1.7 Growth and evolution

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Economies and diseconomies of scale

Once a business is able to meet its first goal, which is to simply survive, it can then focus on other objectives such as profit maximization, expansion and growth among others.

We have taken a close look at some of the tools that businesses use to make strategic decisions, such as the SWOT analysis. One of the consequences of expansion and growth is Internal Economies of Scale. This means that as business gets larger, it is able to take advantage of certain conditions within the organization where the average total costs (ATC) of production fall with increased output. Conditions that are external to the business can also create economies or diseconomies of scale. Lets us first examine the Internal economies of scale as they may exist.

Consider the following. Costs are accumulated with production. As a business increases its production, it invariably needs to increase its input costs. However, if a business gets large enough and produces a certain amount of goods or services, it can take advantage of production circumstances that arise on account of its size. We are all familiar with the wholesale prices. If you were to buy 50 T-shirts, the price would probably be less that if you were to pay for 1 T-shirt. Now consider the advantage of buying 10,000 T-shirts. This is known as purchasing economies of scale. Do you think that IKEA has purchasing power as an economy of scale?


Another economy of scale you may also be familiar with is borrowing funds from a bank. The larger the amount that is borrowed, the lower the interest rates. This is known as a financial economy of scale. Larger financial corporations therefore have a distinct advantage over smaller ones. Consider a financial institution such as J.P. Morgan and the financial economies that it can muster.

The main Internal Economies of Scale that businesses experience are:

1) Purchasing - Whole sale buying power
2) Financial - Borrowing and funding potential
3) Managerial - Expertise that will drive down costs for a business
4) Technical - The best technology that will advantage a business
5) Marketing - More effective marketing through economy of scope

The whole concept of economies of scale can be brought into focus through the writings of Adam Smith. An Inquiry into the Nature and Causes of the Wealth of Nations a popular book by Adam Smith written in 1776 described the production of a pin (yes the pins used by tailors to hold cloth together) as follows:

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head: to make the head requires two or three distinct operations: to put it on is a particular business, to whiten the pins is another ... and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which in some manufactories are all performed by distinct hands, though in others the same man will sometime perform two or three of them.

In the Pin Factory example, Adam Smith illustrates how the concept of division of labor, lowers the costs of production as output increases. He argues that one worker performing all the 18 distinct tasks in a pin factory would make no more that 18 pins a day while 10 men divided and specialized in their tasks would make up to four thousand eight hundred pins.

The concept of economies of scale can be best illustrated in the following diagram:


The Y axis represents the Average Total Cost and the X axis represents the Quantity. As the business produces it experiences falling average costs represented by the ATC curve.


As output progresses the business will begin to experience constant economies and thereafter diseconomies of scale. When output increases but the business experiences neither an increase nor a decrease in its Costs, the firm is experiencing Constant Economies of Scale. However as costs begin to rise with each unit of increased output, the business is now experiencing diseconomies of scale as illustrated by the rising Long Run Average Cost curve (LRAC).

Diseconomies of scale generally occur when a business is so large that it is no longer effectively able to control is costs relative to its output. Bureaucracy or red-tape or managerial diseconomies of scale are a predominant feature of companies that are experiencing diseconomies of scale.

Inefficiency also would result from workers being de-motivated in large organizations where they feel that they are insignificant. In this situation, the firms must decentralize, demerge or create subdivisions in order to decrease the inefficiency.

External Economies of scale are forces within the industry or economy but outside of the business that lower the costs of production. These could be in the form of improved infrastructure (roads, railway or shipping).

External diseconomies of scale are forces within the industry or economy but outside of the business that increase the costs of production. These could be in the form of increased wage rates or material costs.

Apply the concepts of economies and diseconomies of scale to business decisions.

In order to ensure that a business or organization functions at its optimal level is there a point that can be identified as the best or most appropriate scale? Consider your school and the number of teachers and students. Is your school at its optimum size? What would happen relative to benefits or losses if the size were to continue upwards? At what point would the costs outweigh the benefits of size? If costs outweigh benefits then diseconomies of scale have occurred.

Small versus large organizations

In 2010 Walmart is ranked as the largest company in the world with 2,100,000 employees and revenue in excess of 408 billion. Whether size is an advantage for the Walmart is relative to how one weighs the benefits of size relative to the costs of being so large.

