Operating Synergy & Pure Diversification:
Theory of Mergers
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
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 acquirers 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.
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
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.