Growth Methods Utilised by Firms

How many companies can you recognise from the picture below?

20 or 30 of them perhaps?

As you might have guessed from the infographic (courtesy of Oxfam America), each F&B brand that you have identified earlier, is in fact owned by one of 10 very big Multi-National Companies.

Assuming we aren’t pulling your leg (we really aren’t), you might be asking now: How did they get so big? 

In the standard “A” level teaching material, students are taught the market structure spectrum (i.e. Perfect Competition, Monopolistic Competition, Oligopolies and Monopolies). But mention is seldom made of how firms grow.

Many students therefore struggle to answer this seemingly easy question, which is a pity. We think that some knowledge of how firms grow would go some way in understanding the events around us better, hence the motivation behind this short article.

But first, some assumptions.

1) Firms are ultimately profit-maximising. 

This is an undoubtedly over-simplified assumption that says nothing about a firm’s short-term goals and that even longer term goals can be pluralistic (i.e. has many other considerations).

But having this assumption allows us to constrain and frame the rationale behind the firms’ pursuit of growth. Consider the following profit maximisation problem:

Total Profit = Total Revenue – Total Cost

The aim of the firm is to maximise “Total Profit’. Let’s now break it down a little more:

Total Profit = (Price x Output) – (Average Cost x Output)

Total Profit = (Price – Average Cost) x Output

So it becomes clear that to increase total profits, the firm has 2 main ways of achieving this:

1. Increase the difference between Price and Average Cost (i.e. raise Price and/or reduce Average Cost).
2. Increase Output.

Some simple math will inform you that the overall efficacy of Method 1 hinges on Method 2 – you would be hard-pressed to have any profits at all if your output is zero!

Therefore for most part, assuming firms are profit-maximising, they really would prefer to increase output.

2) Growth here refers to an increase in output. 

There is no hard and fast rule to measuring the size of firms.

Frequently used indicators include revenue (turnover), profits (before tax), total output value (at market prices). For simplicity however, we will determine here that a firm grows, when it increases its quantity produced (i.e. total output).

Now that we have established the key assumptions, let us explore how firms may grow.

Firms may grow organically.

For a typical firm earning supernormal profits, they may take the opportunity to reinvest the additional funds in capital expansion, and so increase their capacity to produce more over time.

In such cases, we can say that the firm has grown “organically” – in other words, they had grown through the use of internal resources.

Did you know that Apple is one such company?

Over the last 25 years, Apple has grown largely organically, averaging only 1 acquisition per year, which is unusually low compared to many of its competitors.

Firms often take a “short-cut” and grow inorganically.

As you might imagine, accumulating internal resources and gearing them towards the development of greater productive capacity, or more product variety is often a long-drawn process.

As consumers, there are many items that we do not produce on our own. Instead, we purchase them from shops for consumption, and we do that because of:

1. Convenience, and/or,
2. Our inability to produce them in the time-frame we require the said products.

In fact, firms follow similar logic in deciding the means to expand, through Mergers and Acquisitions (M&A).

In the simplest form:

• A Merger occurs when firms agree to combine and fold their operations and management under a single entity.
• An Acquisition occurs when a firm acquires (purchases) another firm outright, with the latter usually losing autonomy and/or any right to making firm-level decisions in most cases.

In fact, M&A is a very popular firm strategy, accounting for a whopping US$3 trillion in value annually globally.

What drives the popularity of M&A for firms?

There are various reasons to that:

1. Organic growth usually takes a longer time. In many cases, this can mean missed opportunities for the firm since timing is often an important element in business success.
2. M&A allows firms to quickly gain capabilities not easily developed organically. After all, what easier way to gain certain know-how, than to acquire them directly?
3. On the flip side, it can also be used to prevent competitors from doing the same and gaining certain capabilities that might threaten the firm’s performance. 
4. M&A can remove competition that would have otherwise led to depressed prices and lower market share for the industry players. After all, why compete when you can cooperate instead?
5. There is often financial incentive for shareholders of the firms engaging in M&A. For example, shareholders of firms being acquired would receive payouts, and shareholders often benefit from higher firm valuation due to M&A optimism.

The list of well-known M&As are so many that one can google for a list of familiar examples, including Facebook/Whatsapp, Time/Warner etc. In Singapore, local cases include Comfort/Delgro, SMRT/TIBS, 

Firms may grow horizontally.

In many cases, the final product ready for consumption is made in a series of stages, rather than in a single step.

In a typical simplified form, the journey from raw materials to consumption purchase takes the form of the classic supply chain with the following steps:

1. Raw materials
2. Manufacturing
3. Storage/Distribution
4. Retail
5. Consumption

Because it is seldom elaborated in Economics textbooks, students are often aware only of “horizontal” expansion.

Horizontal expansion, referring to the steps listed above, occurs when a firm expands its capacity to produce more within its supply chain rung.

For example, a fashion retailer expanding its product selection sold to include jewelry in its stores, represents a case of horizontal expansion, because it has increased its capacity in the “retailer” step of the supply chain.

Firms may grow vertically.

At some point though, a firm’s expansion ambitions may outgrow any benefits afforded by horizontal expansion for various reasons:

1. The firm lacks control over the other supply chain rungs, which may affect its performance. For example, retailers often run the risk of having nothing in the stores when their suppliers are somehow unable to meet their contractual obligations.
2. The firm is relatively cost uncompetitive as it is not able to control the cost associated with each supply chain rung required for the creation of the final good or service. For example, the fashion retailer may be working with a delivery company who charges $50 per delivery, making the final cost of product fulfilment unattractive.
3. Poor integration with the other supply chain rungs may result in missed business opportunities, as the industry is unable to optimise the offerings at each stage in a seamless fashion. For example, the fashion retailer might be unable to offer silken products because its suppliers have refused to utilise silk for its clothes manufacture, despite strong consumer demand for such products.

In such cases, the firm may therefore choose to expand vertically. A vertical expansion occurs when the firm begins producing goods and services in another supply chain rung.

Large scale examples of vertical expansion, include Amazon’s unprecedented efforts in this enterprise, starting off first as an online retailer, and then expanding to include its own warehouses, and has now even launched its own delivery network!

It is important to note that whether the firm should grow:

1. Organically or via M&A, or
2. Vertically or Horizontally,

do not usually take place as individual decisions. Possible expansion permutations therefore include growing:

1. Horizontally organically
2. Horizontally via M&A
3. Vertically organically
4. Vertically via M&A

There are many other considerations for a firm when expanding.

Finally, we would like to point out that this article merely scratches the surface, to inform the reader of the key growth methods a firm may utilise.

A few other methods or considerations a firm may take note of when expanding include:

1. Government support or regulations
2. Prevailing business sentiments
3. Economies or dis-economies of scale
4. Private or public investments

The article concentrates on the classic modes of growth and does not take away the fact that business expansion is usually a complex decision.

So what other interesting examples of firm expansion can you think of? Do share them with us in the comments below.

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