International Journal of Hospitality Management 31 (2012) 218–228

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International Journal of Hospitality Management

journal homepage: www.elsevier.com/locate/ijhosman

Effect of diversification on firm performance: Application of the entropy measure

Kwangmin Park a,1 , SooCheong (Shawn) Jang b,∗
a
Department of Foodservice Management, College of Hospitality and Tourism Management, Sejong University, Seoul, South Korea
b
School of Hospitality and Tourism Management, Purdue University, West Lafayette, IN 47907-0327, United States

a r t i c l e i n f o a b s t r a c t

Keywords: This study investigated the effects of diversification on firm performance in the restaurant industry. In
Diversification strategy prior studies, the theoretical rationales and empirical results appeared to contradict each other. These
Profitability contradictory results may be due to factors such as industry-specific characteristics or a linear under-
Volatility
standing of the relationship between diversification strategies and firm performance. Thus, this study
Entropy measure
suggested a non-linear hypothesis based on the costs and benefits of diversification strategies with busi-
Restaurant firms
nesses categorized based on their level of diversification. The results of this study showed that restaurant
firms do not benefit from a low level of related diversification. This study also found that when restaurant
firms are involved in both related and unrelated businesses, the optimal mixed ratio of diversification
is approximately half and half. More detailed results, as well as academic and practical implications, are
discussed in this paper.
© 2011 Elsevier Ltd. All rights reserved.

1. Introduction
Corporate diversification strategies establish the scope of a
firm’s business activities and contribute to a firm’s performance
(Hofer and Schendel, 1978; Porter, 1987). Since Rumelt (1974,
1982), the relationship between diversification and performance
(hereafter, DP) has frequently been investigated by strategic man-
agement researchers. Despite improvements in various aspects of
DP studies, the theoretical rationales and empirical results remain
contradictory and the actual effects of diversification strategies
remain ambiguous at best. In the realm of hospitality academia
several researchers have initialized diversification studies (Lee and
Jang, 2007; Jang and Tang, 2009; Tang and Jang, 2010). However,
they focused on either within-industry diversification or geograph-
ical diversification. Little research has been done within hospitality
academia on the effects of market diversification. Thus, this study
examined the relationship between diversification and firm per-
formance from the perspective of market diversification in the
restaurant industry.
Rumelt’s (1974, 1982) proposition that related diversification
produces greater profits than unrelated diversification has gener-
ally been accepted. It is also generally accepted that both related
and unrelated diversifications reduce profit volatility, with a larger
risk reduction effect accompanying unrelated diversification. How-
ever, empirical studies have failed to validate these traditional
conceptions of profitability and risk (volatility). Datta et al. (1991)
∗ Corresponding author. Tel.: +1 765 496 3610.
E-mail addresses: kmpark@sejong.ac.kr (K. Park), jang12@purdue.edu (S. Jang).
1
Tel.: +82 02 3408 3186.
pointed out that prior researchers have overlooked industry struc-
ture (e.g., industry competition, concentration, growth rate, and
profitability). This suggests that the performance of diversifica-
tion strategies depends on the performance of the target industry.
Thus, when the primary and diversifying target industry character-
istics are neglected, the projected performance of a diversification
strategy could be misleading. Further, although there are benefits
to diversification there are also costs associated with diversifica-
tion, such as transaction costs (Jones and Hill, 1988) and a loss of
efficiency and control (Markides, 1992; Rajan et al., 2000; Meyer
et al., 1992). Thus, a non-linear relationship may exist between
diversification and firm performance. Finally, few studies have
investigated the optimal mixed ratio of related and unrelated diver-
sification when firms are involved in both related and unrelated
businesses.
Consequently, the purpose of this study is to examine the
non-linear relationship between diversification strategy and firm
performance in the restaurant industry. Specifically, the objec-
tives of this study are: (1) to examine the effects of diversification
on accounting profitability and risk (volatility) of profitability
according to related and unrelated diversification in the restaurant
industry and (2) to investigate the optimal mixed ratio of related
and unrelated diversification.
2. Literature review
2.1. The definition of diversification and DP studies in hospitality
academia
Corporate diversification can be defined as businesses a corpo-
ration should be involved in (Pils, 2009) and describes the scope

