What is the better off test?
The better off test is a key test to see whether it make sense for a firm to diversify into a new area or not. The test is whether having the businesses in one firm is better than having them in two firms. That is, are there advantages of having the different areas within the same company – potentially sharing the same resources – that can offset challenges associated with having different business units under the same umbrella.
In the absence of genuine advantages that come from having the different business areas combined in the same company, the better off test would advise against diversifying. If the area would more effectively be done by a separate firm, why does it make sense for you to diversify into that area?
Ways that firms can be better off
There are three key ways that having different business areas combined in one firm can be ‘better off’ than having them as separate businesses: revenue-enhancing synergies, cost-saving synergies, and reverse benefits – where the new business area brings benefits to the original business units.
Revenue enhancing opportunities
The first way that having the business areas combined in one firm can be better off than having them separate is through revenue-enhancing synergies. Such opportunities may include the ability to cross-promote the goods, or derive from greater value being provided due to them both being in the same firm (e.g., greater compatibilities between the products), allowing the company to charge a higher price.
The next source of possible benefits with diversification comes from cost-saving opportunities. Potentially the combined entity can be run at a lower cost than two separate firms. Such synergies may come from sharing of resources or reducing the need for duplicated functions within the firm.
Reverse benefits - where the new area benefits the original business
A final potential source of benefits from diversifying are so-called reverse benefits – where the new area can improve the original part of the business. Moving into the new area could for example increase the sales of the original business, potentially by elevating the brand or providing opportunities for cross-selling to this new market. Or it is possible that new technologies or practices developed primarily for the new business area may feed back and lower the costs of operations of the original business. These are all examples of reverse benefits that come from diversifying.
Do the benefits exceed the costs of diversifying
There are always costs associated with diversifying. It takes time and resources for a company to move into a new area. Unless there are genuine advantages that come from having this new area pursued by the business – revenue-enhancing synergies, cost-saving opportunities, or reverse benefits – then it is unlikely that the diversification decision will pass the better off test.
Final thoughts: Be aware of paper synergies
It is important to be aware that when managers are considering diversification – particularly through mergers or acquisitions – there is a tendency to see paper synergies. Such synergies are imagined benefits that never materialize. They can border on wishful thinking – arguments that seem plausible but on closer inspection are unlikely to give the claimed benefits. It is important to be aware of the allure of such imagined benefits – while they make be convincing to get people on board with the diversification (or satisfy yourself that the firm is better off diversifying), if the supposed benefits do not materialize, the company may end up suffering disadvantages associated with unrelated diversification.