In the pre-liberalized economy, which was characterized by inadequately developed market and institutional mechanism, one of the critical success factors for industrial groups' diversification into related and unrelated areas was their ability to deal and interact with the governmental departments. It was expected that firms would continue to make profits irrespective of their choice of related or unrelated diversification strategy. This study explores the `diversification strategy-firm performance' relationship in the large Indian companies of 1989, and examines it in terms of `High' and `Low' total diversifiers, and `Related' and `Unrelated' diversifiers. The analysis shows, contrary to expectation, that `Low' diversifiers have higher profitability, though there seems to be no significant difference in the profitability of `High' and `Low' total diversifiers. The results also indicate that `Unrelated' diversifiers have a distinctly lower level of profitability as compared to `Related' diversifiers, as well as other companies. An examination of the effect of diversification on profitability and controlling for other determinants of profitability, shows that `Unrelated' diversification explains profitability better than `Total' diversification and `Related' diversification. The paper concludes that the `diversification-firm performance' relationship is highly `context-specific' and the `industry effects' have had a profound effect on the `diversification-firm performance' relationship.

The relationship between a firm's diversification strategy and its performance has remained a subject of interest for both academics as well as managers. Arguing from a resource-based point of view, researchers affirm that the opportunity of a firm's businesses to share skills, knowledge and other resources could improve the performance of the diversified firm. Scholars have considered this topic from a range of different theoretical approaches, and as a result, the approach for empirical analysis has also been different. In this regard, as Varadarajan (1986) noted, a review of specialized literature reveals a great divergence in the way that diversification is defined and approached. Chandler (1962) approached from a business policy perspective, Gort (1962) and Markham (1973) approached from the industrial organization perspective, Rumlet (1974, 1982), Montgomery (1982), Christensen and Montgomery (1981) approached from a strategic management perspective. Also, diversification has been measured in different forms. Rumelt (1974) used the Categorical Measures, Jacquemin and Berry (1979) and Palepu (1985) used the Entropy Measures, Varadarajan (1986) used the `Narrow/ Broad Spectrum Diversification Measures, and other measures like the Herfindahl indices have been used by some scholars. A review of studies done on different disciplines of management shows those studies on Industrial Organization (Gort, 1962; Arnould, 1969 and Markham, 1973) concluded that there is no significant relationship between diversification and firm performance.

However, studies in the Strategic Management literature (Rumlet, 1974 and 1982; Montgomery, 1982; and Christensen and Montgomery, 1981) have reported a systematic relationship between a firm's diversification strategy and its performance. The question is why there is a difference in the results between the two streams, especially when both are studying the relationship between the same two variables? The answer lies in the difference in methodology/ measurement of the variable—`corporate diversification'. The studies in industrial economics used simple product count indices (Index Approach) as compared to the strategic management literature which used a classification scheme proposed by Rumlet (Categorical Approach). Rumlet's classification captured an element of diversification that was missed out by the `Industrial Organization streams', i.e., Related and Unrelated components of diversification. Such an element further went to explain the gap that existed between the two streams of literature dealing with profit impact of corporate diversification (Palepu, 1985).

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