Economies of Scale Studies

Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Review Unless you really understand the source of a company’s competitive advantage through pinpointing Wal-Mart’s lower structural fixed costs due to regional economies of scale, NOT absolute size, you will waste time with cluttered thinking inundated by noise. Take, for example, the book: What I Learned from Sam Walton: How to Compete and Thrive in a Wal-Mart World by Michael Bergdahl (2004)

You most become an expert in understanding competitive advantages. The particular type of advantage, a cost advantage, especially a cost advantage associated with economies of scale, will be our focus here. The author writes in the first paragraph (page 15) and italics are my comments: If it seems impossible to compete directly with big-box retailers like Wal-Mart on price, the unvarnished truth is that it is! The combination of their buying power of big brands (We saw that WMT was unable to gain price concessions from branded suppliers), private-label programs (can be imitated), off-shore manufacturing (other competitors can copy this), distribution efficiencies (Yes), incredible technology, (again, able to be copied), culture, expenses structure, company-owned truck fleet (again, able to be copied by competitors) and low-paying non-union jobs (low-paying compared to what?) provide a viselike grip on costs no competitor can match (False—note Target has better profitability in some regions of the country than WMT). By putting all of these competitive advantages together (Company culture is not a structural competitive advantage!), Wal-Mart is able to roll back its prices to the lowest possible levels. You have to be careful not to be lost in CEO charisma, company culture, new technology, etc. when reading business biographies or else your mind will turn to goo. You should have a particular focus on the true source of profitability not on stories or anecdotal suggestions of profitability. Differentiation and Sustainable Profits from Strategic Logic by J. Carlos Jarillo The figure on the next page shows how selling a product that nobody can copy, allows companies to make profits. Coke has a reputation that it can charge somewhat more for its products than an unknown competitor. For the same price most people would invariable choose Coke. Coke can therefore, charge a bit ore and still preserve a large market share. If we choose 20% as our ‘bit more’; for a competitor to start snatching sales away from Coke, it must sell 20% cheaper. The brand is worth 20% of the price. As the leader, Coke can set the price it pleases. But if the price is 60 as shown on the left side, it will find that its competitors, even selling for 20% less, can make money. In normal conditions, these competitors will enter and start reducing Coke’s market share. Evidently, this is not good for Coke. Even, if the margin is good, volume decreases and with it overall profits. But Coke can play the game differently: it can price its product at 50. In this case, potential competitors cannot enter, for they cannot cover costs selling 20% cheaper at that price ($40 or at their level of cost with $0 profit). Coke can, therefore, make real profits (in costs we include everything, even normal www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

returns on capital) and its competitors cannot do anything about it--but no more than the 20% premium. To try to earn more than that by raising prices would be counterproductive, for it will simply open the door to competitors. If Coke really wants to make more money than that, it must improve its premium, that is, the extra money buyers are ready to pay to drink the “real thing.” There is another possibility, of course, which is to lower costs. In this example we have considered that Coca-Cola’s and its competitors costs are the same. It shows that, even with the same costs as everybody else, a company that has something unique, for which its customers are ready to pay, can make real money, in a sustainable way. 70

Red signifies profits while blue shows costs.

60 50 40 30 20 10 0 leader

Potential Competitor

That, to make money, one has to have something unique is so well accepted today that general opinion has gone a step further and maintains that a commodity cannot be profitable. Thus a product completely undifferentiated, always identical to itself, such as gold, a variety of wheat or a grade of oil, cannot justify any price premium, for buyers do not really care who the supplier is. But the examples should already indicate that the statement that commodities cannot be profitable does not really bear scrutiny: both gold and oil have been profitable things to sell for years (wheat less so). The reason is that, as we saw earlier, there are two reasons that prevent entry to a business. The first is the impossibility of actually making the product. The second is the impossibility of making the product on a cost-competitive basis. Entry-deterring Price The leader that has a brand premium and or costs advantages can earn money above opportunity costs in a sustainable way. However, the amount of money to be earned is limited precisely by the importance of these advantages. A company cannot earn more that it ‘deserves’. A company, no matter how dominant, that sets too high a price ($60 in our example) will not earn more, but less. Too high a price will invite entry by competitors, helping them to enter the business profitably despite their higher costs. If the company attracts too many competitors, the market will fragment and volumes will diminish, even for the leading company, perhaps hurting its cost position. The best way to avoid competition is to try to prevent entry, not to try to expel competitors from the market. Coke should have killed Pepsi in its crib www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

when the competitor first entered the supermarket market. Coke ignored this threat. The best way to prevent entry is to set a price that, from the beginning, makes it clear to potential entrants that they will never be able to obtain a decent return on their investment. This is known as the concept of an ‘entrydeterring price’. Cost differences Take the mature video-rental business; all competitors both actual and potential have similar costs. It is difficult to make money in these circumstances: since the offer is essentially identical, the only way to attract customers is with a low price. But in a highly competitive market, there is always someone ready to keep lowering the price until opportunity costs are reached, as we have seen. And if those opportunity costs are the same for everybody, nobody earns much above or below the industry’s cost of capital. What happens, however, if somebody has lower costs then the rest? Imagine a situation where a competitor has costs that are, consistently, 10% lower than those of the others. This competitor, whom we will call the cost leader, will be able to earn real profits, for its competitors cannot sell forever below their own costs. Say the cost leader has costs per unit of $10 while the next competitor--with the next lowest costs are $12--and the remaining competitors have costs above $12. The cost leader has a ‘guaranteed’ profit equal to the difference between its own costs and those of the competitor with the lowest costs (after the leader’s) or $12 - $10 = $2, for this second competitor cannot sell, long-term, below its own costs. But why would a competitor have a consistent cost advantage that the others cannot copy? A new technology, for instance, can lower production costs, but as long as that technology is embedded in machines that anybody can buy, it is not going to be the basis for s sustainable cost differential. As the seller of the machines will make sure that all potential users realize how essential it is that they buy the new technology, lest they allow a competitor to have lower costs. (Think of Buffett’s analogy of everyone standing on tippy-toes to see the horse race—everyone makes an extra effort to stand on their toes but no one has any better advantage than before). A real cost advantage must be based on a unique factor to be the basis for long-term profits. We often find companies basing their hopes for profitability on the adoption of new production techniques, distribution channels or process re-engineering. All these actions, designed to lower costs, may be necessary. But they are not sufficient to make money. If all competitors can copy, they will (if they are effective, of course) with larger margins, be ready to lower their prices a bit to gain market share. However, margins will go back pretty quickly to where they were before the cost reduction programs started. Therefore, we must find factors that may lower the costs for one company (or just a few) in a unique way, to really understand where the sustainable profitability comes from. 1. Economies of scale There are economies of scale (“EOS”) when the unit cost of a product goes down as the volume of production goes up. Therefore, it is cheaper to make cares in factories that produce 300,000 cars www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

