Dimensions of International Diversification: Their Joint Effects on Firm Performance

Lee Li Gongming Qian

ABSTRACT. This study assesses the joint effects of country diversification, regional diversification, and product diversification on firm performance. Findings from this study suggest that their joint effects are curvilinear. At low levels of regional diversification, product diversification has a positive effect on firm performance, but the effect turns negative at high levels of regional diversification. Similarly, with low regional diversification, country diversification has a positive effect on firm performance, but the effect becomes negative with high regional diversification. At low levels of country diversification, product diversification has a negative effect on firm performance. However, the effect may not necessarily turn positive at high levels of country diversification. [Article copies available for a fee from The Haworth Document Delivery
Service: 1-800-HAWORTH. E-mail address: <docdelivery@haworthpress. com> Website: <http://www.HaworthPress.com> 2005 by The Haworth Press, Inc. All rights reserved.]

KEYWORDS. Country diversification, regional diversification, product diversification

Lee Li is Associate Professor, School of Administrative Studies, Atkinson Faculty of Liberal & Professional Studies, York University, Canada. Gongming Qian is Associate Professor, Department of Management, The Chinese University of Hong Kong, Hong Kong, Peoples Republic of China. Address correspondence to: Lee Li, School of Administrative Studies, Atkinson Faculty of Liberal & Professional Studies, York University, 4700 Keele Street, Toronto, Ontario M3J 1P3, Canada (E-mail: Leeli@yorku.ca). Journal of Global Marketing, Vol. 18(3/4) 2005 Available online at http://www.haworthpress.com/web/JGM 2005 by The Haworth Press, Inc. All rights reserved. Digital Object Identifier: 10.1300/J042v18n03_02

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International diversification has become increasingly common in the last decade and has great impacts on diversified firms performance (Delios and Beamish 1999). International diversification can be defined as expansion across borders of global regions and countries into different geographic locations, or markets (Hill et al. 1992). Conceptually, international diversification provides firms with benefits but at high costs (Tallman and Li 1996). The theory of multinationals suggests that international diversification provide diversified firms with the potentials to exploit more market opportunities, to spread market risks, and to seek less expensive inputs and less price-sensitive markets (e.g., Buckley and Casson 1976). However, transaction cost theory suggests that international diversification incur heavy costs, including market entry costs, costs of coordination among business units in different countries, and information-processing costs (Williamson 1985). Under certain conditions, these costs may surpass the benefits (e.g., Sambharya 1995). The key issue is how to determine such conditions. Existing literature suggests that two determinants, i.e., multinationality and product diversification, have great impacts on these costs and the benefits (e.g., Hitt et al. 1997; Tallman and Li 1996). The impacts of these two determinants have been tested a number of times with conflicting results. For example, Grant (1987) suggested that multinationalism should confer advantages over non-multinational firms. Ramaswamy (1993) went further and found that interactions between different measures of international diversification had more significant effects on firm performance. However, Michael and Shaked (1986) indicated that this might not be the case. Hitt and colleagues (1997) showed that product diversification positively moderated internationalizing firms performance but Franko (1989) saw the opposite. The reason for these mixed results, we argue, is that the impacts of these two variables are more complex than has been theoretically argued and empirically tested. Multinationality and product diversification themselves are variables rather than constants. Different levels of multinationality and product diversification have different impacts on international diversification. Moreover, multinationality and product diversification may interact between themselves and the interactions also affect firms international diversification. Based on such expectation, we designed this research to examine the model shown in Figure 1. We drew on the extent theory from several disciplines (i.e., corporate strategies, international diversification, and foreign investments) and specific theoretical domains (i.e., multinational theory, transaction cost

Lee Li and Gongming Qian

FIGURE 1. Joint Effects of Diversification Dimensions on Firm Performance

H3a,b H1a,b Product Diversification Country Diversification

H2a,b Regional Diversification

Firm Performance

theory, and organizational learning theory) to build the conceptual framework. Our model departs from the extant international diversification literature in two significant ways. First, it differentiates two distinct dimensions of multinationality, i.e., country diversification and regional diversification. We believe diversification across countries within a region incurs much lower costs than diversification across regions. As such, the term multinationality is too general to explain the costs and benefits associated with international diversification. The extant international diversification literature does not make such differentiation. Second, the model developed in this paper aims to capture the complexities of the interactions between three dimensions at different levels. Most of existing studies focus on one or two variables and overlook the variations of the variables. We believe our papers contributions on these two fronts can help explain the mixed findings in the existing literature. THE CONCEPTUAL FRAMEWORK AND ITS THEORETICAL BASES As the framework in Figure 1 suggests, we classify international diversification into three dimensions and propose their joint effects (between these dimensions) on firm performance. International diversification consists of three dimensions, i.e., product diversification, country diversification, and regional diversification. Product diversification can be defined as the expansion into product

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markets new to a firm (Saloner et al. 2001). Since Rumelts (1974) seminal study of qualitative type of product diversification, several methodologies have been used to assess its effects on firm performance, including Standard Industrial Classification (SIC) categories (Palepu 1985) and typology variables and SIC code-based entropy variables (Hoskisson et al. 1993). However, the findings have been contradictory (Hitt et al. 1997). The discrepancies may result from unlike measures or from nonlinearities in the relationship between product diversification and firm performance (Tallman and Li 1996). Country diversification is defined as expansions into individual foreign countries. Regional diversification is defined as expansion into different global regions or areas, such as North America or Western Europe. Country diversification and regional diversification are two related but different concepts. Here, we first use an example (there are two firms: Firm A and Firm B) to illustrate the difference. The former has business operations in 40 countries which are located in two different world regions while the latter diversifies in only six countries which spread across five different regions. Firm A has high levels of country diversification but low levels of regional diversification. In contrast, Firm B has low levels of country diversification but high levels of regional diversification. A differentiation between country and regional diversification is necessary and important. High levels of country diversification may not necessarily be risky or costly if a firm restricts its operations in a particular region where most of countries share similar demand patterns and cultures. In contrast, low levels of country diversification can be risky or costly if a firm spreads its limited markets across different regions which are different in terms of psychic distance, competition intensity, demand patterns, and consumer cultures. We draw mainly on three relevant theories (i.e., multinational theory, transaction cost theory, and organizational learning theory) to develop the analytical framework. The theories have been widely employed in the existing literature. Multinational theory relies on foreign direct investment and internalization perspectives to explain international diversification. Foreign direct investments provide the potential to transfer competitive advantages across country borders and minimize factor costs, e.g., labor costs, capital charges (Grant 1987). Internalization, on the other hand, offers an optimal means to overcome market imperfections across different countries (Buckley and Casson 1976). However, foreign direct investments and internalization may incur transaction costs, such as coordination costs, communication costs, exit costs, and the costs of losing flexibility (Williamson 1985). Transaction cost the-

