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Direct Estimation of Synergy:

A New Approach to the


Diversity-performance Debate
Rachel Davis L. G. Thomas
Stern School of Business, New York University, 7-63 Management Education Center, 44 West 4th Street,
New York, New York 10012
School of Business, Emory University, lid Rich Building, 1602 Mizell Drive, Atlanta, Georgia 30322

his study examines the linkages between relatedness and synergy in the context of diversification among U.S. pharmaceutical firms for the period 1960-1980. Rather than assume
(as in the entropy, Herfindahl and concentric indices of diversification) that the levels of synergy
generated by different related combinations of business units are identical, we estimate synergy
directly using a modified version of the concentric index. In addition to estimating synergy
using capital market performance of the firm as a whole, we examine the effects of nondrug
diversification on the innovative productivity of firms' pharmaceutical divisions alone.
Our two main findings are that production relatedness, such as that between drugs and
chemicals, in fact did not imply synergy over the period of our study; and that the patterns of
synergy for different types of relatedness shifted over time with the industry life cycle.
{Diversification; Synergy; Industry-Evolution; Pharmaceuticals)

1. Introduction
If diversification strategy is to succeed it is imperative
that synergy, or super-additivity' in valuation of business combinations, be achieved. The failure to achieve
expected synergies in large part accounts for the mixed
success of diversification strategy among U.S. firms
(Amit and Livnat 1988, Porter 1987). As Reed and
Luff man (1986) have written, "while the benefits of
synergy are truly legendary... as every student knows,
those particular benefits show an unshakable resolve
not to appear when it becomes time for their release."
Given that many combinations of businesses fail to
achieve synergies, it is important for both researchers
and corporate strategists to be able to identify reliable
' By synergy, we mean super-additivity in valuation of business combinations. In simpler terms, synergy means that the valuation of a
combination of business units exceeds the sum of valuations for stand
alone units.
Economies of scope (cost sub-additivity) would produce synergy,
but so also would revenue-side advantages of combinations.

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MANAGEMENT SCIENCE/VOI. 39, No. 11, November 1993

and straightforward proxies for synergy. In the strategic


management literature, the most widely used proxy of
synergy for two businesses is their relatedness (Wrigley
1970, Rumelt 1974), or the presence of similar activities
and shared resources at various points of the value
chain. While there is an ongoing debate as to how to
best measure relatedness, increasingly many researchers
(notably Montgomery 1982, Palepu 1985) have used
shared SIC codes as proxies of relatedness between
businesses. These SIC linkages effectively act as proxies
(of relatedness) for another proxy (of synergy). However, SIC linkages measure relatedness very narrowly,
at only a single point in the value chain, that is, production.^ It is this narrow equation of synergy and production (output-based) relatedness in this latter stream
^ Production or output similarities are defined as including similarities
in raw materials and/or manufacturing technology.
4-digit SIC categories "define an industry as a grouping of establishments primarily engaged in the same or similar lines of economic

0025-1909/93/39n/1334$01.25
Copyright 1993, The Institute of Management Sciences

DAVIS AND THOMAS


Direct Estimation of Synergy

of literature (SIC-based studies) that is the analytical


target of this paper.
Our study examines relatedness and synergy in the
U.S. pharmaceutical industry during the period 19601980. Our two main findings are that production relatedness in fact does not necessarily imply synergy, and
that the actual relatedness-synergy linkages shift dramatically, but predictably, over time. For example, we
find that the drug-chemical linkage, primarily production relatedness, is dissynergistic^ during most of the
period of our study. In contrast, the drug-health products linkage, a marketing-based relatedness, becomes
synergistic by the late 1970s. These changes are consistent with the product life cycle of the pharmaceutical
industry.
The outline of this paper is as follows. Section 2
sketches expected synergies in the pharmaceutical industry, and their development over time with particular
emphasis on the documented dissynergies between
chemicals and pharmaceuticals. Section 3 presents the
analytical framework of the paper, along with a brief
review of the literature. Section 4 discusses the data
and estimation methodologies, while 5 presents the
estimation results. Concluding remarks are given in 6.

2. Synergy in the Pharmaceutical


Industry
This study examines diversification in the U.S. pharmaceutical industry during 1960-1980. We have chosen

activity. . . . In the manufacturing division, the line of activity is


generally defined in terms of the products made, raw materials consumed or manufacturing process used (SIC Manual, 1957, p. 431).
In the SIC Manual, 1987 (p. 645), this definition is loosened, indicating that the industry classification does not "follow any single
principle, such as the use of the products, market structure, the nature
of the raw materials, etc. "
We can surmise from the above that regardless of the criteria used,
the SIC definition of "industry" is not based on criteria such as marketing (e.g., packaged goods industries) or human resource skills (e.g.,
high technology industries).
^ Dissynergy will result when related diversification strategies result
in internal transaction costs outweighing the achieved benefits. Jones
and Hill (1988) point out that diversification increases the bureaucratic
cost of managing the enlarged organization; there will be a decline
in performance unless the additional bureaucratic costs are offset by
increases in operating efficiency.

