge-transfer, co-evolving (relinking), and patching.

INTRODUCTION The pursuit of synergy is at the heart of the rationale for the existence of the multi-business corporation (Kanter, 1989; Porter, 1985). Indeed, the promise of synergies is the primary logic behind strategic moves like acquisitions and diversification (Barney, 1997; Goold & Campbell, 1998; Larrson & Finkelstein, 1999). However, despite the enormous attention that management focuses on different means to achieve cross-business synergies, their realization remains an elusive goal (e.g.: Amit & Livnat, 1988; Berger & Ofek, 1995; Bettis, 1981; Chatterjee, 1986; Davis & Thomas, 1993; Eisenhardt & Galunic, 2000b; Lang & Stulz, 1994; Palepu, 1985; Palich, Cardinal, & Miller, 2000; Ramanujam & Varadarajan, 1989; Servaes, 1996; Stimpert & Duhaime, 1997). Cross-business synergies deal with two crucial relationships in the multi-business firm, the relationships among the business-units and between the business-units and their corporate-parent. Some scholars have questioned whether these relationships have any real effect on firm performance (Schmalensee, 1985). However, recent studies of the sources of variance in firm performance and the diversification-performance linkage suggest otherwise (e.g. see Brush, Bromiley, & Hendrickx, 1999; Brush & Bromily, 1997; Farjoun, 1998; Markides & Williamson, 1994; McGahan & Porter, 1997; 1999; Palich et al., 2000; Roquebert, Phillips, & Westfall, 1996). These studies provide persuasive support for the argument that cross-business synergies (and dissynergies) do in fact exist. Even so, these studies are indirect in that, while they suggest that synergies exist, they do not provide specific insight into the nature of the potential sources of synergy, the contexts within which these potential sources of synergy are likely to be salient, or the processes by which these potential synergies are realized.

Academy of Management Proceedings 2001 BPS: H1

What are Cross-Business Synergies? Synergy is usually defined as potential cost savings arising from economies of scale or scope that can be exploited (Besanko, Dranove, & Shanley, 2000). Similarly, dissynergy can be defined as occurring when related diversification strategies result in internal transaction costs outweighing [realized economies of scope] (Jones & Hill, 1988). More recently, some researchers have suggested that synergies should be described in terms of outcome measures such as revenue enhancements or value creation, rather than simply cost. For example, Davis and Thomas (1993, p.1334) provide a more outcome-based definition that defines synergy as the super-additivity in valuation of business combinations[or]in simpler terms, synergy means that the valuation of a combination of business units exceeds the sum of valuations for stand alone units. Similarly, Goold and Campbell (1998, p.133) define synergy as the ability of two or more units or companies to generate greater value working together than they could working apart -- a more organizational or process oriented view. We define cross-business synergies as the value that is created, over time, by the sum of the businesses together relative to what their value would be separately. Like those above, this definition accounts for value that is created from cost savings as well through revenue enhancements over time.

WHAT ARE THE SOURCES OF CROSS-BUSINESS SYNERGIES? This question has engendered extensive research (e.g., Amit et al., 1988; Bettis, 1981; Brush et al., 1999; Liebeskind, 2000; Montgomery, 1994; Montgomery & Wernerfelt, 1988; Palich et al., 2000; Rumelt, 1974; Stimpert et al., 1997). Most examine a single source of synergy. However, our review suggests three major perspectives on the potential sources of cross-business synergy: economies of scope; market power; and internal governance advantages. The first perspective, economies of scope, focuses on how firms benefit, in terms of efficiency, from sharing resources among business-units, thereby reducing the per-unit cost of production (Bailey & Friedlander, 1982; Panzar & Willig, 1981). An examination of the empirical studies using this perspective suggests that related diversification yields higher performance than unrelated or focused firms, that related and complementary resources are needed to achieve synergies, and that common organizational context is an important in achieving synergies (Davis et al., 1993; Larrson et al., 1999; Palich et al., 2000; St John & Harrison, 1999). The second perspective, market power, argues that diversified firms will thrive at the expense of non-diversified firms not because they are any more efficient, but because they have access to what is termed conglomerate power (Hill, 1985, p.828), which allows them to keep prices high relative to costs through anti-competitive strategies that are not available to smaller or single-business firms. Studies of multi-point contact, predatory pricing and reciprocal buying and selling take this perspective and suggest that coordinated action and resource relatedness among business-units are important factors in creating synergies (Bernheim & Whinston, 1990; Grant, 1998; Karnani & Wernerfelt, 1985). However, these studies are only suggestive because they examine outcomes or rely on econometric models and consequently provide little insight into the actual processes that are necessary to effectively coordinate market power strategies (Bolton & Scharfstein, 1990; Grant, 1998; Saloner, 1987).


