If you open any business newspaper or magazine, you are likely to see CEOs talking about how they are pursuing “scale” or how they will be the largest player globally in their sector in 4-5 years time. Alternatively, you might find quotes from strategy consultants or professional investors saying how they look for “scalable business models”. Readers of such publications have had the word “scale” hammered into their psyche so many times that we are all more or less convinced that “scale” is the silver bullet that delivers outstanding investment returns.
However, data from the real world does not really support such a proposition. A few weeks ago my colleague, Dipankar Mitra, and I did a study on the relationship between profitability and size in Indian businesses. Using the 12,000 company database provided by the Centre for Monitoring the Indian Economy (CMIE), we analysed data from FY03-08 across a range of sectors in India. Some of these sectors – banks, cement, steel, power generation and FMCG – are ones that are considered to classic examples of scale-driven sectors i.e. bigger firms in these sectors are supposed to be more profitable.
Guess what we found? Having analysed eleven sectors, we found that nearly none of them display any meaningful evidence of size effects – it is simply not true that larger firms enjoy better profit margins or better returns on capital. Moreover, this relationship displays no improvement across recent business cycles i.e. it is not as if that recent data is any more supportive of “scale effects” compared to the data from 2003. Even among the sectors where the top 10 firms by size were isolated to find a direct relationship between firm size and returns, except steel and telecom, “scale effects” were conspicuously absent.
So why is that such scale effects, which are so integral to the business community’s perception of how the world works, are absent? Firstly, very few industries demonstrate easy technological upscaling such that fixed costs do not increase proportionately with the size of the operations, a crucial assumption in the academic theory on scale effects. The telecom industry is a classic example where one expects declining marginal fixed costs as an increasing subscriber base may not require laying additional cables or further spend on new infrastructure. However, as we have found in India, continuous technological upgradation results in even the costs of telecom infrastructure becoming a variable (as opposed to a fixed) cost in the long run.
Secondly, in most industries for a variety of reasons, diseconomies of scale set in all too early. This drives a wedge between the technically most efficient production point versus the most sensible production point that is warranted after adding up all the real operational costs. These costs are mostly human, intangible and invisible. Three examples of such cost escalation are provided below.
• Salaries of senior executives are often linked with the scale of operations rather than profitability. For example, during the period FY05-08, Directors’ basic remuneration, the archetypical fixed cost, for 213 Indian IT companies increased at a CAGR of 53% as compared to 34% growth in sales and 37% growth in profit after tax.
• Typically large firms display less satisfied workers due to the monotony of specialization, poor communication and coordination failure, inflexible organization structures and the corporate bureaucracy that it entails.
• In India, the larger a firm gets, the more enmeshed it gets in the country’s political and bureaucratic power structures which impose specific costs (both financial and in terms of management attention).
In the absence of data pointing to the existence of scale effects in the real world, a rational thinker would say that organizational success has little to do with size and a lot to do with a sustained source of competitive advantage eg. patents, brands, networks of relationships and strategic assets such as regulatory licenses.
Unfortunately, such sustained sources of competitive advantage tend to be fairly hard to procure. They either take years of research or careful nurturing of brands and customers or access to expensive strategic assets – whether it be a coal mine or a 3G license. Since most businesses don’t have such advantages, it is tempting for CEOs to cover up their deficiencies by simply building a large empire. Size might not generate superior profitability but it usually generates larger pay packets for management teams and their advisors and also gets them acres of press coverage.
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