1.5

Economies of Scale

Economies of scale (EOS) is the decrease of the average costs of production as an organisation increases the scale of operations and improves its production efficiency.

• Simply put, economies of scale mean this: the larger your business gets, the cheaper it is to produce one item of your product.

Diseconomies of scale

Diseconomies of scale (DOS) is when your average costs (costs per unit of output) increase as your company increases its scale of operations.

• Simply put, the larger your business gets, the more expensive it is to produce one item of your product.

Costs

Cost is an amount of money that needs to be paid for producing the output.

• Costs (C) can be average (A), total (T), fixed (F) and variable (V).

Fixed costs

Fixed costs remain the same regardless of how much you produce

Variable costs

Variable costs are the ones that change depending on how much you produce

Total costs

Fixed costs + Variable costs

Quantity

Quantity is the amount of output that you produce.

Average costs

Average costs = Total Costs / Quantity

Average costs = Average Fixed Costs + Average Variable Costs

Scale of operations

Scale of operations refers to how much output is produced and how big the production facility is.

Efficiency

Efficiency is the decrease of AC (average costs) that is caused by changing: scale, fixed costs (FC), variable costs (VC), or total costs (TC), or keeping costs the same but increasing the quantity of output produced (Q).

Internal economies/diseconomies of scale

Internal EOS and DOS refer to the business only, they happen within the business.

External economies/diseconomies of scale

External EOS and DOS refer to the entire industry, to all the businesses that produce similar products, they are outside the single business but within an industry.

Purchasing EOS (internal EOS)

Purchasing EOS happen when suppliers provide a discount in exchange for buying more.

Marketing EOS (internal EOS)

Marketing EOS occur when a company increases marketing budgets to advertise extensively so that customers purchase more.

Risk bearing EOS (internal EOS)

Risk-bearing EOS happen when a firm diversifies its product portfolio

Managerial EOS (internal EOS)

Managerial EOS occur when a company hires a really experienced and efficient manager who saves costs and who works as efficiently as several regular managers.

Technological progress (external EOS)

Technological progress: new inventions that everyone benefits from.

Educated workforce (external EOS)

Educated workforce: higher education levels in the country benefit all businesses, because additional training and supervision is not required.

Regional specialization (external EOS)

Regional specialisation means a certain region focuses on producing a certain thing.

• It means that all businesses in that region can share infrastructure, delivery costs, can negotiate better prices with suppliers, etc.

Infrastructure (external EOS)

Infrastructure: roads, power supplies, transportation networks, etc.

• The better the infrastructure, the shorter the delivery times are and the more efficient all businesses are.

Bureaucracy (internal DOS)

Bureaucracy: too many procedures and paperwork may increase administrative costs

Inert working culture (internal DOS)

Inert (not adaptive) working culture: change does not take place and organization stagnates, resulting in outdated processes and inefficiencies.

Complacency (internal DOS)

Complacency (when company does not have a clear picture of reality and is overconfident in its success)

Marketing DOS (internal DOS)

Marketing DOS: marketing failure that impacts the entire product portfolio and results in low sales.

Infrastructure (external DOS)

Infrastructure: roads, power supplies, transportation networks, etc.

• If infrastructure is bad, it can have the opposite effect in the entire industry and result in inefficiencies for all.

Educated workforce (external DOS)

Educated workforce: higher education levels in the country result in increased labour costs for all.

Increased rents (external DOS)

Increased rents: as cities and their populations grow, rent increases.

Pollution (external DOS)

Pollution: even though costs might not apply to businesses, employees and local community are affected negatively which will eventually have a detrimental effect on all business in a given industry.

Business growth

Business growth refers to the increase in size of the business.

Business size

Size of the business can be measured by market share, revenue, profit, workforce and capital employed

Market share

Market share — the portion of company sales in total sales in the industry

Revenue

Revenue  — price multiplied by quantity of items sold

Profit

Profit — the difference between revenue and costs

Workforce

Workforce — the number of employees

Capital employed

Capital employed — investment that is used for operating the business

Internal (organic) growth

Internal (organic) growth happens when businesses grow using their own resources and capabilities.

• Businesses grow using their own resources and capabilities

• Low risk

• Lower potential benefits

• Slow and steady

• Relatively inexpensive

• Retention of full control

• Strengthens corporate structure

• Ansoff matrix

External (organic) growth

External (inorganic) growth happens when businesses deal with other external organisations.