0278-4319/$ – see front matter © 2011 Elsevier Ltd. All rights reserved.
doi:10.1016/j.ijhm.2011.03.011
 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
of business activities (Hofer and Schendel, 1978; Porter, 1987).
However, various definitions of diversification have been used in
previous studies. For instance, Ansoff (1957) first used the term
‘diversification’ to illustrate corporate growth strategies involving
entering new markets with a new product. On the other hand,
Berry (1971) defined diversification as an increase in the number of
industries a business participates in. The term ‘market diversifica-
tion’ is more specific because diversification could also be carried
out by entering new markets with present products or services
(Ansoff, 1957; Berry, 1971). Thus, diversification implies a firm
moving into a number of markets (sectors, industries, or segments)
it was not previously engaged in. Hereafter in this study the term
diversification indicates market diversification.
The DP relationship has been frequently investigated in strate-
gic management but there has been little effort within hospitality
academia to explore it. Singh and Gu (1994) failed to find any
differences in the operational performance of diversified hotel
firms and undiversified firms. However, Lee and Jang (2007)
found that within-industry diversification by hotel firms (diver-
sification into luxury, upscale, mid-priced, economy, or budget
segments) improved the stability of their financial performance but
not accounting profits. Jang and Tang (2009) found that interna-
tional diversification has a moderating effect on the relationship
between financial leverage and profitability in the hotel industry
and Tang and Jang (2010) stated that firm value discounts exist in
association with international diversification. However, they also
indicated that the relationship between international diversifica-
tion and excess value is curvilinear (U-shaped), suggesting that
highly diversified hotel firms could still benefit from international
diversification. However, the focus of Jang and Tang’s (2009) and
Tang and Jang’s (2010) studies was on geographic diversification,
not on market diversification. Thus far, prior hospitality research
has focused on only geographic diversification or within-industry
(operation) diversification. Similarly, there are only a few studies
that have investigated the diversification strategies of tourism-
related companies. Liu and Wang (2007) and Wang and Xu (2008)
found that diversification strategies recently enhanced in Chinese
tourism companies. Based on this review of past diversification
studies, there is still a need to examine the relationship between
market diversification and firm performance in the hospitality and
tourism industry.
2.2. Related diversification vs. unrelated diversification and
profitability
Theoretical arguments on the profitability of related and unre-
lated diversification are contradictory. On the one hand, Rumelt
(1974, 1982) argued that related diversification produces superior
profits as opposed to unrelated diversification, which suggests that
related diversification allows for a larger transfer of core tangible
and intangible capabilities (i.e., product lines, knowledge, skills, and
experience) into the diversifying target business (Penrose, 1959;
Rumelt, 1974). This rationale is based on economies of scope and
scale and the synergy hypothesis. From this perspective, unre-
lated diversification requires certain substantial costs derived from
new and unfamiliar business environments, which could adversely
reduce profits.
On the other hand, the internal market efficiency hypothe-
sis favors unrelated diversification. The internal market efficiency
hypothesis (Higgins and Schall, 1975; Lewellen, 1971; Scherer,
1980) argues that diversified firms can allocate their capital
resources more efficiently than undiversified firms by optimally
using internal capital. Accordingly, these internal market efficien-
cies allow diversified firms to access relatively inexpensive external
funds and transfer capital between businesses within its portfolio
(Meyer et al., 1992). Diversification is a source of varied efficiencies
219
that are difficult for single business firms to achieve. Thus, prof-
itability can be enhanced by unrelated diversification strategies
(Scharfstein and Stein, 2000). Defenders of unrelated diversification
contend that firms utilizing related diversification have investment
options that are very similar to their current situation, but firms
utilizing unrelated diversification have a variety of investment
options. Thus, unrelated diversification could be more profitable
than related diversification because unrelated diversified firms are
in a better position to reduce the cost of capital and optimally invest
(Hill and Snell, 1988).
Since Rumelt (1974, 1982), however, many empirical studies
have claimed that related diversification enhances profits more
than unrelated diversification (Bettis, 1981; Lecraw, 1984; Lubatkin
and Rogers, 1989; Palepu, 1985). Bettis (1981) found that related
diversification outperforms unrelated diversification by approxi-
mately one to three points of return on assets. Along the same
line, Palepu (1985) reported that profitability growth is signifi-
cantly larger with related diversification as opposed to unrelated
diversification. Lubatkin and Rogers (1989) also stated that related
diversification has a tendency to produce better market returns
than unrelated diversification. Nevertheless, Bass et al. (1977),
Chatterjee (1986), Grinyer et al. (1980), and Ravenscraft (1983)
could not find any evidence that related diversification offers more
advantages than unrelated diversification. Consequently, the profit
superiority of related diversification is contradictory in terms of
both its theoretical rationale and the empirical findings.
2.3. Related diversification vs. unrelated diversification and risk
(volatility) of profitability
The impact of diversification strategies on risk is also contra-
dictory. Researchers have generally accepted that diversification
reduces risk based on the portfolio theory (Markowitz, 1952).
Montgomery (1985) argued that managers consider diversifica-
tion strategies in order to avoid unfavorable uncertainties within
a single market. Regarding the DP relationship, Rumelt (1974)
claimed that diversification could be understood as an aggregation
of two or more income streams. Thus, negatively correlated income
streams could produce a smaller variance as compared to a single
income stream. Of course a perfect negative correlation is rare in
the real world, but if two income streams are weakly correlated
the volatility of the combined income stream can be reduced. Thus,
in comparison to related diversification, unrelated diversification
reduces volatility because the aggregated income stream of unre-
lated diversification tends to be more weakly related to the primary
market.
However, as West (1967) argued, corporate diversification can-
not produce the same outcomes as financial diversification. In
financial diversification, an asset portfolio is composed of various
investment options: securities in the stock market, real estate, and
other financial options. These assets can be bought and sold by port-
folio owners and adding or substituting an asset does not affect
the return and risk of the remaining individual assets. Thus, the
volatility of a portfolio can constantly be reduced by adding new
investment options. However, in corporate diversification any busi-
ness in the business portfolio influences the remaining individual
business segments as well as the overall corporate structure and
efficiency (Bettis and Hall, 1982; Lubatkin and O’Neill, 1987). This
means that risk reduction based on the portfolio theory could dif-
fer between financial diversification and corporate diversification.
This implies that the consequences of corporate diversification per-
formance may not be a linear function (Lubatkin and Chatterjee,
1994).
A number of studies have investigated the relationship between
diversification and risk. Amit and Livnat (1988) found that unre-
lated diversification lowers risk. However, Barton (1988), Bettis
220 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
(1981), Bettis and Hall (1982), and Montgomery and Singh
(1984) found that unrelated diversification increases risk. Fur-
ther, Lubatkin and O’Neill (1987) found that related diversification
reduces risk while unrelated diversification increases risk. Conse-
quently, the actual risk reduction effect of various diversification
strategies is theoretically and practically ambiguous.
2.4. Industry-specific effects on performance
Christensen and Montgomery (1981) argued that differences in
diversification performance are due to market structure. Datta et al.
(1991) also pointed out that diversification studies have shown
little interest in industry-specific factors, such as industry concen-
tration, growth, and profitability. Schmalensee (1985) suggested
that industry-specific effects could be even more important than
firm-specific effects in terms of the performance of diversification
strategies. For example, Bass et al. (1977) found that diversification
strategies had a positive effect in slow-growth industries but a neg-
ative effect in high-growth industries. Bettis and Hall (1982) also
concluded that in terms of profits and risk there are no differences
between related and unrelated diversification once industry factors
are incorporated. Thus, when the primary industry-specific effects
are neglected, as well as the diversifying target industry-specific
effects, the predicted performance of a diversification strategy
could be misleading.
It is well known that the restaurant industry has low profitability
and high risk (Kim and Gu, 2003; Skalpe, 2003). In terms of related
businesses, restaurant firms frequently diversify into the franchis-
ing segment. The performance of this segment would be the same
as the primary business. Further, the food-production industry,
another frequently diversified segment, is a big challenge because
it relies on high volume, low profits, and slow growth in sales
(MacGregor and Sever, 1996). The situation of related segments
in the restaurant industry is not very different from that of the
primary industry. Consequently, if restaurant firms diversify into
related segments it is unlikely they will achieve profit enhancement
due to the low profitability of the related businesses. In addition,
in terms of risk of profitability the income streams of related busi-
nesses might be highly correlated with the primary business. Even
though the portfolio theory (Markowitz, 1952) predicts moderate
risk reduction from related diversification, the risk could actually
increase because the aggregated income streams should behave
similarly.
In contrast, unrelated diversification of restaurant firms could
enhance profitability if the unrelated businesses are relatively
profitable compared to the primary business. This means that
diversification into a relatively profitable target industry could con-
tribute to profit enhancement. Further, unrelated diversification
of restaurant firms could reduce risk considerably if the income
streams of the primary business and the unrelated business are
weakly (or perhaps even negatively) correlated. Consequently, the
overall expectations for restaurant diversification could differ from
the traditional rationale when restaurant industry-specific charac-
