Profit Boosters – Scale

In his book, Competitive Strategy, Michael Porter describes two generic strategies – differentiation and cost leadership. He shows diagrammatically that return on investment (under each of these strategies can be optimized).

 

He explains that, under a differentiated strategy, the organization focuses on creating a point of difference in its service offering to an homogeneous niche market(s). Because customers perceive value in exchange, they are prepared to pay a slight price premium. Although costs are well managed, the differentiated player is not the lowest cost player in the industry (see diagram below).  Because the niche provider enjoys higher prices, they are able to deliver a high return on investment. In mature, commodity product companies, there may not be an opportunity to differentiate.  These organizations need to follow a cost leadership strategy.

 

Under a cost leadership strategy, maximizing capacity and throughput delivers efficiencies and  drives costs down. The player that follows this strategy will service mass markets that are price sensitive. A combination of high volumes and low prices maximizes revenue, profits and provides a high return on investment (see diagram below). All companies that are capital intensive with a high investment in plant and equipment, need to have high levels of throughput to spread these high costs over high volumes. New or emerging industries generally provide the opportunity to differentiate as the product has not yet been adopted by the mass market.

 

Porter asserts that, those companies that attempt to follow both strategies try to be everything to everybody, and in the process, become nothing to anybody. These enterprises become ‘stuck in the middle’ and have the lowest returns on investment in the industry.

 

Today, strategist generally disagree with Porter’s view and believe that it is possible to differentiate market offerings whilst simultaneously seeking economies of scale. So how can managers create economies of scale that promote efficiencies and drive average unit costs down? Some potential sources of scale are described below:

 

Procurement

Large organizations seek to achieve scale effects by centralizing the procurement (purchasing) function. By consolidating all purchases from different regions and/or divisions, the organization can negotiate better pricing, volume discounts, loyalty discounts etc. By centralizing procurement, management can potentially optimize inventory management by ensuring that excess stock in one location is distributed to another location where there is a high demand for that item. This philosophy is predicated upon having good systems and processes that ensure that stock is available whenever it is required. If not, inefficiencies will occur, negating lower prices.

 

Smaller organizations may not have the same opportunities to centralize procurement. These enterprises still have a number of options.

  1. Partner with suppliers. In return for providing exclusivity, the supplier guarantees supply at a price below that which the enterprise was previously paying.
  2. Create a buying cooperative in which competitors in different geographical areas, combine their purchasing power to negotiate lower prices and guaranteed supply
  3. Guarantee minimum volumes to the supplier under a long-term supply contract  in exchange for lower prices

Technology

By applying new technology before it is adopted by the mass market, managers can achieve first mover advantages that provide a small window of opportunity to improve efficiencies and drive costs down before competitors.

 

This approach means that the organization is an early adopter of all technology that is relevant to its business model. For example, in manufacturing, new or improved technology for plant and equipment can improve production throughput with the same or less inputs. The internet and social media have ongoing improvements, enhancements and emerging applications for speeding up product to market, expanding markets and building brands.

Asset Utilization

In organizations that have a large number of expensive vehicles, plant and equipment, particularly if the assets are geographically widespread, economies of scale in maintenance can be achieved by either centralizing maintenance or partnering with a specialist to outsource the maintenance. Clearly, one would need to undertake a cost benefit analysis and develop a business case for outsourcing these tasks.

 

Implementing preventative maintenance programs will also ensure that equipment is optimally deployed.  When a piece of equipment has failed in the field due to a broken hose or some other minor issue, the opportunity cost to the company of more fully utilizing the asset will be lost. Keeping stock of mission critical spares will also ensure that catastrophe failures can either be preempted or  will compress the time needed to maintain that piece of equipment.

 

Finally, it is imperative to have a good system that tracks the utilization of each piece of equipment together with the cost of maintenance as the equipment gets old. Equipment that is being under-utilized, can be transferred to another location that has higher demand. Alternatively, management can brainstorm ways of increasing utilization through product bundling, longer-term contracts etc. Finally, if the equipment is no longer paying its way, sell it and invest the proceeds in equipment that will be better utilized.

Learning Curve Effect

Whenever one starts something new, such as learning to drive, we start out by being unconsciously incompetent. We don’t know what we don’t know. The more time that we put into learning how to drive, the better we become. As we start to learn how to drive, we move from being unconsciously incompetent to being consciously incompetent. As we become more familiar with the vehicle and the road, we gradually become consciously competent. We now know how to drive, but need to concentrate on what we are doing. As we gain more experience, we become unconsciously competent. Indeed, some people can do many things whilst driving, like talk on the telephone, read maps, listen to music etc. In his book Outliers, Malcolm Gladwell asserts that to become an expert in any field requires a minimum of 10,000 hours of application.

 

This concept that one becomes more productive, more efficient and works smarter is called the learning curve effect. The learning curve asserts that in any industry or task, one can calculate the percentage that costs will reduce every time output doubles. The predictable percentage that costs will reduce differs from industry to industry and is a function of relative complexity.

Industry Consolidation

There are frequently opportunities to build scale in fragmented industries. For example, in Australia, the furniture manufacturing industry comprises a large number of small manufacturers and is regarded as a ‘cottage industry’.  There are opportunities to acquire and combine a number of smaller manufacturers to achieve scale in production, procurement, administration, sales and marketing and branding.

Conclusion

No matter what industry you operate within and irrespective of the current size of your business, you can find ways to increase efficiency and reduce costs by thinking creatively and executing flawlessly.

 

 

 

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