Part 2: Measuring Current Economies of Scale
Caveat on the Belief in Size
Capsule: A company should not put too much belief in the simple advantage of size. Most industry market share leaders do not lead their industries in Return on Investment. Size can confer advantages, but only if management sets specific targets for unit costs.
For helpful context on this step:
It is important to avoid the assumption that simply getting bigger will allow the Company’s costs to decline through Economies of Scale. We illustrate this concern with a story and some data.
Some years ago, we worked for a company in the aircraft manufacturing industry. The head of manufacturing of that company told us of an experience he had years earlier. He was then working for another company who also produced aircraft. His company had begun to measure its Productivity and the decline in the labor hours per plane the company achieved as it increased its production. It was comparing itself at the time to statistics that Boeing had released on its improving Productivity in production of bombers for the Second World War. The executive explained his frustration when he found, month after month, that his company was lagging behind the rate at which Boeing had reduced its labor hours per aircraft (number of Inputs/number of Outputs, using aircraft as the measure of Output).
After some months, the company realized that it had made a critical, wrong, assumption. It had assumed that its labor hours would decline at the same rate as Boeing’s had declined simply as it got larger. Its labor hours did, indeed, decline but they did not decline at the rate that Boeing’s level of labor hours declined. The company failed to match Boeing’s improvement in Economies of Scale.
The company conducted an analysis of the situation to understand why they did not achieve Boeing’s Productivity. The explanation was in Boeing’s management. Boeing had managed its improvement in Productivity with more attention than had the company. The company’s research indicated that Boeing had instituted specific targets for its production organizations to achieve. Armed with this insight, the company used the Boeing rates of productivity improvement as targets for its own manufacturing organization. With time, the company achieved Boeing’s rate of Productivity. The lesson this executive told us he had learned is that increasing size alone will not necessarily produce industry leading Economies of Scale.
This conclusion came back to us many years later when we looked at the relative economic performance of leading market share companies in nearly 240 industries. We were measuring the impact of market share on profitability. The results we found were quite a surprise. We found that industry leading market share helped in creating higher profitability, but not a lot.
Our test was simple in concept and execution. We measured the market share ranking of the top four competitors for industries that had five or more competitors, each reporting at least $50MM of sales. We found 240 of these industries. In these 240 industries, we ranked the top four competitors on the basis of their sales in the industry. We then calculated the percentage of time that the company ranked first in market share performed at the top among the four industry competitors in return on investment. If market share leaders were to lead in proportion to their representation in the sample, the industry share leader would lead its industry in return on investment 25% of the time. In the total of the 240 industries, the industry market share leader led the industry in returns on investment 29% of the time, only 4% more than random chance would have predicted. 70% of the time, the industry leader in market share saw one of the other three top competitors lead the industry. Our results excluded consideration of the returns of those industry competitors ranked below #4. So the likelihood of the industry’s market share leader leading in returns on investment was below 29%.
The conclusion we draw is that a company who would be effective in managing costs and driving Economies of Scale must set ambitious and specific targets in order to ensure that its Productivity and Economies of Scale grow. Size alone will not do the job.
Both large and small companies might benefit from the design to value approach to managing costs at lower levels in the organization. In the late 1980s, Japanese companies pioneered the design to value approach to managing the cost of innovation. Since then, many companies have adopted this effective practice. In the design to value approach, you determine specific innovations you would like to introduce for your customers. You set a maximum cost for that innovation and then design your cost structure to produce the benefits for their target cost, or less. This design to value approach enables the Company to produce attractive and profitable products and assists in creating Economies of Scale at all levels in the organization.
Caveat on the Belief in Size Questions
Inputs of People are usually the most difficult to control in a company. Yet those who succeed in managing People costs usually succeed in controlling other costs effectively. In the next section we turn our attention to measuring the Economies of Scale by salary grade within the Company.
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