Unit 1.7: Growth and Evolution

From Paul Hoang textbook, the free textbook

Growth of a business can be measured in several ways such as:
  • The value of the firm's sales turnover (sales revenue)
  • The firm's market share (the sales revenue of the business as a percentage of the industry's sales)
  • The value of the firm's capital employed
  • The number of employees hired by the business
There are reasons for growth, which includes:
  • Economies of scale
  • Gaining a larger market share
  • Survival against rivals in the industry
  • Spreading risks by diversifying into new markets and industries

Economies and diseconomies of scale

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As a firm operates on a larger scale, economies of scale are experienced, up to the optimal level of output (where average costs are minimized). Thereafter, any further increases in output bring about diseconomies.

(Apply the concepts of economies and diseconomies of scale to business decisions)
Economies of scale refer to the lower average costs of production as a firm operates on a larger scale due to an improvement in productive efficiency. Economies of scale, sometimes referred to as increasing returns to scale, can help business to gain acompetitive cost advantage over small rivals because lower average costs can mean a combination of lower prices being charged to customers and a higher profit margin being made on each unit sold.

There are two main categories of economies of scale, internal economies of scale and external economies of scale.

Contrary to popular belief, it is possible for business to become too large. There is a point when the economies of scale can no longer be exploited and the economies of scale becomes diseconomies of scale. Diseconomies of scale, sometimes called decreasing returns to scale, are the result of higher unit costs as a firm continues to increase the size of its operations. In other words, the organization becomes outsized and inefficient and average costs therefore begin to rise.

There are also two main categories of diseconomies of scale, internal diseconomies of scale and external diseconomies of scale.


Internal economies of scale

Internal economies of scale are those that are within the organization's control and occur within the firm.
  • Technical economies
  • Financial economies
  • Managerial economies
  • Specialization economies
  • Marketing economies
  • Monopsony economies
  • Commercial economies
  • Risk-bearing economies

(Exam tip: Many students define economies of scale as 'the benefits of buying in bulk'. However, even small businesses can buy in bulk; the term refers to the cost-reducing benefits enjoyed by firms engaged in large scale operations. Financial, techonological and managerial economies of scale are probably far more important in reducing average cost of production than their ability to buy in bulk.)

External economies of scale

External economies of scale are those that occur within the industry that the business operates and are largely beyond the control of the business.
  • Technological progress (e-commerce)
  • Improved transportation and communication networks
  • Better trained labour
  • Regional specialization

Internal diseconomies of scale

Internal diseconomies of scale are those that occur within the organization's control and occur within the firm. It usually arises due to managerial problems.
  • Lack of control and coordination
  • Poorer working relationships
  • Specialization of labor
  • Bureaucracy
  • Complacency

External diseconomies of scale

External diseconomies of scale refer to an increase in the average costs of production as a firm grows due to factors beyond its control.
  • Increasing market rents
  • Traffic congestion
  • Higher wages and labor attraction

Dealing with diseconomies of scale

Since diseconomies of scale results in higher unit costs of production, firms will need to make decisions to protect their competitiveness. Firms have two main options:
  • Reducing their level of output (Firms may simply have grown too fast and expansion plans need to be reviewed)
  • Introducing measures to remove productive inefficiencies (e.g.: if workers are slacking, then outsourcing or performance-related payment systems may be introduced)

Large versus small organizations

(Evaluate the relative merits of small versus large organizations)
The size of an organization can be measured in several ways, an increase in the value of any of these figures indicated growth:
  • Market share
  • Total revenue
  • Size of workforce
  • Profit
  • Capital employed
  • Market value

Besides economies of scale, large organizations may also have other benefits, including:
  • Economies of scope
  • Brand recognition
  • Image
  • Conveniences for customers
  • Discounts and customer loyalty
  • More choices

Small organizations can survive and flourish as well due to several reasons, with some that hinder large organizations:
  • Cost control
  • Financial risk
  • Government aid
  • Local monopoly power
  • Personalized services
  • Flexibility
  • Small market size

The optimum size for a business depends on its internal structure, its costs and the size of the market (which is beyond the control of the firm). A firm may not operate at its financially optimum level because of a lack of resources or demand. Neither can it expand if it is unable to secure appropriate and sufficient sources of finance. Furthermore, it cannot expand output if it lacks productive capacity to do so.
Recommend an appropriate scale of operation for a given situation.

Internal (Organic) growth

(Explain the difference between internal and external growth)
There are two methods of business growth and these are known as organic growth and external growth. Organic growth occurs when a business grows internally, using its own resources to increase the scale of its operations and sales. External growth is distinguished by growth through mergers and acquisitions (M&A). This type of growth is also known as amalgamation or inorganic growth.

