Thursday, February 02, 2012
Overestimating economies of scale
The Wall Street Journal's Heard on the Street column yesterday discussed Fiat's relationship with Chrysler. The article cites the risks that Fiat faces, particularly in its home market given the EU fiscal crisis. It suggests that Chrysler and the American market may be even more key to Fiat's future viability than many people originally thought. The column stresses, however, that Fiat remains a sub-scale automaker, with only about 2 million units of production annually. It points out that Fiat CEO Sergio Marchionne believes automakers must reach 6 million units to be cost competitive in the global market. I think it's dangerous to simply take a CEO's assertions about economies of scale at face value. CEOs often over-estimate minimum efficient scale for several reasons. First, they assume market share is more highly correlated with profitability than it actually is. Second, executives are often obsessed with top line growth, believing it will always bring greater profits. Of course, undisciplined growth often harms earnings. Third, CEOs derive personal satisfaction from running bigger and bigger firms. They garner power and fame as a firm expands in size. Fourth, leaders often overestimate synergies that will emerges they merge entities to go after scale economies. Finally, executives forget to account for the very real possibility of diseconomies of scale that may emerge as large firms become more complex and bureaucratic.