The Problem with size

In big companies, bureaucratic inertia and loss of clarity start to outweigh advantages such as sheer purchasing muscle. David Sadtler points out the elephant in the room.

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Last Updated: 09 Oct 2013

Does corporate size necessarily confer an advantage in business? With some highly focused exceptions, very large companies eventually lose their effectiveness and performance deteriorates. Even those exceptions usually have 'bigness' challenges. The causes are clear, as are the decisions that produced the problem, and the disadvantages that eventually become apparent. Remedies include spin-offs, demerger, breakup, unbundling, and the abandonment of efforts to become ever larger. The new CEO at Ford, Alan Mulally, is doing this now: let's hope he's not too late. The objective of any downsizing should be the focused business portfolio with a convincing strategic rationale.

This is frustrating news for all successful businesses and their managers. Your very success in building a large enterprise through superior competitive performance can eventually be your undoing. Ultimately, just faring well in the known competitive battles won't be enough. You'll want to grow. Ever bigger. And that's when the problems start.

Managers in big companies often complain that decision-making is too slow in their organisations, especially when competing with smaller upstarts that can move more quickly. Recently, one student from an American conglomerate told me: 'In our organisation it takes four months for capital investment project approval. Often, the situation described in the proposal changes during the process and we get involved in a seemingly endless cycle of explanation, further questioning, and so forth. My operating colleagues see it as a major source of competitive disadvantage.'

They speak of frustration at their own powerlessness because they can't seem to see the impact of their work on the performance of the company. They also complain about remote managers at the highest level enriching themselves beyond what seems fair. I have heard all these complaints repeatedly when conducting discussions on corporate-level strategy.

You might say, who cares? Some managers accept these organisational disadvantages in return for the benefits and expected security of employment from the big and, hopefully, successful company for which they work. But it's not that simple. There is persuasive evidence that these phenomena impede performance. Slow decision-making leads to eventual competitive failure in the market. Bureaucratic isolation is demotivating and inhibits spirited creative performance. And alienation from the behaviour of top managers and their board colleagues damages loyalty. Unless careful attention is directed at the potential for these problems, commercial performance can decline, and financial results along with it.

Indeed, the evidence for decline is persuasive. The core idea behind most academic work on problems of corporate size is this: companies enjoy advantages from economies of scale in single businesses (not portfolios thereof) as they grow larger and achieve leading market-share positions. All other things being equal, these economies confer major cost advantages, which can in turn provide the basis for high levels of competitive advantage. Economies of scale arise because fixed costs rise less quickly than sales revenue, allowing more of the available margin to drop to the bottom line. Many competitive battles are based on this notion and many succeed.

But these benefits from economies of scale eventually level off. This can be because, at some point, infrastructure costs must grow to accommodate the growing business. Also, competitors themselves reach a size where they too are reaping similar benefits. At the same time, some of the problems noted above begin to mount up, as the enterprise grows ever larger. There eventually comes a point where these difficulties (identified below as diseconomies of scale) overwhelm the positive economies. At this point, the cost of excessive bigness sets in, and the road to irreversible decline begins. That's the over-arching theory.

At the same time, there has been important theoretical and analytical challenging of scale benefits in large organisations.

Ronald Coase, in one of the most famous management articles of all time ('The Nature of the Firm', published in the journal Economica in 1937), noted the struggle between the marketplace and the internal bureaucracy. Coase's idea was that firm size is limited by transaction costs. Eventually, the cost of bureaucratic procedures within companies exceeds the cost of transacting with outsiders to do the same thing. That's why firms never keep growing in size to, say, a million employees (except Wal-Mart) or even 10 million. Coase's work had such an impact that a conference was actually held 50 years later to consider its lasting effects. His conclusion was that the market works better.

Similarly, Oliver Williamson (Markets and Hierarchies: Analysis and antitrust implications (Free Press, New York, 1975) noted the destructive impacts associated with organisational growth - which, unsurprisingly, are quite close to those I mentioned above. Thinking like an economist, he referred to these barriers to effectiveness as 'diseconomies of scale'. The core idea was - and I agree with it - that economies of scale that accrue with great size eventually tail off and are submerged by disadvantages.

Correspondingly, there is also evidence for a payoff from 'smallness'. Robin Dunbar, an anthropologist, has developed the idea that 150 is the ideal size for any group trying to accomplish anything. He draws this conclusion from studying primitive groups, religious sects, military organisations, and even some commercial companies, such as WL Gore, maker of Gore-Tex. He believes the human brain can handle relationships in groups of this size, but that above it, effectiveness is sapped by procedures, rules and bureaucracy. These constructs weaken morale and enthusiasm and lead to sub- optimal performance.