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As we observed earlier, size or scale does have its advantages. A large corporation like IKEA will be able to use its very large economies of scale to ensure long-term contracts with suppliers and bring down costs of raw materials through wholesale or bulk-buying. IKEA is also able to make demands on its suppliers and offer long term contracts of engagement.

However, smaller companies are the ones that usually emerge to be recognized as being more personal service orientated, more flexible, inventive and innovative. Businesses such as Amazon.com and Facebook all emerged from small backgrounds.

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Amazon.com was formed by one of the pioneers of e-commerce, Jeff Bezos. Bezos left his position as vice-president of a Wall Street firm D.E. Shaw and drew up a list of 20 products that could be sold on the Internet.At this time Amazon.com focused on books, compact discs, computer hardware/software and videos. Amazon.com has posted a revenue of approximately $7 billion in 2010.

The number one social networking site Facebook now commands membership estimated at approximately 500 million. It is also valued at approximately $50 billion. The history of Facebook is not about a business concept that was applied with successful outcomes, but rather Harvards students creating a platform for platform for their students which slowly spread to other Universities and high schools.
Eduardo Saverin, Dustin Moskovitz, Chris Hughes and Mark Zuckerberg founded Facebook through their creative whims.

The question is whether these same companies will benefit as much from their size as they did when they were smaller. Larger companies may not have the culture of invention and freedom autonomy that workers cherish, thus stifling creativity. In addition as businesses grow, bureaucracies emerge and these inevitably will become an impediment.

Recommend an appropriate scale of operation for a given situation.

Canadian Springs is a Canadian supplier of drinking water to homes and offices. They employ 600 workers and have 42 distribution centers and 8 plants. Is this an appropriate size for this business? If Canadian springs were to enter other regions globally, it would have to compete against other suppliers. Considering the transportation related costs of water and the sourcing of the product from underground sources across Canada, this would be unrealistic.

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Internal/organic growth

Explain the difference between internal and external growth.

When a business seeks to grow its operations, it increases factor inputs and thereby achieves greater output. Internal growth therefore means that the business has continued to expand its operations through the sale of existing products or services. Internal growth can take place through sales in a region, country, or internationally. By using existing resources and relying only on itself internal growth can take a long time for companies to achieve the scale of operations they desire.

External growth

Therefore, in order to grow more rapidly, external growth becomes an option. Through Joint ventures, alliances, mergers or acquisitions, growth can be more rapidly achieved. Therefore, external growth would imply that resources outside of the company are called upon. The method by which external resources are called upon is where we can now examine the options that a business has at its disposal.

Joint ventures

One option for growth is the joining of one or more companies in the achievement of objectives or goals. The Joint venture allows companies to benefit from each other’s expertise in a particular area. Contracts are drawn out that detail the costs and responsibilities as well as the profit to be shared. A Joint venture is particularly useful if a company would like to expand into a different region or country that it is unfamiliar with. A joint venture would therefore prove to be an advantage due to the cost savings involved in setting up a new business in a foreign country, where the risks of a foreign market and laws may to be prove time consuming.

Strategic alliances

One of the longest strategic alliances is between Disney and McDonalds. These two giant corporations have teamed up in a global marketing alliance signed in 1996. The first Disney movies that promoted by McDonalds were Flubber, A Bugs Life, Mulan and 101 Dalmations.

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The "Happy Meal" is a menu that includes the Disney promotional toys. A strategic alliance is therefore a long-term commitment that involves the sharing of costs and profit.

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Volvo the car manufacturer is also another example of a company that entered into a Strategic Alliance with Renault. Volvo’s vulnerability in the 1990s due to an economic recession and an increased market competition led to a strategy agreed upon in the company that emerged as alliance agreement made with Renault. Both companies are very active in each others manufacturing units and have revealed operational "secrets" to each other. Therefore, in a strategic alliance the interaction between two or more companies is so close that they would need to share various business functions in order to benefit from individual core competencies.

Mergers and takeovers

The most popularly known form of growth strategy is the merger and acquisition or takeover.

A merger takes place when two companies agree to become one thereby eliminating competition between themselves and taking advantage of synergies that would help them meet their goals. When mergers take place costs can be lowered and companies can more easily achieve economies of scale.

An acquisition or takeover by publically listed corporations takes place because shares are traded and available in the openly traded financial markets. The Corporation interested in the acquisition is referred to as the Raider and the corporation being taken over is referred to as the Target. Acquisitions or takeovers can be either friendly (invited or negotiated) or unfriendly (uninvited). When shareholders give up sufficient shares to provide the Raider with a controlling stake (51%), then the Takeover or Acquisition has been successful.

