Size and Scale 3: Size does not guarantee survival

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If there is not much evidence to support the view that large firms outperform small, or that industrial structures are becoming more concentrated, why do so many people still believe these things are true?

Size & Scale

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If there is not much evidence to support the view that large firms outperform small, or that industrial structures are becoming more concentrated, why do so many people still believe these things are true? These views dominate almost all discussions of business strategy today. They are frequently based on the loose thinking that comes from the use of dead metaphors. People talk of the need for ‘critical mass’, assert that there will soon only be a small number of ‘global players’ and proclaim the need to get on the dance floor before all the nice girls have already found partners.

The most pervasive of these false analogies is the military metaphor. In war, success does depend in large degree on the sheer volume of resources which can be deployed. But that is because war is often a process of attrition, in which each side inflicts damage on the other until one side is no longer able to continue the fight. In this key sense, competition in business is not like war at all: detergents and colas are only two of the markets in which the same firms have fought each other for decades (and one likely to do so for many more decades) while each continuing to do very profitable business.

There are some industries in which scale truly is all important. The development of a new commercial airliner really does demand a scale of investment beyond the capability of all but the largest companies. But this is exceptional. Pharmaceutical companies correctly emphasise the scale of resources needed in their industry today. The development and marketing of a new drug might now demand an investment of $500m. But this is well within the resources of even a second rank pharmaceutical company, such as Zeneca. It is only 1% of that company’s market capitalisation.

The most recent block-buster drug is produced by a Swedish company, Astra, which is small even today and was barely known to anyone before it began to market Losec. And this is not the first time this has happened. It is less than 30 years since Glaxo told the Monopolies Commission that it was too small to survive and its future depended on a merger with Boots or Beecham. The Commission wisely rejected the argument and Glaxo went on to eclipse both Boots and Beecham and become the world’s leading pharmaceutical company.

The advantages of size are mostly tangible – based around plant size and distribution efficiencies. The disadvantages are mostly intangible – to do with control, coordination, motivation and the dissemination of information. The history of British electricity illustrates the tension. The old Central Electricity Generating Board built stations that were an engineer’s dream. They were designed for maximum technical efficiency, but because of planning and labour relations problems they were never completed to time or to budget. The newly privatised industry favours, and builds successfully, smaller plants to well-tested designs. It is easy to delude yourself that you will reap all the benefits of scale but none of the costs.

And there are many factors to foster that delusion. Managers would be less than human if they were not easily persuaded of their capacity to run organisations much larger than those they presently control, and of the public as well as personal benefits that would arise if they were allowed to do so. And an army of advisers is ready to encourage these beliefs.

And yet there are important reasons for thinking that the advantages of size will be, less not more, important in future. Manufacturing processes, which typically yield scale economies, are of steadily diminishing importance in total output. And this is simply a particular application of a more general phenomenon. Those economic activities where size is likely to be a disadvantage – the ones which involve trust relationships between individuals, the sharing of information within groups, and the coordination of disparate knowledge – account for an increasing proportion of value added. The costs of making and distributing physical products, where scale is often of benefit, are correspondingly a smaller and smaller proportion of total output.

That contrast is immediately apparent if you compare the leading companies of 1912 with their counterparts today. US Steel, Singer, and International Harvester have gone: Coca-Cola, Intel, and Merck have arrived. All manufacturing companies, but today’s manufacturers, unlike yesterdays make objects that fit in your pocket. And the same difference between hardware and software is evident if you compare the General Electric of 1912, based on heavy electrical machinery, with the General Electric of 1998, reliant on defence technologies, aero engines, and financial services. Microsoft’s rivalling of IBM is a literal illustration of the trend. It is also a reminder that the arguments which are today used to demonstrate the invincibility of Microsoft are very similar to those which were used only a decade ago to demonstrate the invincibility of IBM – sometimes by the same people.

We look around and see that large firms are generally successful firms and that today’s large firms include many of those – like Coca-Cola, Intel, Merck, General Electric and Microsoft – which have recently been particularly successful. But that is why they are large: the relationship runs from success to size, not the other way round, and tells us nothing about whether these firms will be more than averagely successful in future or point to benefits that other firms would reap by achieving similar size (other than through similarly exceptional performance).

And that directs our attention to the competitive advantage which is the only real basis of exceptional performance. Competitive advantages are derived from factors that cannot easily be replicated. One repeated lesson from business history is that size provides no protection for a firm which lacks competitive advantage, or fails to sustain it. From USX to IBM, via Midland Bank and British Leyland, there is a long list of companies which mistakenly believed their existing size would sustain them, or that achieving greater size would support them after their competitive advantages had been overtaken by others.

Size is not a sustainable competitive advantage. It can be replicated, and will be, by a company that has a true competitive advantage. It seemed incredible in the 1960s that Toyota – not so long ago a small Japanese manufacturer of textile machinery – could overtake the enormously larger and well established General Motors simply by building cheaper and more reliable automobiles more attuned to customer needs. It was, nevertheless, true. And in that lies a lesson for Glaxo Wellcome Smithkline Beecham Barclays NatWest, Deutsche SBC Warburg Dillon Reed Morgan Merrill, and KPMG Coopers Price Waterhouse Ernst and Young.

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