The boundary conditions for growth: Exploring the non-linear relationship between organic and acquisitive growth and profitability

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Abstract

The nature of the relationship between growth and profitability remains inconclusive, despite prior research. To contribute to a better understanding of the growth-profitability relationship, we examine its non-linear character. We achieve this by deconstructing growth into organic and acquisitive modes, and by theorizing how the particular costs and benefits of each mode affect the profitability, which we measure as return on assets. Furthermore, we propose that the interaction of these two modes can also affect profitability. By studying these relationships with a panel data set of established German firms during a 13-year period, we uncover an inverted U-shaped relationship between growth and profitability that is mainly driven by acquisitive growth. These decreasing returns at higher levels of acquisitive growth are related to the higher internal costs of managing acquisitions. Consistent with our logic, we find that organic growth has a declining positive profitability effect. The interaction of both growth modes also shows that increasing acquisitive growth negatively impacts the positive effect of organic growth on profitability.

Introduction

Growth through the recognition and pursuit of opportunities represents a common objective for firms at various stages of their development (Penrose, 1959). Through growth, firms can strengthen their market position, achieve cost advantages, and become less dependent on economic downturns (Davidsson et al., 2009). However, an ongoing pursuit of growth does not necessarily lead to higher performance outcomes (McKelvie and Wiklund, 2010). Particularly, the costs of those growth efforts—which may also vary for different modes of growth—may be difficult to predict and manage. This can greatly influence profitability.

In this study, we question contemporary understandings of the relationship between growth and profitability, and re-evaluate their underlying assumptions (Dagnino et al., 2017). Particularly, we reject the assumption explored in prior literature that the growth profitability relationship is best represented as linear and positive. Instead, we propose that there are profitability limits to growth. We consider this assumption to be plausible, given that not only positive (e.g., Brush et al., 2000; Geroski et al., 1997; Wolff and Pett, 2006) but also negative (e.g., Jang and Park, 2011; Reid, 1995) and insignificant relationships have been found in prior research (e.g., Markman and Gartner, 2002; Roper, 1999). Our central argument is that the non-linear shape of the growth-profitability relationship depends on the rate of growth and the mode of growth. By re-evaluating the assumption of linearity and by distinguishing the relationships across growth modes, we can also examine the strategies of firms that are capable of actively pursuing both modes simultaneously. We represent this scenario as an interaction between organic and acquisitive modes of growth.

Firms can grow in two primary manners—through organic growth or through acquisitive growth. Organic growth is growth (i.e., increasing output and sales) that firms achieve via resources and activities from within their organizations, for example, by successfully creating new products and expanding their sales force. Acquisitive growth—realized through mergers and acquisitions (M&As)—is growth that firms achieve by adding external entities and their activities to their existing organizations. In prior literature, the two modes of growth are rarely distinguished when exploring the effect on performance (for an exception, see Moatti et al., 2015). Since these modes can pose vastly different costs and benefits (Davidsson et al., 2009; Delmar et al., 2003; Lockett et al., 2011; McKelvie and Wiklund, 2010), we expect differences in their impact on profitability. Specifically, we propose a positive but declining relationship between organic growth and profitability, and an inverted U-shaped relationship between acquisitive growth and profitability, which mainly stems from higher internal costs for managing the acquisition-related integration activities.

To test our theoretical models, we leverage a longitudinal sample of German DAX and TecDAX firms from 2000 to 2012. With an empirical focus on accounting-based profitability1 (i.e., ROA), we employ a fixed-effects panel analysis alongside further robustness tests that use a generalized method of moment (GMM) technique. Given the empirical emphasis in prior literature of the growth-profitability nexus for more entrepreneurial firms (i.e., Davidsson et al., 2009; Steffens et al., 2009), we also conduct post hoc, sub-sample tests to reveal how the growth-profitability relationship varies for smaller and younger firms, and also for those firms with more or less acquisition experience.

Not only do we find empirical support for our two hypotheses linking organic growth and acquisitive growth to profitability, but we also examine the consequences of both growth modes being pursued simultaneously (Kim et al., 2011; Lockett et al., 2011; Vermeulen and Barkema, 2001). This yields a more complex interaction between the two growth modes as they impact profitability. In accounting for the corresponding cost-benefit relationships inherent in each growth mode, we find that concurrent acquisitive growth reduces the positive profitability effects of organic growth. We thereby show that the distinction between growth modes is important to understand the performance implications that transpire from pursuing unique growth paths. Through our characterization of this relationship as a non-linear model, we offer a new and important direction in this domain. By investigating the nuanced variations in growth-profitability relationships, we uncover the boundary conditions to enhancing firm value through the pursuit of growth.2

