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Scale diseconomies

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Modern society would have us believe that bigger is better. Today, our homes are bigger, our cars are bigger, our televisions are bigger and just about everything else we have is bigger. Moreover, our cities are replete with taller buildings, mega malls and busier airports - the world is on steroids!

Business too appears focussed on one outcome - the largest market share. Growth has long been the key imperative in business and economics. Growth strategies that increase scale are lauded. Indeed, they are considered best practice and are to be emulated by others.

But with size comes the challenges of diseconomies of scale. Larger companies are typically bureaucratic, inflexible and slow to react to changes. In contrast, newer firms constantly enter markets and take market share from established giants as they (smaller firms) are more agile and therefore better able to adapt to changing consumer needs.

Size also creates inefficiencies when it comes to decision making. Hampered by their mass, big companies are not naturally nimble and innovative. The rigid organisational structures necessary to manage corporate behemoths inhibit the fluidity required to become the next Facebook or Apple.

In service industries, bigger firms often find it difficult to provide a high level of personal service. My wife and I have experienced this in the travel industry. We invariably find that smaller boutique hotels offer a far more intimate and caring standard of service than larger hotel chains.

Similarly, I still lament the closure of my neighbourhood hardware store which fell victim to the big brand players. Whereas I used to be warmly greeted by the local hardware store owner, I must now deal with an inexperienced young “concierge” at a mega-barn who sends me off to some far away aisle.

The Australian Superannuation Industry also espouses the big is better mantra. The prevailing wisdom of scale posits that bigger superannuation funds are cheaper for members. However, a 2012 working paper prepared for the Australian Prudential Regulation Authority (APRA) found that fund size does not have an overall positive impact on the performance of retail superannuation funds.

In a 2016 paper, The myth of economies of scale: bigger is not necessarily better for super funds, academic, Dr. Rob Nicholls, also examined the claim that larger funds have an advantage in economies of scale over smaller funds. Specifically, he set out to test the belief that:

… superannuation funds with more assets under management … benefit from economies of scale, because the costs of running a superannuation fund are largely fixed and do not change much, whether you are managing assets of A$500 million or $50 billion.

For years, we have been told that superannuation funds with more assets under management spend proportionally less on administration and overheads. This allegedly allows them to make more competitive returns and supposedly gives them an edge in the marketplace.

However, Dr. Nicholls’ findings were in stark contrast to the prevailing wisdom about the superannuation sector and indeed the classic economic theory of economies of scale. He noted:

Not only do the biggest funds have no discernible efficiency advantage over the much smaller mid-sized funds, but there are some positively tiny funds which are just as efficient as some of the very largest.

In banking, there is the problem of too big to fail or - as some would say - too big to save. Since the Global Financial Crisis (GFC), there have been waves of calls to break up massive banks around the world that are systemically too important to fail. Chopping them up into manageable bits is seen as a solution.

However, this “solution” fails to recognise that all banks - big and small - are interconnected in their activities. Banks are financially exposed to one another through the payments system and other types of activities such as loans and derivatives thereby creating interbank liabilities.

These balance sheet linkages between financial institutions mean that they are “too interconnected to fail”. This is why bank failures create a domino effect. Financial difficulties at one bank can quickly spill over to other banks or the financial system as a whole, resulting in a wave of distressed institutions.

This is what occurred in Spain during the GFC. Many of Spain’s small savings banks stumbled and collectively caused as much disruption as one distressed big bank. So troubled small banks can create a level of damage equal to a troubled big bank.

Please let me conclude this post by underscoring that bigger is not always bad, but it’s not always better. Bigger is better for some things but not everything. What is clear is that you need to jump through more hoops to get things done in a big business whereas small businesses are largely free from inefficient red tape.

In both my professional and personal lives, I believe that the quality of what you do is far more important than the quantity. This is why I have enormous respect for small and medium sized enterprises (SMEs). In Australia, the SME sector is the largest employer in the country providing jobs for almost 60 per cent of the workforce.

Around the world, SMEs are the bedrock of most domestic economies. They account for 60 to 70 per cent of jobs in most OECD countries and are essential, therefore, to a prosperous economy. Increasingly, SMEs are creating a digital presence to combine local strength with global reach.

It’s true that big business dominates the business pages while small business receives a minuscule amount of media attention. But small business is responsible for a lot of big thinking. And remember, every big business started as a small business.

Regards,
Paul J. Thomas, CEO

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CEO Paul Thomas