Part 2: Measuring Current Economies of Scale

Measuring Economies of Scale in Each Functional Cost Organization

Capsule:
Economies of Scale implies that a bigger company should have a lower cost than a smaller company due to the fixed costs in the cost structure. The Company can determine its rate of creation of Economies of Scale by measuring its Productivity as it grows. Still, size alone will not create low costs.

Videos:

• Video #75: Overview of Costs Part 1: How to Look

• Video #76: Overview of Costs Part 2: What to Expect

• Video #77: Overview of Costs Part 3: What to Do

• Video #52: Economies of Scale and Acquisitions

• Video #53: Productivity and Economies of Scale in Hostility

Perspectives:

• “Getting Bigger, Getting Smarter”

• “Is Bigger Really Better?”

• “Making Acquisitions Work in Hostile Markets”

• “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets”

• “Success Under Fire: Policies to Prosper in Hostile Times”

Symptoms and Implications

• The industry is adding new, more efficient capacity in the effort to reduce costs

• Outsourcing is a growing phenomenon in the industry

Eventually, the Company exhausts its opportunities to use comparisons with competitors’ approaches in order to determine where and by how much it needs to reduce its costs. At this limit, the Company turns to improvements in Productivity to reduce its unit costs. It measures its improving Productivity over time by building an internal information system to compare itself today with its smaller self in an earlier period. This comparison reveals the Company's creation of Economies of Scale as it grows.

Virtually every company operates under the imperative of growth. Each tries to increase its sales and market share in its industry. The impetus for this growth imperative comes from the belief that a larger company has lower costs than a smaller competitor. This is the concept behind Economies of Scale. Economies of Scale measure the cost advantages that a larger company enjoys over a smaller company. In order to measure the Company’s creation of Economies of Scale, the Company must measure the change in its Productivity over a period of time. These measures should show that the Company is reducing its physical costs as the business grows.

The drive for an increase in company size and better Economies of Scale derives from the assumption that the larger company will have lower costs and better prospects of long term prosperity. This assumption is often incorrect. The Company may create Economies of Scale as it grows, but it is unlikely that the Company will produce lower costs than competition unless the management team sets specific unit cost goals as the Company grows.

We discuss each of these ideas in the following sections:

The Concept of Economies of Scale

Capsule: Costs go down as a company gets bigger because some costs rise more slowly than sales rise. So, bigger companies should have lower costs than smaller companies. This is the implication of the term "Economies of Scale."

Productivity and Time

Capsule: An increase in Productivity creates Economies of Scale when between a larger company and a smaller company. The same increase in Productivity reflects Economies of Scale when the Company compares its current size and cost structure to an earlier period in the Company’s history.

Caveat on the Belief in Size

Capsule: A company should not put too much belief in the simple advantage of size. Most industry market share leaders do not lead their industries in Return on Investment. Size can confer advantages, but only if management sets specific targets for unit costs.

We begin this diagnostic with a short explanation of Economies of Scale.

Basic Strategy Guide Users Return to: Step 28

Summary Points

Next: The Concept of Economies of Scale