July 2018 | 

How Big Is Too Big? Two Tests that Reveal the True Cost of Owning Multiple Businesses

How Big Is Too Big?

New research by Wharton management professor Emilie Feldman identifies some surprising hidden costs that come with owning too many businesses — ones that can hurt your market value and profitability. “When companies own too many businesses,” says Feldman, “they can run into diseconomies of scope. It’s common for C-suite executives to think bigger is better, but that is clearly not always the case.”

One not-so-obvious cost is managerial distraction. “Let’s say, for example, you buy one of your suppliers,” she says. “Because you might not have the expertise needed to run that business, you have to spend time on tasks that you’re not very capable of. That’s time you don’t have to attend to anything else. Distraction can be a real threat to your original business.” Feldman teaches a session on corporate strategy and scope in Wharton’s The CFO: Becoming a Strategic Partner program.

She says another cost that companies often don’t consider is social comparison. “When you own different businesses in a range of industries that have varying compensation levels, employees in those businesses are getting paid very different rates. From an emotional perspective, that’s problematic, but it’s not something leaders in the acquiring company typically expect.”

In The CFO program, says Feldman, “We look at both sides of scope: expansion and reduction. They are opposites, but they both require the same underlying logic. Really understanding that ownership can carry costs is a big insight that can apply equally to growth and reduction.”

The CFOs in the program learn to take a more strategic, company-wide perspective, helping them think about decisions in terms of the organization’s comprehensive trajectory. “The participants are finance experts. They’re quite familiar with organic growth, allocating resources to initiatives, M&A, and budgeting. But where they have less experience is looking at where individual transactions fit into the overall strategy. It is easy to run the numbers without really understanding the strategic logic of scope decisions. Weighing the hidden costs of ownership can help to inform both decisions.”

Feldman shares a two-part proprietary framework that the CFOs, and their senior leadership teams, can use when making decisions on both expanding and reducing their company’s scope:

  1. The “Better Off” Test: How does owning a new business or keeping an existing business help your company create value? In terms of diversification, why would you want to add the new business or expand? In terms of scope reduction, does it still make sense to own the existing business?
  2. The Ownership Test: Do you have to own a business to create value from it? If you’re considering an acquisition, would you be better off writing a contract to get the inputs you need without ownership? Do you actually have to own it within the corporate portfolio? Or, if you’re considering a divestiture, would you do better transacting with an existing business separately with a contract instead of owning it?

“What’s useful about the framework is that it helps to justify both decisions,” says Feldman. “This is why it's important to teach diversification and divesture in the same session. The same logic applies in both directions. The ideas I introduce help to show that organizations can gain access to benefits, and reduce risk and costs, by explicitly considering whether or not ownership is needed.”

Feldman says if CFOs don’t appreciate what could go wrong with a strategy, and it gets implemented, it will end up hitting their bottom line. “To make better decisions and avoid potential pitfalls, they must carefully consider the true costs of expanding or reducing the business. If they can get access to the same benefits without incurring those costs, that could be a better way to go.”