Section snippets

The relationship between growth and profitability

Over the past quarter century, studies of growth and profitability have investigated a great variety of empirical settings, from micro-entrepreneurs in late-1990s Scotland (Reid, 1995) to the Fortune Global 500 in the early 2000s (Raisch and von Krogh, 2007). Although wide variation exists in prior research designs when it comes to the types of variance found in extant samples (including time period and industry scope), growth measures (including growth modes), profitability measures, and

Sample and data sources

The data set of our empirical study includes all firms listed in German stock indices—i.e., DAX in the years 2000–2012 and TecDAX in the years 2003–2012. We collected panel data on these firms for the period from 2000 to 2012. We included large and medium-sized public firms, as they account for the major share of acquisitions, with the large and medium-sized firms usually being the acquirer and the smaller firms the targets (Hagedoorn and Duysters, 2002). Furthermore, we also followed McKelvie

Results

Table 2 provides means, standard deviations, minimum and maximum values, and correlations among the variables. When analyzing the means of the independent variables—i.e., undifferentiated growth, organic growth, and acquisitive growth—we note that, on average, more than two-thirds of the sales growth of a firm stem from organic growth.

Table 3 presents the results of the fixed-effects panel analysis. In Model 1, the control model, we only include the control variables. In Model 2 and Model 3, we

Discussion

Building on the main assumption of a limit to growth's positive influence on profitability, it is important to understand those boundary conditions of growth. To explore this, we leveraged a 13-year panel data set of publicly-traded German firms to test our hypotheses that growth affects profitability non-linearly and that the character of the growth-profitability relationship varies according to the growth mode—i.e., either organic or acquisitive.

Our results show that the mechanisms creating

Conclusion

By exploring how organic and acquisitive growth modes uniquely influence profitability, we further develop the literature at the growth-profitability nexus (e.g., Moatti et al., 2015; Raisch and von Krogh, 2007) and enrich related research domains, such as studies of growth through diversification (e.g., Helfat and Eisenhardt, 2004; Montgomery, 1985; Qian et al., 2010) or through acquisition (e.g., Haleblian et al., 2006; Haleblian et al., 2009; Kim et al., 2011). By exploring how profitability

CRediT author statement

Martin Weiss: Conceptualization Methodology Formal analysis Writing - Original Draft Writing - Review & Editing Dominic Herrmann: Conceptualization Methodology Writing - Original Draft Theodore E. Khoury: Conceptualization Methodology Writing - Original Draft Writing - Review & Editing Markus Kreutzer: Conceptualization Writing - Original Draft Writing - Review & Editing Marc Hummel: Methodology Formal analysis Writing - Original Draft.

Acknowledgements

We wish to thank participants at the 2014 annual meeting of the Strategic Management Society, the 2015 annual meeting of the German Academic Association for Business Research, and the 2019 annual meeting of the Academy of Management for helpful comments on earlier versions of this paper. This paper builds on material from the second and fifth authors' dissertations.

Martin Weiss is an Associate Professor of Strategy at the Vlerick Business School (Belgium). His areas of interest include diversification strategies, growth strategies, and the impact of environmental uncertainty on strategic decision making. He earned his PhD at the University of Erlangen-Nuremberg (Germany).

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  • Cited by (0)

    Martin Weiss is an Associate Professor of Strategy at the Vlerick Business School (Belgium). His areas of interest include diversification strategies, growth strategies, and the impact of environmental uncertainty on strategic decision making. He earned his PhD at the University of Erlangen-Nuremberg (Germany).

    Dominic Herrmann is a manager at Nürnberger Versicherung and a post-doc researcher affiliated with the University of Erlangen-Nuremberg. His research focuses on corporate growth strategies. He received his PhD from the University of Erlangen-Nuremberg (Germany).

    Theodore E. Khoury is a Full Professor of Management and Strategy at Portland State University (PSU). His research focuses on the role of institutions and social forces within entrepreneurship and innovation processes. He holds a PhD from the University of Texas at Dallas (USA).

    Markus Kreutzer is a Full Professor at EBS Business School in Oestrich-Winkel (Germany). His research focuses on strategic management, with a particular focus on strategic renewal and strategy as a process. He obtained his PhD from the University of St. Gallen (Switzerland).

    Marc Hummel is a Project Manager at Dr. Ing. h.c. F. Porsche AG and a post-doc researcher affiliated with the EBS Business School. His research focuses on business models, co-opetition, and corporate growth. He received his PhD from EBS Business School (Germany).

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