MANAGEMENT SciENCE/Vol. 39, No. 11, November 1993

this industry for two reasons. First, the present form of


competition in the global pharmaceutical industry
emerged only in the 1950s. Thus, a study covering the
period 1960-1980 will encompass several different
phases of the industry life cycle. Second, this industry
has been extensively studied by management scholars,
economists and others, and we, therefore, have a good
grasp of the bases for strategic success in this industry
(Cool and Schendel 1987, 1988; Department of Commerce 1986; Grabowski et al. 1978; Hill and Hansen
1991; Hansen 1979; NAE 1983; Schwartzman 1976;
Temin 1980; Thomas 1990). Presented below is a brief
description of the pharmaceutical industry.
Before 1945, the industry was essentially noninnovative, with most firms selling different brands of a
common product set (NAE 1983). Chemical firms were
suppliers of bulk drugs, made up in pharmacies, and
were prominent among the infrequent innovators of
new drug products. Thus, chemicals and pharmaceuticals shared both production and innovation synergies
in this basically noninnovative period (Temin 1980).
This competitive environment changed drastically after
World War II, with the emergence of a new form of
competition through innovation of fundamentally new
products. Not only did innovation increase in strategic
importance relative to production, but the process of
innovation needed to discover new pharmaceutical
products steadily changed after the 1950s, beginning at
a level of simple screening in the 1950s (the so-called
"dope and hope" approach) and ending with explicit
designing of compounds through molecular biology in
the 1980s (NAE 1983, Department of Commerce 1986,
Teitelman 1989).
As the required innovation skills in pharmaceuticals
evolved and became more specialized, the character of
research shifted from a chemical to a biomedical basis.
In a very similar manner, the strategic importance of
pharmaceutical marketing increased over time and
changed in nature. The stringent market-access regulations put into place by the 1962 Amendments to the
Food, Drug, and Cosmetic Act fundamentally shifted
the marketing skills needed for strategic success in this
industry towards the ability to convince academic medical experts of the comparative efficacy and superiority
of specific drugs (Thomas 1990). Gaining acceptance
from the medical community for new drug products
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DAVIS AND THOMAS


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required extremely sophisticated marketing skills, above


and beyond any innovation skills.^ Further, as the extent
and expense of innovation costs increased, rapid marketing rollouts and large market shares for new products
became essential to recoup innovation costs and gave
marketing additional strategic significance. In summary,
the complexity, distinctiveness, and expense of both innovation and marketing skills steadily increased after
1950, and particularly after 1962 in the U.S.
In this historical context, the significance of cost-based
synergies from the continuing production relatedness
of pharmaceutical and chemical industries steadily
dwindled in strategic importance for the following reasons: (a) production costs accounted for a small and
continually decreasing share of total costs in the pharmaceutical industry; and (b) competition in the pharmaceutical industry is primarily differentiation-based
rather than cost-based. Thus, the drug-chemical linkage
became dissynergistic as declining strategic benefits were
outweighed by the bureaucratic costs of managing the
linkage (Jones and Hill 1988, Hill and Hansen 1991).
With the evolution of the pharmaceutical industry,
synergies between chemicals (SIC codes 2810, 2860)
and Pharmaceuticals (SIC 2830), primarily production
in origin, have steadily declined over the industry life
cycle, as production declined in strategic importance.
Meanwhile, synergies between pharmaceuticals and
health care products (SIC codes 3830, 3840, 3850,
2020), primarily marketing and to a lesser extent innovation in origin, have increased over time as innovation and marketing have become more strategically
significant and interrelated.'

* The importance of marketing skills in the pharmaceutical industry


is effectively illustrated by the Zantac-Tagamet rivalry. It is commonly
argued in the pharmaceutical industry that there are only truly minor
medical differences between Zantac (the leading anti-ulcer medication
sold by Glaxo) and Tagamet (the first-mover which is now a distant
second in sales). Glaxo's triumph with Zantac in overtaking Tagamet
is due more to sophisticated marketing skills than to innovation.
' Both Drugs and Chemicals fall in the same 2-digit SIC category
(Drugs SIC 2830 and Chemicals SIC 2810, 2860). By contrast. Health
Products includes a number of different 2-digit SIC categories: Surgical,
Medical, Dental, Ophthalmic, Laboratory and X-ray Equipment, all
falling in 2-digit SIC-3800 (Instruments and Related Products). As
well as other types of hospital supplies from Baby Formula (2020) to
Hospital Gowns (2381), Cottonwool and Dressing (2241). Using the

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The strategic importance of the drug-chemical dissynergy should not be underestimated. Hill and Hansen
(1991) found that pharmaceutical firms had few opportunities for related diversification in SIC 2800
(Chemical and Allied Products), and that attempts in
this direction were not associated with value creation.
Furthermore, the existence of drug-chemicals dissynergy
provides strong explanation for the nonentry of most
U.S. chemical firms into pharmaceuticals (refer Table
1), despite the fact that pharmaceuticals are among the
most profitable industries in the U.S. (Comanor 1986).

3. Analytical Framework
There are two approaches to the measurement of relatedness in the literature. Existing measures of relatedness have tended to be described as categoric (Wrigley
1970, Rumelt 1974) or continuous (Montgomery 1982,
Palepu 1985); however, the critical difference between
them is not in the scale of their data but rather in their
approaches, judgmental versus mechanistic, to determining relatedness.
The categoric measurement of relatedness, originated
by Wrigley (1970) and more fully developed by Rumelt
(1974), is judgmental in nature as it depends greatly on
the individual researcher's judgement for its execution.
In this approach, classification of relatedness is based
on business units being "in some way" related through
"common skills, resources, markets, or purpose" (p. 29).
The correct use of Rumelt's schema requires that the
researcher have intimate knowledge of each of the many
firms to be classified, as well as extensive knowledge of
different types of relatedness at all points of the value
chain across all industries. Then, in a manner that is
difficult to specify and to replicate, relatedness is determined by the researcher as an implicit weighted average of similarities/dissimilarities at different points
of the value chain. These informational and judgmental
demands have led researchers to search for alternatives
that were simpler to use and more straightforward to
replicate.

output-based rationale of relatedness by 2-digit SIC codes, healthproducts (3800) and drugs (2830) appear to be unrelated, but they
are clearly related on the basis of marketing to hospitals and physicians.

