We all know about economies of scale: the economic concept of achieving lower per unit costs as the level of production increases. This simple idea has driven many industries to consolidation through mergers and acquisition, from software to automobiles; from financial services to supermarkets. With the current global financial crisis, it will become an even more powerful tool in the arsenal of CEOs to achieve lower costs and survive in a challenging competitive landscape.
Yet the truth is that there is a limit to cost efficiencies achieved through economies of scale. According to research by Staffan Canback (http://canback.com/archive/thesis.pdf), a less popular yet equally important economics concept called diseconomies of scale can in fact increase per-unit costs as volumes of production increase.
There are many reasons why achieving larger scale can result in less efficient production of goods and services. Escalating communication costs, duplication of effort, increased management costs, office politics, slower response times and pure inertia are some of the factors that create this effect.
When observed in a wider context than the production of goods and services, diseconomies of scale can explain why small can be better. Let’s take the example of investments in the share market. If I have a small portfolio of investments, it is possible (at least in theory) to invest in a small diversified portfolio that will outperform the market. But what happens when your investment pool is equal to half of the market? In this case, to outperform the market you will need to identify the top half of the market that has above average returns. And what if your investment pool was 80% of the market size? Finding the bottom 20% of the market to divest becomes even trickier. As such, achieving investment returns that are significantly higher than market performance becomes harder as your success as an investor grows.
A similar case presents itself for companies that achieve market dominance. Growing sales when you have no market share is easy; you just need to find the ‘easy picks’ in the potential prospects universe, and present a compelling sales pitch to them. But when you own 50% of the market or more, the remaining prospects are (by definition) harder to convert into a sale than those that are already your customers.
Because of diseconomies of scale, bigger is better up to a certain point. From then onwards, it becomes an ever-growing liability.
With the current crisis of our financial and economic systems, it’s easy to wonder whether we have gone past this optimal point of production, and have started down the dangerous slippery-slide of diseconomies of scale.
What do you think?