The Growth of Firms
Why do firms seek to grow?
The following factors are commonly
associated with the desire of firms to
grow:
1. The profit motive: Businesses
grow to expand output and
achieve higher profit. The
stimulus to achieve year-on-year
growth is often provided by the
expectations placed on a
business by the capital markets.
The stock market valuation of a
firm is influenced by
expectations of future sales and profit streams so if a company achieves disappointing
growth figures, this might be reflected in a fall in a company‟s share price. This opens up
the risk of a hostile take-over and makes it more expensive for a quoted company to
raise fresh capital by issuing new shares onto the market.
2. The cost motive: Economies of scale have the effect of increasing the productive
capacity of the business and they help to raise profit margins. They also give a
business a competitive edge in domestic and international markets.
3. The market power motive: Firms may wish to grow to increase their market
dominance thereby giving them increased pricing power in specific markets.
Monopolies for example can engage in price discrimination.
4. The risk motive: The expansion of a business might be motivated by a desire to
diversify production so that falling sales in one market might be compensated by
stronger demand and output in another market.
5. Managerial motives: Behavioural theories of the firm predict that the growth of a
business is often spurred on by the decisions and strategies of managers employed by a
firm whose objectives might be different from those with an equity stake in the business.
How do firms grow?
Organic growth
This is also known as internal growth and comes about from a business expanding its own
operations rather than relying on takeovers and mergers. Organic growth might come about
from:
Expansion of existing production capacity
Investment in new capital & technology
Adding to the workforce
Developing & launch of new products
Growing a customer base through marketing
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External growth of a business
The fastest route for growth is through integration i.e. through mergers or contested takeovers. In recent years there has been a boom in merger and takeover activity.
Horizontal integration: Horizontal integration occurs when two businesses in the same
industry at the same stage of production become one – for example a merger between two
car manufacturers or drinks suppliers. Recent examples of horizontal integration include:
Nike and Umbro
Body Shop and L'Oreal
NTL and Telewest (new business eventually renamed as Virgin Media)
Capital Radio and GWR to form GCap
AOL and Bebo
Tata and Jaguar
Virgin Active and Holmes Place
British Airways and Iberia Airlines
The advantages of horizontal integration include the following:
1. Increases the size of the business and allows for more internal economies of sale –
lower long run average costs – improved profits and competitiveness
2. One large firm may need fewer workers, managers and premises than two – a process
known as rationalization again designed to achieve cost savings
3. Mergers often justified by the existence of “synergies”
4. Creates a wider range of products - (diversification). Opportunities for economies of
scope
5. Reduces competition by removing rivals – increases market share and pricing power
Vertical integration: Vertical Integration involves acquiring a business in the same industry but
at different stages of the supply chain. Examples of vertical integration might include the
following:
Film distributors owning cinemas
Brewers owning and operating pubs
Tour operators / Charter Airlines / Travel Agents
Crude oil exploration all the way through to refined product sale
Record labels, record stations
Sportswear manufacturers and retailers
The main advantages of vertical integration are:
1. Greater control of the supply chain – this helps to reduce costs by eliminating
intermediate profit margins
2. Improved access to important raw materials
3. Better control over retail distribution channels
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Lateral Integration
This involves subsidiary companies joining together that produce similar but related products.
Good recent examples include:
eBay and Skype
Google and You Tube
Gillette and Proctor & Gamble
Other sources of monopoly power
Monopoly power also comes from owning patents and copyright protection or exclusive
ownership of productive assets (e.g. De Beers – diamonds). Monopoly power can also come
from winning bidding races for exclusive agreements – the best example of which is probably
the monopoly on broadcasting live soccer games on TV owned by BSkyB as a result of winning
auctions organised by the Premier League.
The government and its agencies may also give legal monopoly power to some business
through franchises and licences. Monopoly power can of course come organically through
internal growth where a firm takes advantage of economies of scale.
Stobart powers on
Undeterred by rising fuel costs and signs of an economic slowdown, Stobart the UK‟s largest
road haulier has continued to expand posting a 27% rise in revenues over the last year. The
business now operates 1,500 trucks and 2,900 trailers and has worked at 81% capacity
utilisation, up from 71% four years ago. Stobart has grown externally by merging with fellow
haulier Westbury and acquiring O‟Connor, the inland container terminal operator. Stobart has
also purchased transport engineer WA Developments and has taken an option on buying
Carlisle Airport. The business has a strategy of building a mutli-modal capability mixing road,
rail, sea and air transport.
Source: Adapted from news reports, June 2008
Outsourcing
The tendency of companies to outsource some of their production operations overseas has
become an important issue in recent years. Over 30% of UK companies now do some of their
production work abroad, whilst 10% have over half of their manufacturing offshore in lower cost
locations. Dyson is a high profile example of a company that has relocated production abroad to
Malaysia, whilst keeping their research and design operations in the UK. Most recently we are
witnessing a trend for service sector businesses to follow suit. In recent times we have seen
Norwich Union, Abbey National, Tesco, British Airways and National Rail Enquiries all transfer
parts of their operation overseas.
