Part 2: Measuring Current Economies of Scale


Productivity and Time

Capsule: An increase in Productivity creates Economies of Scale between a larger company and a smaller company. The same increase in Productivity reflects Economies of Scale when the Company compares its current size and cost structure to an earlier period in the Company’s history.

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Symptoms and Implications

The concept of Economies of Scale calls for increasing Productivity and a decline in unit costs as the business grows. The physical cost structure does not grow as fast as physical sales because some parts of the cost structure are fixed while others are variable. As the number of units of Outputs grows, the number of units of Input should grow slower due to the impact of fixed costs on the cost structure. Improving Productivity implies that the ratio of the number of Inputs divided by the number of Outputs declines with the growth of the business. The Productivity measure enables the Company to quantify its own Economies of Scale by measuring the change in Productivity as it grows. The Company measures its Productivity ratio today compared to its Productivity ratio some time ago.

The Company may measure these Productivity ratios and the creation of Economies of Scale most readily using numbers of employees, FTEs. As the Company uses this measure to evaluate the creation of Economies of Scale within its functional cost organizations, it may find that some of those functional cost organizations are creating Diseconomies or Super-economies of Scale. Neither of these conditions can be long lasting. One method to gain Economies of Scale might be acquisitions of competitors in the same industry.

Economies of Scale in Functional Cost Units

The Company can measure its own creation of Economies of Scale by comparing its Productivity ratio of today with the same ratio at a point several years ago. We have found that a period of at least three years is sufficient to measure Productivity and Economies of Scale inside the Company. The Company may use People, that is, full time equivalents (FTEs), to measure Inputs and customer orders to measure Outputs. The Company would gather FTE information for each functional cost organization and then compare the growth rate of the FTEs in each functional cost organization to the growth rate of Output.

As the Company applies this approach to measuring its Economies of Scale, it may find that functional cost organization units have come into or gone out of existence during the period. This is most likely to happen when the Company measures Economies of Scale within a functional cost organization, such as finance or marketing. Unless the management of the functional cost organization feels confident in allocating FTEs through the period of time, this greater level of detail is probably not worth pursuing.

If the functional cost organizations possess good manpower data over time, the Company evaluates the Economies of Scale that the functional cost organizations are creating. It measures the Productivity, the number of FTEs divided by the number of customer order Outputs, for the current period and for the period at least three years earlier. The Company itself should be creating Economies of Scale by improving its Productivity ratio. Many of the functional cost organizations will also be creating sustainable Economies of Scale. Functional cost organizations that are growing their FTEs, but at a rate slower than the growth in units of Output, are producing Economies of Scale that are sustainable over a long period of time. Some, however, will not. They will be creating Diseconomies of Scale or Super-economies of Scale.

Super-economies and Diseconomies of Scale

The Company’s functional cost organizations could experience Super-economies or Diseconomies as well as Economies of Scale. Super-economies of Scale occur when the Input FTEs actually decline as Output increases. Using the simplified example from The Concept of Economies of Scale
(link to dcostconcept), if the Company's workforce fell from ninety to eighty-five during the period that the Company increased its output from nine hundred to one thousand boxes, the Company would have produced Super-economies of scale. This unusual, and unsustainable, condition implies that the Company would eventually need no employees to produce more boxes than it is producing today. Super-economies of scale occur during major changes in approaches to managing a functional cost, when many employees are replaced by a capital investment. For example, Super-economies of scale may occur when new information technology replaces many people managing the flow of information.

The Company might also experience Diseconomies of Scale. In this more frequent condition, the Company's Input FTEs would increase by a greater percentage than Output increases. Using the simplified example, if the Company increased its production from nine hundred to one thousand boxes and increased its workforce from ninety to one hundred and ten people, its growth would have produced Diseconomies of Scale. Diseconomies of Scale, while frequent, cannot continue over long periods of time. They imply that the Company grows more costly as it grows larger. Eventually, the increased cost would prohibit its continued participation in the market.

The Company may use the same time-based approach to measure the components of Productivity, Efficiency and Effectiveness. To do this, the Company must be able to count ICDs in the earlier period and assign FTEs to each ICD. Where this is not practical, the Company may wish to set up measurement systems for the FTEs and ICDs, beginning with the current period, so that it might measure the components of Productivity in the future.

Acquisitions and Economies of Scale

Many companies have turned to acquisitions in order to increase their size and decrease their unit cost. Acquisitions have a checkered history. Many academic studies have suggested that most acquisitions produce relatively poor results. However, if the Company is good at managing its costs, and better at it than most of its competition, then an acquisition may be a sound way to grow. For an acquisition to help the Company, it must first and foremost enable the Company to hold the customer volume that it purchases. This is not a question of cost. It is a question of relative value offered the customer. Some acquisitions flounder on the value question and give up most or all of the benefits of the acquisition. If the Company can retain and even grow this acquired customer volume, then it should be able to create more Productivity and Economies of Scale for itself in the bargain.

Productivity, Size and Time Questions

Analysis 58
Economies of Scale by Department

  • Using Productivity measures from today and several years ago, determine the Productivity of the Company and each of its functional cost organizations using FTEs as the measure of Input.

  • Determine the reasons for the variability of Economies of Scale from one functional cost unit to another.

  • Identify the functional cost organizations creating Super-economies of scale.

  • Identify the functional cost organizational units producing Diseconomies of scale.

  • Seek explanations for those unsustainable conditions.

  • If the Company has acquired another company during the period, has the acquisition accelerated the Company’s creation of Economies of Scale?

  • If competitors have acquired other companies in the industry, have these acquisitions improved the Economies of Scale for the acquirers? (Note: one indication of improved Economies of Scale would be an improvement in the acquirer’s Return on Sales and Return on Net Capital Employed relative to those of the competitors.)

So far in this diagnostic, we have discussed the theory of Economies of Scale. Sometimes they work and sometimes they don’t. In fact, more often than not, reality contradicts the theory because companies do not force the creation of Economies of Scale. We will see more about this in the next section

Basic Strategy Guide Users Return To: Step 28

Summary Points

Next: Caveat on the Belief in Size