Economies of Scale and Scope

Is Bigger Really Better?

In this chapter the following questions in strategy are covered:

◦ How do we define our firm? ◦ What activities do we do? ◦ What are our firm’s boundaries?

Introduction

We mostly think about economies of scale as a key determinant of a firm’s horizontalboundaries, which identify the quantities and varieties of products and services that it produces.

An understanding of the sources of economies of scale and scope is clearly critical for formulating and assessing competitive strategy.

Introduction

Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase.

The initial investment in capital is diffused through an increase in production, and the marginal cost of producing a good or service decreases when each additional unit of production is added.

Economies of scale means a reduction in the per unit costs of a product as a firm's production increases.

Economies of Scale

Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market).

A common example is a factory:◦ An investment in machinery is made, and one worker, or

unit of production, begins to work on the machine and produces a certain number of goods.

◦ If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation.

◦ The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges.

Where do Economies of Scale Occur Most?

U-Shaped Cost CurveThe Properties of the U-Shaped Curve are: Average cost declines as fixed costs are spread

over larger volumes Average cost eventually starts increasing as

capacity constraints kick in U-shape implies cost disadvantage for very small

and very large firms Maybe the unique optimum size for a firmThe long-run average-total-cost curve is typically

U-shaped, but is much flatter than a typical short-run average-total-cost curve.

Short Run vs. Long Run

U-Shaped Average Cost Curve

When average cost curves are L-shaped, average costs decline up to the minimum efficient scale (MES) of production and all firms operating at or beyond MES have similar average costs.

Minimum efficient scale (MES) or efficient scale of production is a term used in industrial organization to denote the smallest output that a plant (or firm) can produce such that its long run average costs are minimized.

L-Shaped Cost Curve

L-Shaped Cost Curve

Competitive Implications of Minimum Efficient Scale◦ MES is the minimum point on the LRAC curve.

Competition is most vigorous when:◦ MES is small in absolute terms.◦ MES is a small share of industry output.◦ Disadvantage to less than MES scale is modest.

Minimum Efficient Scale

◦ Terminal, line-haul and inventory costs can be important.

◦ High transport costs reduce MES impact.

Transportation Costs and MES

The advantages of large scale production that result in lower unit (average) costs (cost per unit)

Our Formula:◦ AC = TC / Q

AC=Average Cost TC=Total Cost Q= Quantity

Economies of scale – spreads total costs over a greater range of output

Lets do the Math!

Applying the FormulaAC=TC/Q

Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00

Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility

What happens and why?

Capital Land Labour Output

TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

Applying the FormulaAC=TC/Q

Capital

Land Labour

Output

TC AC

Scale A 5 3 4 100 112 $1.12

Scale B 10 6 8 300 212 $0.71

Doubling the scale of production (a rise of 100%) has led to an increase in output of 200%

therefore cost of production per unit has fallen Don’t get confused between Total Cost and Average Cost Overall ‘costs’ will rise but unit costs can fall Why?

Cost elasticity is εC = ∂C/C ÷ ∂Q/Q. εC < 1 means falling AC, increasing

returns. εC = 1 means constant AC constant

returns. εC > 1 means rising AC, decreasing

returns.

Cost Elasticity and Economies of Scale

Economies of Scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately.

Closely related to economies of scale. The terms “Economies of Scale” and

“Economies of Scope” are sometimes used interchangeably

Managers may cite economies of scale and scope (even when they do not exist) to justify investment in growth.

Economies of Scope

It is cheaper for one firm to produce both X and Y than for two different firms to specialize in X and Y each

TC(QX, QY) < TC(QX, 0) + TC(0, QY) TC(QX, QY) – TC(0,QY) < TC(QX, 0) Production of Y reduces the incremental cost of

producing X

Economies of Scope

Common expressions that describe strategies that exploit the economies of scope◦ “Leveraging core competences”◦ “Competing on capabilities”◦ “Mobilizing invisible assets”◦ Diversification into related products

Economies of Scope

Internal Economies of scale

External Economies of scale

Types of Economies of Scale

These are economies made within a firm as a result of mass production. As the firm produces more and more goods, the average cost begin to fall because of:

◦ Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively.