per year than make them in factories produce 2,000, and this is true even if the cars are almost identical. The causes of this phenomenon are multiple and can be found in every one of the company’s activities. Thus, R&D expenses are independent of production volume and therefore go down (per unit) as volume goes up. See Intel as an example of this. It is also often the case that prices paid for raw materials are lower if the amounts purchased are larger. (Cargill and Nestle purchasing bulk commodities). The same frequently applies to distribution costs, for it is not the same to transport a few units considerable distance as full trucks or even entire trains worth of the finished product. Indeed all functions in a company can give rise to economies of scale. Possible economies of scale in the different functions of a company R&D Spread R&D costs over more units sold Purchasing Volume discounts and savings in inbound logistics Manufacturing Mass production techniques. Possibility of specializing machine and even factories. Marketing Possibility of spreading advertising expenses over a large number of units Distribution Logistics advantages. Bargaining power vis-à-vis distributors.

Imagine a cost curve where costs per unit move down on the vertical axis while volume increases to the right on the horizontal axis, the minimum efficient size or ‘critical’ mass is the minimum size that a company must reach to be cost-efficient or the lowest point on the cost curve. The specific shape of the curve (or the discontinuous movement of unit costs vs. volume produced. Cost curves are a theoretical construct to simplify analysis and improve understanding) for a particular business tells us what the ideal size for that business is. For example, to paint someone’s house takes x pounds of paint and x hours of labor. Painting two houses will require exactly twice as much paint and labor/time. There are no savings to be gained with growth: there are no economies of scale. Let’s imagine that somebody invents a robot that can go around the house spraying a thin yet regular coat of a special paint that produces excellent results. The robot costs $1 million. If it could paint 10 houses per day, it would be cost-efficient, provided the company can paint 2,000 houses per year. In this case, the robot could be amortized over five years, and still achieve cost per house of $100, well below what it would cost to paint the house by hand. The robot can paint at a lower cost per unit provided the robot has enough volume to spread its fixed costs over many homes painted. There are businesses like painting, dentistry, or home-building where technological advances the imply economies of scale have not happened. Sometimes a technology like a gas-fired genset may allow a small building or hospital to go off-grid and generate its own electricity. So the (fixed) cost curve would be pushed to the left to make the minimum efficient scale smaller. Today, economies of scale in production dictate that electricity must be generated in large factories and then transported at great cost to the final user. In the end, economies of scale determine how many competitors can survive in a given industry. Let’s take the car industry. If the minimum efficient scale (“MES”) is around three million cars per year, and the European market fluctuates below the 15 million cars/year mark, it is evident that www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

there cannot be more than four competitors in the long term; otherwise some would be below the MES. Companies that are below the MES earn no money or lose money over time since their costs are too high. They defer R&D, putting off the introduction of new models, and the managers will spend less on advertising, thus going into a downward spiral. The weaker competitors will have to be merged, shut down or do joint ventures. We can divide the total market of 14 million cars per year by the minimum efficient scale of around 3 million cars per year; we obtain the maximum number of competitors that can profitably stay in the industry, which is four. Total market size/MES = 14 million cars demanded/3 million cars for MES = 4.66 or 5 competitors. That formula shows how the presence of important economies of scale can generate a monopoly. Take Boeing, a manufacturer of Jumbo Jets, makes jets for about $100 million each and sells them for $150 million. A 50% margin is attractive, so why hasn’t anybody copied Boeing to push down margins? Airbus does not lack the necessary technology to develop such a plane nor the production or financial capabilities. What is the matter?

Boeing and Airbus To develop a jumbo jet costs sine $10 billion. This is what Airbus would have to spend to enter the business and what Boeing paid many years ago; the total annual market amounts to 30 planes. If Airbus were to spend the $10 billion, it would have to earn $1.5 billion a year, once the plane was on the market, to justify the investment. But at a price of $150 million per plane, it would need about half the market to earn that amount of money for making each plane also costs money. And this does not take into account the possibility that Boeing may lower the price, which it can do, thanks to its huge margin. In the end, the problem is that the market is big enough for only one competitor (MES is as big as the total market), and the competitor who enters it first obtains an unassailable competitive position. Economies of scale, when they are important, determine that only a handful of companies can survive in a given market and act as barriers to entry, which allows incumbent competitors to enjoy good margins. They are also relatively permanent. Until somebody invents a different way to make a product or deliver a service efficiently at a lower volume, the maximum number of competitors is predetermined and fixed. There can be diseconomies of scale since a large corporation has larger coordination and management costs are higher. The concept of market niche: what matters is relative size, not absolute size. Shimano, manufacturers of gear systems for mountain bikes. IT is certainly a relatively small company has sales of $300 million in 2001 but it has 90% market share. Its market dominance www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

