Diseconomies of Scale: New Normal for Many Growing – Decentralized Groups

October 01, 2020

I see countless examples of significant diseconomies of scale in growing, decentralized groups. Based on my early management experience in airline, manufacturing and retail and continuing on today in our Spend Management practice, I believe that centralized management structures as it relates to staff functions such as HR, Purchasing, and IT perform better, more efficiently and more cost effectively than the decentralized organization structures that are common today.

I would also argue that organizations that are focused on growth, and the inherent “economies of scale” that come with well planned and executed growth and acquisitions are actually realizing “diseconomies of scale” if they operate with a decentralized management structure. Decentralized management structures by their very nature cede management control and authority to several managers in various locations. While the decentralized approach may be viewed as more in touch with local needs, the risks, inefficiencies, and additional costs that come with decentralized management are eye opening if well understood.

Many successful organizations seek growth and scale…. with the expectation that the group will become more efficient, more profitable, and create a sustainable competitive advantage. I would argue however, that If that growth strategy is not aligned with the right management philosophy and the right management structure, the expected benefits from growth might turn into unexpected higher costs and new inefficiencies, which is contrary to the intended objectives.

Organizations on a growth trajectory or those that have already achieved those growth objectives expect that growth will provide the ability to do more, at less cost, driving new efficiencies, throwing off additional profit in the process and achieving competitive advantage.

While our business supports many types of organizations, large and small, profit and non-profit, I see countless examples of significant diseconomies of scale in growing, decentralized groups costing organizations hundreds of thousands and millions of dollars each year.

Auto Dealership Space

While retail in general is undergoing an upheaval with frequent store closings and bankruptcies, the Dealership space is undergoing consolidation through mergers and acquisitions. The pace in the dealership world doesn’t appear to be slowing down. Large Dealership groups are buying single and dual point stores, large groups are buying other large groups and so on. The notion of consolidation makes sense to anyone with a fundamental understanding of economics……consolidation should bring economies of scale, less cost, more efficiency, more profits…competitive advantage.

Economies of Scale – Expectations of Leadership

Executives driving growth through mergers and acquisitions expect to realize economies of scale across the organization that will be realized through the following new benefits

  • Shared Business Functions – Businesses or units share centralized functions
  • Staff Efficiencies – Fewer staff needed to support a larger organization
  • Purchasing Leverage – Larger spend and leverage should reduce prices and costs
  • Specialization – Larger size allows for more specialization in staff and functions reducing risk
  • Lower Capital Costs – Improved cost of capital opportunities given larger asset base
  • Facility Consolidation – Fewer or better sized facilities to house the organization
  • Knowledge / Data – Greater efficiency from additional data/knowledge
  • Cost Advantages – New efficiencies, higher output, lower costs should provide cost advantages
  • Competitive Advantage – All of the above listed benefits should provide competitive advantage over smaller, less efficient competition

Diseconomies of Scale – New Normal in Many Large Decentralized Groups

For organizations that operate in a “decentralized environment” and are growing, diseconomies of scale can occur from the following:

  • Duplicative Functions – Rather than sharing a centralized function, functions are replicated throughout an organization, causing waste. This is often referred to as over-crowding…. too many people doing the same task and/or occupying a space that is physically too small for them.
  • Staff inefficiencies – It is easy to reason that additional staff and management will be required to staff and support duplicative functions.
  • Lack Purchasing Leverage – Decentralized purchasing functions generate smaller purchases with more suppliers, sub-optimizing their leverage, realizing higher costs than are necessary and creating more work for payables staff to pay more suppliers. A centralized Purchasing function will aggregate and leverage their unique spend position to maximize efficiencies and price.
  • Lack of Specialization – Many Executives view many of their managers as “utility players” who can learn and play any position such as Human Resources, Purchasing, Information Technology, Safety and more. Managers who receive no formal training and little operational direction in their newly assumed responsibilities may have good intentions but can’t generate results locally that an experienced resource could achieve in a centralized environment. They lack the data, the process experience and most often the time required to generate solid results.
  • Facility Duplication– A large group might operate with eighteen(18) Accounts Payable offices which is inherently less efficient than one central Accounts Payable location……using more space and labor than is required to pay suppliers, not to mention technology costs and other miscellaneous expenses.
  • Lack of Actionable Information – While data has potential value, greater volumes of data doesn’t add value if not mined, utilized, or applied to the appropriate management challenges. As an example, if your centralized corporate office does not know how much they spend in a given expense category annually across an organization or know who the suppliers are in a given expense category, you are not using your data effectively and wasting a valuable opportunity to leverage your spend.
  • Cost Increases – Poor specifications and requirements, too many suppliers, the wrong purchasing philosophy (tactical vs. strategic), weak or non-existent purchasing processes, will all guarantee poor pricing, increased costs, inefficient processes, unfavorable business terms and new risk. This is an all too common occurrence in decentralized purchasing environments.

