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Economies Of Scale Argumentative

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1.) For each of the main sources of internal economies of scale (technical, commercial, financial, managerial, risk bearing) think of an example of how these could apply to the electronic/electrical goods industry and explain your reasoning.

Technical – The shift from analog to digital technology had been tremendously affecting both audio and video electronic products, took a variety of forms over the recent years and was evident in nearly all countries covered, albeit to varying degrees. While the analog color TV has long dominated video products, and analog video cassette recorders (VCRs) have been a mainstay of playing and recording video material, analog-based audio cassettes have given way to digital compact disc (CD)-based media in audio products, particularly in personal/portable audio.

The acknowledged higher audio quality and promoted long life and perceived indestructibility of CDs resulted in a rapid conversion from vinyl/cassette music listening to the new digital format following the launch of the personal/portable CD player, in-home audio hi-fi systems featuring multiple disc changers, and the greater availability of software to allow back-cataloguing of vinyl/cassette music collections.

Moreover, the emergence of MP3 technology and digital music downloading may yet provide another twist to the evolution of music listening, as increasingly sophisticated MP3-based personal/portable audio products can carry entire music collections on a hard drive-based format no larger than the conventional analog audio cassette. This is why consumer electronics companies have been virtuously spending well on developing novel innovations to keep themselves afloat in these fast-changing times.

Commercial – According to Euromonitor International (18 December 2004), the US continued to lead global volume sales of consumer electronics in 2003, with sales reaching over 139 million units in 2003. In value terms, the country held a clear lead over second placed China, with sales approaching US$33 billion. However, in terms of both volume and value, US performance in 2003 was particularly disappointing, as a weak economy impacted demand, and strong gains in certain areas, such as DVD players and portable MP3 players, failed to counterbalance declines in older, competing formats, such as VCRs and CD players.

Moreover, consumer electronics companies have chosen to concentrate its focus on the Chinese market. China strengthened its position as the second largest global market for consumer electronics with volume growth of almost 25% over the 1998-2003 period, and sales of 109.1 million units in 2003. This gave the country a 20.9% share of the global market in that year.

With strong GDP growth averaging 8% per annum since late 2001, rising household incomes resulted in a 3% increase in consumer electronics sales in current value terms in 2003. While audio products saw growth in current value terms of almost 6%, and of 2% in volume terms, video products’ double-digit volume growth of nearly 13% did not readily translate into equally positive value growth due to falling prices, and as a result video products saw an increase of only 1.5% in current value terms during 2003.

Financial – One of the most successful consumer electronics company, Matsushita Electric Industrial has been consistent throughout the years because the company has a broad product portfolio with manufacturing operations spanning a range of electronic products and components including audiovisual (AV) components, information and communications equipment, home appliances, and electronic devices for consumer, business and industrial use.

The company leveraged its wide product portfolio to enhance cross-selling opportunities, which gives it a competitive advantage. Furthermore, it has a diversified revenue stream comprising AVC networks (38.5% of total revenues in fiscal 2005), MEW and PanaHome (16.9%), components and devices (13.2%) and home appliances (12%). A broad product portfolio along with a diversified revenue stream shows that the company is not over dependent on any particular segment. This has made the company resilient towards disturbances in demand in any single product category.

Managerial – The Japan Electronics and Information Technology Industry Association (JEITA) has forecast an approximately 37% increase in worldwide consumer DVD player and DVD recorder sales, from 62 million units in 2003 to 85 million in 2008, and strong growth in recordable DVD drives, from 23 million units in 2003 to 88 million units in 2006 worldwide (FinanceAsia.Com, 2 February 2006). The sales of plasma displays worldwide are expected to increase from one million units in 2003 to eight million in 2008. With a positive outlook for the industry, consumer electronics companies will benefit from a strong market position in the coming years.

The most effective management strategy, as the Korean company LG believed is that the customers are essential for their survival. And in response, their management objectives are geared to address their commitment to put it all on the line to meet out customers’ needs. Their customer-oriented objectives are not written in a book but practiced as fundamental management principles. From their first product, the radio, to today’s industry-leading digital TVs and mobile phones, all their products have been derived from the hearts of their customers.

Risk-Bearing – The rising prices of copper, a key raw material for manufacturing of electronic products has increased sharply in recent years, is an inevitable threat for consumer electronic companies. Copper prices have increased by five times (as of May 2005), as compared with 2001 levels. During the first five months of 2006, copper prices have risen sharply by over 77%. Continued increase in copper prices would lead to higher costs for the company’s business, further suppressing its profits (Faiez, 10 May 2006).