◦ Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc.

◦ Financial economies made by borrowing money at lower rates of interest than smaller firms.

◦ Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output.

◦ Commercial economies made when buying supplies in bulk and therefore gaining a larger discount.

◦ Research and development economies made when developing new and better products.

Internal Economies of Scale

These are economies made outside the firm as a result of its location, and occur when:◦ A local skilled labour force is available. ◦ Specialist, and local back-up firms can supply parts or

services. ◦ An area has a good transportation network. ◦ An area has an excellent reputation for producing a

particular good. For example, Iowa is known for its wheat and grain production.

External Economies of Scale

As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale.

There is a fine line between making money and losing money.

This can result in:◦ Internal Diseconomies of Scale◦ External Diseconomies of Scale

Is Bigger Really Better?

These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because:

◦ The disadvantages of the division of labour take effect- too many people doing different jobs add to costs.

◦ Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase.

◦ Decisions are not taken quickly and there is too much form filling.

◦ Lack of communication in a large firm means that management tasks sometimes get done twice.

◦ Poor labour relations may develop in large companies.

Internal Diseconomies of Scale

These occur when too many firms have located in one area. Unit costs begin to rise because:◦ Local labour becomes scarce and firms now have

to offer higher wages to attract new workers. ◦ Land and factories become scarce and rents begin

to rise. ◦ Local roads become congested and so

transportation costs begin to rise.

External Diseconomies of Scale

Small firms are able to compete with large firms because:◦ Some products cannot be mass produced, eg

contact lenses. ◦ Some products have only a limited demand, eg

horse shows. ◦ Some products require little capital, eg window

cleaning. ◦ Small and large firms both receive grants and

subsidies from the government.

How can Small Businesses Compete?

The exploitation of economies of scale helps explain why companies grow large in some industries.

Agriculture in Iowa represented an excellent opportunity to capture the benefits of economies of scale.

Farmers found that by increasing the factors of production (mechanization, larger farms, better seed, more fertilizer & pesticides, better farming techniques etc.) their productivity increased significantly.

The productivity of Iowa farms grew enormously and the unit cost of food for the consumer fell sharply.

The demand for food did not grow as fast as its production. People would rather spend their extra money on other goods and services.

As farms grew larger and more capital intensive (mechanized), the number of farm workers declined sharply while the opportunities and wages in the urban areas grew significantly.

Economies of Scale in Agriculture

As with everything life moderation does seem to be the rule of thumb.

Economies of scale must be understood and growth in some industries works fine while in others it may be best to stay small and find those niche markets.◦ Examples:

Organic Farming Unique production items: art

Moderation may be the best Policy

Learning economies are distinct from economies of scale

Learning economies depend on cumulative output rather than the rate of output

Learning leads to lower costs, higher quality and more effective pricing and marketing

Other Topics: The Learning Curve

Measures the percentage decrease in additional labor cost each time output doubles.

An “80 percent” learning curve implies that each time output doubles, the labor costs associated with the incremental output will decrease to 80% of their previous level.

The figure illustrates an 80-percent learning curve.

The Learning Curve

A downward slope in the learning curve indicates the presence of the learning curve effect. ◦ workers improve their productivity with practice

The slope of a process is the relative size of the average cost when cumulative output doubles

A slope of 0.8 (the observed median) indicates that the average cost will decline by 20% when the cumulative output doubles

Learning flattens out over time and the slope eventually becomes 1.0

The learning curve effect acts to shift the SRAC downward.

The Learning Curve

Expand output rapidly to benefit from the learning curve and achieve a cost advantage

May lead to losses in the short term but ensure long term profitability

Rewards based of short term profits may discourage the exploitation of the learning curve

Learning Curve Strategy

The basic elements of strategy are as follows:

◦ Choosing objectives for the organization◦ Positioning the organization relative to others in

its market or environment◦ Steering the organization over time through the

policies and decisions that affect its performance

The Product Life Cycle: Blockbuster

Standard strategy methods answer the first two of these needs, but there’s little to help with the last challenge. And this matters because answers to the first two questions, whilst important, do not change often, whereas steering strategy has to be done constantly. To see why this is so, consider the history of the Blockbuster video-rental business.

