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Can companies be too big?

Updated Friday 19th June 2009

Peter Walton discusses why the size of a company is critical, but can often reduce freedom of action.

It’s easy to show that size impacts profitability but, in practice, managers frequently can only make decisions that affect size in the medium to long term. In the short term they are highly constrained by their existing set-up, always limited by demand in the market place.

A container lorry [image by 28481k, some rights reserved] Creative commons image Icon by 28481k, some rights reserved under Creative-Commons license
A container lorry.

All businesses have two types of cost: fixed costs (that do not vary with output) and variable costs (that increase as output increases). To illustrate with a simple example, suppose you had a heavy goods driving licence and wanted to run a trucking service. You buy a truck for £100,000 and you can use it for five years. Before you drive a kilometre, you have a fixed cost of £20,000 a year to pay for the basic equipment. Items such as annual insurance and road tax raise the fixed costs to £25,000. Leaving aside your salary, every kilometre you drive costs (say) £1 in diesel, servicing, tyres and so on. So you have fixed costs of £25,000 and variable costs of £1 per kilometre. In the short term you have to work within those constraints.

The size of your business is critical. If you can sell transport at £6 per kilometre travelled, you need to sell at least 5,000 kilometres to break even:

Sales (5,000 x £6)

30,000

Variable costs (5,000 x £1)

-5,000

Fixed costs

-25,000

Profit or Loss

0

Suppose the physical limitations are that you can drive a maximum of 75,000 kilometres a year. You can see that your profitability will vary according to the amount of work you do. Below 5,000 kilometres a year, you have no salary and are making a loss. Between 5,001 and 75,000 kilometres a year, every extra kilometre adds £5 to your earnings (£6 price less £1 variable cost) so your earnings rise uniformly to £350,000.

However, the moment you increase your activity beyond 75,000 kilometres, you have to acquire a second truck and hire a driver, so profits would then decrease as size increases. You’re either too big or not big enough at that level of activity.

There is also the issue of whether there is enough business available so that you can expand without limit. Often this is not the case and, as you look to boost business, you have to reduce prices. In an ideal world you would maintain your basic price of £6 for some business and offer special deals to gain extra business. As long as you were getting more than £1 and you were already covering fixed costs, you should increase earnings. However, it is difficult to reduce price in a limited way and you may find that existing business moves down from £6 to perhaps £4, so your increase in size reduces the value of your sales while increasing your variable costs – you’ve got too big.

The effects of size can be both beneficial and damaging.

Size matters at the individual business unit level but it also matters in the multi-unit business. The effects of size can be both beneficial and damaging. On the positive side, a multi-unit business can spread its risks better. A costly, failed business initiative can wipe out a single unit business instantly, whereas a multi-unit business can more easily bear the risk of expansion. Also, a multi-unit business can afford to have in-house specialists who bring extra expertise to aspects of management of the business.

On the negative side, key decisions are usually made remotely from the business unit. Normally the group operates with business budgets that must be agreed the year before and then adhered to. This can build in inflexibility because there is usually resistance to departing from the budget to take advantage of an opportunity that presents itself. Equally, central management will be concerned at managing risk across the group, and may turn down an expansion possibility in one unit because it prefers to take a risk in another. The group will probably establish standard procedures that sometimes do not make sense at unit level.

The bigger a group is, the more remote central decision-makers are from front line businesses and so the more controls the group needs in place to monitor what is happening at the unit level. These added layers add costs and not profits, they cause delays in seizing opportunities and often end up making front line staff feel frustrated and unappreciated. Big can be stifling.

Find out more

Get to grips with the big business questions: visit The Open University Business School

Watch Evan Davis discuss the right size for companies

 

For further information, take a look at our frequently asked questions which may give you the support you need.

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