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ory assesses various costs incurred in the transactions across country borders. However, transaction cost theory overlooks the fact that these costs may be reduced when firms increase their country-specific knowledge and the market penetration competencies. Organizational learning theory, on the other hand, focuses on the development of managerial competencies to manage complexities and uncertainties of internationalization. Such process is time-dependent and firm-specific. As such, the process is a unique path shaped by learning mechanisms, including practice, codification, mistakes, and pacing (Eisenhardt and Martin 2000). However, organizational learning does not address directly the impacts of external factors which are out of firms control. Our study will integrate these theories to explain and assess corporate diversification and its relationship to firm outcomes. The relationship is more fully explicated in the arguments that follow, and testable hypotheses are proposed. CONCEPTUAL FRAMEWORK Product Diversification and Country Diversification At low levels of country diversification, product diversification will vary negatively with firm performance. Multinational theory indicates that low country diversification constrains firms operational scale, as firms restrict their operation in certain countries (Grant 1987). Low country diversification limits market opportunities and growth potential for each product line within a diversified firm as low country diversification limits market size (Delios and Beamish 1999). Diversified firms can hardly achieve large volume with low country diversification. Consequently, they can hardly spread R&D costs and promotion costs of each product line over a large volume and thus suffer high costs (Habib and Victor 1991). In other words, diseconomies of scale lead to high operation costs of each product line. Organizational learning theory suggests that firms can hardly accumulate product expertise and competition knowledge with limited operational scale (Morck and Yeung 1991). A firm that diversifies into a new product line generally knows less about the new product than competitors. Limited sales volume associated with limited market size retards the market followers process to swiftly catch up and surpass market leaders in terms of R&D capabilities, production efficiencies, and promotion competencies (Saloner et al. 2001). Moreover, limited

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product expertise and competition knowledge restricts diversified firms capabilities to achieve synergies between product lines. With limited product expertise and competition knowledge, they can hardly transfer or share knowledge-based resources between product lines (Eisenhardt and Martin 2000). Increased country diversification beyond a certain degree will reduce the costs of product diversification. Multinational theory suggests that wide country diversification provides opportunities for each product line in various markets. In other words, each product line can achieve reasonable volume across various countries. Large volume leads to economies of scale (Porter 1985). With wide country diversification, firms can also amortize investments in critical functions such as R&D and brand image over a broader base (Hitt et al. 1997). Moreover, wide country diversification increases the flexibility and spreads the risks for each product line. A particular product lines failure in certain countries can be compensated by its success in other countries. Wide country diversification provides the opportunities for multinational manufacturers to exploit market imperfections (e.g., differences in capital charges and labor costs) by performing many activities internally (Buckley and Casson 1976). In addition, wide country diversification helps a firm to build up its internal capital market (Hill et al. 1992). This facilitates the allocation of financial resources between different businesses and helps the firm to overcome sharp fluctuations in financial needs. Moreover, firms with internal capital markets may have informational advantages, as external sources of capital have a limited ability to know what is specifically taking place inside a large organization (Hitt et al. 1997). Wide country diversification exposes a firm to a rich array of environments. Organizational learning theory suggests such exposure to different environments speed up the firms learning process as the firm has to transfer, integrate, and create knowledge-based resources to manage uncertainties associated with different environments (Sambharya 1995). Managers who look after various countries can gain detailed product management and country-specific knowledge. This builds and maintains firm-specific capabilities and speeds up the innovation process, as the firm can combine different skills and knowledge to develop innovations and new products (Ettlie 1998). Innovation enhances the competitiveness of each product line (Porter 1985). Moreover, operation across different countries forces firms to integrate, build and reconfigure their internal and external competencies to address different environments (Teece et al. 1997). Such capabilities are the important

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source of sustained competitive advantages (Eisenhardt and Martin 2000). Therefore, we propose: Hypothesis 1a: At low levels of country diversification, performance should vary negatively with the degree of product diversification. Hypothesis 1b: At high levels of country diversification, performance should vary positively with the degree of product diversification. Regional Diversification and Country Diversification Countries that are located in the same region or area, such as North America, Western Europe, or Greater China (Mainland China, Hong Kong, and Taiwan), may share similar cultures, demands or competition intensity. Similarity is defined in a relative rather than absolute sense. In other words, differences between two countries located in different regions will be much more substantial than those between two countries in the same region. If a firm diversifies into various countries within a region, it enjoys increased market opportunities and growth potential but at the same time avoids a great diversity of customer cultures, demands, and competition intensity. Relative similarity between countries in a region has great strategic implications for diversified firms. Transaction cost theory suggests that such similarities reduce coordination costs, distribution costs, management costs, information searching costs, and information processing costs, as the similarities reduce both managerial, technological, and coordination complexities and facilitate communications between business unites located in different countries (Williamson 1985). Multinational theory suggests that similar market environments within a region help firms make it possible for diversified firms to standardize their products and rationalize production in the particular region (Tallman and Li 1996). As countries in the same geographic area share many similar market characteristics, customers there may accept similar product features. Standardization saves costs as it provides economies of scale and scope (Hitt et al. 1997). Moreover, it makes it easier for the firm to exploit the synergies between countries. Core competencies developed in one country can be applied to similar countries in the same region (Tallman and Li 1996). It is also easier to transfer resources or assets, such as brand image, between countries in the same region.

