A Blog by Jonathan Low


Sep 23, 2013

The End of the Scale Economy

The theory behind the notion that bigger is better was based on a sound principle: the more sales you had, the less impact your costs would have as they were spread over a broader array of products and a higher number of sales. The inevitable result would be fatter margins and juicier profits.

But that was back when people and companies actually owned the means of production. And distribution. And marketing. And so forth.

Now access to networks that help you achieve scale without having to buy it has changed the way in which enterprises calculate the meaning of success.

The equation on which the advantages of scale - and of competitive advantage - were based is being recalculated. Markets, and the access to them, have become global. But instead of requiring a global organization to reap the benefits it proffers, institutions can optimize their impact by more cleverly managing the network they have established, even if - like many established companies - they didnt realize they were creating 'a network' when they were simply expanding their supplier and customer base.

The challenge for most institutions is in figuring out how to identify and then manage the drivers in this new value chain. The old levers may no longer deliver the same kind of return, as the auto companies have learned from both their suppliers and the customers on whom they thought they could count. This has implications for the digital economy, as well.

That the 10 year old Huffington Post fetched over $60 million more in its sale to a private equity firm than the much larger and @160 year old Washington Post did to a mega-billionaire illustrates, as explained by the article below, how perceptions of worth and the prices they earn are reconfiguring the way in which financial impact is realized. Big data's most significant role may be in helping enterprises determine where value lies and how to access it by pinpointing sources of potential advantage, however fleeting - or perhaps especially because they are fleeting.

In the short run, it will be harder to generate returns from these smaller bases because of the time it takes to learn how to do it efficiently and because it runs counter to much of what traditionally trained and experienced executives know - or believe. But in the long run this may liberate institutions from the burden of being, well, institutional. JL

Greg Satell comments in Digital Tonto:

Clearly, digital technology has enabled a new semantic economy where access and scale have been decoupled.  When access is universal, or nearly so, size doesn’t really matter
Every manager and entrepreneur wants to grow their business.  Get bigger and more powerful, the thinking goes, and you’ll have it made. The added heft will give you the upper hand in negotiations with suppliers and the doors of customers will swing wide open.
That used to be true to a certain extent, but not so much anymore.  Digital technology has  markedly evened out the playing field.  Startups become billion dollar companies overnight while venerable brands like Kodak and Blockbuster hit the skids.
This turn of events presents considerable challenges for managers.  While there are still some advantages to scale, the disadvantages often outweigh them.  Big firms lots of customers, a large workforce and stodgy institutional investors to keep happy, which often results in strategic rigidity.  To compete in the new economy, we need a new playbook.

The Scale Economy

The idea that scale has significant advantages for a business has two major theoretical underpinnings.  First was Ronald Coase’s groundbreaking 1937 paper, The Nature of the Firm, (for which he won the Nobel Prize), which argued that the function of an organization is to lower transaction costs, especially informational and search costs.
The second was Michael Porter’s concept of Competitive Advantage, in which he proposed that firms optimize value chains, the entire range of activities that go into producing a product or service.  While he wasn’t arguing for vertical integration per se, he clearly argued that scale could leverage value chains through his five forces framework.
Both implied that the advantages to scale stem not only through the efficiencies gained by a lower ratio of overhead to production, but that greater scale allows firms to exert power on the marketplace through better information.  In effect, they argued that bigger was also smarter.
However, as Rita Gunther McGrath points out in her new book, The End of Competitive Advantage, it doesn’t matter so much which assets you own, but what you can access.

When Scale Fails

Heads turned when Jeff Bezos bought The Washington Post for $250 million.  WaPo is, after all, a historic institution, founded in 1877 and famous for breaking stories like the Watergate scandal.  With 640 journalists and the clout that comes with a storied heritage, the paper exemplifies the kind of scale advantages that Coase and Porter touted.
Yet in 2011, the 6 year-old Huffington Post, with just a handful of journalists, sold for $315 million.  By any conventional measure, HuffPo is no match for WaPo in size or stature, but yet it is worth more.  How could that be?
I think a big part of the answer lies in something James Manyika, a Director of the McKinsey Global Institute, told me about data analytics.  He said that even firms of the same size, in the same industry with the same IT budget and competing for the same customers, vary markedly in their ability to use technology.

The End of Power

As political scientist Moisés Naím explains in his new book, The End of Power, the trend goes far beyond the business world.  Everybody, from governments, to religions, to even militaries on the battlefield are having to learn to live with diminished advantages to scale.
He says, “Power is easier to get, but harder to use or keep,” and I think that encapsulates what’s going on.  It’s not that big is bad, it just doesn’t give you what it used to. Conventional trappings of power, scale being just one of them, offer little protection these days.
The fact is that the world has become less stable.  Big or small, we’ve all become beholden to the interdependencies that come with increased connectivity.  When something happens in one place it affects what happens everywhere else.  You can no longer insulate yourself.
“Stability, not change is the state that is most dangerous in highly dynamic competitive environments,” notes Rita Gunther Mcgrath and she’s right.  Large organizations used to be able to depend on stasis to protect their prosperity.  Those days are over and, most likely, they are never coming back.

New Times, New Methods

There have always been disadvantages to scale.  Even in Coase’s famous 1937 paper he advised that at some point organizational costs would mitigate scale advantages.  That’s the situation we have today, except that transactional and informational costs have fallen dramatically, while practices within organizations rarely keep pace.
Fortunately, there are a variety of strategies that can help limit organizational costs and overcome the disadvantages of scale.  Here are three:
Networking The Organization:  In the old industrial economy, enterprises could afford to function as hierarchies.  Orders flowed from the top and were carried out down in the organization.  Employees were paid for carrying out tasks diligently.  Thinking was not required nor was it necessarily encouraged.
These days, the lunatics run the asylum, so management’s primary task is to help them run it right by networking the organization.  Digital technologies, such as Yammer, can be helpful in this regard, but other strategies, such as best practice programs, open office plans and internal training programs can also encourage cross-pollination.
Open Innovation: Whereas innovation used to be an activity strictly performed behind closed doors, large enterprises are learning how to open up and collaborate through startup accelerators and Open API’s, as well as through platforms like Innocentive and P&G’s Connect + Develop.
This is a great way to get the best of both worlds.  Open innovation helps to combine the energy and ingenuity of small firms and individuals with the resources only large organizations can offer.
Simulation:  One of the most exciting developments in recent years is the use of big data to create simulations of business activity.  Rather than argue for months in stodgy boardrooms, executives can examine countless “what if” scenarios and test them in the cheap virtual world of bits rather than the costly and time-consuming world of atoms.
The new breed of companies, such as Google, Facebook and Amazon, run thousands upon thousands of experiments every day.  In the recent presidential race, Mitt Romney’s team of “the best and the brightest” strategized endlessly, while Barack Obama’s team ran 62,000 simulations per night.  The results couldn’t have been more clear.

The New Game of Strategy

In the old economy of Porter’s value chains and five forces, a manager’s job was to continually build competitive advantage by increasing leverage in the marketplace.  However, in the new economy, Rita Gunther McGrath suggests that “transient advantage” is more realistic.  We increasingly live in an environment of uncertainty, not permanence.
To put it another way, in the old economy managers played chess.  You succeeded by seeing a move or two further than your opponent.  However, the new game of strategy is more like an online role playing game.  You go on missions, earn new skills and artifacts, but you are continually looking for new quests.
So scale isn’t what it used to be and the old days of empire building are over.  Competing to win in the new economy is more of a journey than a construction project.  Your purpose must be clear, your skills must be honed and you only take what you need.  Anything more is just an encumbrance.


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