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Table 1

Chemical -Pharmaceutical Business Combinations among U.S. Firms


25 Largest

25 Largest
Chemical Firms

Nondrug Chem.

Drug

Pharmaceutical Firms

Nondrug Chem.

Drug

(Rank-ordered)

% Total Sales

% of Total Sales

(Rank-ordered)

% Total Sales

% of Total Sales

2.5
0.0
0.0
0.0
0.0
0.0
0.0

75.0

Pfizer

15.0

25.0

Upjohn

20.0

38.4

0.0
0.0

35.0

Richardson-Merrell

10,0

34,6

Searle

10,0

38,7

Squibb

23,4

Winthrop/Sterling

0,0
0,0

American Cynamid

30.0

9,0

Syntex

18.3

51.7

Robins

0,0
0,0
0,0
0,0
0.0

75,0

Du Pont

99.0

0.8

Dow Chemical

54.3

10.6

6.6

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0,0
0.0
0.0
9.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0

Exxon
Monsanto

38.7

Union Carbide

63.2

Celanese

100.0

Shell Oil

18.6

Standard Oil (Ind)

10.3

Atlantic Richfield

8.3

WR Grace

50.1

Allied

24.2

Phillips Petroleum

16.8

Gulf Oil

9.0

Occidental Petrol.

19.7

Eastman Kodak

18.9

Mobil
Hercules

3.0
100.0

American Cyanamid

30.0

Rohm & Haas

93.2

Stauffer Chemicals

88.1

Tenneco

11.9

Texaco

2.6

Ethyl Corp.

62.6

US Steel

11.5

Borden

33.7

Merck
Amer. Home Prod.
Eli Lilly
Smith Kline French
Johnson & Johnson
Bristol-Myers Co.
Warner-Lambert

Schering-Plough
Abbott

Eaton-Norwich
Rorer
Marion
Block
Pennwalt
Carter-Wallace
Baxter

31,5
45,3
52,1
18,8
25,4
23.0

25.9

23.0

15,8
75,0
86,0
23.0

50.0

6.0

0.0
0.0

34.0

5,6

Source: COMPUSTAT segment tapes and sample of study.

In contrast to Rumelt's (1974) methodology, the continuous measures of relatedness suggested by Montgomery (1982) and Palepu (1985) are mechanistic in
their application. These measures are based on the assumption that all relatedness between business units is
fully delineated by 2-digit SIC codes. Thus, using this
single criterion, combinations of business units within
the same 2-digit code are deemed as related, and therefore, synergistic, while combinations of units with different 2-digit codes are deemed as unrelated, having
neither synergy nor dissynergy. The most commonly
used of these continuous, mechanistically generated
measures are the Herfindahl index (Berry 1974, Montgomery 1982), the entropy index (Amit and Livnat
1988, Jacquemin and Berry 1979, Palepu 1985), and

MANAGEMENT SCIENCE/VOI. 39, No. 11, November 1993

the concentric index (Caves et al. 1980, Montgomery


and Wernerfelt 1988).
There are three problems with these mechanistic
measures, and our hypotheses derive from our discussion of them. The first problem with the mechanistic
approach is that the SIC consists of aggregations of
businesses based only on production or output similarity. By production similarity, we mean commonality in
the physical characteristics of the products, raw materials, or manufacturing processes. Similarities are completely ignored for consumer characteristics, marketing
practices, distribution procedures, innovation activities,
human resource skills, management technique, etc.^
' Discussed in footnote 2,

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Second, despite the fact that SIC groupings are based


on production and output similarities, SIC code similarity fails even to capture the full scope of production
relatedness in a strategic sense. Business units with SIC
codes not falling in the same 2-digit classification may
not only be related, but could in fact be vertically integrated, Davis and Duhaime (1992) address this issue
at some length. In an example they show that, SICs
3721 and 3664, a combination of businesses common
among aircraft manufacturers, would be labeled as unrelated manufacturing activity under the mechanistic
approach. But SIC 3721 is aircraft manufacturing and
SIC 3664 is the manufacture of search, detection, navigation and guidance systems. Activity in SIC 3664 provides critical instrumentation used in all types of aircraft.
A third problem with the mechanistic approach is
that the levels of synergy generated by different related
combinations of business units are assumed to be identical. All business combinations in the same 2-digit SIC
code generate the same level of synergy, while business
combinations across 2-digit SIC codes generate neither
synergy nor dissynergy. Clearly however, some business
combinations will be significantly more synergistic than
others. Indeed some attempted combinations will even
be dissynergistic (Hill and Hansen 1991, Jones and Hill
1988, Porter 1987, Ravenscraft and Scherer 1987), Yet
the mechanistic approach, as effected in the studies cited
above, completely ignores both dissynergy, and variations in synergy over time.
In summing up the above, we propose three key hypotheses:
HI. Production relatedness, especially as measured by
2-digit SIC categories, is not always synergistic.
H2.

Dissynergy exists.

H3. Sources of synergy change over time, accentuating


different points of the value-chain at different points in the
industry life cycle.