2) What disadvantages might there be for consumers of firms experiencing economies of scale?

When a firm refers to economies in scale, it is sourced from the ability of large firms to employ increasingly specialized equipment or personnel. This theory goes back more than 200 years to Adam Smith, who argued that the division of labor is limited by the extent of the market. As a firm’s output expands, it is better able to fully utilize specialized equipment and can justify hiring specialized personnel. For example, consider a metal stamping machine that is used in the production of body parts for automobiles.

The machine can be purchased in a customized form, which is optimized for the production of a particular type of body part—say door panels—or a general-purpose form that will produce any kind of body part. The general-purpose form is less efficient and costs more to purchase than the customized form, but it is more flexible. Because these machines are very expensive, costing millions of dollars each, they have to be used continually to recoup a return on their costs. Fully utilized, a machine can turn out about 200,000 units a year.

If an automobile company sells only 100,000 cars per year, it will not be worthwhile purchasing the specialized equipment, and it will have to purchase general-purpose machines. This will give it a higher cost structure than a firm that sells 200,000 cars per year, and for which it is economical to purchase a specialized stamping machine. Thus, because a firm with a large output can more fully utilize specialized equipment (and personnel) it should have a lower unit cost than a generalized firm.

However, when other source material prices increases, the cost of product will also sharply increase to the detriment of the customers. Another disadvantage to consumers is that they would be compelled to settle for mass-produced products and they will be hard pressed to find unique items (either for gifts, personal pleasure or to fulfil a unique need).

Lastly, the disadvantage would be that the possible low cost of such mass-produced products could make it difficult to market new and competing items from rising firms. Eventually, this could lead to the oligopoly of the larger firms, which may lead to higher future costs and even less innovation in the electronics industry, for instance. In general, the capital intensity of an industry is an important determinant of the potential for economies of scales. In industries like microprocessors, companies are spending upwards of $2 billion on single fabrication plants. In order to pay down fixed costs, companies have a huge incentive to standardize output and push per unit costs down to a bare minimum.

In other industries, like shoe repair or high-end jewelry manufacturing, there are relatively few cost advantages that come from scale. Moreover, while scale economies are an important potential benefit of globalization, they are not the only benefit. Advertising and promotion need to be globalized too. It is just as possible to advertise to global similarities as to national differences, but to do it successfully requires a lot of understanding of the mood and mind-set of different regions. There is an enormous difference between successful global advertising, and the view that what’s good for Iowa or Ontario is good for India or Malaysia. The same is true for global product design.

3) What might economies of scale be inappropriate, undesirable or inaccessible for some firms?

When economies of scale are inappropriate, undesirable or inaccessible, they become diseconomies of scale. This phenomenon occurs where an organization has grown so large that the cost of managing and tracking its activities outweighs the benefits associated with size. Increasing size can bring greater complexity, inefficiencies due to the need to manage a complex system, and a loss of focus. Organizations that suffer from bureaucracy, wherein decisions are passed up and down a chain of command experience large diseconomies of scale.

Many small, quickly growing organizations with fewer than 100 employees experience significant drops in their growth rate and profitability when they pass the 100-employee threshold. The smaller company could operate quite well on an informal basis, since it was fairly likely that all the employees knew one another and had frequent interaction. However, as companies grow, it is no longer possible to know everyone and communication often becomes more complicated and more formal. While the bureaucratization or standardization of communication allows an organization to more tightly control its processes, since no one individual can efficiently manage so many people, it comes at the expense of efficiency (Melnyck and Swink, 2004).

Moreover, Staffan Canback (European Business Forum, 2003) classified diseconomies into four categories: atmospheric consequences, bureaucratic insularity, incentive limits and communication distortion. Atmospheric consequences means that as companies expand, there will be increased specialization of function for employees, but also less commitment on the part of those employees.

Employees often have a hard time understanding the purpose of corporate activities, or to value appropriately the small contribution that each of them makes to the whole. Bureaucratic insularity means that as companies increase in size, senior managers are less accountable to the lower ranks of the organization and to shareholders. Thus, they become insulated and will often strive to maximize their personal benefits rather than overall corporate performance.