The third perspective, internal governance, argues that multi-business firms can outperform their single-business counterparts by creating a more efficient transacting environment than exists in the market (Coase, 1937/1991; Rindfleisch & Heide, 1997; Williamson, 1975; 1996a; 1996b) (Alchian & Demsetz, 1972; Berle & Means, 1932; Burawoy, 1979; Fama & Jensen, 1983). Here value is created by appropriately placing exchange relationships inside or outside of the firm (Helper, MacDuffie, & Sabel, 1999; Klein, 1988), by efficiencies resulting from the ability to access both internal and external capital markets, by rapidly shifting capital among businesses for more productive usage (Besanko et al., 2000; Fluck & Lynch, 1999; Liebeskind, 2000) and by business-unit manager incentives. Underlying each of these perspectives are the orthodox economic assumptions of equilibrium, profit maximization and a well-defined choice set (Nelson & Winter, 1982) that are particularly valid in relatively stable market contexts. Moreover, the processes by which business-unit managers attempt to realize potential cross-business synergies remains relatively unexplored.

EFFECTS OF MARKET DYNAMISM ON CROSS-BUSINESS SYNERGIES In the previous section we focused on the sources of cross-business synergies. These perspectives are primarily focused on cost efficiency, profit and relatively static contexts. We also noted that the paucity of research and theory about how managers actually organize to achieve synergies. This omission becomes particularly crucial in dynamic markets, where the specific sources of cross-business synergy in multi-business firms are constantly changing as markets evolve, collide, split and/or become extinct. Consequently, the traditional content-centered views of the sources of synergy fail to capture the importance of the strategic processes that are essential to creating new synergies as existing advantages diminish and new ones emerge. For example, economies of scope may exist around a shared engineering talent at one point in time, but may then diminish as the technological trajectories of the cooperating businesses diverge. In such situations, processes that create a series of synergies become crucial to the realization of cross-business synergies. In addition, diversification decisions like acquisitions, market entry, business reconfiguration, and divestiture can take place in a series of continuous ongoing moves. These moves often build on each other and thus spread the real cost of developing or acquiring the resources necessary to create synergies over time. In this section, we take a look at the process perspectives on synergy realization. There are three streams of research: knowledge transfer, which is a particularly well-studied economy of scope; coevolving, the process of relinking the collaborations among the business-units; and patching, the process of recombining business-units to create new matches to changing market opportunities. Knowledge-transfer The process of knowledge-transfer (i.e., deployment of experience, skills, information, routines) is an important source of potential synergy creation in the multi-business firm (Eisenhardt & Santos, 2000c; Grant, 1991; 1996; Winter, 1987). The logic behind knowledge-based synergies is that, when the costs and time required to transfer and integrate knowledge among business-units are less than the time and cost it would take competitors to develop or acquire similar knowledge, then the cross-business synergies can be realized. Knowledge differs from other organizational resources in two important ways. Knowledge is a more fungible resource than physical assets and so can often be applied to very different product categories. For example,


capability in lean production can be applied across a wide variety product and service categories (Womack & Jones, 1996). Second, knowledge is organizationally embedded, making it particularly difficult for competitors to imitate (Mahoney & Pandian, 1992; Markides & Willaimson, 1996; Peteraf, 1993). Likewise, knowledge can be more readily transferred between businesses with a common organizational context than it can be between single-business organizations in the market. The fungible nature of knowledge-based resources makes them particularly relevant as market dynamism increases (Miller & Shamsie, 1996). The second process is coevolving (re-linking), which are the business-unit processes of routinely changing the collaborative links and relationships among the business-units to exploit changing market opportunities (Eisenhardt et al., 2000b). Coevolution is about balancing the adaptability of business-units with the potential of achieving economies of scope through sharing resources balancing the autonomy and coordination of the business-units. Co-evolution is about continuously creating new linkages between businesses (i.e. sharing resources and coordinating moves) to exploit new opportunities and dropping those linkages that are deteriorating. The links between businesses thus constantly shift all along the business-units value-chains in content and number. Coevolving creates cross-business synergies (value) in three important ways: First, coevolution focuses on those potential economies of scope that have the most value-creating potential for the individual business units. Second, coevolution creates internal governance advantages by selectively limiting the internal exchange transaction to only those transactions that are currently creating value. Likewise, coevolution can also facilitate market power by selectively limiting the coordinated action of business-units to those moves that have the greatest probability of revenue enhancements (keeping prices high) for the individual business-units. For example, Michael Eisner, CEO of Disney, in his interview with Wetlaufer (2000), attributes the success of Disneys synergy efforts to the building of strong social relationships, a shared understanding of Disneys related businesses, and a common corporate context among his senior business leaders. This in turn makes it possible for Disneys business-unit managers to initiate a variety of collaborate linkages among themselves, resulting in different collaborative relationships for different products that shift over time. Similarly, in a profile of OfficeSys (a pseudonym), Brown and Eisenhardt (1998) describe OfficeSyss evolution from two to four related businesses in which businesses engaged in a variety of shifting linkages that were formed to capture potential synergies and released once the value of the synergy was dissipated. The third key process of cross-business synergy realization is patching, which is the corporate level processes of adding, splitting, transferring, exiting, or combing chucks of businesses whereby corporate executives remap or reconfigure the businesses of the multi-business firm to changing market opportunities, comes into play (Eisenhardt & Brown, 1999,: 74). These strategic moves differ from traditional reorganizations in that they are small, frequent and similar and thus become part of the organizational routines (Galunic & Eisenhardt, 1996). Patching creates cross-business synergies (value) in two important ways: First, patching creates economies of scope by putting underutilized (or under-realized) value-creating resources to their most productive use and thereby creates growth opportunities that are unavailable to single-business competitors. Second, patching creates a form of market power, by creating opportunities for strategic advantages from resource transfers and recombination that would take


