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Is consolidation a good thing for business?

There is a pattern that growing companies follow, as the costs to run them increase, they focus excessively on efficiency and centralisation, which results in a reduction in innovation. In the end, this almost always results in a lack of adaptivity, which in turn can lead to bankruptcy or a hostile takeover.

This is not a happy tale, but it is a systematic pattern that a large group of scientists regularly observe. One of them, the theoretical physicist Geoffrey West (former president of the renowned Santa Fe Institute) explains this beautifully in his book Scale. I’m surprised not so much that companies themselves do not learn from this knowledge, but that legislators and regulators worldwide explicitly strive to consolidate banks and insurers in particular. The paradox is that well-intended “safe” consolidation has, in many cases, paved the way to rigidity and ultimate downfall.

For decades, Geoffrey West and his colleagues have been studying how cities grow and comparing this with how companies grow. They have found that, worldwide, there is a consistent difference between the dynamics in urban growth and in business growth. Cities growth is superlinear: every time the population doubles, the income per inhabitant increases by roughly 15%, the innovation increases by 15% and the diversity of businesses also grows by 15%. Unfortunately, this growth rate applies also for less pleasant metrics such as crime.

Disadvantages of Scale

West’s research has found that the exact opposite happens for companies: they grow sublinearly. As the turnover per employee decreases, the profit per employee decreases and the research and development (R&D) spend per employee decreases with growth in the number of employees. Moreover, this is with a much larger variance in outcomes than in relation to cities and without consistent percentages. It is certainly not too far to say that the revenue per employee, for example, decreases by 10% when the number of employees doubles.

These scale disadvantages arise because as the size of the business increases, more maintenance costs are required within the network to connect employees. More rules, more communication channels (e.g. meetings) and more top-down control makes the organisation’s running costs higher. More layers of management lead to more principal-agent problems: management has other objectives for themselves than acting in the pure interest of the company. The job itself and promotion opportunities then become more important than reinvigorating the company. The bureaucracy that arises from different management layers breeds a pressure to maintain profit through cost reduction, with less room for precious creativity, innovation and adaptability.

So many companies end up being over-specialised and very sensitive to small changes in the business environment. There is nothing wrong with specialisation, but the combination of optimisation and efficiency with increasing size and costs of keeping the company together results in increasing fragility. A change in the business environment can result in that company being left behind and ending up at the corporate cemetery. A few examples of companies who have suffered this fate include Polaroid and Blockbuster.

Management often attempts to compensate for disadvantages of scale with higher growth objectives. Often this is imposed. This results in, for example, hasty acquisitions, but also losing the focus on the purpose of the company. One only has to look at Volkswagen, the largest car manufacturer in the world, which had to commit (technical) fraud in a desperate attempt to meet their growth expectations.

Avoid risk at all costs

Finally, large companies are often risk averse when it comes to new technology because they are afraid of the failure that trying something new could bring. Settling for small short-term profit that cost saving creates is easier than suffering short-term loss thanks to investing in future-proofing the business. This is how Dyson could beat Hoover – the older, bigger Hoover was too scared of the new technology.

In practice this means that, in order to secure their long-term survival, businesses must react and adjust faster. Innovation comes from diversity in thinking, R&D and decisiveness. It is critical for every company to check whether R&D spend and innovation are in slow decline.

Innovation and small-scale business experiments should be an objective in the key performance indicators (KPIs) of any company. It is also good to analyse whether your own business units can operate autonomously or if they are part of a larger whole, which introduces the disadvantages of scale. A great example of this is W.L. Gore, producer of Gore-Tex, that fosters great autonomy from local groups with few management layers and few top-down checks. Using West’s terminology, the maintenance costs remained low for this large company. The result is very high employee satisfaction and a lot of innovation for a long period of time.

Unfortunately, all of these principles are radically contradicting the global trend to consolidate. It is a trend that is supported by supervisors who are increasingly steering companies towards merging in order to create scale. Big is strong. Except in the reality that Geoffrey West exposes so beautifully.