teristics are incorporated.
2.5. Non-linear hypothesis regarding the DP relationship
Palich et al. (2000) proposed a non-linear hypothesis that related
diversification (i.e., a moderate level of diversification) increases
firm performance but unrelated diversification (i.e., a high level of
diversification) decreases it. However, Palich et al. (2000) proposed
a simple synthesis of Rumelt’s (1974, 1982) propositions regarding
the total level of diversification: (1) related diversification posi-
tively effects firm performance and (2) unrelated diversification
negatively effects firm performance. Thus, in Palich et al. (2000)
there is no consideration of the non-linear relationship between
each separate related and unrelated diversification. Likewise, Palich
et al.’s (2000) limited studies investigated the non-linear DP rela-
tionship at the level of total diversification. Grant et al. (1988),
Tallman and Li (1996), Nachum (2004) and Narasimhan and Kim
(2002) found that profits increase up to a certain point of total diver-
sification but decrease beyond that point. Moreover, Palich et al.’s
(2000) hypothesis assumed that firms first diversify into related
businesses and then later move into unrelated businesses. How-
ever, this assumption does not always hold for diversified firms.
Another limitation of Palich et al. (2000) is the ambiguous con-
ceptual separation of the diversification level into moderate and
high levels of diversification. To clarify performance differences
according to the level of diversification, businesses must be clearly
separated into low and high levels of diversification. Thus, when
we hypothesized diversification performance we separated diver-
sification into low and high levels for both related and unrelated
diversification in order to examine the costs and benefits of diver-
sification according to the level (low or high) and type (related or
unrelated) of diversification.
At a low level of related diversification, profitability might
decrease because the costs of related diversification (i.e., low prof-
itability of the related businesses) can dominate the benefits of
related diversification (i.e., economies of scale and scope and syn-
ergy between businesses). On the other hand, profits might increase
with a high level of related diversification because the benefits of
related diversification could dominate due to economies of scale
and scope and synergy. Thus, profitability decreases up to a cer-
tain level of related diversification but increases beyond that level,
which might be described as a U-shaped curve. In the relationship
between unrelated diversification and profitability, lower levels of
unrelated diversification could increase profitability because unre-
lated businesses might create more profits, relatively, than the
primary business. However, at a high level of unrelated diversi-
fication profitability might decrease as firms stray further away
from the primary business. In other words, high levels of unrelated
diversification can lead to a loss of control and lack of managerial
capacity. Markides (1992) and Nachum (2004) argued that man-
agers have a limited capacity to cope with increased complexity,
loss of control, and increased inflexibility. It can also be difficult to
transfer a firm’s competitive advantages across markets and prod-
ucts. Further, inefficiencies may arise if there are problems adapting
to environmental differences.
Hypothesis 1. Profitability decreases up to a certain level of
related diversification, but beyond that level it increases as related
diversification increases.
Hypothesis 2. Profitability increases up to a certain level of unre-
lated diversification, but beyond that level it decreases as unrelated
diversification increases.
In spite of encouragement by Palich et al. (2000), scholars have
presently made no attempt to investigate the non-linear relation-
ship between diversification and the risk (volatility) of profitability.
The conventional hypothesis follows portfolio theory (Markowitz,
1952) and expects consistent risk reduction with both related and
unrelated diversification. However, low levels of related diversifi-
cation could increase risk because the similar risk characteristics
of the highly correlated income streams would likely overpower
the effects of risk reduction. On the other hand, at high levels of
related diversification profit volatility would decrease because the
risk reduction effects of portfolio theory (Markowitz, 1952) might
dominate the synthetic related business risk. Consequently, profit
volatility increases up to a certain level of related diversification but
decreases beyond that level. Risk decreases up to a certain level of
unrelated diversification due to the weak (or even negative) cor-
relation of income streams as stated in the portfolio theory, but it
 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
increases beyond that level due to business risk and a loss of control
and flexibility.
Hypothesis 3. Profitability risk increases up to a certain level of
related diversification, but beyond that level it decreases as related
diversification increases.
Hypothesis 4. Profitability risk decreases up to a certain level
of unrelated diversification, but beyond that level it increases as
unrelated diversification increases.
Finally, when considering diversification strategies it is impor-
tant to note that firms can utilize related and unrelated
diversification simultaneously. Thus, finding the optimal mixed
level of related and unrelated diversification is crucial. Nev-
ertheless, no prior studies have examined the optimal mixed
level of related and unrelated diversification. Based on our prior
hypotheses, the influence of related and unrelated diversification
is completely opposite. In order to counterbalance the positive and
negative effects of related and unrelated diversification, the optimal
mixed level would be approximately half and half between related
and unrelated diversification. Consequently, it is expected that
profitability might be maximized and profitability risk (volatility)
minimized when related and unrelated diversification are mixed in
the same proportions.
Hypothesis 5. Profitability is maximized when related and
unrelated diversifications are mixed in approximately the same
proportions.
Hypothesis 6. Profitability risk is minimized when related and
unrelated diversifications are mixed in approximately the same
proportions.
2.6. Endogenous relationship between diversification and
performance
A handful of prior studies have examined the endogenous
relationship between diversification and firm performance. This
means that diversification could affect firm performance, but firm
performance might also influence diversification. Lang and Stulz
(1994), Hyland and Diltz (2002), and Graham et al. (2002) inves-
tigated the endogenous relationship between diversification and
firm performance. Those studies investigated whether low perfor-
mance motivates corporate diversification. Rijamampianina et al.
(2003) listed a firm’s motivations to diversify as follows: (1) stock
value enhancement, (2) firm (or sales) growth, (3) internal mar-
ket efficiency, (4) stability of income stream, and (5) profitability
enhancement. This suggests that low performance could influ-
ence diversification decisions, as well as the level of diversification.
Because diversification could also be perceived as an investment
behavior, firms with enough managerial and financial capacity
could easily diversify into other industries. Consequently, firm per-
formance could be a determinant of the decision to diversify and at
what level to do so. Thus, this study expects an endogenous rela-
tionship between diversification and firm performance. Due to the
biased results from OLS (Ordinary Least Square) regression, we con-
trolled the endogeneity issue in this study using the instrumental
variable regression method.
3. Methodology
3.1. Data
This study used diversification data on the U.S. restaurant indus-
try from 1980 to 2008 retrieved from the Compustat Segment
Database (Primary SIC is 5812). The sample included a total of 308
companies and 2829 observations. Of the 308 restaurant firms, 77
221
firms were diversified. The Compustat Segment Database provides
annual sales of each business segment based on the four-digit SIC
(Standard Industrial Classification). Performance data, such as prof-
itability and risk (volatility) of profitability, were collected from
Compustat Fundamental Annual Database and merged with the
Compustat Segment data. If the sales generated from the primary
segment (SICs 5812) were less than 50% the observation was elim-
inated.
3.2. Dependent variables
The major interest of this study was to investigate the effects of
diversification strategy on firm performance using profitability and
risk (volatility) of profitability as major performance variables. For
robust results we incorporated two variables for profitability and
risk respectively. As profitability measurements, we used adjusted
return on assets (ROA) and return on sales (ROS). These variables
(ROA and ROS) are ratios that include positive and negative values.
To examine risk (volatility) of profitability, we used the three-year
variance of adjusted ROA and ROS. The adjusted ROA was calculated
as the ratio of net income plus total interest paid on the total assets
at the beginning of the year. Likewise, adjusted ROS was measured
as the ratio of the sum of net income and total interest paid on net
sales for the year.
Prior studies used the conventional variance calculation method
to measure the variance of profitability. The conventional mea-
sure uses the average of the previous three years to calculate
variance. However, this assumes that profitability is stationary,
which implies that profitability remains approximately the same
for several years. However, Mueller (1977, 1986) found that
profit increases up to a certain level, which means that profit is
non-stationary. To overcome this limitation, we incorporated the
predicted value from a simple AR(3) regression using a series of
adjusted ROA and ROS. For example, profitability at time t is the
dependent variable, while profitability at times t-3 to t-1 were used
as independent variables. Then, we used the predicted value from
the AR(3) model as the expected value, instead of the prior three-
year average, to calculate the variance. However, the variance had a
unique distribution characteristic, which was censored because the
variance did not allow for negative values. Consequently, we ulti-
mately used the logarithmically transformed three-year variance
as the risk (volatility) of profitability (adjusted ROA and ROS).
3.3. Independent variables
The independent variable in this study is the diversification
measure. Thus, this study incorporated the entropy measurement.
Initially, Boltzmann (1896) invented entropy to measure disor-
der, chaos, and uncertainty of a state in physics. The entropy
measure spread into science and engineering, but usage and def-
initions differ slightly in each research field. Jacquemin and Berry
(1979) introduced the entropy measure into diversification studies
because it has several benefits. In comparison with prior measures
(e.g., Wrigley/Rumelt measurement), the entropy measure is objec-
tive, continuous, and decomposable. Decomposability means that
total diversification entropy could be broken down into related and
unrelated diversification entropy. The calculation method for the
entropy measure is as follows:

n 1
DT = Pi × ln
Pi
i=1
where Pi = the ratio of the firm’s total sales within the ith industry
segment; n = the number of industry segments in which the firm
participates.
222 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
DT represents total diversification entropy; Pi is the share of
the ith business within the firm; and n is the number of business
segments identified by the four-digit SIC code. Thus, a larger DT
means a higher degree of overall diversification at the firm level.

M
DR = DRj × Pj
j=1
where DRj = diversification within industry groups; M = number of
industry groups (n ≥ M); and Pj = the ratio of the firm’s total sales
within the jth industry group.
DR represents related diversification entropy; DRj is the related
diversification arising from operating in several businesses within
an industry group j; and Pj is the share of the segment jth group’s
sales out of the total sales of the firm. Thus, a lager DR means that
a firm is highly diversified into related businesses.

M  
1 produce products and services, which implies that firms with a
DU = Pj × ln
Pj
j=1
where M = the number of industry groups; Pj = the ratio of the firm’s
total sales within the jth industry group.
DU implies unrelated diversification entropy; Pj is the share of
the jth industry group’s sales out of the total sales of the firm; and M
is the number of industry groups (Palepu, 1985). Likewise, a larger
DU means that a firm is highly diversified into unrelated businesses.
DT = DR + DU
Finally, total diversification entropy is the sum of related and
unrelated diversification entropy. This is the decomposability of
the entropy measurement. As indicated earlier, to examine the
non-linear relationship between diversification and performance
we incorporated the square terms of the entropy measures: DR2
(square term of DR) and DU2 (square term of DU).
Finally, the last diversification measurement is the ratio of
unrelated entropy to total entropy (RUTE). When firms are simul-
taneously considering both related and unrelated diversification
strategies, it is difficult to decide how firms should mix them.
Thus, this study incorporated the ratio of unrelated entropy to total
entropy in order to identify the optimal mixed ratio of related and
unrelated diversification. In this measure, a value of “one” implies
that the firm is wholly diversified into unrelated businesses, and a
value of “zero” indicates that the firm is diversified fully into related
businesses. Similar to prior entropy measures, we incorporated the
squared term (RUTE2 ) in our analysis.
3.4. Classification of related and unrelated diversification
When measuring related and unrelated entropy, whether a
business (industry or sector) is classified as either related or
unrelated is important. Prior studies tend to favor Rumelt’s classi-
fication. However, it has limitations due to categorizing businesses
as related or unrelated based on the SIC classification system.
Conventional Rumelt’s classification identifies the relatedness of
businesses based on whether the first two-digit SIC codes are the
same or not. If they are same, the two businesses are categorized
as related businesses. Otherwise, they are categorized as unre-
lated businesses. However, the SIC classification system does not
represent the relatedness of businesses. Thus, this study modi-
fied the classification method based on the basic characteristics of
each diversifying target industry. Because restaurant firms provide
food-related products and services, we categorized food-related
businesses, such as food retail and food production, as related to
the primary business.
3.5. Control and instrumental variables
Following prior studies, we included a number of control vari-
ables in the model. Firm size is critical to our analysis because the
dependent variables are divided by firm size. Thus, to control for
the size effect on the dependent variables we used logarithmically
transformed total assets and sales and their squared logarithmically
transformed variables. We also incorporated financial and oper-
ating leverage. In prior studies, debt leverage positively affected
profitability in Hurdle (1974), but negatively affected it in Hall and
Weiss (1967) and Gale (1972). However, highly leveraged firms
can reduce wasteful investments and increase firm performance
through managerial discipline (Jensen, 1986; Stulz, 1990). To con-
trol for the financial leverage effect, we used the logarithmically
transformed ratio of total debt to total assets. Ito (1997) found that
a fixed-asset ratio had a positive effect on profitability. A higher
fixed-asset ratio means that more physical assets are needed to
higher fixed-asset ratio have a larger market share. Most diversi-
fied restaurant firms had food manufacturing and equipment lines.
Many had even invested in real estate in order to diversify into
hotel/motel industries. Considering the purpose of this study, it
is necessary to examine this factor in the relationship between
diversification and firm performance. Thus, to control for operating
leverage the logarithmically transformed ratio of property, plant
and equipment to total assets and the ratio of depreciation to total
assets were included.
According to the free cash flow hypothesis (Jensen, 1986), exces-
sive free cash flows allow managers to pursue personal goals
regardless of firm value. Although cash flow has a positive effect on
firm performance because it can be used for profitable investment,
Brush et al. (2000) found that free cash flow can have a negative
influence on firm performance due to unprofitable investments.
Thus, we incorporated cash flow, a dummy of Tobin’s Q, and free
cash flow in the model. Also, we followed Himmelberg et al. (1999)
method to calculate Tobin’s Q. Similar to Brush et al. (2000), if
Tobin’s Q is less than one the firm has free cash flows, but if Tobin’s Q
is larger than one there are no free cash flows. Additionally, because
mergers and acquisitions might change firm size, we incorporated
an M&A dummy. We also controlled for size change using total asset
growth and net sales growth. Finally, to control for changes in the
primary market size we incorporated the average prior three-year
sales growth, which is the average of the primary market (SIC 5812)
sales growth at times t-1, t-2 and t-3. Detailed descriptions of all
variables are provided in Table 1.
Methodologically, the instrumental variable (IV) regression
needs reliable and valid instruments for first stage estimation. The
appropriate instrumental variables for this study are determinants
of corporate diversification, as we addressed in the discussion of
the endogenous relationship between corporate diversification and
firm performance. For instance, many firm-level factors are related
to diversification decisions: firm size, fixed assets, overall firm
growth advertising expenditures, and capital structures such as
total and long-term debt leverage or debt/equity ratio. Simply put,
large firms can diversify more easily since they have more resources
and low growth firms are more likely to diversify than high growth
firms. Also, firms with higher advertising expenditures are better
situated to exploit their market reputation when diversifying. Since
diversification is a kind of investment behavior, capital structure
is also associated with diversification (Jang and Tang, 2009). All
instrumental variables (IV) in the analysis used the average prior
three-year variable. In other words, the average value from time t-1
to time t-3 was used. Theoretically, the diversification decision is
determined by long-term performance rather than short-term per-
formance. Thus, using the prior three-year average value is more
logical. Another advantage of the prior three-year average is that it
 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228 223