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Organizational learning theory suggests that similar environments within a region facilitate learning and reduce uncertainties (Habib and Victor 1991). Knowledge gained through trial-and-error process in one country can be applied to similar countries in the same region. Business units in different countries of the same region can share cutting-edge product knowledge and marketing knowledge. In addition, knowledge-based resources accumulated from similar environments can be combined and integrated relatively easily to create new competencies (Eisenhardt and Martin 2000). If a firm diversifies widely in different world regions/areas, it has to deal with unknown cultures, new competitors, and strange and complex environments that are characterized by different sets of political, economic, and legal factors (Sambharya 1995). Transaction cost theory argues that the cultural diversity arising from operations in different marketplaces brings with it numerous problems of communication, coordination, control, and motivation (Kogut and Singh 1988). Different cultures, levels of economic development, levels of competition intensity, and customer needs across regions/areas make it difficult for a firm to standardize its product and distribution management. Hence, it must adapt its marketing mix to fit different regions/areas, which will incur governance and management costs (Van Raaij 1997). An increased psychic/cultural distance between the firms home country and its locations in different world regions/areas negatively influences cross-border administration costs (Geringer et al. 2000). As such, continued regional expansion contends with the increasingly difficult prospect of managing a multicultural, multi-location workforce that serves distinctly different customer markets, and navigating through a maze of formidable constraints imposed by the sheer number of locations in which operations are established (Gomes and Ramaswamy 1999). Consequently, managerial constraints increase with multi-regional operations (Grant 1987). It is true that diversified firms can enhance their competencies to manage the managerial complexities and reduce administration costs through learning process. However, such learning process takes time and can be too slow when diversified firms face threats from formidable competitors. Organizational learning theory suggests that institutional and cultural factors are formidable barriers to the transfer of marketing knowledge and product knowledge between regions (Kogut and Singh 1988). The organization will become too complex when a firm has an increased proportion of foreign businesses located in a great number of different regions, and learning is hampered by information overload (Delios and

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Beamish 1999). Such large complex operations across different regions can hardly survive competition in high-velocity markets where changes frequently along unpredictable and nonlinear paths (Eisenhardt and Martin 2000). The centralized system is too slow in responding to market changes as information flow between hierarchy layers within the firms is hardly efficient (Hitt et al. 1997). Decentralized system can be problematic as well. Decentralization will lead to resource waste. As business units in different regions can hardly share resources, they have to duplicate and repeat same functions or activities in different regions (Sambharya 1995). Moreover, decentralization may trigger off civil wars between business unites in different regions. Therefore, we propose: Hypothesis 2a: At low levels of regional diversification, performance should vary positively with the degree of country diversification. Hypothesis 2b: At high levels of regional diversification, performance should vary negatively with the degree of country diversification. Product Diversification and Regional Diversification Low levels of regional diversification exposes a firm to similar environments but, at the same time, may not necessarily restrict the firms market opportunities if the firm diversifies into various countries within a particular region. Low levels of regional diversification minimize the disadvantages of product diversification, as the environmental similarities reduce the costs of coordination between product lines (Geringer et al. 2000). More importantly, low levels of regional diversification provide opportunities for firms to exploit synergies between product lines (Hitt et al. 1997). Environmental similarity makes it easier for different product lines to share resources or assets, such as R&D capabilities and marketing competencies (Porter 1985). International expansion within a region, on the other hand, brings strategic benefits. Some product lines, which may not survive at home market due to small home market size, may become successful when they enter overseas markets, as individual small markets can add up to a reasonable volume. In addition, each product line can increase its returns by exploiting its unique assets, such as brand equity, patents, or unique processes, across a great number of similar markets (Delios and Beamish 1999). International expan-

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sion within a region increases the profit stability of each product line (Habib and Victor 1991). If a product line fails in a particular country, its success in other countries may compensate the losses and thus rescue the product line. Low levels of regional diversification do not increase managers information asymmetries and information overload when volume rises rapidly (Hitt et al. 1997). Organizational learning theory suggests that low regional diversification may facilitate product diversification (Morck and Yeung 1991). Increased operations, which result from operations in various countries, lead to increased knowledge spillover between product lines (Saloner et al. 2001). With low environmental uncertainties, firms become increasingly confident and aggressive. Consequently, they tend to learn and diversify into different product segments in an effort to exploit unexplored market opportunities or achieve economics of scope. When firms diversify into various different regions, they have to deal with great varieties of environments and experience high complexities and managerial constraints. Product diversification may dilute firms focus (Geringer et al. 2000). Such lack of focus, combined with high levels of complexities and managerial constraints, may make diversified firms vulnerable to cost competition from formidable competitors (Porter 1985). High governance costs associated with product diversification may overwhelm the scope of economies of multiple markets (Tallman and Li 1996). In addition, high levels of regional diversification can also lead to diseconomies of scale. When firms diversify into different regions, they have to adapt products, promotion, and prices of each product line to fit different markets, such adaptation increases the operation costs of each product line and thus reduce their competitiveness. Organizational learning theory suggests that the complexities resulting from the combination of product diversities and market diversities will hinder a firms learning (Kogut and Singh 1988). In order to manage complexities and constraints, diversified firms usually have to use multidivisional structure. Each division has to look after a different set of markets. High market diversities and product diversities make it difficult for individual divisions to share, transfer, and integrate information and knowledge-based resources, as they individually deal with substantially different environments (Hitt et al. 1997). Therefore, we propose:

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Hypothesis 3a: At low levels of regional diversification, performance should vary positively with the degree of product diversification. Hypothesis 3b: At high levels of regional diversification, performance should vary negatively with the degree of product diversification. METHOD Research Sample The sample for this study was drawn from the largest U.S. firms on the Fortune 500 list. There are two reasons for selecting the largest firms. First, the history of both of their product and international diversification is much longer (Didrichsen 1972; Koptis 1979). Many of them have operated in multiple and disparate product and international markets (Geringer et al. 2000; Hitt et al. 1997). Second, these firms have more financial resources to carry out both product and international diversification. However, these diversified firms need to constantly struggle to balance their total diversification endeavors in both the different product markets and country or geographic areas to optimize their overall performance (Sambharya 1995). We used both company-level data including annual reports and 10-k fillings, and other data sources such as Moodys Industrial Manuals and World Investment Report.1 We selected only those firms that have nontrivial product diversification and are competing in international markets. To smooth annual fluctuations in the accounting data, we used a five-year average for the 1993 through 1997 period for each variable in the study. The initial base sample consists of all firms in the Fortune 500 listing in independent existence over this period. Because there were some missing data on many firms, however, it is necessary to make some adjustments to the original data base, leaving the present sample of 167 firms, for which all of the requisite data for 1993-97 was available.2 Dependent Variable Performance (PERF). Three accounting-based measures were initially considered as possible indicators of firm performance: return on assets (ROA), return on sales (ROS) and return on equity (ROE). They

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have been commonly employed in strategic management research (Hitt et al. 1997; Qian and Li 2002; Tallman and Li 1996). ROA and ROS were employed only because ROE is more sensitive to capital structure differences (Hitt et al. 1997).3 These measures indicate how much net income is earned from each dollar of assets and sales per revenue. They were measured as the after-tax profit (before extraordinary items) divided by total assets and total sales. Diversification Variables Product Diversification (PD). As in prior studies (e.g., Hitt et al. 1997; Palepu 1985; Riahi-Belkaoui 1996; Sambharya 1995), the entropy measure of product diversification was employed to measure total product diversification. As this index recognizes the degree of relatedness among various product segments and allows the decomposition of total product diversification into two additive components (i.e., related and unrelated production diversification), it has become increasingly popular in strategic management research (Hill et al. 1992; Hitt et al. 1997).4 Given a firm operating in n industry segments, the entropy measure of product diversification is defined as: PD = Pi In(1 / Pi )
i=1 m

where Pi is the sales attributed to segment i and In(1 / Pi) is the weight given to each segment within the same two-digit industry group. This measure considers both the number of segments in which a firm operates and the proportion of total sales each segment represents. Country Diversification (CD). In previous studies, the degree of country diversification was measured by the scale of foreign operations or multinationality, such as foreign sales in a host country as a percentage of total sales (Geringer et al. 1989; Grant et al. 1988), foreign assets in a host country as a percentage of total assets (Daniels and Bracker 1989; Ramaswamy 1993), and number of foreign employees in a host country as a percentage of total employees (Kim et al. 1989). Moreover, in recent years, some researchers (e.g., Dunning 1996; Gomes and Ramaswamy 1999; Ietto-Gilles 1998; Sullivan 1994) combined sales, assets, and employment to construct multidimensional index. Following this recent development, we calculated the multidimensional index as the average of the above three ratios and used it to measure country diversification.

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CD = (FATA + FSTS + FETE) / 3 Where FATA is the foreign assets as the percentage of a firms total assets; FSTS is the foreign sales as the percentage of a firms total sales; and FETE is the foreign employees as the percentage of a firms total employees. Regional Diversification (RD). Again, we used the entropy approach to measure regional diversification strategy. It is defined as: RD = Pi In(1 / Pi )
i= 1 m

where Pi is the sales attributed to global market region i and In(1 / Pi) is the weight given to each region. The advantage of using the entropy measure of regional diversification is that it considers both the number of global market regions in which a firm operates and the relative importance of each global market region to total sales (Hitt et al. 1997). According to the World Bank (2001), there are ten global regions/areas in the world, which serve as the criterion to classify the geographic distribution of a firms sales.5 Control Variables Following previous studies (e.g., Geringer et al. 2000; Tallman and Li 1996), we included several control variables, including firm size, leverage, R&D, industry and country effects. Firm size represents physical and financial resources (Ito and Rose 1998). Therefore, it is frequently used as a proxy for competitive positioning (e.g., economies and diseconomies of scale) within an industry (Johnson et al. 1997). Although the sample firms were all derived from Fortune 500 list, they might still differ in size. To control for the size difference, we measured it by the natural logarithm of total sales. Firm leverage, operationalized as the percentage of long-term debt to total capital (debt plus equity), was used to control for the potential effect of non-capital financing on firm performance. R&D, an important determinant of firm profitability, was measured using the firms annual expenditure on R&D investment divided by revenues. Effect of industry participation was included a control variable. Since these firms operated in 13 industries, the question is that homogeneity existed across industry groups. Different industries, however, have different struc-

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tural characteristics which may involve different degree of risks and the capital may also have different perception of risks involved (Bettis and Hall 1982; Porter 1985), it is therefore important to control for the industry differences. As in previous studies (e.g., Hitt et al. 1997; Tallman and Li 1996; Markides 1995), we classified firms into two-digit SIC categories on the basis of sales revenue and introduced the industry dummy variables to measure industry effect. Accordingly, there are 13 industries in which these firms operated. Country effect was used to control for external environments given that external environments differ from country to country (Barkema and Vermeulen 1998). The size and growth of a local market may influence firms internationalization and performance (Zejan 1990). Following previous studies (e.g., Barkema and Vermeulen 1998; GomesCasseres 1990; Zejan 1990), two variables were used: the growth of the market, measured by the growth in GNP; and the level of development of the host country, measured by GNP per capita. Regression Model We pooled our cross-sectional and time series data to take advantage of the greater degrees of freedom offered by pooling, and to capture both the dynamic information of time series and the variation due to cross-sections (Lu and Beamish 2000). A panel data should potentially be very informative about the parameters to be estimated (Qian 1997). If we use a pure cross-sectional analysis, we are unlikely to get an unbiased estimator of the causal relationships between variables (Wooldridge 2000). We used fixed effects models with the lagged dependent variable in the regression specification, and tested the hypotheses proposed in the study. A model (T = 5 in our study) with observed explanatory variables is expressed as: PERF = 1 + 2 d94 + 3 d95 + 4 d96 + 5 d97 + PERF1 + 1 (PD CD) + 2 (PD CD 2 ) + 3 (PD RD) + 4 (PD RD 2 ) + 5 (CD RD) + 6 (CD RD 2 ) + Control Group I + Control Group II + i + it where:

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d94, d95, d96 and d97 = dummy variables for T5 in the study (they do not change across firms); PERF 1 = lagged dependent variable (performance in the previous period); ai = an unobserved effect; mit = idiosyncratic error; Control Group I = all individual diversification variables; and Control Group II = all of the variables shown in the above Control Variables. We took ai to be a group specific constant term in the regression model. In fixed effects models, the variable ai captures all unobserved, time-constant factors that affect the dependent variable. Meanwhile, lagged dependent variable was used in regression analysis.6 As the regression contains any lagged values of the dependent variable, regression models will no longer be unbiased or consistent (Greene 1997). Using a lagged dependent variable (PERF 1) in the model provides a simple way to account for historical factors that cause current differences in the dependent variable that are difficult to account for in other ways (Wooldridge 2000). When applied to our case in the study, firms with high historical profitability rates may spend more on corporate (either product or international or both) diversification (Grant 1987; Grant et al. 1988). RESULTS Table 1 provides descriptive statistics and intercorrelations for all quantitative variables in the study.7 Preliminary analysis revealed low intercorrelations among these variables, which suggested that multicollinearity was not a serious problem. To further check its tenability, however, we made other regression diagnoses (e.g., VIFs) to detect whether or not there was severe multicollinearity. This was done by looking at the extent to which a given explanatory variable could be explained by all of the other explanatory variables in the equation. The results suggested no problem with multicollinearity as the VIF values for all independent variables were comparatively low [(VIF( i ) < 2]. Our another concern was autocorrelation and heteroscedasticity in the equation because we pooled our cross-sectional and time series data. Since the time period in our study was only five years, it normally did

22 TABLE 1. Means, Standard Deviation and Correlations for the Quantitative Variables
Variables Means s.d. 1 2 3 4 5 6 7 8 9 1. Profitability 2. Product diversification 3. Country diversification 4. Regional diversification 5. Firm size 6. R&D intensity 7. Firm leverage 8. GNP growth 9. GNP per capita 4.979 3.877 1.507* 0.121 1.316 3.192 0.113 0.064 0.088 0.117 0.091 0.175 0.133 0.071 0.101 0.728 0.494 0.081 0.060 0.029 7.139 4.057 0.293*** 0.155* 0.164* 0.155* 0.033 0.094 0.080 0.111 7.684 8.233 0.075 0.114 0.081 0.092 0.147* 0.045 0.036 0.027 0.092 0.025 0.071 0.059 0.069 0.023 0.017 0.033 0.049 0.085 0.053 0.365 0.182 0.187** 0.093 0.102 0.473 0.261 0.192** 0.111 1.347 1.253 0.160* 5.434 4.026

10. Profitability (lagged 1)

*p < .10; ** p < .05; *** p < .01. N = 167.

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not involve the problem of autocorrelation. To avoid the possible emergence of problems that stemmed from autocorrelation, however, we compared the estimates across the two different models (i.e., OLS and GLS) using Durbin-Watson d statistic and p value. The sign of Durbin-Watson d statistic (an estimate of OLS) and r (an estimate of the GLS regression) was unchanged. r was very close to being zero, indicating no problem of serial correlations [the observed DW d statistic was much higher than the critical d values (du)]. In testing heteroscedasticity, we conducted a White test to test the overall significance for the squared residuals of the estimated regression. The test statistic is much smaller than the critical chi-square value at the 1 percent level, indicating no heteroscedasticity. Thus, the assumptions of regression analysis were met. Table 2 presents the results of the regression analyses with a firms profitability (both ROA and ROS) as the dependent variables. Our research hypotheses were tested using six regression models. All the control variables (including time dummy variables and lagged independent variable) were entered first, followed by the explanatory variables, each time with their individual and interaction variables, and finally with all variables (including the control variables) simultaneously. The baseline model (Model 1 in Table 2) included lagged dependent variable, time dummies and all control variables (i.e., both Control Groups I and II). First, we identified that lagged dependent variable (PERF 1) was positively and significantly related to both ROA (p < .10) and ROS (p < .10). Second, in Control Group I, only R&D had a significant and positive effect on ROA (p < .01) and ROS (p < .01). Third, in Control Group II (industry groups), three industry dummies (Measurement and Scientific Equipment, Office Equipment, and Pharmaceuticals) in particular had regression coefficients that were significantly different from zero at the 0.01 levels. Finally, the remaining control variables were insignificant even at the 0.10 levels, exerting minimal influence. In particular, we found that the effect exerted by country control variables was not statistically significant in spite of positive coefficients. These results were consistent across the remaining models. Model 2 tested the effects of the individual explanatory variables. There were curvilinear relationships between the three dimensions of corporate diversification and performance. First, there was a statistically significant, positive relationship between product diversification and performance (p < .10 for both ROA and ROS). Furthermore, there was a negative, significant relationship between product diversification

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Model 1 ROA 2.003 (1.463) 0.367 (0.299) 0.224 (0.169) 0.287 (0.215) 0.418 (0.288)
1

