1.5 Growth and evolution

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to understand what growth is and how businesses can grow, if they actually want to, because there are certainly benefits of staying small and success is not synonymous to growth.

As usual, before talking about the central concept of the class, we have to figure out the meaning of something else. This time, this “something else” is economies and diseconomies of scale and once you understand what that is, you will see how it relates to growth and why it’s important.

Economies of scale (EOS) is the decrease of the average costs of production as an organisation increases the scale of operations and improves its production efficiency. Simply put, economies of scale mean this: the larger your business gets, the cheaper it is to produce one item of your product. Diseconomies of scale (DOS) is the exact opposite of economies of scale, they happen when your average costs (costs per unit of output) increase as your company increases its scale of operations. Simply put, the larger your business gets, the more expensive it is to produce one item of your product.

For example, you squeeze oranges and sell fresh orange juice. Every day you only buy 10 kilos of oranges from local farmer and he charges you $2 per kilo. Then you create a partnership with your friends and you start selling orange juice all over town. Now you need 50 kilos of oranges a day, so you ask the farmer to give you a discount, because now you buy five times more! He agrees and now he charges you $1,5 per kilo. Now your business has grown and at the same time producing one litre of fresh orange juice has become cheaper than before forming a partnership with friends. Congratulations, you have just exploited economies of scale!

If you look back at the definition of economies of scale above, you will see more business terms in it:

1. costs,
2. scale,
3. efficiency.

Let’s define them too in order to understand of economies of scale like a boss.

Cost is an amount of money that needs to paid for producing the output. Costs (C) can be average (A), total (T), fixed (F) and variable (V). Fixed are the ones that remain the same regardless of how much you produce (for example, internet fee or electricity fee) while variable costs are the ones that change depending on how much you produce (for example, the costs of raw materials, such as oranges in the example above). More about costs in Unit 3. One more variable that you need to know is quantity (Q) — the amount of output that you produce. Now look at the equations below, they should make sense to you:

AC = TC ÷ Q
AC = AFX + AVC
AFC = TFC ÷ Q
AVC = TVC ÷ Q

Do they? If not, please re-read the previous paragraph.

Scale of operations refers to how much output is produced and how big the production facility is. For example, there are two factories (X and Y) and each of them produces 100 chairs a day, but factory X has 10 employees and they use 10 machines, while company Y has 8 employees that use 8 machines. Apparently, factory Y’s scale of operations is smaller, and yet their output is the same as in factory X, which means that it’s more efficient.

Efficiency in this class (there will be slightly different definitions in Unit 5) means the decrease of AC (average costs) that is caused by changing any of the variables above: scale, fixed costs (FC), variable costs (VC), or total costs (TC), or keeping costs the same but increasing the quantity of output produced (Q).

Now you know pretty much everything about economies and diseconomies of scale in general and hopefully the graph below will make perfect sense to you:

Economies and diseconomies of scale can be internal and external. Internal EOS and DOS refer to the business only, they happen within the business. External EOS and DOS refer to the entire industry, to all the businesses that produce similar products, they are outside the single business but within an industry. Let me give you four examples of each type of EOS and DOS but please keep in mind that there are more than 4, I’m just providing the most common and important (in my opinion) examples. Also, bear in mind that the ones that are in bold are also business terms, so try to use them in your business-related conversations, class discussions and exam-style answers.

Internal economies of scale:

• Purchasing EOS happen when suppliers provide a discount in exchange for buying more. The fresh orange juice example with farmer’s discount is an example of this type of EOS.
• Marketing EOS occur when a company increases marketing budgets to advertise extensively so that customers purchase more. For example, Coca-Cola spend billions of dollars on advertising and if you think about it, probably you see Coca-Cola logo at least once a day… As a result, people always remember about Coke and are constantly reminded about it, which results in higher sales, which means that average costs of production fall.
• Risk-bearing EOS happen when a firm diversifies its product portfolio, i.e. produces more things in order to have a Plan B, C, etc. In this case, if product A is not sold well, then the sales of product B or C can compensate for that and thus reduce the costs of production.
• Managerial EOS occur when a company hires a really experienced and efficient manager who saves costs and who works as efficiently as several regular managers. This, again, results in the decrease of average costs of production.