Table 1
Variable description. 2
Volatilityi,t = ˇ1 × (DR)i,t + ˇ2 × (DR)i,t + ˇ3 × ln (TDL)i,t
+ ˇ4 × ln (Firm Size)i,t
Variable Description 2
+ ˇ5 × ln (Firm Size)i,t + ˇ6 × (Firm Size Growth)i,t
ROAi,t Adjusted return on assets [(net income + interests +ˇ7 × Avg Pri NSGRi,t
paid) ÷ total assets at the beginning of time t] + DYt
ROSi,t Adjusted return on sales [(net income + interests Model 3-a & Model 3-b
paid) ÷ net sales at time t]
ln(Var ROA)i,t Logarithmic transformed modified 3-year variance of
2
adjusted ROA Volatilityi,t = ˇ1 × (DU)i,t + ˇ2 × (DU)i,t + ˇ3 × ln (TDL)i,t
ln(Var ROS)i,t Logarithmic transformed modified 3-year variance of + ˇ4 × ln (Firm Size)i,t
2
adjusted ROS + ˇ5 × ln (Firm Size)i,t + ˇ6 × (Firm Size Growth)i,t
DRi,t Related diversification entropy +ˇ7 × Avg Pri NSGRi,t
DR2i,t Squared term of related diversification entropy + DYt
DUi,t Unrelated diversification entropy Model 4-a & Model 4-b
DU2i,t Squared term of unrelated diversification entropy
RUTEi,t Ratio of unrelated entropy to total entropy DR represents related diversification entropy and DU repre-
[DU ÷ (DR + DU)] sents unrelated diversification entropy. Models 1-a and 1-b apply
RUTE2i,t Squared term of RUTEi,t to Hypothesis 1, which concerns the relationship between related
ln(TDL)i,t Logarithmic transformed total debt leverage [ln(total
diversification and profitability. It was expected that coefficient ˇ1
debt ÷ total assets)]
ln(NS)i,t Logarithmic transformed net sales would be negative and ˇ2 would be positive. Models 2-a and 2-b
2
ln (NS)i,t Squared logarithmic transformed net sales were proposed to examine Hypothesis 2. It was expected that coef-
ln(TA)i,t Logarithmic transformed total assets ficient ˇ1 would be positive and ˇ2 would be negative. Models 3-a
2
ln (TA)i,t Squared logarithmic transformed total assets and 3-b were suggested to investigate Hypothesis 3. It was expected
ln(PP&E)i,t Logarithmic transformed fixed asset ratio [ln(PP&E ÷ total that coefficient ˇ1 would be positive and ˇ2 would be negative and
assets)]
DEPi,t Depreciation of firm i at time t
significant. Models 4-a and 4-b were suggested for Hypothesis 4. It
CFi,t Cash flow of firm i at time t [(operating income before was expected that coefficient ˇ1 would be negative but coefficient
depreciation − total income taxes − change in deferred ˇ2 would be positive.
taxes from the previous year to the current year − gross
2
interest expense − preferred dividend requirements on Profitabilityi,t = ˇ1 × (RUTE)i,t + ˇ2 × (RUTE)i,t + ˇ3 × ln (TDL)i,t
cumulative preferred stocks and dividends paid on + ˇ4 × ln (Firm Size)i,t
2
non-cumulative preferred stock − total dollar amount of + ˇ5 × ln (Firm Size)i,t + ˇ6 × ln (PP&E)i,t + ˇ7 × DEPi,t
dividends declared on common stocks) ÷ total assets] + ˇ8 × CFi,t + ˇ9 × DQi,t 
DQi,t Dummy Tobin’s Q = 1 if Tobin’s Q is larger than 1/ = 0 if + ˇ10 × FCFi,t + ˇ11 × DM&Ai,t + DYt
Tobin’s Q is less than 1 Model 5-a & Model 5-b
FCFi,t Free cash flow of firm i at time t = CFi,t if Tobin’s Q is less
than 1/=0 if Tobin’s Q is larger than 1
2
DM&Ai,t Dummy M&A = 1 if firm i executed M&A at time t/ = 0 Volatilityi,t = ˇ1 × (RUTE)i,t + ˇ2 × (RUTE)i,t + ˇ3 × ln (TDL)i,t
otherwise + ˇ4 × ln (Firm Size)i,t
2
NSGRi,t Net sales growth [(net salesi,t − net salesi,t-1 ) ÷ net salesi,t-1 ] + ˇ5 × ln (Firm Size)i,t + ˇ6 × (Firm Size Growth)i,t
TAGRi,t Total assets growth [(total assetsi,t − total assetsi,t-1 ) ÷ total +ˇ7 × Avg Pri NSGRi,t
assetsi,t-1 ] + DYt
Avg Pri NSGRi,t Average sales growth of the primary business (SIC 5812) Model 6-a & Model 6-b
 from t-1 to t-3
DYt Year dummies Finally, RUTEi,t represents the ratio of unrelated entropy to total
entropy for firm i at time t. Models 5-a and 5-b apply to Hypothesis
5, which represents the relationship between the ratio of unrelated
reduces redundancy and helps avoid over-identification. Multiple entropy to total entropy and profitability. It was expected that coef-
usages of the same IV tend to make the model over-identified. (For ficient ˇ1 would be positively significant but coefficient ˇ2 would
example, using average prior three-year total debt leverage rather be negatively significant because the positive and negative effects
than the three total debt leverages from time t-1 to time t-3). Fol- of the two types of diversification were mitigated when they were
lowing these theoretical rationale and prior studies, instrumental equally mixed. Models 6-a and 6-b were suggested for Hypothesis
variables were also used in the analysis. 6. We expected that coefficient ˇ1 would be negative and ˇ2 would
be positive.
3.6. Proposed models
3.7. Estimation method
To examine the hypotheses regarding the relationship between
diversification and firm performance, this study proposed the fol- There were two estimation issues in this study. The first is the
lowing models: firm-specific effect, which refers to an unobservable heterogene-
ity in each firm’s behavior. To overcome heterogeneity problems
2
Profitabilityi,t = ˇ1 × (DR)i,t + ˇ2 × (DR)i,t + ˇ3 × ln (TDL)i,t panel estimation is frequently used to account for fixed-effects in
+ ˇ4 × ln (Firm Size)i,t
2 the model. The fixed-effect estimation could control the variation in
+ ˇ5 × ln (Firm Size)i,t + ˇ6 × ln (PP&E)i,t + ˇ7 × DEPi,t
error terms between heterogeneous firms. Thus, the current study
+ ˇ8 × CFi,t + ˇ9 × DQi,t  applied the fixed-effect estimation in our analysis. Additionally, this
+ ˇ10 × FCFi,t + ˇ11 × DM&Ai,t + DYt
Model 1-a & Model 1-b study included year dummies to control for time variation because
performance differences could be affected by time variations. Con-
2 sequently, this study applied the panel estimation model on the
Profitabilityi,t = ˇ1 × (DU)i,t + ˇ2 × (DU)i,t + ˇ3 × ln (TDL)i,t
+ ˇ4 × ln (Firm Size)i,t firm-specific effect and applied the time variation to the analysis.
2
+ ˇ5 × ln (Firm Size)i,t + ˇ6 × ln (PP&E)i,t + ˇ7 × DEPi,t The second estimation issue relates to the appropriateness
+ ˇ8 × CFi,t + ˇ9 × DQi,t  of instrumental variables since we used instrumental variable
+ ˇ10 × FCFi,t + ˇ11 × DM&Ai,t + DYt regression. First, if an instrument cannot appropriately predict
Model 2-a & Model 2-b the endogenous variable (diversification variable) the second stage
224 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
Table 2
Mean values of diversified and undiversified firms.
