StrategyStreet and the Board of Directors


10. Is the company creating Economies of Scale as it grows?

This question pertains both to operating and capital costs. In theory, operating margins and returns on capital should increase as the business grows. This is because some of the costs in the business are fixed. They should not rise in direct proportion to a rise in sales. In practice, the world is not so simple. A falling price reduces operating margins and can hide part of all of a decline in costs. But practice may be even worse than that.

Costs may not decline as a company grows larger. Nor does a larger company have a necessary cost advantage over its smaller competitor – witness Southwest Airlines compared to American Airlines. In fact, our work in tough markets has shown that the industry market share leader often yields pride of place in returns on investment to a smaller peer.

Costs decline because management insists that they will do so. Aggressive managers ensure the creation of Economies of Scale by focusing their organizations on improving Productivity. GE has done this for years.

To avoid the confusion that price changes cause in the measurement of operating costs and investment returns, a company needs a few measures that do not have money multipliers – physical measures like headcount per customer transaction. The board should ask for and monitor these kinds of measures in order to be confident that growth, indeed, improves the company's competitive posture.

For further discussion of this question, see:

Basic Strategy Guide Step 27: Create countable measures of Productivity.

Basic Strategy Guide Step 28: Evaluate Economies of Scale in each functional cost department.

Basic Strategy Guide Step 29: Measure Economies of Scale by type of employee.

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