208-Dis-Economies of Scale

McKinsey research has found that only 10% of cost reduction programs sustain their results after three years. The problem seems to be overhead. Companies have exploited manufacturing efficiencies to reduce the cost of goods sold as a percentage of revenues by nearly 3% over the past decade. On the other hand, sales, general and administrative costs have remained about the same. The performance of sales, general and administrative SG&A costs is an example of dis-economies of scale.

A few definitions are in order. Economies of scale is the phenomenon where unit costs decline as the number of units sold increases. (See “Audio Tip #195: Economies of Scale and Their Measurement” on StrategyStreet.com) This happens because part of the cost structure is fixed, so it grows at a fraction of the rate of growth of the unit volume the company sells. Dis-economies of scale occur where units of costs increase at a rate that is greater than the increase in the units of output. (See “Audio Tip #198: Diseconomies of Scale” on StrategyStreet.com) In other words, there appear to be no significant fixed costs in the company’s cost structure when dis-economies of scale occur. At the other end of the cost spectrum, you see super-economies of scale. Super-economies occur with costs decline, even as the number of units sold increases. (See “Audio Tip #199: Super-Economies of Scale” on StrategyStreet.com) Usually the super-economies occur due to changes in technology, when the company replaces many employees with technology capital investments.

Now let’s return to the problem of SG&A costs. In 1998, the SG&A costs for the S&P 500 companies were roughly 22% of sales. By 2008, SG&A costs still commanded 22% of the sales dollar. During those ten years, the physical units of output the S&P 500 companies produced certainly increased. On the other hand, the SG&A costs remained the same as a percentage of sales. Are none of the SG&A costs fixed? If there were some fixed costs in SG&A, the companies should have been able to increase the units sold without a proportional increase in numbers of people in the SG&A functions, creating economies of sale. But they did not produce economies of scale as measured as a percentage of revenue. What happened then? Either the number of people employed in the SG&A functions grew with unit sales or the companies paid the average SG&A employee at a higher rate than sales grew. In either case, you have dis-economies of scale operating in SG&A.

Over the years, we have been involved in many cost reduction efforts. We have seen that it is hard to sustain the results of a cost reduction effort over a long period of time. The McKinsey study serves as ample testimony to this fact. What may be helpful is to tie physical units of costs, for example numbers of full time equivalent employees, to physical measures of output, such as customer orders. If the ratio of physical units of cost to physical units of output goes down, the company has an excellent chance of creating economies of scale.

Posted 7/29/10

Update:

For many years, we assumed that the larger companies in an industry had economies of scale advantages over the smaller competitors simply on the basis of their relative size. However, when we dug into the details of that assumption, we found that it was mostly wrong. We found that size, by itself, does not create economies of scale. Rather, size creates the opportunity to develop superior economies of scale. Most industry leaders fail to develop and exploit that potential. See HERE for the evidence.

10/22

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