Understanding the better off test in diversification decisions
The better-off test in diversification decisions is a test for whether activities are better performed together in one firm or not. Unless there are advantages that come from combining the activities in one company, it is typically better to have the activities in separate firms. There are additional overheads associated with running the activities in one firm, and unless there are some advantages to overcome these (i.e., being better-off together), then there is little reason to expect the activities to be better combined together in one company.
Ways in which activities can be better together include:
- Revenue-enhancing synergies: Where sales can be increased from the activities being performed together (such as a shared brand allowing a higher price to be charged)
- Cost-saving synergies: Where there can be cost savings from performing the activities together, typically from sharing resources between the existing and the new area.
- Reverse benefits: Where entering the new area can enhance the existing business.
Why is the better off test important?
The better-off test is important in diversification decisions because unless there are some benefits that come from having the activities combined in one firm, then the combined entity is likely to perform worse than if it was operating as two separate businesses.
In the absence of passing the better-off test, the diversification is likely unrelated diversification – diversification that is unconnected to the core existing business. Unrelated diversification is associated with many disadvantages and is typically viewed as poor management practices.
What happens if diversifications don't pass the better off test
If the diversification does not pass the better off test there is little reason to assume that the activities are better organized together in one firm. There isn’t identified cost savings, revenue-enhancing opportunities, or reverse benefits that would offset potentially greater oversight costs associated with having the firms combined in one area. In essence, there is little justification for why the activities make sense together.