Total sample Undiversified
Obs. 2829 2432
Total entropy 0.0697 – 0.4966
Related entropy 0.0365 – 0.2602
Unrelated entropy 0.0332 – 0.2364
RUTE 0.4546 – 0.4546
Adjusted ROA (%) 4.56% 4.23%
Adjusted ROS (%) 3.55% 3.53%
Variance of adjusted ROA 0.0115 0.0118
Variance of adjusted ROS 0.0049 0.0050
Tobin’s Q 1.7805 1.8527
Total assets (US million $) 376.226 362.366
Net sales (US million $) 490.477 434.655
Note: RUTE is the ratio of unrelated entropy to total entropy.
estimation is biased. Thus, the appropriateness of the instrumen-
tal variables should be put to an under-identification test. We used
the Kleibergen-Paap LM rk statistics to test for under-identification.
The null hypothesis of the under-identification test was that the
equation is weakly (or under) identified. Second, if an instru-
ment is significantly correlated with the endogenous dependent
variable (here profitability and risk of profitability) the equation
could be over-identified. If the equation is over-identified the esti-
mates are also biased. Thus, this study tested for over-identification
using Hansen J-statistics. The null hypothesis of this test was that
the instruments are exogenous (or not over-identified). Finally, to
check the endogenous DP relationship, we included an endogeneity
test based on the Husman test statistics (Wu-Hausman F-statistics).
The null hypothesis of this test was that the variables are exoge-
nous. Additionally, to avoid heteroskedasticity this study applied
the heteroskedastic-robust standard errors.
4. Results
4.1. Descriptive statistics
Our data included 308 restaurant firms with 2829 observations.
In our sample, 77 firms were identified as diversified. As indicated in
Table 2, the total diversification entropy of the diversified firms was
approximately 0.5, related diversification entropy was 0.26, and
unrelated diversification entropy was 0.23. This means that restau-
rant firms tended slightly more toward related diversification. The
ratio of unrelated entropy to total entropy was approximately 0.45,
which also confirms that restaurant firms were moderately more
inclined toward related diversification.
In terms of firm performance, the adjusted return on assets
(ROA) in the restaurant industry was 4.56% and the adjusted return
on sales (ROS) was 3.55%. Both profitability measures were higher
for diversified firms than undiversified firms. Thus, it seems that
diversification might increase profitability. In terms of risk (volatil-
ity) of profitability, the variance of adjusted return on assets (ROA)
and return on sales (ROS) was lower for diversified restaurant firms.
Thus, the overall risk of diversified firms appears to be lower than
the overall risk of undiversified firms.
As we mentioned earlier, we re-categorized related and unre-
lated segments based on industry characteristics. Because the
restaurant business deals with products and services related
to food, we re-categorized food-related businesses to include
categories such as food retail and production. Typically, these busi-
nesses would be classified as unrelated diversification. Finally, we
identified that restaurant firms were diversified into 55 industries:
21 industries related to the primary business and 34 industries
unrelated to the primary business.
Diversified
397
6.61%
3.62%
0.0091
0.0045
1.3404
461.132
832.438
Fig. 1. Prediction of ROA for related and unrelated diversification entropy.
4.2. Related and unrelated diversification entropy and firm
performance
Hypotheses 1 and 2 address the relationship between
related/unrelated diversification entropy and profitability. Table 3
presents the results of Models 1-a and 1-b testing Hypothesis 1
and Models 2-a and 2-b testing Hypothesis 2. The coefficient of
related diversification entropy was negatively significant, whereas
the coefficient of the squared term was positively significant (see
Table 3). Thus, Hypothesis 1 was accepted. This means that prof-
itability decreases up to a certain level of related diversification, but
beyond that level profitability increases. In other words, at lower
levels of related diversification the costs are larger than the benefits
due to the relatively lower profitability of related businesses. How-
ever, at higher levels of related diversification the positive effects of
related diversification (i.e., scale and scope economies and synergy)
dominate the negative effects.
Further, the coefficient of unrelated diversification entropy was
positive and the squared term was negative (see Table 3). Thus,
Hypothesis 2 was accepted. This implies that profitability increases
up to a certain level of unrelated diversification, but beyond that
level profitability decreases. As we expected, at low levels the pos-
itive effects of unrelated diversification are larger than the costs.
Within this range, the influence of relatively profitable unrelated
businesses is dominant. However, beyond that level the positive
effects are dominated by the costs of unrelated diversification, such
as internal transaction costs, loss of control and effort, and lack
of flexibility. Excessive unrelated diversification signals a greater
distance between the primary industry and its diversifying indus-
tries. Consequently, this can lead to a dilution of business focus and,
ultimately, deteriorating profits. Figs. 1 and 2 present predictions
regarding the effects of related/unrelated diversification entropy
on profitability. The overall patterns were very similar between
ROA and ROS. The overall effect of various diversification entropy
measures on profitability was very similar, regardless of the type
of profitability, which implies robust results.
Hypotheses 3 and 4 apply to the relationship between
related/unrelated diversification entropy and risk (volatility) of
profitability. Table 4 presents the results of Models 3-a, 3-b, 4-a,
and 4-b. As seen in Table 4, the coefficient of related diversifica-
tion entropy was positively significant and the squared term was
negatively significant. This means that volatility increases up to a
certain level of related diversification, but beyond that level risk
decreases as related diversification increases. Thus, Hypothesis 3
was accepted. The results indicate that at lower levels of related
diversification the synthetic business risk of related businesses
 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228 225