TABLE 2. Results of Regressing Product, Country and Regional Diversification on the Profitability of Largest U.S. Firms
Model 2 ROA 2.152 (1.649) 0.393 (0.291) 0.267 (0.210) 0.293 (0.227) 0.442 (0.314) 1.769* (0.918) 2.849* (1.495) 3.545* (1.857) 1.707 (1.192) 1.315 (1.069) 3.679** (1.664) 2.317 (2.096) 3.507** (1.575) 2.119 (1.926) (0.959) 1.172 (1.047) 1.486 1.592 (1.108) 1.226 (0.996) 3.556** (1.601) 2.216 (1.950) (1.681) (1.752) 3.226* 3.345* 3.109* (1.573) 1.403 (0.972) 1.119 (0.895) 3.420** (1.541) 2.032 (1.847) (1.351) (1.412) (1.235) 2.537* 2.704* 2.354* (.812) (0.881) (0.790) 1.544* 1.683* 1.502* 1.639* (0.867) 2.688* (1.400) 3.507* (1.817) 1.629 (1.132) 1.307 (1.041) 3.528** (1.596) 2.308 (2.051) (0.273) (0.288) (0.131) (0.260) 0.385 0.409 0.365 0.402 0.361 (0.252) 1.477* (0.768) 2.307* (1.197) 3.211* (1.675) 1.441 (1.002) 1.158 (0.942) 3.404** (1.534) 2.105 (1.904) (0.209) (0.212) (0.196) (0.218) (0.190) 0.266 0.281 0.253 0.277 0.249 (0.157) (0.160) (0.131) (0.168) (0.135) 0.199 0.214 0.163 0.219 0.171 0.256 (0.193) 0.299 (0.231) 0.453 (0.319) 1.725* (0.901) 2.803* (1.467) 3.597* (1.873) 1.687 (1.189) 1.372 (1.120) 3.713** (1.668) 2.344 (2.100) (0.247) (0.276) (0.233) (0.258) (0.223) (0.294) 0.338 0.349 0.305 0.326 0.293 0.398 (1.471) (1.443) (1.469) (1.449) (1.489) (1.477) (1.510) 0.347 (0.263) 0.188 (0.149) 0.270 (0.217) 0.390 (0.281) 1.531* (0.802) 2.512* (1.322) 3.263* (1.694) 1.456 (1.013) 1.198 (0.991) 3.545** (1.589) 2.128 (1.889) 1.917 1.961 1.853 1.972 1.877 2.018 1.903 ROS ROA ROS ROA ROS ROA ROS Model 3 Model 4 Model 5 Model 6 ROA 1.954 (1.293) 0.331 (0.255) 0.209 (0.158) 0.273 (0.211) 0.398 (0.284) 1.617* (0.856) 2.627* (1.385) 3.308* (1.733) 1.555 (1.088) 1.204 (0.978) 3.509** (1.584) 2.209 (1.955) ROS 1.827 (1.448) 0.298 (0.234) 0.176 (0.143) 0.248 (0.190) 0.357 (0.255) 1.446* (0.757) 2.299* (1.218) 3.043* (1.601) 1.387 (0.963) 1.101 (0.895) 3.388** (1.542) 2.014 (1.825)

Variables ROS 1.889 (1.503) 0.312 (0.239) 0.178 (0.140) 0.259 (0.205) 0.377 (0.267) 1.519* (0.795) 2.463* (1.283) 3.187* (1.659) 1.431 (1.007) 1.143 (0.948) 3.492** (1.580) 2.069 (1.741)

Intercept

d94

d95

d96

d97 1.702* (0.889) 2.781* (1.472) 3.463* (1.789) 1.675 (1.160) 1.288 (1.023) 3.613** (1.612) 2.248 (2.017)

PERF

Beverage

Chemical

Food

Forest products

Electrical

Industrial and farm equipment

Office equipment (1.573) 1.345 (1.271) 4.255*** 3.875*** (1.334) 1.486 (1.064) 2.388 (1.593) 5.463*** 5.018*** (1.661) 1.395 (1.476) 0.773 (0.631) 3.088*** 2.579*** (0.948) 1.244 (1.184) 0.804 (0.518) 0.347 (0.253) (0.196) (0.276) 0.268 0.373 0.305 (0.228) (0.475) (0.534) (0.484) 0.737 0.833 0.769 (1.054) (1.272) (1.102) (1.137) 0.808 (0.524) 0.328 (0.239) 1.092 1.356 1.163 1.209 (0.805) (1.009) (0.877) (0.967) 3.251*** 2.808*** 3.046*** 2.567*** (0.801) 1.008 (0.962) 0.727 (0.471) 0.247 (0.186) (0.559) (0.679) (0.584) (0.596) (0.552) 0.692 0.840 0.722 0.751 0.684 (1.399) (1.426) (1.407) (1.455) (1.421) (1.447) 0.749 (0.590) 3.117*** (0.976) 1.289 (1.221) 0.824 (0.538) 0.339 (0.248) 1.341 1.417 1.353 1.402 1.362 1.387 (1.540) (1.695) (1.569) (1.687) (1.547) (1.604) (1.525) 1.320 (1.402) 0.665 (0.533) 2.749*** (0.859) 1.106 (1.037) 0.752 (0.494) 0.256 (0.189) 5.595*** 5.114*** 5.498*** 5.106*** 5.296*** 4.913*** (1.406) (1.588) (1.447) (1.571) (1.413) (1.531) (1.410) 2.117 2.405 2.175 2.397 2.133 2.326 2.109 (1.036) (1.135) (1.053) (1.092) (1.058) (1.105) (1.029) (1.121) 2.447 (1.618) 5.639*** (1.724) 1.468 (1.537) 0.851 (0.715) 3.193*** (1.027) 1.328 (1.255) 0.846 (0.561) 0.368 (0.271) 1.407 1.508 1.435 1.493 1.416 1.499 1.420 1.519 (1.250) (1.386) (1.257) (1.344) (1.225) (1.375) (1.269) (1.363) 4.318*** 4.392*** 4.173*** 3.784*** 4.296*** 3.908*** 4.363*** 4.042*** (1.301) 1.438 (1.049) 2.199 (1.457) 5.247*** (1.595) 1.382 (1.424) 0.730 (0.591) 2.793*** (0.872) 1.124 (1.048) 0.783 (0.510) 0.294 (0.219) (1.198) (1.338) (1.231) (1.298) (1.107) (1.319) (1.124) (1.383) (1.197) 1.209 1.446 1.267 1.377 1.215 1.396 1.223 1.479 1.290 (1.507) (1.601) (1.526) (1.615) (1.503) (1.638) (1.547) (1.642) (1.529) (1.536) 1.313 (1.228)

5.073*** 4.755***

5.212*** 4.839***

5.186***

4.804***

5.409***

4.953***

5.417***

4.986***

5.020***

4.712*** (1.487) 1.199 (1.110)

Metal product

Measurement equipment

4.118*** (1.303) 1.477 (1.087) 2.304 (1.507) 5.317*** (1.654) 1.361 (1.437) 0.738 (0.588) 3.026*** (0.941) 1.209 (1.125) 0.799 (0.523) 0.335 (0.248)