Other Issues that can create Diseconomies of Scale

Some of the other issues that acquisitions, and growth provide can add to overall diseconomies of scale:

  • Complexity – Too many locations, too little management control and too many products purchased or sold can add complexity and waste.
  • Bureaucracy – When an organization becomes so big, so bureaucratic that management decision-making is continually delayed, or not made at all, inefficiencies are created and become institutionalized in time.
  • Broad Span of Control – Management spans of control can increase to the point that leaders can’t effectively manage or control anything. Managers without stretch objectives, proper oversight and management attention can turn into “caretakers” just going through the motions, never improving performance to any large degree.
  • Insecurity – Acquisitions and mergers tend to cause uncertainty among the remaining staff, which can breed insecurity and the desire by those who “made the cut” to play it safe and not rock the boat.
  • Management Ineffectiveness– Some managers just refuse to lead and manage – others are “too busy” to act, their plates are too full to address obvious problems, which frequently becomes an excuse for doing nothing. Doing nothing will often lead to institutionalized inefficiencies that are hard to reverse later.

Examples of Diseconomies of Scale in Large Groups

Diseconomies of scale can manifest themselves in many ways throughout an organization. Below are some glaring examples:

  • Pricing – Newly acquired stores have better shipping rates with UPS and FedEx than the acquiring group. How could that be? The larger group should have more leverage and better buying power to achieve better rates than the acquired store, but never used their leverage effectively.
  • Supply & Service Costs – Stores within a large automotive group have higher supply prices (at the item level) than smaller single point stores within the same geographic area. Sourcing at the organization level has not taken place.
  • Supply Base – There are no more than 130 expense categories in a dealership. If the organization was “lean and smart” they would have no more than 3 suppliers per category or a total of 390 active suppliers. Yet it is common to find 1,000, 1,500, 2,000 or more suppliers across larger organizations. This is a tell-tale sign that the group is “tactical” in their purchasing approach, sub-optimizing their unique leverage which is the primary reason they are paying prices 25% higher costs. Additionally, they now need an army of AP clerks and more offices to pay all those suppliers.
  • Management Specialization – Many large groups operate with a completely decentralized model. In this case many managers across an organization are working(sourcing) the same category(crowding) arriving at different results (price inconsistency) and growing the supply base(inefficiency) which requires additional administrative costs to support. Imagine twelve different service managers negotiating with different suppliers and applying twelve different shop supply solutions across a large group for the same items. A centralized model would capitalize on economies of scale and would utilize one or two people sourcing a common solution across the entire enterprise.
  • Controls – Large enterprises are sometimes ignorant, unwilling, unable, or too busy to implement small process changes that can result in thousands of dollars in savings to an organization. Sending information across town to other stores via FedEx Overnight when a courier can deliver information in the same timeframe at ½ the cost is a prime example of ignoring obvious efficiencies than can be achieved. Yet this occurs all the time. Why does his happen? Management hasn’t considered the logistics and the costs because they are too busy or afraid to implement a corporate policy to eliminate this waste.
  • Lack of Planning – Decentralized operations just happen without much if any planning. There is no sourcing plan, few if any expectations about cost reduction and not much attention is paid to the purchasing tasks unless problems occur. Without a plan, performance improvements do not occur. If problems and inefficiencies already exist, the problems are then exacerbated by growth and inefficiencies grow larger and become standard operating procedure.

Diseconomies of Scale – The Cost is Huge!

Independent research firms such as Aberdeen and Gartner have numerous studies concerning the inefficiencies created by a de-centralized management approach to purchasing and other functional disciplines. The problems they cite are only multiplied across organizations that become larger. Aberdeen, a few years back reported that organizations that “centralize” their procurement functions will realize 25% cost savings across that spend, which we achieve through our practice. Imagine 25% reduction in costs, with those dollars falling to the bottom line as new profits? Why wouldn’t a leader jump on this opportunity and get moving yesterday? The decentralized management philosophy that is in play is responsible for these wasted dollars and weaker than expected profit levels, yet management in many cases ignores the problem and the new profit opportunity.