creates profits but where does the protection come from? Competitors realize that the size of the market does not justify the necessary investment, even assuming success. In the end, what determines the number of competitors is the ratio between the size of the market and the minimum efficient scale. The protection is only real if the MES is truly independent of other products. If designing and building cars were to help Peugeot build better and cheaper gear systems for bicycles (through the use of common elements, for instance), then Shimano would quickly be driven out of business. A given business is a niche because its cost curve is thoroughly independent of any other. Otherwise, it is not really a different business, not matter how much the company wants it to be so. This niche characteristic of many businesses explains why, in the real world, real profitability often accrues to little known companies, far from the fashionable industries. One of Tyco’s most profitable divisions was a plastic hanger producer. Volume (in dollars) is not enormous, but there are important economies of scale when making these hangers. Through acquisitions, Tyco has developed a monopoly position in the business and nobody can enter it now, for the volume necessary to have costs as low as Tyco’s is simply too large for the size of the market*. If EOS were not important, nothing would prevent a competitor entering the business, even if Tyco had a monopoly position, and start eroding Tyco’s profitability. * Tyco Rules Plastic-Hangers Market Through Aggressive Acquisitions By MARK MAREMONT Staff Reporter of THE WALL STREET JOURNAL The Wall Street Journal Interactive Edition -- February 15, 2000 When Tyco International Ltd. bought a company that makes the plastic hangers that Kmart Corp. uses to display clothing, the retailer's executives weren't very concerned. Then Tyco snapped up Kmart's other hanger supplier. Then two more hanger companies. Fearful that Tyco could corner the market, Kmart started funneling much of its $40 million hanger account to one of the remaining independents, a small New York outfit called WAF Group Inc. Last fall, Tyco also gobbled up WAF. Kmart now has little choice but to accept a recent Tyco price increase for most of its supply, says Bill Adams, a Kmart divisional vice president. "Consolidation in this industry is going just a little too far," he says. Acquisitions are the lifeblood of Tyco, a once-obscure conglomerate that in the past six years has spent upward of $30 billion to acquire more than 120 companies, turning itself into a titan with $22 billion in annual revenue. Tyco's playground is a long way from the sexy dot-com world; it thrives in the gritty recesses of the old industrial economy. Among its product lines are fire-sprinkler systems, electrical connectors and valves for water systems. Lots of Leverage Executives of Tyco, which is registered in Bermuda but has its main offices in Exeter, N.H., have said the acquisitions frequently allow them to bring leadership to fragmented, inefficient industries. Purchased firms are melded with Tyco units and the overlap eliminated. Profit margins of acquisitions often double in just a year, the company says. But a closer look suggests that in at least a few industries, Tyco also may be profiting by grabbing unusually large market shares, then using its dominance to raise prices or wring concessions from customers. Because these are obscure subsectors of the economy, not many people seem to notice, or care. In less than four years, Tyco has amassed a hanger business with annual revenue of more than $400 million and 70% to 80% of the U.S. market for plastic garment hangers, by industry executives' estimates. Only a handful of rivals remain in the U.S., none with the global manufacturing reach that big retailers and garment makers prefer. Billions of

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

the plastic hangers -- retailers generally don't use wire -- are used in the U.S. each year to display clothing. 'Over a Barrel' Angered by rising prices and deteriorating service, some big retailers and clothing makers say Tyco is abusing its dominant position. Tyco "has basically monopolized the market," says Amy Bennett, a hanger buyer in the children's division of VF Corp., the maker of Lee, Wrangler and Healthtex garments. VF says Tyco has raised prices twice since buying the No. 2 hanger company, Batts Inc., last spring. For many models, "they have us over a barrel," she says, adding that she would switch to another supplier "in a minute" if that were possible. At J.C. Penney Co., hanger buyer John Davis says he was "stunned" when the federal government allowed Tyco to buy Batts, then his company's main supplier, because it "created a monopoly." Mr. Davis says he complained about the deal last year to a staffer at the Federal Trade Commission but has heard nothing. An FTC spokeswoman declines to comment. After the deal, Mr. Davis says, service worsened. He says deliveries last fall were so late that some stores had to buy hangers in smaller batches from local distributors at 50% higher prices. Andrew Zuckerman, president of Tyco's hanger unit, A&E Products Group, blames most service glitches on a software switch-over that has now been completed. As for the price increases, they stem from unexpectedly large cost rises on raw materials, he says, particularly two kinds of plastic resin. Those resins have indeed gone up, about 40% over the past year. Market Share Mr. Zuckerman agrees that his company is the U.S. and global leader in plastic hangers. But, counting plastic hangers of nearly every sort -- including those used to display shoes, socks, blankets, towels, automobile mats and carpet swatches, along with those sold directly to consumers -- Mr. Zuckerman says A&E has only 30% of the U.S. market. He acknowledges this figure doesn't count hangers made for the U.S. market by A&E's overseas licensees, even though they bear A&E's logo. He declines to estimate A&E's share in just the garment-hanger market. Industry executives say the 30% overall figure is very misleading because garment hangers are a distinct business, one A&E clearly dominates. A firm that recycles many stores' hangers, Uniplast Industries Inc. in Hasbrouck Heights, N.J., says, "In most everything we buy, it's all A&E product. Judging from those percentages, they have nearly all of the business." Of course, sometimes the reason one company has most of a retail chain's business is simply that the chain chose that firm as its main supplier. But in the past, retailers could pick a main supplier after playing one highly competitive vendor off against another for the lowest price. That is what they say has changed. Mr. Zuckerman says the business is still very competitive. "Do we have a better position than our competitors in this particular market segment? Yes we do," he says. But he says Tyco spent a lot of money to get there. And customers still have plenty of choices, he argues. For instance, retailers could finance the expansion of rival hanger companies, or they could "choose to manufacture hangers themselves." There is a parallel in another field where Tyco operates. In fire-protection equipment, many customers also grumble about a pattern of price increases following Tyco acquisitions. For years, Tyco vied with a company called Central Sprinkler Corp. to sell the sprinkler heads embedded in buildings' ceilings. Customers say prices declined by as much as 25% over five years because of technology and competition. But last summer, Tyco bought Central, giving it three of the six major sprinkler brands and more than half of the U.S. market, by industry executives' estimates. A few months later, Tyco announced a price increase averaging about 8%, blaming rising costs for manufacturing and handling. Customers say prices rose 40% on a popular type of sprinkler that only Tyco and Central made. "When Central was independent, they were very aggressive on their pricing," says Marty Giles of Virginia Sprinkler Co., an installer. "But since Tyco owns them all now, they can push their prices up."

