Last month we discussed the benefits cap (economies of scale) that come from scale and growth if an organization has centralized its key support functions. This month, I’d like to focus on the diseconomies of scale that many growing groups experience when they are decentralized.
I would argue that organizations that are focused on growth, and the inherent “economies of scale” that come with well-planned and executed growth and acquisitions are actually realizing “diseconomies of scale” if they operate with a decentralized management structure. Decentralized management structures by their very nature cede management control and authority to a number of managers in various locations. While the decentralized approach may be viewed as more in touch with local needs, the risks, inefficiencies and additional costs that come with decentralized management are eye opening if well understood. I see countless examples of significant diseconomies of scale in growing, decentralized groups costing organizations hundreds of thousands and millions of dollars each year.
Diseconomies of Scale – New Normal in Many Large Decentralized Groups
For growing organizations that operate in a “decentralized environment” diseconomies of scale are very real and are found in the following ways:
Duplicative Functions – Rather than sharing a centralized function, functions are replicated throughout an organization, causing waste. This is often referred to as over-crowding…too many people doing the same task and/or occupying a space that is physically too small for them.
Staff inefficiencies– It is easy to reason that additional staff and management will be required to staff and support duplicative functions.
Lack Purchasing Leverage– Decentralized purchasing functions generate smaller purchases with more suppliers, sub-optimizing their leverage, realizing higher costs than are necessary and creating more work for payables staff to pay more suppliers.
Lack of Specialization– Many executives view their managers as “utility players” who can learn and play any position such as Human Resources, Purchasing, Information Technology, Safety and more. Managers who receive no formal training and little operational direction in their newly-assumed responsibilities may have good intentions but can’t generate results locally that an experienced resource could achieve in a centralized environment. “Utility players” lack the data, the process experience and most often the time required to generate solid results.
Facility Duplication – A large group might operate with 18 Accounts Payable offices which is inherently less efficient than one central accounts payable location…using more space and labor than is required to pay suppliers, not to mention technology costs and other miscellaneous expenses.
Lack of Actionable Information– While data has potential value, greater volumes of data doesn’t add value if not mined, utilized or applied to the appropriate management challenges. As an example, if your centralized corporate office does not know how much they spend in a given expense category annually across an organization or know who the suppliers are in a given expense category, you are not using your data effectively and wasting a valuable opportunity to leverage your spend.
Cost Increases– Poor specifications and requirements, too many suppliers, the wrong purchasing philosophy (tactical vs. strategic), weak or non-existent purchasing processes, will all guarantee poor pricing, increased costs, inefficient processes, unfavorable business terms and new risk. This is an all too common occurrence in decentralized purchasing environments.
Other Issues that can create Diseconomies of Scale
Some of the other issues that acquisitions and growth provide can add to overall diseconomies of scale:
Complexity– Too many locations, too little management control and too many products purchased or sold can add complexity and waste.
Bureaucracy– When an organization becomes so big, so bureaucratic that management decision-making is continually delayed, or not made at all, inefficiencies are created and become institutionalized in time.
Broad Span of Control– Management spans of control can increase to the point that leaders can’t effectively manage or control anything. Managers without stretch objectives, proper oversight and management attention can turn into “caretakers” just going through the motions, never improving performance to any large degree.
Insecurity– Acquisitions and mergers tend to cause uncertainty among the remaining staff, which can breed insecurity and the desire by those who “made the cut” to play it safe and not rock the boat.
Management Ineffectiveness– Some managers just refuse to lead and manage – others are “too busy” to act, their plates are too full to address obvious problems, which frequently becomes an excuse for doing nothing. Doing nothing will often lead to institutionalized inefficiencies that are hard to reverse later.
Diseconomies of Scale – The Cost is Huge!
Independent research firms such as Aberdeen and Gartner have numerous studies concerning the inefficiencies created by a decentralized management approach to purchasing and other functional disciplines. The problems they cite are only multiplied across organizations that become larger. Aberdeen, a few years back reported that organizations that “centralize” their procurement functions will realize 25% cost savings across that spend, which we achieve through our practice. Imagine 25% reduction in costs, with those dollars falling to the bottom line as new profits? Why wouldn’t a leader jump on this opportunity and get moving yesterday? The decentralized management philosophy that is in play is responsible for these wasted dollars and weaker than expected profit levels, yet management in many cases ignores the problem and the new profit opportunity.
Based on my data and experience, a 15% or 20% reduction in spend is certainly achievable annually if the organization is centralized. And, if centralized, the demands on the AP and finance staff will be greatly diminished resulting in new “soft costs savings” from labor.
You would think owners, investors, shareholders and executive management would be excited about the newfound efficiencies and profits available with “centralized management models” so that they could realize the economies of scale that comes with growth. The reality is that most groups have not centralized operations and finance to any large extent…wasting significant dollars and resulting in lost profit opportunities. I suspect this reality might change if the economy softens a bit.
How to Achieve Your Economies of Scale in Operations
In business school, most of us where taught that effective leadership, effective management required us to ensure that we understood what our obligations to the organization are. Quite simply, leaders and managers should ensure the following approach is accomplished for and through our teams:
Plan – Executives create a vision, a plan, and set stretch objectives
Organize – The Executive team will organize and provide resources, remove obstacles to success, get the team onboard with the vision, plan and objectives
Direct – The leadership team will build a team of strong managers, give them the direction and then get out of the way. Getting out of the way does not mean abdicating responsibility however.
Control – Well-defined and well-aligned performance metrics are a staple of any effective management team and must be tied to the company and corporate objectives to ensure alignment, focus and success.
Centralization to Realize Economies of Scale
Managing for economies of scale is tough to execute and achieve in a decentralized environment, where everyone is in charge. Reliance on decentralized functions will sub-optimize results, cost your organization money and reduce your profitability.
A centralized approach is absolutely imperative to organizations hoping to realize all of the benefits of scale through acquisitions and mergers. The economy of scale opportunities are there and the benefits are significant to the bottom line. The first step toward this end is for senior management to set that centralization objective in stone and getting the team on board.
Ultimately, diseconomies of scale are allowed to occur by executive management who have not made the decision to centralize functions. Realizing complete economies of scale across a growing organization can provide significant, sustainable profit improvement opportunities to an organization frequently providing millions of dollars in new profits. The first step for executive management is to examine current profitability levels in light of the organization structure. If the organization is decentralized, particularly the purchasing, HR, and IT functions, then management needs to set new, challenging expectations and objectives to centralize those functions across the organization quickly. Once centralization has occurred and is managed effectively, new efficiencies will occur which will be visible with new bottom-line profitability, the ultimate objective driving growth to begin with.
Author: Doug Austin
Doug Austin is the founder and President of StrategicSource, Inc., the leading provider of Spend Management Services (strategy, spend mapping, sourcing, process improvement and audit) for the automotive and truck dealerships, and various other vertical markets. Doug is a veteran of the U.S. Marine Corps, a graduate of the University of St. Thomas, and a speaker at various conferences and 20 Groups. Doug has acquired over 30 years of line, staff and executive experience in Spend Management and Supply Chain Management in various vertical markets, and is also a trainer, speaker, consultant and business owner.