Mergers and acquisitions can be vertical or horizontal. Vertical mergers and acquisitions are between companies that are in different stages of production along the supply chain. For example a company that sells T-Shirts, referred to as a retailer, would receive supplies from a manufacturer, but agree to merger or takeover a supplier. This is referred to as Backward Vertical Integration.

Another form of merger and acquisitions is Forward Vertical Integration. In this situation, a T-Shirt wholesaler would decide to merge or takeover the Retail Store.

Evaluate joint ventures, strategic alliances, mergers and takeovers as methods of achieving a firm’s growth objectives.

All of the aforementioned, joint ventures, strategic alliances, mergers and takeovers are methods through which businesses can join together and expand their activity. When economic downturns or recessions occur and businesses are not able to survive, these options represent a lifeline. However, in some instances if a company is the target of a raider corporation it may be the victim of Asset Stripping. This is where the targets shares are bought at a price that is below the value of its assets, is stripped off all its assets and dissolved.

HL only Evaluate internal and external growth strategies as methods of business expansion.

The consolidation of companies is closely monitored in the Mergers and Acquisitions index. Joint ventures, strategic alliances, mergers and takeovers may change with Joint Ventures becoming Strategic Alliance or as mergers become demergers (which is the reverse of a merger).

HL Porter’s generic strategies

Michael Porter, a leading academic from Harvard University on Company competitiveness, has provided numerous strategies on how business can apply strategies that will improve their performance. One of these strategies for competitiveness is Porters Generic Strategies which examines the position of the business in the industry and how it can maximize its strengths.

A matrix is presented to illustrate the strategies with the Y Axis representing the scope of the market competition. It is therefore to be determined if the company is operating in a broad market or a narrow niche market. The X Axis represents the sources of competitive advantage. Here it is to be determined if the products are differentiated or if the company has the lowest costs of production in the industry.

Porter argues that the business’ strengths are either in its cost advantage or differentiation or focus. Depending on where the company is positioned the strategy within its scope should be applied.

The Matrix below illustrates Porter's generic strategies:


1. Cost Leadership.
If a company has a cost advantage by being able to secure the lowest production costs in the industry, it has a distinct competitive advantage and can assume cost leadership. The growing phenomena of outsourcing and off-shoring by the competition are compelling companies to also seek the very same cost advantages in production. We will look at some other related strategies adopted in Operations and Management known as Just-in-Time production.

2. Differentiation
Differentiation implies that similar goods or services are unique and distinguishable from the competition. When a company innovated and improves a product to meet the needs of the consumer the differentiation benefit has been achieved. Consider the extra services and products offered by a car manufactures such as BMW. The differentiated service of this premium brand not only distinguishes the company by virtue of price and quality, but also by the extra perks and accessories customers my opt for. The company targets the broad market with this differentiation strategy. This approach will generate higher costs but they can be recovered through greater market share if the strategy is effective.

3. Focus or Niche strategy.
If a company is not able to target the broad market, it is therefore selecting a segment of the market or population. This is referred to as the niche market and usually applies to smaller companies. The niche strategy is where a company either retains a cost advantage focus for the narrow group or a differentiation focus.
Although cost advantages are difficult to achieve in smaller companies they have the advantage of specialized service in niche markets.

HL only Examine how Porter’s generic strategies may provide a framework for building competitive advantage.

Let us take McDonalds and their source of competitive advantage and market competition in direct application of the above.

We can easily agree that McDonalds operates in a broad market. This is because they appeal to a wide group of people across all segments of the population. With respect to the source of competition it is constantly being challenged by other fast food companies. Therefore, McDonalds also makes a remarkable attempt to keep is products priced competitively and will continually offer a very differentiated selection of products. For example, McCafe has hit the market with remarkable success.

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It can therefore be suggested that the Strategy that McDonalds adopts is differentiation, since they are not a cost leader. McCafes serve as a good example of differentiation as does the continually changing menu of foods offered.

Analyse the advantages and disadvantages of a franchise for both franchisor and franchisee.

Franchising is an external growth strategy used by companies such as McDonalds to expand business. The many McDonald stores that are located around the world are not branches and are not owned by the Parent Company McDonalds. In essence all the individual outlets are part of the growth strategy that McDonalds implemented.