In terms of incentive limits, large corporations tend to base incentives on tenure and position, rather than on merit. This puts them at a disadvantage when compared with smaller enterprises, in which employees are often given a direct stake in the success of the company. Communication distortion is a consequence of the inevitable adding of hierarchical layers. Information passed between layers becomes distorted, and this reduces the ability of high-level executives to make decisions based on facts. This research by Canback (European Business Forum, 2003) has a number of practical implications. First, strategy and structure appear to be intimately linked, and strategic development cannot be done in isolation from organizational development.

Also, much of the rationale for mergers and acquisitions seems to be weak, at best. Proponents of mergers typically argue that the resulting larger entity after a merger will realize economies of scale, but the impact of diseconomies of scale is either discounted or not fully recognized. In general, big companies have a harder time when it comes to managing assets and motivating employees than do small companies, and as the company gets still bigger so the problems become still harder.

Lastly, diseconomies of scale may also result from an expanding global business. Lines of communication become longer and more complex. These problems are likely to be greater, the greater is the attempted level of control exerted by the parent company: in other words, the more the parent company attempts to conduct business as though the subsidiaries were regional branches. Multinational organizational structures where international subsidiaries operate largely independently of the parent state will tend to minimize such problems (Suneja 2001, p. 204).

4) What are the implications for the regulatory authorities of the concept of “minimum efficient scale”?

Collins Dictionary of Economics (2000) deemed that the minimum efficient scale is the point on the firm’s long-run average cost curve at which economies of scale are exhausted and constant returns to scale begin. In the theory of costs, the long-run average cost is conventionally depicted as being U-shaped, with economies of scale serving to reduce average cost as output increases to begin with, but then diseconomies of scale set in and average cost rises as output increases.

However, statistical studies suggest that for many industries long-run average cost curves are L-shaped, as shown in Fig. 1. In industries where the minimum efficient scale is large relative to the total size of the market, we would expect to find high degrees of seller concentration, for the market may support only a few firms of minimum efficient scale size. The potential cost disadvantage to firms seeking to enter a market on a small scale vis-à-vis large established firms can also serve as a barrier to entry in certain industries.

Figure 1. The minimum efficient scale (Collins Dictionary of Economics, 2000).

An essential decision facing an international firm choosing to increase its economies of sale is where to locate its production activities to achieve the goals of minimizing costs and improving product quality. For the firm contemplating international production, a number of factors must be considered. These factors can be grouped under three broad headings: country factors, technological factors, and product factors.

One of the most important technological factors is the minimum economies of scale. The concept of economies of scale tells us that as the firm’s plant output expands, unit costs decrease. The reasons include the greater utilization of capital equipment and the productivity gains that come with specialization of employees within the plant (Hill & Jones, 2004). However, beyond a certain level of output, few additional scale economies are available. Thus, the “unit cost curve” declines with output until a certain output level is reached, at which point further increases in output realize little reduction in unit costs.

The level of output at which most plant-level scale economies are exhausted is referred to as the minimum efficient scale of output. This is the scale of output a plant must operate at to realize all major plant-level scale economies. The implications of this concept are as follows: The larger the minimum efficient scale of a plant relative to total global demand, the greater the argument for centralizing production in a single location or a limited number of locations.

Alternatively, when the minimum efficient scale of production is low relative to global demand, it may be economical to manufacture a product at several locations. For example, the minimum efficient scale for a plant to manufacture personal computers is about 250,000 units a year, while the total global demand exceeds 35 million units a year. The low level of minimum efficient scale in relation to total global demand makes it economically feasible for a company such as Dell to manufacture PCs in six locations.

However, everything is not rosy to simply consider the economies of scale. As what happened to Philips company which had invested some $2.5 billion in China. The company now operates 23 factories in China; 6 are wholly owned and 17 are joint ventures. Together they employ some 30,000 people. Philips exports nearly two-thirds of the $5 billion in products that the factories produce every year.

Philips accelerated its Chinese investment in anticipation of China’s entry into the World Trade Organization. The company also planned to move even more production to China by 2005. In April 2003, Philips announced it would phase out production of electronic razors in the Netherlands, lay off 2,000 Dutch employees, and move production to China. Earlier, Philips had stated it would expand capacity at its semiconductor factories in China, while phasing out production in higher-cost locations elsewhere (Einhorn, 27 November 2003).

China’s attractions include continuing low wage rates, an educated workforce, a robust Chinese economy, a stable exchange rate, a rapidly expanding industrial base that includes many other Western and Chinese companies that Philips uses as suppliers, and easier access to world markets given China’s entry into the WTO. Philips has stated that ultimately its goal is to turn China into a global supply base from which the company’s products will be exported around the world. In 2002, more than 20 percent of everything Philips made worldwide came from China, and executives say the figure is rising rapidly.

