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Operating Synergy & Pure Diversification: Theory of Mergers

Operating Synergy

The operating synergy theory of mergers states that economies of scale exist in industry and that before a merger takes place, the levels of activity that the firms operate at are insufficient to exploit the economies of scale.

Operating economies of scale are achieved through horizontal, vertical and conglomerate mergers. Operating economies occur due to indivisibilities of resources like people, equipment and overhead. The productivity of such resources increases when they are spread over a large number of units of output. For instance, expensive equipment in manufacturing firms should be utilised at optimum levels so that cost per unit of output decreases.

Operating economies in specific management functions such as production, R&D, marketing or finance may be achieved through a merger between firms, which have competencies in different areas. For instance, when a firm, whose core competence is in R&D merges with another having a strong marketing strategy, the 2 businesses would complement each other.

Operating economies are also possible in generic management functions such as, planning and control. According to the theory, even medium-sized firms need a minimum number of corporate staff. The capabilities of corporate staff responsible for planning and control are underutilised. When such a firm acquires another firm, which has just reached the size at which it needs to increase its corporate staff, the acquirer’s corporate staff would be fully utilised, thus achieving economies of scale.

Vertical integration, i.e. combining of firms at different stages of the industry value chain also helps achieve operating economies. This is because vertical integration reduces the costs of communication and bargaining.

Pure Diversification

Diversification provides several benefits to managers, other employees and owners of the firm as well as to the firm itself. Moreover, diversification through mergers is commonly preferred to diversification through internal growth, since the firm may lack internal resources or capabilities required. The timing of diversification is an important factor since there may be several firms seeking to diversify through mergers at the same time in a particular industry.

Employees: - The employees of a firm develop firm-specific skills over time, which make them more efficient in their current jobs. These skills are valuable to that firm and job only and not to any other jobs. Employees thus have fewer opportunities to diversify their sources of earning income, unlike shareholders who can diversify their portfolio. Consequently, they seek job security and stability, better opportunities within the firm and higher compensation (promotions). These needs can be fulfilled through diversification, since the employees can be assigned greater responsibilities.

Owner-managers: - The owner-manager of a firm is able to retain corporate control over his firm through diversification and simultaneously reduce the risk involved.

Firm: - A firm builds up information on its employees over time, which helps it to match employees with jobs within the firm. Managerial teams are thus formed within the firm. This information is not transferred outside and is specific to the firm. When the firm is shut down, these teams are destroyed and value is lost. If the firm diversifies, these teams can be shifted from unproductive activities to productive ones, leading to improved profitability, continuity and growth of the firm.

Goodwill: - A firm builds up a reputation over time in its relationships with suppliers, creditors, customers and others, resulting in goodwill. It does this through investments in advertising, employee training, R&D, organizational development and other strategies. Diversification helps in preserving its reputation and goodwill.

Financial and tax benefits: - Diversification through mergers also results in financial synergy and tax benefits. Since diversification reduces risk, it increases the corporate debt capacity and reduces the present value of future tax liability of the firm.

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