Given the limitations of both the judgmental and


mechanistic approaches, it is perhaps not surprising that
many studies of related diversification and performance
(achieved synergy) fail to find the hypothesized positive
linkage among U.S. firms (Dubofsky and Varadarajan
1987, Jose et al, 1986, Michel and Shaked 1984, and

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Rajagopalan and Harrigan 1986), as well as among


British firms (Grant et al. 1988, Grant and Jammine
1988, Luffman and Reed 1982). These contrarian empirical findings would have been predicted by several
theoretical studies on the relatedness-synergy linkage
(Ansoff 1965, Chandler 1962, Dundas and Richardson
1980, Jemison and Sitkin 1986, Reed and Luffman 1986,
Salter and Weinhold 1978).
In light of the above, we propose a third approach,
the direct estimation of synergy, based on a modification
of the concentric index. That index is formally computed
as:
N-1

Concentric Index

(1)

1=1 y=i+i

where f, denotes the proportion of corporate assets invested in industry I, and Stj is the coefficient of synergy
between industries ; and ;. This index is designed to
approximate the contribution of relatedness to synergy
across all business combinations of the firm. In the
studies by Caves et al, (1980) and Montgomery and
Wernerfelt (1988) mentioned above, the values for the
coefficient, Sy, were mechanistically imposed and arbitrarily assumed to be 1 if industries i and / have the
same 2-digit codes (hence are "related"), and assumed
to be 2 if industries i and ; have different 2-digit SIC
codes (hence are "unrelated"). These studies also computed the concentric index at the 3-digit level,^ We will
use the concentric index in Equation (1), but will replace
the mechanically imposed coefficients Sjj with statistically estimated valuesOLS coefficients on variables
{Fi*Fj), such as (% drugs*% chemicals) or (% drugs*%
health). When S,y is estimated to be positive, there is
synergy between industries i and;', When S^ is negative
there is dissynergy in combination of industries i and

' Caves et al, (1980) and Montgomery and Wernerfelt (1988) overcome an important limitation of the SIC by using 3-digit SIC codes
as the basis for relatedness. Many 2-digit categories are very diverse
and thus when used as the sole basis for relatedness, relatedness is
often overstated. However, Davis and Duhaime (1992) (discussed
above) show that both 2-digit and 3-digit SICs fail to effectively capture relatedness, as output-based relatedness often goes across 2-digit
SIC codes. It is this latter type of relatedness which is not captured
by the SIC (2-digit or 3-digit) on which we focus our attention.

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j . When Sij is zero, there are neither synergies nor dissynergies. Equation (1) is thus a linear approximation
to some true but perhaps more complicated formula for
synergy (super-additivity).
We will estimate the synergy coefficients S,y as follows.
For the moment, we will develop our model under circumstances where only physical capital and synergy
contribute to the value of the firm, so that we may focus
on the role and measurement of diversification. Later,
in the empirical section, we will add back into the model
prior to estimation other important factors that contribute to valuation of thefiirm,such as short-term disequilibria and intangible capital. Consider first operations
in only two industries i andj. Denote the physical assets
invested in industry i as K, and physical assets in industry / as Kj. These assets are appropriately measured
at replacement cost value. With no short-run industry
shocks and no intangible capital, we may approximate
the capital-market value (denoted M) of a diversified
investment in both industries as:
M = (Ki + Kj) +

(2)

where S,; is the estimated coefficient of synergy, and K


is the sum of physical capital in all industries, (K, -I- Kj)
in this instance. We must divide the rightmost term in
(2) by the sum of all physical capital K to preserve scale;
note that if we double both K, and Kj, then M exactly
doubles. Equation (2) is the most simple, direct test for
synergy, and has a natural interpretation in terms of
Tobin's Q. Note that M (the market value of assets)
represents the numerator of Tobin's Q, while the sum
K (the replacement-cost value of assets) represents the
denominator.
For a firm with operations in three industries, the
capital-market value M becomes:
M = (Ki + Kj + KO +

(5)

which, after linearization, may be estimated. In contrast,


we propose to make no assumptions as to the S^ coefficients and to directly estimate Equation (4), after linearization. Note again, that we will have to add in other
factors that determine capital market value other than
just physical capital and diversificationfactors such
as short-run disequilibrium and intangible capital. We
will postpone these extensions of Equation (4) until the
empirical section.
In addition to estimation of synergy using capital
market performance of the firm as a whole, we propose
to examine the effects of diversification on the innovative productivity of the pharmaceutical division alone.
As discussed above in 2, the discovery of new drugs
is the core of competitive advantage for the pharmaceutical industry after 1950. If business combinations
of Pharmaceuticals with chemical, health-care, or agricultural divisions improve the abilities of firms to discover such new drugs, then this synergy is of large
competitive importance. Note that this second approach
will only capture the benefits of synergy associated vnth
the pharmaceutical division and the innovative stage of
the value-chain. We model the effects of diversification
on innovative productivity as:
Idrug =

(6)

;#drug

r^-

(^^

and for a firm with operations in N different industries,


the capital-market value is:
N-l

= K*(l + Concentric Index)

Kj *Kk* Sjk

K
K

Note that the rightmost term in (4) is simply K times


the concentric index in (1). Both the mechanistic approach and our new approach are identical to this point.
From here on, however, the mechanistic approach
would make assumptions as to the expected values for
each Sij (somehow) and using these values compute the
double-sum of the concentric index. This process converts Equation (4) into:

/V

2 m

MANAGEMENT SCIENCE/VOI. 39, No. 11, November 1993

where Idmg denotes drug innovations and R&Ddrug denotes pharmaceutical research and development expenditures (properly capitalized). The coefficients of
synergy Pj indicate whether the combination of pharmaceuticals and industry ' / ' improves or worsens the

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DAVIS AND THOMAS


Direct Estimation of Synergy

innovative productivity of drug research. Equation (6)


will be adapted and expanded in the data and estimation
section below.
Evidence for HI will be provided by estimated coefficients of synergy Sjy or Py that are zero or negative
despite production relatedness (same 2-digit SIC code
for industries i and;') or that are positive despite production unrelatedness. Evidence for H2 will be provided
by negative estimated coefficients of synergy Sy or Pj
for some pairings of industries i and;'. With regard to
H3, in the context of 2 of our paper above, we expect
that production relatedness becomes less synergistic
over time in the pharmaceutical industry as marketing
relatedness becomes more synergistic. Specifically, we
expect that the coefficient of synergy between drugs
and chemicals will decline as the coefficient of synergy
between drugs and health products increases.

Table 2

Sample Firms

1. Abbot

24. Mallinkrodt

2. Alcon

25. Mead Johnson

3. Allergan

26. Merck

4. American Cyanamid

27. Merrell

5. American Hospital Supply

28. Miles Labs

6. American Home Products

29. Parke Davis

7. Armour

30. Pennwalt

8. Baxter

31. Pfizer

9. Block

32. Plough

10. Bristol Myers

33. Proctor & Gamble

11. Calbioghem

34. Robins

12. Carter Wallace

35. Rohm & Hass

13. Chattem

36. Rorer

14. Cooper

37. Schering

15. Cutter

38. Searle

16. Dow

39. Smith Kline

17. Dupont

40. Squibb

18. (Norwich-) Eaton

41. Sterling

19. International Rectifier

42. Syntex

20. Johnson & Johnson

43. Upjohn

4. Data and Estimation

21. Key

44. US Vitamin

22. Lilly

45. Warner Lambert

The sample for this study consists of 45 major U.S.owned firms participating in the drug industry. These
firms have been identified by FDA approvals of new
chemical entities (NCEs), U.S. patent office filings of
bio-affecting compositions, and scholarly studies of the
pharmaceutical industry (refer Table 2 for the list of
sample firms).
Data for 'M', constant dollar stock market value of
common equity, are taken from the COMPUSTAT tapes
and supplemented by the National Stock Summary. Stock
prices are deflated by the U.S. GNP deflator.
Data for R&D are a distributed lag of defiated corporate expenditures for research and development. R&D
expenditure data are from the COMPUSTAT tapes,
supplemented by corporate inquiries in 5 percent of the
cases where there were missing data, and are deflated
by the U.S. National Institutes 'of Health (NIH)
biomedical deflator. Weights for the distributed lag are
from Thomas (1990) (adapted from Wardell et al. 1982
and Hansen 1979). The estimates of pharmaceutical
R&D used by this study (when reported accounting data
were not available) were provided by the strategic
planning divisions of two large U.S. drug firms. These
corporate estimates were used in approximately 5 percent of all observations. The data provided by both firms

23. Marion

1340

The following sample firms exited due to acquisition


during the sample period:
Alcon

Miles Labs

Allergan

Mead Johnson

Armour

Parke Davis

Calbiochem

Plough

Cutter

US Vitamins

Virtually all of these firms were small relative to other


sample firms, and suffered from diseconomies of scale due
to FDA regulationsee discussion of results in 5.

were highly similar, hence corroborating, and provide


a complete tabulation for all sample firms back to 1960.
Idrug consists of nonbiological, self-originated, single
new chemical entities (NCEs); thus drugs discovered
by one firm but marketed by another firm are attributed
to the discovering firm, and compound drugs are excluded. Data on Idrug are from DeHaen (various).
Additionally, completely new data on corporate diversification for the 45 sample firms are collected by
this study, as described below. Most studies that use
continuous, cross-sectional measures of diversification
must rely on corporate financial reports of sales by sec-

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Direct Estimation of Synergy

tor. These reports are problematic because of the very


different levels and methods of aggregation employed
by different firms. For example, some firms report drug
sales as an independent segment, while otherfirmslump
drug sales into either a consumer goods segment, a
chemical segment, or a health care segment. In contrast,
this study begins with highly reliable estimates of pharmaceutical sales for each samplefirmin each year drawn
from the proprietary reports of IMS, a commercial medical statistics firm (data used with permission). Thus
we know precisely how much of each firm's corporate
sales are in pharmaceuticals, for all sample years back
to 1960.
The resulting data set has three particular strengths.
First, we have a complete set of data back to 1960, enabling comparisons of the effects of diversification over
two full decades. A critical limitation for many studies
is their reliance on corporate financial statements that
do not comprehensively report certain key variables,
such as R&D expenditures, until the mid-1970s when
changes in U.S. laws compelled such reporting. This
nonreporting of R&D expenditures is especially pronounced for smaller firms, which forces either a (statistically dubious) focus on a nonrandom selection of
firms that do report data or else a truncation of the
study time frame to begin only in the mid-1970s. In
contrast, we have a complete set of data back to 1960.
A second strength is that we have a very concrete
measure of the productivity of each pharmaceutical unit
in the samplethe number of FDA-approved new
drugs that were discovered. Most studies rely solely on
financial measures of diversification impact. While examination of financial success is important, and is replicated here, it is useful to provide more direct, tangible
confirmation of hypothesized diversification synergies.
While pharmaceutical innovation is not the sole activity
of the diversified firms in the sample, it is the core strategic activity of firms in this industry.
A third strength of the data used for this study is the
improved precision with which diversification is measured here. As mentioned above, most studies that use
continuous, cross-sectional measures of diversification
rely on corporate financial reports of sales by sector.
Different firms employ very different levels and methods of aggregation, lumping a variety of products in the