External economies of scale:

• Technological progress: new inventions that everyone benefits from. For example, a new method of chair manufacturing is invented and all the furniture companies use it and save costs.
• Educated workforce: higher education levels in the country benefit all businesses, because additional training and supervision is not required.
• Regional specialisation means a certain region focuses on producing a certain thing (for example, Suzhou for silk, Hollywood for movies, Silicon Valley for IT, Bali for surfing). It means that all businesses in that region can share infrastructure, delivery costs, can negotiate better prices with suppliers, etc. Even though these businesses are competitors, why not cooperate on certain things that benefit everyone?
• Infrastructure: roads, power supplies, transportation networks, etc. The better the infrastructure, the shorter the delivery times are and the more efficient all businesses are.

Internal diseconomies of scale:

• Bureaucracy: too many procedures and paperwork may increase administrative costs.
• Inert (not adaptive) working culture: change does not take place and organisation stagnates, resulting in outdated processes and inefficiencies.
• Complacency (when company does not have a clear picture of reality and is overconfident in its success): for example, Kodak and Nokia thought they will remain market leaders and digital cameras and touch-screen smartphones are just a short trend in fashion.
• Marketing DOS: marketing failure that impacts the entire product portfolio and results in low sales. For example, there was a scandal in China when D&G created an offensive ad where a Chinese lady is eating pizza with chopsticks. That resulted in a fall in sales revenue and having to apologise to the people of China.

External diseconomies of scale:

• Infrastructure: roads, power supplies, transportation networks, etc. We’ve already talked about it, but from the positive perspective. If infrastructure leaves much to be desired, it can have the opposite effect in the entire industry and result in inefficiencies for all…
• Educated workforce: higher education levels in the country result in increased labour costs for all. We talked about this one too. On the one hand, educated people are great, but on the other hand they demand higher salaries. That is why in many developed economies most of the secondary sector activities are outsourced to developed economies (if this sentence doesn’t make sense, please review this class).
• Increased rents: as cities and their populations grow, rent increases. Shanghai was basically a small town about 100 years ago, so imagine how cheap land in Shanghai was back then and how expensive it is now when it turned into a megapolis.
• Pollution: even though costs might not apply to businesses, employees and local community are affected negatively which will eventually have a detrimental effect on all business in a given industry…

Once again, there are more than 4 in each category. Please keep in mind that my examples are not prescriptive, they are just examples that I personally think are important.

Now, before we move on, think of a question: “How to avoid diseconomies of scale as company grows? What can be a potential remedy?” There is an answer to this question in this class. I hope you’ll find it!

First of all, business growth refers to the increase in size of the business. Judgements about business growth only make sense when they are relative, i.e. when you can make comparisons between similar businesses. Size of the business can be measured by several things:

• Market share — the portion of company sales in total sales in the industry (more in Unit 4).
• Revenue  — price multiplied by quantity of items sold (more in Unit 3).
• Profit — the difference between revenue and costs (more in Unit 3).
• Workforce — the number of employees (more in Unit 2).
• Capital employed — investment that in used for operating the business (more in Unit 3).

Growth can be internal (organic) and external (inorganic). Internal (organic) growth happens when businesses grow using their own resources and capabilities. For example, you open a cafe and after one year you build the second floor and add 20 more tables. External (inorganic) growth happens when businesses deal with other external organisations. For example, you open a cafe and one year later you buy another cafe in another part of town from another entrepreneur.

Internal growth does not have any types, it just means that business is growing naturally. Some of the Ansoff Matrix strategies can actually be examples of internal growth. External growth has several types/methods, that are discussed in the next part of this class. Some of the main characteristics and key differences between organic and inorganic growth are summarised below:

Internal (organic) growth:

• Businesses grow using their own resources and capabilities
• Low risk
• Lower potential benefits
• Slow and steady
• Relatively inexpensive
• Retention of full control
• Strengthens corporate structure

External (inorganic) growth:

• Businesses grow by dealing with other external organisations
• High risk
• Higher potential benefits
• Fast and rapid
• Requires significant finance
• Hard to control
• Challenges/weakens corporate structure

I assume these characteristics are clear. If not, please leave a comment below and I will elaborate on each of them.

It is often assumed that all businesses want to grow and become large, and it is believed that large business is an indicator of success. In fact, this is not always true. There are certain benefits and reasons for businesses to grow as well as reasons and benefits for businesses to stay small.

