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The Big, the Bad, and the Beautiful

Size comes in three flavors — scale, scope, and network. Choose wisely from the menu.

Illustration by Lars Leetaru
Wal-Mart Stores Inc. dominates the retail industry. The Microsoft Corporation controls the market for PC software. General Electric Company has generated superior returns for decades. Each one ranks, on the basis of annual revenues, as the largest company of its type. Are they succeeding because they are large, or are they large because they are succeeding?

Consider three New Economy survivors: Amazon.com Inc., eBay Inc., and Cisco Systems Inc. During the Internet boom, companies pursued growth and size as key elements of their business strategy. Most failed in that pursuit. Were the few that succeeded simply lucky, or did they understand something that their competitors did not?

Size does matter, but only if you understand why and use that knowledge to create a competitive advantage. Three theories support the bigger-is-better argument: scale economies, network effects, and economies of scope. Each theory derives its logic from a different source and applies only in certain circumstances. Pursuit of size without a clear understanding of these concepts can lead to oblivion rather than dominance.

Scale Economies
The theory of increasing returns to scale, or scale economies, dates to the beginning of the 20th century and a set of British economists, including Alfred Marshall, A.C. Pigou, and Nicholas Kaldor. Building upon Adam Smith’s original observations, these economists reasoned that larger companies would achieve productivity advantages due to greater opportunities for division of labor.

Technically, a scale curve measures production costs as a function of facility capacity. Plotted on a logarithmic scale, the slope of the curve shows the fixed percentage reduction in cost for each doubling of capacity. Businesses with operations that offer significant economies of scale, such as wafer fabrication for integrated circuits, have steep scale curves where costs drop significantly when facility capacity increases — which is why the Intel Corporation and other chip makers regularly invest upward of a billion dollars in new higher-capacity facilities.

Other businesses, such as apparel-producing plants, exhibit very limited scale economies. Since there is little opportunity to automate the process of sewing a dress or shirt, a larger apparel plant simply contains more sewing machines. A plant with 200 sewing machines run by individual operators doesn’t produce shirts and dresses much more cheaply than one with only 100 machines. There is little value in having a bigger apparel factory.

Wal-Mart now ranks as the largest company on the planet. Although retailing, in general, has relatively limited opportunities to benefit from economies of scale, Wal-Mart has prospered by leveraging scale where it matters. For example, a Wal-Mart store building does not offer dramatic scale economies. A 100,000-square-foot store costs slightly less to build per square foot than a 50,000-square-foot store, but not enough less to provide a big competitive advantage. A retail distribution network, on the other hand, exhibits significant scale economies by enabling a business to exploit a lower cost trade-off among facility costs, inventory costs, and transportation. Wal-Mart’s distribution network dwarfs its smaller retail competitors’ networks and produces a 1 to 2 percent margin advantage by our estimates. Given the thin margins in retail, this advantage is significant.

Amazon.com has sought, and in some cases achieved, scale economies. Its distribution network, although a fraction of the size of Wal-Mart’s, ranks among the largest networks for fulfilling direct customer orders (rather than moving full cases and pallets as a traditional retailer does). But, frankly, the scale economies in fulfillment remain relatively marginal. Amazon’s key source of scale has come from its ability to amortize its massive investment in the Web shopping engine across multiple categories and also across service contracts with partner companies like Toys “R” Us Inc., the Target Corporation, and Circuit City Stores Inc. The cost of building and maintaining a user-friendly online shopping interface has proved to be beyond the means of many Amazon competitors.

 
 
 
 
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