3.722*** (1.209) 1.401 (1.041) 2.071 (1.366) 4.982*** (1.556) 1.287 (1.301) 0.652 (0.515) 2.533*** (0.817) 1.055 (1.016) 0.726 (0.469) 0.253 (0.181)

Motor vehicles

Non-electrical machinery

Pharmaceuticals

Textile

Firm size

R&D intensity

Firm leverage

GNP growth

GNP per capita

25

26 TABLE 2 (continued)
Model 1 ROA 2.699* (1.386) 1.738** (0.784) 3.717** (1.674) 1.167** (0.621) 2.681** (1.207) 2.106** (0.907) 4.309*** (1.135) (1.198) 3.955*** (0.850) 1.883** (1.074) 2.377** (0.483) 0.919** (1.485) 3.294** (0.682) 1.507** (1.167) 2.240* ROS ROA ROS ROA ROS ROA ROS ROA ROS Model 2 Model 3 Model 4 Model 5 ROA 2.553* (1.326) 1.679** (0.761) 3.575** (1.606) 1.095** (0.570) 2.443** (1.100) 1.988** (0.896) 4.118*** (1.241) Model 6 1.185 (0.886) 0.936 (0.696) 1.014 (0.726) 3.792*** (1.144) 3.406*** (1.061) 3.655*** (1.079) 1.902** (0.854) 1.685* (0.875) 1.747** (0.788)

Variables

ROS 2.147* (1.097) 1.423** (0.644) 3.184** (1.435) 0.858** (0.454) 2.252** (1.013) 1.748** (0.782) 3.827*** (1.163)

Product diversification

Product diversification squared

Country diversification

Country diversification squared

Regional diversification

Regional diversification squared

Product diversification

Country diversification

Product diversification

0.914 (0.689)

Country diversification (squared)

Country diversification

3.287*** (0.972)

Regional diversification

Country diversification

1.568* (0.812)

Regional diversification (squared)

Product diversification

3.563*** (1.191) 1.582* (0.842) 0.184 0.173 0.130 7.145 14.187 13.886 9.873 9.378 0.309 0.298 0.210 0.202 0.351 0.342 0.252 0.243 0.287 0.244 11.335 0.276 0.235 10.996 0.269 0.228 10.712

3.271*** (1.085) 1.339* (0.714) 0.258 0.216 10.288

3.417*** (1.139) 1.431* (0.757) 0.505 0.462 22.103

3.117*** (1.037) 1.207* (0.645) 0.481 0.439 21.743

Regional diversification

Product diversification

Regional diversification (squared)

R2
Adjusted R
2

0.142 7.790

F-statistic

Standard errors are in parentheses. The regression coefficients for the industry groups show each groups impact on profitability relative to that of the excluded industry (Other manufacturing). Probabilities of all F-statistics are less than .01. *p < .10 level; **p < .05 level; ***p < .01 level.

27

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squared and ROA (p < .05) and ROS (p < .05). This suggests that the relationships were positively related up to a point, after which an increase in product diversification was associated with declining performance. The above relationships were also found to be tenable for both country and regional diversification. That is, the coefficients of the country diversification variables, and of the regional diversification variables were positive and significant at the 0.05 levels respectively. However, those of the variables on the squared term were negatively signed and statistically significant at the 0.05 levels. This suggests that before country diversification and regional diversification reach a certain threshold, they have positive effects on firm performance. Beyond this threshold, they can erode firm performance. Model 3 examined the joint effects exerted by product diversification and country diversification on performance. With low levels of country diversification, moderately product-diversified firms were related negatively to ROA (p < .01) and ROS (p < .01). However, the performance turned positive (though insignificant) as firms involved heavily in foreign countries. Therefore, the results are in full support of Hypothesis 1a, but do not offer support for Hypothesis 1b. Hypotheses 2a and 2b, which concentrated on the joint effects of country diversification and regional diversification on firm performance, were tested in Model 4. With low regional diversification, moderately countrydiversified firms were related positively and significantly to performance (all being significant at the 0.01 levels for both ROA and ROS). The performance appeared negative and significant as they diversified heavily into different regions/areas (the significance levels ranging from the 0.10 to the 0.05). Thus, the results provide full support for Hypothesis 2a and Hypothesis 2b. These two relationships indicate a potentially inverted U-shaped relationship between international diversification and performance. Model 5 tested Hypotheses 3a and 3b concerning the relationships between product diversification and regional diversification, and their joint impacts on firm performance. The effects of regional diversification and performance in moderately product-diversified firms were initially positive and statistically significant for ROA (p < .01), and ROS (p < .01). However, such effects turned negative with further regional diversification (the significance levels all being at the 0.10 levels). Thus, the results lend support to Hypothesis 3a and Hypothesis 3b. Model 6 presents the full model. When all the control and explanatory variables were included, the sign and significance levels of the individual and interaction variables were similar to those of the earlier

Lee Li and Gongming Qian

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models. But the model documented a significant increase in variance explained. While models testing the individual and joint effects explained between 21% and 30.9% of the adjusted variance in firm performance (as measured by adjusted R2 in Model 2 through Model 5), the combined Model 6 was able to explain 46.2% and 43.9% of variance for ROA and ROS (adjusted R2) respectively. DISCUSSION AND CONCLUSIONS This study tested the hypotheses that were developed in our framework. H1a was supported but H1b was rejected. That is, at low levels of country diversification, the performance of a diversified firm tends to vary negatively with its product diversification and the negative effects may turn positive but insignificantly at the high levels of country diversification. Perhaps, firms in our data diversified into various regions in order to achieve high levels of country diversification. In other words, high levels of country diversification came with high levels of regional diversification. Consequently, the firm lacked adequate country-specific knowledge to manage its various product lines. Simultaneously, transaction costs, such as the costs of coordination between product lines at different countries, arose with regional diversification. The second possible interpretation is that firms do not accumulate large volume for each product line when they diversify into numerous countries. They have to adapt their products to fit each country and thus hurt economies of scale. The third possible interpretation is that countries, even within a region, can be quite different and the differences incur high transaction costs. Consequently, product diversification, combined with country diversification, seldom gives good rewards. Transaction costs cancel out the benefits of economies of scale when firms diversify simultaneously into different products and different countries. H2a, 2b and H3a, 3b were fully supported. This suggests that when the level of regional diversification is low, product diversification and country diversification have positive impacts on firm performance. Over the optimal levels of regional diversification the impacts will become negative. In addition to the above main findings, other results from this study also deserve attention. First, the effects exerted by these diversification variables jointly were highly significant when compared to those ex-