Based on my data and experience, It is not a stretch to suggest that “diseconomies of scale” are costing large groups(Groups with $750MM+ annual sales) a minimum of $2MM to $5MM in unnecessary costs annually, or said another way….in lost profits. For groups north of $500MM a year in overall sales, annual spend will be at least $25MM annually for supplies and services. A 15% or 20% reduction in spend is certainly achievable annually if the organization is centralized. And, if centralized, the demands on the AP and finance staff will be greatly diminished resulting in new “soft costs savings” from labor.

You would think owners, investors, shareholders, and executive management would be excited about the newfound efficiencies and profits available with “centralized management models” so that they could realize the economies of scale that comes with growth. The reality is that most groups have not centralized Operations and Finance to any large extent…. wasting significant dollars and resulting in lost profit opportunities. I suspect this reality might change if the economy softens a bit.

How to Achieve Your Economies of Scale in Operations

In business school most of us where taught that effective leadership, effective management required us to ensure that we understood what our obligations to the organization are. Quite simply, leaders and managers should ensure the following approach is accomplished for and through our teams:

  • Plan – Executives create a vision, a plan, and set stretch objectives
  • Organize – The Executive team will organize and provide resources, remove obstacles to success, get the team onboard with the vision, plan, and objectives
  • Direct – The leadership team will build a team of strong managers, give them the direction, and then get out of the way. Getting out of the way does not mean abdicating responsibility, however.
  • Control – Well defined and well aligned performance metrics are a staple of any effective management team and must be tied to the company and corporate objectives to ensure alignment, focus and success.

Centralization to Realize Economies of Scale

Managing for economies of scale is tough to execute and achieve in a decentralized environment, where everyone is in charge. Reliance on decentralized functions will sub-optimize results, cost your organization money, and reduce your profitability.

A centralized approach is absolutely imperative to organizations hoping to realize all the benefits of scale through acquisitions and mergers. The economy of scale opportunities are there and the benefits are significant to the bottom line. The first step toward this end is for senior management to set that centralization objective in stone and getting the team on-board.

In Summary

Growing companies pursue growth with a common objective to achieve economies of scale including, new efficiencies, lowered costs, improved profitability and in the end to achieve competitive advantage. Size can provide economies of scale…no doubt. Size can also provide diseconomies of scale and increase organization costs.

Centralization of organization functions is key to realizing economies of scale. Business functions that are decentralized are by their very nature, less efficient than the alternative. Decentralized functions will increase inefficiencies, increase costs, slow down decision-making, create frustrations with staff and ultimately cost an organizations hundreds of thousands and/or millions of dollars in excess costs and…lost profits.

Ultimately, diseconomies of scale can occur by executive management who have not made the decision to centralize functions. Reasons for this can include:

  • Weak Expectations – Executives are busy and there is competition for their limited time. High expectations can drive “breakthrough performance”. But if executive management does not take the time to lay out clear, challenging expectations for the new larger group, which includes operational efficiencies, those performance improvements will never happen.
  • Bias Toward Revenue – Auto Groups are focused on top line sales and net profit. Most profitability problems can be addressed by selling more. Operational improvements are left to those further down the chain of command and often do not occur.
  • Decentralization – The management philosophy allowing decentralized functions to exist is the primary contributor to diseconomies of scale
  • Management Fear/Indifference – Growth brings change. Some management can see the economies of scale opportunities and will attack them. Others may see the opportunities, but may be afraid to act, or they may be “too busy” to take action, or they may hope the problem will be addressed by someone else.

Realizing complete economies of scale across a growing organization can provide significant, sustainable profit improvement opportunities to an organization frequently providing millions of dollars in new profits. The first step for executive management is to examine current profitability levels considering the organization structure. If the organization is decentralized, particularly the Purchasing, HR, and IT functions, then management needs to set new, challenging expectations and objectives to centralize those functions across the organization quickly. Once centralization has occurred and is managed effectively, new efficiencies will occur which will be visible with new bottom line profitability, the ultimate objective driving growth to begin with.