Reasons to grow:

• Economies of scale: see the first part of this class if you forgot what it means.
• Lower prices: again, because you can lower the costs due to economies of scale you can charge lower prices and attract more customers pushing your competitors out of the market.
• Increased market share: this would be the result of lower prices and decreased competition.
• Brand recognition: the more customers you have, the more people know and recognise your brand (more about it in Unit 4)
• Higher revenues: the more people buy, the more money you make.

Reasons to stay small:

• Prestige/uniqueness: small businesses are perceived as something upscale, special, VIP, not for all, that creates a sense of uniqueness and prestige among customers.
• Adding more value (reminder: see 1.1 to review what added value is): this sense of uniqueness and prestige can allow businesses to charge higher prices, thus increasing the added value.
• Higher prices & profit margins: higher added value results in greater difference between revenues and costs of production, even though costs do not increase.
• Retaining control: smaller businesses are easier to manage and it is more likely for them to avoid internal diseconomies of scale.
• Less competition: smaller businesses usually specialise on a specific market niche and competition there is limited, as opposed to mass market where large businesses dominate.

This way or another, large or small, all of these reasons above eventually result in higher profits. So, one way is not better than another, these are just two different approaches to maximise profitability.

A typical example of a large business would be Coca-Cola. Their business model only makes sense when Coke is a mass product. Without economies of scale and large scale of operations it will not be sustainable. However, 37 Signals (Basecamp) — the company that created, among other products, Basecamp (it’s like ManageBac, but for businesses) and Ruby on Rails (it’s a programming language) — operates using a completely different business model. They are a very small company and yet extremely successful. They actually wrote a book (ReWork) about an unconventional way of running a business that I eagerly recommend to read to all of my students.

Since you already know what external growth is, we’ll cut to the chase right away. There are four methods of external growth: M&As, joint venture, strategic alliance and franchising. I highly recommend you to copy the table below and fill it in as you read:

M&As refers to mergers and acquisitions. Merger means two or more companies forming one larger company (A + B = AB). An example of a merger could be ExxonMobil or Kraft Heinz. Acquisition (or takeover) happens when one company takes ownership of another company (A + B = A). An example of an acquisition could be Google taking over Android or Disney taking over Pixar and Marvel. As you remember from 1.2, privately held companies do not trade their shares on stock exchange, so it would be quite hard to take over a private company. With regards to public limited companies, their shares are traded on stock exchange and are available to everyone, which means that sometimes publicly held companies can be taken over even if they do not want that. This situation of undesired acquisition of a publicly held company is called a hostile takeover.

Another thing that I hope you still remember from 1.2 is supply chain and sectors of economy. Another way to express growth of a company through M&As is through the sectors of industry. This way of describing growth is called integration. It is not another method of external growth, we’re still talking about M&As here, but we are just adding a new perspective to M&As. There are three types of integration:

• Horizontal integration: when M&As happen between companies in the same sector of industry. For example, a bank takes over another bank (both are in tertiary sector).
• Vertical forwards integration: when a company merges with or takes over a company from a “higher” sector of industry. For example, a car manufacturer (secondary sector) takes over a car dealership (tertiary sector).
• Vertical backwards integration: when a company merges with or takes over a company from a “lower” sector of industry. For example, a furniture shop (tertiary sector) merges with a furniture factory (secondary sector).

Another perspective to talk about M&As is to see whether acquisition or takeover happens between similar/related businesses or not. For example, even though a bakery that produces bread (secondary sector) merges with a bakery that sells it (tertiary sector) that would be vertical forwards integration between related businesses. Integration between unrelated businesses is called conglomerate merger (or conglomeration or diversification or conglomerate integration). An example of a conglomerate could be The Walt Disney Company that has businesses in media, entertainment, amusement parks, resorts and consumer products.

Some of the advantages of M&As include:

• Economies of scale (see part 1 of this class if you forgot what that is).
• Minimising risk (if one business fails, another one will back it up and act as Plan B).
• Synergy (when cooperation has more benefits than operating independently, when 2+2=5).
• Market leadership (being able to reduce competition and increase market share instantly).

Some of the disadvantages of M&As include:

• Managerial diseconomies of scale (see part 1 of this class if you forgot what that is).
• Cultural clash (each organisation has its own culture that might be very different from the other company involved in M&As, more about it in Unit 2).
• Increased government control and interference (large companies might face anti-monopoly issues that government has a strict control of).
• Redundancies (having to let people go (“lay off”), because two of everything might not be needed in a newly formed company. But these lay-offs are not free, people have to be paid severance pay before they leave because it is not their fault the company mo longer requires their service, more about it in Unit 2).