Table 3
The related/unrelated diversification entropy effect on profitability.

Model 1-a (D.V.: ROA) Model 1-b (D.V.: ROS) Model 2-a (D.V.: ROA) Model 2-b (D.V.: ROS)

DRi,t −5.2171** −1.8969**

DR2i,t 5.5475*** 2.1273**
DUi,t 12.5228*** 7.0048**
DU2i,t −14.9808** −9.3911**
ln(TDL)i,t −0.0735** −0.0435*** 0.0033 −0.0308
ln(NS)i,t 0.1441** −0.0292
2
ln (NS)i,t −0.0101** −0.0080
ln(TA)i,t −0.0026 −0.0788
2
ln (TA)i,t −0.0005 0.0028
ln(PP&E)i,t −0.0060 −0.0072 0.1172*** 0.0716
DEPi,t −1.7156*** −1.3156*** −3.1443*** −1.7777***
CFi,t 0.1878** 0.1022 0.0721 −0.1800
DQi,t 0.0146 0.0015 −0.0014 −0.0158
FCFi,t −0.0857 −0.1834 −0.7743 −0.4507
DM&Ai,t 0.0388 0.0067 0.0048 −0.0061

Number of Obs. 1401 1221 956 832

Under-identification test (Kleibergen-Paap LM statistics) 8.008** 18.489*** 13.521** 14.155**
Over-identification test (Hansen J statistics) 0.112 4.020 3.526 4.852
Endogeneity test 18.651*** 13.742*** 28.936*** 7.446**

Note: Results of year dummies are not presented.

*p < 0.1.
**
p < 0.05.
***
p < 0.001.

dominates the risk-reduction effect. However, at higher levels of
related diversification the risk-reduction effect dominates the syn-
thetic business risk from related businesses.
As seen in Table 4, the coefficient of unrelated diversifica-
tion entropy was negatively significant and the squared term
was positive, but only significant for the volatility of ROA.
This means that the volatility of ROA decreases up to a cer-
tain level of unrelated diversification, but beyond that level
the risk of ROA increases as unrelated diversification entropy
increases. However, the risk of ROS linearly decreased as unre-
lated diversification increased. This suggests that asset efficiency
decreases at an extreme level of unrelated diversification. How-
ever, squared unrelated diversification entropy remained positive
on the volatility of ROS. Thus, Hypothesis 4 was partially
accepted. Figs. 3 and 4 show the predictions of the relationship
between related/unrelated diversification entropy and profitability
volatility.
4.3. RUTE (ratio of unrelated entropy to total entropy) and firm
performance
The final hypotheses examine the optimal mixed levels of
related and unrelated diversification that maximize profitability
and minimize profitability volatility (Hypotheses 5 and 6). To test
these hypotheses, we incorporated the ratio of unrelated entropy
to total entropy. Table 5 shows the results of Models 5-a and 5-b,
which relate to Hypothesis 5. The linear term of the ratio of entropy
to total entropy (RUTE) was positively significant, and the squared
term (RUTE2 ) was negatively significant. If we took derivatives of
ROA and ROS with respect to RUTE for the results of both Models 5-a

Table 4
The related/unrelated diversification entropy effect on risk (volatility) of profitability.

Model 3-a D.V.: ln(VAR ROA) Model 3-b D.V.: ln(VAR ROS) Model 4-a D.V.: ln(VAR ROA) Model 4-b D.V.: ln(VAR ROS)

DRi,t 28.6970** 21.8741**

DR2i,t −48.2268** −47.3671**
DUi,t −88.6641*** −43.0451**
DU2i,t 155.2150** 79.3548**
Ln(TDL)i,t 0.3460 0.6997*** 0.5073*** 0.7922***
Ln(NS)i,t −2.9070*** −3.1580***
2
ln (NS)i,t 0.1911*** 0.1968***
TAGRi,t 0.1237 0.2187
Ln(TA)i,t −1.3738* −1.2696**
2
ln (TA)i,t 0.0731 0.0544
NSGRi,t −0.3313 −0.2741
Avg Pri NSGRi,t −1.0351 0.1383 0.4092 −0.3424

Number of Obs. 635 522 1,039 894

Under-identification test 15.018** 20.325*** 9.026** 10.215**
(Kleibergen-Paap LM
statistics)
Over-identification test 7.079 8.467 1.472 4.479
(Hansen J statistics)
Endogeneity test 10.557*** 12.268*** 20.165*** 8.553**

Note: Results of year dummies are not presented.

*p < 0.1.
**
p < 0.05.
***
p < 0.001.
226 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228

Table 5
The effect of ratio of unrelated entropy to total entropy on profitability and volatility.

