«ERIM REPORT SERIES RESEARCH IN MANAGEMENT ERIM Report Series reference number ERS-2002-51-ORG Publication May 2002 Number of pages 7 Email address ...»
GOVERNANCE STRUCTURE, PRODUCT DIVERSIFICATION, AND
ASWIN A. VAN OIJEN, GEORGE W. HENDRIKSE
ERIM REPORT SERIES RESEARCH IN MANAGEMENT
ERIM Report Series reference number ERS-2002-51-ORG
Publication May 2002
Number of pages 7 Email address corresponding author email@example.com Address Erasmus Research Institute of Management (ERIM) Rotterdam School of Management / Faculteit Bedrijfskunde Erasmus Universiteit Rotterdam P.O.Box 1738 3000 DR Rotterdam, The Netherlands Phone: +31 10 408 1182 Fax: +31 10 408 9640 Email: firstname.lastname@example.org Internet: www.erim.eur.nl
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Data obtained from a sample of 118 cooperatives and corporations are used to test the hypotheses. We find significant differences between cooperatives and corporations. Therefore, our main conclusion is that governance structure does matter for product diversification and its performance. Other governance structures, besides corporations and cooperatives, and their influence in other areas, besides product diversification, could be promising directions for future research.
Library of Congress 5001-6182 Business Classification 5546-5548.6 Office Organization and Management (LCC)
Product diversification and its financial outcomes have been studied exhaustively. However, previous literature has focused on corporations, ignoring other important legal organizations or governance structures. In this paper, we study the diversification strategies of cooperatives and compare them with corporations. We develop hypotheses that predict that cooperatives differ from corporations with respect to the extent, type, and performance of product diversification. Data obtained from a sample of 118 cooperatives and corporations are used to test the hypotheses. We find significant differences between cooperatives and corporations. Therefore, our main conclusion is that governance structure does matter for product diversification and its performance.
Other governance structures, besides corporations and cooperatives, and their influence in other areas, besides product diversification, could be promising directions for future research.
Product diversification is a central topic of research in business (Ramanujam and Varadarajan, 1989). Many empirical studies have been devoted to the performance outcomes of product diversification, but the findings are mixed (Palich, Cardinal, and Miller, 2000). One of the reasons for these mixed findings may be differences in legal organization or governance structure of the companies (Bethel and Liebeskind, 1998). 1 However, the influ ence of the governance structure on product diversification and its financial outcomes has been rather neglected.
The vast majority of studies are based on (public) corporations. No studies are available about the diversification strategies of cooperatives. This is remarkable, since cooperatives still play an important role in many national economies and sometimes an even crucial one in specific sectors, like food and agriculture. Therefore, more insight into potentially value-creating or -destroying strategies of these companies seems important.
In this paper, we try to answer two questions. First, do the diversification strategies of corporations and cooperatives differ? Second, do the diversification strategies of corporations and cooperatives have different implications for financial performance? After sketching the theoretical background, we develop three hypotheses, which link governance structure, product diversification, and financial performance. Following a description of the methods, we present the results of an empirical test of the hypotheses, which is based on a sample of 118 cooperatives and corporations. The results indicate that governance structure does matter for product diversification and its financial outcomes. The final section of this paper contains a short discussion and conclusion.
Before going into the theories that explain product diversification and its relationship with performance, we first provide a brief description of the differences between corporations and cooperatives (see, e.g., Hendrikse and Veerman, 2001).
Corporations have shareholders. The shares give them rights to the assets, including the rents, of the corporation. The shares can be traded with relative ease. The managers of corporations can but do not necessarily have to own shares of the firm. Cooperatives have members, who have rights to the assets, including the rents of the cooperative. The rights are difficult to transfer from one member to another. In addition, the members are suppliers or customers of the cooperative (or both). For example, in agriculture, farmers have formed cooperatives that buy, process, and market their produce and cooperatives that sell them supplies like animal feed and seeds (or cooperatives that do both). In r etail, shopkeepers have formed cooperatives that supply them with products and services. Cooperatives are managed by managers who are usually not a member of the cooperative.
Literature that directly links cooperatives to product diversification is not available. However, clues might be found in existing perspectives that explain the choice of product diversification (Hoskisson and Hitt, 1990; Montgomery, 1994; Ramanujam and Varadarajan, 1989). These perspectives are rooted in different theories or paradigms, notably agency theory (Jensen, 1986), transaction cost economics (Williamson, 1975), the resource-based view of the firm (Penrose, 1959), industrial organization (Palepu, 1985) and strategic contingency theory (Venkatraman, 1989). Of these five perspectives, agency theory, transaction cost economics and the resource-based view of the firm are the most promising, because they include factors that may discriminate between corporations and cooperatives.
