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Limitations which arise from diversifying an organization’s operations are numerous. A good example of expansion is geographic diversification which entails spreading the business activities far and wide on a wide geographical platform. Some companies would prefer to run their investment portfolio on a local scale so as to benefit from a monopoly whereby the local markets will not be competitive. Financial institutions in such monopolized markets argue that diversifying their operations might result in intensified competition leading to increased overheads. However, in this paper, the question of why a financial institution’s profitability can be limited by geographic expansion is discussed. This is evident from the fact that financial institutions which do not venture into external markets eventually miss out on the benefits accrued from economies of scale.
According to Jiatao and Yue, economies of scale refer to the expenditure merits that a financial institution obtains as a result of expansion (2008). This is in fact the main advantage of expanding business activities beyond the local borders. Financial institutions which cannot execute or diversify their business volume lose out on the possibility of minimizing costs. There are parameters that lead to a producer’s cost per unit of production going down owing to the large scale. Economies of scale have been found to significantly reduce the cost of production (Kim & Mathur 2008). There are a variety of ways through which a financial institution can diversify its scale of production. The most common is through setting up more units of the same firm in different geographical locations. This translates to geographical diversification (Kim &Mathur 2008).
On the other hand, diseconomies of scale would inflict those financial institutions which do not have access to external or expanded markets. Ravichandran et al (2009) argue that diversifying a firm’s activities will reduce the risk factors alongside boosting its volume of output. They add that the main rationale behind starting a financial institution is to make profit. Although local firms’ operations enjoy a monopoly, this cannot be equated to the returns that can be accrued from untapped markets. Any firm wishing to expand its scope of operation can engage in economies of scale. Geographical diversification of resource inputs of a financial institution is very important as far as its profitability is concerned (Driffield, Du & Girma, 2008). Companies that are not capable to expand usually record low profit margins. One of the key areas where they miss trade benefits is on bulk purchases of goods and services through agreements that are long term. Moreover, these institutions do not get trade discounts as a result of buying in bulk hence their profit margin remains relatively low. Jiraporn, Kim and Mathur (2008) observe that apart from buying in large volumes, financial institutions with diversified operations enjoy better managerial skills due to division of labor and specialization by managers. This in turn leads to increased output and profit base for the institution. In addition to the above limitations, firms that optimize on monopolies on the local market do not have outright chance of borrowing loans from banks at low interest rates (Kim & Mathur 2008). Financial institutions can save or reduce company overheads by taking advantage of these low interest loans which can only be accessed by institutions that have geographically diversified their activities.
As can be noted from the above discussion, financial institutions which have not diversified their business activities are likely to suffer low profit margins. This is attributed to a lack of economies of scale which in the long run cuts down on the cost of both managerial and financial input. For instance, institutions with large geographical operational bases will benefit from trade discounts and low rates of interest on loans borrowed. This will in turn improve profitability of such institutions.
References
Driffield, N., Du, J., & Girma, S. (2008). Optimal geographic diversification and firm performance: evidence from the U.K. Journal of Productivity Analysis, 30(2), 145-154.
Jiatao, L., & Yue, D. (2008). Market Size, Legal Institutions, and International Diversification Strategies: Implications for the Performance of Multinational Firms. Management International Review (MIR), 48(6), 667-688.
Jiraporn, P., Kim, Y., & Mathur, I. (2008). Does corporate diversification exacerbate or mitigate earnings management?: An empirical analysis. International Review of Financial Analysis, 17(5), 1087-1109.
Kim, Y., & Mathur, I. (2008). The impact of geographic diversification on firm performance. International Review of Financial Analysis, 17(4), 747-766.
Ravichandran, T., Liu, Y., Han, S., & Hasan, I. (2009). Diversification and Firm Performance: Exploring the Moderating Effects of Information Technology Spending. Journal of Management Information Systems, 25(4), 205-240.
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