MANAGEMENT SCIENCE/Vol. 39, No. 11, November 1993

same segment. By contrast, we start with highly reliable


estimates of pharmaceutical sales from the proprietary
reports of IMS. Using this data we are able to disaggregate corporate sales by product area with greater accuracy, thus providing a more precise picture of diversification among pharmaceutical firms.
In addition to these strengths, there are three limitations to our data. The first is that we require a proper
(replacement cost) value for tangible assets of each firm.
For this study we will use the book value of corporate
equity, as it is an available stream of data back to 1960.
Data on the replacement cost value of equity is available
from the financial statements of U.S. firms only after
the mid-1970s. Re-estimation of our results using replacement cost data, for those handful of years to 1980
where data are available does not change our findings,
and thus we regard this limitation as not serious.
A second, similar limitation concerns intangible marketing capital. In addition to data for the tangible
(physical) assets of each pharmaceutical firm in the
sample, we should have at least proxies for corporate
intangible capital in research and marketing. We indeed
have data on intangible research capital, and as discussed above these data are especially good. However,
data on advertising expenditures by each firm, traditionally used as a proxy for intangible marketing capital,
are available only after the mid-1970s. When we reestimate our results appropriately adding advertising
data for those few years when such data are available,
the estimated effect of greater advertising capital is surprisingly negative, though insignificant; ourfindingson
synergies are unchanged. Actually, the insignificance of
the advertising variable should not surprise us as the
bulk of marketing for pharmaceuticals in the U.S. consists of office visits to doctors and medical institutions
by sales staff ("detailing"), rather than advertising. Thus
advertising is a poor proxy for overall marketing expenses in this industry, and we are unable to assess the
seriousness of this data limitation for our study.
The third limitation is almost universally shared by
other diversification studies. When assessing the determinants of asset-based financial performance, we
should measure diversification with the shares of corporate assefs that are held in various industries. These
data are not available to us before the mid-1970s for

1341

DAVIS AND THOMAS


Direct Estimation of Synergy

most sample firms, and when available are subject to


the whims of corporate divisional breakouts in financial
statements. Further, the value of each asset is recorded
at its historic rate; thus, comparability of value across
assets at any point of time is limited. To overcome these
impediments we use the shares of sales of a firm in
various industries to measure diversification. These data
are available for this study, and as discussed above are
especially good.
For estimation, our first goal is to examine the effects
of diversification on the stock market value of common
equity of the 45 sample firms. We must adapt Equation
(4) from 2, because the capital market value of the
firm will depend on more than simply physical capital
and diversification, as Equation (4) for expositional
convenience denotes. Additional sources of market
value arise from corporate holdings of intangible capital
in research and marketing, and from short run industry
shocks that create either positive or negative rents. Intangible research capital has been well-computed for
this study, as discussed above. Data for intangible marketing capital available for this study are however quite
limited, as also discussed above. As regards short-run
disequilibrium shocks, a common proxy for the capital
market effects of these shocks is the growth rate of corporate sales, GROW. Rapid, positive growth is regarded
as associated with positive short-run shocks that add
to the capital market value of the firm, while slow or
negative growth is regarded as associated with the reverse effects. Adding capitalized R&D expenditures and
the sales growth rate to Equation (4) gives us:
= K*(l +

-I- ajGROW

+ 2 2 h*Fi*S,A. (7)
Equation (7) is nonlinear in the independent variables: K, R&D/K, GROW, and the disaggregated components of the Concentric Index. Taking logarithms of
both sides of Equation (7), using the approximation
that X log(l + x) when x is small, we have a linear
approximation ^:
' This procedure and specification is based on the work by Montgomery
and Wemerfelt (1988).

1342

log (M) =flo+flilog(K) +


N-l

+ 2 2 F,*Fy*S,;.

(8)

Equation (8) gives us the expected value for log(M)


for a given firm in a given year. We regard the dependent variable, log(M) as normally distributed around
this expected value. We also expect the individual realizations of the dependent variable to be independently
distributed, except perhaps for autocorrelation. Positive
or negative differences between the expected values for
log(M) based on (8) and the actual values may well
represent strategic successes or failures uncaptured by
our analysis. The effects of such strategic successes and
failures may well persist beyond a single year. Thus,
the parameters of Equation (8), including the S;, parameters of the concentric index, will be estimated using
least squares, corrected within the observations of each
firm for autocorrelation.
Our second goal for estimation is to examine the determinants of the number of new FDA-approved drugs
discovered by a sample firm. These discoveries, or new
chemical entities (denoted NCE), are estimated using
the following equation:
log(NCE) = bo + bi*log(R&D)
2

i'yfy.

