Thursday, July 31, 2008

Economies of Scale at Work...And Not

Economies of Scale are important, at least in the minds of many managers and investors. Often, we can see these Economies of Scale at work in powerful ways. Sometimes, they seem to disappear.

Within an industry, Economies of Scale tend to be greater from one competitor to another when the industry has high growth. As an example, consider software companies. Oracle Corporation has found that software companies with annual sales of $250 million to $1 billion have operating margins of about 10%. This means that these companies spend 90% of their revenues on costs of People, Purchases and the Capital costs of depreciation. When the size of the companies increases to $1 billion to $5 billion in sales, operating margins go up to 16%. These companies spend only 84% of their revenues for People, Purchases and the Capital costs of depreciation. The largest companies, those with more than $5 billion in revenue, include Oracle, SAP, Microsoft and IBM, a group in rarified atmosphere. These companies have average operating margins of 30%, spending only 70% of their revenues on People, Purchases and Depreciation. Economies of Scale are quite high in this fast-growing industry. (See Steps 27 thru 29 of the Basic Strategy Guide on

Now consider an industry that is actually shrinking in physical units sold. Here we will measure Economies of Scale by the number of employees required to produce and deliver one thousand shipments. The leading company in the industry requires 4.5 employees to produce these one thousand shipments. Another major competitor in the industry is less than one quarter the size of the leader, but this company can provide a thousand shipments using about 5 employees per thousand. The smaller firm requires about 11% more employees per thousand shipments than does the much larger company. This contrasts with the roughly 30% more people required by the smaller companies than the largest companies in the software business.

You can also see Economies of Scale at work in an industry over time. You can see it as the industry grows and reduces its costs and consequent prices. A good example is the U.S. cellular service market. In 1997, cellular service cost about 42 cents per minute and customers bought 105 monthly minutes per subscriber on average. By 2004, after much growth and consolidation in the industry, a minute of cellular service cost about 13 cents and the average customer purchased 280 minutes per month. Costs dropped substantially due to Economies of Scale.

Economies of Scale are not a sure thing in many markets. In fact, the leading company in an industry, more often than not, has a Return on Investment lower than that of a smaller competitor. (See the Perspective, “Is Bigger Really Better” on Economies of Scale are the result of strenuous management efforts, not the gift of size alone.

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