Will big mergers really pay off ? Being bigger can mean lower returns !

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Large size of business organizations is supposed to produce economies of scale. Superior size has the potential to reduce each of a company’s three major costs per unit of sale: cost of people, purchases, and capital. Costs can be spread over more units of sale thus reducing cost of sales and providing the bigger company with a cost advantage which it could use to lower prices and increase market share. So far the theory behind many recent big mergers.

The US based strategy consulting firm Windermere Associates recently made the discovery by conducting an extensive study of the financials of more than 300 industries that industry market-share leaders in most cases do not make better returns than their smaller competitors ! The study revealed, that the median market share leader in the 300 industries the study covered commands a 37 percent share of the market. On average, the share leader is almost five times as large as the average fourth-ranked market shareholder. Despite this overwhelming size advantage, the top shareholder has a better return on assets (ROA) than the fourth-ranked shareholder only 56 percent of the time.

But the story becomes even more interesting: Size and economies of scale ought to have their greatest impact in tough, highly competitive markets, in which prices are low and cost advantages are premium commodities. In these markets, the market share leader’s superior economies of scale should increase the likelihood that the company leads its market in returns on investment. But Windermere Associates found out in their study that relative size confers even less benefit in very tough markets: The market share leader beat the industry average return on assets (in “tough” industries) only 51 percent of the time, compared to the 59 percent performance in all industries. In fact, among the four largest competitors, the share leader in tough markets was more likely to be last rather than first in return on assets.

Conclusion: In many industries, economies of scale are nonexistent. And this has some important implications for the management of business: In order to reap the benefits of size and create economies of scale, a management team must identify its best customers, concentrate its products and cost structure on them, and then force the economies of scale their volume provides. Poor choice of customers underlies the poor returns of many leading companies. Too often the pursuit of size leads a management team to recruit as customers people who ask too much and pay too little. Many management teams (and also many financial analysts and brokers) make the assumption that getting better automatically means that unit costs will fall. But growth will reduce costs only when a disciplined management team forces costs to fall as volume grows.

Source: “Scale Matters” by Donald V. Potter, president of strategystreet.com and of Windermeere Associates, an article published in “Across the Board, July/August 2000” – The Conference Board Magazine, page 36-39. You can try to get a free copy of the magazine at conferenceboard.org.

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