There are three main drivers promoting outsourcing as a business strategy:
(1) Technological change – Information, communication and telecommunication costs are
falling - this makes it much easier to outsource both service and manufacturing
operations to sub-contractors in other countries. Technological advances now promote
"Just in time delivery" inventory strategies for the delivery of components and
finished products and encourage the development of "virtual manufacturing".
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Communication costs are dropping sharply - the average price of a one minute
international call was 74% lower in 2003 than in 1993.
(2) Increased competition in a low-inflation environment - which increases the pressure on
businesses to achieve lower costs as a means of maintaining market share.
(3) Pressure from the financial markets for businesses to improve their profitability.
For many large businesses, there are clear cost advantages to be gained through doing
business via a call centre located overseas. Outsourcing is not simply confined to service sector
industries. Many manufacturing businesses are using outsourcing as a means of reducing their
costs, providing greater flexibility of production levels at times of volatile demand and also in
speeding up the time it takes to get their goods to market, especially new products.
Joint Ventures
Joint ventures occur when two or more businesses join together to pursue a common project
or goal. This type of business agreement is becoming common especially as firms become
aware of the potential of collaborative work in reaching a mutually strategic target. Firms might
come together for joint-research projects e.g. in sharing some of the fixed costs of expensive
research projects.
Good examples of joint ventures include:
Sony Ericsson - mobile phone joint venture
Google and NASA
Hollywood studios fighting internet piracy
Hugo Boss and Proctor & Gamble
Boeing and Lockheed
MySpace and Skype
Renault-Nissan‟s joint venture with Indian firm Bajaj to produce a £1,276 car
Evaluation comments on mergers and takeovers
Many takeovers and mergers fail to achieve their aims.
1. Financial costs of funding takeovers including the burden of deals that have relied
heavily on loan finance
2. The need to raise fresh equity to fund a deal which can have a negative impact on a
company's share price
3. Many mergers fail to enhance shareholder value because of clashes of corporate
cultures and a failure to find the all-important "synergy gains“
4. With the benefit of hindsight we often see the ‘winners curse’ - i.e. companies paying
over the odds to take control of a business and ending up with little real gain in the
medium term.
5. Competition policy concerns can come into play especially when there is a risk of
monopoly power from vertical and horizontal integration
6. Integration often leads to sizeable job losses with economic and social consequences
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The survival of smaller businesses in the economy
Over time there is a clear trend towards larger scale business operations partly because of the
pressures of competition; the need to achieve economies of scale and the effects of mergers
and takeovers. However this process is not purely a one-way street. There are plenty of
examples where businesses are de-merging and divesting themselves of some of their existing
assets. And even in industries where giant businesses dominate the market place, there is
frequently room for smaller firms to compete and survive profitably.
1. Many smaller businesses can make profits by acting as a supplier / sub-contractor to
larger enterprises
2. They might take advantage of a low price elasticity of demand and high income elasticity
of demand for specialist „niche‟ goods and services
3. Smaller businesses are often highly innovative, flexible and can avoid diseconomies of
scale
Private equity
Private equity is the name given to a particular type of company ownership. Some businesses
such as Tesco plc or British Petroleum plc are publicly-owned by outside investors who can buy
and sell their shares on the stock market. In contrast, privately-owned firms are owned by
groups of individuals or families and also by private equity funds. These funds raise capital from
institutions such as pension funds and make investments in companies that they feel can be
improved and achieve higher profits.
Some of the better known private equity firms include Permira, KKR (Kohlberg, Kravis and
Roberts) and 3i. In recent years, private equity firms have acquired a string of well-known
business names in the UK ranging from Birds-Eye frozen foods to Saga holidays, from Fitness
First gyms to Madam Tussauds Group. Some commentators have called them „casino
capitalists‟ borrowing heavily to fund takeover bids for companies and then engaging in severe
asset stripping to realise the values of newly bought businesses. Defenders of private equity
believe that they can provide a means by which inefficient management is removed and that
successful takeovers can create many more jobs than they lose over the medium term.
Demergers
A demerger is the opposite of a merger or acquisition and happens when a business decides to
spin off one or more of the businesses that it owns into a separate company - this might take
the form of a management buy-out. A demerger may be full, or partial. A partial demerger
means that the parent company retains a stake (sometimes a majority stake) in the demerged
business. The aim is nearly always to improve shareholder value by giving new management to
chance to focus on a particular core business and also to reduce levels of debt. Demergers can
also result from government intervention - perhaps because the competition authorities want a
business with monopoly power to be broken up to some extent to maintain competition.
Examples of recent demergers
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1. Demerger of Cadbury's North American drinks business creating a new business called
Dr Pepper Snapple Group (DPSG)
2. Severn Trent Water demerged its waste management business Biffa
3. Demerger of British Gas into the UK gas pipeline business Transco and an international
oil and gas exploration company
4. Woolworths was demerged from Kingfisher
Suggestions for further reading on the growth of firms
Amazon boss on profits rise (BBC news, July 2008)
Cadbury to go ahead with split (BBC news, August 2007)
Clubbing together to beat the big boys (BBC news, July 2008)
Co-op buys Somerfield for £1.57bn (BBC news, July 2008)
Face hooked – the growth of Facebook (Money Programme, December 2007)
Organic growth for Costa (Tutor2u blog, April 2008)
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