• Businesses grow by dealing with other external organisations

• High risk

• Higher potential benefits

• Fast and rapid

• Requires significant finance

• Hard to control

• Challenges/weakens corporate structure

Reason’s for businesses to grow

• Economies of scale

• Lower prices: you can lower the costs due to economies of scale you can charge lower prices and attract more customers pushing your competitors out of the market.

• Increased market share: this would be the result of lower prices and decreased competition.

• Brand recognition: the more customers you have, the more people know and recognise your brand

• Higher revenues: the more people buy, the more money you make.

Reason’s for businesses to stay small

• Prestige/uniqueness: small businesses are perceived as something upscale, special, VIP, not for all, that creates a sense of uniqueness and prestige among customers.

• Adding more value: this sense of uniqueness and prestige can allow businesses to charge higher prices, thus increasing the added value. USP

• Higher prices & profit margins: higher added value results in greater difference between revenues and costs of production, even though costs do not increase.

• Retaining control: smaller businesses are easier to manage and it is more likely for them to avoid internal diseconomies of scale.

• Less competition: smaller businesses usually specialise on a specific market niche and competition there is limited, as opposed to mass market where large businesses dominate.

Methods of External Growth

Mergers and Aquisitions, Joint Ventures, Strategic Alliance and Franchising

Mergers and Aquisitions

Merger means two or more companies forming one larger company (A + B = AB)

Acquisition (or takeover) happens when one company takes ownership of another company (A + B = A)

Hostile takeover

With regards to public limited companies, their shares are traded on stock exchange and are available to everyone, which means that sometimes publicly held companies can be taken over even if they do not want that. This situation of undesired acquisition of a publicly held company is called a hostile takeover.

Integration

Another way to express growth of a company through M&As is through the sectors of industry. This way of describing growth is called integration.

Horizontal integration

Horizontal integration: when M&As happen between companies in the same sector of industry.

Vertical forwards integration

Vertical forwards integration: when a company merges with or takes over a company from a “higher” sector of industry.

Vertical backwards integration

Vertical backwards integration: when a company merges with or takes over a company from a “lower” sector of industry.

Conglomerate merger (conglomeration / diversification / conglomerate integration)

Integration between unrelated businesses is called conglomerate merger (or conglomeration or diversification or conglomerate integration).

Advantages of M&A’s

• Economies of scale

• Minimising risk

• Synergy - when cooperation has more benefits than operating independently

• Market leadership - being able to reduce competition and increase market share instantly

Disadvantages of M&A’s

• Managerial diseconomies of scale

• Cultural clash - each organisation has its own culture that might be very different from the other company involved in M&As

• Increased government control and interference - large companies might face anti-monopoly issues that government has a strict control of

• Redundancies - having to let people go (“lay off”), because two of everything might not be needed in a newly formed company. But these lay-offs are not free, people have to be paid severance pay before they leave because it is not their fault the company no longer requires their service

Joint venture

Joint venture is formed when two or more companies create a third company that operates for their mutual benefit (A and B create C)

• This newly formed company C is a real tangible business entity

• Sometimes joint ventures are formed even between competitors, because they might have several things that are worth cooperating on.

• Joint ventures can be temporary and only operate until the completion of the project

• Sometimes joint ventures are a government requirement and the only way to enter a foreign market.

Advantages of Joint Ventures

• Entry to foreign markets,

• Synergy (same as in M&As),

• Splitting the costs and risks,

• Reduced competition.

Disadvantages of Joint Ventures

• Too much reliance on a partner,

• Control and “final say" issues (having to agree on all decisions with a partner),

• Having to share certain expertise (for example, some methods of production or some secret technologies).

Strategic alliance

Strategic alliance is a cooperation of two or more companies in certain aspects for their mutual benefits (A and B cooperate, C is not created)

• can happen between competitors because sometimes cooperation with competitors has benefits.

• The advantage of strategic alliances is splitting the costs only when necessary without the burden of creating a new business entity.

• The disadvantage is that strategic alliances are not really binding which prevents companies from serious commitments.

Franchising

Franchising is a way of external growth whereby franchisor company allows other companies (franchisees) to sell their products and trade under its brand (franchise) in exchange for royalty payments (regular payments for using the franchise) and franchise fee (payment to “buy” the franchise).

Advantages of Franchising

• Rapid growth without jeopardising control over brand and low risk for franchisees because they only have to deal with operations.

Disadvantages of Franchising

• rely on franchisees and putting brand at risk (from franchisor’s perspective)

• having to share profits with franchisors (from franchisee’s perspective).