Joint venture is formed when two or more companies create a third company that operates for their mutual benefit (A and B create C). This newly formed company C is a real tangible business entity (unlike strategic alliances that we’ll talk about later). Sometimes joint ventures are formed even between competitors, because they might have several things that are worth cooperating on. For example, two drink manufacturers sharing a bottle factory, or two car manufacturers sharing an assembly line. Joint ventures can be temporary and only operate until the completion of the project (for example, The Channel Tunnel). Sometimes joint ventures are a government requirement and the only way to enter a foreign market. For example, in China for a long time that was the only way for foreign companies to enter the market — only by forming a joint venture with a Chinese counterpart (for example, BMW Brilliance). Very often, the costs and profits of a joint venture between two companies are split evenly: 50/50. In addition to examples above, Hulu is a joint venture of NBC and ABC.

Some of the advantages of joint ventures include:

• entry to foreign markets,
• synergy (same as in M&As),
• splitting the costs and risks,
• reduced competition.

Some of the disadvantages of joint ventures include:

• too much reliance on a partner,
• control and “final say" issues (having to agree on all decisions with a partner),
• having to share certain expertise (for example, some methods of production or some secret technologies).

Strategic alliance is a cooperation of two or more companies in certain aspects for their mutual benefits (A and B cooperate, C is not created). A new business entity is not created (unlike joint ventures). Similar to joint ventures, strategic alliances can happen between competitors because sometimes cooperation with competitors has benefits. Typical examples of strategic alliances could be SkyTeam and Star Alliance. Both of them are not companies, they are just systems to save miles for flying with certain airline companies that can result in discount when buying a ticket. The advantage of strategic alliances is splitting the costs only when necessary without the burden of creating a new business entity. The disadvantage is that strategic alliances are not really binding which prevents companies from serious commitments.

Franchising is a way of external growth whereby franchisor company allows other companies (franchisees) to sell their products and trade under its brand (franchise) in exchange for royalty payments (regular payments for using the franchise) and franchise fee (payment to “buy” the franchise). Examples are McDonald's, KFC, Burger King, Subway, Cinnabon. Franchising is a great solution to avoid diseconomies of scale. Can you imagine if McDonald’s was one company and it had to manage every single restaurant? That would be extremely difficult. It is much more efficient to establish the procedures and let franchisees run the business under strict guidelines.

Some of the advantages of franchising are rapid growth without jeopardising control over brand and low risk for franchisees because they only have to deal with operations. Some of the disadvantages are having to rely on franchisees and putting brand at risk (from franchisor’s perspective), and having to share profits with franchisors (from franchisee’s perspective).

As a brain exercise, think of several (let’s say 7) of your favourite companies and suggest an ideal “partner” for them for each of the 4 external growth methods. For example, if Muji had to merge with another company, what would be the best company to merge with and why? How about an ideal company to be taken over by Muji? An ideal company to have a joint venture and strategic alliance with? And would it be a good idea for Muji to operate as a franchise and why?

Make sure you can define all of these:

1. Economies of scale
2. Diseconomies of scale
3. Costs
4. Fixed costs
5. Variable costs
6. Total costs
7. Quantity
8. Average costs
9. Cost per unit
10. Scale of operations
11. Efficiency
12. Internal economies of scale
13. External economies of scale
14. Internal diseconomies of scale
15. External diseconomies of scale
16. Purchasing EOS
17. Marketing EOS
18. Risk-bearing EOS
19. Managerial EOS
20. Regional specialisation
21. Inert working culture
22. Marketing DOS
23. Business growth
24. Business size
25. Market share
26. Revenue
27. Profit
28. Workforce
29. Capital employed
30. Internal (organic) growth
31. External (inorganic) growth
32. Brand recognition
33. M&As
34. Acquisition (takeover)
35. Hostile takeover
36. Integration
37. Horizontal integration
38. Vertical forwards integration
39. Vertical backwards integration
40. Conglomerate merger (conglomeration / diversification / conglomerate integration)
41. Synergy
42. Joint venture
43. Strategic alliance
44. Franchising
45. Franchise
46. Franchisor
47. Franchisee
48. Royalty payments