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Mr. Giles and other big customers say Tyco also has been raising prices on two kinds of sprinkler-system pipe, plastic and thin-wall steel. Industry executives say Tyco has had about a 70% U.S. market share in thin-wall steel pipe since buying its chief rival about three years ago, and gained more than 60% of the plastic-pipe market with the Central takeover. In a written statement, a Tyco spokeswoman, Judith Czelusniak, says the company won't comment on its market share in fire-protection segments for competitive reasons. She says Tyco has raised its prices on steel pipe because steel is more expensive. If Tyco's prices rise "to a degree that cannot be supported," customers will switch to thickerwalled pipes from abroad, Ms. Czelusniak says. She confirms that Tyco has raised the price of one type of sprinkler head 40%, but says the item is a small part Tyco's sprinkler business, and prices of other models have declined or stayed the same. Garment hangers, though essential to the retail clothing industry, are items most people don't notice. At wholesale, most hangers cost between six cents and 25 cents each. The lower price buys the flimsy, all-plastic white hangers found at mass merchandisers; toward the upper end are the sturdy, clear hangers with metal hooks seen at many department stores. Until a few years ago, most U.S. retailers inserted hangers in clothes at distribution centers or at each store. Then, to cut labor costs, many switched to a system called "garment on hanger," or GOH. Garments are put on hangers at the point of manufacture and don't have to be touched till they're ready for display. Although the change means that most hangers are purchased by garment makers, some big retailers still negotiate hanger prices, telling garment makers whom to buy from. Other retailers just give garment makers a list of acceptable hanger suppliers. The shift has given an edge to larger hanger makers that have global networks of factories and licensees. Although there are dozens of smaller manufacturers around the world, retailers and garment companies say it is time-consuming and costly to buy from scattered suppliers of uneven quality. Head to Head For years, the two biggest sources were A&E, which was part of a Phoenix plastics company, and Batts, a familyowned Michigan company. With about 35% of the U.S. garment-hanger market each, they had a sharp rivalry that helped drive U.S. hanger prices down by 15% to 20% in the late 1990s, industry executives say. "Batts and A&E were like Michigan and Ohio State," says Russell Nagel, a former Batts president. A&E would "come in and lowball an account to get it, and we'd respond." Tyco entered the picture in 1996 by buying A&E's parent company. Less than a year later, Tyco bought a rival called Different Dimensions Inc. and hired its president, Mr. Zuckerman, to head A&E. Hangers are in Mr. Zuckerman's blood. His father started an A&E predecessor company, and father and son founded a now-defunct hanger maker about 30 years ago, when Mr. Zuckerman was only 18. Last April, Mr. Zuckerman became the undisputed king of the hanger world, pulling off a coup that eliminated Tyco's major competitor: He bought Batts. He immediately announced Tyco was closing all three Batts factories in Michigan, eliminating 500 jobs. Within weeks, Tyco tried to raise hanger prices. Resisting the Move Ms. Bennett at VF Corp. says her unit let Tyco know it had other options, including buying from WAF, the only other supplier approved by many of VF's retailer customers. After negotiations, she says, Tyco backed off from what she says was a proposed 10% increase. But her unit agreed to pay shipping charges on its hangers. Over at Kmart, Mr. Adams says he, too, was counting on WAF to curb Tyco. WAF was supplying about a quarter of Kmart's hanger needs, and when Tyco tried to raise Kmart's hanger prices last spring, "we wouldn't accept it -- we told them we'd take all of our business to WAF." Tyco rescinded its increase, he says. Mr. Zuckerman acknowledges that A&E pulled back on some proposed price increases, which he says wasn't because of customer resistance but because raw-materials prices briefly looked as if they might head lower. He says A&E never officially raised prices to Kmart, although it may have suggested they would go up.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

In September, A&E abruptly ended the game of chess. It bought WAF. "WAF was going after A&E's customers. That's why they bought them out," says Ronald Schweitzer, co-owner of Active Trimming, a garment-supply distributor in New York. Tyco's Mr. Zuckerman denies buying WAF to remove a pesky competitor. He says Tyco was more interested in WAF's other business -- distributing jacket linings, zippers and other trim to the garment trade -- which was complementary to Tyco's. Nonetheless, in hangers, "if we have more volume running through our facilities, it's possible we will be able to produce at a lower cost," he says. But after absorbing WAF, Tyco in December and January again told customers it was raising prices. Mr. Zuckerman says the average increase was 5% to 6% and didn't even cover the rising costs of raw materials. At Active Trimming, Mr. Schweitzer says his prices went up 10%, and a new delivery charge was added. "Who are you going to complain to -- they have a monopoly," he says. K-Resin Unlike last May, this time the increases stuck. Tyco's price increases to Kmart averaged about 8%, Mr. Adams says, and in some countries they were as high as 20%. He says that when he complained, Tyco told him that "WAF was just too cheap in those countries." Seeking new sources for a part of its needs, Kmart has just signed agreements with three overseas hanger companies. VF's Ms. Bennett says Tyco's price-increase letter said raw-materials costs had "risen dramatically." She was especially unhappy that Tyco raised prices about 25% on two models of clear hangers made mostly from a plastic called K-Resin. Yet K-Resin prices haven't budged since 1995, says the material's maker, Phillips Petroleum Co. Mr. Zuckerman agrees but says other materials used in the hangers have gone up. Another VF unit, the one that makes Lee and Wrangler jeans, complains about the service from A&E since it acquired Batts. "They ship late, and they ship product different from what you order," says Frank Rakestraw, a buyer for that unit. He blames consolidation. Mr. Zuckerman says he can't comment on relations with individual customers. But the fact that VF buys some of its KResin hangers elsewhere proves "there are lots of other choices," he says. There are a half-dozen or so hanger companies still competing with Tyco in the U.S. But one is focused on a niche (intimate apparel), and most others are tiny. Industry Standard With Tyco dominating mass merchandisers, most of the small fry rely on selling to garment makers that supply major department-store chains. Many chains, among them Federated Department Stores Inc., have championed a system in which they set an industry standard for hangers and then certify suppliers as able to meet that standard. Federated, which has five approved hanger suppliers, believes this helps keep competition alive. But Tyco has been trying to convince some retailers in the industry-standard camp that it should be their sole approved supplier -- including sole supplier for used hangers, a business Tyco entered last year with another acquisition. Jennifer Bagley, who coordinates a new standardized-hanger program at Nordstrom Inc., says Tyco's pitch went something like this: The hanger industry is short on capacity, and clothing makers are having trouble getting enough. But if Nordstrom makes Tyco its sole hanger vendor, Tyco will make sure Nordstrom's garment suppliers get "priority." In addition, Tyco wanted Nordstrom to require its garment suppliers to buy their used hangers from Tyco at new-hanger prices instead of the usual 30% less. Ms. Bagley says Tyco made clear that if Nordstrom didn't make it the sole supplier, Nordstrom's garment makers "won't be a priority," and might not be able to get hangers they need.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