a long period of time for competitors imitate. For example, in a case study of patching (business-unit charter change) of a multi-national firm in a hyper-competitive environment, Galunic and Eisenhardt (1996; 2001) observed that cross-business synergies were realized by through processes of: internal competition for business-unit charters; transfer of charters to create better business-unit focus; and correcting misalignments between evolving markets and business-unit skills and culture. Moreover, they found that the structure, skills, knowledge and power of the top-management-team (e.g. modular organization form, understanding of business unit capabilities, the market context, and the skill to exercise fiat effectively) were critical elements in the ability of the firm to effectively shift charter assignments and knowledge-based resources between divisions without unproductive resistance. In particular, they observed that related technological bases of knowledge and similar research and production processes were essential to the capability of making charter changes between divisions. In addition, this study highlights the importance of the role of the multi-business team the group of business-managers and corporate officers that control the allocation of human, organizational and physical resources in the organization, has in realizing potential synergies.

DISCUSSION AND SUMMARY COMMENTS This paper explores cross-business synergies. We approached this exploration by conducting an extensive review of the literature. We found is that while the research domain is large, it has yet to generate a set of reasonably consistent and generalizable findings. Debates still persist regarding the definition of synergy, the existence of synergy, the sources of synergy, the processes of synergy realization, and how synergy is affected by market dynamism. We have several key observations. First, while there is persuasive evidence in the variance in performance and diversification literatures that synergies (and dissynergies) exist, a much broader conception is needed for the sources of those synergies. We found that there are three primary sources of cross-business synergies: economies of scope (spreading costs), market power (keeping prices high) and internal governance advantages (internal efficiencies). Second, synergies are context dependent i.e., factors like rate of market change, related technology bases, human resource practices, administrative controls and business culture are all important factors in determining the sources and processes by which potential synergies might be realized. We found that physically based resources (e.g. facilities, equipment, location, ownership rights) appear to be most relevant to achieving synergies in relatively stable market situations where strategic advantages can be maintained. In contrast, knowledge based resources are more flexible and fungible than physical resources and consequently appear to become more relevant as market dynamics increase which suggests that the degree of market change may affect the strategic logic of cross-business synergy realization. Third, we found three interrelated business-unit/corporate level processes that become particularly salient as market dynamics increase: knowledge-transfer (transferring knowledge-based resources between business-units), coevolving (relinking the web of business-unit collaborations) and patching (reconfiguring the business-units to address changing market


opportunities). These processes help bring the market inside the corporation and thereby facilitate the coexistence of collaboration and competition among the businesses. Moreover, these processes create value by allowing business-unit managers to maintain their focus on changing market opportunities, while at the same time allowing them to selectively take advantage of resource sharing and coordination opportunities. In general, traditional economic, financial, strategic and organizational views of cross-business synergy view synergy as resulting from efficiencies that are realized over market contracting through economies of scope, market power, internal capital markets, and reduced agency and transaction costs (Alchian et al., 1972; Coase, 1937/1991; Fluck et al., 1999; Williamson, 1975; Yeung, 1998). These views focus on how synergies can create a defensible advantage a static view of synergy realization that is mature theoretically, but remains somewhat equivocal empirically. What is different in dynamic markets is that processes become more important to the realization of potential synergies and knowledge becomes the more crucial resource. Likewise, as the bases of synergies constantly shift, synergies that relate to growth/adaptation become more important than those focused on efficiency/cost reduction and even profit. This emerging perspective of synergy that we observed views synergies as resulting from processes of resource recombination over time (Anderson, 1999; Burgelman, 1991; Eisenhardt & Martin, 2000a; Eisenhardt et al., 2000b; Lewin & Volberda, 1999; Martin & Carlile, 2000; Van den Bosch, Volberda, & Boer, 1999). Moreover, this perspective focuses on how cross-business synergies can be used to create a series of temporary advantages in dynamic markets. However, it is a perspective that is still forming theoretically and empirically. Likewise, there has been little attention paid to the role of the multi-business team in realizing potential synergies. Consequently, we argue that the field needs new research directions that focus on how cross-business synergies are achieved, especially in dynamic markets.

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