38-Economies of Scale at Work…And Not

Economies of Scale are important, at least in the minds of many managers and investors. Often, we can see these Economies of Scale at work in powerful ways. Sometimes, they seem to disappear.

Within an industry, Economies of Scale tend to be greater from one competitor to another when the industry has high growth. As an example, consider software companies. Oracle Corporation has found that software companies with annual sales of $250 million to $1 billion have operating margins of about 10%. This means that these companies spend 90% of their revenues on costs of People, Purchases and the Capital costs of depreciation. When the size of the companies increases to $1 billion to $5 billion in sales, operating margins go up to 16%. These companies spend only 84% of their revenues for People, Purchases and the Capital costs of depreciation. The largest companies, those with more than $5 billion in revenue, include Oracle, SAP, Microsoft and IBM, a group in rarified atmosphere. These companies have average operating margins of 30%, spending only 70% of their revenues on People, Purchases and Depreciation. Economies of Scale are quite high in this fast-growing industry. (See Step 27, step 28 and step 29 of the Basic Strategy Guide on StrategyStreet.com.)

Now consider an unnamed industry that is actually shrinking in physical units sold. Here we will measure Economies of Scale by the number of employees required to produce and deliver one thousand shipments. The leading company in the industry requires 4.5 employees to produce these one thousand shipments. Another major competitor in the industry is less than one quarter the size of the leader, but this company can provide a thousand shipments using about 5 employees per thousand. The smaller firm requires about 11% more employees per thousand shipments than does the much larger company. This compares with the roughly 30% more people required by the smaller companies than the largest companies in the fast growing software business.

You can also see Economies of Scale at work in an industry over time. You can see it as the industry grows and reduces its costs and consequent prices. A good example is the U.S. cellular service market. In 1997, cellular service cost about 42 cents per minute and customers bought 105 monthly minutes per subscriber on average. By 2004, after much growth and consolidation in the industry, a minute of cellular service cost about 13 cents and the average customer purchased 280 minutes per month. Costs dropped substantially due to Economies of Scale.

Economies of Scale are not a sure thing in many markets. In fact, the leading company in an industry, more often than not, has a Return on Investment lower than that of a smaller competitor. (See the Perspective, “Is Bigger Really Better” on StrategyStreet.com/Tools/Perspectives.) Economies of Scale are the result of strenuous management efforts, not the gift of size alone.

Posted 7/31/08

Update:

By 2018, the average cellular service customer paid $118 a month. Industry sources estimate that about 25% of that monthly cost covered the cost of cellular minutes. So, the average per minute cost has continued to drop. However, cellular plans now are dominated by data usage. Few if any customers now purchase cellular service on a cost per minute basis.

While many analysts argue that industries with high variable costs, such as service industries, have difficulty producing economies of scale, we found some exceptions to the rule. For example, in one of our clients in a service industry, we found that the client’s outlets had decreasing variable costs as the size of the outlet increased. So, even variable costs contain some fixed elements.

Here is more on the idea of Economies of Scale.

Many companies could benefit by measuring the Productivity of the company’s Input costs in producing the Outputs for the customer. This system creates physical measures of both costs and benefits. A company’s measurement of these physical costs and benefits creates measures of Productivity, the ratio of the number of Inputs required to produce the Outputs for customers. In most cases, a company is able to create countable measures of cost Inputs and benefit Outputs for customers.

Once the Company has produced countable measures of Productivity, it can begin to measure the Economies of Scale that it is producing as it grows. As the Company increases in size, the fixed costs in the Company’s cost structure do not grow as fast as the Outputs for the customer. This creates more Productivity as the Company becomes larger. Over time, this better Productivity creates Economies of Scale, which is a superiority in cost structure that a larger company should enjoy over a smaller company because of the fixed costs in both companies’ cost structure. The Company can measure this Productivity improvement over time, to measure the Economies of Scale for the Company and for each cost function in the organization.

In the majority of companies, the most important cost is the cost of People. As a result, the Company would want to be particularly sensitive to the Economies of Scale the Company produces with its People. There are at least three different types, or levels, of People in each functional cost organization. The Company can improve its control over its growth of Productivity and Economies of Scale by measuring the creation of Economies of Scale among its People for each of the three different types of employee.

Go HERE for more explanation.

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