In addition, she says, Tyco said it might stop selling Nordstrom the high-end black hangers it uses to display moreexpensive garments, forcing the retailer to scramble for another source. To sweeten the deal, Tyco offered Nordstrom a 2% rebate on the hangers bought by the chain's apparel suppliers. Ms. Bagley calls that a "kickback" offer, because Nordstrom would be profiting at the expense of its clothing suppliers. Tyco "went and bought all the other manufacturers," she says, "which put them in a position where they could create a shortage in the marketplace. Then they could go to the retailers and say, 'If you don't do what we say, your program won't be successful. Therefore, you have to go with us exclusively.' " Nordstrom has told Tyco it won't go along with a single-source arrangement. Mr. Zuckerman agrees that Tyco made a proposal along those general lines, but he says Tyco "never even implied" that it might stop selling black hangers to Nordstrom, and it never uses priority delivery or the lack thereof in its pitches. Threatening not to deliver hangers bound for a particular retailer would be "impossible," he says, because a given garment maker serves many retailers, and Tyco couldn't tell which hangers were destined for which chains. Mr. Zuckerman also says Tyco didn't create shortages but, in fact, has added to capacity. As for the 2% rebate, he says that was a "volume discount" to reward Nordstrom for more business. On Friday, Nordstrom sent its final rejection of Tyco's proposals, Mr. Zuckerman says. The retailer told Tyco it would be one of several approved hanger vendors, he says, and chose someone else to handle its used hangers. The rejection, Mr. Zuckerman adds, proves that "there is competition in the market."

Remember that the level of costs, in and of itself, has nothing to do with profitability. This is determined by the height of the barriers to entry. (Source: The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments by Pat Dorsey) Cost advantages can stem from: 1. 2. 3. 4.

Cheaper processes (Dell’s early advantages in assembling and selling PCs, Southwest Airlines). Better locations (Vulcan Materials’ quarry locations; Waste Management’s landfill locations) Unique Assets (Compass Minerals cheap source of materials; Supermodel’s body) Greater scale—when is bigger really better—our focus today.

A locational advantage often shows up in commodity products that are heavy and cheap—the ratio of value to weight is low—and that are consumed close to where they are produced. Let’s look at quarrylevel economics of an aggregate company. Stone, sand and gravel cost roughly $7 per ton at the quarry site, and an additional $0.10 to $0.15 per ton for every mile spent on the back of a truck getting to the delivery site. So, just five to seven miles of transport increase costs by 10 percent, which is passed on to the customer. In practice these costs mean that aggregate companies have basically a mini-monopoly on construction customers located fairly close to the quarry, and relatively little competition within the 50 mile radius that is roughly a quarry’s addressable market. The same economics apply to cement and certain steel plants, for example. --

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

The Size Advantage: Bigger can be better, if you know what you are doing. Cost advantages that stem from scale The absolute size of a company matter much less than its size relative to rivals. Two massive firms that dominate an industry—for example Boeing and Airbus--are unlikely to have meaningful scale based cost advantages relative to each other. But as we will discuss, even a company that is small in absolute terms can have quite a solid moat if it is much larger than its competition. To understand scale advantages, it is important to remember the difference between fixed and variable costs. See discussion on next page.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Variable Costs and Fixed Costs

All the costs faced by companies can be broken into two main categories: fixed costs and variable costs. Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc. Variable costs are costs that vary with output. Generally variable costs increase at a constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in production, etc. In accounting they also often refer to mixed costs. These are simply costs that are part fixed and part variable. An example could be electricity--electricity usage may increase with production but if nothing is produced a factory still may require a certain amount of power just to maintain itself. Below is an example of a firm's cost schedule and a graph of the fixed and variable costs. Noticed that the fixed cost curve is flat and the variable cost curve has a constant upward slope.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

If you think about your local grocery store, its fixed costs are rent, utilities, and salaries for some base level of staffing. The variable costs would be the wholesale cost of the merchandise that the store needs to stock the shelves, and extra compensation costs for high traffic times of the year like the holidays. A real estate brokerage office, by contrast, would have almost exclusively variable costs. Aside from an office, a phone, a car, and a computer with a link to the database of homes for sale, an agent doesn’t’ have many costs aside from commissions, which vary with real estate sales: no sales, no commissions. The higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater. It is no surprise that there are only a few national packagedelivery companies (UPS and Fed-ex), or automobile manufacturers, or microchip producers—but there are thousands of small real-estate agencies, consultancies, law offices, and accounting agencies. A law firm with 1,000 lawyers has no cost advantage over a law firm with 10 lawyers. It may have a greater range of services it can offer, and it may get additional business from that angle, but it is not going to have a meaningful cost advantage over a smaller competitor. We can break down sale-based cost advantages further into three categories: distribution, manufacturing, and niche markets. Although manufacturing scale tends to get all of the attention in Economics 101, the cost advantages stemming from large distribution networks or dominance of a niche www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