(9)

We have adapted Equation (6) into Equation (9) in


that we approximate purely pharmaceutical R&D by
the product of total firm R&D and the firm sales in
pharmaceuticals (Fdmg). The x = log(l -I- x) approximation is also used.
Equation (9) gives us the expected value for NCE for
a given firm in a given year. The NCE-dependent variable is however clearly extremely nonnormal in distribution. The number of NCEs discovered in a given year
is highly skewed, with a vast majority of observations
in each year having NCE value of zero, and the frequency of larger values of NCE monotonically and
sharply declining. Second, the realized values of NCE
are completely discrete, ranging from integers of zero
to at most four. Third, the distribution of NCEs is highly
heteroscedastic, meaning that the variance of NCE is

MANAGEMENT SciENCE/Vol. 39, No. 11, November 1993

DAVIS AND THOMAS


Direct Estimation of Synergy

Strongly positively correlated with the mean for each


observation. Consider an observation in Equation (9)
where the expected value of NCE is extremely small,
say because the level of corporate R&D expenditures is
quite small. Both mean and variance of NCE for this
observation will be near zero. Next consider an observation where the expected value of NCE is relatively
high, say because the level of corporate R&D expenditures is quite large. The highly skewed nature of the
discovery process for new drugs implies that NCE discoveries arrive in a extremely irregular pattern, so that
both mean and variance of NCE will be high.
The distribution for NCE we have just described is
essentially Poisson, which is discrete, skewed, and heteroscedastic, with equality of the mean and variance of
the distribution. The exact equality of mean and variance
required by the Poisson distribution however represents
a unneeded assumption. For the estimation of this study,
we will take NCE as distributed with:
Variance(NCE) = s^*mean(NCE)

(10)

where s^ is a parameter to be estimated. Note that if s^


were exactly equal to unity, then NCE would be distributed exactly Poisson.
Equations (9) and (10) may be estimated using maximum quasi-likelihoods. The maximum quasi-likelihood
technique uses the standard iteratively weighted nonlinear least squares routines of common statistical packages (such as SAS) to estimate parameters in Equation
(9) above. In other words, we specify Equations (9)
and (10) at once, using the variance terms in (10) as
weights to estimate parameters in (9). For further details, see Thomas (1990).

5. Results
The effects of diversification on the stock market value
of common equity of the 45 sample firms of this study
are estimated using Equation (8) and reported in Table
3. The key coefficients are the S^ terms of the estimated,
disaggregated concentric index (defined above in Equation (1)). We examine the pharmaceutical firms' diversification into four industries: two industries, general
chemicals and agricultural products (predominantly
pesticides and veterinary drugs), that have the same 2digit SIC code (2800) as pharmaceuticals, and two in-

MANAGEMENT SCIENCE/VOI. 39, No. 11, November 1993

dustries with differing 2-digit SIC codes health-care


products (3800, 2000), and all "other" industries. The
components of the concentric index that do not pertain
to the pharmaceutical industry are suppressed. The
sample is split into four time periods, with the date of
the 1962 Amendments to the Food, Drug, and Cosmetic
Act being a natural dividing point. The remaining 18
years are divided into three six-year periods. Finally,
because there is a such a clear trend over time in most
coefficients, a pooling of all four time periods is reported
at the far right of Table 3, with appropriate interaction
terms with time.
The estimated coefficients reported in Table 3 conform
to our hypotheses of shifting patterns of synergy over
the industry life cycle. After 1962, we find strong, statistically significant dissynergy between drugs and
chemicals. The linkage between these two industries is
only production relatedness, and as the pharmaceutical
industry became a mature industry in its own right, any
similarities at this point of the value chain became
swamped by dissimilarities at other points. In contrast,
we find after 1962, strong and significant synergies between drugs and agricultural products, although here
the synergy is probably not due to a production relatedness either, but rather relatedness at the innovation
stage of the value chain. These results are not surprising
as agriculture products consist mostly of pesticides and
veterinary pharmaceuticals. Finally, we find a statistically significant dissynergy between drugs and health
care before 1962 that becomes synergistic by the late
1970s. The rise of the drug-health synergy parallels the
rising relative importance of marketing to health care
professionals for pharmaceutical firms during the sample period.
The deviations between these findings and the traditional wisdom of the diversification literature are evident, in accordance with our hypotheses. First, production relatedness is a questionable guide to patterns
of synergy. Second, dissynergy exists and is important.
Third, the patterns of synergy shift over time with the
industry life cycle, and thus can only be poorly captured
by any static schema.
Two additional empirical findings in Table 3 should
be noted briefly. The coefficient on log (equity) is an
elasticity of scale, measuring the advantages and dis-

1343

DAVIS AND

THOMAS

Direct Estimation of Synergy

Table 3

OLS Estimates of Diversification Contributions to Stocic Market Valuations, U,S, Pbarmaceutical Firms, 1960-1980
1960-1980
Time Periods

Independent
Variables
Intercept

In (Book value)

R&D/Book value

Growth

Drug*Chemicals

Drug* Health

1960-1962

Drug* Other

1975-1980

Variable
*(year-60)

Variable

-0,17

0.68

-0,09

-0.31

1,32

-0.10

(3.21)

(-0.28)

(-1.13)

(4,85)

(-5,14)

0.89

0.95

(19.67)

(32.99)

1.08
(30,83)

1.14
(45.92)

0.95

0.01

(27,43)

(2,49)

7.10

9,03

5.04

2,26

4.33

-0.07

(6.09)

(4.87)

(3.39)

(2.08)

(3.21)

(-1,40)

0,72

0.46

0.34

0,47

0.33

0.01

(2.35)

(2,72)

(1,30)

(1.14)

(2.55)

(0,21)

0.40

-2.80

-5,73

-4.06

-2.80

-0.19

(0,21)

(-2,68)

(-3.50)

(-2.97)

(-5.14)

(-1.04)

-2.17

0.51
(-0.85)

