Rationalization: Overview, Types, Pros and Cons, and FAQs


Investopedia / Michela Buttignol

What Is Rationalization?

Rationalization is the reorganization of a company in order to increase its operating efficiency. This sort of reorganization may lead to an expansion or reduction in company size, a change of policy, or alteration of strategy pertaining to particular products offered. Similar to a reorganization, a rationalization is more widespread, encompassing strategy as well as structural changes. Rationalization is necessary for a company to increase revenue, decrease costs and improve its bottom line.

Rationalization may also refer to the process of becoming calculable. For example, the introduction of certain financial models or financial technologies rationalizes markets and makes them more efficient. The introduction of the Black-Scholes model for options pricing, for instance, helped to rationalize the options markets in Chicago in the late 1970s.

Key Takeaways

  • Product and applications rationalization are two forms of rationalization.
  • Rationalization is done by a company to improve its operations.
  • Company rationalization often entails a change of policy, alternation of products, and it may lead to reducing or adding employees. 
  • Often rationalization occurs when a company is seeking to improve its bottom line and improve revenue. 
  • Disadvantages to rationalization include focusing too much on efficiency at the expense of human capital, a loss of initiative from the workforce, its costliness (of both time and money), and it provides no guarantee of improved returns.

Understanding Rationalization

In the business world, rationalization is a process that most organizations consider. That's because it's aimed at improving efficiency, getting rid of waste, standardizing processes, and ultimately boosting the bottom line.

Depending on the company and strategy, rationalization can result in the expansion or reduction in the size of the firm. It can also lead to structural changes.

Specifically, the process of rationalization may involve corporate actions including sales or closures of underperforming business segments, the expansion of outperforming segments, a complete restructuring of the company's financial structure, and a streamlining or modernizing of manufacturing or other operations.

In a large number of cases, asset rationalization results in the loss of hundreds of jobs.

Examining a company’s application portfolio is important to attain more efficient operations and cost integrations, reducing stranded costs left by a seller and streamlining the portfolio to best serve the business.

The Need for Rationalization

There are several reasons that a particular organization might need to go through the process of rationalization. They include the need to:

  • Reduce costs
  • Maximize profits
  • Conserve resources
  • Unlock shareholder value
  • Improve transparency and governance
  • Simplify the business model
  • Eliminate unnecessary products and idle capacity
  • Update old machinery and other business processes

The process of rationalizing is especially common during recessions and after corporate actions such as a merger, acquisition, or new CEO hire.

Types of Rationalization

The following subheads are examples of rationalization.

Products Rationalization

Product rationalization is an important part of managing a product’s lifecycle. If products are not rationalized, their numbers continue to increase, adding complexity and increased support costs to the company’s bottom line. According to the 80/20 Rule, the bulk of a company’s revenue and profit (80 percent) comes from a fraction of its products (20 percent). Therefore, when rationalizing a product line, executives need to consider various factors.

The portfolio effect describes how a product’s addition or removal affects the rest of the company’s products. Sales may go to other products or be lost completely. Although rationalization may reduce complexity in the supply chain, as well as redundancy in both the portfolio and support costs, the costs can be difficult to quantify. The portion of sales that will not transfer to other products needs to be estimated and compensated for by new products entering the portfolio or the sales growth of existing products.

In addition, when products leave the portfolio, fixed costs typically remain the same; the costs must be spread across the remaining product line, increasing unit costs.

Production volume must be transferred to new or more profitable products to ensure the business remains solvent. Also, customer migration becomes an issue, as sales and operations managers must create and carry out migration plans. This is especially important with customers buying multiple products who may leave a company that is no longer providing one-stop shopping.

Applications Rationalization

Engaging in applications rationalization, especially during mergers and acquisitions, helps companies reduce costs, operate more efficiently, and focus on supporting deal objectives, legal and regulatory issues, systems and process integration, and business continuity.

Most businesses accumulate a vast information technology application portfolio over time, especially when companies grow and do not fully integrate operations and assets with each transaction.

Many applications do not support the company’s objectives after each merger or acquisition and need revision to support the new business.

Rationalization of Markets

In terms of market structure, financial models, theories, and technologies that embody these concepts have the force to rationalize markets—to make them calculable and more efficient, in terms of the efficient markets hypothesis (EMH).

As more information of various types is able to be processed by information technologies, transmitted and disseminated using communications technology, and incorporated into the market microstructure, prices become more efficient and the market appears more rational.

The increased use of mathematical formulas and financial models also helps with the rationalization of markets as they become dissociated with human emotion and fallibility.

Advantages and Disadvantages of Rationalization

Rationalization helps companies standardize business processes in order to become more efficient and boost productivity.

It lets management introduce modern techniques and systems, allowing workers to improve their efficiency levels. In turn, rationalization can lead to better working conditions and higher pay for the workforce, ultimately leading to a higher standard of living in society.

Additionally, rationalization can translate into both reduced prices and a higher standard of products for consumers.

On the other hand, rationalization often focuses too much on efficiency at the expense of human capital. The emphasis on modernization and standardization often has negative consequences such as mass layoffs, a loss of initiative from the workforce, a significantly increased workload for the workers that remain, and a worse-off work environment.

Moreover, the process of rationalization is costly, requires consistent monitoring, and provides no guarantee of improved returns.

Pros of Rationalization
  • Helps companies become more efficient and boost productivity

  • Allows management to implement modernized techniques and systems

  • Lowers market volatility

  • Can provide the workforce with better working conditions and higher pay

  • Translates into a higher standard of living in society

  • Can lead to lower prices and better products for consumers

Cons of Rationalization
  • Emphasizes efficiency at the expense of human capital

  • Often involves large layoffs

  • Can lead to a significantly increased workload for the workers that remain

  • Loss of initiative from workers due to the mechanization of processes

  • Costly and requires consistent monitoring

  • No guarantee of improved returns

Rationalization FAQs

What Is Asset Rationalization?

Asset rationalization is the process of reorganizing a company's assets in order to increase operating efficiencies and, ultimately, improve its bottom line.

What Are the Dangers of Rationalization?

Dangers of rationalization include focusing too much on optimization at the expense of human capital, the possibility of negative cultural changes, and allocating capital in an ultimately inefficient manner.

What Is Rationalization in Economics?

In economics, rationalization is the process of changing a pre-existing workflow into one that's more goal-oriented and based on a specific set of rules.