market are just as powerful—and, in an increasingly service-oriented economy, there are more common as well. For further study on costs go here: http://hspm.sph.sc.edu/courses/econ/Cost/Cost.html The Value of the Van Large distribution networks can be the source of competitive advantages, and you see when moving material from point A to point B. Let’s look at the fixed and variable costs of running a fleet of delivery trucks. The trucks themselves--whether purchase or leased—are a fixed cost, as are the salaries of their drivers and most of the gasoline that the trucks need to consume as they trundle along their routes. The only real variable costs are overtime wages for busy periods, and some proportion of the gas. Although building and operating the delivery network is an expensive proposition for a base level of service, the incremental profit on each item that the truck fleet delivers is large. Once the fixed costs are covered, delivering an extra item that is on a delivery route is extremely profitable because the variable cost of making an extra stop is almost nothing. Now imagine that you need to try to compete with a company that has an established distribution network. It has likely covered its fixed costs and is making large incremental profits as it delivers more stuff, while you will need to take on large losses for a time until (if) you gain enough scale to become profitable. One of the reasons that UPS has much higher returns on capital than rival Fed-ex is that it earns a larger proportion of its operating profits from door-to-door delivery of packages, as opposed to overnight letter services. A dense ground delivery network has much better returns on capital than an overnight express service. A deliver can that is only half full will still likely cover its costs, where as a halffull cargo jet with time sensitive packages likely will not. Many businesses with delivery networks can dig this type of economic moat. Consider Darden Restaurants, which operates the Red Lobster chain of casual seafood restaurants in the United States. Supplying fresh seafood to 650 restaurants across an entire continent is not a small task—and having a large distribution network allows Darden to accomplish this more efficiently and at a lower cost than its competitors. With many more restaurants that its closed competitor, Darden clearly benefits from distribution scale. Moving from crab legs to the less palatable world of medical waste, you can also see a huge distribution advantage in a company called Stericycle, which is the largest company collecting and disposing of medical waste in the US. Stericycle is 15 times larger than its nearest competitor, giving it unrivaled route density (Our Regional or Local Economies of Scale). Having more stops per route leads directly to more profitable routes, higher returns on capital, and a wider economic moat—a large and dense distribution network means that Stericycle can potentially underprice competitor and still generate higher profits. Large distribution networks are extremely hard to replicate, and are often the source of very wide economic moats. We see this in companies from Sysco, the largest food-service distributor in the US to Fastenal, one of the largest U.S. distributors of fastening products from manufacturing firms, to large beverage companies such as Coca-Cola, Pepsi, and Diageo.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Bigger can be better Cost advantages can also stem from manufacturing scale. The classic example of this is a factory with an assembly line. The closer the factory is to 100 percent capacity, the more profitable it is, and the larger the factory, the easier it is to spread fixed costs like rent and utilities over a larger volume of production. Also, the larger the factor, the easier it is to specialize by individual tasks or to mechanize production. With globalization and the enlargement of markets, the prevalence of this type of cost advantage has diminished somewhat in the recent past as enormous low-cost pools of labor in China and Eastern Europe have become integrated into the global economy, causing some manufacturing to shift from Europe and North America. Exxon Mobil Corp, which has the lower operating costs than any of the other super major integrated oil companies by virtue of achieving scale economies in many of its operating segments. Although the scale advantage is less apparent in the company’s upstream operations that explore for and extract oil and natural gas, it is very apparent in the firm’s refining and chemical operations, which have returns on capital that dwarf those of competitors like Valero and BASF Corporation. Manufacturing scale needn’t be limited to owning a larger production facility than the competition. If we think about scale in terms of spreading fixed costs over a larger sales base, we can see that nonmanufacturing companies can also benefit from economies of scale. Video-game giant Electronic Arts, has an easier time creating video games than smaller companies because the cost of bringing a video game to market—currently around $25 million—is essentially fixed, and Electronic Arts can spread the massive development costs of its video games over a larger overall sales base. In the United Kingdom, we see at BskyB, the largest provider of pay-television services in the country--it has about three times more subscribers than Virgin Media, its closest competitor. So, Sky can purchase more Premier League football matches, more first-run movies, and more hit U.S. television shows, which attract more subscribers which, in turn, gives Sky the financial muscle to keep improving its content offerings. Absent a new market entrant outbidding Sky for significant chunk of this content and being willing to suffer large financial losses as it tried to poach subscribers, it looks like Sky has a pretty wide economic moat. Big fishes in small ponds make big money A final type of scale advantage is domination of a niche market. Even if a company is not big in an absolute sense, being relatively larger than the competition in a specific market segment can confer huge advantages. Companies can build near-monopolies in market that are only large enough to support one company profitable, because it makes no economic sense for a new entrant to spend the necessary capital to enter the market (WDFC dominates in lubricant oil for the home—WD-40). The Washington Post owns a number of cable0TV systems in smaller cities like Boise, Idaho, that are only large enough to support a single cable-service operator. Competitors do not spend the capital needed to build a competing system because the profits pool is only large enough for one company. If a competitor did build a second cable system, neither it nor the incumbent would have enough customers to be comfortably profitable. Although the attractive economics of these small-city cable operations have diminished somewhat wince satellite television entered the fray, they are still good examples of www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

the niche-market moat. Focus your search for profitability on regional Telco’s rather than on nationwide Telco’s like AT&T. Graco, Inc. in Minneapolis makes paint sprayers and pumps for food processing. The company generates in excess of 35% returns on capital. The total market for high-end industrial pumps is not all that large, limiting its attractiveness to large, well-financed competitors. Second, Graco spends liberally—about 3% to 4% of sales—on research and development, ensuring that is stays at the cutting edge of customers’ requirements. Thirds, Graco’s products deliver results that are highly visible to the end consumer, but represent a small fraction of total production costs. Again, in the software worlds, there is a firm called Blackboard which has about two thirds of the market for learning management systems, a type of university wide software application that connects faculty and students. Like industrial pumps, this is not a large market so it is less likely to attract a giant like Microsoft or Adobe. It5 is a highly specialized market, so a competitor would need to expand substantial resources to learn what customers want before being successful—and because the market is relatively small, few companies will attempt to. Private infrastructure firms like airports allow for single competitor economics. Many markets have only enough air traffic to support a single airport profitably so potential entrants stay away.