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erted individually (e.g., PD CD compared to either CD or PD). Thus, a diversification dimension will moderate the effects of other diversification dimensions. Product diversification and international diversification may create or destroy value, depending on the firms overall diversification strategies. Second, the joint effects (with either component of the joint diversification variables being squared) were found to be less adverse than the effects exerted by the individual variables squared [e.g., CD2 was negative and significant while (PD CD2) was insignificant, though negative in sign]. This implies that product diversification is able to mitigate the adverse effects brought about by either heavy country or heavy regional diversification. Third, moderating effects of a diversification dimension on other diversification dimension is curvilinear rather than linear. After a certain threshold, their impacts on firm performance may turn opposite. The evidence shed light on the controversies in the extant diversification literature. Last, the study confirms the argument that R&D intensity and industry effects have significant impacts on firm performance. The findings of this study provide following important theoretical implications. First, the internalization benefits and transaction costs can cancel each other out. In other words, the greater internalization benefits a diversified firm desires to obtain, the higher transaction costs it has to pay. Therefore, it is important to determine an optimal level where firms can maximize the internalization benefits, and, at the same time, minimize the transaction costs. This study identifies such levels which depend on the interaction between various factors. Second, the findings from this study offer a reasonable explanation for the long-lasting controversy over the value of product diversification. That is, product diversification may create or destroy value, depending on the level of diversification in terms of the country and regional dimensions. Third, the terms international diversification and multinationality, which have been commonly used in existing literature, are too general to assess internationalizing firms performance determinants. Internationally diversified firms or multinational firms can be quite different among themselves in terms of country diversification and regional diversification and they experience quite different costs. In other words, country diversification and regional diversification are more accurate to describe a firms foreign operations. The findings of this study have the following managerial implications. First, internationalization has been an important issue for most firms and managers in the last decade. Internationalization provides

Lee Li and Gongming Qian

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firms with opportunities but incur high transaction costs as well. Transaction costs include coordination costs, communication costs, and the costs to manage diversities. Transaction costs vary substantially with the number of regions and countries a firm has entered and the product lines the firm has carried. Thus, managers have to be aware of these transaction costs when they select their markets and product lines. Second, for those firms that concentrate their business in certain regions, product diversification can be profitable. In other words, they should provide different products in the markets and expand their product lines. In contrast, firms that have operated across various regions have to control their product diversification. That is, they should focus on a small number of product lines. Again, those firms that concentrate their operation on certain regions should expand markets fast and enter more countries within the regions. However, those firms that have diversified widely across various regions have to limit their markets. Those firms that concentrate their business in a small number of countries have to control product diversification. Third, product diversification, country diversification, and regional diversification are related. When managers make decisions on these individual issues, they have to consider the impacts of other factors. As such, product diversification, country diversification, or regional diversification individually can be beneficial for some firms and not for others. In other words, firms should not copy each others diversification approach or strategies. They have to assess their own situation regarding those three dimensions before they design their own diversification strategy. The study has sample limitations that restrict its generalization but make our findings more notable, as the sample was rather homogeneous. As most sample firms were large multinational corporations, the findings do not apply to small firms and domestic firms. Another limitation is that this study does not differentiate sample firms in terms of product life cycle and risk-taking. This study has left an important problem unsolved. Though it shows that firm performance is curvilinear with three diversification dimensions, it does not specify their thresholds or the optimal point where diversified firms can maximize their profitability. The determination of thresholds is very important for managers when they allocate resources and design market entry strategies. However, the specification of such thresholds can be difficult, as firms of different characteristics (e.g., resources and firm-specific capabilities) may have different optimum ratios. In other words, the inverted U-shaped relationship between corporate diversification and profit performance can vary in shape and height, depending on the characteristics

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of individual firms. In addition, thresholds can vary depending on industry characteristics. Our future studies will aim to differentiate these firm and industry characteristics, and to specify optimum diversification threshold values for different firms in various industries. NOTES
1. The data on firm performance, product diversification and control variables (except for country control variables which came from World Investment Report) were derived from Fortune 500 (each issue) and corporate financial report. The data on both country and regional diversification came from the following sources: Directory of American Firms Operating in Foreign Countries (various issues), Moodys Industrial Manuals and Who Owns Whom (North America). 2. The principal reasons for their adjustments are: (1) figures no longer published; (2) merged into anther firm; (3) no longer classified as an industrial; (4) acquired by another firm; (5) liquidated after business failures; and (6) no published figures in certain years. 3. To test the robustness of our results, we also used the ROE measure which gave results similar to those for ROA and ROS, although their statistical significance was generally lower. 4. The entropy measure of (total) product diversification recognizes the degree of relatedness among various product segments. Related diversification captures diversification across four-digit SIC industries within a two-digit SIC industry, and unrelated product diversification captures diversification across two-digit SIC industries. We first calculated a firms related and unrelated product diversification and then derived (total) product diversification by combining them into one index (i.e., related + unrelated = total product diversification). 5. The World Bank (2001) grouped all countries into ten regions, namely the European Union, Other Western Europe, North America, Other Developed Countries, Latin America and the Caribbean, Africa (excluding South Africa), Asia (excluding Japan), The Pacific, Central and Eastern Europe, and Other Developing Europe. 6. The lagged dependent variable substitutes for the inclusion of other lagged independent variable. Therefore, when a lagged independent variable is included in the regression, it is not necessary to include lagged independent variables (Gaynor and Kirkpatrick, 1994). 7. We have also used ROA in the correlation analysis (in Table 1). The results remain largely the same.

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SUBMITTED: June 2004 FIRST REVISION: August 2004 SECOND REVISION: September 2004 ACCEPTED: October 2004