Tuesday, September 21, 2010

Where are the Economies of Scale in Your Business?

Many CEOs like to claim that powerful scale economies exist in their industries. Why? Well, if large economies of scale exist, then they can make a persuasive argument for growing the size of their firms. Larger firms means more power and more pay in many cases. However, the question is whether such enormous scale economies exist in every industry. The answer is simple: Of course not! In some industries, such as airplane manufacturing, the scale economies are huge and obvious. In others, such as fitness centers, the economies of scale are rather modest. As investors and analysts of companies, we need to become much more critical and skeptical of scale economy arguments. We can't just accept the assertion that bigger is better.

In some industries, it is especially important for executives, investors, and analysts to understand precisely WHERE the scale economies exist in the value chain. For instance, many people presume that large scale effects exist in the cola business, given that there are two large, dominant players. However, a closer look reveals that the scale effects exist in bottling, distribution, and marketing - much more so than in concentrate production. Similarly, if we look at the personal computer industry, we find that the scale effects are much more pronounced in the operating system business than in the personal computer assembly business.


Elco Jol said...

Dear Mr. Roberto,

Your arguments encouraged me to reason further. Finally I arrive at a question of which I hope you could help me with.

Increasing the company's size and monopolistic power (with the goal of creating economies of scale) is a performance differential that only works in some industries.
In another industry the driving performance differential might be innovation. This holds for many increasing returns markets (e.g. facebook, myspace). Also in other industries ‘efficiency’ might be the driving performance differential.
To conclude, different industries are driven by different performance differentials and therefore the economies of scale argument only holds in some cases.

Then isn't it the CEO's job to find out which performance differential particularly drives the industry of the firm and subsequently explain any mayor action’s of the firm (e.g. expansion) from this approach?

Thank you


Michael Roberto said...

Yes, the CEO should do that... in a perfect world. However, my point is that CEOs aren't always interested in pursuing the actions that are in the best interests of shareholders. Sometimes, they are simply trying to rationalize actions that are in their self-interest. Moreover, making arguments about network effects or other performance differentials can be difficult. It's easier to argue to the average investor that it's a scale economy issue... even if it's not.

Elco Jol said...

But, wouldn't the sensible analysts/economists pick up on any irrational statements of CEO's?

Maybe you could give a real life example in which a CEO used the 'economies of scale argument' and thereby mislead ordinary shareholders to rationalize actions that are in their self-interest.

Thank you,