Franchising gives the Franchisee (the person or business who runs the business) independence and a fair amount of flexibility. However there are certain conditions that all the individual McDonalds owners must meet.
In order for the Franchisor (the person or business who owns the business concept) to be able to license a business idea, it must be associated with a recognizable brand name and therefore be established enough to generate interest in ownership.

McDonalds Franchisees are known as owner/operators. They not only own the business, but also have the independence of operation. Their obligations of the Franchisee to the Parent Corporation (the Franchisor) are laid out in what is known as a Franchise Agreement.

Evaluate the use of franchising as a growth strategy.

When then do all the McDonald outlet look the same if they are owned by different people or businesses? Unlike other Franchises, Owner-operators in McDonalds must rent the outlet from McDonalds, who own the land and store, as well as meet conditions of the Franchise agreement. Other Franchises depending on the Franchise Agreement may require the construction of outlest under specific guidelines such as design and color. So how much does it cost to own a McDonalds?

In the USA The McDonald's Corporation requires a minimum of $250,000 of non-borrowed personal funds in order to be considered as a potential applicant. To date there are approximately 30,000 McDonald outlets in over 120 countries.

This matrix was developed by Igor Ansoff in 1957 to give business strategic business options they can chose from in order to plan their growth and meet specific objectives.

The matrix takes into account existing markets and new markets and existing products and new products for business growth and development. Similar to Porters Generic Strategies that we examined, there are also four quadrants in the Ansoff Matrix.
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(1) Business Growth with Existing Products in Existing Markets. The approach here is Market Penetration. In this situation the business will face the full challenges of market competition. Penetration pricing and brand loyalty are examples of how this can be achieved. The market penetration strategy is the least risky.

(2) Business Growth with Existing Products in New Markets. This approach is Market Development. With the phenomena of Globalisation, many companies have decided to take their products to new markets such as China. This expansion creates unique opportunities and challenges, but typically has more risk than a market penetration strategy.

(3) Business Growth with New Products in Existing Markets. This approach is Product Development. A business may improve through innovation and creativity in creating more products that generate market sales. Consider Apple Computers and what it does in the development of new products such as the ipod and ipad. Similar to market development, product development carries more risk than market penetration.

(4) Business Growth with New Products in New Markets. This approach is Diversification. This is when a business moves away from its core activities to providing services or products that are in a different sector, for example Phillip Morris not only makes Cigarettes but has gone on to acquire Kraft foods which makes chocolate among other things. Also called the “suicide cell” strategy carries the most risky because it calls for a company operating outside of its core competencies of the firm in an unknown market.

Explain the value of the Ansoff matrix as a decision-making tool.

When a business intends to achieve growth strategies, the Ansoffs Matrix is a valuable market auditing and planning tool. It provides the basis for an organization to set objectives and can be used alongside other models. There are risks associates with each strategy in the quadrant and these can all be now weighed in the decision-making process.

Apply the Ansoff matrix growth strategies to a given situation.

Offshoring is when a company decides to move its business activities or business to another geographic region. Companies can achieve cost savings in production, improved taxation conditions more lenient company and employment laws, more lenient accounting and banking procedures/systems, more suitable political or legal conditions. By choosing to off-shore a company may be looking for domestic market penetration in its overall growth strategy at home. This can therefore be achieved by passing the savings through to consumers in the form of lower prices or an increased marketing campaign.

Outsourcing is the when a company decides to contract work that is not geographically sensitive. Outsourcing is similar to off-shoring in that cost advantages can be quickly achieved.

Ernst & Young outsources tax preparation work to India and is therefore able to more effectively penetrate the competitive accounting sector in its domestic base.

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Corporations come is all shapes and sizes. Most distinguishable however, is their relative size. Of the 100 largest economic entities 51 are corporations and 49 are countries!! Measured by 2006 revenues and profits in $ million the following corporations were ranked in the top three.

Revenues in $Million
Profits in $Million
Exxon Mobil
Wal-Mart Stores
Royal Dutch Shell

Is bigger really better? Large corporations have distinct advantages of size, however becoming too large also has its disadvantages and caveats.

Read the article entitled **17th June 2005 Economies of scale** and answer the question in the last paragraph. The response should be between 100 - 150 words.

IB Corner


What are economies of scale? Provide 2 examples of types of economies of scale that are beneficial to a company.