A business can grow organically, or internally, in several ways:
  • Changing price, which depends on the price elasticity of demand
  • Advertising and promoting
  • Selling in different locations (placement)
  • Offering customers preferential credit payment terms
  • Increasing capital expenditure (investment)
  • Improving training and development

Benefits of organic growth

  • Better control and coordination
  • Relatively inexpensive
  • Maintains corporate culture

Limitations of organic growth

  • Diseconomies of scale
  • Overtrading
  • A need to restructure
  • Dilution of control and ownership

External growth

(Evaluate joint ventures, strategic alliances, mergers and takeovers as methods of achieving a firm’s growth objectives)
External growth, often referred to as inorganic growth, occurs through dealings with outside organizations. Such growth comes in the form of alliances or mergers with other firms or through acquisitions (takeovers), which are collectively known as the amalgamation or integration of firms.

Benefits of external growth

  • A faster way to grow and evolve
  • Quick way to reduce competition in a market
  • Can bring about greater market share
  • Working with other businesses means a sharing of good practice and ideas
  • Help a firm to evolve, thereby spreading risks across several distinct markets

Limitation of external growth

The main disadvantage of external growth is the cost. The cost of external growth tends to be relatively higher than that of internal growth. Takeover bids can be especially expensive.

Other advantages are covered within the different methods of external growth.

Joint venture

A joint venture occurs when two or more businesses decide to split costs, risks, control and rewards of a business project. As such, they form a new legal entity, while maintaining both their identities. For example, Japan's Sony and Sweden's Ericsson created the joint venture Sony Ericsson.

Some benefits are:
  • Higher sales and market share
  • Synergy
  • Spreading costs and risks
  • Entry to foreign markets
  • Cheap method
  • Exploitation of local knowledge
  • High success rate

Strategic alliances

A strategic alliance is quite similar to a joint venture in the sense that they form a mutually beneficial affiliation and they share costs of product development, operations and marketing as well as the risks and rewards of a business project. However the affiliated businesses remain independent organizations and they do not form a new entity

Some benefits include:
  • Synergy
  • Creditability and brand awareness
  • Economies of scale
  • Benefits from added value services for customers

Mergers and takeovers (Mergers and acquisitions)

Mergers and acquisitions refer to the amalgamation or integration of two or more business to form one single company. A merger takes place when two firms actually agree to form a new company. While a takeover or acquisition occurs when a company buys a controlling interest in another company, in other words by buying enough shares in the target business to hold a majority stake. In order to make shareholders of the target company to sel their shares, the price offered by the buying company is likely to be well above stock market value of the shares.

There are some advantages:
  • Greater market share
  • Economies of scale
  • Synergy
  • Survival
  • Diversification

However there are also some disadvantages:
  • Loss of control
  • Culture clash
  • Conflict
  • Redundancies
  • Diseconomies of scale
  • Regulatory problems

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Diagrams depicting the distinct types of external (inorganic) growth possible: joint ventures, strategic alliances, mergers and takeovers

Franchises

(Analyse the advantages and disadvantages of a franchise for both franchisor and franchisee)
A franchise is a form of business ownership where a person or business buys a license to trade using another firm's name, logo, brands and trademarks. In return for this benefit, the purchaser of a franchise (franchisee) pays a license fee to the parent company of the business (franchisor).

Some benefits for the franchisor:
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Examples of franchised businesses

  • Parent company experiences rapid growth without risking money
  • Allows business to have international presence
  • Economies of scale
  • Benefit from growth without worrying about running costs
  • Receive royalty payment that is set as a percentage of profits
  • Franchisees have more incentives then salaried managers meaning success
  • Franchisees will have greater awareness of local market conditions and culture

Advantages for the franchisee:
  • Low risk due to tried and tested formula
  • Lower start-up costs since the business idea was already developed
  • Added-services will be provided by the franchisor
  • Benefits from large scale advertising by parent company

Disadvantages for the franchisor:
  • Difficult to control activities of franchisees
  • Huge risk in reputation by allowing other businesses to use their names
  • Not as quick a method of growth as mergers or acquisitions

Pitfalls for the franchisee:
  • Money to buy a franchise is expensive
  • They have to pay a significant percentage of their revenues to the franchisor
  • Less flexibility for franchisees to use their own initiative due to restraints from the franchisor

Evaluate the use of franchising as a growth.

Ansoff matrix

(Explain the value of the Ansoff matrix as a decision-making tool)
The Ansoff matrix, named after its creator Professor Igor Ansoff in 1957, shows strategies depending on if a business wants to market new or existing products in either new or existing markets.
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The Ansoff matrix created in 1957 by Professor Igor Ansoff showing various strategies for product and market growth strategies


Apply the Ansoff matrix growth strategies to a given situation.