Several products, such as CD and DVD players, now are made only in China. Philips also is starting to give its Chinese factories a greater role in product development. In the TV business, for example, basic development used to occur in Holland but was moved to Singapore in the early 1990s. Now Philips is transferring TV development work to Suzhou near Shanghai. Similarly, basic product development work on LCD screens for cell phones recently was shifted to Shanghai (Leggett and Wonacott, 10 October 2002).

Philips is not alone in this process. In 2002, more than half of all exports from China came from foreign manufacturers or their joint ventures in China. By 2002, China was the source of more than 50 percent of cameras sold worldwide, 40 percent of microwave ovens, 30 percent of air conditioners, 25 percent of washing machines, and 20 percent of refrigerators (The Wall Street Journal, 8 April 2003).

Some observers worry that Philips and companies pursuing a similar strategy might be overdoing it. Too much dependence on China could be dangerous if political, economic, or other problems disrupt production and the company’s ability to supply global markets. Some observers believe that it might be better if the manufacturing facilities of companies were more geographically diverse as a hedge against problems in China.

The fears of the critics were given some substance in early 2003 when an outbreak of the pneumonia-like SARS (severe acute respiratory syndrome) virus in China resulted in the temporary shutdown of several plants operated by foreign companies and disrupted their global supply chains. Although Philips was not directly affected, it did restrict travel by its managers and engineers to its Chinese plants.

According to Yip (2003), government regulations serve as competitive drivers for firms that raise the globalization potential of their industry and spur the need for a response on the global strategy levels. The common competitive drivers include:

  1. High Exports and Imports Tariffs. The level of exports and imports of final and intermediate products and services (i.e., the extent of interaction between countries) has a significant bearing on the use of a global strategy.
  2. Competitors from Different Continents and Countries. Global competition among rivals from different continents tends to be more severe.
  3. Interdependent Countries. Competitive interdependence among countries through shared business activities can help such firms to subsidize attacks on competitors in different countries. This can spur greater coordination of efforts by competitors to counterattack these subsidies.
  4. Globalized Competitors. When a business’s competitors use global strategy to exploit industry globalization potential, the business needs to match or preempt these competitors.

An essential issue in many international businesses is determining which component parts should be manufactured in-house and which should be outsourced to independent suppliers. Thus, firms should consider much the costs of outsourcing their productions and consider regulatory authorities that might hinder them. Because issues of strategic flexibility and organizational control loom even larger for international businesses than purely domestic ones, an international business should be particularly wary of vertical integration into component part manufacture. In addition, some outsourcing in the form of offsets may help a firm gain larger orders in the future.

Bibliography

Collins Dictionary of Economics (2000). Minimum Efficient Scale. Retrieved 09 November 2006, from xreferplus. http://www.xreferplus.com/entry/1411519.

Einhorn, B. 2003. “Philips’ Expanding Asia Connections,” BusinessWeek, (November 27).

Euromonitor International. 2004. The World Market for Consumer Electronics. UK: Global Market Information Database, (December 18).

European Business Forum. 2003. “Diseconomies of Scale”  16 (Winter): 70.

Faiez, R. 2006. “Copper Prices Score Historical Record at $3.545 by Pound.” The America’s Intelligence Wire (May 10).

Hill, C.W.L. and  Jones, G.R. 2004. Strategic Management: An Integrated Approach, Boston: Houghton Mifflin.

Leggett, K. and Wonacott P. 2002. “The World’s Factory: A Surge in Exports from China Jolts the Global Industry,” The Wall Street Journal, (October 10): A1.

Melnyck, S.A. & Swink, M. 2005. Chapter 4: Capacity Management, Value-Driven Operations Management: An Integrated Modular Approach, 1st ed. NJ: The McGraw-Hill Companies.

O’Meara, P., Mehlinger, H., and Krain, M. (eds.). 2000.  Globalization and the Challenges of the New Century: A Reader. Bloomington, IN: Indiana University Press.

Porter, M. 1986. “Changing Patterns of International Competition,” California Management Review, 28: 9–40.

Suneja, V. 2001. Understanding Business Markets. Florence, KY: Routledge.

The Wall Street Journal . 2003. “Philips NV: China Will Be Production Site for Electronic Razors,” (April 8): B12.

Yip, G.S. 2003. Total Global Strategy. Upper Saddle River, NJ: Pearson Education, Inc.

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