What are synergies?
Synergies are the benefits associated with different activities being conducted together in one firm. They are often used to justify mergers and acquisitions or diversification more broadly. By expanding into related areas you may be able to make more profit than having the two areas operate as separate firms.
Types of synergies in diversification
There are two fundamental types of synergies: revenue-enhancing synergies and cost-saving synergies.
Revenue-enhancing synergies are the possibility that it is possible to generate greater sales by being in two areas than if they were separate. For example, by acquiring another firm, the total sales across the two companies will be greater than if they were separate businesses. Some of the reasons behind revenue-enhancing synergies are:
- The ability to cross-sell goods: If one firm is strong in one particular market, and the other a separate market, then the revenue of both firms may be increased by cross-selling one company’s goods through the other’s sales channels and vice versa.
- New product possibilities: It may be possible to create new revenue streams by combining the technologies of both firms.
- Ability to charge higher prices: It is possible that having a portfolio of related products, or the sharing of better brand recognition, may allow the firm to charge a higher price than can be achieved across areas.
While revenue-enhancing synergies are associated with the possibility of generating greater sales through the expansion, cost-saving synergies are associated with savings that may result from being in both areas. The most direct source of cost-saving synergies is reducing duplication – tasks that are performed twice across firms. If there is a way of streamlining these operations, then the firm may be able to operate at a lower cost base than if the areas were separate.
The connection between synergies and the better-off-test
The existence of synergies is the basis of the better-off test in diversification decisions. The better-off test is essentially whether there are reasons to believe that the firms will be able to more effectively compete as one company vs two. If there are substantial synergies to be gained from operating across areas then it make may make sense for the firm to diversify. If on the other hand there is an absence of synergies from operating across multiple areas, then it would not make sense for the firm to diversify.
Final thoughts: Be aware of imagined synergies
When considering expansion decisions, it is easy to see synergies everywhere. While some of these may be genuine cost-saving or revenue-enhancing opportunities, others will be paper synergies – that don’t actually transpire in reality. Make sure you critically examine the source of the synergy, and ascertain whether there is a sound basis to expect it either to lead to enhanced revenues or reduced costs relative to two separate firms.