The Independent and Joint Effects of
the Skill and Physical bases of
Relatedness in Diversification
Farjoun, 1998, Strategic Management Journal
Presented by Jenna Moore
Overview
Motivation of study: Present approach that
captures the skill base of relatedness (i.e., the
human element)
Purpose: Develop a conceptualization of
relatedness that is multi-dimensional
 No prior study had used a skill-based measure of
relatedness
 Through juxtaposition of physical and skill bases,
Farjoun (1998) elucidates a better understanding of
underlying assumptions and advantages/
disadvantages of these bases
Overview
Research questions:
1. How do the skill and physical bases differ in
the ways they identify relatedness in the same
set of industries (or lines of business)?
2. What are the separate and joint contributions
of the two approaches in explaining firm-level
performance differences?
Separate effects of physical & skill
Bases of Relatedness
Physical bases: firms and industries as
collections of material resources (e.g., raw
materials, plant and equipment, etc.)
 More observable than skills
 More product-specific, so range of applicably
across industries is limited
 Performance benefits are through economies of
scope and scale
Separate effects of physical & skill
Bases of Relatedness
Human bases: firms as interrelated bodies
of human knowledge
 Can be difficult to observe
 Have room for improvement and learning,
knowledge transfer across domains
 Performance benefits are through continued
learning, knowledge transfer, and innovation
 ‘Dynamic reciprocity’
Separate effects: Hypotheses
Hypothesis 1a: The level of related
diversification as indicated by the physical
base of relatedness will be positively
associated with financial performance
Hypothesis 1b: The level of related
diversification as indicated by the skill
base of relatedness will be positively
associated with financial performance
Joint effects of Physical & Skill Bases
of Relatedness
Physical and skill bases are complementary—
each base extends the other
They interact and overlap (e.g., as in car
production)
Affect performance in 2 ways:
1. More potential interrelationships are identified
2. When physical resources (e.g., common
components) and skill resources (e.g., precision
production skills) are combined, cost and learning
benefits will accrue
Joint effects: Hypothesis
Hypothesis 2: The level of related
diversification indicated by a combination
of both the physical and skill dimensions
will be positively associated with financial
performance
Method
Sample Selection: Diversified manufacturing
firms on the 1985 Fortune 500 list
 Manufacturing focus because: (1)vertical
integration is widespread and (2) the occupational
skill profile should be refined to sector-specific
occupations
Each industry was characterized by skill and
physical bases of relatedness
 Levels of relatedness were measured using Entropy
measure of diversification
Method
Performance measures: (1)ROA, (2) ROS,
(3) MBOOK (market to book ratio), and
(4) Jensen’s alpha
 Taken together, they represent accounting and
market-based performance indices
Industry control variables: used industry
dummy variables for the firm’s primary industry
 Controls for industry structure effects on
performance
Results
Identifying physical relatedness: Share
similar raw materials, end use, or physical
aspects of production
Identifying skill relatedness: Share
similar production, engineering,
administration, and marketing and service
skills
Results
 Relationship between relatedness and performance:
 H1a: The level of related diversification as indicated by
the physical base of relatedness will be positively
associated with financial performance (Not supported)
 H1b: The level of related diversification as indicated by
the skill base of relatedness will be positively associated
with financial performance (Not supported)
 H2: The level of related diversification indicated by a
combination of both the physical and skill dimensions
will be positively associated with financial performance
(Supported)
Conclusions
 When diversification was related on physical and
skill bases, relatedness had a strong effect on
performance
 Provides support for the complementary benefits of the
two bases
 Joint effects influence performance by: (1) extending
range of benefits, and (2) reinforcing those benefits
when the two bases agree
 A multi-dimensional view of relatedness furthers
our understanding of the reasons underpinning the
existence of firms as value creating entities
Implications
 Practical implications (diversification decisions):
 A more conservative definition of relatedness is
important—include combination of key bases
 Integrating across business units with highly
complementary skill and physical bases is most
beneficial
 Theoretical implications:
 Future research should examine other important bases
of relatedness (e.g., customer group similarity in service
industries), other measures of performance, and should
better isolate effects of within-sector vertical integration