Definition of 'Minimum Efficient Scale' or MES The smallest amount of production a company can achieve while still taking full advantage of economies of scale with regards to supplies and costs. In classical economics, the minimum efficient scale is defined as the lowest production point at which long-run total average costs (LRATC) are minimized. The minimum efficient scale may be expressed as a range of production values, but its relationship to the total market size or demand will determine how many competitors can effectively operate in the market. Read more: http://www.investopedia.com/terms/m/minimum_efficiency_scale.asp#ixzz1kOV5t4L9

Long run costs of production Introduction The time periods that we use in Economics can sometimes appear somewhat arbitrary – they help to provide a framework within which we can analyze the behavior of businesses in different markets and industries, but the length of time that constitutes the short run clearly varies across industries and the reality is that most businesses can vary the amount of capital input in the short run by leasing items of machinery and renting additional commercial property and factory space if it is available. The key point about the long run is that all factors of production are assumed to be variable, in other words a business can vary all of its inputs and change the whole scale of production. How a firm’s output responds to a change in factor inputs is called returns to scale. The hypothetical returns for a business varying the scale of production is shown in the table below

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Labor Input

Plant 1 Plant 2 Plant 3 Plant 4 40 100 130 150 100 160 180 210 130 180 240 250 150 200 255 275 160 210 270 290 Capital Input 10 20 30 40 In the example shown when the business increases the scale of production from Plant 1 (with 10 units of labor and 10 units of capital) to Plant 2 (a doubling of the inputs used), total output quadruples. This shows increasing returns to scale leading to a fall in the average total cost of production. A further increase in scale to Plant 3 demonstrates constant returns to scale where both inputs and output have increased by 50% and a further expansion of scale to Plant 4 illustrates decreasing returns to scale where inputs have grown by 33% but output has grown by just 15%. When a firm experiences decreasing returns to scale, then average total cost will rise – in other words diseconomies of scale exist. 10 20 30 40 50

Economies and Diseconomies of Scale In the long run the scale of production can be increased or reduced, because all factors are variable. This allows the firm to move on to new average cost curves. For each size of firm there is an equivalent short run average cost curve. As the firm expands, it moves on to different short run average cost curves. If expanding the scale of output leads to a lower average cost for each level of output then the firm is said to be experiencing economies of scale. The long run average total cost curve (LRAC) shown in the diagram below is the locus of points representing the minimum average total cost of producing any given rate of output, given current technology and resource prices. The LRAC curve or envelope curve is drawn on the assumption of infinite plant sizes. The points of tangency do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. MES is the minimum level of output required to fully exploit economies of scale in the long run:

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis One way of interpreting the minimum efficient scale is to consider the cost disadvantage of producing an output below the estimated MES. Consider the diagram below. The lowest point of the LRAC occurs at an output of 90,000 per month where average total cost = £10 per unit. At an output level of ½ of MES (45,000 per month) the average cost is estimated to be £25 per unit. At an output level of just 1/3 of MES the cost disadvantage is even greater with AC rising to £40 per unit.

The steeper the fall in the LRAC up to the MES, the greater the cost advantage in exploiting economies of scale. The LRAC will tend to fall steeply when the overhead costs of production are high and the marginal costs of producing extra output are low – the classic examples of industries where this occurs are in markets such as steel production, motor-car manufacturing, pharmaceuticals and computer software. The long run average total cost curve does not always have to have the shape illustrated in the diagram above. With a natural monopoly, the cost structure is different. For example, in industries where massive networks or national distribution channels are required, the overhead costs relative to the running costs are likely to be high. There is also likely to be great potential to exploit technical economies of scale. As a result the MES will be a high proportion of total market demand. There may be room only for one business to fully exploit the increasing returns to scale available in the industry. We assume for a natural monopoly that the long-run average cost curve falls continuously over a very large range of output. This is shown in the diagram below – the average cost per unit declines over the full range of output.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

This does not mean that a natural monopoly is an industry with only one supplier. Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation which allows smaller suppliers to sell their output at a premium price to the market average, taking advantage of the willingness and ability of consumers to pay higher prices to cover the increased cost per unit. Nonetheless when the minimum efficient scale of production is high relative to total market demand, we expect to see a high level of industry concentration. The long run average and marginal cost curves can be summarized as shown in the final diagram below. When LRAC is falling, then LRMC must lie below it but when LRMC is rising and is above LRAC then diseconomies of scale have set in and average costs are rising. The firm has gone beyond the output of productive efficiency in the long run.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

A2 Markets & Market Systems Economies and Diseconomies of Scale

In the long-run all factors of production are variable; the whole scale of production can change. In this note we look at economies and diseconomies of large scale production. Economies of scale Economies of scale are the cost advantages exploited by expanding the scale of production in the long run. The effect is to reduce long run average costs over a range of output. These lower costs represent an improvement in productive efficiency and can feed through to consumers in lower prices. But economies of scale also give a business a competitive advantage in the market-place. They lead to lower prices and higher profits! The table below shows a simple representation of economies of scale. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited. Long Run Output (Units) 1000 2000 5000 10000 20000 50000 100000

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Total Costs (£s) 12000 20000 45000 80000 144000 330000 640000

Long Run Average Cost (£ per unit) 12 10 9 8 7.2 6.6 6.4

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

500000

3000000

6

Returns to scale and costs in the long run The table below shows a numerical example of how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs. Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labor Output Total Cost Average Cost Scale A 5 3 4 100 3256 32.6 Scale B 10 6 8 300 6512 21.7 Scale C 15 9 12 500 9768 19.5 Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labor = £200

Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C. Increasing Returns to Scale Much of the new thinking in economics focuses on the increasing returns to scale available to a company growing in size in the long run. If a business can sell more output, it may become progressively easier to sell even more output and reap the benefits of large-scale production. An example of this is the computer software business. The overhead costs of developing new software programs are huge - often running into hundreds of millions of dollars or pounds - but the marginal cost of producing additional copies of the product for sale in the market is close to zero. If a company can establish itself in the market in providing a piece of software, positive feedback from consumers will expand the customer base, raise demand and encourage the firm to increase production. Because the marginal cost of production is so low, the extra output reduces average costs, giving the business the scope to exploit economies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders of a business. The long run average cost curve The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance. The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs in the production process might lead to a more than doubling of output leading to increasing returns to scale. Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale. There are many different types of economy of scale. Depending on the characteristics of an industry or market, some are more important than others. Internal economies of scale (IEoS) Internal economies of scale arise from the long term growth of the firm itself. Examples include: www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis 1. Technical economies of scale: (these relate to aspects of the production process itself): a. Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist machinery. For example, a supermarket might invest in new database technology that improves stock control and reduces transportation and distribution costs. It may not be cost-efficient for a small corner shop to buy this technology. We find that highly expensive fixed units of capital are common in nearly every mass manufacturing production process – a good example is investment in robotic technology in producing motor vehicles or in assembling audio-visual equipment. b. Specialization of the workforce: Within larger firms the production process can be split into separate tasks to boost productivity. c. The law of increased dimensions or the “container principle”. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – the application of this law opens up the possibility of scale economies in distribution and transport/freight industries and also in travel and leisure sectors. Consider the new generation of super-tankers and the development of enormous passenger aircraft capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. d. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves” or “learning curve effects”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale.

1. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a much greater output and it can also purchase its factor inputs in www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis bulk at discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers also have significant monopsony power when purchasing supplies from farmers and wine growers and in completing supply contracts from food processing businesses 2. Managerial economies of scale: This is a form of division of labor. For example, large-scale manufacturers employ specialists to supervise production systems. And better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs. 3. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities with favorable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market. They are also likely to pay a lower rate of interest on new company bonds because of a better credit rating. 4. Network economies of scale: (Please note: This type of economy of scale is linked more to the growth of demand for a product – but it is still worth understanding and applying.) There is growing interest in the concept of a network economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. We can identify networks economies in areas such as online auctions and air transport networks. The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale. EBay is a classic example of exploiting network economies of scale as part of its operations.

The container principle at work- an example of an internal economy of scale www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis Economies of scale – the effects on price, output and profits for a profit maximizing firm The next diagram illustrates the effects of economies of scale using cost and revenue curve analysis. Note: To understand the following diagram you will need to have covered the profit maximizing rule for a business where marginal revenue = marginal cost.

External economies of scale (EEoS) External economies of scale occur outside of a firm but within an industry. Thus, when an industry's scope of operations expand due to for example the creation of a better transportation network, resulting in a decrease in cost for a company working within that industry, external economies of scale have been achieved. Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the center of manufacturing are also an external cost saving. Agglomeration economies may also result resulting from the clustering of similar businesses in a distinct geographical location.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis Economies of Scale – The Importance of Market Demand The market structure of an industry is affected in the long term by the nature and extent of the economies of scale available to individual suppliers and also by the size of market demand. In many industries, it is possible for small firms to operate profitably because the cost disadvantage of them doing so is small. Or because product differentiation allows a business to charge a price premium to consumers which more than covers their higher costs. A good example is the retail market for furniture. The industry has some major players in each of its different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA and a number of other mass-volume producers. However, much of the home furniture market remains with smaller-scale suppliers with consumers willing to pay higher prices for bespoke furniture. One reason is that the price elasticity of demand for furniture products is more inelastic than at the volume end of the market. Small-scale furniture manufacturers can exploit the higher level of consumer surplus that is present when demand is estimated to have a low elasticity. Economies of scope Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product. In the publishing industry for example, there might be cost savings to a business from using a team of journalists to produce more than one magazine. Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope. There are many good examples of this – consider the way in which Cadbury has rapidly widened the product range associated with Dairy Milk chocolate bars in recent years. The minimum efficient scale (MES) The minimum efficient scale (MES) is best defined as the scale of production where the internal economies of scale have been fully exploited. The MES corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency. The MES is not a single output level – more likely we describe the minimum efficient scale as comprising a range of output levels where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit in the long run.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

The MES must depend on the nature of costs of production in a particular industry. 1. In industries where the ratio of fixed to variable costs is high, there is scope for reducing average cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, or perhaps a monopoly) – indeed economies of scale may act as an effective barrier to the entry of new firms because existing firms have achieved cost advantages and they then can force prices down in the event of new firms coming in! 2. In contrast, there might be only limited opportunities for scale economies such that the MES turns out to be just a small percentage of market demand. It is likely that the market will be competitive with many suppliers able to achieve the MES. 3. With a natural monopoly, the long run average cost curve falls over a huge range of output, there may be room for perhaps only one or two suppliers to fully exploit the available economies of scale. Diseconomies of scale Diseconomies are the result of decreasing returns to scale. The potential diseconomies of scale a firm may experience relate to: 1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation which can lead to stakeholder conflict? 2. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry’s supply chain. 3. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. Traditionally this has www.csinvesting.wordpress.com

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis been seen as a problem experienced by large state sector businesses, examples being the Royal Mail and the Firefighters, the result being a poor and costly industrial relations performance. However, the problem is not concentrated solely in such industries. A good recent example of a bitter dispute was between Gate Gourmet and its workers. Avoiding diseconomies of scale A number of economists are skeptical about diseconomies of scale. They believe that effective management techniques and the appropriate incentives can do much to reduce the risk of rising long run average costs. Here are three reasons to doubt the persistence of diseconomies of scale: 1. Developments in human resource management (HRM) are an attempt to avoid the risks and costs of diseconomies of scale. HRM is a horrible phrase to describe improvements that a business might make to any of its core procedures involving worker recruitment, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply. Recruitment and retention of the most productive and effective employees makes a sizeable difference to corporate performance in the long run (as does the flexibility to fire those at the opposite extreme!) 2. Likewise, performance-related pay schemes (PRP) can provide appropriate financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. 3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production.

Author: Geoff Riley, Eton College, September 2006 Addendum: As Wal-Mart increases ever more in absolute size then the company can become a political target for unions and politicians to extort.

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