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 / Winter 2003 / Issue 33(originally published by Booz & Company)


The Big, the Bad, and the Beautiful

Such product line expansion does not necessarily lead to economies of scope. If Cisco had not consolidated the manufacturing activities of its acquisitions and enabled its sales forces to offer complete solutions, it would have captured little advantage from the broader product line.

In fact, economies of scope can be negative as well as positive. Empirical research has demonstrated the value of “focused factories,” which were first described by Harvard Business School professor Steven Wheelwright in the early 1970s. Arguments for focusing on core competencies, or more colloquially “sticking to one’s knitting,” stem from a recognition that multiline businesses suffer from “costs of complexity.” (Sometimes described by the misnomer diseconomies of scale, the disadvantages of size are more appropriately viewed as diseconomies of scope.)

The ill-fated diversification strategy of Sears, Roebuck and Company in the 1980s offers a prime example of a failed attempt to capture economies of scope. Sears, which had owned Allstate insurance since the 1930s, set out to build a consumer-oriented financial-services business by acquiring the real estate broker Coldwell Banker & Company and the stock brokerage firm Dean Witter. The company would accrue economies of scope by locating the stockbrokers within the Sears stores and by sharing information across business units. After all, the purchaser of a new home likely needs new appliances and homeowner’s insurance, too.

Unfortunately, the expansion led to what marketers call perceptual incongruity. Consumers accepted that Sears was a great source for appliances and power tools, but failed to accept that it could offer equal expertise in financial services. Furthermore, the added complexity of managing the disparate businesses drained the attention of Sears management. And the core department store business began to struggle. Ultimately, Sears reversed its diversification strategy and sold off its nonretail businesses in the early 1990s.

As these examples demonstrate, neither product line expansion nor business diversification automatically generates economies of scope. Economies of scope accrue only to companies that identify and capture synergies while simultaneously managing the risk of added complexity. Thus, scope expansion provides a powerful but double-edged sword. Broader scope can provide supply-side and demand-side advantage. But increased complexity can confuse consumers and distract management from the core value proposition of a company. Although a multiline company should seek synergies across unrelated business units, beware a company that tries to justify an expansion strategy purely on the basis of economies of scope.

Defense vs. Offense
So, returning to our opening question, does size drive success or does success drive size? Although the three distinct theories described above propound solid arguments for the advantages of size, we believe that more often than not, success generates superior size rather than vice versa.

Although Wal-Mart posted $244 billion in revenues in 2002, its revenues in 1983 were a mere $4.7 billion, about one-eighth those of then-dominant retailer Sears. Not until 1990 and 1992, respectively, did Wal-Mart pass the Kmart Corporation and Sears in total revenues. Wal-Mart grew to a dominant position because it offered a superior customer proposition. As it grows, it certainly leverages its size for further advantage — but it didn’t gain its dominance simply through the pursuit of size as a strategic objective.

In fact, size may offer a more effective defense than offense. The General Motors Corporation, Wal-Mart’s predecessor in defining American business, provides ample evidence of the lingering, but continually fading, value of size. GM passed Ford Motor Company as the No. 1 global producer of automobiles in 1931 and became such an icon that Charles E. Wilson, a former GM executive, proclaimed before a congressional committee in 1952, “What is good for the country is good for General Motors, and what’s good for General Motors is good for the country.” Today, GM remains the largest producer of automobiles in the world by revenues, but ranks eighth in profits among vehicle producers, behind Toyota, Volkswagen, Daimler-Chrysler, BMW, Peugeot, Renault, and Honda (rankings based on an average of 2001 and 2002). Toyota has less than half the sales of GM but nearly four times the profits. Size may provide an advantage, but size without profitability is of limited value.

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