1.20

2.91

-0.86

0.12

(1.33)

(4,96)

(-1.46)

(3.85)

-3.02

1.66

6,30

4.85

3,02

0.15

(-0.96)

(1.25)

(3.95)

(5.10)

(3.64)

(0.96)

0.54

-0.48

1,84

0.05

0.94

-0,05

(0.65)

(-0.85)

(2.04)

(0.11)

(1.33)

(-0.75)

0.92

1969-1974

(-0.33)

(-2,39)
Drug*Agrlc,

1963-1968

79
0.22

0,87

195
0,26

0,86

212

0.93

194

0.18

0.88

693

0,31

0.23

Notes: Dependent variable is logarithm of constant-dollar stock market value of common equity for each observation.
f-statistics in parentheses.
The right-most specification pools all 4 sample periods and 16 independent variables, i.e., 8 base variable and 8 interaction terms
comprised of the base variable multiplied by (year-60) for each observation.

advantages of firm size holding diversification strategy


constant. When this coefficient is less than one, there
are diseconomies of scale; when it is greater than one
there are economies of scale. The estimated and statistically significant rise in this coefficient documents the
increasing advantages for larger pharmaceutical firms
after the 1962 Amendments (Thomas 1990), Additionally, the significant positive coefficient on the R&D/
equity ratio indicates that intangible R&D capital contributes to market value along with tangible physical
capital; note that the movements over time in this coefficient are not statistically significant.
The effects of diversification on the innovative productivity of the 45 sample firms are estimated using
Equation (9) and reported in Table 4. There are two

1344

major sources of agreement between Tables 3 and 4.


First, we find that drugs and chenucals are dissynergistic
in both tables. Embedding a pharmaceutical division
within a chemicalfirmreduces the ability of that division
to discover new drugs, and hence the stock market value
of the firm. The negative and significant coefficients on
the percentage of firm sales in chemicals in Table 4 indicate once again the drug-chemical dissynergy. Second,
we find an even sharper upward trend in economies of
scale in Table 4, The coefficient on log (R&D) indicates
the advantage of size, where size here is correctly measured as scale of research activity.
Examining Table 4 we find neither synergy nor dissynergy for drug innovation with health care or agricultural products. We must stress that we do not expect

MANAGEMENT SciENCE/Vol, 39, No, 11, November 1993

DAVIS AND THOMAS


Direct Estimation of Synergy

Table 4

Maximum Quasilikelihood Estimates of Diversification


Contributions to New Cfiemicai Entities Discovered,
U.S. Pfiarmaceuticai Firms, 1960-1980
Time Periods

Intercept

1960-1962

1963-1968

1969-1974

1975-1980

-1.85

-3.09
(-5.72)

-4.11
(-5.07)

-7.16
(-6.02)

0.97
(4.61)

1.49
(6.20)

(-3.77)
Log (R&D)

0.30
(2.50)

0.84
(5.25)

Log (% Drug)

1.02
(2.91)

0.60
(2.60)

% Chemicals

2.19
(1.52)

-1.15
(-2.14)

-1.40
(-2.06)

-1.55
(-2.27)

% Health

0.52
(0.47)

0.94
(1.22)

0.14
(0.64)

1.66
(1.86)

% Agriculture

0.70
(0.53)

0.50
(0.77)

0.64
(1.05)

1.02
(0.97)

Chi-squared
Dispersion parameter
Observations

38.7
1.34
123

65.1
0.84
250

0.63
(2.13)

74.6
0.82
230

0.57
(2.19)

135.7
0.56
211

Notes: Dependent variable is nunnber of new chennical entities (NCEs) introduced,


f-statistics in parentheses.

the findings of Tables 3 and 4 to be in one-to-one agreement, and thus are not surprised when there are differences between the two tables. In the case of health
care, the expected synergies during the later sample
years are probably due to marketing of given innovations, not discovery of more innovations. Such noninnovative synergies will not be captured in Table 4. In
the case of agricultural products, any drug-agriculture
synergies may well occur in agricultural innovation, not
in discovery of new drugs for humans that is the basis
for Table 4. Synergies realized outside the human pharmaceutical industry will not be captured in Table 4.

6. Conclusion
Though our study focussed on the historic patterns of
diversification within the pharmaceutical industry, our
findings are generalizable to other industries. Our contribution to diversification research derives from our
exploration and testing of the critical assumption that
all relatedness is synergistic. We studied the assumption

MANAGEMENT SCIENCE/VOI. 39, No. 11, November 1993

of relatedness-synergy equivalency as comprised of two


parts: (1) the levels of synergy generated by different
related combinations of businesses; and (2) the relationship between relatedness and synergy for various
combinations of businesses.
Our findings indicate that all types of relatedness are
not synergistic at any given point of time. In fact, over
time certain types of relatedness which were previously
synergistic become synergy neutral or negative. We
show that shifts in synergy are not random events,
rather they appear to be influenced by industry life cycles. For example, chemicals and drugs are related on
the basis of production. This basis for relatedness declined in synergy with the maturation of the pharmaceutical industry. Meanwhile the drugs-health products
combination based on marketing relatedness increased
in synergy.
In addition to the above findings we also show that
the direct estimation of achieved synergy, as a measure
of strategic diversity, overcomes the drawbacks of the
judgmental and mechanistic schema currently in use.
Since relatedness is merely an imperfect substitute
measure for achieved synergy, direct estimates of synergy provide unambiguous and strategically relevant
representations of diversification for both researchers
and practitioners.
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