According to the resource-based view, firms can have excess capacity in resources (Penrose, 1959). The resources can be redeployed in new businesses, which implies product diversification. Several types of resources 1 The governance structure or legal organization comprises those organizational arrangements that determine how the company contracts with imp ortant stakeholders, such as buyers, suppliers, lenders, and investors (Bethel and Liebeskind, 1998).
1 can be used for diversification (Chatterjee and Wernerfelt, 1991). A priori, no differences with respect to physical and intangible assets can be expected, but, in general, cooperatives have less financial resources than corporations. Specifically, cooperatives can only generate additional equity by retaining earnings and obtaining extra funds from the limited pool of members. In contrast, corporations can retain earnings and raise extra equity in the stock market from any investor who is willing to take the risk. Consequently, cooperatives may have fewer means to diversify than corporations.
Agency theory suggests that firms diversify because their managers have personal motives to do so.
Managers do not return free cash flows to shareholders, but spend them on diversification projects, because of motives like empire building, pay increases, and reduction of employment risk (Jensen, 1986). This is not in the interest of the shareholders, for instance because they can diversify risks themselves by building an efficient stock portfolio. However, in a corporation the interests of shareholders and managers can be aligned, for instance by granting stock options to managers, which could help to eliminate diversification projects that destroy value.
This instrument is not available in a cooperative. In addition, risk reduction through product diversification might actually be in the interest of the members of the cooperative, since a large portion of their wealth is tied to the cooperative.
Finally, according to transaction cost economics, firms diversify to realize benefits that are costly to realize through market transactions. The most important benefits of product diversification are economies of scope and economies of internal capital markets (Jones and Hill, 1988). Economies of scope arise when the costs of jointly producing two products are lower than the costs of producing them separately (Teece, 1982). In an internal capital market, the corporate headquarters attracts cash flows, reallocates them to the most attractive investment proposals of the divisions, and monitors their deployment (Williamson, 1975). This is presumed to result in superior allocation and policing, compared with the external capital market. Related-diversified corporations are able to realize economies of scope and economies of internal capital markets, though not simultaneously, because the required administrative mechanisms are conflicting (e.g., Hill, Hitt, and Hoskisson, 1992).
Unrelated-diversified corporations can only attain economies of internal capital markets (Jones and Hill, 1988).
Depending on their type of diversification, cooperatives may also be able to realize the two types of benefits.
However, the benefits of internal capital markets may be more restricted, since, as argued earlier, cooperatives cannot obtain equity from the stock market to allocate to attractive investment proposals.
Departing from the theoretical framework, we formulate three hypotheses, one for the level, one for the type, and one for the performance of product diversification. Each hypothesis compares cooperatives with corporations.
As explained earlier, cooperatives have less financial resources than corporations. Both can get, for example, bank loans, but cooperatives are more restricted when it comes to equity. Therefore, given that cooperatives are not willing to sacrifice solvability and jeopardize the entire enterprise, they have fewer funds to start new activities. In contrast, corporations have better access to new equity. Moreover, they can use their own stock to pay for acquisitions. Consequently, for corporations it is easier to start new activities, including activities in different industries.
An additional argument can be found in the interests the shareholders and members have in the corporation and cooperative. Shareholders are primarily interested in the future profitability of the corporation, which is the basis for dividends and stock value. As a consequence, they are prepared to ratify any activity that is expected to improve profitability, including activities in a new industry. Members also have a stake in the future profitability of the cooperative. In addition, since they are suppliers or buyers of the cooperative (or both), they are interested in obtaining more and cheaper inputs from the cooperative or selling more outputs at a higher price to the cooperative (or both). As a result, if they have to choose between, for example, an investment in an enlargement of an existing plant that processes their output and an investment in a new industry, they might go for the first option.
Both arguments lead to hypothesis 1:
Hypothesis 1: Cooperatives are less diversified than corporations.
Managers may prefer to diversify, even into activities that reduce the value of the firm, because of personal mo tives, like reduction of employment risk (Montgomery, 1994). Since the shareholders of a corporation have other means to reduce their risks, they are assumed to oppose this kind of diversification. By granting the managers stock options, the shareholders can bring them into line. The members of a cooperative do not have this instrument at their disposal. Besides, they may actually have a preference for product diversification to reduce their risks. As mentioned in the theoretical background, a substantial portion of their wealth is tied to one cooperative.
They cannot reduce their risks through small memberships in many cooperatives. The degree to which product diversification reduces risks depends on the correlation between the separate returns of the activities. The smaller 2 the coefficient of correlation between the returns, the lower the variability of total profits (Teece, 1982). Because the correlation between the returns of two unrelated activities is usually lower than the correlation between the returns of two related activities, unrelated diversification is more useful for risk reduction than related diversification. In sum, if they diversify, we expect cooperatives to have a larger inclination to pursue unrelated product diversification than corporations.