Malcolm Gladwell popularised this idea in his book The Tipping Point. Believers structure their organisations so that large groups are continually reconfigured so as not to exceed this number in any one physical location.

My colleague Stephen Bungay, also a noted military historian, points out that the Romans organised themselves around 'centuries', run by centurions. The century developed to an effective size of 80 to 160 men, and the key role of the officer in this structure led to the idea of a 'centurion' being the word for officer in general. The century is the ancestor of the infantry company, led by a major, again around 100 to 150 men. All armies use this unit. Bungay was also a partner at the Boston Consulting Group, which formed new offices when existing ones reached 150 to 200. BCG's German business grew that way, as did its operations in the US.

Author and entrepreneur Richard Koch expresses it more succinctly: 'We all know why firms are too big - because CEO's interests and those of investors are misaligned. CEOs always want bigger firms because of self-aggrandisement, personal greed, boredom and sheer egotism. This is the biggest fault of public company structures and it is insoluble, whatever you or I may say. Only when the stock exchange is a tiny relic of the economy will the problem be fixed. And this will happen, although not necessarily in our lifetimes.'

In a brilliant doctoral thesis entitled Bureaucratic Limits of Firm Size, Staffan Canback of Henley Management College applied the Williamson theory to a large sample of US companies in the early 1990s, analysing their financial performance and concluding that the factors he identified actually do inhibit effectiveness and that all Williamson's explanations and expectations are validated by empirical data. Canback says that Williamson's predictions about performance diseconomies in large organisations can be directly observed. For example, he points out that no US company has ever managed to deal with more than 10 organisational levels. That would appear to be a limit in itself. And none (until Wal-Mart recently) employs more than a million people.

But you might say: wait a minute, I can think of a number of very large companies that are continuously successful. Why haven't they fallen into the trap of bigness?

I recognise that there are such companies. My message is that bigness presents major problems for management and the high likelihood of problems for such companies. It is not a certainty, but the efforts to avoid such problems become ever more challenging as size increases. Let's analyse the pros and cons of some of the world's biggest corporations.

Wal-Mart Wal-Mart is by a long way the largest corporate employer in the world. It has built its impregnable position in many markets by being operationally better than any other competitor. Its supply-chain management is an exemplar for the world. As it has grown larger, it has also benefited from huge economies of scale, especially by exploiting its buying leverage with suppliers. Its recipe for success seems to be one of doing everything possible to deliver its products more efficiently and cheaply than anyone else. Wal-Mart really understands retailing. A triumph of focus.

On the other hand, there are problems. By virtue of its very success, it is now the world retailing gorilla. Its pressure on competitors, its impact on communities, its treatment of employees and its dealing with suppliers have all, to varying degrees, generated badwill for the company. There are even books, films, and occasional conferences devoted to denigrating Wal-Mart. Its top management has recently unveiled a number of actions and recommendations to make it appear to be a more responsible corporate citizen. Absolutely correct. The smart thing to do. But again, it's an example of a hugely successful company that is beginning to suffer the effects of great size.

BP This is a great company made greater by John Browne (he was even mentioned in the press as the one who might restore Shell to its former glory as industry leader). The adulation proffered to Browne extended to his nickname: 'the Sun King'. BP had been doing very well and not just because of rocketing oil prices. It pulled off one of the acquisition coups of the 1990s with its takeover of Amoco. The secret of this deal was timing. Amoco had huge oil reserves, and BP experts figured that the prevailing oil price of $10 per barrel (imagine!) was unlikely to decline further, for structur- al reasons. Such big deals are fraught with danger, but when buttressed with superior in- dustrial and competitive insight can be a bon- anza. BP is an exceptionally good deal-doer.

But deal-doing isn't everything. With big companies, good operational execution is essential. BP's ability to control its far-flung operations has clearly been damaged by recent developments at its Texas City refinery. Many safety lapses were discovered, following an investigation into an explosion in which 15 lives were lost. Then came evidence of a big environmental problem in BP's Alaskan operations. Embarrassingly, the company has recently had to shut down much of this operation. There has also been an ignominious revelation about its US trading operations, where the US government is accusing BP of manipulating the price of propane, an important heating fuel.

These developments have constituted a major embarrassment for BP's top management team. John Browne's exalted reputation (quite apart from the recent revelations about his personal life) declined and his retirement date was brought forward.

The new chief executive, Tony Hayward, raised further doubts about the company in a recent speech, deploring BP's performance and blaming it on organisational complexity. In a statement to staff, he commented that 'there is massive duplication and a lack of clarity of who does what... We will reduce the number of organisational units. We will reduce the number of layers from the workers up to the chief executive from 11 to about seven.' BP, in other words, is suffering from the penalties of excessive size. Has BP become too big? I think so.

