First-year student Rohan Rajiv is blogging once a week about important lessons he is learning at Kellogg. Read more of his posts here.
If you ask for five words that form part of traditional business jargon that people hate, the word “synergy” would likely be right up there. Given its horrible reputation, I was curious to learn more. We discussed the idea at length at our intro strategy class. Here are a few notes:
1. The economic view on synergy is: (how big are the gains) x (how achievable are they) – (costs involved). So, in essence, synergy is just a calculation that multiplies potential gains by the probability of achieving them and subtracts the costs involved.
2. The core idea is that two organizations can combine to create more value as a group than they did individually. Value can be created by either increasing benefit to customers or reducing cost. But this is where things get a bit nuanced and tricky.
3. Combining two organizations just because they have something in common does absolutely nothing. Good strategy is when the acquisition enables the acquirer to fundamentally change something about how they do what they do. This works well when they have strengths that complement each other. A great example of this is Disney acquiring Pixar. Pixar gave Disney strength in computer generated cartoons and a creative engine that churned out a great movie every two years. Disney, on the other hand, could use all of Pixar’s characters in its theme parks and merchandise. In order to avoid too many organizational costs like a clash of cultures, Disney allowed Pixar to operate separately, and this acquisition has worked incredibly well for them.
4. It does gets tricky at this point, however, because acquisitions we read about in the press largely talk about potential gains and completely neglect the potential costs. That’s the part of the synergy equation that is normally forgotten or omitted. Researchers have dug into this question over many years: Why are acquisitions regularly over valued when they fail so often? There have been many explanations with CEO hubris and poor decision making processes being suggested as possible explanations. But, the fact remains that the costs of a potential acquisition are generally glossed over. And every time you see an acquisition announced, it is definitely worth looking for whether the acquirer discusses potential costs and challenges. It is quite amazing how regularly this isn’t discussed given the base rate of failure.
5. Warren Buffet once said, “Synergy is a term widely used in business to explain an acquisition that otherwise makes no sense.” And he’s absolutely right. Synergy has been used to describe business decisions that can best be described as illogical or fuzzy. The take-home message is definitely continue to be wary when you hear “synergy” because very few actually understand it and use it consistently with its economic definition.
6. Finally, a quick personal application. Every gain we foresee comes at a cost. It is regularly tempting to only think about and discuss the gain. When we do that, it pays to remember that we’re guilty of the exact mistake that costs many companies billions of dollars and many smart executives their job. Make sure we look at both sides of the decisions made. As economists like to say, there is no “free” lunch.
So, yes, we are back full circle to where we started in terms of our suspicion of the word. But hopefully, the journey has been useful.
Rohan Rajiv is a first-year student in Kellogg’s Full-Time Two-Year Program. Prior to Kellogg he worked at a-connect serving clients on consulting projects across 14 countries in Europe, Asia, Australia and South America. He blogs a learning every day, including his MBA Learnings series, on www.ALearningaDay.com.