Model 5-a D.V.: ROA Model 5-b D.V.: ROS Model 6-a D.V.: ln(VAR ROA) Model 6-b D.V.: ln(VAR ROS)

(RUTE)i,t 6.0578** 3.0727** −11.1632*** −9.9220**

2
(RUTE)i,t −5.7968** −3.0817** 9.1265** 9.0778**
ln(TDL)i,t −0.0435 −0.0164 1.6539* 1.5296*
ln(TA)i,t 0.1098 1.2810
2
ln(TA)i,t −0.0136 −0.0287
ln(NS)i,t −0.0202 −5.0657**
2
ln (NS)i,t −0.0060 0.3259**
ln(PP&E)i,t 0.3418*** 0.0994
DEPi,t −1.3643 −1.4712
CFi,t 0.2202 0.2967**
DQi,t 0.0143 0.0380
FCFi,t −0.1668 0.3426
DM&Ai,t 0.0370 0.0118
TAGRi,t −0.3089
NSGRi,t −1.2732
Avg Pri NSGRi,t −2.2733* −2.1894

Number of Obs. 119 108 72 65

Under-identification test 13.860** 11.043** 21.929** 11.062**
(Kleibergen-Paap LM
statistics)
Over-identification Test 8.630 1.577 9.249 5.026
(Hansen J statistics)
Endogeneity test 18.775*** 14.239*** 26.737*** 7.443**

Note: Results of year dummies are not presented.

*
p < 0.1.
**
p < 0.05.
***
p < 0.001.

Table 6
Summary of hypotheses and results.

Dependent variable Independent variables Hypo. Result Hypothesis accept/reject

ROA ROS

DR − − −
Hypothesis 1 is accepted
DR2 + + +
Profitability
DU + + +
Hypothesis 2 is accepted
DU2 − − −

DR + + +
Hypothesis 3 is accepted
DR2 − − −
Profitability risk (volatility)
DU − − −
Hypothesis 4 is accepted
DU2 + + +

RUTE + + +
Profitability Hypothesis 5 is accepted
RUTE2 − − −

RUTE − − −
Profitability risk (volatility) Hypothesis 6 is accepted
RUTE2 + + +

Note: NS means “Not Significant”.

Fig. 2. Prediction of ROS for related and unrelated diversification entropy. Fig. 3. Prediction on the variance of ROA for related and unrelated diversification
entropy.
 K. Park, S. Jang / International Journal of Hospitality Management 31 (2012) 218–228
Fig. 4. Prediction on the variance of ROS for related and unrelated diversification
entropy.
and 5-b and set the equation at zero, the maximized ratio appears
as follows:
∂ROA
= 6.0578 − 2 × 5.7968 × RUTE = 0
∂RUTE
RUTE ≈ 0.523
∂ROS
= 3.0727 − 2 × 3.0817 × RUTE = 0
∂RUTE
RUTE ≈ 0.499
Consequently, when we mixed related and unrelated entropy
at approximately half and half profitability was maximized. Thus,
Hypothesis 5 was accepted.
Finally, Table 5 shows the results of Models 6-a and 6-b. The
coefficient of RUTE was negatively significant, while RUTE2 was
positively significant. Likewise, if we took derivatives with respect
to RUTE for the results of both Models 6-a and 6-b and set the
equation at zero, the maximized ratio appears as follows:
∂ ln(Var ROA)
= −11.1632 + 2 × 9.1265 × RUTE = 0
∂RUTE
RUTE ≈ 0.612
∂ ln(Var ROS)
= −9.9220 + 2 × 9.0778 × RUTE = 0
∂RUTE
RUTE ≈ 0.546
The calculation results show that when related and unrelated
entropy are mixed in approximately the same proportions, the
volatility of profitability is minimized. Thus, Hypothesis 6 was also
accepted. Finally, Table 6 shows a summary of all the hypotheses
and results of this study.
5. Conclusion
The DP relationship deserves the attention it has garnered in
the field of strategic management. However, few efforts have been
made to understand the DP relationship in the hospitality field.
This study investigated the relationship between diversification
strategies and accounting performance in the restaurant industry
using an entropy measure. In particular, the current study exam-
ined the non-linear effect of diversification on firm performance by
controlling for endogeneity and firm-specific effects.
This study found that related diversification decreases prof-
itability up to a certain level, which means that at a low level of
related diversification the negative effect from relatively unprof-
itable related business segments dominates. However, beyond that
level profitability increases as related diversification increases. At
227
high levels of related diversification the positive effect from scale
and scope economies and synergy overrules the negative effect.
On the other hand, unrelated diversification increases profitability
up to a certain level, which implies that at a low level of unre-
lated diversification the positive effects of the relatively profitable
unrelated business segments dominate. However, beyond that level
unrelated diversification decreases profitability, which implies that
at high levels of unrelated diversification internal transaction costs
increase and there is a loss of control and effort due to the distance
from the primary business.
In terms of the volatility of accounting profitability, related
diversification increases volatility up to a certain level. This means
that at low levels of related diversification the synthetic related
business risk is larger than the risk reduction effect. However,
beyond that level of diversification volatility decreases because at
high levels of related diversification the risk reduction effect domi-
nates. Conversely, unrelated diversification decreases volatility up
to a certain level because the income streams of unrelated busi-
nesses are weakly correlated. However, at high levels of unrelated
diversification volatility increases because the firm faces various
business risks and loses managerial control.
A number of managerial implications could be derived from
the results of this study. First, restaurant managers should be cau-
tious when they consider diversifying into related businesses as
a first diversification strategy because it will inevitably be situ-
ated at a low level of related diversification. Within this range
of related diversification, profitability decreases and volatility
increases. Thus, it is recommended that restaurant managers just
beginning to diversify should move into unrelated businesses.
Second, even though diversification into unrelated businesses pro-
duces positive outcomes, at high levels of unrelated diversification
profitability decreases and volatility increases. Accordingly, when
managers decide to increase the unrelated businesses in their
business portfolio they should be cautious. Finally, well balanced
diversification into both related and unrelated businesses is the
best strategy for restaurant firms. The negative and positive effects
of both types of diversification can be counterbalanced, and prof-
itability is maximized while volatility is minimized.
This study is not free from limitations. Other factors may influ-
ence the DP relationship, such as organizational efficiency and
structure, managerial capability and experience, and ways to diver-
sify. Further, the results of this study cannot be generalized to
other industries due to the sample’s uniqueness. Because of limita-
tions in the public data this study could not reveal each segment’s
profitability at the firm level. Thus, future studies might improve
our understanding of the DP relationship by incorporating pri-
vate information about firm level segment profitability. Further,
investors could benefit from corporate diversification even if they
are not diversifying their investment assets portfolio. However,
such benefits for investors have not been examined in the hos-
pitality industry. Thus, the investor’s perspective on corporate
diversification strategies could be an interesting subject for future
research.
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