General Electric In recent years, whenever I have spoken publicly and in the classroom about the difficulties of corporate diversification and the challenges of managing a broad portfolio of businesses, someone always asks: what about GE? Quite right. It is an amazing company with a very large spread of businesses and makes excellent financial returns. How do I explain this?

My answer is: Jack Welch. Very infrequently, companies are blessed with such effective leaders, possessing such telling insights about what the company needs, that they can just about do everything well. During Welch's 20-year spell at GE, this was the case. Jack recognised that after a period of slimming down, the company was too diverse for him to spend his time worrying about individual strategies and interfering in the businesses. In any case, given the effort directed at picking people and developing managers, he knew that the people running his businesses could do a fine job without help from him. So he built a system to inspire and develop managers through key themes and the sheer force of his charismatic personality.

When the concept and success of the company is built around the skills and talent of one person, it is hard to believe that their successor will have the same dramatic effect and be able to manage something this huge. Jeffrey Immelt must be an enormously effective executive, simply to have been chosen by Welch. But he isn't Welch. The company is still performing well, but the stock is down considerably; the job may be too big for a mere mortal.

An article in Fortune ('The Bionic Manager,' September 19, 2005) described Immelt's workday and travels, and I wouldn't recommend his schedule to anyone. My guess is that, within five years, the company will break up into three major pieces: GE Capital; the other services businesses, especially in entertainment and media; and the manufacturing businesses. These residue companies will still be awfully big and have bigness problems of their own, but their leaders will then have a more manageable spread of activities on which to focus.

Pfizer: This is another hugely successful company, enjoying high margins and profits, as befits the world's largest pharmaceutical company. But it too has had its problems. The aggressive acquisition strategy of the previous CEO and the high prices paid for those acquisitions have worried analysts. These issues, together with several product failures and an apparently diminishing product pipeline, have caused a major decline in Pfizer's share price.

The new-product future is particularly worrying. Says one senior Pfizer executive: 'We have tremendously talented people but great difficulty keeping clarity and simplicity of aim and moving complex information around among them. Our sheer size and geographical footprint make it difficult to connect every one up to the right information at the right time. That's one of the reasons that new-product development productivity is less than we hoped.'

The problem of excessive size isn't hard to spot. In most such organisations, this situation is clear for all to see, especially observers who are reasonably objective. The 'Health check' panel (p55) suggests a diagnostic approach. If three or more of the questions are answered in the affirmative, excessive size is a likely cause.

The answer is self-evident - focusing, slimming down and reversion to a portfolio of businesses that really makes sense, where there is a value-added rationale that everyone - managers, investors, and the wider community - can believe in. Many managers will resist this but, in the long run, markets will demand it.

David Sadtler is an associate of the Ashridge Strategic Management Centre, specialising in business unit and corporate strategy

Contact: david.sadtler@googlemail.com HEALTH CHECK - IS YOUR COMPANY TOO BIG?

Three or more 'yes' replies and you may have a size problem...

1. Does top management constantly reinforce the need for further growth?

2. Does the company seem to embrace each new industrial fad and fashion and use it to justify major expansion initiatives?

3. Has any of the top management team recently been knighted or ennobled?

4. Do financial analysts advocate breakup of the group? Have any published calculations of breakup proceeds appeared?

5. Has the company's bond rating and overall creditworthiness declined in recent years?

6. Has financial performance declined? Are returns on capital lower in the past decade than in the previous decade?

7. Are financial returns consistently lower than those of your competitors and comparator companies?

8. For each of the five largest businesses in the group portfolio, are financial returns below those of the most threatening rivals?

9. Is the company losing good people?

10. Is the company disappointed with the results of recent employee attitude and satisfaction surveys?

11. Has the company failed to articulate a proper strategy for adding value to the businesses in its portfolio?

TEN CAUSES OF CORPORATE CORPULENCE

Bigger is better. Most managers believe that the biggest players are likely to make more money than smaller ones.

Fads (eg, one-stop shopping, converging industries). Top managers are susceptible to passing business fashions.

Synergy. The idea that two plus two may equal five can justify the existence of an otherwise awkward portfolio of businesses.

The growth imperative. Many managers believe that they simply must make their companies grow.

Shareholder pressures. Even though it's not always in their best interests, shareholders continually push managers to make the company bigger.

Internal push. Operational managers are ambitious people and seek new horizons.

Defending against takeover. Some see sheer size as an effective takeover defence. If the company is large, it is thought it will be tougher for anyone to finance a takeover.

Managerial hubris. An executive's arrival at a position of great power is often attended by an overweening self-confidence, the assumption that mistakes are impossible.

Desire to justify higher pay. The bigger the company, the higher the pay...

Honours. For many managers, getting a knighthood or an ennoblement is seen as an end in itself, the culmination of a life's work, even if it is of no corporate benefit.

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