Reasons for Growth of the firm

Although sustained, profitable growth is almost always the result of deliber- ate intentions and careful planning, firms cannot always choose their pace of growth. A firm’s pace of growth is the rate at which it is growing on an annual basis. Sometimes firms are forced into a high-growth mode sooner than they would like. For example, when a firm develops a product or service that satis- fies a need for many customers and orders roll in very quickly, it must adjust quickly or risk faltering. In other instances, a firm experiences unexpected competition and must grow to maintain its market share.

This section examines the six primary reasons firms try to grow to increase their profitability and valuation, as depicted in Figure 13.1.

1. Capturing economies of scale

Economies of scale are generated when increasing production lowers the av- erage cost of each unit produced. Economies of scale can be created in service firms as well as traditional manufacturing companies.16 This phenomenon occurs for two reasons. First, if a company can get a discount by buying com- ponent parts in bulk, it can lower its variable costs per unit as it grows larger. Variable costs are the costs a company incurs as it generates sales. Second, by increasing production, a company can spread its fixed costs over a greater number of units. Fixed costs are costs that a company incurs whether it sells something or not. For example, in a manufacturing setting, it may cost a com- pany $10,000 per month to air-condition its factory. The air-conditioning cost is fixed; cooling the factory will cost the same whether the company produces 10 or 10,000 units per month. In a service setting, a hotel’s registration areas, restaurants, and other areas must be air-conditioned regardless of the number of rooms that have been filled for a particular evening.

A related reason firms grow is to make use of unused resources such as labor capacity and a host of others. For example, a firm may need exactly 2.5 full-time salespeople to fully cover its trade area. Because a firm obviously can’t hire 2.5 full-time salespeople, it may hire 3 salespeople and expand its trade area.17

2. Capturing economies of scope

Economies of scope are similar to economies of scale. With economies of scope, the advantage a firm accrues comes through the scope (or range) of a firm’s op- erations rather than from its scale of production.18 For example, a company’s sales force may be able to sell 10 items more efficiently than 5 because the cost of travel and the salesperson’s salary is spread out over 10 products rather than 5. Similarly, a company such as TOMS, the focus of Case 2, captures econo- mies of scope in its advertising when the same feature is used to advertise TOMS shoes along with TOMS eyewear and TOMS coffee.

2. Market leadership

Market leadership occurs when a firm holds the number one or the number two position in an industry or niche market in terms of sales volume. Many firms work hard to achieve market leadership, to realize economies of scale and economies of scope, and to be recognized as the brand leader. Being the market leader also permits a firm to use slogans such as “Number 1 App in the Apple App Store” in its promotions, helping it win customers and attract talented em- ployees as well as business partners.

3. Influence, power, and survivability

Larger businesses usually have more influence and power than smaller firms in regard to setting standards for an industry, getting a “foot in the door” with major customers and suppliers, and garnering prestige. In addition, larger businesses can typically make a mistake yet survive more easily than entre- preneurial ventures. Commenting on this issue, Jack Welch, GE’s former CEO, once said, “Size gives us another big advantage; our reach and resources enable us to go to bat more frequently, to take more swings, to experiment more, and unlike a small company, we can miss on occasion and get to swing again.”19

A firm’s capacity for growth affects its survival in additional ways. For ex- ample, a firm that stays small and relies on the efforts and motivation of its founder or a small group of people is vulnerable if those people leave the firm or lose their passion for the business. This reason was partly to blame for the failure of Prim, as profiled in Chapter 1. Prim failed in part because its found- ers lost interest in the business and decided to move on to other things. As a firm grows and adds employees, it’s normally not as vulnerable to the loss of a single person or a small group of people’s participation or passion for the business.

4. Need to Accommodate the growth of Key customers

Sometimes firms are compelled to grow to accommodate the growth of a key customer. For example, if Intel has a major account with an electronics firm buying a large number of its semiconductor chips, and the electronics firm is growing at a rate of 20 percent per year, Intel may have to add capacity each year to accommodate the growth of its customer or else risk losing some or all of its business.

5. Ability to Attract and retain  talented employees

The final reason that firms grow is to attract and retain high-quality person- nel. It is natural for talented employees to want to work for a firm that can offer opportunities for promotion, higher salaries, and increased levels of re- sponsibility. Growth is a firm’s primary mechanism to generate promotional opportunities for employees, while failing to retain key employees can be very damaging to a firm’s growth efforts. High turnover is expensive, and in knowledge-based industries in particular, such as biotechnology and software development, a company’s number-one asset is the combined talent, training, and experience of its employees.20 In less knowledge-intensive settings, turn- over may not be as critical, but it is still costly. The American Management Association estimates that the cost of hiring and training a person earning $8 per hour varies from 25 percent to 200 percent of annual compensation.21

Entrepreneurial ventures rarely have the excess financial capital needed to support the unfavorable relationship between employee hiring and turnover. However, when talented individuals leave a large company either voluntarily or through layoffs, entrepreneurial ventures have opportunities to hire people with skills the venture did not pay for them to develop.

Source: Barringer Bruce R, Ireland R Duane (2015), Entrepreneurship: successfully launching new ventures, Pearson; 5th edition.