A strategy life-cycle: Blockbuster

This company took off when video-cassette recorders [VCRs] made it possible to view movies at home - before DVDs, before widespread internet, and before down-loading videos was more than a distant dream. The figures below show how the company’s store numbers, revenues and operating profits changed from 1985 to 2007.

Blockbuster

Blockbuster

Blockbuster’s story goes through the following typical broad phases: Start-up, growth, maturity and then decline.

The following figure shows the four broad phases, together with the impact made by [a] initiatives to add to the original strategic positioning, both by acquisition and extension, and [b] a revision of that position when it becomes unsustainable and threatens collapse.

Blockbuster

Generalized strategy life-cycle

Blockbuster's early objectives might have been to open, say, 20 stores each year, grow revenues to perhaps $50 million after 3 years and generate $10 million in profits.

The positioning was to offer larger neighborhood stores with a wider range of family oriented movies than the many smaller mom-and-pop stores, using smart IT systems based on customer membership cards for control and to ensure popular movies were available.

Steering the strategy needed continued decisions on the range of movies to offer, price levels, staff hiring and training, marketing spend and message and the rate, location, size and design of new store openings. Rapid growth gave strong buying power with the movie distributors, and hence low costs and access to new titles.

Start-up

The business objectives changed in response to early success and the big perceived opportunity. Growth targets increased to hundreds of stores per year, aiming for revenue of over $1 billion, and profits of hundreds of millions of dollars.

The business’s positioning did not change during this period. VCR-owners were still the target, renting movies to view at home from local stores was still the core offer, and the successful operating system continued.

Although no changes to business model or positioning were needed, this did not mean that ‘strategic management’ stopped. Steering the strategy still required on-going decisions on product range, pricing, staffing, marketing, and store design, branding and opening rate.

Growth

Significant initiatives were taken to extend the strategy:

Business growth was accelerated by adding a franchising scheme.

The aggressive growth was supplemented with acquisitions of other store chains.

The same successful formula was copied internationally, with acquisitions and growth in the United Kingdom, Australia, Japan and other countries.

By 1995, store numbers hit 4500, including 1000 franchised outlets. Nearly a third of the business was outside the USA. Revenues hit $2.4bn and operating profits $785m – over 30% return on sales!

Growth

With everything going so well in 1995, how come profits stalled and then fell back so sharply between 1997 and 2001? Commentary from the time suggests that nothing significant threatened the basic business model. Instead, it suffered a serious loss of operational effectiveness, after being acquired by Viacom.

Objectives still focused on growing the store network and revenues, rather successfully it seems. Of course, the business kept trying to deliver profit growth as well as sheer scale, though conditions made that increasingly hard. When its profits dropped to just $310m in 1997, no-one realistically expected them to jump back over $700m the following year.

The business’s positioning still did not change significantly – DVDs replacement of video cassettes did not alter the basic value proposition, target market or operating model.

Again, then, the main strategic management activity through this period consisted of steering the strategy from quarter to quarter.

Maturity

2007 saw the first signs of the final phase of strategy’s life-cycle – the threat of decline and ultimate closure. Netflix started up an internet-based rental service with postal delivery, but Blockbuster quickly offered the same. Netflix.com revenue for 2007 hit $1.2bn, and similar services from Amazon.com and others hurt the company’s store-based revenues. The vicious price competition that followed hit profitability.

Objectives now switched to sustaining revenue and managing the decline of the store-based business.

The positioning of the stores business remained essentially the same, though with the postal service added on top.

So for the stores business, the main strategic management activity was still about steering the strategy from quarter to quarter.

Decline

The company filed for bankruptcy on September 23, 2010, and on April 6, 2011, was won by satellite television provider Dish Network at auction for $233 million and the assumption of $87 million in liabilities and other obligations. The acquisition was completed on April 26, 2011.

End of the Story

Questions?