3.9.1 Assessing a change in scale

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    3.9.1 Assessing a change in scale

    The reasons why businesses grow or retrench

    Retrenchment = when a business decided to significantly cut or scale back its activities, and use their resources more effectively/carefully

     

    Factors that cause retrenchment:

    • An uncompetitive cost structure
    • Inadequate returns on investment
    • Poor competitive position
    • Financial distress (e.g. decline in sales revenue)
    • Market decline – more people buy online rather than going to department stores
    • Failed takeovers
    • Economic downturn (e.g. during a recession, a firm will reconsider their options)
    • Change of ownership

     

    Methods of retrenchment:

    • Reduced output and capacity
    • Product and market withdrawal
    • Downsizing/rationalisation
    • Disposals of business units
    • De-mergers

     

    Why businesses grow:

    • Profit – firms grow to achieve higher profits and provide better returns for shareholders. The return to shareholders might be a combination of a rising share price allied with a share of profits via dividend payments.
    • Costs – economies of scale in the long run increase the productive capacity of the business whilst also leading to lower average costs. Experiencing economies of scale help a business to raise their profit margins at a given market price
    • Market share – firms may wish to increase market dominance giving them increased pricing power. This market power can also be used as a barrier to the entry of new businesses in the long run
    • Risk – growth might be motivated by a desire to diversify production and/or sales so that falling sales in one market might be compensated by stronger demand in another sector.
    • Managerial – motivational theories of the firm predict that business expansion might be accelerated by the demands of senior and middle managers whose objectives differ from major shareholders.

     

    The difference between organic and external growth

    Internal (Organic) Growth = this involves expansion from within a business, for example by expanding the product ranges or number of business units and location

    • It builds on the business’ own capabilities and resources. For most firms, this is the only expansion method used

     

    Types of organic growth:

    • Developing new product ranges
    • Launching existing products directly into new international markets (e.g. exporting)
    • Opening new business locations – either in the domestic market or overseas
    • Investing in additional production capacity or new technology to allow increased output and sales volume

     

    Advantages of organic growth:

    • Less risk than external growth (e.g. takeovers)
    • Can be financed through internal funds (e.g. retained profits)
    • Builds on the firms strengths (e.g. brands, customers)
    • Allows the business to grow at a more sensible rate

     

     

    Disadvantages of organic growth:

    • Growth achieved may be dependant on the growth of the overall market
    • Hard to build market share if business is already a leader
    • Slow growth – shareholders may prefer more rapid growth as they will receive lower dividends
    • Franchises (if used) can be hard to manage effectively

     

    External Growth = this involves expansion from outside the business mostly through mergers (where two company’s work together usually because both are starting to become unsuccessful) and takeovers (original company no longer exists – e.g. Asda is owned by Walmart but is still called Asda in the UK)

    • For positive synergy to occur, the result should mean higher revenue or profits than the two individual businesses achieved

     

    How to manage and overcome the problems of growth or retrenchment

    Barriers to growth:

    • Economies of scale (including technical, purchasing, and managerial) and diseconomies of scale
    • Economies of scope
    • The experience curve
    • Synergy
    • Overtrading

     

    Economies of Scope = this occurs when it is cheaper to produce a range of products rather than specialise in an handful of products

    • The management structure, administration systems, and marketing departments are capable of hung out these functions for more than one product
    • Expanding the product range to exploit the value of existing brands is a wag of exploiting economies of scope
    • Brand extension to widen the brand appeal
      • Example = Easy Group under the control of Stelios where the distinctive Easy Group business model has been applied (with varying degrees of success) to a range of markets (e.g. EasyJet, EasyMoney, EasyBookings, EasyCar etc)

     

    The Experience Curve = a curve showing the theory that the more experienced the firm is  apt making a product, the better, faster, and cheaper it is able to make it

    Logic behind the experience curve:

    • As firms grow, they gain experience
    • Experience provides an advantage over the competition in the industry
    • The ‘experience effect’ of lower unit costs is likely to be particularly strong for large and successful businesses (market leaders)
    • Therefore:
      • Experience is a key barrier to entry
      • Firms should try to maximise their market share to gain experience
      • External growth (e.g. takeovers) may be the best way to do this

     

    Evaluative factors of the experience curve:

    • Market leaders often become complacent
    • Experience can cause resistance to change and innovation
    • This could cancel out cost benefits of experience
    • The experience curve concept is a relatively old theory that is less relevant in a competitive environment that changes is rapidly
    • Example = Yorkshire Tea was founded in 1886 in Harrogate and has remained one of the leading brands for tea bags – it has recently overtaken Tetley to become the 2nd largest tea brand in the market (shows market share is expanding due to the experience they have gained throughout the years they have been in business) OR Amazon who have learnt that their model of selling more than any other retailer is their key strategy and it works very effectively

     

    Synergy = a key concept associated with external growth. It happens when the value of two businesses brought together is higher than the sum of the value of the two individual businesses

    • Cost synergy is where cost savings are achieved as a result of external growth – this is an example of economies of scale
    • Revenue synergy is where additional revenues are achieved as a result of external growth

     

    Cost synergies:

    • Eliminating duplicated functions and services (e.g. combining the two accounting departments) – achieve managerial economies of scale
    • Getting better deals from suppliers which might be possible if combining two businesses gives them improved bargaining power – achieve purchasing economies of scale
    • Higher productivity and efficiency from shared assets; can capacity utilisation of the combined businesses be improved, perhaps by closing down spare capacity – achieve commercial economies of scale

     

    Revenue synergies:

    • Marketing and selling complimentary products
    • Cross selling into a new customer base
    • Sharing distribution channels
    • Access to new markets (e.g. through existing expertise of the takeover target)
    • Reduced competition – more control over the market

     

    Overtrading = this happens when a business expands too quickly without having the financial resources (capital employed and working capital) to support such a quick expansion. If suitable sources of finance are not obtained, then overtrading can lead to business failure

     

    Symptoms of overtrading:

    • High revenue growth but low gross and operating profit margins
    • Persistent use of a bank overdraft facility
    • Significant increases in the payables days and receivables days ratios
    • Significant increase in the current ratio (current assets and current liabilities)
    • Very low inventory turnover ratio
    • Low levels of capacity utilisation

     

    Managing the risk of overtrading:

    • The most effective steps to avoid overtrading are essentially those that would be taken as part of a sensible cash flow and working capital management. For example:
      • Reducing inventory levels
      • Scaling back the pace of revenue growth until profit margins and cash reserves have improved
      • Leasing rather than buying capital equipment
      • Obtaining better payment terms from suppliers
      • Enforcing better payment terms with customers (e.g. through prompt payment discounts)

     

    Greiner’s Model of Growth = this suggests and attempts to predict that there are six phases and five crises that businesses may experience as they grow

    Direction – crisis of leadership:

    • Informal communication starts to fail
    • Business is now too big for leaders to get involved in everything

     

    Delegation – crisis of autonomy:

    • Business now has functional management
    • The founder/leader is still struggles to let go

     

    Coordination – crisis of control

    • More formal management structures in place – separate departments
    • New layers of hierarchy are needed to keep control

     

    Collaboration – crisis of red tape:

    • A dangerous growth in organisational bureaucracy, rather than in fundamental activities
    • Slowing decision-making, and the businesses misses external changes (e.g. in the economy or in social trends)

     

    Alliances – crisis of growth:

    • Growth slows down due to the business running out of ideas
    • Alliances are sought (including new business owners)

     

    Evaluative points of Greiner’s growth model:

    • Growth is a difficult thing to achieve
    • Growth poses many management and leadership challenges (crises) that firms have to overcome
    • Leadership and organisational structure have to evolve to reflect the growth of a business
    • Businesses that don’t adjust as they grow will experience lower growth than those that do

     

    Disadvantages of Greiner’s growth model:

    • Like most models, it is simplistic
    • Not every business will suffer crises as it grows as many adapt easily without enduring any obvious panics or crises – this could be due to the type of business, the environment they operate in, and the style of leadership they adopt
    • The model doesn’t really take account of the pace of growth, particularly in an increasingly dynamic external environment

     

    The impact of growth or retrenchment on the functional areas of the business

    Constraints on growth:

    • Resistance to change by employees and unions
    • The cost of implementation
    • Availability of finance
    • The time period required
    • The effect upon the brand image and marketing
    • Types of organisational culture

     

    Cost of implementing growth:

    • Growth will incur all sorts of fixed, variable, and sunk costs. This can restrict a business from changing because:
      • Short term owners (shareholders) may not see the need for the change which undermines their profit and dividends
      • Fixed costs in terms of an increase in salaries and management systems
      • Variable costs in terms of an increase in payments to reward performance
      • Sunk costs in terms of reorganising employees and training

     

    Availability of finance to implement change:

    • Growth will always require finance, however it may be difficult to source additional funds because:
      • Banks may be unwilling to lend to a business that needs to change as the risk may be deemed too high
      • The returns from the growth are difficult to quantify and hence justify finance

     

    The time needed to implement growth:

    • It is necessary for individuals to have time to adapt to the change
    • High labour turnover may undermine successful implementation of growth
    • Short term objectives must support the overall strategy rather than undermine it

     

    Marketing implications of growth:

    • Growth will affect how the good or service is perceived by the customer:
      • Bad social media or press reviews may undermine the morale of the employees as the organisation changes
      • Marketing campaigns may need to be adapted to signal a change in the organisation of the business and how it affects customers
      • Attention must be paid to the quality of service and the goods to ensure that they meet the expectations of the customer
      • The change may cause an aggressive response from competitors

     

    Implications of retrenchment for change management:

    Assessing methods and types of growth

    Types and direction of integration:

    Backward Vertical Integration:

    • This involves acquiring a business operating earlier in the supply chain (e.g. a retailer buys a wholesaler)
    • Example = IKEA buying forests in Romania and Bulgaria in order to reduce unit costs and have a sufficient supply of raw materials at the right price. This also eliminates suppliers as they have their own prices for the materials now

     

    Conglomerate Integration:

    • This involves the combination of firms that are involved in unrelated business activities (e.g. investment funds that fund in entrepreneurs)
    • Example = when Dragons Den invests in entrepreneurs who come to pitch their ideas and products OR when Walt Disney and American Broadcasting Company merged and the combined company brought together the most profitable television network and its ESPN cable service with Disney’s Hollywood film and television studios, the Disney Channel, its theme parks and its well-known cartoon characters and the merchandise sales they generate

     

    Forward Vertical Integration:

    • This involves acquiring a business further up in the supply chain (e.g. a vehicle manufacturer buys a car parts distributer)
    • Example = Bookers took over £40m worth of Budgens and Londis grocery stores. This would’ve caused positive synergy to occur because neither grocery stores had sufficient market share and bookers has a large market share in the wholesaled industry. Because of this, their profits/revenue would be much huger combined

     

    Horizontal Integration:

    • Businesses in the same industry and which operate at the same stage of the production process are combined
    • Example = Marriott bought Starwood to become to largest and most successful hotel chain in order to reduce competition and expand their hotels into other cities and areas. This would’ve caused positive synergy to occur because their net profit would be much more than what it was before

     

    Merger = this is a combination of two previously separate firms which is achieved by forming a completely new business into which the two original firms are integrated.

    • A merger can be seen as a decision made by two businesses that are broadly “equal” in terms of factors such as size, scale of operations, customers etc.
    • The enlarged, merged business, through the changes made by combining both together, can cut costs, grow revenues and increase profits – which should benefit shareholders of both the original two businesses.
    • What typically happens in a merger is that a new company is formed – and the shares in the new company are distributed to the shareholders of the two original businesses in a suitable split.

     

    Takeover (or Acquisition) = this involves one business acquiring control of another business

    • Takeovers are the most common form of external growth, particularly by larger businesses.

     

    Reasons for undertaking takeovers:

    • Increase market share
    • Acquire new skills
    • Access economies of scale
    • Secure better distribution
    • Acquire intangible assets (brands, patents, trade marks)
    • Spread risks by diversifying
    • Overcome barriers to entry to target markets
    • Defend itself against a takeover threat
    • Enter new segments of an existing market
    • Eliminate competition

     

    Why takeovers are preferred over organic growth:

    • Existing products are in the later stages of their life cycles, making it hard to grow organically
    • The business (in particularly its management) lacks expertise or resources to develop organically
    • Speed of growth is a high priority
    • Competitors enjoy significant advantages that are hard to overcome other than acquiring them

     

    Disadvantages of takeovers:

    • Takeovers are the highest risk method of growth
    • High cost involved – with the takeover price often proving too high
    • Problems of valuation (see the price too high, above)
    • Upset customers and suppliers, usually as a result of the disruption involved
    • Problems of integration (change management), including resistance from employees
    • Incompatibility of management styles, structures and culture
    • Questionable motives

     

    Why takeovers fail:

    • Price paid for takeover was too high (over-estimate of synergies)
    • Lack of decisive change management in the early stages
    • The takeover was mishandled
    • Cultural incompatibility between the two businesses
    • Poor communication, particularly with management, employees and other stakeholders of the acquired business
    • Loss of key personnel and customers post acquisition

    Competitors take the opportunity to gain market share whilst the takeover target is being integrated

     

     

     

     

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